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Is the economy in a logjam? - Outside View by S.S. TARAPORE
Is the economy in a logjam?

After a few years of 8-9 per cent growth, the Indian economy slowed down gradually after the global crisis of 2008, and in 2012-13, growth was only 5 per cent. Policymakers the world over find it hard to accept that the world could be in the throes of a long cycle of low growth. In India too, the official policy line is to generate confidence and to claim that the slowdown is temporary and that in 2013-14, we would see a revival of growth, which would , in the next few years, put us on the path to the cherished 8 per cent growth rate.

The present logjam

Along with a low growth rate of 5 per cent in 2012-13, we have a year-on-year inflation rate, based on the Consumer Price Index (CPI) of 9.4 per cent. The authorities, as part of confidence-building, would understandably say that with the Wholesale Price Index (WPI) at 4.9 per cent, inflation has been brought under control. From the viewpoint of the common person, what is important is not only the rate of inflation, but the level of inflation, which determines purchasing power of the common person. Unfortunately, we are still far from a CPI inflation of rate of below 5 per cent.

In the enthusiasm to stimulate investment, the government has been explicitly nudging the Reserve Bank of India ( RBI) to reduce the present 7.25 per cent policy repo rate (i.e. the rate at which the RBI lends to banks against the collateral of government securities), and also to keep overall liquidity easy. Furthermore, banks are being pressurised to lower lending rates. The problem is that in the relentless endeavour to reduce lending rates, real deposit rates are negative (i.e. deposit rates minus the CPI inflation rate). It is, therefore, not surprising that household sector savings in financial assets have gone down sharply and savers have moved to physical assets, particularly gold.

The gap between investment and savings is reflected in a balance of payments current account deficit (CAD). The CAD is the excess of payments for merchandise imports and services over the receipts for merchandise exports and services. It has been accepted, as a rule of thumb, that a CAD of 2.5 per cent of GDP can be comfortably financed. The problem in 2012-13 is that the CAD has reached 5.0 per cent of GDP, which is worrisome. The fact that the CAD could be financed in 2012-13 does not mean that it can be easily financed in subsequent years. Capital inflows are capricious and there can be very large and sudden outflows, which would seriously dislocate the economy. Thus, bringing down the CAD is a policy imperative.

Recent policy on gold

The authorities attribute the high CAD to large imports of gold; it could be attributed to the import of any other merchandise or services. The high import of gold reflects the symptoms and not the malady. The malady is that wonky financial policies have discouraged financial savings.

Inappropriate exchange rate

The rupee exchange rate has been artificially kept too high. A couple of months back, most analysts were forecasting the dollar-rupee exchange rate twelve months hence to be around Rs 53-54. With the recent sudden fall of the rupee, analysts are now veering to a rate twelve months hence of Rs 58-59. In short-term projections, forecasters give undue importance to the current position. Analysts consider a rate of Rs 60 as an outer limit for the exchange rate a year hence. It bears mentioning that an exchange rate of Rs 60 would still leave the rupee grossly over-valued.

An appropriate dollar-rupee exchange rate should reflect the long-term inflation rate differential between the US and India say for the period 1993-2013 which would warrant an exchange rate of US $ 1=Rs 70. A few months ago, I had expressed the thought that the appropriate exchange rate was US $ 1=Rs 70 and it was treated as heresy. With the recent depreciation of the rupee this thought is now not considered that outrageous! A rate of Rs 58 still favours large industry, which is import-intensive and is biased against medium, small and tiny industries, which is export-intensive. Moreover, with an overvalued exchange rate, cheap imports wipe out otherwise non-import competing efficient domestic industry. A case in point was the sticking glue industry, which has been wiped out by very cheap imports. The depreciation of the rupee in the last few days is highly desirable and the RBI should not sell forex to stem the depreciation.

Monetary policy response

The government continues to think that the way out of the logjam is to lower interest rates. On the contrary, there is a pressing need to increase interest rates. Given the political economy realities it would indeed be heroic if RBI Governor D Subbarao is able to withstand pressures to reduce interest rates. Common person's response

What should be the common person's response to evolving policies? First, depositors should continue to lock themselves into the longer maturities. Secondly, depositors should move funds out of Savings Bank Accounts, especially in the case of banks which continue to offer only 4 per cent on savings deposits, and move into higher interest bearing seven days' fixed deposits, with automatic roll-over facilities. Thirdly, the common person should not be persuaded to move away from gold; in fact savers should ensure that they invest 5-10 per cent of their savings in gold. If the authorities really want an effective counter to gold, they should not hesitate to offer savings instruments for say five years, with a 3 per cent real rate plus the CPI increase; if the CPI increase is 9 per cent, the saver should get 3+9=12 per cent, but this could be lower if the CPI increase slows down. Furthermore, the saver should have inflation protection for the capital. Only such a scheme would drastically reduce the demand for gold.

Medium-term outlook

The medium-term outlook is one of low growth, high inflation, an overvalued exchange rate for the rupee and a high CAD. Unless there is a rapid, significant and enduring reduction in the inflation rate, it would be totally rational for savers to reduce financial savings to the extent this is possible. (Syndicated)

Please Note: This article was first published in The Free Press Journal on June 17, 2013. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.


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