What does China’s rate cut mean to us?

In an unexpected shift in its monetary stance, the People’s Bank of China cut rates on Friday to try and shore up economic growth. The slowdown in real GDP growth to a predicted 6.5 per cent from the glory days of 12 per cent, prompted immediate response measures from the policy authorities. The Chinese action was an admission that 6.5 per cent growth is an insufficient national target and reinstates the widely held belief amongst global investors that China is not insulated from the economic events in the rest of the world either.

Brazil, India and Russia, for reasons unique to each of their economies, are still pursuing a tight money policy. This recent development in China is interesting and lends food for thought on whether India should be doing any adjustments to its own monetary policy framework.

In a world starving for economic growth, the battle for exports will continue. The growth game has now evolved into one where countries are actively trying to devalue their currencies through easy money with a view to stimulating export-oriented growth.

There is one problem here. To export goods and services aggressively, there needs to be an open-ended receptacle to absorb these exports seamlessly. Unfortunately, there is no logical receptacle in the world that can absorb the massive need and desire to export emanating from countries like India, China, Japan, Brazil and Germany, to name a few.

If the US is supposed to be that receptacle, the world is looking in the wrong place. Despite its lukewarm 2.5 per cent average GDP growth for 2014, the US is reeling from the weight of its own debt structure and cannot afford to absorb the global exports endlessly. Europe, facing the threat of deflation and growing at less than 1 per cent, is not the answer either. This is where India needs to have a differentiated strategy to prosperity and growth.

Tempting prospect It is tempting for Governor Raghuram Rajan, on the back of the PBOC action, to ponder the possibility of taking the foot off the brakes and cutting rates to increase liquidity in the economy and stimulate growth. I’m certain most corporate CEOs in India would welcome that. After all, inflation has been coming down and growth is slowly beginning to pick up. Whilst it is tempting, this action would most certainly be the wrong policy move for the RBI governor to take at this stage.

Recently, market interest rates in India have edged lower on the back of a reduction in expected inflation, and with global energy prices moving sharply lower, the trade deficit numbers will improve. It’s no surprise that the rupee is finally beginning to show signs of stability.

A stable currency is important in a quasi-open economy to cushion the blow of volatile global commodity prices that may adversely affect input costs and put pressure on domestic inflation.

The annual wholesale price inflation in India just recorded 1.77 per cent in October, the lowest since October 2009. A move to an easier money policy at this stage will undo most of the good work that Rajan has embarked upon since getting there. More importantly, not cutting rates now gives him the flexibility to keep potential rate cuts in his back pocket if energy prices were to rise and cause a slowdown in growth.

Target inflation Unlike the US, India is generally less dependent on asset prices and wealth creation derived from stock and bond markets to drive consumption and growth. Further, with the Indian stock markets behaving as though they are already on steroids, an infusion of additional liquidity at this stage will most certainly be counter-productive.

The RBI must continue to focus on dampening inflationary expectations through inflation targeting. This will create an environment for a stable rupee. They should then leave it to Delhi to deliver on much needed fiscal reform and consolidation to set the conditions for real interest rates to edge lower and to get growth back on its right trajectory.

It is now a well accepted fact in economic literature that the long run real growth rate for an economy is determined by the ratio of gross investment to GDP as well as the productivity of the capital that is employed. So fiscal policy measures that attack the issue of increasing gross private investment and incentivising that capital to be more productive is what is most needed at this stage. To do this, the government needs to ask to what extent their fiscal deficits (through higher real interest rates) are crowding out private investment and creating supply side constraints.

Recent research completed by our firm Meru Capital on the crowding out effect of government deficits in India document interesting implications for public policy. A 1 per cent increase in the fiscal deficit holding all other factors constant, impacts private sector investment adversely by approximately 25 bps. In other words, government deficits do end up crowding out private investment.

Deficits out investments The only place where our research finds this elasticity to be actually positive is in sectors where the fiscal deficit is targeted specifically at infrastructure spending. Here the results of a 10 per cent increase in public investment targeted at infrastructure projects has a positive 3 per cent impact on new private sector investment spending, albeit with a lagged effect. The time lag that we find in the pick-up of private investment is typically two to three years. This is because the infrastructure created by the government makes it eventually easier for the private sector to do business due to reduced frictional costs which gives the private sector the confidence to co-invest.

Given these findings, the simplest way for the government to impact growth positively is to embark on a five-year goal to balance its budget by 2020. To do this it needs to ruthlessly eliminate useless subsidies that kill incentives for people to go to work and to let product and labour market prices be determined by the forces of supply and demand.

The government’s role should be restricted solely to providing world class infrastructure and quintessential government services, thereby help lead a supply side revolution in order to create non-inflationary and inclusive growth. Doing this will alter permanently the trajectory of growth for India and make us a worthy competitor of China.

The writer is the founder-CEO of Meru Capital Group and a former CEO of Old Lane

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