GDP data and monetary policy: Elementary, dear Watson?

The Q4 estimates of the Gross Domestic Product (GDP) released recently (on May 31, 2019) sets the tone for the Reserve Bank of India’s second bi-monthly monetary policy to be announced on June 6, 2019. The RBI had gone in for a rate cut after 18 months in February 2019. This was followed by a second rate cut in April 2019, bringing down the policy repo rate by 50 basis points over February-April 2019. The policy repo rate currently stands at 6 per cent. Two questions arise in the context of the RBI’s monetary policy decisions in the wake of the current GDP data: One, what will the RBI do? And two, more importantly, what should the RBI do?

The domestic developments around the GDP and inflation figures makes it almost certain that one will witness a third rate cut in 2019. The real GDP growth rate fell from 7.2 per cent in 2017-18 to 6.8 per cent in 2018-19. The drop in consumption – reflected in the drop of growth of two-wheeler sales- which had been posited by the Ministry of Finance’s monthly report dated May 1, 2019 is not borne out by the Ministry of Statistics and Programme Implementation (MOSPI) data. The latter reflects an increase (albeit miniscule) of 0.4 percent in private consumption in 2018-19, at 59.4 per cent of the GDP.

However, on the supply side, agriculture and much of industry has experienced a decline in growth, with agricultural growth at just over half the rate achieved in 2017-18 and mining suffering a sharper decline in gross value added. The manufacturing sector performance was dismal in Q4 2018-19, growing at 3.1 per cent compared to a growth rate of 9.5 per cent in Q4 2017-18, and 12.1 per cent in Q1 2018-19. There was little incentive for private investment, which is reflected in the low gross fixed capital formation in 2018-19 at a mere 29.3 per cent of GDP, while overall investment was also low at 31.3 per cent. An important reason for the slowing down of growth is on account of such lack of private investment. A revival of private investment is then sufficient argument for favouring a policy rate cut.

This argument gains credence in the light of data pertaining to exports and imports. While exports remained at below 20 per cent of GDP (at 19.7 per cent), imports rose in 2018-19 (to 23.6 per cent of GDP) compared to 22 per cent in 2017-18. The latter can be attributed to the rising crude prices, which increased by about 30 per cent since January 2019, due to the OPEC and its allies cutting down oil supplies. Exports are unlikely to grow given the growing protectionism in the wake of the US-China trade war, as also the dip in growth rates in many of the Advanced Economies (AEs). The resultant higher Current Account Deficit (CAD) provides enough rationale for India to try and rely on domestic demand to spur growth.

Inflation data for April 2019 point to a further softening of Headline Consumer Price Index (CPI) inflation, in particular food inflation which stood at 1.38 per cent. The reduction in inflation rates provides enough head space for a decline in policy repo rates by the RBI. However, the moot question is what should the RBI do? By the government’s own admission, the effects of the first two rounds of monetary easing have not yet been transmitted to the weighted average lending rate of the banks, and as such have not yet led to investment increases. Rate of interest increases, though the populist method, would not guarantee the desired spur in private investment activity. Shoring up economic growth will require structural reforms in every sector.

In particular, investment in irrigation, warehousing and agro-industries for the agricultural sector and land, labour and banking sector reforms for industry can provide long-term solutions to India’s growth, rather than mere tinkering with interest rates with their transmission problems et al. The structural reforms proposed all lie within the scope of the government, while interest rate changes alone lie within the scope of the RBI. The answer to the question what the RBI must do, should then be in the words of Sherlock Holmes (as he may have said to his able assistant, Dr. Watson), “Elementary, my dear Watson.” The author is professor of Economics at S P Jain Institute of Management & Research, Mumbai. Views are personal.

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