You don’t respond to supply shocks by adding demand: JPMorgan’s Jahangir Aziz9 min read . Updated: 06 Oct 2017, 01:09 AM IST
On India’s state of economy, trigged by the slowest GDP rate of 5.7% in three years, JPMorgan Chase chief Asia economist Jahangir Aziz says both policymakers and analysts haven’t got the diagnosis right
Singapore: Amid the ongoing debate in India on the state of its economy, trigged by the latest quarterly gross domestic product (GDP) rate of 5.7%, the slowest in three years, Jahangir Aziz, chief Asia economist at JPMorgan Chase and Co., says that both policymakers and analysts haven’t got the diagnosis right.
India has been confronted with a supply shock that took away 3 percentage points from GDP growth, Aziz said in an interview.
“You do not respond to a supply shock by adding more demand. If you do that, then the extra demand that you just added either through rate cuts or higher fiscal deficit will almost instantaneously get transferred into higher imports that will widen the trade deficit and put downward pressure on the rupee. So our concern is that if you get the diagnosis wrong, you will probably get the treatment wrong, too," he said.
Are investors worried about India’s faltering macro numbers? So far, despite India failing to register much of an earnings growth recovery, or credit growth, investors appeared happy with the country’s macro numbers. Is that changing?
I don’t think so. While this is not my point my view, I am expressing what clients think about India. People are surprised why there is so much attention paid by the Indian government, analysts and the media on the 5.7% growth number. These things happen, and in the larger context, 5.7% is still a very good number. Just from a purely clients’ point of view, I would say, the further away you go from India, the less you are caught up in the noise and the hype, and therefore the less concerned you are about one quarter of bad GDP number.
That said, people still don’t understand why India had to undertake demonetisation. People are looking at it in terms of how successful it has been in meeting its objectives. Similarly with GST—everyone knows it will improve efficiency and it converts India into a single market for the first time, but why have five bands?
We know from experience from other countries that GST works only when the bands are much fewer than 5. In India itself, we had about 15 years of experience of the service tax, which had worked so well because it was a single rate.
So there are question marks about certain policy actions, and a lot of bemusement at the excessive attention on the 5.7% growth number.
If 5.7% is just one quarter number, does India face an economic mess at all?
What I had said earlier was the view of most clients that we speak with, and it was not our view.
Our view is that the problem with the 5.7% number is that almost everyone seems to believe that this is due to a demand shock. If you actually look at the numbers, and look at the arithmetic behind it, you will realize that if India’s imports in the last quarter had grown at the same pace as that of the previous quarter, then GDP growth would have been 8.7%, because most of the demand that got disrupted under demonetisation has come back.
Instead, it was not just demand that got disrupted, but supply chains, too, so that when the demand came back, it was not domestic production that fulfilled it, but it was higher imports.
Manufacturing imports today is running at 24-25% year-on-year growth rate, and trade deficit, which used to be $4-5 billion in the middle of 2016, is now running at $14 billion, and therefore our concern is that both policymakers and analysts haven’t got the diagnosis right.
It is a not a demand shock that you respond to by cutting interest rates or by easing fiscal policy. It is a very large supply shock that took away three percentage points from GDP growth. You do not respond to a supply shock by adding more demand.
If you do that, then the extra demand that you just added either through rate cuts or higher fiscal deficit will almost instantaneously get transferred into higher imports that will widen the trade deficit and put downward pressure on the rupee.
So our concern is that if you get the diagnosis wrong, you will probably get the treatment wrong too.
So what is the way forward for India?
The way forward is doing what this government has been doing right from the beginning, namely reducing the cost of doing business.
You do that by continuing what has been done in the last three years—create systems that are more efficient, create infrastructure networks that are more efficient. GST will have teething pains, and you have to stick to it, but you can’t have five bands. That raises the cost of GST.
These are unnecessary and they increase the cost of doing business. Demonetisation increased the cost of doing business in the informal sector.
The cost of business, which the government can reduce today, is the price of petroleum. If you look at the pump price of petroleum in India, when oil price fell from $110 to $25, the equivalent of the pump price did not fall from $110 to $25—it got stuck at $75-$77 per barrel, and the entire decline in oil price after that has been collected as excise tax.
