A V Rajwade: Growth, monetary policy & expectations

Irrespective of what happens globally, the Indian economy will continue on its growth path for the foreseeable future.

Clearly, the events in the US credit market over the last couple of months have undermined the confidence of the global equity investor, as evidenced by the fall in many stock markets. However, this does not seem to have affected the Indian market very much. Even last Friday's US employment report "" a drop in employment of 4,000 against expectation of an increase of 100,000; a sharp downward revision of the employment growth in the previous two months "" has failed to make much of an impact on the Indian market. True, in parallel with its global counterparts, the Sensex had softened; but it has quickly regained the lost glory, and is back to near its peak level. (So, incidentally, is the Shanghai Index; the India-China coupling is working in this area as well.) The belief seems to be that, irrespective of what happens globally, the Indian economy will continue on its growth path of perhaps 9per cent per annum for the foreseeable future: the confidence has of course been bolstered by the Q1 numbers, which came out earlier this month.

On the issue, I am tempted to defy Keynes' advice about the safety of being with the crowd. For one thing, there clearly are signs of some slowdown in the housing, vehicles and consumer durable sectors, thanks to the monetary tightening imposed by the central bank in a bid to curb credit growth and "cool" the economy. The corollary is that real interest rates are very high "" close to double digits for large segments of borrowers "" and the rupee is overvalued in real effective terms by 10 per cent plus. Bank credit growth has come down. If all this is not to be deflationary, one would have to conclude that the power of the central bank has been greatly exaggerated. However, this is unlikely to be the case: Surely, monetary policy will start telling on the growth, of course with a lag, but within the year? The sharp deceleration in the IIP in July supports this view.

To be sure, central banks make their impact felt by changing expectations than through a direct effect of specific measures. One could argue, therefore, that the monetary measures have failed to dent expectations about growth, or dampen the animal spirits of the entrepreneurs or investors, to any significant extent "" and hence the continued buoyancy. It is of course true that strong expectations to the contrary can vitiate policy objectives. We can see this in another segment: The central bank's inaction in Q1 of the current fiscal has created such strong expectations of continued rupee appreciation that the subsequent intervention does not seem to be creating much of an impact. What a contrast to the sentiment and expectation change in the exchange market which Dr Reddy's speech at the forex conference created a decade back!

Some other points are worth making:

In 2006-07, goods and services export growth amounted to 40 per cent of the increase in GDP; adjusting for import-intensive exports, the contribution of merchandise exports to GDP growth was surely 1 per cent plus. In the current fiscal, this contribution could well be zero, if not negative "" in the first four months, merchandise export growth in rupees was zero for all practical purposes, even before the lagged impact of rupee appreciation has started reflecting in the numbers. A possible recession in the US could further worsen the prospects.

Corporate profits for Q1 manifested two divergent influences. Operating margins came down, but the net profit was helped by a significant increase in "other income", in particular translation gains on foreign currency debts. The latter seems unlikely to be repeated in Q2.

Political uncertainties and growing threats from terrorists on the Left and religious fundamentalists.

High global oil prices and the need to adjust domestic prices.

Would the likely increase in the current account deficit mean a higher absorption of capital inflows in real capital investment, underpinning growth? The current account would widen but this could as well be because of increase in the import of consumption goods and services, rather than investments. As a corporate consultant, I would hesitate to advise an investor, whether in financial or real capital assets, to invest in the Indian economy in the current exchange and interest rate scenario. Availability of capital does not necessarily translate into real capital investments unless the macro-economic environment is favourable. In short, on both growth and the stock market, I am less optimistic than most of the commentators and analysts: I hope I am wrong! Objectives of monetary policy
While going through the Reserve Bank's Annual Report, I gave a "find" command for "exchange rate" and "real interest rate" to the text of the report available on the CD. I found little meaningful analysis of the issues. On the other hand, I found some very interesting observations in the recent "Trade and Development Report, 2007" published by UNCTAD. Some extracts, without comment:

"The most successful cases of economic catch-up, namely those in Asia, consistently rejected the simple concept of using monetary policy to achieve price stabilization. Indeed, the assignment of policies to reach this target was just the opposite of the orthodox approach. In the Asian model of stabilization, monetary policy sought to stimulate investment and growth whereas heterodox tools were used to control inflation. Monetary policy focuse(d) mainly on the external sector, including the exchange rate. Clearly, in an environment of extremely rapid growth with its notorious risk of creating an overheated economy, this approach has passed the acid test...

"...empirical evidence has shown that changes in the real effective exchange rate (REER) "" the most comprehensive measure of the overall competitiveness of nations (TDR 2004) "" have the potential to reduce deficits or to induce swings in the trade and current account from deficit to surplus (IMF, 2007; Deutsche Bundesbank, 2007). If the real exchange rate consistently moves into the 'wrong' direction, there is hardly an easy way out of a protracted imbalance. In other words, such 'false' price movements have to be avoided at all costs.

"Developing countries need flexibility to prevent excessive volatility of the whole external sector, which threatens long-term investment. Evidence does not support the orthodox belief that, with free floating, international financial markets will perform that role by smoothly adjusting exchange rates to their "equilibrium" level"

Email: avrajwade@gmail.com