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Export growth: New economics!
July 21, 2007
It is clear that I don't want to be smoking what the economic czars of the UPA government have been indulging in for the last several months. Some weeds can lead to inexplicable mistakes, and in an increasingly competitive world, that is unaffordable.
The background of an inherited robust domestic economy and unprecedented worldwide growth has most likely dulled the economic senses of the UPA. They feel they can afford to experiment with the Indian economy, and have it grow considerably below its potential with the logic that hey, we are still growing above 6 per cent, so why are you complaining?
The technocratic Economic Advisory Council (EAC) of the Prime Minister of India has just made a forecast for Indian export growth over the next year: Exports would grow to $147 billion from $124 billion in 2006-07, an 18 per cent rise.
On the face of it, this forecast is unexceptionable. Indian exports have been growing at 20 per cent plus for the last several years and in the fiscal year just ended, the increase was 25 per cent.
However, over the last six months the seasonally adjusted (seasonal factors from RBI Bulletin, November 2006) export growth has been a full 10 percentage points lower at 15 per cent.
This figure is close to the 18 per cent growth forecast made by the EAC, so what is the problem? Just that in April-May the rupee appreciated by 10 per cent, and exports occur with a lag (the gap between contract and delivery is often a few months).
Thus, the December 2006-May 2007 figures represent export growth before the 10 per cent rupee appreciation. And even this growth of 15 per cent is well below the bold EAC forecast!
And if the rupee appreciation is sustained, export growth in 2007-08 is likely to be at least 25 per cent below trend. Unless something was exceptionally, and temporarily, the problem with our exports in the last six months (unlikely; our exports should have shown an acceleration especially with world GDP accelerating to new highs above 5 per cent per annum, and exports above 20 per cent), it is likely that Indian export growth will average around10-12 per cent in 2007-08.
The slowdown in recent export growth, and the seasonal factors, etc. are well-known to the EAC, so why a forecast that is likely to have an error of around 50 per cent (12 vs. 18 per cent)?
A similar large error was recently made by the authorities with respect to inflation, so at least the trend is continuing! In mid-2006, international oil prices rose, and were soon followed by a rise in international (and domestic) wheat prices.
Both rose by upwards of 20 per cent. This supply shock meant that overall inflation temporarily exceeded the comfort zone of 5.5 per cent. So what could the government have done--nothing, as it successfully did in the 1998 food (onion) price inflation episode. Supply shocks have a tendency to work themselves out. Just look at the following supply shock--oil prices have quadrupled in the last four years, yet world inflation has stayed shockingly stable.
Contrast that with the 1973 oil quadrupling, when the world was not prepared and ended up with stagflation. Alone among mature economies, India responded to the 2006 supply shock as if nothing had changed in the last 35 years, and if everything had changed since the last analogous supply (food) shock in 1998.
The government (the RBI or Ministry of Finance?) messed up in its analysis of inflation. Its first response to slaying the non-existent excess inflation dragon was to jack up interest rates.
This was a gift to foreign investors (including Indian NRIs), who now had a higher yield on Indian investments; and was a gift to foreign banks, who could now lend more money to Indian firms through the ECB window. This led to, uh-oh, large inflows of dollars, which put pressure on the Indian rupee. And the government allowed the rupee to appreciate in order to fight inflation. The circle goes on.
Now the government says that the rupee appreciation does not matter--indeed, according to the EAC logic, new economics is being invented. The demand curve, erroneously thought to be downward-sloping (as prices go up, less is demanded) is actually upwardly-sloping--costlier Indian exports, costlier by around 10 per cent, will actually lead to an acceleration in the rate of growth of exports.
So let me see: a 10 per cent appreciation in the rupee leads to an acceleration in export growth by 3 percentage points, so a 20 per cent appreciation should lead to an acceleration of 6 percentage points. So, the EAC forecast for 2007-08 might well be: rupee at 36 and export growth at 21 per cent. We can extend this logic, but� .
The real world of course is different. In the world of downwardly-sloping demand curves, a sustained appreciation of 10 per cent in the exchange rate is likely to lead to a decline in GDP growth of at least two percentage points*.
Given India's excess productivity growth of around 3 per cent, the net effect of the rupee appreciation would be somewhat less than 2, likely around 1.5 per cent. Thus, we should expect GDP growth next year to be about 1-1.5 percentage point lower than the 9.5 per cent growth just experienced. A rather large cost to the experimentation with the invention of new laws of economics.
The 18 per cent export growth seems an impossible belief, even by "India Shining" standards. So why did the EAC make such a forecast? Politics? But how--what election are the technocrats running for? Wishful thinking? But what does that achieve? Something that they are smoking? Likely, and you don't want to smoke the same.
*Details about the relationship between the change in real exchange rates and GDP growth are contained in "Second Among Equals: The Middle Class Kingdoms of India and China", forthcoming 2007, Peterson Institute of International Economics, Washington, DC.
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