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Journalism of Courage
With the rupee sliding to record lows, Jahangir Aziz, Head of Emerging Markets Economic Research, JP Morgan, is of the view that the exchange rate depreciation is a good thing and not a bad thing as it’s allowing the built-up depreciating pressures to vent off. “And therefore, monetary policy doesn’t have to be held hostage to the exchange rate. It can now focus on domestic issues…”
In an interview with Aanchal Magazine, Aziz said that the downward trend in core inflation for a protracted period is proving to be a telltale sign of excess capacity. Ad hoc factors should not be blamed for the underperformance of private corporate investments, he said, adding that it should be conceded that the drivers are structural and “look for structural reforms to get private investment going.” Aziz also spoke about the GDP (Gross Domestic Product) data, the “serious statistical methodological issues underlying India’s construction of real GDP” due to usage of wholesale prices and not producer prices to deflate nominal GDP, suggesting that implied services inflation from GDP data might be understated. “The RBI will have to address the question why it is necessary to ease monetary policy when the recorded official growth rate is 8.2%.” Edited excerpts:
In the backdrop of the rupee slide, what were the challenges before RBI just ahead of the monetary policy.
The exchange rate depreciation is a good thing, not a bad thing. It is allowing the built-up depreciating pressures to vent off. And therefore, monetary policy doesn’t have to be held hostage to the exchange rate. It can now focus on domestic issues rather than constantly being worried about what might happen on the exchange rate front.
If you leave aside the external side of the economy, the rupee depreciation etc. and if you focus on just the domestic part of the economy, which is typically the dominant driver of monetary policy decisions, for at least close to two years, core inflation in India has been sliding. People have been talking about inflation falling in the last few months, but core inflation has been sliding for much longer. And when core inflation keeps sliding for such a protracted period, it is almost always a sign that there is a lot of excess capacity in the economy. But as core inflation keeps slowing, it is also a sign that excess capacity is increasing, not declining.
There are other factors in play that people talk about and I’m not denying their importance such as falling Chinese import prices etc., but they are not large enough to explain this persistent decline. One can have episodic declines in core inflation because of some shock in the economy, but you can’t have a systematic decline taking place over such a long period of time without that being a telltale sign of excess capacity. And it is a sign that the excess capacity is worsening rather than improving.
Turning to the exchange rate, I think the RBI is trying to disassociate the interest rate from the exchange rate by letting the depreciation pressures work themselves out. That’s how I make sense of the timing. Once you let those pressures out, then you can cut interest rates without fearing a large exchange rate reaction. This allows monetary policy to focus on the domestic economy.
So if there is such huge excess capacity, then the expectation of private sector investment picking up sooner is unlikely. It would actually be much later than sooner…
Yes, this is also the reason as to why private investment hasn’t picked up. But private investment not picking up is not a recent problem. It is not that private investment was booming two years back. It wasn’t. In fact, you have to go back 15 years. Since 2011-12, private corporate investment has flatlined around 12%of GDP. There are small quarterly variations, but it has not broken out of the 12% of GDP range. Over these 15 years, you’ve had numerous global and local shocks. The only thing that has remained constant is private investment in 12% of GDP range.
So, I think we should stop blaming ad hoc factors for the underperformance of private investment. It is not a cyclical phenomenon that changes to monetary or fiscal policies can solve. After 15 years, we should concede that the drivers are structural and look for structural reforms to get private investment going.
When you talk to bankers, they themselves are not so keen on cutting rates further because the deposit rates will need to be cut…
That’s correct. Look, different sectors get affected differently by interest rate changes. The RBI, as we all know, de facto juggles several objectives. At any given point in time, one of MPC’s and RBI’s biggest policy challenges is to decide what is their dominant objective. And that dominant objective is the objective that will drive monetary policy decisions. I think that the dominant factor today is the excess capacity that domestic demand is unable to absorb. There has been some improvement in consumption because of the GST cuts. But the GST cuts will have only a one-off impact on consumption.
Why do you say that? Prices are down…
Yes, inflation will fall as long as it takes for the GST tax cuts to filter through the economy. Once that is done, then inflation goes back up. It’s not that GST rates will be cut every year. If you take the elimination of the GST compensation cess and the rejigging of tax slabs, then together they amount to about 0.6% of GDP in less tax revenues. This means that household incomes will go up by that amount. Indians broadly consume 70% of their incomes. So, the total increase in consumption will be around 0.4% of GDP. For the period of time it takes for the increase to complete, the growth rate of consumption will rise. But once this adjustment is complete, the growth rate will return to whatever is the rate at which household incomes grow.
After high growth in the first two quarters, we’ll see the impact of the GST rate cuts in the third quarter. Does that pose questions to RBI that when the economy is doing very well, do you need to further cut rates?
I think the RBI will have to address the question why it is necessary to ease monetary policy when the recorded official growth rate is 8.2%. As is well known now, there are serious statistical methodological issues underlying India’s construction of real GDP.
