All economic policies are based on certain stylized expected outcomes that are dictated by economic theory. Accordingly, various indicators are tracked and policies are fine-tuned. But what in case there are contrary signals sent by these indicators? In 2009-10, there is evidence of contradiction where final outcomes have deviated from the expected. This makes it difficult for policymakers to conjecture future outcomes based on present observations, which would otherwise easily be taken as prior justifications for policy moves. Let us consider the five such situations India threw up last year.
The first relates to gross domestic product (GDP) growth. India was anyway not sure of the outcome of the financial crisis in early 2009; the monsoon failure just strengthened the belief that the economy would be in for a roller-coaster ride. However, the Central Statistical Organization estimates 2009-10 growth at 7.2%, others not ruling out 8%-plus. While this is good news, the conclusion is that the economy has got decoupled from agricultural performance—a sector that could be in the negative zone notwithstanding a healthy rabi harvest.
Illustration: Jayachandran / Mint
Conventional theory says that agriculture affects the economy in two ways. One is on the demand side, where farm incomes are directed to non-farm goods and services. This has not dampened the growth in industry—especially for consumer durable goods—lending credence to the thought that a sector which has an 18% share of the GDP may not be the be-all-end-all for the country’s economic growth. The other is that this sector provides inputs for production of food products, which come into the Industrial Index of Production (IIP). If one looks at the IIP data, industry has moved ahead quite exceptionally: This means that growth through the capital goods and intermediate goods sector can propel the economy even if agriculture fails. The fiscal stimulus has, no doubt, played its part in reversing a potential adversity.
The second situation relates to the slower growth of bank credit, at 16.7% in 2009-10 against 17.5% in 2008-09. This is the quickest indicator of industrial growth, but sends contrary signals when juxtaposed with the actual IIP data. Clearly, industrial growth cannot be linked only with credit as the other avenue of funds—capital markets—has been ebullient, around Rs2.59 trillion being mobilized in 2009-10 against Rs1.54 trillion the previous year. Disintermediation has played its role—the bank is no more required as a middleman. This proves that bank credit is a sufficient, though not necessary, condition for growth. Alternatives do exist.
The third atypical trend seen in the credit market is the absence of a liquidity squeeze despite heavy government borrowing. Borrowings exceed Rs 4.5 trillion in both 2009-10 and 2010-11. Yet, it has been the case in the past that the Reserve Bank of India (RBI) has managed these borrowings without the environment getting obtrusive for private players. The “crowding out” theory—that government asking for funds deprives the private sector of the same funds—does not always hold. More importantly, cogent liquidity management by RBI through open market operations and unwinding Market Stabilization Scheme, or MSS, bonds has made the environment less stifling by infusing more cash. RBI’s monetary policy for 2010-11, released last week, can draw solace from this.
Fourth, the rupee should have been under pressure due to the gradual reversal in trend of trade— both exports and imports have increased. The trade deficit is at $97 billion for the first 11 months, which would ordinarily dictate that, because more non-rupee goods are in demand than rupee goods, the rupee should be weak. Yet the rupee is stronger, having appreciated by around 11% this year.
In the past, the trade deficit was critical; only remittances and software inflows provided some cushion. But, this has been passé for the last few years, as foreign capital has galloped into India through the capital account route. Foreign direct investment inflows and new foreign institutional investor flows were each around $24 billion between April and February. This demand for rupee assets has made the rupee stronger. The message is that a current account deficit may not matter that much today.
Fifth, there is an apparent paradox of food inflation amid overcrowded government warehouses. How is this possible? In actuality, the country is rich in only rice and wheat—these were around 46 million tonnes in March; there is shortage of other products such as pulses, oilseeds, vegetables and fruits, which has directly increased these food prices. And when the government reiterates the existence of high food stocks, it is more of propaganda; in fact, the government has affected rice and wheat prices too. Higher procurement at increased support prices and excess buffering by the government has meant less for the market and, thus, higher prices for us consumers.
All these pictures actually explain how the economic dynamics have deviated from conventional wisdom. This raises some interesting conundrums for policy formulation. Does growth in farm output, bank credit, government borrowings or trade deficit really matter in the broader picture? Or are farmer-supportive policies neutral in their impact? A fresh look beyond the textbook may be required. Policymakers can no longer assume that established shibboleths always hold.
Madan Sabnavis is chief economist, CARE Ratings. Comment at firstname.lastname@example.org