Rama Krishna Vadlamudi, HYDERABAD 31 August 2011
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For quite some time, economists and market pundits have been telling that the Indian economy is in a slowdown. This has now been confirmed by the latest figures of GDP released by the Government of India. As per the data released on 30 August 2011, the first quarter (April-June 2011) GDP growth rate has come down to 7.7 per cent as against 9.3 per cent in the corresponding quarter of last year. However, the growth rate of April-June 2010 quarter is revised down to 8.8 per cent from 9.3 per cent as per the new series of Index of Industrial Production (IIP) with 2004-05 as base year.
What is noteworthy is that the quarterly growth rate has been on a downward spiral since April-June 2010 quarter as the RBI has been increasing interest rates since March 2010.
It is now official that economic activity is slowing down. What is pulling down the economy is a sharp dip in the growth rate of construction sector to 1.2 per cent in the latest quarter compared to the 7.7 per cent growth rate in April-June 2010 quarter. Other sectors that have contributed to the lower economic activity are: Mining and quarrying: 1.8 % (7.4%); and Community, social & personal services: 5.6 % (8.2%). The sectors that are doing better are: Agriculture, forestry & fishing: 3.9 % (2.4%); and Electricity, gas & water supply: 7.9% (5.5%). (Figures in brackets are for April-June 2010 quarter).
Policymakers are usually in the habit of talking up the economy. Of course, it’s their job! The cheerleaders say that the Indian economy will pick up pace in the second-half of the fiscal year. However, as is well known, empirical evidence suggests otherwise. In the last seven years, second-half growth rate is lower than that of first-half growth rate in five years.
Equity markets have taken the GDP figures in their stride and the reaction is muted except for the negative effect on prices of Larsen & Toubro and others. Now, the markets are trying to guess what the RBI will do on September 16th when it meets for policy rate revision. There are two strong opinions about further rate hikes by RBI. One camp feels that RBI should not raise rates further as the economy is already slowing and the stubborn inflation is caused by supply-side factors and other factors not connected with monetary measures. The second viewpoint is that RBI will opt for a further 25 basis point (0.25%) increase as inflation is not showing any signs of cooling down. My guesstimate is that RBI will go for a Repo rate hike of 25 basis points on September 16th.
GDP Growth Rate Declining
The steady decline in growth rate is due to a variety of factors, the main being the relentless raise of interest rates by Reserve Bank of India since March 2010. RBI’s hawkish monetary policy seems to be having the desired effect. Other factors contributing to the decline of GDP growth rates are: slowdown in investment cycle, policy-related issues such as, delays in land acquisition for new projects and environmental clearances. Major projects have been help up over the past few years.
Notes: Q1 2011-12 figure is based on new IIP series 2004-05 and other quarters are based on old IIP series 1999-2000.
Q1 – 1st quarter (Apr-Jun), Q2 – 2nd quarter (Jul-Sep), Q3 – 3rd quarter (Oct-Dec), and Q4 – 4th quarter (Jan-Mar). Source: CSO
RBI’s Repo rate hikes
Reserve Bank of India has been increasing Repo rates (the main policy rate) since March 2010. The Repo rate under RBI’s liquidity adjustment facility (LAF) has been raised by 325 basis points in the last 18 months; with 125-bp hike coming in the last three months.
Source: RBI
Overheard!
(It is fashionable to convert
everything into gold now)
Investment cycle slowing down
Estimates based on the expenditure side of the GDP also point to a slowdown in growth rate. If one looks at the figures of gross fixed capital formation (GFCF), it is very clear that the total investments made in the economy are tapering off. GFCF figure of Rs 4.11 crore (at constant 2004-05 prices) for the first quarter shows a year-on-year growth of only 7.9 per cent against 11.1 per cent growth rate in the corresponding quarter of previous year. Other two indicators, private final consumption expenditure (PFCE) and government final consumption expenditure (GFCE), are also pointing out the same downward trend. (See below for some definitions)
Half-yearly GDP growth rates
Many economists and policymakers want us to believe that second-half (October-March) growth rate is greater than that of the first-half (April-September). Empirical evidence suggests otherwise. Between 2004-05 and 2010-11, GDP growth rate in first-half (blue bar) was higher than that in the second-half (red bar) of the financial year in five out of seven years as can be seen from the graph below. Only in 2009-10 and 2005-06, second-half growth rates were higher than those of first-half. Of course, GDP in absolute terms is traditionally higher in the second-half compared to first-half.
