Wait, watch the uncertainty

Indian Express, 27 July 2009

The RBI will announce its monetary policy this week. While there has been talk about the RBI reversing its monetary policy stance, and reasons why it should start tightening, to do so now would be a mistake. It is too early to tighten. Real interest rates remain high, uncertainly continues to prevail and investment announcements have shown a dip, spelling bad news for the months ahead. Further, consumer price inflation has slowed down in the last quarter, despite some rise in food prices. The economy still faces a shrinking world economy and inflation will not see a serious upsurge as long as demand remains weak.

While for international investors it may make sense to think of India as one of the fastest growing economies in the world, what is pertinent for policy is to compare the Indian economy against last year. Even though India continues to witness GDP growth of 5-6 percent, the drop that we have witnessed in a year, of more than 400 basis points in the growth rate of GDP, is comparable to the drop witnessed by many developed countries.

Monetary policy for the coming months should be guided by a prediction about demand conditions in the Indian economy. These are still showing signs of contraction, and the fiscal stimulus has not been enough to counter this contraction.

The arguments in favour of reversing the expansion in RBI's monetary policy stance of October 2008, and thereafter, are based mainly on the expansionary fiscal stance. The expansion in the fiscal deficit from 6 percent of GDP in 2008-09 to 6.8 percent of GDP budgeted for 2009-10 is an expansion of 0.8 percent of GDP. But this does not translate into an expansion in aggregate demand. When we analyse aggregate demand, the situation appears quite dismal. Investment demand has fallen sharply, as seen in the contracting purchases of capital goods. Both production and imports of capital goods have been shrinking. Note that is not merely that their growth rate is declining. It is actually negative.

Second, CMIE's CAPEX database suggests that while projects under implementation have broadly held up, new annoucements have come down considerably. At the same time, exports continue to contract at an average annualised rate of about 20 percent per month. These depend on economic conditions abroad. The US coincident indicator continues to go down. Once this picks up, we can hope to see export recovery come back. This is, however, still some way off. And, even when this picks up, the growth in US consumer demand, which is one of the most important drivers of exports from India, may not pick up at the same rate. US consumers are increasingly saving more, something that is good for the global economy and may reduce global imbalances, but not necessarily good for Indian exports at a time like this.

The illusion of an economy doing reasonably well is greatly helped by the unavailability of employment data. The lack of this data should not misguide us into thinking that job growth is not badly hurt. Not long ago, it was job growth in exports and construction, hotels, finance and IT that was seen as leading employment growth. Today these sectors are facing difficult times. Consequency they are cutting costs and there is a freeze on hiring in many firms. In other economies like the US where unemployment data is observed, it is seen that employment is a lagging indicator. If the data for unemployment in India were available, we would expect to see that it may still be falling, and, further, that even after the recovery shapes up, it may be a while before job growth starts picking up. At first the slack available in the system will get used up.

The impression of recovery is also helped by incorrect data analysis. For example, inflation based on consumer prices, is being looked at in comparison to 12 months ago. Trends of the last six months are not captured when looking at year-on-year growth rates. When we examine month on month (seasonally adjusted) data we find that consumer price inflation is not showing signs of a pickup. On the production side, there is a small pick up in industrial production but not in sales of companies. The quarterly sales growth of all listed companies put together in the CMIE Prowess data base show that sales continued to slow down in 2009. More strikingly, in the Jan-March Quarter 2009, sales actually fell, declining by 0.1 percent. In the context of the industrial production data this seems to suggest that there may have been a decline in inventories in the in the previous quarter and firms may now be producing more to build up stocks.

Fiscal expansion leading to inflation is a concern when an economy is operating at full capacity and a rise in demand leads to a pressure on prices. However, when the economy is facing shrinking demand on account of both exports and investment, then rising prices is not the thing to worry about. (We would still worry about the rising burden of public debt, of interst payments on government borrowings pre-empting a large share of government expenditure, or of sucking out bank finance). During the rest of 2009, at the very least, the role of monetary policy would be to ensure that there is adequate liquidity in the system for investors who wish to invest and that the real rate of interest remains low. To reiterate, this is not the time to tighten monetary policy.

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