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The RBI view of India's macro challenges

The RBI view of India's macro challenges Anthony Harrington

In a fascinating speech to the London School of Economics, Duvvuri Subbarao, the Governor of the Reserve Bank of India (RBI) talked about the RBI's perspective on the macro economic challenges facing India. First and foremost, there is the fact that where India was averaging 9.5% growth in the three years leading up to the 2008 global financial crisis, today the country faces sharply decelerating growth, high and stubborn inflation and falling investment. Plus the current account deficit is now at record levels. All of this is causing anxiety to both government and the private sector, with people asking whether the country has been derailed as far as its high growth trajectory is concerned.

"Has India's potential growth rate declined? Are the growth drivers that worked our way during 2005-2008 still intact? Has the world lost confidence in India's growth promise?" All these questions require answers, the Governor said.

Subbarao is pinning his hopes on the fact that the India growth story still has legs and that the long term growth drivers are still there and still working.

"If we do the right things, we can get back on a high growth trajectory," he told his audience, but he pointed out too, that there is nothing inevitable about a return to high growth from the current prediction of 5% GDP growth for 2013.

Getting back to near double digit growth is going to take substantial and wide ranging economic and governance reforms, he warned.

India's high rate of growth pre the crisis came from a variety of factors, including the rise of entrepreneurship, the country's rapid integration with the global economy and, most of all, a massive increase in investment, driven largely by domestic savings, which in turn created a very large increase in capacity. Investment jumped from 26.9% of GDP in 2003/4 to 38.1% of GDP four years later. Improvements in technology, organisation, financial intermediation and external and internal competitiveness drove productivity, with the current account deficit running at just 0.3% of GDP. Private consumption in India accounts for some 57% of GDP and this was buoyed by rapid credit growth which ushered in higher inflation.

Growth picked up again post the crash but over the last two years a combination of factors, including much lower private investment, lower business profitability and rising input prices, particularly with respect to fuel and food prices, has caused growth to fall back by at least 4 percentage points, from 9% in 2010 to 5% in 2013. Private consumption too, retracted, down from 8.3% in 2011 and 2012 to just 4.1% in 2013. Where inflation had run at an average of 5.4% in the decade from 2000 to 2010, for the last three years it has averaged 8.7%, with a peak of 10.9% in April 2010. Subsidizing fuel prices has not protected India from inflation, Subbarao pointed out. Instead the cost of subsidies has raised the fiscal deficit which in turn fuels inflation. Those in favor of continuing welfare subsidies in India argue that removing them will cause price inflation to accelerate. Subbarao argues that while this would happen in the short term, higher prices would knock back demand, which would cause prices to adjust, while lowering subsidies would improve the fiscal deficit. Removing subsidies would also remove price distortions, improve efficiency and provide a much better investment environment, he notes.

India has also seen strong wage pressure, which in turn continues to fuel inflation.

"Nominal rural wages increased at double digit rates over the last five years. Indeed, they increased so rapidly that despite high retail inflation, real wage growth surged close to double digits in the last three years."

As the RBI Governor points out, when the per capita income of a country is down around US$1,500, any increase in real wages automatically feeds through into increased consumption, so this meant that retailers found their margins were protected despite inflation. What has happened post the crisis is that with investment declining and consumption demand staying constant until at least 2012, buoyed in part by Government subsidy programs, core inflation soared and is stubbornly persistent now despite falling output growth.

The real question then is what should India's target growth rate be going forward? What is it reasonable to expect and what should policy be geared to? Here he draws on work by the IMF and the Bank for International Settlements, which argues that real growth rates are moderating everywhere, including in developing economies. Stubbornly high inflation suggests that India's real growth rate is actually under 7%.

The RBI acted fast post the crisis to reverse accommodative monetary policies, raising the policy rate 13 times by a cumulative 375 basis points, from 4.75% to 8.5%. Wage inflation has responded slowly but it has responded, falling from 10.9% in April 2010 to 6.6% by January 2013. Inevitably the RBI has taken some stick for tightening monetary policy, and has been blamed for "choking off growth", but Subbarao says that the bank will be sticking to its guns:

"(Our) anti-inflation stance is motivated by the dictum that inflation is inimical to growth and that only in a situation of price stability can consumers and investors make informed choices."

While tight monetary policy inevitably constrains growth in the short term, and indeed, is designed to do so since it curbs demand in order to drive inflation down, in the medium term, low and stable inflation secures sustained, high, medium term growth. This is what the RBI is all about.

Further reading on India and the BRICS:

Tags: Duvvuri Subbarao , India , Indian banks , Indian Budget , Indian Business , Indian economy , Indian investments , price distortions , RBI , Reserve Bank of India , subsidies , wage inflation
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