Home / Opinion / Lower rates alone can’t propel growth

The Reserve Bank of India’s (RBI’s) decision to cut rates by 50 basis points (bps) on Tuesday, more than the 25 bps expected by market consensus, highlights that India’s growth recovery has been more gradual than was initially anticipated.

India’s gross domestic product (GDP) growth rate decelerated to 7% in the first quarter of this fiscal year, from 7.5% in the prior quarter, while the rupee has fallen by 4.4% against the US dollar since January. These trends reveal that although domestic demand drives India’s economy, global growth and capital market trends can still exert a significant economic impact.

Still, India has fared better than many of its emerging market peers. GDP growth of 7% is higher than the average for most large emerging markets in the first half of 2015. And the rupee has depreciated less than the Malaysian ringgit, Indonesian rupiah and the Brazilian real over the last year, suggesting that India has suffered less from capital outflows than these peers.

This relative resilience owes to three factors. The first is structure. India’s economic size and diversity help it absorb growth shocks. The abundance and low incomes of its labour force support growth potential, as does the agility of its private sector, which has demonstrated the capacity to survive adverse domestic and global circumstances.

Second, India benefits from its status as a commodity importer. Oil imports accounted for about third of the value of its merchandise imports when oil prices were at their peak, but their subsequent decline has reduced the country’s import bill and current account deficit, despite a weak export performance.

Moreover, India’s balance of payments has escaped the capital account volatility that afflicts commodity exporters, as markets respond to potentially lower growth and profitability in those countries. In addition, falling commodity prices have helped lower inflation which, in turn, has improved household purchasing power and supported the gradual recovery in domestic demand that now appears underway.

These factors contribute to the third reason for India’s resilience: the current uptick in the domestic business cycle occurs at a time when the forecast for most large emerging markets is for slower growth when compared to previous averages. This situation attracts capital flows, which may be scarcer for other emerging markets, given rising risk aversion, and the prospects of higher monetary
policy rates in the US.

However, whether the Indian economy will take advantage of current global conditions to propel itself to a higher growth path will ultimately depend on whether India’s policy framework creates conditions for such growth to be pursued by the private sector.

Monetary policy has supported the growth outlook for India but not simply through the rate cuts that commenced this year. In fact, India’s resilience to global volatility, described above, owes partly to the monetary policy tightening that occurred two years ago in response to high inflation and wide current account deficits in 2012-13. This tightening—in conjunction with other factors such as lower commodity prices—has helped restore the country’s macro-economic balance.

This balance came at the price of growth over the last two years. But current lower inflation levels and strong monetary policy credibility have set the stage for higher growth to continue for longer than would have been the case under uncertain monetary policy conditions. A demonstrated commitment to low and stable inflation will also constitute an important determinant of foreign investor interest.

Following RBI’s decision to cut interest rates by 50 bps, market attention has turned to the likelihood of another cut in the future. But lower monetary policy rates alone cannot propel growth towards a sustainable higher trajectory. For that, the operating environment for private investment would have to improve further.

Policies that ease regulatory complexity and increase government effectiveness in service delivery will allow the manufacturing and infrastructure sector to take advantage of current low commodity prices and global capital seeking productive investment destinations. Global conditions offer India a window of opportunity to accelerate GDP growth. Monetary stimulus can help revive growth, but without structural reform, it will be difficult to sustain this growth.

Atsi Sheth is associate managing director (sovereign risk group) at Moody’s Investors Service.

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