Squeeze GDP to set rupee right

“The only cure for inflation is to reduce the rate at which total spending is growing. There is no way of slowing down inflation that will not involve a transitory increase in unemployment; and a transitory reduction in the rate of growth of output. But these costs will be far less than the costs that will be incurred by permitting the disease of inflation to rage unchecked.” That was Milton Friedman on the ravages of inflation and how to control it.

Modify that Friedman statement slightly to substitute “current account deficit” for “inflation”. It appears that Indian policy makers — read Indian government — could significantly curtail India’s gaping trade and current account deficits by adopting that “modified” Friedman rule.

Govt-RBI combine

The “modified” Friedman statement, in fact, would apply only to Government. Simultaneously, the Reserve Bank of India would be required to follow the Friedman rule without any changes — that is, with a single-minded focus on killing inflation.

For, while spending reductions and output deceleration would apply downward pressure on the CAD from the (output) income side, any gains on that front should not be frittered away by persistent high local inflation, which will keep import prices competitive in our local markets.

Further, it will only be much lower local inflation which will significantly enhance the quality of any “prospective” spending adjustments. (For instance, the quality of the spending adjustment is suspect when Government is able to show a lower fiscal deficit/nominal GDP ratio by increasing the size of the denominator by price level changes, as it has been doing in the past many years).

This combined approach from Government and the RBI seems to be the only near-term hope for at least significantly reducing the large trade deficits India runs; and through that reduction, staving off further significant downward pressures on the Indian rupee.

An analysis of the macro-financial statistics shows that the income elasticity of Indian demand for imports is quite high at significantly more than 1. This means that for a 1 per cent rise in GDP (income), imports rise much more than 1 per cent (see graph). Whatever may be the structural reasons for such a state of affairs, such (structural) factors may be amenable to correction only in the long-term (if at all our policy-makers want such corrections).

The near-term demand or requirement to stave off a free fall in the rupee in the ensuing period (which will make the last two years’ fall in the rupee a mere dress rehearsal) though, calls for: 1) the Government to not be averse to significant GDP compression in the short-term 2) RBI to aid that objective by allowing market interest rates to rise very sharply.

Imports highly elastic to GDP

As the graph shows, while GDP has increased by a factor of 3 in the past eight years, total imports and, within that, oil imports have increased by a factor of nearly 6.

What does the out-sized rise in imports relative to the rise in GDP imply?

It is simply that India’s import demand is highly elastic to growth in GDP (income). In fact, if we can plot a table with factor incomes, one would generate an even larger gulf between the growth in incomes and growth in imports.

Oil and non-oil imports

India is a large net importer of petroleum, oil and lubricants (POL) products. In 2012-13, for instance, oil imports amounted to $170 billion out of a total (all) import bill of nearly $500 billion — i.e. one-third.

Oil imports into India do not compete (in any significant manner) with any local manufacture of oil/oil products. In other words, oil import demand is driven mainly by growth in nominal incomes rather than movements in relative prices between imports and local manufactures.

Curbing oil imports, therefore, is dependent mainly on arresting the growth in nominal incomes. While this seems a blasphemous or heretical thing to say, it seems to be the blunt truth.

Without significant GDP and income compression, it does not seem like oil import demand is going to come off in any notable manner — it has grown at more than 15 per cent annually in the last decade.

The argument is noticeably different in the case of non-oil imports — both goods and services which compete with local manufactures and those imports — which are accumulated (not consumed as propagated by our policy-makers) by Indian households as financial safety nets viz. gold.

This is where the role of the Reserve Bank becomes critical. If at all the RBI can influence the trend and course of the CAD, it is by keeping local inflation low and stable. You cannot hope to ward off gold import demand when consumer inflation is 12-13 per cent and local savings generate pitiable negative real returns. Simultaneously, import demand for other goods and services would continue to be robust even if the rupee falls to 70, as with continued high local inflation, local manufactures would continue to be out-priced. (Note that non-oil imports are a sizeable 70 per cent of total imports, much of it influenced by developments in relative prices).

All in all, it seems that India would have to be prepared to take a very bitter economic medicine in the form of sharply compressed GDP outcomes and loss of employment. Deep institutional reforms encompassing the RBI should form part of the medicine kit. The earlier the medicine is administered voluntarily, the shorter will be the transition period to renewed growth.

(The author is a Chennai-based financial consultant.)

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