Posts Tagged ‘Surjit Bhalla’

Charting a Case: Interest Rates & GDP Growth rates.

3 August 2012

The article, Ban Elevator Economics, of which the chart alongside forms the fulcrum, was apparently triggered by the policy statement of Reserve Bank of India of June 18: <<Our assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small. Consequently, further reduction in the policy interest rates at this juncture, rather than supporting growth, could exacerbate inflationary pressures>>. RBI asserted that (higher) interest rates are playing relatively small role in the (current) slowdown in (economic) activity, particularly in investment. The article further highlights an RBI observation: <<one implication of the rupee depreciation over the past several months is that domestic producers have gained in competitiveness over foreign producers. Over time, this should result in expanding exports and contracting imports, thus acting as a demand stimulus>>; and then concludes, <<RBI logic may be expressed as follows — we need growth to accelerate, rupee depreciation is providing that, interest rates don’t really matter for investments and growth, so let us not reduce interest rates>>.

Having summed up the opposition’s case (RBI’s monetary stance), it says: <<Proof should be required; both assertions — interest rates do not affect growth and real devaluations have a large effect — were rigorously tested in a 2010 paper and results are presented alongside the chart. Interest rates are represented by a one-year lag of the SBI prime lending rate (deflated by the GDP price deflator) and one-year lag of real currency depreciation by an index presented in Bhalla (2012)>>. The results of the chart were given as: <<The impact of interest rate is an increase in GDP growth of 0.44 percentage points (ppt) for each 100 basis points reduction in interest rates. Lending rates have averaged close to 13 per cent the last few years, a period when inflation (GDP deflator) has averaged 7 per cent. This yields a real lending rate of 6 per cent, a level double that prevailing in China. The impact of real exchange rate depreciation is -0.015, that is, each 10 per cent sustained real depreciation in the rupee leads to an increase in GDP growth of 0.15 ppt. Therefore, at best, the equivalence of a 10 per cent depreciation is a 35, not 100, basis-point reduction in interest rates>>. Therefore, it argues that while both real interest rates and real exchange rate depreciation do influence real GDP growth rate in a major way; the lion’s share in this influence is taken by the real interest rates. This is so, because a 35 basis point reduction in real interest rate would give an added real GDP growth of 0.15 (=35 x 0.44) percentage points, which is same as what would a 10% real depreciation of exchange rate would achieve. Therefore, contrary to what RBI posits it declares that real interest rates affect inversely the real GDP growth rate majorly than what real depreciation of exchange rate can achieve.

The chart supposedly depicts a regression equation that considers percent real GDP growth as a function of percent real exchange rate & percent real currency depreciation, both lagged by one year. The real currency depreciation index used in the chart is taken from author’s upcoming publication and therefore, not accessible to us. The other data was available from World Banks Site here and here. The data given at these sites is for *Real interest rate, which is the lending interest rate adjusted for inflation as measured by the GDP deflator (This was adjusted to 1 Year Lag)* & *Annual percentage growth rate of GDP at market prices based on constant local currency*.

Based on this data, two charts were plotted, one for Real GDP Growth Rate – Y axis Vs. Real Interest Rate (1 year lag) – X axis; and the other for Predicted Real GDP Growth Rate – Y axis Vs. Real Interest Rate (1 year lag) – X axis. The predicted real GDP growth rates were obtained by using the coefficients obtained by fitting the regression equation (Y=-0.543X+9.824).

Examining these two charts in conjunction with the one at the beginning, it is quite obvious that all are representing the same data set that is common to both (depreciation of currency exchange is not considered in chart 2 & 3) and regression fitting in both the exercises is similar. (Note: Y axis in first chart starts at 2% whereas in 3rd chart it starts at 4% leading to visual change in the presentation of Fit-Line). The next chart shows Real GDP Growth Rate and Predicted GDP Growth Rate plotted against time (years).

The comparison is striking. The divergence between predicted values and actual values is so large as to be obvious even to a casual observer. The predicted values move between a tighter bands (5% to 7.5%) as is to be expected. Isn’t it the purpose of fitting a regression line? But this divergence nails the hypotheses that Real Interest Rates are the single best predictor or major determinant of the real GDP growth rate. If it was so, then actual real GDP growth rates should have followed predicted values more closely and trending similarly. Real interest rates certainly do influence the real GDP growth rates, but quantum of that influence is circumscribed by other economic conditions. And those economic conditions are constantly evolving dynamic entities that are influenced by choices made locally & globally at every instant. The central banks and fiscal authorities are constitutionally tinkerers. They would, thus, always provide ammo to analysts and pundits to score brownie talking points.

Mainstream economists do not understand the fundamental crisis of capitalism. Capitalism is predicated on growth, not just growth but exponential growth. It is well-nigh impossible to have infinite growth on finite resources or finite planet. The last two centuries of economic development was literally fueled by cheap energy from fossil fuels. The fossil fuels were created through processes that were at work for hundreds of millions of years. But the effects of their accelerated depletion have begun to affect us in just 200 years. Unless these long range forces are understood, any amount of jugglery, analysis, and fancy theories about what is happening to local or world economy will remain fanciful amusements for pundits with little relevance for the real world.

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