No, because year-on-year data mask a sharp upward correction in industrial growth but a rate rise could see a surge of fund flows into India and prove counter-productive
RAMYA SURYANARAYANAN
India Economist, DBS Bank
If rates are left unchanged for fear of attracting capital inflows, the unintended consequence may be higher inflation — both in goods and asset markets
Much of the debate surrounding the Reserve Bank of India’s (RBI’s) monetary policy seems to centre either on the near-term inflation readings or the volatility in year-on-year (YoY) industrial production growth rates. Of late, the pressure for exchange rate appreciation arising from rate differentials is an added point of contention. We think none of these are the right variables (or data transformations) to focus on.
Those calling for a rate hike at the upcoming November policy meeting usually point to the still high 8.6 per cent (YoY) inflation figure in September. Those calling for a “stand pat”, point to the expected decline in inflation in the next five months and the recent volatility in industrial production data. However, near-term inflation trends, whether low or high, should not be the determinant of policy action since rate changes take time to work through the system (unless the monetary brakes are slammed) and policy is not concerned with transient inflationary pressures. Further, the headline YoY inflation, which is the data transformation of focus, is also distorted by base effects and food prices, neither of which policy can control. The policy-relevant horizon for inflation is the inflation trends over the next 12 months and the goal (and scope) of policy should be to keep ex-food inflation in the comfort zone (say, 5 per cent) in that period. Though it is not possible to accurately predict the level of inflation in the next 12 months, central banks work around this uncertainty by raising rates as the growth rate picks up and the gap between the actual growth rate and the estimated potential or full-capacity growth rate lowers or turns negative (so-called output gap). By doing so, central banks can stay one step ahead of inflation, for inflation will normally lag growth.
So, the question about the RBI policy boils down to the outlook for growth and the output gap. If the output gap will tighten or capacity constraints will be hit soon, either in product or labour markets or even in terms of infrastructure capacity, inflation will firm up over the next 12 months. Here again, the policy debate is complicated by the focus on YoY industrial production growth rates as opposed to seasonally-adjusted levels or month-on-month (MoM) growth rates. The trouble with the YoY changes is that they don’t immediately or precisely capture the turns in the economic cycle, the very information that helps estimate the position of the economy in the business cycle and assess the output gap. Instead, the YoY changes averaged out the monthly growth that took place in each of the past 12 months. The rationale for using YoY growth rates is that they are far less volatile than the MoM growth rates. However, YoY rates are less volatile precisely because they have smoothed out the information we actually need.
According to our assessment, in the period October 2008 and June 2009, growth slowed more than fundamentals dictated due to panic arising from the failure of Lehman Brothers. From July 2009 to March 2010, to compensate for the earlier slowdown, output grew rapidly and surged (above trend). Right now, output is rightly moderating and normalising to trend. Since businesses operate with imperfect information in an uncertain world, the normalisation doesn’t happen in a straight line and we are currently seeing some “undershoot”. This explains the weaker industrial production readings. Seen from that perspective, a sharp upward correction in production is on the cards in the next few months. This should keep growth on track for our slightly above-consensus GDP growth forecast of 8.8 per cent in 2010-11.
On inflation, our concern is the medium-term “core” inflation pressures will increase as the economy grows well above 8 per cent in the year ahead even as we are optimistic that the headline WPI will ease to 5 per cent by March. Credit growth has been running at a 22 per cent annual rate (average MoM annualised rates of growth) since January 2010, not the 18 per cent rate indicated by the YoY rate (which will rise to 22 per cent belatedly from September onwards). If rates are left unchanged for fear of attracting capital inflows, the unintended consequence may be higher inflation — both in goods and asset markets. As such, we think further interest rate increases are necessary and forecast the repo rate at 6.50 per cent by March 2011, up from 6 per cent currently. At the November policy meeting, there is still scope for the RBI to leave rates unchanged but it would have to get back to rate increases soon. Of course, all this may mean that, eventually, controls on capital flows may have to be reviewed to limit exchange rate volatility.
