The unstable macroeconomy

Business Standard, 5 March 2008

GDP growth did a massive swing from 3.8% in 2002-03 to 9.6% in 2006-07. This large high-low range of GDP growth reflects the risks of the Indian economy owing to a faulty framework of fiscal policy and monetary policy. Neither fiscal nor monetary policy in India stabilise the business cycle. As a consequence, in the event that a slowdown comes about, the downside risk for India is greater than that found in mature market economies.

Some signs of a business cycle slowdown are perceptible. GDP growth for the December quarter came out to 8.38%, which is a bit lower than the highs of 10% of 2006-07. Revenue growth of non-financial corporations for the December quarter was 18% - which is good in absolute terms but is lower than the above-25% values of 2006-07. Profit growth of these corporations also showed strong growth at 28% in December. The P/E of the broad market (the CMIE Cospi index) is at 27, which is higher than the historical average of 19.3.

There are now strong fears of a global recession, and the US economy has perceptibly slowed. As yet, there is little distress in India. The last twelve months had exports growth of 20.3%, compared with 22.4% in the previous twelve months. I track transport equipment exports as a measure of how modern manufacturing exports are faring. This shows an acceleration in the latest 12 months of data to 40%, compared with 24.5% in the previous 12 months.

Things look good. My main claim in this article is that things look deceptively good. Owing to a flawed macro policy framework, India is ill-equipped to cope with shocks. In a mature market economy, fiscal policy and primarily monetary policy stabilise the business cycle. Neither of these responses are found in India.

The most important element in thinking about the Indian business cycle is investment. Gross capital formation went up sharply from 23.8% in 2002-03 (the lowest GDP growth in recent times) to 34.6% in 2007-08: a swing of more than 10% of GDP. Roughly half of investment is by the private corporate sector, so the decisions of CEOs on investment matter greatly.

Investment by the private sector is driven by expectations about the future. Projects are undertaken when there is a good likelihood of profits, and vice versa. The autonomous swings of expectations, and thus private investment demand, are now the most important source of fluctuations of GDP. Some observers think that the tax breaks given by Budget 2008 will stimulate demand and hence GDP growth. However, if the spectacle of MPs cheering the debt waiver hampers investment confidence, the size of that impact could dwarf the small tax breaks that have been given out.

If a global recession unfolds, many global firms would be selling goods at low prices in an attempt to preserve capacity utilisation and market share at a time of soft demand. This would impact on the profitability of a large swathe of corporate India, owing to `import parity pricing'. The channel through which a global recession impacts upon the domestic business cycle runs from global prices to corporate profitability to corporate investment.

Regardless of whether difficulties arise because political uncertainty triggers off fears in the minds of CEOs, or because a global economic slowdown impacts on India, the question is: What happens in a slowdown?

In a mature market economy, when a downturn comes, tax revenues go down. Expenditures on programs such as NREG go up. The deficit enlarges. At the same time, there is never any fear of a fiscal crisis. In India, fiscal deficits and public debt are in unsafe territory. As a consequence, in good times, tax revenues are buoyant and the government spends. When a downturn comes, tax revenues come down, and there is no fiscal space to enlarge the deficit. Even today, after a few years of an unprecedented business cycle upturn, we do not have the space to enlarge the fiscal deficit in a downturn. Thus, fiscal policy in India does not play a stabilising role.

In a mature market economy, the central bank moves the short-term interest rate to stabilise the economy. When times are good, the policy rate goes up. When times are bad, it is dropped. The actual mechanics through which this is done is by targeting inflation. Buoyant business cycle conditions lead to pressure on prices. Central banks target inflation, so when inflationary pressures are found, the policy rate is raised, and vice versa. In a mature market economy, the central bank does not worry about exchange rates, banking regulation, or all the other things that RBI does; it only cares about the business cycle.

In India, none of this is in place. RBI is a central bank in name, but in behaviour, it does not look like the central banks of mature market economies. The drama of the credit policy announcement mimics what real central banks do. However, monetary policy setting actually takes place every day in RBI's currency trading.

Exchange rate pegging has increasingly robbed RBI of the autonomy to think about inflation or business cycle conditions. As an example, interest rates were sharply raised in January 1998, at a time when Indian business cycle conditions were gloomy. From 2002 onwards, when a massive business cycle upsurge came along, real interest rates were dropped owing to exchange rate pegging.

RBI does not have the institutional mechanisms through which interest rate setting can stabilise the business cycle. Even if this is rapidly put into place, the next leg of the story - the `monetary transmission' - is missing. The monetary transmission is the market process through which changes to the short-term rate by the central bank lead to changes in all interest rates in the economy. This requires a properly functioning Bond-Currency-Derivatives Nexus. India lacks this, owing to a repressive license-permit raj. Even if the task of interest rate setting were done correctly, it would fail to exert a stabilising influence on the economy until the BCD Nexus is put into place.

Without mechanisms of stabilisation, GDP growth has swung from 3.8% in 2002-03 to 9.6% just four years later. If and when a slowdown commences, it will be nastier than what we see in mature market economies. India has a high trend GDP growth rate, but a substantial volatility around this owing to the poorly constructed macroeconomic policy framework.

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