Its forecasts assume a drop against the dollar that current inflation-differential trends can’t justify
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The International Monetary Fund (IMF) publishes its World Economic Outlook (WEO) twice a year after its Spring and Autumn meetings. It provides mini updates in January and July as well, for some countries where the facts on the ground may have altered significantly. The most recent edition of the WEO was published last month.
For India, in April, the Fund had projected a real gross domestic product (GDP) growth rate for 2021-22 of 12.5% in Indian rupee (INR) terms. However, that forecast has now been lowered to 9.5%. Its forecast for 2022-23 was 6.9% earlier and has been upgraded to 8.5%. To an extent, the 2021-22 downward revision is understandable. India endured a second wave of covid infections in April and May this year. However, since then, many private-sector economists have upgraded their forecast for India’s economic growth this financial year to more than 10%, based on more recent and real-time indicators including mobility data. The Reserve Bank of India (RBI) has kept its forecast at 9.5%.
In the case of China, the Fund’s forecast for 2021 has come down too. Compared to April, it is down by 0.4% to 8.0%. It is down by 0.1% from the July estimate. For 2022, the GDP growth estimate is lower by 0.1% at 5.6% compared to July. Compared to April, it is unchanged. It follows that, in the July WEO update, the Fund had actually upgraded China’s growth estimate for 2022 by 0.1% over April. But more interesting is the Fund’s medium-range forecasts for the next five years. For India, it is up to 2026-27 and for others that follow the calendar year, it is up to the year 2026.
In October, India’s nominal GDP for 2026-27 was projected at ₹392.84 trillion and $4.393 trillion. In the April WEO edition, the corresponding forecasts were ₹389.01 trillion and $4.534 trillion. So, secondary-school arithmetic will tell us that the Fund has become relatively more pessimistic on the Indian rupee versus US dollar (USD) in October than in April. From 70.9 in 2020-21, the Fund sees the rupee depreciating to 89.4 against the US dollar by 2026-27. In April, the implied exchange rate forecast for 2026-27 was 85.8. So, the US dollar is stronger by 4.2% at the end of 2026-27 as per the October 2021 forecast versus April’s. The effect is that India’s nominal GDP in USD terms in 2026-27 is $140 billion lower than the April forecast.
Let us examine what the Fund did to its forecasts for China. For 2026, in April, the Fund forecasted nominal GDP of CNY161.883 trillion and $24.128 trillion. In October, these forecasts had changed to CNY160.5 trillion and $24.996 trillion. This is the opposite of the revisions made to India’s GDP forecasts. In India’s case, the nominal GDP in rupee terms has been bumped up by nearly ₹4 trillion and the dollar GDP is lower by $140 billion. In China’s case, nominal GDP in CNY terms is approximately 1.4 trillion lower and higher by nearly $900 billion. In sum, China’s GDP is nearly $25 trillion in 2026 and India’s is quite some way off from $5.0 trillion by 2026-27, as per the Fund’s projections.
When it comes to forecasting exchange rates, the literature informs us that economic fundamentals do a poor job for any horizon under three years. After that, fundamentals assert themselves and do a pretty good job. Of all the economic fundamentals that influence exchange rates, the one enduring factor is the inflation differential. In other words, relative purchasing power parity holds over long horizons. Nearly a decade ago, in their annual investment returns yearbook for Credit Suisse, financial historians Dilroy, Marsh and Staunton noted that the pound sterling had depreciated by about 1% on average per annum between 1904 and 2004. The annual inflation differential between the UK and the US was also around 1%. So, assuming that inflation differentials will do a better job of explaining the dollar-rupee exchange rate over a 5-year horizon is not an unrealistic assumption.
But space for disagreement arises in the interpretation of incremental data flow between April and October. Even the US Federal Reserve concedes that the high inflation rate in America that was considered transient is now deemed more permanent. Consumer-price inflation rate has been stubbornly at or above 5% for the last five months. There is talk of a ‘Great Resignation’ movement in America. Many workers are leaving their jobs. There is a data chart on unfilled US job openings available with just a keystroke or two that is a sight to behold (bit.ly/3CPqRpE). Workers are feeling emboldened to announce industrial action. These trends portend higher wage inflation and hence higher consumer price inflation. Lest we forget, ‘inflation targeting’ was a political-economy project launched in the 1980s to tilt the balance of power towards capital away from labour. The wheel may have come full circle. Pandemics have that effect. Finally, as Goodhart and Pradhan remind us in their book, The Great Demographic Reversal, Western economies may have no choice but to choose the lesser evil of inflation to reduce the threat of the other evil, ‘debt’.
So, for any USD-INR forecast, higher inflation rates in India over the US that have been the default factor for the past few decades cannot form the basis. The Fund may have to revisit its implicit forecasts for USD-INR in April 2022.