The global economic environment has been a sour point for the Indian investor. There are worries on the lines that how can India grow at a time when global growth is slowing down.
Interestingly, historical data points towards the fact that India’s strong economic performance in the FY04-FY08 period was driven largely by domestic factors rather than the much thought about external factors which were actually a net drag. Furthermore, it is still possible for that performance to be repeated today.
The drivers of the Goldilocks phase from FY04-FY08 The 5-year period from FY04-FY08 was a strong growth phase (GDP grew 8.8% p.a.) for India. It is often argued that this performance was possible only because global growth was strong. However, the numbers clearly do not support this “reliance on the global economy” thesis.
Specifically, the contribution of the external sector (net exports) to India’s growth during this phase was actually negative (on average -0.9% p.a.). Yes, export growth was strong, but that only partly offset the higher import bill (during this period net oil imports increased from $15 billion to $51 billion). On a net level, the contribution of the external sector remained negative.
So what drove the strong performance? Well, domestic demand — both investment and domestic consumption — was strong.
Specifically, investment on an average contributed 5.7% while consumption contributed 5.1% to annual growth. The one factor that enabled this investment growth was higher domestic savings rate.
The savings rate which had languished in the low to mid 20% range till the early 2000s, increased sharply to mid-30% range. Essentially, the economy was in a virtuous cycle. A higher savings rate enabled higher investments and consequently, capacity creation and this capacity was absorbed by domestic demand.
The fundamental point is that the only reason an economy needs exports is to pay for its imports. As long as you can pay for your imports (i.e., the current account is in reasonable shape), exports are not a limiting factor for growth. Domestic demand can support growth.
Currently, for the Indian economy, the short-run challenge today is shortfall in aggregate demand, and accommodative monetary policy is the best solution for this problem.
Supply side reform, while key for the long-run, will not by itself address the short-run problem.
The case for accommodative monetary policy
What ails the Indian economy today is excess capacity. Policy, therefore, should stimulate demand. Evidence of weak demand and low capacity utilisation is not difficult to find.
The cement sector is operating at only about 70% utilisation. Similarly, commercial vehicle output in FY16 was below FY12 levels, while passenger car output in FY16 was only at FY12 levels. Even steel consumption growth had dropped to zero for a few months in FY17.
So, if the economy has excess capacity it is only logical to argue for policies that stimulate demand. It then comes down to choosing between monetary and fiscal policies.
The reason for preferring a monetary stimulus is that it can be reversed easily once demand has picked up. A fiscal stimulus generally tends to be difficult to reverse (e.g., 7th Pay Commission).
So while in theory, a “timely, targeted and temporary” (Larry Summers’ criteria) fiscal stimulus would be equally effective — in practice, fiscal actions seldom meet these criteria. A permanent fiscal expansion, of course, hurts the long-run growth potential.
Some economists argue against a monetary stimulus on the grounds that investment is being held back not so much by interest rates but by other bottlenecks. The question I would like to ask them is “would you not argue against a 2% increase in the interest rate on the grounds that it would hurt investment?”
Essentially, it is inconsistent to argue that raising rates will hurt investment and lowering rates will not help. The fact that there are other headwinds hindering investment is an argument for greater monetary easing — not an argument for doing nothing.
Separating the short run from the long run
An argument for demand stimulus is not an argument against structural or supply side reform.
Supply-side reform has to be implemented to raise trend growth rate (or the potential output of the economy). The argument for a demand stimulus recognises that currently, output is below potential (growth is below trend) and it is important to close this gap. Increasing capacity without stimulating demand would amount to pushing on a string.
This article was published on November 04, 2016 in Economic Times
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