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Warning: Inflation ahead

By Devangshu Datta
August 08, 2018 10:31 IST
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'Election years tend to see high government expenditure on unproductive schemes, though that money sloshing around can boost private consumption.'
'Again, it can mean higher inflation,' explains Devangshu Datta.
Illustration: Uttam Ghosh/

One of the most interesting lines in the Reserve Bank of India's June Monetary Policy Statement is in paragraph 20: 'The Monetary Policy Committee notes that domestic economic activity has exhibited sustained revival in recent quarters and the output gap has almost closed.'

The output gap is the difference between actual economic output and potential output.

According to estimates, Gross Domestic Product grew in Q4 (January-March 2018) at 7.7 per cent, pulling 2017-2018 FY growth to 6.7 per cent.

Q4 saw the fastest growth rate in seven quarters. It was a substantial improvement on 7 per cent in Q3.

For what it's worth, GDP in 2016-2017 grew at 7.1 per cent which is higher than 2017-2018.

However, the second half of 2017-2018 indicates that the economy is pulling out of a trough.

The output gap has indeed closed somewhat. But GVA (which is GDP minus taxes, net of subsidies) hit 7.6 per cent in Q4.

But core Gross Value Added (GVA), which is GVA minus government expenditure and agriculture, fell slightly to 7.2 per cent from 7.4 per cent in Q3.

Exports also declined. Government expenditure rose by 17 per cent, and government deficits also expanded.

For the fiscal 2017-2018, GVA grew 6.5 per cent, agriculture grew 4.5 per cent and manufacturing grew 5.7 per cent.

Construction received a boost from government road-building, and rose by 11.5 per cent in Q4.

Both construction and agriculture gained from low-base effects.

Gross Fixed Capital Formation improved to over 31 per cent of GDP.

The hike signals a trend reversal in the interest rate cycle.

If the output gap is closing, and fuel inflation is also up, due to higher crude and coal prices, the RBI must tighten, to prevent overheating.


The MPC statement in June also made hopeful noises about the Insolvency and Bankruptcy Code accelerating resolution of non-performing assets.

The RBI has retained its April projections for GDP growth for 2018-2019 running at 7.4 per cent though it sees inflation moving a little higher.

It also sees a small slowdown in the second half of 2018-2019. There are several possible problem areas that make this estimate look optimistic.

First, this level of government expenditure may not be sustainable, except by allowing the fiscal deficit to spiral beyond targeted levels.

Second, inflation isn't likely to ease, going by the RBI's own projections.

Third, while the IBC has accelerated NPA resolution, the banking system is nearly busted, and will require huge recapitalisation from government funding, before credit disbursal can improve.

If it doesn't improve, growth rates of 7 per cent plus will be hard to sustain.

It isn't clear where the money for recapitalisation will come from again unless the government is prepared to let the fiscal deficit zoom.

For that matter, the rate of NPA generation might not have peaked yet.

It is also an election year. It means the government will pay more heed to political sensitivity, than to economic prudence.

Election years tend to see high government expenditure on unproductive schemes, though that money sloshing around can boost private consumption.

Again, it can mean higher inflation, especially if there isn't a large enough output gap to meet consumption demand.

It is likely that the policy rates will be hiked again. That will be forced upon the RBI, if the ECB and the US Federal Reserve hike rates.

The FPIs have sold huge quantities of rupee debt in calendar 2018.

If the rupee yields rise, they may continue to sell, driving the rupee down.

Exporters will have to seize that opportunity, if it arises.

The stock market has already seen some correction with smaller stocks hit much harder than index heavyweights.

It will be a difficult time for capital-intensive and working capital-intensive businesses if we see, say, two rate hikes over the next 9 to 12 months.

It's hard to see broad-based capital gains in the medium-term.

Valuations are far too high, compared to earnings growth rates and the stock market rarely does well when interest rates are moving up.

But if private consumption picks up, there will be pockets of growth.

Apart from construction, defensive sectors like fast-moving consumer goods, information technology and perhaps, pharma, could come to the fore again.

The debt market always struggles when rates move up. This may lead to asset reallocation.

The bulk of debt-fund inflows could shift from medium-term and long-term debt to very short-term debt, which means inflows for liquid and money-market funds.

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Devangshu Datta
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