What is India’s sustainable growth rate, the rate at which inflation is kept low? It’s 7%, according to the Reserve Bank of India (RBI). In an interview to The Wall Street Journal, governor D. Subbarao asks, “What is our potential growth rate, non-inflationary stable growth rate?” and replies to his own query: “Non-inflationary growth rate is about 7% or so.”
In other words, growth beyond 7% results in the economy overheating. In a speech in Chennai last month, RBI deputy governor Subir Gokarn had said the growth threshold was 7% in the mid-1990s, but had gone up to 8.5% in the early 2000s.
In the interview, Subbarao says that in order to grow beyond 7% without having high inflation, it’s necessary to increase supply. And the key structural change RBI is looking for is reform in public finances.
Subbarao’s statement has several implications. It means the slowdown in GDP growth this year to 6.9% is not an aberration and it is what RBI wants, given the current structural constraints in the economy. It should follow, therefore, that RBI would be loath to ease policy solely in order to improve growth beyond 7%. Since the government estimates GDP growth in 2011-12 at around 7%, that implies growth in the second half at around 6.5%. RBI will, therefore, cut rates to get growth back to 7%, but the rate cuts won’t be much and they will be cautious. Supply-side measures take time to work, so the 7% target for non-inflationary growth should hold for 2012-13, too, unless the go ernment is able to take credible steps to improve its finances or implement structural reforms.
That brings us to the upcoming budget and its importance in 1) putting government finances on a firmer footing, and 2) announcing steps to augment supply. If, as Subbarao says, reform in public finances is so important, then it’s unlikely that RBI will announce rate cuts at its next monetary policy meeting, simply because the budget will be presented only a day later.
On the other hand, as Saugata Bhattacharya, senior vice-president and economist at Axis Bank Ltd, points out, “If the Union budget announces measures to improve the supply side, then the non-inflationary rate of growth will rise to a higher level and RBI will be in a position to be more aggressive with its rate cuts.” Such an outcome is also likely if the government reduces fiscal deficit, because that will constrain growth and RBI will respond with larger rate cuts to maintain growth at 7%.