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Sunday, August 14, 2022

It’s the interest rate,stupid

With real rates of interest at 9%,it is no wonder GDP is crawling to a 16-quarter low of 4.4%.

Written by Surjit S Bhalla |
August 31, 2013 4:28:48 am

With real rates of interest at 9 per cent,it is no wonder the GDP is crawling to a 16-quarter low of 4.4 per cent.

The GDP data for the second quarter of this year has just been released and it paints a crisis picture for the economy. The year-on-year GDP growth rate came in at 4.4 per cent,making it the third successive quarter when GDP growth has come in below 5. The previous two quarters’ year-on-year (yoy) GDP growth registered at 4.8 and 4.7 per cent respectively. If this fiscal year (2013/14) GDP growth comes in below 4.8,it will mark the third-slowest GDP growth since 1991,with the slowest growth observed in both 1997 and 2000 at 4 per cent.

In his address to the nation today,the PM talked of a 5.5 per cent growth for the fiscal year. Given that we have the yoy data for the first quarter (Zyfin Research,,recently published near perfect forecasts of GDP and deflator growth,both sequential and yoy),sequential quarterly growth in this quarter is around 4.2 per cent,SAAR. Thus,sequential growth rate for each of the next three fiscal quarters will have to be close to 6 per cent to meet the PM’s forecast. There are some other scary implications. The finance minister earned the trust and confidence of many when he kept to his fiscal deficit promise of 5.2 per cent of GDP for FY2012/13. For 2013-14,the target was ambitiously lowered to 4.8 per cent of GDP.

Contained in these estimates is tax revenue growth of close to 19 per cent,expenditure growth of 16.3 per cent and nominal GDP growth of 12.8 per cent. It is near impossible that the FM will even come close to the 4.8 per cent deficit target. Nominal GDP growth expanded by 10.2 per cent. Simple math suggests that in order to meet the FM’s nominal GDP growth target of 13 per cent,the Indian economy will have to expand at a 14 per cent nominal annualised rate in each of the next three quarters. This is simply not possible.

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This low growth rate cannot be ascribed to external factors,US Federal Reserve tapering,etc. Most of our GDP decline is home-grown,and it is encouraging to note that several policymakers have admitted in recent days that it is not the outsiders,stupid. Both the FM and D Subbarao are absolutely right (unlike the UPA apologists who believe that what is the problem,all countries are more or less equally affected) or misguided experts who believe that 10 per cent (food)-CPI inflation and 4 per cent GDP growth is a sign of an overheated economy.

Potentially,there are two sources of grief for an economy — fiscal and monetary policy. Regarding fiscal policy,several or most observers (including the outgoing RBI governor,Subbarao) agree that the UPA 2 regime has been responsible for possibly the worst fiscal policy that India has endured,and I would hazard a guess that outside of Venezuela,possibly the worst fiscal policy of any modern economy. And the nightmare just does not end. We have just witnessed the passage of two more populist bills,bills of a kind that would have severely embarrassed,had he been alive,the last of the great populists,Hugo Chavez of Venezuela.

What is not as well recognised,or appreciated,is that monetary policy is also responsible for the economy being in deep crisis. Given the high CPI inflation,many have defended the tight RBI policy of keeping interest rates high. Some even argue that the governor should have tightened much more,or that the RBI should begin a new tightening mode to bring down double-digit inflation. But is inflation in double digits or even close? The latest yoy deflator inflation is 5.8 per cent,the lowest since 2007 — that is the inflation rate. By definition and construction,the GDP deflator is a more comprehensive measure of inflation. But because of its more timely nature,most analysts take the CPI as a surrogate.


And so they should. Data for over 120 countries show that there is a close relationship between the CPI and GDP deflator. On average,the difference in the inflation shown by the two variables is less than 0.25 per cent. The same holds true for India for the long time-period,1980 to 2007. For this 28-year period,average CPI inflation was 7.6 per cent per annum,and average GDP deflator inflation 7.2. Around 2007,this historic equivalence broke down. For the last five years,CPI inflation has been 9.6 per cent per annum and GDP deflator 6.8 per cent,an annual difference of 2.8 per cent. According to the just released GDP data,for 2012-13,this difference is 4.2 percentage points.

The reason for this large anomaly is food inflation. As commented by me on several occasions over the last three years,this high food inflation was literally engineered by the UPA government via massive increases in procurement prices. In the space of three short years,2006-08,the relative price of food increased by 33 per cent. This food inflation is what is causing the divergence between the GDP deflator and the CPI. The latter has a near 50 per cent weight of food,while the former has a weight of agriculture of less than 20 per cent.

The divergence is large,very large. The difference is so large that it changes the very nature and interpretation of monetary policy. It suggests that the RBI,fully supported by the PM’s Economic Advisory Council headed by C. Rangarajan,has been fighting inflation that was not there,or that it could not affect. Food inflation in India is political inflation,and inflation caused by administered,not market,prices. Monetary policy cannot affect the magnitude of administered prices. Food inflation might play well on TV channels and be good for their TRPs,but it is not inflation that the RBI or the ministry of finance or now governor-designate Raghuram Rajan should be looking at.


There are two very strong implications of this misguided misreading of inflation. First,in contrast to protestations of the RBI,there is a divergence of 4 percentage points in the real rate of interest. If the lending rate is 15 per cent,and inflation 6,then most borrowers are paying 9 per cent real; with the CPI,the real rate is “only” 5 per cent. Is it any wonder then that the economy has stalled,and stalled at near historic low growth-rates of 4.5 per cent for the better part of the last two years?

Most investors do not have the time,inclination or expertise to even begin to question the words of a central banker. They take it as given that the RBI must know what it is talking about and if the RBI governor says that inflation has been 10 per cent plus for the last few years,so it must be. They plunk this 10 per cent average into their excel sheets,along with considerably more reliable CPI for other countries and lo and behold,they get a “crude” value of Rs 70 to the dollar as the new fair value of the rupee. But if inflation has been cumulatively some 17 per cent lower,the “experts” will get a lower,fair crude value of the rupee at 60 (70 divided by 1.17).

What is to be done now? There are countries like Brazil and Indonesia who are hiking rates,not because of tapering,but because their correctly measured inflation rates have accelerated beyond their “targets”. India has the opposite problem. And regardless of whether you are an inflation target policy believer or not,you should be recommending to India that it cut short-term rates,not raise them. Incidentally,Zyfin Research monthly GDP calculations suggest that sequential GDP inflation is down to a 1.7 per cent annualised rate.

India’s growth recovery can only begin once policymakers (and their advisors) recognise they have made some grotesque errors of data interpretation and monetary policy. The time to cut rates was well before yesterday.

The writer is chairman of Oxus Investments,an emerging market advisory firm,and a senior advisor to Zyfin,a leading financial information company

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First published on: 31-08-2013 at 04:28:48 am
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