These are not new problems. Substantial portions of manufacturing, such as the use of company profits as a proxy for a firm’s overall manufacturing value added, and all of India’s services economy, which is about 55% of the total, is first computed in nominal terms. This is true for most countries too. However, most other countries use a producer’s price deflator to convert nominal estimates into real. India uses the wholesale price index. Much of WPI is dominated by global commodity prices, especially crude oil. So, when crude oil prices fall, as has been the case over the past two years, WPI inflation falls. And this overstates real GDP. For example, except for refineries, no one uses crude oil as an input. We use refined oil. And refined oil prices have not moved at all despite crude oil prices falling because of the very tight refinery capacity globally.
What is even more problematic is to use global commodity prices to deflate services. Last quarter (July-September), in which India’s real GDP was 8.2%, inflation in the services sector, as far as the NSO (National Statistics Office under Ministry of Statistics and Programme Implementation) is concerned, was 1.2%. You live in India, you pay doctor’s fees, school fees, restaurant bills, legal charges, and taxi fares. These are the services that go into making the services side of the economy, which is about 55% of GDP. Tell me whether you feel that the inflation rate of those services last quarter was 1.2%?
The 1.2% services inflation is a key basis by which NSO computed the 8.2% real GDP growth rate. You have to accept both. One can’t take the 8.2% GDP growth rate and ignore the 1.2% services inflation. One can’t have it both ways. So, going back to your original question: yes, RBI will have to address why an economy growing at 8.2% rate needs additional policy support. We’ll have to wait and see how RBI does that.
You spoke about how GDP is calculated and how more work is to be done there. But, what are the other points of concern? Say, for instance, one of the aspects which the current Chief Economic Advisor has also raised is that the formal sector wages haven’t risen as much as the corporate profits. Basically saying if you don’t care about your employees then where will this consumption come from? Is that a limited point as far as the economy is concerned because the formal sector anyway is small or do you think that that’s a very large point?
The broad argument is true. If you take the real GDP growth numbers at face value, then you should expect household income and consumption to grow broadly at those levels. You haven’t seen that. Because household incomes haven’t grown at those levels. And therefore, neither has consumption. Now, the bigger question is why aren’t wages growing? The labour market, especially the formal level, is significantly more mobile today and more flexible today than it was 25 years back. If you are not getting paid well, then you will leave the job and find employment elsewhere. So why aren’t wages growing? Because finding alternative employment has become quite hard for all the reasons we have been talking about. So, firms are not paying higher wages because no one is walking away.
With regard to external factors, the trade deficit is also adding to the whole currency pressure. And even though current account deficit (CAD) is not being seen as a worrying factor accompanying rupee fall, it is also expanding. How big is it a concern, especially amid the uncertainty regarding the India-US trade deal?
The CAD has gone up from about 0.6% of GDP last year to about 1.3% of GDP this year. In the past, a CAD of 1.3% of GDP would actually be seen as a very good outcome. What is disconcerting is not that the CAD has increased but that India is finding it hard to fund deficit of even 1.3% of GDP, which in the past it could very easily do. During the taper tantrum, the CAD breached 4.5-5% of GDP that led to a near financial crisis. In India, you typically start getting worried if the CAD breaches 3% of GDP. Now we are worrying about 1.3% of GDP of CAD.
So, the bigger question is what happened to the FDI (foreign direct investment) inflows, portfolio inflow, foreign borrowings by the corporate sector?
On FDI, there are two major reasons. First, the US 10-year yield has remained in the 4-5% range over the last two years. This has been a key factor behind the slowdown in global FDI. The other is India specific. There was a lot of hope pinned on India benefitting from China plus One diversification of global supply chains. However, beyond a selected set of areas such as smartphones and data centers, not many investments have occurred. Instead, countries like ASEAN and Vietnam have continued to benefit. And now, of course, there are significant onshoring efforts by the US itself. This is unrelated to the current concerns over tariffs. And therefore the pressure that remains on us on the current account is not so much, the current account itself is blowing up, it is that we can’t fund even a small increase in the current account.
For the portfolio inflows, the Indian equity market has been seen as being overvalued for some time. I’m not an equity analyst, but it is hard to see India attracting sustained equity inflows without creating new global firms. If you look at the last 25 years, barring a handful of cases, the top ten firms in almost every sector have remained the same. This is despite a few hundred thousand of start-ups. If there isn’t a pipeline of new global firms, then one only has the traditional corporates, which are largely seen as being overvalued, to invest in. It is hard to see meaningful persistent inflows under these circumstances. We talk about countries, but no one invests in a country. One invests in companies that happen to be in a country.
When you talk about the FDI flows being such a concern, what steps do you think are needed to course correct?
I don’t think just focusing on FDI works. FDI or portfolio flows are a reflection of the overall strength of the economy and the firms that make up the economy. I don’t think giving a little bit of incentive here or there, helps.
So, one needs to turn to the domestic policy and the institutional frameworks and the reforms needed in India’s input and product markets. I think that’s where the focus needs to be.
