Jamal Mecklai: What's this overheating stuff?

MARKET MANIAC

In the kitchen, I know that if you overheat a souffle, it will collapse. From physics, Gay-Lussac's law states that if you heat a gas at constant volume, the pressure rises""by obvious extension, if you overheat a gas, the pressure will rise unsustainably, till the container explodes. While one could debate about whether the Indian economy is all gas, it is certain that it is not a constant volume gas""it's growing at a real rate of at least than 9.2%. Unsurprisingly, more detailed mathematical calculations about Gay-Lussac's law show that even if the volume of the gas were increasing, overheating would have the same impact""i.e. the container (the Indian economy, in this case) would explode at some point, leading to subsequent collapse.

Thus, the concern about overheating is that it could drive the economy into a high-pressure situation, where something""the equity market, for instance""explodes, after which the economy collapses sharply, cooling things down.

Anecdotal evidence from all over India suggests that, more than just overheating, the economy is on fire. And, recent data confirm that we are definitively afflicted by the classic symptoms of overheating""a sudden (and rapid) rise in inflation and (again) a sudden and sharp widening of the current account deficit""as well.

Inflation has already taken all us Jiminy Crickets by surprise""the WPI reading last Friday (February 9) showed it at 6.58%, well above the RBI's desired level (of 5%); importantly, on-the-ground inflation is running quite a bit higher, and has been for some time. The reference to Jiminy Cricket, if lost on some of you younger folk, is to complacency""WPI inflation has been north of 5% since September last year, and, although the RBI has tried several measures to douse it, the overweening attitude (both from the RBI and the government) has been that inflation is under control.

The current account deficit, too, has been widening, and, here, too, the government, through a report from the respected Dr Rangarajan, remains complacent that the deficit this year would be well contained at 1.5% of GDP. However, as the surly Economist correctly points out, if we were to exclude remittances from the current account, the deficit would be closer to 5% of GDP. Be that as it may, there may be a further disquieting wrinkle. Classically, when an economy heats up too much, the current account deficit shoots higher because of rising import demand. Imports are, indeed, growing strongly""April-December imports were some 25% higher than the previous year, but there has been no sudden surge. Exports too have been growing reasonably well""about 22% on a nine-month basis; however, export growth in December came in at an anaemic 7% over the previous year, and since hitting $10 bn in May 2006, exports have gone nowhere on a month-over-month basis. Thus, while the data are not yet definitive, it is possible that the widening in our current account deficit may be due as much to slowing exports as to rising imports, which would make any medicine that much more difficult to design.

Clearly, the government's simplistic suggestions""a Press article reported that the finance ministry is leaning on the RBI to permit the rupee to appreciate to assist the process of "cooling down" inflation""will not do much good, and, indeed, could be counterproductive if it turns out that export competitiveness is beginning to get eroded.

The RBI, whose permanently smiling face is rapidly changing colour, has been using several inflation-fighting weapons""CRR hikes, repo rate hikes, focused provisioning norms""in a series of let's-see-if-this-works shots at the market. Their efforts have had little impact, which is hardly surprising, given that even in very liquid markets, monetary tightening takes time to impact demand; in an economy like ours, where markets are very thin and where demand appears to have a life of its own, it is far from clear as to whether the monetary action so far has had""or will have""any impact whatsoever.

In my view, the inflation cat is out of the bag and, since the issue is really one of supply constraints, the solution for which is singularly political, any further action on interest rates or money supply by the RBI will have minimal impact. In fact, any further tightening of interest rates may be counterproductive since it will push costs up without really addressing the supply/demand imbalance.

Better to let the problem play itself out, and let the markets take the brunt. The stock market, which is showing some signs of nervousness, will probably fall by 10-15% over the next couple of months, and the rupee will surprise everyone by weakening, as sentiment turns. Unfortunately, of course, this is India""meaning that growth is not going to let up any time soon""and I would expect that markets will revert to their near-hysterical state""viz. strong foreign inflow, rising equity markets, strengthening rupee""in another six months.

I say unfortunately because the underlying strength of the economy will not permit a real crisis, which means the politicians will continue their silly games and we will have to put up with sub-10% growth.