Perhaps the only thing everyone can agree upon is that we live in times of heightened macroeconomic uncertainty. The economics of demonetisation are complicated and nuanced. Every day, assessments are changing about the quantum of any negative wealth effect, either directly from any unreturned old tender or from a spillover to other asset classes such as real estate, as deposits continue to come in. Every day, assessments are changing about how long the liquidity constraint to households will bind for, based on the pace of remonetisation. Reasonable people can agree to disagree on how much of this is demand destruction versus demand merely being postponed down the line. Every day, assessments are changing about whether there will be a supply shock, either temporary or more enduring. Given these uncertainties, it’s hard to have strong convictions on the growth trajectory in the coming quarters, barring some more data. And just because growth may be weaker, it’s not necessary that inflation will be necessarily softer, to the extent that any demand shock is accompanied by a supply shock.
Furthermore, all this is only half the story. Global uncertainties have arisen, as the US is on course to pursue reflationary policies, yield curves have steepened, the dollar has strengthened, oil is up, and the Italian referendum has created new uncertainties in Europe. Unsurprisingly, the pressure on emerging markets (particularly, commodity importers) will rise if global financial conditions tighten and oil prices rise in tandem.
Against this backdrop, it was hard to harbour strong convictions about how monetary policy should and would react. At some level, therefore, it’s understandable that market expectations (which ranged a 25-50 bps cut) diverged from the Reserve Bank of India (RBI), because the underlying assumptions were different, which is perfectly understandable in this time of uncertainty. In particular, many market analysts are pencilling in a meaningful growth slowdown in the second half of the year. As a consequence, they have forecasted a softer trajectory of inflation, which potentially opens up some space for easing.
In contrast, the Monetary Policy Committee’s (MPC) view was that any growth impact from demonetistion is likely to be more shallow and transient. To be sure, the RBI marked down its full-year growth forecast for 2016-17 by 50 bps, from 7.6 per cent to 7.1 per cent, but much of this was largely on the back of the growth disappointment in the first half of the year. First half growth has averaged 7.2 per cent. Therefore, by pegging full-year growth at 7.1 per cent, the MPC is pegging second half growth at seven per cent, just 20 bps lower than in the first half.
The implication, therefore, is that the RBI is slightly less worried about a deep or prolonged slowdown. This is a perfectly legitimate view for the MPC to adopt for now. With deposits surging into the banking system (75 per cent of the outstanding notes have already deposited by December 6), markets have begun to fade any negative wealth shock, and the RBI’s policy statement also indicated that any such wealth shock is likely to be limited. Most growth write-downs have therefore been predicated on the fact that liquidity constraints that are impinging on household consumption will endure for a while, given that it may take time to remonetize the economy. Indeed, the current cash/gross domestic product (GDP) ratio (as of December 5) was at 4.1 per cent of GDP versus 11.8 per cent before the demonetisation. However, implicit in the RBI’s growth forecast is the that the growth hit from liquidity constraints could be less than feared, either because the remonetisation could proceed faster than expected or because there is more migration to non-cash forms of payment. Indeed, between November 27 and December 5, the new notes that entered circulation jumped from Rs 2.5 trillion to Rs 3.8 trillion, a higher-than-expected run rate. To be sure, uncertainties remain because, to the extent that the focus is now on printing Rs 500 and Rs 100 notes, the pace of increase of the “value” of new notes could slow, even though “effective currency in circulation” could rise if these notes induce a greater circulation of the Rs 2000 notes. The point is that there are too many known unknowns. But the fact that the cumulative value of new notes has jumped in the last 10 days, combined with the RBI’s more hopeful view on growth, suggests that the re-monetisation may proceed faster than expected.
Finally, the MPC had to assess whether the economy is being hit just by demand shocks or by a combination of demand and supply shocks, especially with oil prices rising more than 10 per cent in the last week. It obviously believed that there are also supply shocks at play, because that explains why it marked down its growth forecast, but did not change its baseline inflation forecast (though the upside risks are less).
So, if the MPC believes the growth hit is transient and is composed of both a demand and supply shock, it’s perfectly understandable why it stayed on hold. What’s also clear is that the prevailing global uncertainty — the prospect of a stagflationary shock emanating from tightening global financial conditions, but also rising oil prices — gave the MPC some pause. Clearly, they are waiting to see how these uncertainties resolve. We don’t rule out more easing in this cycle. If the growth hit is more sustained and downside risks to the five per cent inflation target arise, we believe the MPC is likely to ease again.
Markets may be temporarily disappointed. But it’s perfectly understandable why, at a time of heightened uncertainty, policymakers would choose to act cautiously, rather than act in haste and be forced to reverse course down the line.
The author is chief India economist at J P Morgan
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
