Sunday, June 17, 2007

Economist resurrects 'India overheating' hypothesis

The Economist created a bit of a flutter in February this year when it weighed in in favour of the 'India overheating' hypothesis. In a nutshell, the magazine contended that there was no way that the recent growth rate (average of 8.5% over the past four years) could be sustained and that the rise in the inflation rate was an indication of this.

In its last issue (June 7), the Economist resurrects this hypothesis. It presents four arguments to support its contention:
  • Inflation has been caused not just by supply shocks- in the form of shortages of agricultural products- but by a rise in manufactured product prices; the latter points to excess demand
  • Supply-side measures taken by the government, such as cutting duties on imported products, can only be a palliative, they can't cure the problem
  • The rise in investment will augment capacity soon enough
  • Interest rate rises effected by the central bank should serve to curb demand

What do we make of the Economist's stance?

First, let me say that I have no difficulty accepting all of the above points, especially points one and two, namely, inflation is the result, not just of supply shocks, but of excess demand. Hence, augmenting supply alone won't do. Indeed, the case for a slowing down of the economy has been accepted by India's central bank.

We are seeing a slowdown in bank credit growth and money supply due the many rounds of interest rate increases effected in the last year. Growth in home loans as well automobile loans is lower than in the previous year. So, there is every indication that higher interest rates are beginning to impact on retail loans. But, corporate demand for credit is rising thanks to ambitious investment plans.

There are two policy issues that need to be addressed. First, how much of a slowdown do we need? On present showing, GDP growth for this year is projected at around 8-8.5% compared to last year's 9.4%. If the trend in the reduction in the inflation rate seen in recent weeks ( the rise in the WPI has slipped below 5% in the last week) is sustained, then this may constitute enough of a slowdown.

Second, the answer to excess demand does not lie in further central bank tightening- or such tightening alone. Money supply increases arise from foreign inflows. The central bank cannot allow the rupee to appreciate beyond a point because such appreciation undermines export competitiveness- and it also exposes the economy to serious risks if capital inflows should reverse or dry up. The central bank buys up foreign inflows - and this causes domestic money supply to expand.

So, we need to contain foreign inflows. The government has taken several steps for this purpose, including imposing tighter norms for external commercial borrowings. Some of the FDI is in the form of private equity and this is more in the nature of portfolio flows- we may need to impose controls on these as well. Nearly 50% of FII flows is in the form of Participatory Notes- we may need to substitute these with direct investment in the stock market. It's a tough job but containing foreign flows is the key at the moment.

Greater monetary tightening, which the Economist urges, can have the perverse effect of stimulating greater foreign flows at a time when rupee appreciating. It will also dampen capital spending that will augment supply down the road. So further tightening is not the answer.

Agreed, managing a higher growth rate poses major challenges for the Indian authorities. But I detect a hint of a suggestion in the Economist's tone that a growth of 8% plus is somehow excessive for India- and the same journal, I am sure, does not have a problem accepting that 10% is okay for China. Part of the problem is that the Economist, like many domestic advocates of further reforms simply did not believe that India could reach 8% without sweeping reforms- privatisation, labour reforms, financial sector reforms, subsidy cuts, the works. But 8% has happened. So they are conjuring up reasons as to why it can't last.

Sorry, folks, India is going to disappoint you- we will keep growing at 8% plus.


Krishnan said...

India is not China (the obvious does not seem obvious to legions of economists/pundits out there ... certainly not ET!) yet, they cannot help but keep comparing the two growing economies. The differences go way beyond the obvious - that India, being part of the British Commonwealth (and it's own history) has a history that is fundamentally different from that of China. In the US, I see a slow but growing realization that China will never ever be the kind of economic competitor that India can and will become very soon. The Communists in China will never, ever let loose of their citizens like India can and is beginning to ... one cannot sustain economic liberalization without a nation of truly free people.

I have difficulty understanding why there should be direct intervention with the appreciation of the rupee ... (or why the US always seems to want to debase it's own currency, the dollar - by talking it down whenever there is a trade deficit) - the trading of the rupee may be indicating that there is value to be found in India - ... let the people running companies/innovating figure out ways to make what they do even more efficient (The Japanese yet used to be about 360 yen to a dollar when Japanese manufacturers started making cars/electronics - and slowly but surely beat out their competitors as they figured out how to deal with the appreciating Yen - It is true that this was NOT in a vacuum and that the Bank of Japan did meddle some - but the fact that the Yen appreciated almost three fold YET Japanese manufactuers maintained their ground indicates that the problem with trade is NOT simply a matter of exchange rates ... in my own limited view of the world!)

8%? 8.5%? 9%? Who knows ... the critical issue, as always, is what happens to the good neighbor Pakistan - if there is a lot of turmoil there with violence accompanying any change in government from Military to Civilian Hands and possibly back to Military again, all bets are off ... The money inflow to India will stop, abruptly - the economy will slowly but surely slow down ...

Raj said...

While I loved the line, "Sorry, folks, India is going to disappoint you- we will keep growing at 8% plus", I am curious to know the reasons for your unbridled optimism, in terms of macro-indicators, fundamentals, etc.

Anonymous said...

Dear Gentleman,

I accept your arguments at their face value. You may be correct. I am not sure. However,if I accept your 8% growth and that jazz, how so many Indians are moving out of the country in search green pastures?

Krishnan said...

People will always seek greener pastures - and for many that may be outside India ... yet, there are some clear trends ... the rapid growth in India is changing this dynamics - Non Resident Indians are either returning or otherwise investing or collaborating and there is anecdotal information that fewer bright students are seeking to pursue higher education since they seem to be able to do what they want in India ... as long as the country remains open to new ideas and opportunities - life will only get better and India will overtake China for sure ... China does not have the will nor the ability to let their people loose since they fundamentally distrust the democratic process and will remain authoritarian and so limit what their citizens can do.