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Mainstream, VOL LV No 45 New Delhi October 28, 2017

How does Expectation work in India?

Monday 30 October 2017

by Anshuman Gupta

The most pressing question today facing the Indian economy is how to boost the animal spirit to increase private investment in the economy. The expectation plays an important role in the decision-making of entrepreneurs. There are different ways of forming expectation depending upon the average education level in the economy. In a country like India, generally adaptive expectation works, whereby the economic agents adjust their expectation about economic variables as per the difference in the expected value and actual value. The static expectation works in poor countries with very low level of education and rational expectation works in advanced economies, whereby even developed market mechanisms with mature economic agents help in making expectation and there is little difference in the expected and actual outcome.

This time the RBI has left the repo rate unchanged and projected the inflation rate as per the CPI to rise from 3.6 per cent in August to 4.2 to 4.6 per cent in the second half of this fiscal year. It would have impact on the real interest rate. How far is the cost of capital (interest rate) responsible for increasing investment? What is the most important factor for boosting the investment? Is India facing some extraordinary circumstances requiring extraordinary policy-responses? The cost of capital is, of course, a significant factor impacting the investment level, especially in the capital-intensive sector. Investment is a function not only of the current real interest rate but also the expected real interest rate in future. If the expected real interest rate is on the downward trend, it must enthuse the businesses to invest more as per the rational expectation theorists. The expected real interest rate depends on two points—one, the expected future nominal interest rate and two, the expected future inflation rate. It might, in turn, give rise to two cases.

• If the future nominal interest rate and inflation rate are expected to go down and the expected decrease in inflation rate is more than the expected reduction in the nominal rate, it would likely discourage the invest-ment even today.

• On the contrary, if the anticipated decrease in the nominal interest rate is more than the expected reduction in the inflation rate, or the expected reduction in the nominal rate and the expected increase in the inflation rate take place simultaneously, they would likely to impact investment positively.

The first case generally occurs in times of deep recession when the expected squeeze in the income level is so large that it hardly motivates the businesses to invest in the economy. They expect that the deflationary impact would be larger than the decrease in the nominal interest rate. Moreover, in such times, no amount of decrease in the interest rate would motivate the investors because of the extent of squeezed aggregate demand in the economy. This is because the current investment is also a function of the expected future income along with the expected real interest rate. This case resembles more to subdued responses of businesses in the USA, Europe and Japan to extraordinary monetary easing policies at the start of the sub-prime crisis.

The second case is what happens in normal times. Generally the reduction in the nominal interest rate is accompanied with the increase in the inflation rate at a time when the economy is operating just below the potential level of the GNP. This augurs well for investment. The benign impact of the monetary policy goes on unless the economy enters the overheating zone, whereby the RBI is likely to resort to a contractionary monetary stance and increase the nominal interest rate. It starts feeding the expected increase in the real interest rate.

The author conducted an adaptive regression analysis and found that the nine per cent impact of the future expected real interest rate on industrial production is realised in quarter of a year (36 per cent within a year).

If one analyses the current Indian scenario, it does not belong to any of the above cited cases. The Indian economy is not facing a deep recession, though it is undergoing a growth recession, as is evidenced from the GDP growth number, which was 5.7 per cent in the June quarter of the fiscal 2017-18. It is well below the potential level and almost all firms are operating below their capacity.

It is not even the second case as happens in normal times because of many reasons. First, the Indian economy is facing the twin balance-sheet problem, which is the result of reckless lending during the last boom phase till the year 2007-08. This resulted in many industries, especially heavy, and infrastructure going through rough patches during the slowdown.

Secondly, that Indian businesses, especially small and medium, could barely come out completely from the jolt of demonetisation that they faced another turmoil of complying with the GST.

Thirdly, India still fares poorly on the ease-of-doing-business front. A lot more is desired in labour laws, land acquisition laws, the infrastructure front, etc. Unless these problems are resolved, no amount of decrease in the real interest rate would have much impact on investment.

Prof Anshuman Gupta belongs to the University of Petroleum and Energy Studies, Dehradun.

ISSN : 0542-1462 / RNI No. : 7064/62