Notes: H1 - April-September, and H2 – October to March. GDP at factor cost at constant prices (1999-2000) for years from 2004-05 to 2008-09 and for years 2009-10 & 2010-11, figures are GDP at factor cost at constant prices (2004-05). Source: CSO
Yearly GDP growth rates
As can be seen from the graph depicted below, the yearly GDP growth is on a roller coaster, moving up and down every two to three years.
Notes: GDP at factor cost at constant prices (1999-2000) for years from 2004-05 to 2008-09 and for years 2009-10 & 2010-11 figures are at constant prices (2004-2005). These are as per old base year of IIP series 1999-2000. The growth rate for 2007-08 is revised up to 9.2% from 9.0% as per new IIP series 2004-05. CRISIL opines the GDP growth rate for 2010-11 may be revised upward to 8.9 per cent as the latest estimates.
GDP prediction for 2011-12
We are already inundated with various estimates of GDP growth rate for the current financial year 2011-12. While RBI has come out with a forecast of 8 per cent GDP growth rate, the Centre for Monitoring Indian Economy (CMIE) has revised down its forecast to 8.2 per cent. However, many brokerage houses have revised their forecasts downward following the relentless raise of interest rates by RBI and global headwinds in the form of sovereign debt crisis in eurozone and the US losing its AAA credit rating. Their prediction is around 7.5 per cent growth rate for Indian Economy. Considering all the macro economic indicators, it would be safe to assume that India’s GDP growth rate will be in the range of 7.5 to 8.0 per cent for 2011-12.
Arguments for and against further policy rate hike by RBI
There are two powerful arguments at this point of time in favour of and against further rate hikes by RBI. The industry is of the opinion that the Reserve Bank of India should not further increase interest rates as GDP growth will be further contracted in future. Monetary measures will not be able to contain inflation caused by supply side factors.
Another view is that RBI will increase LAF-Repo rate by another 25 basis points (0.25 per cent) on September 16th during its interest-policy review meeting. It is argued that RBI will continue to focus on curbing inflation as the headline inflation is showing no signs of coming down. Even after the S&P downgrade of US’ credit rating, RBI top officials have given the impression that the biggest concern for them is inflation.
Arguments For Rate Hike Arguments Against Rate Hike
Food inflation is still high at 9.8% Crude oil prices have cooled off
Headline inflation is still at 9.2% and as such RBI and the Government are not comfortable with stubborn inflation Inflation is due to supply side factors and interest rates have no impact on supply chain bottlenecks
The Government seems unable to do anything thro fiscal measures, hence RBI is solely responsible for inflation containment Employment-generating sectors, like, construction, are adversely impacted
RBI's moves were dovish in 2010, hence it needs to continue with its hawkish outlook in 2011 Power sector, which is vital for the economy, is already suffering from coal shortages and interest burden
RBI does not want to be seen as going slow on controlling inflationary expectations Slowdown in GDP is already visible in automobiles, housing, etc., which may kill growth
Brent crude oil price touched 2011-year high of $127 and Nymex crude $114 per barrel – both during the second week of April 2011 and the prices have since cooled off. Now, Brent crude is quoting at $114 and Nymex crude at $88 per barrel. There are concerns about India’s fiscal deficit going out of hand. The effect of interest rate hikes is usually felt with a time lag of one to two years and their full impact is yet to be felt in the economy. The progress of monsoon till August is fairly good. Exports growth in the last three quarters is quite robust though imports too are growing at a strong pace. In toto, the signals are a bit mixed.
