The Curious Case of Rising Cost of Falling Inflation

1. The Curious Case of Rising Cost of Falling Inflation
The global economy is struggling with strong deflationary pressures rarely seen in a non-recessionary
environment. Three years of below-trend global growth combined with a collapse in energy prices has
primarily been responsible for unleashing these deflationary forces across the world. These deflationary
forces pose some serious risk for an already fragile global economy. These risks are mainly being
manifested in two areas:
 Firstly, given the high levels of indebtedness across the world, low levels of inflation greatly
hurts borrowers by reducing their debt servicing capabilities. High and rising leverage
accompanied by high inflation and thus higher nominal growth doesn't destabilise the leverage
ratios or pinch the borrowers much, even if the debt accumulation remains steady. However, the
other way round could be debilitating.
For example – in case of Greece, after five years of recession, the economy expanded by 1% in real
terms in 2014. At the same time, due to strict austerity, government debt also declined by 1% in
the same period. Yet, public debt as a % of GDP (an indicator of debt servicing capacity) rose in
2014 thanks to deflation which resulted in a slump nominal GDP. On the other hand, in case of
India, government borrowings almost doubled between FY09-FY15. Yet public debt as % of GDP
fell from 75% to 65% during the same period, courtesy high inflation levels, which pushed up
nominal GDP much faster than the rise in public debt.
In most developed markets (DM) while the pace of debt accretion slowed down post the 2008
financial crisis, there was rapid debt accumulation in emerging markets (EM). In fact, most EMs are
now grappling with high levels of leverage and falling nominal growth. This unfavourable gap
between high debt on one side and weakening nominal growth on the other has resulted in
sharp asset price deflation in EMs. Due to broad-based disinflation and slower global trend
growth, even currency depreciation isn't helping countries to export out of their problems.
 Secondly, in a deflationary environment, policy makers lose control over real variables such as
real interest rates and real wages, given downside rigidities in nominal rates and wages. Though
it could be an extreme eg – despite 115bps of lending rate cut and 150bps of RRR cut by the
People’s Bank of China (PBoC) since November-2014, monetary conditions in China continues to
remain exceptionally tight as reflected in rising real corporate bond yields.
Globally, policymakers are increasing getting concerned about the consequences of high debt and low
inflation. In response, there has been an unprecedented policy effort all across to bring reflation and
more importantly avoid any deflationary bust. Efforts are on but success so far remains elusive.
Coming to the Indian context, India’s inflation had got decoupled from global inflation between FY10-
FY14 largely on account of domestic imbalances. However, in the last one year, India has benefitted
massively from the global deflationary forces, so much so that nominal GDP growth has now converged
with real GDP growth. This in turn implies that the calculated inflation level (deflator) in the economy
has gone down to 0%.

2. This glaring convergence between nominal and real is resulting into peculiar things which are not getting
much attention:
 Half of the sub sectors in India's GDP now have lower nominal growth versus real growth.
Agriculture sector had one of the highest nominal growths in 1QFY16 viz-a-viz other sectors in
the economy. Thus, income effect is quite different across sectors as compared to output
growth.
 Real cost of capital in India has risen to record levels despite significant easing by the RBI.
 Credit growth and money supply growth has significantly risen in real terms.
 Imports have risen to record high levels in volume terms (as proxied by port data) while they
remain contained in value terms.
There are many such examples which are of great significance. For instance, while many experts have
started to believe that India’s external imbalance has been corrected, it is actually the price effect which
is masking the imbalance. Similarly, corporate sales growth remains under pressure due to price effect
resulting in poor asset turnovers and therefore lesser debt servicing ability.
What are some of the implications of this?
 Investors should differentiate between the real and nominal gaps and in the absence of global
and local inflation recovery, they should focus more on bottom line stories rather than top line
stories as top lines may remain unusually subdued. Moreover, profits growth for companies
which does not have serious debt problem will continue to outpace sales growth.
 The current fiscal deficit target assumes nominal GDP growth of 11.5%. The previous two
quarters' nominal GDP growth has been 8%. With the nominal numbers unlikely to improve,
tax buoyancy may drop a bit and therefore over reliance on Government expenditure to prop
growth shouldn't be there. That said, risk to Government finances is limited in FY16.
 The yawning gap between CPI and WPI means that while real interest rates (adjusted for CPI)
remains at reasonable levels for savers, it remains prohibitively high for borrowers (if adjusted
for WPI). Thus, even though the RBI has now adopted a CPI inflation targeting regime, it should
focus more holistically on all inflation gauges (i.e. broad underlying trend). This is because a
multifaceted economy like India cannot solely rely on one single parameter, especially when
different parameters are sending completely different signals. While the RBI must be mindful
of the growth-infation tradeoff, with the current approach the damage could be much more
than what they would have been envisaging.

3. Disclaimer: The author is Investment Strategist at Reliance Capital. Views are personal.
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Chart 1: High levels of indebtedness in a low inflation
world
Chart 2: The gap between India’s nominal and real GDP
growth has collapsed
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RealInterest Rates for
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RealInterest Rates for
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Chart 3: Real cost of capital has risen to record levels in
India despite significant RBI easing
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RealReserve Money Growth
(Adjusted by GDP Deflator)
Chart 4: Reserve money growth is not weak in real
terms in India