In a recent post, I wondered if there was a “schizo-economic” way of thinking about macro in India. On the one hand some indicators (consumer inflation and the current account deficit) are symptomatic of overheating, while others (GDP growth, industrial production, loan growth) appear to signal a significant slowdown. This matters as the policy response depends on the view. If we believe the economy is overheating the appropriate response is to hike interest rates. On the other hand a slowdown calls for rates to be cut. The Reserve Bank appears to have swung from the latter to the former view last month.
So how does one reconcile the two views? How does one square the circle?
The key to understanding this lies in potential growth. Overheating is a situation where the economy is operating above potential. GDP growth or level is higher than the potential output of the economy. In this situation, the excess demand has to be met from imports. This situation is called “positive output gap”, i.e. output is greater than potential. A “negative output gap” occurs when the economy is producing below its potential. Typically this should lead to falling inflation rate (if not actual deflation, or falling prices).
Given that we are experiencing high inflation and a current account deficit, it appears we have a positive output gap (note the most recent RBI view available talks of a negative output gap). How could this be since growth has slowed to a 10-year low? The answer is that potential growth has fallen sharply.
Over the past couple of years, thanks to high interest rates and government policy & corruption issues we have seen a significant fall in the investment rate in the economy. Investments lead to productive capacity; and productive capacity provides avenues for growth. In India Gross Capital Formation has held steady at about 36% of GDP in the last few years. The Gross Fixed Capital Formation has fallen from 33% in 2010 to 28% in 2012 (World Bank data; chart above 1). The gap is explained by a surge in invesments in valuables (notably gold) in recent years. The reduction in fixed capital formation is largely due to the private corporate and public sectors. Households’ fixed capital formation has held steady – primarily in residential buildings (RBI annual report, Economic Survey; links and chart below 2,3). The savings rate has fallen from around 33% to 28% in the last two years according to WB, while the Eco Survey estimates the fall as about 3%. Either way we see a fall in the savings and investment rate in the economy. [Incidentally falling savings rate while total capital formation holds steady means the economy needs to bring in net capital from abroad. To run a capital account surplus there must be a current account deficit.]
The fall in the savings and fixed capital formation rate leads to a fall in the potential growth rate in the economy. If there are fewer fresh investments higher growth rates are not possible.
If our understanding of growth potential is incorrect, what we interpret from the economic slowdown must change. If potential GDP growth has fallen to 4% for example, even a growth of 5% seen last year would be above potential (positive output gap). It is not possible with the data currently available to make a positive statement to that effect, but monetary policy appears to have swung to that belief, at least temporarily.
The policy answer to falling potential GDP growth has to be on two lines:
1. Monetary policy should commit to low inflation, keeping short term rates high enough even though it may be politically unpopular. However there needs to be some study on whether and how much interest rates have contributed to the slowdown. For sure there has been reckless lending not least thanks to the 2009 loan restructuring allowed by the RBI. There needs to be proper accounting of loan losses and work-outs. Too much has been brushed under the carpet.
2. Fiscal and industrial policy must focus on supply side factors. Too little attention is being paid to why there is such a collapse in business confidence. Government needs to get out of the way and allow the private sector to flourish. Some easy wins of the past have been given up including privatisation of electricity. Keeping unprofitable public sector units going have deprived the private sector of profits. Not to mention corruption and crony capitalism at amazing levels.
1 Source of chart: World Bank
3 Economic Survey 2012-13 (warning, excel file)