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Charts & Analysis

Subbarao on the Economy, With Interesting Graphs


Some of the best inferences to future macroeconomic policies are hidden inside the speeches made by key RBI personnel. On March 13, just a day prior to the release of the Feb inflation number, RBI Governor D. Subbarao presented at the London School of Economics. Some notes and takeaways.

Growth has dropped


What’s interesting is that the only period of high growth was 2003 to 2007. I had done a post long back, on how the Great Indian Stock Market Story was only 5 good years. Reproducing that chart here:


The stats pretty much show that unless GDP grows at a real 7%+, we’re going to be in for some trouble. And we’re at 5%.

Consumption and Investment – both are slowing

One of the reasons the economy did so well was the rapid increase in private consumption. Subbarao has this chart:


With both private consumption and investment coming down below 5%, is it a surprise that the economy grows less than 5%? Remember, the other two big ticket items in the equation are:

a) government expenditure, which as a result of the high fiscal deficit, has to come down (though the budget shows a massive increase of nearly 15% this year, we aren’t likely to reach there)

b) net exports. The gap between imports and exports is widening and if anything this is going to be even more negative.

Look carefully at the graph above. The GDP growth chart pretty much mirrors the growth in private consumption – which is around 65% of the GDP calculation.

Protein Food Inflation: Not Exactly The Cause for Food Inflation?

A reason Subbarao gave for high inflation was that protein prices were high due to rural demand and shift from cereals to proteins as people got richer.


Yet, if you look at the above chart, we should be seeing food inflation coming down if proteins were really causing good prices to go up. However:


Earlier protein prices may have caused inflation but in recent times, the two have diverged significantly.

Wages Gone Berserk

This graph has it:


Wage increases are running at 18% (nominal)! No wonder we’re seeing consumer price inflation of gargantuan proportions. However, this might eventually be compensated by the lack of such increases at white-collar jobs.

We want inflation to be below 6%

It is important to note in this context that the relationship between growth and inflation is non-linear. At low levels of inflation and stable inflation expectations, there is a trade-off between growth and inflation – some inflation can be tolerated to grease the wheels of growth. But above a certain threshold level of inflation, this relationship reverses, the conventional trade-off disappears, and high inflation actually starts taking a toll on growth. Estimates by the Reserve Bank using different methodologies put the threshold level of inflation in the range of 4 to 6 per cent. Inflation above 6 per cent would therefore justify, indeed demand, tightening of the monetary policy stance. It is this understanding that informed the Reserve Bank’s monetary policy stance.

(Emphasis mine)

Is this a clue? Since this was a day before the inflation announcement, we aren’t sure of what he knows, but I believe he expected inflation to keep coming in at lower numbers until it reached 6%. However, Feb saw an increase in the number, to 6.84%.

If the real deal is to get to 6%, then we might not see a rate cut at all on Tuesday. He doesn’t have to cut – it’s an intermediate policy checkpoint and if the situation doesn’t warrant it, he can wait till April in the regular policy schedule.

Plus, look at this statement:

Admittedly, there were supply shocks too, in addition to demand pressures,that were stoking inflation pressures. Monetary policy response to supply shocks is a deliberate balancing act because errors can be costly in terms of lost growth. If the judgement is that the supply shock is transitory (such as cyclical increase in vegetable prices), the preferred policy response should be to not respond by monetary tightening. If on the other hand, the judgement is that the supply shock is structural in nature and will persist, monetary policy has to respond since persistent inflation, no matter what the driver, stokes inflation expectations. Monetary policy is inevitably the first line of defence to guard against inflation getting generalized through unhinged inflation expectations. The Reserve Bank’s policy response has been guided by the above consideration.

(Emphasis mine)

Essentially, he’s telling the government: Fix your supply problems, because I’ll keep raising rates even if you think rates don’t change a thing about the supply problem.

Equity flows Love Lower Rates

On the other criticism about the impact of capital flows required to finance the CAD, it must be noted that interest rate differential is only one of the several push and pull factors that influence capital flows. Moreover, debt and equity flows have traditionally responded differently to a rate cut. While debt flows may be more sensitive to a narrowing of the interest rate differential, equity flows may actually increase because they see in this a signal of lower inflation and better investment environment. This has been the experience of India leading some analysis to all this, the ‘Indian exceptionalism’.

(Emphasis mine)

Eventually, of course, when inflation strikes, equity flows leave just as easily, based on inflation expectations (not really rate hikes).

In Conclusion

These are formidable challenges, but by no means insurmountable. For people who despair, it is important to remember that the drivers of the India growth story – get up and go entrepreneurism, the demographic dividend, a large and growing middle class, the opportunity for productivity catch up, democracy and a decent legal system – are all intact.

And I say this is mostly wrong now. Entrepreneurism isn’t being encouraged at all, and even today it takes more time to start a legit business than otherwise. And then you have high set up costs because of high real estate prices which is a function of RBI looking the other way. There is no demographic dividend if the people we produce aren’t employable – and its turning out that most are not.

The middle class, in the presence of negative real rates (that is, inflation > savings growth) is going to stagnate. Productivity catch up can only happ
en if there is employable population, and labour reform (that allows you to fire). Democracy and a decent legal system – well, given that we’ve just voted the SP back into power in UP, and that no one has recently been convicted of the “corruption” crimes in the last few years, I stick my nose up to them.

We’ve gotta change. And it will come when we accept that the bad stuff has hit the fan, and we’ve got to make some sweeping changes. My suggestion to the RBI/govt: free the rupee completely, remove barriers to external borrowing, raise rates till inflation is below 5%, rapidly induct new banks and reduce barriers to credit by SMEs by even buying their securitized loans. And remove agricultural land laws.


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