Against this scenario, will RBI raise interest rates further? It is a difficult question to answer. However, if one goes by the RBI’s moves in the last few years, one may come to a conclusion on this issue. Let us go back a little to understand RBI’s moves. When RBI started raising interest rates in March 2010, it said its measures were ‘baby steps’ in order to keep growth prospects intact. It was trying to maintain a balance between growth and inflation. At that time, the expectation of the RBI was that inflation would come down by November/December 2010. RBI continued its dovish monetary policy till December 2010 by raising Repo rate by small measures of 25-basis points each.
But, economies have a habit of tossing up surprises and we need to expect the unexpected. RBI’s expectations about inflation proved wrong as inflation (RBI uses wholesale price inflation index– WPI – for inflation management) did not show any signs of relenting even after December 2010. During the early part of this calendar year (2011), RBI changed its dovish stance and turned hawkish. And it started raising rates more aggressively. During the first seven months of this calendar year, RBI has raised interest rates by 175 basis points or 1.75 per cent.
Even though global developments – in the form of sovereign debt crisis in Europe and downgrading of US’s credit rating – have turned negative, RBI would find it difficult to take any drastic steps and change its hawkish stance toward interest rates. RBI may opt for some kind of consistency in its approach toward monetary policy. Until headline inflation shows clear and sustainable signs of deceleration, RBI may not change its current stance and may opt for a 25-bp rate hike on September 16th giving some indications of interest rates peaking – and this view is subject to one condition that there won’t be any nasty surprises in eurozone or in other countries.
Some Terms Explained
1. GDP at factor cost: GDP at factor cost is calculated as the total of all the eight sectors, namely:
1. Agriculture, forestry & fishing
2. Mining & quarrying
3. Manufacturing
4. Electricity, gas & water supply
5. Construction
6. Trade, hotels, transport & communication
7. Financing, insurance, real estate & bus. sers
8. Community, social & personal services
Broad classification of GDP at factor cost is as follows:
I. Agriculture : Item 1 above
II. Industry : Aggregate of items 2, 3 & 4
III. Services : Aggregate of items 5, 6, 7 & 8
2. GDP at market prices: GDP at market prices is the sum of the gross values added of all resident producers at producers’ prices, plus taxes less subsides on imports, plus all non-deductible VAT (or similar taxes). GDP at market prices is equal to GDP at factor cost (as per 1 one above) plus taxes minus subsidies. It can also be calculated by adding PFCE, GFCE, GCF and exports and reducing imports
PFCE – Private final consumption expenditure is expenditure incurred for consumption of food, beverages, tobacco, gross rent, fuel & power, clothing & footwear, furniture & appliances, medical & health services, transport & communication, recreation, education and others.
GFCE - Government final consumption expenditure consists of expenditure incurred by the government on both individual consumption goods and services and collective consumption services.
Gross Capital Formation (GCF) refers to the aggregate of gross additions to fixed assets (fixed capital formation), increase in stocks of inventories or change in stocks (CIS) and valuables. (GCF = GFCF + CIS + valuables)
Gross fixed capital formation (GFCF) is a measure of total investments made in the economy. It is measured by the total value of all fixed assets acquired less disposals, plus certain additions.
Notes:
The estimates of Quarterly GDP have been compiled by CSO using the new series of Index of Industrial Production (IIP). The new series of IIP with base 2004-05 was released by CSO on 10th June, 2011. The new series of IIP is based on a representative item basket comprising 682 individual items.
Abbreviations: CRISIL – Credit rating agency, CSO – Central Statistics Office (formerly known as Central Statistical Organisation), GDP – Gross Domestic Product that is national income, IIP – Index of Industrial Production, LAF – liquidity adjustment facility of the RBI, RBI – Reserve Bank of India, and US – United States.
Disclaimer: The author’s views are personal. He has a vested interest in the stock markets and his views should be taken with a pinch of salt. He may change his views very fast without any notice depending on the market and economic conditions. His views should not be construed as investment recommendation. Investors need to consult their certified financial adviser before making any investment decisions.
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