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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.

  • Free rupee: it’s mostly free
    Remove barriers to external borrowings: raises external debt risk profile at a time when high CAD has already made us vulnerable. Can cause currency shock in case of global crisis l
    Raise rates: correct theoretically, crazy in reality. Will finish off whatever growth is there without necessarily cooling down inflation. Try improving food situation instead
    Induct new banks: setting up a bank and starting lending will take time. Besides Govt is buying all bank credit anyway.
    Buy securitized loans: might increase circulation of capital but who will believe your loan book in these NPL days?
    Remove agri land laws: and? This is the one area where wealth effect is still there. Structural change? Yes. Immediate solution? No. Instead try State Govt’s freeing up/investing in land for industry.

    • Rupee – not free at all. No capital convertibility. That’s the key. Gotta allow foreigners to own rupee bonds etc., and even sovereigns to own rupee.
      This external debt problem thingy is a relic of old style thinking. It is not any different from internal debt when you have size, and when you have a free currency. Really. High CAD has to be reduced through freeing of the rupee. If it has to go to 75,let it – the CAD will come down automatically, (fuel prices shoudl stay unsubsidized)
      Raise rates: Remember volcker. It’s teh bitter pill, but it will give us a fantastic 20 year growth for 2 years of degrowth.
      New banks – if you don’t start now, you’ll alwasy have that lead time.
      Securitized loans: This is no different from, say subsidizing export loans which is what the RBI does, or farming loans which is what the govt does. Buying securitized SME loans with strict origination and doc rules (and some credit enhancement) will allow credit to flow to where it generates the max impact – the SMEs.
      Agri land laws: if you remove them, the rural poor will become rich. Right now it’s limited to the politicians or their cronies. And you’ll get better productivity on the farms.

  • On the contrary the case for running external debts is a relic of 90s Asian crisis thinking. Look what other ASEAN countries have done. By all means encourage foreign flow, but I’d rather have it as FDI (which has the potential to create jobs) rather than FII, ECBs, etc which are volatile. Besides by your own argument, once new banks open up, capital flows internally should improve.
    Letting the rupee depreciate and CAD worsen has already happened at the detriment of the economy. These are symptoms not the cause. Would rather look at sustainable structural long term solutions like ending subsidies, encouraging manufacturing and creating infrastructure. Yes that’s old school also but it’s also proven. Open up the markets after you’ve achieved that, not before. I’m not defending the Govt here but I don’t think I’ll let market forces determine India’s economy to such an extent. Look at the West. And also look at how China has come up.
    Try convincing a banker to buy securitized SME loans today. No one will touch it. Again, these are cyclical. Once things improve and NPLs ebb, bank loans will come back.
    The rural poor have already become rich by selling their land. Those left behind would benefit more by agri productivity via higher investment, irrigation, etc. then change the land laws

    • Look what ASEAN countries were,mate. I think this concept of FDI versus FII is also a relic – it doesn’t matter, and it shouldn’t. You promote free flows, and things will happen. There are down times and up times, and you need both; the asean economies of then did not focus on actual freedom, and would rather not default. Look at iceland – they let their banks default and boom, they are in fabulous shape now. Compared to Greece or Ireland.
      CAD will not worsen if the rupee depreciates. That’s like saying inflation goes up if we free fuel prices. Sure they do, but it’s short term until stability comes! Same with the rupee. Don’t tell me we have to do things “when we are ready”. I have heard that tripe all my life. Rajiv Gandhi said we were not ready for a free press. We were, we always were. We have been ready for a free rupee for over a decade now. I do not agree with this “RBI can determine economy but markets cannot” philosophy. OPen it up, let us learn from the challenges that come up. Going back to license raj is no longer an option, but when we were in license raj we thought that privaate fellows would murder us all if we opened up the economy. It is a leftover socialist ideal, we should absolutely get rid ofit.
      SME loan securitization has a precendence in the US small business loan funding mechanism. The system isn’t perfect, and bankers will attempt to fraud that also, but if we have a solid fraud punishment system it can be made to really work.
      Rural poor – I beg to disagree. The sheer numbers disprove your argument. A few anecdotal cases do not help, I’m sorry. the outskirts of Gurgaon <> all of India.

  • Anil Kumar Tulsiram says:

    Thanks for posting link to Mr. D. Subbarao speech. Its really amazing one and for the first time I could understand macro economics much better.

  • Ravi Shankar says:

    Agree with Deepak! Just to add, a real negative interest rate (inflation adjusted) regime just transfers wealth from the savers to the borrowers. For those opposed to rate hikes because of growth, I have a suggestion, let the RBI print a bunch of currency and circulate in the economy and vola you will have some growth initially and then will come massive inflation. Capital formation happens when the providers of capital have enough incentive to do that, which is compensation by way of positive real interest rates. Else the government and the RBI can ramble as much as they want and net result would be inflation. Period.

  • Karl says:

    The speech is all smoke and mirrors. One needs to understand that all central banks are nothing but legalized counterfeiters which have a mandate to transfer wealth form the productive sector to the parasitic banking sector that lives off the interest income on the fraudulently created currency. We have been sold a lie that moderate inflation is somehow good for the economy and raising interest rates is the solution to lower inflation. Inflation is theft, so moderate theft cannot be good for the economy!
    Currency is created out of debt i.e every rupee in your pocket is someone’s loan. If all the debts public and private were paid back in full there would be no money in circulation. Lets pause and grasp that concept for a moment. Every rupee in circulation is a loan from the RBI and has to be repaid with interest. Now how can we repay the interest when it is only the principal of the loan that has been placed into circulation?
    The payment of interest has to be satisfied with further borrowing. Thus there is artificial scarcity created whereby the total debt (principal + interest) always exceeds the currency in circulation and one needs to resort to further borrowing to repay the interest. This leads to an ever increasing national debt and consequently higher interest costs which need to be paid by our taxes. Over a period of time the interest cost itself will exceed the amount of currency in circulation and the economy will be bankrupt. This is a characteristic of a ponzi scheme. It is this increasing interest cost over a period of time which is responsible for rising prices. If interest is not paid, companies and individuals experience bankruptcy so they will try to meet this cost by raising prices. Thus a fraudulent debt based interest bearing monetary system is the primary cause of inflation.
    When the RBI raises rates further and together with the entire banking system either halts or slows down lending, one can no longer repay the interest and we witness certain sections of the economy experiencing bankruptcy or are close to defaulting. This leads to a slowing / falling demand from these entities and this leads to a temporary fall in prices. In this fraudulent system, the only way to reduce prices is to make certain sections of the economy deliberately bankrupt by halting lending!
    When asset prices are depressed, the RBI again prints currency and the biggest beneficiaries are the banks and big corporations who get to make the first use of the currency and buy the assets at depressed prices and consolidate their wealth. This unholy nexus between central banks, big businesses and politicians has destroyed most western economies and I fully expect the same to happen to our country if people do not wake up and reform our fraudulent monetary system.
    A few years after the creation of the Federal Reserve in America, Henry Ford is said to have remarked “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning”.
    Please consider how absurd it is that we pay taxes to meet the interest cost of a monetary system that is designed to make us bankrupt! It is high time that there is a revolution in our country to rid us of this parasitic banking system and replace it with a lawful alternative.

  • DJ says:

    I don’t know why people like Subbarao don’t have an understanding of democracy. Democracy is only superior when we have a well functioning republic to enforce some constraints on government. When the republic isn’t functioning, democracy is reduced to kakistocracy. We should stop giving lip service to democracy and ask if we are or even if we ever want to be a republic? And, that starts from the well-to-do people. Do they ever want to obey laws, when they have no need to break laws?