IIP is not as bad as it seems; but revival depends on Jaitley, not Raghuram Rajan

Sometimes, the headlines don’t say it all. This is the case with the two index numbers released yesterday (12 May). The Index of Industrial Production (IIP) hit a “five-month low” of 2.1 percent in March from 4.9 percent in February 2015, says one headline. Retail inflation, as measured by the Consumer Prices Index (CPI), easing to 4.87 percent in April from 5.25 percent, was the other important data marker. [caption id=“attachment_2240296” align=“alignleft” width=“380”] Union Finance Minister Arun Jaitley.[/caption] The first headline overstates the gloom, when the reality is that the “five-month low” is largely the result of a statistical base effect; the second understates the huge success this government has had (aided by dollops of good luck on oil prices, no doubt) in beating back inflation. Retail inflation is now sustainably low, and fast approaching the four percent target set for long-term inflation under the agreement between the Reserve Bank of India (RBI) and the government. Ignored largely in all the fuss over the IIP’s “five-month low” was the sharp uptick in April tax revenues - indirect tax collections were up by a hefty 46.2 percent to Rs 47,747 crore, giving a significant confidence booster for the fisc this year. If this sustains, 2015-16 will be a real economic turnaround year. Taken together, the modest IIP number, the drop in retail inflation, and the spike in indirect tax revenues (aided by the NDA’s smart decision last year to tax oil more) tell us this: the economy is reviving, industrial gloom is slowly abating, the government’s fiscal math could improve, and, with inflation nearly licked, we have now built a sound long-term base for sustained growth. India should hit double-digit growth by 2017-18, if not earlier. The keys to double-digit growth, however, are not held by the RBI or its ability to reduce interest rates. They are actually held by Arun Jaitley and the finance ministry: the two keys in his hands are quick recapitalisation of nationalised banks, and a sharp revival in public sector capital spending, which will convert the moderate upturn in the growth cycle into a virtuous cycle of higher investment, higher output, lower inflation, higher savings, faster growth and higher tax revenues. To break free from the cycle of negativity – which the stock markets are beginning to reflect – Jaitley must shed fiscal conservatism and focus on reviving the investment cycle, never mind the short-term impact on the fiscal deficit, if any. What matters is not the size of the fiscal deficit, but its quality. The deficit is intended to fall from 4.1 percent to 3.9 percent this year, but it would not matter even if it remains at 4.1 percent or 4 percent as long as the India growth story gets second wind from the right type of government spending. Explanations are in order, based on the latest set of index data. First, there is no reason for breast-beating over the IIP’s “five-month low” in March. Reason: March 2014 saw a huge spike in the IIP, driven by high election spending and the usual year-end balance-sheet window-dressing (companies and banks try and show improved performance in the last month of the financial year in order to close their accounts on a high note). The IIP for March 2014 jumped 12 percent from the month before (i.e, February 2014) from 172.7 to 193.3. This gave us a high base for March 2014. But this year, the jump from February to March was a good 9 percent, from 181.1 to 197.3. The base effect may have brought down the IIP’s year-on-year rise to 2.1 percent, but the mere fact that it is positive is a healthy sign. Gloom would have been warranted if it had been flat or negative. A slow turnaround is indicated by the full year’s figures: in 2013-14, the IIP was stagnant (at -0.1 percent); this year it was 2.8 percent. This is revival with a small ‘r’. Some of the other signs are also positive. Both basic and capital goods are doing better than last year, being up from 2.1 percent and 3.1 percent to 6.9 percent and 6.2 percent. It is intermediate and consumer goods that are worrying: both declined, the former from 3.1 percent to 1.6 percent and the latter from -2.8 percent to – 3.5 percent. Clearly, what this suggests is that industry is emerging from the boondocks, but consumers are still not confident enough to start spending. They are waiting and watching to verify that the early signs of “achche din” are for real. The main reason for this consumer diffidence is rural distress – brought on by slow rural wage growth and some degree of drop in farm output last year. But this farm distress is actually the low water-mark for economic despair. It has nowhere to go but up, unless the government screws up. This “farm distress” is actually providing the base for lower inflation overall, which will lay the foundations of a strong and sustainable recovery not only in industry, but also the rural sector. Trends in retail inflation are important to understand this. The CPI fell in April to 4.87 percent, a four-month low. Taken together with the negative trend in wholesale inflation, which