ASHWIN DANI
Vice President, Ficci
Any increase in interest rates will accentuate fund flows into India and could prove counter-productive. The rates should be revised downwards to discourage flows of ‘hot money’
With the next monetary policy review due just in a few days from now, all eyes are on the Reserve Bank of India (RBI). So what stand should the RBI take on November 2? To answer this question, we need to look at trends in three key macro variables. First, the trend in the index of industrial production (IIP), particularly the disaggregated sectoral figures. Second, the trend in inflation rate. Third, the trend in trade and the overall external situation.
On the IIP front, between December 2009 and May 2010 industrial production showed robust double-digit growth. Then in June 2010, industrial growth slipped to 5.8 per cent. In July 2010, it recovered to 15.2 per cent but slipped again to 5.6 per cent in August 2010. So, the question is, are we seeing some early signs of a slowdown? There are reasons to believe we are.
Strong IIP growth was driven by high growth in two sectors, namely capital goods and consumer durables. And in recent months, both these segments have shown signs of a deceleration. In fact, growth in capital goods entered the negative territory on two occasions — June and August 2010. Even if these are considered an aberration, a continuation of the recent trends would surely pull down overall industrial performance. Consumer non-durables have been growing at an anaemic rate for some time now and growth in intermediate goods is also tapering.
Both capital goods and consumer durables are sensitive to interest rates, which have been rising since May 2010. As monetary policy acts with a lag, recent trends in IIP growth should be a matter of concern. In fact, it should not be a surprise if we see a sharper slowdown in the months to come.
Notably, the RBI has already raised key policy rates five times this year, increasing the repo rate 125 basis points, reverse repo rate 175 basis points and cash reserve ratio 100 basis points. The banks waited for some time but eventually took the cue and increased lending rates. Prospects are that, going forward, lending rates will increase again even without RBI’s intervention. Therefore, another policy rate rise will certainly queer the pitch to a level where industry will be affected.
Secondly, policy rate increases by the RBI can possibly affect only manufactured goods inflation. Both food and now, to some extent, fuel inflation is determined by market forces. Therefore, an increase in policy rates at this juncture is not imperative since manufactured goods inflation is coming under control, and food and fuel inflation would demand a larger supply-side intervention.
Thirdly, the overall global situation is extremely uncertain and this is affecting India. Our export growth is slowing, with overall exports plateauing on a month-on- month basis. Imports, however, are rising and continue with their growth momentum. Further, though the rupee has been appreciating against the dollar, the currency of our most important competing country – China – has not appreciated in the same manner. This, perhaps, explains why imports are rising at such a fast clip. This is also affecting Indian industry in its home turf. There are reasons to believe that several countries are trying hard to push their products into the Indian market.
Further, on the external front, our finance minister said in Seoul that a huge flow of funds was directed at the Indian markets in search for higher yields. Since interest rates in the US and the EU remain close to zero, it is extremely profitable to borrow dollars and place them in the Indian markets. Noted economist Nouriel Roubini has given several warnings about this “carry trade” in dollars over the last one year.
We believe that a rise in interest rates in the US and other western economies could lead to a sudden withdrawal of these inflows, thereby creating an element of uncertainty. In such a situation, any further increase in domestic interest rates will accentuate fund flows into India and could prove counter-productive. If at all interest rates have to be moved, these should be revised downwards to discourage flows of “hot money”.
Finally, inflation is a major worry and we need to bring it down to lower levels. A policy package for containing inflation must emphasise supply-side intervention rather than tweaking monetary levers, which have often proven to be ineffective.
We are seeing an ominous parallel to the situation that prevailed from the mid-2006 to 2008 when food inflation was rising and interest rates were raised in successive doses to check inflation, but this did not play a very effective role. The result was a sharp slowdown in the industrial sector. The global meltdown was also an aggravating factor.
