Source :BS:Rajeev Malik / January 11, 2012, 0:56 IST
The only good thing about 2011 is that it is over, and the only good thing about India for investors is that no one has anything good to say. The latter is a reflection of how low investor expectations are. Admittedly, in such a setting, small positive changes can bring about a quick and sizeable adjustment in expectations. But there is still a lot of wishful thinking and fairy tale-like expectations about a sustained pick-up in growth for 2012-13. We could be pleasantly surprised with a born-again government that pushes ahead with active decision-making and disbursal of investment-related projects. However, there is little evidence that this quadriplegic-like government can move its limbs.
The consensus view that GDP growth in 2012-13 will be higher than in this fiscal year appears to have wishful thinking and hope as its key building blocks, rather than any palpable evidence. Such expectations are based largely on monetary easing and an improvement in government decision-making that will lead to higher confidence and a pick-up in investment.
However, India is not experiencing a normal economic cycle. There are two drivers of India’s economic slowdown; first, a cyclical deceleration that is a direct result of tighter monetary policy and was a key policy objective; and, second, broader policy inertia and corruption scandals that have hurt confidence. These domestic factors have added to the adverse impact of global headwinds, and have taken a bigger toll on growth. Further, growth moderation is poised to broaden and include consumption as well, after having been restricted to the investment downturn.
The fiscal-monetary mix is completely out of whack and there is hardly any flexibility on the fiscal front. More importantly, some fiscal responsibility in the upcoming Budget will warrant spending cuts and revenue enhancement in order to shrink the fiscal deficit. This, in the near term, will affect inflation and consumer spending. This is an important but unpleasant part of fiscal adjustment that India has to digest.
As we near the turning point in India’s monetary cycle, there is widespread expectation that the Reserve Bank of India’s (RBI’s) actions will get economic growth back on track. Headline wholesale price index (WPI) inflation is coming off mainly because of food, but core inflation remains uncomfortably high, which in turn will probably prevent the RBI from cutting the repo rate on January 24. There are issues with how core inflation is used by the RBI; but we in the trenches cannot ignore the framework as long as the central bank is sticking with it. What the RBI should do is not always the same as what it likely will do, and that distinction should not be ignored.
It is a foregone conclusion that the RBI will have to again cut its GDP growth forecast; probably to seven per cent (actual outcome could be sub-seven per cent). Thus, it will need to be seen as doing something later this month, even as it will – irresponsibly – avoid any guidance on growth and inflation for 2012-13. How the RBI expects to anchor expectations without offering one- or two-year forward guidance remains a puzzle.
The recent upturn in the purchasing managers’ index reading for December and the anticipated improvement in industrial production for November are probably affected by the post-Diwali impact on production, and are not indicative of an economic upturn. Still, the RBI appears to be underestimating the loss in economic momentum and its focus on core inflation (strangely, it offers no forecast) is resulting in policy rates being higher than what they should be.
The uncertainty over adjustments in the local fuel price – to cut the subsidy bill – and over the current level of global crude oil price will prevent early rate cuts. Repo rate cuts are likely after the federal budget, in my view.
However, a cut in the cash reserve ratio (CRR) should not be ruled out later this month. The RBI appears to have double standards about how it treats excessive open-market operations (OMOs) and a cut in CRR. In the absence of a CRR cut, which will also signal policy easing without cutting the policy rate, the RBI will have to conduct large-scale OMOs. It is not clear why the RBI thinks that monetising the fiscal deficit is appropriate, but cutting the CRR is not.
Monetary easing will have some positive impact, but its magnitude and effectiveness shouldn’t be exaggerated. Unlike the aggressive response following the global financial crisis in 2008, the RBI’s easing this time will be more limited and less effective. More importantly, the easing is unlikely to fix political handicaps or policy inaction. In fact, the experience of the second half of the 1990s is instructive. Investment did not recover until the early 2000s, despite a multi-year reduction in interest rates. Now, recovery in investment needs much more than lower rates.
Few central banks make comments that have an adverse impact on their exchange rates, but the RBI appears to be made of different material. After having inadvertently contributed to the rupee’s large depreciation, it has been in desperate damage control mode by announcing measures to boost capital inflows.
Expectations about sustained rupee appreciation are similar to the forecast of a rebound in growth — most people incorrectly think that these are preordained for India. The rupee’s slump reflects the basic interplay of our large current account deficit and a reliance on volatile capital inflows that turned out to be inadequate. But there is no reason why the slide should not have been better managed by the RBI. If the RBI relies on some valuation metric – say, the real effective exchange rate – for the rupee, it needs to come clean and explain how that fit its hands-off policy for more than a year, even though this metric indicated overvaluation.
A currency is a relative price; and no central bank, least of all of a country with a sizeable current account deficit, will dig in at a particular level and keep running down its foreign exchange reserves if the US dollar rebounds, as is likely this year. The RBI understands this but has been unable to properly communicate it to financial markets. The rupee still got whacked, while the RBI’s foreign currency assets dropped around $13 billion (including revaluation change) in the December quarter. The rupee has been more resilient so far in January — but just wait for the dollar rebound.
In the final tally, the great reset of expectations on the rupee, like the wishful thinking on growth rebound in 2012-13 and of the RBI as saviour, remains substantially incomplete. Happy New Year.
Rajeev Malik
The writer is senior economist at CLSA, Singapore.
These views are persona
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