hit -2.33 percent in March and will remain negative in April too, it is clear that inflation is not the challenge it was when UPA was mismanaging the economy during 2009-2013 with high fiscal spends on unproductive subsidies. The fall in CPI inflation has been driven by a sharper fall in food inflation despite some amount of crop failure last year due to hailstorm and a less-than-normal monsoon. Food inflation in April 2015 fell by a sharp 1 percent, from 6.14 percent to 5.11 percent. This fall is sustainable and for real. As Chetan Ahya, co-head of global economics at Morgan Stanley, wrote in The Economic Times yesterday (12 May): “The combination of a deceleration in rural wage growth, lower non-wage operating costs and falling global commodity prices has meant that the systematic causes of high food inflation in the 2009-13 period have reversed. So, food inflation will continue to head systematically lower.” This means even if global oil prices rise, there is little chance than overall inflationary trends will be high this year. Nor should lower wage growth necessarily lead to higher farm distress. Lower wage growth and lower input costs mean minimum support prices (MSPs) can be moderate, which – far from increasing rural distress – will enable the landless to buy food cheaper. It is only large farmers with large output surpluses – a constituency Rahul Gandhi seems to be batting for - who will be clamouring for larger hikes in MSPs. Small farmers and the landless either will not lose much in the bargain, or will balance their losses on MSP with gains in lower food consumption costs. A slow industrial revival accompanied by stable (or falling) inflation, especially the sensitive issue of food inflation, provides a great base for growth. However, there are two flies in the ointment – and both are there, courtesy, the finance ministry. To ensure that the nascent industrial revival takes root, banks must be willing to lend and cut rates. But this can’t happen if banks are nursing over Rs 3,00,000 crore of bad loans, and further starved of capital. In this year’s budget, Jaitley provided a measly Rs 7,940 crore for recapitalising public sector banks. Last year, he cut down the recap budget from over Rs 11,000 crore to just Rs 6,990 crore. The logic is that state-run banks will raise money from the market. And, in any case, the government will not encourage inefficient state sector banks by giving them more capital to blow up. Moreover, they have been given the green signal to raise more capital from the stock markets. Actually, Jaitley is being poorly advised by his economics team. The logic of what he is being told is right, but the timing it wrong and counter-productive. Public sector banks cannot raise money easily from the markets when their bad loans are so huge. Not only will they get bad valuations for their shares, they will also not be able to raise much money this way. This is why there is no queue forming among banks to raise capital. Moreover, the logic of not recapitalising poorly-run banks has to be sustained over a period of time. These banks did not turn inefficient overnight. They became so due to the lack of autonomy and poor governance record over the last decade. Correcting this will take at least a few more years, even assuming all future bank CEOs and boards get enough autonomy and capital to turn their wards around. In the short run, the only way out is to recapitalise most banks (and merge the rest) and put them under good, autonomous boards which will focus on performance. If the idea is to achieve the turnaround first and then recapitalise them, then the revival in lending will be delayed. Both politically and economically, the decision to cut down on bank recap is wrong. Jaitley should, in fact, immediately provide Rs 30,000-40,000 crore of recap funds in the next month or two, either by letting the fiscal deficit bloat temporarily or by creating an SPV to which bank shares can be offloaded in lieu of instant capital injection. The SPV can then offload the shares and repay the money to the government. This will enable banks to write off bad loans and resume lending to infrastructure and other sectors. Pressing for rate cuts from Raghuram Rajan is fine – the RBI will probably do so in June or a bit later – but it will make no difference to actual bank lending rates as banks will be reluctant to grow their loan books when bad loans are killing their appetite for risk. They are instead trying to conserve cash by keeping lending rates high. The two rate cuts by Rajan have not reduced lending rates appreciably. From every perspective, Jaitley has to put bank recap at the top of his agenda for revival. The signs are propitious for this – with tax revenues showing an uptick, inflation trending down, oil prices remaining benign, and industry slowly picking up. He should go for growth – and the way to do it is to recapitalise banks quickly. He will find that the resultant growth will make his fiscal deficit target easier to achieve even assuming he dips into his own pocket to give banks their additional capital. Jaitley should not opt for fiscal conservatism at this juncture.