Currently, the pump price may be equal to around $75 per barrel, whereas you are buying oil at around $55, and so there is almost a $20 excise tax per barrel on Indian petroleum.
Reduce this to zero and there is almost 35% to 40% decline in the pump price instantaneously—that brings down inflation massively—almost a 6-7 percentage point decline that will happen over 3-4 months.
That means RBI’s (Reserve Bank of India’s) space for cutting rates opens up massively.
You can then reduce the cost of GST and demonetisation to the inputs to the manufacturers with that 35% to 40% decline in transport costs, and at the same time, you are increasing the disposable income of individuals. But there is a cost, which is lost revenue from the excise tax, and that means higher fiscal deficit.
If you are so concerned about higher deficit, then increase privatization. That’s the way to respond to a supply shock with a supply-side policy change and it can happen today with instantaneous effect.
If we were to look at August data, does it point to early signs of revival in economic growth? Sales of two-wheelers, commercial vehicles and tractors, power generation, steel production, airport traffic and fund-raising from equity markets by businesses are all up in August when compared to previous month—does this data suggest that aftershocks of demonetisation and GST rollouts are wearing off?
As I have said earlier we think that the last quarter growth decline was because of a supply, not a demand shock. The key variable that I am going to wait for is industrial production.
Most of the other data you are suggesting doesn’t lend itself easily to extracting supply vs demand components.
For example, electricity production is going up because people are using more electricity because August was a hot and humid month, or is it because industries are operating for longer hours? I would therefore wait for industrial production numbers and also for the trade numbers. If IIP (index of industrial production) starts moving up and imports are moving down, I would say the supply-side shock is dissipating.
Considering that everyone is talking about big reforms, and in the process, are we missing out on the smaller steps or policy changes that can be taken, that will have an immediate impact?
Of course! There is an endless list of reforms that are seemingly small but can have a huge impact—some of them are very technical and some are non-technical. Some of these reforms are such that no one will even bother about it—forget about there being political pressures. But whatever you want to do, it has to stem from an understanding of where India is, and where the global economy is. And if you get that diagnosis wrong, then you will be chasing reforms that are inappropriate. For example, right now, the conversation is on the massive demand shock that has rocked India’s growth—there is no demand shock in India, and it is a supply shock.
If you take health insurance in India, the amount an insurance provider pays to an individual is capped over his or her lifetime.
So an individual has to pay the residual which could be very large and consequently, we are forced to save an enormous amount unnecessarily. Most countries have the opposite. The out-of-pocket expense of an individual is capped, the residual is the responsibility of the insurance company. If India does what most other countries do then this seemingly small step will ensure households no longer need to save large amounts for health. This would open up space for spending on other things, providing a significant boost to industries that cater to domestic demand. Such steps don’t have fiscal costs—you just have to ask the regulator to do it.
When you look at India from abroad, are investors concerned about the tax cases, be it corporates or even individuals, are they concerned about the so called tax terrorism?
There are obviously 1-2 cases that remain in the headlines, and these are muddied enough that no one really focuses on them.
These are longstanding issues that both sides need to resolve. I don’t see that kind of reaction that happened back in 2012 when retroactive tax was suggested—that has faded.
From a foreign investor point of view, it is an irritation and we are not getting anywhere by keeping the problem festering.
Looking at job creation, how big a challenge is that?
It is a huge issue. Let us not pretend otherwise. Now, there is an argument that India has seen jobless growth over the last 10 years. This is an exaggeration. Just because we don’t have data on employment doesn’t mean no jobs were created. I would argue we have fallen behind adequate job creations though.
The number of new entrants into the job market for the next 10 to 15 years—because of demographics—is going to increase significantly. If you take China vs India, one of the reasons China can afford to let its growth slow, is because it is no longer adding 12 million new workers to its labour force every year as it did back in the mid-2000s.
So rather than the number of jobs, China can instead focus on the quality of jobs. India has exactly the opposite problem. That necessarily means India not only has to grow, but has to grow faster than it has been growing so far, just to keep pace with new entry of workers into its labour market.
The problem is, the Indian labour force that is entering the market has very low skills, and not just this government, but also the previous government has never really focused on skill development.
The number of public universities, schools, technical institutions—all of these should have expanded many more times to deal with 13-14 million of new entrants into the labour force annually, and we have not done that.