Commodity prices are moderating. But India’s investment-led growth depends on a stable price environment
Rates Strategist, Nomura India
“The uncertain global environment and a subdued manufacturing inflation mean that monetary policy should continue to support growth”
The year 2011 was a forgettable one for the Indian economy. Real gross domestic product (GDP) growth fell sharply below its trend, with real GDP growth in the fourth quarter of 2011 recorded as 6.1 per cent year-on-year, falling from a peak of 9.4 per cent in the first quarter of 2010. A lack of reforms and high interest rates caused investment activity to plummet. Despite the growth moderation in the year 2011, the monetary policy authorities could not support growth through interest rates, as inflation remained well above anyone’s comfort level.
Responding to inflationary pressures, the Reserve Bank of India (RBI) hiked the repo rate from its December 2010 level of 6.25 per cent to 8.5 per cent by October 2011. Only towards the end of 2011 did the RBI change its stance from anti-inflationary to neutral. And only in April did the central bank cut rates by 50 basis points, bringing the repo rate back from 8.5 per cent to eight per cent. Recently, activity has begun to show some signs of recovery. But it is probably too early to assume all is well on the growth front, especially in the face of an uncertain global environment.
A close look at recent activity data throws up, at best, a mixed picture on the growth front. For instance, the purchasing managers’ indices (PMIs) are up for both manufacturing and services in the first quarter of 2012 from the average observed over the fourth quarter of 2011. However, industrial production continues to surprise on the downside, even if one accounts for the volatility of the industrial production index of India. For instance, the latest industrial production reading for March has shown a broad-based decline and continues to call for support on the policy front. With global uncertainty prevailing, the support from external demand remains at risk.
On the global front, after a few months of relative calm over the debt crisis in Europe, renewed concerns are visible. This, along with global macro data which indicate a slower rate of recovery in the global economy, with some slowing down of growth in the United States and China, continues to pose risks to the domestic economy.
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As noted above, one of the reasons why monetary policy makers could not focus on growth in the year 2011 was that inflation (as measured by the wholesale price index) remained stubbornly above nine per cent for most of that year. However, wholesale price index-based inflation has moderated sharply from those levels to close to seven per cent in the first quarter of 2012, on an average. It is notable that although headline inflation is expected to remain sticky, manufacturing inflation is expected to moderate over the year. Manufacturing inflation in India is highly correlated with commodity prices. And though oil prices are still elevated, broad-based commodity prices (as measured by Reuters’ CRB index) have declined over the past year. Even taking rupee depreciation into account, commodity prices have remained stable in rupee terms. This suggests that the country is likely to continue to see gradual moderation in manufacturing inflation over the year.
Overall, the uncertain global environment and a subdued manufacturing inflation mean that monetary policy should continue to support growth. However, having said that, the real push on the growth front needs to come from the government’s side. The Indian government needs to act on various reforms to revive the investment climate. Along with this, the government needs to reduce the fiscal deficit by increasing fuel prices, which will help reduce the subsidy bill.
Overall, this combination of tighter fiscal policy and easy monetary policy should be the right mix to revive the growth story in the country, without fuelling inflationary pressures. Another notable fact is that if growth picks up, it could have a positive impact on sentiment towards India — and this could result in a pickup in capital flows and, consequently, could abate the anxiety over funding the current account deficit. Also, the revival in growth would help bring in buoyancy in tax collections and aid the hope of a mild reduction in the fiscal deficit.
The bottomline is: in an uncertain global environment, where the growth picture is mixed and inflationary pressures are expected to remain stable – primarily owing to stable commodity prices – the India authorities should continue to focus on a revival in growth.
CEO and MD, Fitch Ratings
“For India, it is quite important to focus on a moderate to low inflation regime that is conducive for a longer-term high-growth phase”
The inflation versus growth question has occupied centre stage in the Indian policy debate for the last couple of years. There is a consensus that high inflation and high economic growth cannot coexist for a long period. The debate continues about the sustainability of growth amidst moderate inflation (five to eight per cent) in the long term. Different countries have different inflation targets ranging from low (Europe/US) to medium (India). Given the target inflation rate, co-ordinated fiscal and monetary measures are required to control different types of inflation episodes.
Only if inflation is demand-driven can it can be controlled by a combination of fiscal and monetary policy action. If inflation is due to supply-side bottlenecks, it translates into a structural problem, and inflation cannot be brought down until supply constraints are addressed. In any case, immediate relief from inflation is unthinkable. While fiscal measures – changing tax rates and duties – have an immediate impact on prices, monetary measures – liquidity control, interest rate changes, and so on – take a longer time to bring down inflation.
Persistently high inflation pushes up interest rates, reduces savings and impacts long-term capital decisions — negatively impacting growth rates of investment-driven economies. Additionally, the lack of capital investment prevents the supply-side constraints from being addressed. Thus, high inflation lurks alongside subdued growth rates. This combination, in the extreme, creates “stagflation”.
Faster income growth-induced domestic consumption demand tends to add a structural factor to high inflation. Indian income levels between 2005 and 2010 were increasing faster than consumption. Growth in per capita personal disposable income and per capita private final consumption expenditure in the last six years has been substantially higher than their growth in preceding six years. Rural wages have increased faster than the consumer price index for rural labour — a contributing factor in India’s “rural consumption story”.
The trajectory of inflation will depend on the interplay of various domestic and international economic parameters. There is a large amount of “suppressed” inflation in the economy. This includes the under-recovery of costs on diesel, kerosene and LPG. Although petrol prices have been deregulated since 26 June 2010, oil marketing companies still face these under-recoveries.
The other factors that could potentially push up inflation are: the depreciation of the rupee, as India is a net commodity importer; the increase in indirect taxes in the 2013-14 Budget; rising wages across rural and urban areas; and structural bottlenecks in supply, especially for agricultural produce.
Consumer price inflation averaged above 10 per cent between 2010 and 2011, reducing household disposable income. Growth in household savings for 2011 was six per cent, compared to 16.5 per cent between 2003 and 2010. India’s gross national savings as a percentage of GDP have come down to 29.9 per cent in 2011 from 33 per cent (the average for 2005 to 2010). Unsurprisingly, the investment-to-GDP ratio has also come down from 38 per cent to 34 per cent over the same period. This does not suggest a return to eight per cent growth in a hurry.
India’s growth story is investment-led. As against China, which has excess investments as compared to consumption, and hence is facing a slowdown, India needs higher investments to address a supply-side shortage. Given wage inflation is above the CPI, demand is not expected to slow down. Therefore, policy measures should address supply-side constraints. For this, the government is rightly focusing on capital formation in infrastructure through foreign investors in debt and equity. It may be noted that most of these investors hail from sustained low/moderate inflation regimes, and have similar operating environment preferences.
Inflation expectations are as worrying. The recent yo-yo in the yield of 10-year government securities (G-sec) reveals that inflation is still not off the minds of investors. A case in point is: while G-sec fell to 8.35 per cent after the RBI’s recent rate cut, the yields are now moving northwards above 8.50 per cent. The market probably still worries that inflation is not subdued.
In conclusion, it must be noted that, empirically, in the last decade, a GDP growth rate of eight per cent was always preceded by a low inflation rate (below five per cent). Thus, for India – an investment-led growth story – it is quite important to focus on a moderate to low inflation regime that is conducive for a longer-term high-growth phase.
These views are personal