Too early to signal an exit

Indian Express, 19 January 2010

The Indian economy has been showing strong growth in production. Both industrial production and non-agricultural GDP growth have exceeded expectations. Yet, there are reasons for concern. Apart from the runaway food price inflation, other leading indicators of the business cycle do not appear to be strong. These include growth in non-oil import, bank credit and investment projects. These suggest that policy makers should not become complacent yet, despite the high production figures. In other words, when food become too expensive and consumers are buying cars, it is not a time to say all is well.

November 2009 witnessed strong growth in industrial production, especially in manufacturing. This high growth was driven by strong automible production in particular and consumer durables in general. The data for industrial production in December 2009 may be even better as shown by high car sales. High car sales in were prompted by year end discounts, tax incentives to producers, low interest rates, improved consumer sentiment and the effect of higher salaries for government employees. Month on month export growth (seasonally adjusted and averaged over 3 months) has picked up after the shock last year so the level of exports is now back to where it was last year. High import growth in the US, an unprecedented 33 percent monthly average, is no doubt contributing to the good preformance of exports. Corporate profits also came back on track returning to near 20 percent growth rates. Equity markets and capital flows responded both to the return of the India growth story and the recovery in emerging markets.

Some observers argue that all is well and the government and RBI can now start withdrawing both the fiscal and the monetary stimulus. Considering the high level of fiscal deficit, there is, of course, a good case for a reduction in government expenditure. High inflation in food prices, has been largely attributed to shortages owing to the drought and increase in demand as a result of public spending on programs such as the NREGA that puts income in the hands of the poor who demand more food. Still there is a case for tightening monetary policy to control excess liquidity in the system and manage inflationary expectations.

While both fiscal and monetary policy have been easy for the whole year, and despite the fact that some governments around the world, such as China, have started tightening, in India the government and the RBI have been cautious, and have not particularly withdrawn the stimulus or suggested that they would do so in a very strong way in the near future. The reasons for this caution become apparent when we look at the some of the other macroeconomic indicators of the Indian economy. Inflation is, in general, a very difficult phenomenon to understand, as it is caused by both supply and demand side factors. Tightening policy is a good idea when inflation appears to be caused primarily by excess demand. This is because the monetary or fiscal tightening reduces demand which then reduces prices. Today it is not clear that price rise is caused by excess demand. Indeed, it is possible that the improvement in production is temporary, caused by the stimulus, and could peter out soon.

What are the causes for concern? First, growth in non-oil imports has been weak. Since India primarily imports capital goods and basic raw materials, non-oil imports are in general an indication of production a few months later and longer term capacity creation in the economy. If firms are not increasing their imports, it is a reason for concern. Second, bank credit growth has slowed down significantly. Non-food credit growth has fallen to barely 10 percent. This is caused by a number factors. One, expansion plans of most companies, which came to a halt a year ago, have still not got back on track. Two, price of inputs for production, and thus working capital requirements, has come down with lower commodity prices. These two factors have resulted in a decline in demand for credit in nominal terms. To some extent the situation may not be as worrisome as it appears at first blush, since firms are borrowing from non-bank sources. By borrowing through commercial paper, rather than through banks, as they get cheaper credit. Still, if capacity creation has slowed down it does not augur well for growth.

Considering the above, no doubt, the withdrawl of stimulus has been limited. In the coming weeks there will be two occasions for the government to signal its policy of exiting from its expansionary policies. First, in January end, the RBI Governor will present his credit policy. It is expected that in this he will raise the cash reserve ratio, thus withdrawing some of the excess liquidity from the banking sector, but not significantly raising interest rates or leading to serious demand contraction. Serious tightening of monetary policy is also difficult because of the impact it will have on the rupee. Higher interest rates will attract higher capital inflows leading to rupee appreciation. The government has already announced one incentive package for exporters, it is unlikely to want to counter the impact of this by giving them both higher interest rates and a stronger rupee. In other words, the RBI will have a difficult job of managing the rupee and pressures from the exporter lobby, were it to raise interest rates.

Second, in February end, the Finance Minister will announce the Union Budget. In this he is unlikely to take any serious steps towards contraction of demand. The FM could approach the budget in two ways. Either he could leave the estimated budget deficit high and at the end of the year have a smaller deficit if he can earn some revenue from disinvestment, or he could show a smaller budgeted deficit, factoring in disinvestment. In either case the government is unlikely to take strong measures to reduce demand. Today politicians all over the world are afraid of rocking the boat by withdrawing the stimulus given after the crisis. Fear of the impact on growth and the reaction of the electorate will no doubt continue to constraint them till they can be sure that all is really well.

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