On June 18, the Reserve Bank (RBI) will come out with its first mid-term credit policy review for this fiscal. This comes two months after its annual policy statement on April 17. Plenty of data has been released during this period on a host of macroeconomic parameters, such as GDP, investment, exports, industrial output, and the wholesale price index. The data sheds crucial light on the performance of the economy in 2011-12. It is, therefore, time for the RBI to take stock of its earlier policy measures, while preparing for the coming months.
Fallacy in Argument
The data tell us that while the economy has slowed down, prices continue to be sticky. The RBI did say in the past that it would not mind sacrificing a bit of growth to bring inflation under control. But the growth numbers for 2011-12 would surely have been a source of discomfort to RBI.
In a recent interview, the RBI Governor, Dr D. Subbarao, pointed out that given the inflation dynamics in the economy, 7 per cent may be the potential growth rate. The implicit argument is that 7 per cent growth would bring down inflation to more acceptable levels. This approach, of effectively curbing growth, delayed the rate-easing cycle by almost two quarters, before its fallacy became evident.
Economic growth was down to 6.5 per cent growth in 2011-12, but average headline inflation was 8.8 per cent. In contrast, average WPI inflation for 2010-11 was 9.6 per cent, while the economy grew at 8.5 per cent. Hence, a growth reduction by 2 percentage points brought down inflation by only 0.8 percentage points.
Let us assume headline inflation falls to a more acceptable 5 per cent, but with severe growth compression to say, 4 per cent.
Can we then say that the potential growth rate of Indian economy is 4 per cent? The potential rate of growth cannot be anchored to a desired level of headline inflation, when part of the inflation is structural and driven by government policy.
Growth Compression
About a year ago, some observers of the Indian economy had floated the idea that 2011-12 will be a year of two halves. They said from a growth and inflation perspective, the second half would be much better than the first.
The projection of better growth numbers for the second half was based on the following assumptions: normal monsoon, sustenance of export momentum and a pick-up in investment. While we had a normal monsoon, given the high growth of agricultural output in 2010-11 agriculture posted a growth of just 2.7 per cent.
Exports grew at a robust pace till the first half of 2011-12, but their growth was quite weak in the second half, leading to an overall growth of 21 per cent, compared with 38 per cent in the previous year. If we consider investment (the sum of gross fixed capital formation, change in stocks and valuables) as a proportion of GDP, it was around 35 per cent, similar to the levels of the previous two years.
What, then, prompted growth to fall sharply? The picture becomes clear if we look at the behaviour of the components of investment. While the share of gross fixed capital formation (GFCF) in GDP was down by almost 1 percentage point (from 30.4 per cent to 29.5 per cent), the share of valuables increased by 0.7 per cent (from 2.1 per cent to 2.8 per cent) in 2011-12, compared with 2010-11.
The GFCF fell over four consecutive years, from 32.8 per cent in 2007-08, to 29.5 per cent in 2011-12. It is the continuous fall in GFCF ratio that has brought growth down to such low levels.
Seen from a sectoral perspective, corporate sector investment, which reached a peak of 17.3 per cent of GDP in 2007-08, dipped to 11.3 per cent with the onset of the global financial crisis in 2008-09. Corporate sector investment witnessed an upturn in 2009-10 to 12.7 per cent, but fell to 12.1 per cent in 2010-11.
We do not have sectoral investment rates for 2011-12, but it would not be any better than that for 2010-11. Public sector investment as a ratio of GDP also fell in 2009-10 and 2010-11. The fall in corporate sector investment has, to some extent, been compensated by an increase in investments by the household sector.
However, the multiplier effect of corporate and government investment is perhaps much higher than that for the household sector. If we are to achieve a growth of 7 per cent, a pick-up in corporate investments is a must. A lower interest rate regime could help in this regard.
What Should be Done
Rupee depreciation imparts an inflationary bias to the economy. Fortunately, international oil prices, a major component (around 30 per cent) of our imports, have seen a significant decline.
Further, as export growth remains subdued, the liquidity impact of depreciation will be limited. Therefore, depreciation may not act as a major cause of inflation. With Q4 GDP growth being low and RBI spelling out a focus in favour of growth, we can expect a bias towards easy policy. One would not be surprised if RBI opted for a 25 basis points rate cut.
(The author is Associate Dean, Xavier Institute of Management. Views are personal.)