Strong credit dynamics suggest that the IMF and ADB’s warnings are valid, but key indicators like the average inflation rate and the trade and power deficit suggest otherwise.
Siddhartha Roy
Economic Advisor, Tata Group
One sign of overheating is the rising trade deficit. In the case of Indian trade, deficit has started coming down since the third quarter of 2010-11
To insist that the economy is overheating is another way of suggesting that 8.6 per cent GDP growth is not sustainable. Overheating is a favourite bogey of the media and the cognoscenti in international policy-making bodies. In the last 20 years we have revisited this problem four or five times. In the current context persistent inflationary pressure has added an urgent dimension. Traditionally, overheating refers to a situation in which the productive capacity of the economy cannot match aggregate demand. This situation is normally marked by capacity limitations that constrain growth; as a corollary to excess demand, the inflation rate goes up sharply and firms start exercising their pricing power provided supply constraints are not met through imports. Excessive imports can often lead to a major trade imbalance. Further, excess demand reflects itself in other areas, such as greater power shortages or infrastructural constraints.
Before I proceed, it may be useful to examine the facts. On a year-on-year basis, average wholesale price index inflation in the first half of 2010-11 was 9.9 per cent and it came down to 8.5 per cent in the second half. If you consider the inflation rate of manufactured products, in first half of 2010-11 it was 5.6 per cent, in the second half it came down to 5.25 per cent. There was hardly any demonstration of pricing power. On the contrary, margins took a beating as commodity prices and interest rates went up.
The issue of containing overheating has assumed its current importance in the context of the trade-off between growth and inflation. The inflation dynamics could be dependent on several factors, such as: (a) excess demand or output gap, (b) expectations about inflation, (c) supply shocks related to cost push, and (d) inertia of inflation based on the previous period’s inflation rate. In India, the current inflation has been propelled by supply shocks in the food sector; this has been buttressed by fuel price hikes. During April to March 2010-11 food prices went up 11.24 per cent and fuel prices 12.27 per cent over the previous financial year. The supply side issues can be solved only over a longer time period, as that would require improving agricultural productivity, better functioning of commodity markets, drawing up long-term petroleum and gas contracts, acquiring raw material assets abroad, and so on. Consequently, inflation modelling throws up the existence of a certain degree of inertia in the Indian inflation rate. This inertia is more important than inflationary expectations. For the selection of an appropriate policy measure, appropriate weights should be given to the drivers of inflation. To suggest excess demand-curbing solutions like restraining credit and raising its cost can have a negative impact on investment and industrial growth.
As stated earlier one perceptible sign of overheating is the rising trade deficit. In the case of Indian trade, deficit has started coming down since the third quarter of 2010-11. Further, higher invisible earnings reduced the current account deficit to 2.5 per cent of GDP by the third quarter of 2010-11. Coming to power shortages; they have, in fact, come down. In 2008-09 the power deficit was 11 per cent; it dropped to 8.6 per cent in 2010-11.
Output growth is dependent on growth of labour, capital and total factor productivity. Indian GDP grew at an average rate of 5.9 per cent between 1992-93 and 2002-03. This was supported by an investment rate of 24.4 per cent and savings rate of 23.5 per cent. In 2003-04 to 2010-11, the average savings rate touched 33.8 per cent and average investment rate 34.6 per cent, which gave an average growth rate of 8.4 per cent. A 2.5 per cent increase in the average GDP rate was made possible by an incremental investment of 10.2 per cent giving an incremental capital output ratio of around four per cent. Currently, the investment rate is around 37 per cent. If the policy bottlenecks – land acquisition, regulatory hurdles and high interest rates – are removed, more than 9.2 per cent growth rise within the realm of possibility. At a time when gross fixed capital formation has taken off, employment is growing at around two per cent and total factor productivity is improving at 2.5 per cent a year, it would be difficult to accept the notion of overheating without questioning it.
Rupa Rege Nitsure
Chief Economist, Bank of Baroda
With output gaps closing, it is not surprising that we are seeing overheating pressures building both in our goods and asset markets
Recently, the ADB and the IMF have warned against the growing risks of overheating for emerging Asian countries, including India. Technically speaking, overheating follows a prolonged period of good growth leading to higher levels of inflation with damaging consequences for future economic prosperity.
Coming to India, there is no doubt that India’s recovery has progressed healthily throughout 2010-11 on the back of strong exports and domestic demand. During April-February, 2010-11, Indian exports grew a robust 31 per cent, whereas the growth of private final consumption expenditure (at current market prices) has been as high as 21.5 per cent. Thanks to a normal monsoon and price incentives by the government, agricultural growth has been substantial with foodgrain production expected to touch a record 240 million tonne. Similarly, growth posted by the industrial and services sectors averaged 8.7 per cent and 9.3 per cent, respectively, in the first three quarters of 2010-11.
Credit dynamics also remain strong. Bank credit has grown at a higher-than-expected level of 21.4 per cent (year-on-year) during 2010-11 (up to March 25) with credit demand becoming broad-based every month. Strong momentum is being seen in both the working-capital and term-loans led demand reflecting robust economic activity. The latest RBI data on sectoral deployment of credit show that loans extended to services and personal segments continue to accelerate as well.
Although credit demand has picked up in recent months, it will take some time for this to get translated into actual capacities that would help satisfy growing requirements of India’s ever-expanding middle and upper middle classes. As IMF pointed out, with output gaps closing, it is not surprising that we are seeing overheating pressures building both in our goods and asset markets.
India’s headline inflation rate (WPI) rose sharply to 8.98 per cent in March, 2011 way above the RBI’s projection of eight per cent. With increased availability of foodgrain, food inflation has eased, but inflation in non-food, non-manufacturing articles (comprising several important industrial raw materials) has been stubbornly high at 26 per cent. With demand staying at elevated levels, the manufacturing sector has been able to pass on these cost pressures to final consumers. For instance, manufactured product price inflation has steadily risen from 4.90 per cent in November, 2010 to 6.21 per cent in March 2011.
Sustained high levels of inflation have given way to rising inflation expectations. According to the RBI’s recent survey on inflation expectations, urban households in India do not expect any immediate respite from price rise and a majority of them feel it would accelerate in the coming quarters. According to this survey, inflation is likely to accelerate to 13.1 per cent by the end of this year. This means, going forward, there will be stronger demand for wages hikes in the organised sector, with its spillover effect on generalised inflation.
Besides, the unfolding disaster in Japan and the continuing turmoil in West Asia have raised new concerns and uncertainties over economic prospects, including their impact on food and commodity prices, especially oil.
While RBI has increased the repo rate by 200 basis points in 2010-11 as a measure to contain inflationary pressures, with the repo rate at 6.75 per cent and inflation close to nine per cent, the real interest rate is still negative suggesting at least three more rounds of tightening in 2011. Vigorous policy tightening is essential to moderate excess demand pressures.
Rising cost pressures combined with interest rate increases may cause some moderation in growth in the short run but would certainly promote macroeconomic stability in the medium term. Rising interest rates may not act as a major deterrent to credit expansion, since credit growth in the past has been strong when interest rates were rising. Today, the real drivers of credit are domestic demand and an upsurge in global trade volumes.
But monetary policy is not the only tool to deal with overheating. Close coordination among monetary, fiscal, trade and investment policies is vital to address the medium-term growth challenges – infrastructure, agriculture, sustaining the FDI/FII flows – and put India on the path to sustainable development with low inflation.
