We attempt to answer two burning questions on India’s economy. In doing so, we argue that they are, in fact, connected in a way that has implications for central bank policy action. How serious is farm distress at the moment? And why is currency in circulation (CIC) rising?
Data from India’s rural economy is confusing. On one hand, record crop production lifted 4QFY18 agriculture growth to its highest in a year. And some consumer companies have reported that their sales in rural India have picked up. On the other hand, rural wage growth is stuck at low levels and the unemployment rate seems to have risen. What’s going on?
At the risk of oversimplifying, we believe that dividing rural India into the “landed” and the “landless” helps solve the puzzle. We define the “landed” as those owning more than one hectare of land, making up 30% of rural India, and having access to bank credit. We define the “landless” as those owning less than one hectare of land, making up 70% of rural India, and depending heavily on rural wages, which in most parts, the landed pay. We believe that the landed have been faring better than the landless over the last few months.
At the heart of the problem lies food prices. They have remained low, thanks to a combination of factors, such as bumper harvest, low minimum support prices (MSPs) over the last few years, low international food prices, the back-to-back shocks of demonetization and the goods and services tax (GST), and low demand for food items.
We find that the landed may be doing better than before, thanks to “remonetization” (the printing and circulation of new notes) and the farm loan waivers implemented by a few states. This has increased the purchasing power of the landed and explains the rise in the sale of consumer durables, two-wheelers and tractors.
Sadly, given that the price of food remains low, this rise in incomes has not been sufficient to trickle down to the wage-earning class. Rural wage growth has in fact fallen from more than 6% in September 2017 to around 3.5% in early 2018. Thankfully, the outlook is better. To test more formally, we ran a series of regressions to understand what drives rural wages. We found that it is largely recent inflation experience, highlighting the backward-looking nature of wage bargaining in India. Other factors such as agricultural output, construction growth and MSPs also play their part.
Encouragingly, all of these variables are looking up right now, implying that rural wages, and therefore the fortunes of the landless, are likely to do better in time. To be more precise, we plug our expectations of these drivers of rural wages into our regression and estimate that rural wage growth is likely to swing up from 3.4% in early 2018 to average 6-9% in FY19. And what is more interesting is that since the building blocks are in order, this will happen without any need for additional fiscal stimulus to revive rural India. To sum up, the rural landed may be faring better than before, but this is not trickling down to the wage-earning rural landless. Chances are, however, that the landless will fare better in FY19.
All of this has implications for currency in circulation. We find that historically, CIC rises and falls with rural demand and, more specifically, with rural wages. Understandable, given that rural India is largely cash dependent. So it is a mystery that for the last six months, CIC has been growing above trend, despite rural India being weak. We attribute much of this to remonetization since early 2017. Moreover, demonetization dealt a blow to the cash-intensive informal sector, which we believe is now gradually recovering.
The GST was implemented in mid-2017. We are confident that the GST regime will shift output from the unorganized, informal sector to the organized, formal sector over the long term. However, in the short run, glitches in the GST framework (delays in tax refunds, teething issues with the new IT network), much higher tax rates for services, and related “adjustment costs”, have not yet allowed it to rein in informality.
The combination of remonetization and the still nascent implementation of the GST regime, in our view, explains the acceleration in CIC over the last few months. But, things may change from here. As the GST regime settles down, the e-way bill system matures and improvements in the IT system expedite refunds, tax evasion may fall. The rise in informality in recent months could begin to peter out. On the other hand, as already discussed, rural wages could begin to rise again around the same period. This could spur CIC growth.
Our estimates suggest that these two forces, i.e. the plateauing of the growth in informality and a revival of rural demand, are likely to cancel each other out, leaving FY19 CIC growth where it stands now, i.e. well above trend.
There are important implications for the RBI here. RBI’s neutral liquidity regime requires that it replenish “durable” liquidity leakage from the banking system (to, say, support a growth uptick in rural India) with “durable” liquidity injection. One could argue that liquidity infusion sits oddly with the recent rate hike by the RBI and a weakening rupee. After all, in standard theory, rate hikes are transmitted best when liquidity is tight. But not necessarily so. In our view, moderate rate hikes to control inflation, and domestic liquidity injections to keep liquidity at neutral and support the genuine growth needs of the economy, can coexist. And as long as liquidity is at neutral (and not venturing towards surplus), it won’t be inflationary, nor will it play a decisive role in weakening the rupee.
With limited opportunities to inject domestic liquidity via forex purchases, the RBI will, we believe, have to resort to a string of open market operation (OMO) purchases of government bonds, especially in the second half of the year. We believe these will have to amount to more than Rs1 trillion. This, in turn, could provide some respite to bond yields, which have soared recently. And, yes, this has happened before. During the taper tantrum period of FY14, the RBI was in a situation where it was both raising the repo rate and doing OMO purchases to inject domestic liquidity. Indeed, extraordinary years need extraordinary treatment.
Pranjul Bhandari is chief India economist at HSBC.
Comments are welcome at theirview@livemint.com