ROOM FOR RECOVERY
Manufacturing growth is still barely positive but it has pulled out of the free fall of the past year. Since downward cycles can become cumulative the halt is a positive. Fixed investment is hardly growing but its level is still reasonable— underlying demand for housing may be sustaining construction.
But the manufacturing slowdown has now lasted five quarters; even in 2008 the slowdown was only for three quarters. Then, coordinated and aggressive monetary and fiscal stimulus pulled growth up. Interest rates could be cut because wholesale prices crashed with global oil prices. Subsidies and transfers pumped up consumption. Today oil prices are firm and fiscal deficits high— there seems to be no space for either a fiscal or monetary stimulus, while the political logjam vitiates space for reforms.
But this is at the aggregate level. A finer reading of the economy reveals many feasible policies. These follow from the causes of higher inflation since 2007. Research at IGIDR shows there were multiple cost shocks, starting with the international food price shocks, the outflows and rupee depreciation associated with the global financial crises and then with the Euro debt crisis, global liquidity driving up oil prices despite lower net demand, and the failure of the monsoon in 2009— the only period global shocks had moderated.
Government deficits were geared towards helping the consumption of the aam admi. A major share of the stimulus therefore created demand for diversified types of food which dominate the average consumption basket. But restrictions in agricultural marketing and food retail, in an attempt to preserve existing jobs at the cost of new ones, prevented an adequate supply response. Government foodgrain stocks were ineffectively used, but anyway cannot restrain price rise in other non- cereal items. Rising food inflation, aspirations, and schemes such as MGNREGA triggered large rises in average wages, which in turn pushed up prices. Since wages overcorrected, the rise is slowing currently. Moreover, research shows that since there was some rise in productivity, the wage rise in itself was not sufficient to sustain rising costs— it was the other supply shocks that did that.
This analysis solves a puzzle: We are told there is excess demand and the economy is overheating because inflation, the fiscal and current account deficit ( CAD) are high. But how can there be excess demand when manufacturing growth has collapsed to 0.2 per cent?
The answer is demand is in excess only for certain commodities where rigidities prevent an expansion in supply, while capital outflow- driven rupee depreciation keeps the cost of imports high. Inelastic demand for oil, in the absence of local price pass through, and for gold, given the absence of other inflation hedges, explains the CAD— it is not due to generalised excess demand.
The analysis also has clear implications for policy. Since export, investment and consumption demand have all fallen there is excess capacity in manufacturing. But shortages continue elsewhere, notably in infrastructure. The Government must clearly identify bottlenecks and kickstart stalled investment there. A focused resolve can push through select decisions independent of politics, and would be rewarded in the elections. Most of investment is now private. This tends to aggravate cycles since animal spirits sink as easily as they rise. Countercyclical measures become necessary. As shortages are alleviated costs will fall for a wider range of firms.
With some action from the Government, the RBI can support credit expansion and gradually reduce interest rates. The kind of sharp rate cuts that worked in 2008 are not possible since sticky inflation has reduced the rate of growth of bank deposits below that of bank credit. Financial savings have fallen as savers get very low real rates.
However, some recovery in the monsoon and signs of slowing wage growth mean the RBI needs to worry less about focusing inflation expectations. Low growth will contribute to anchoring inflation expectations as will some supply response facilitated by the Government. Policy should be set in a forward- looking manner based on windows of opportunity appearing at the margin. The key issue is not that inflation is still above comfort levels, but that inflation is falling and the fall is likely to continue, making gradual easing possible.
The top 50 cash- rich firms are content with high interest rates on their cash balances; smaller indebted firms are in trouble. As falling interest rates revive consumer durables demand, compensating for lower export demand, firms will turn again towards producing, investing and creating jobs for a growing workforce.