Wake up and smell the coffee

Written by Sajjid Z Chinoy | Updated: Apr 2 2014, 08:37am hrs
With equity markets continuously scaling new highs, who would guess that Indias growth is on course to print below 5% for a second successive year Or that CPI inflation is still at 8%, the highest among the G20 universe Its almost as if Indias growth-inflation fundamentals have ceased to matter. Instead, markets continue to rally largely on growing expectations of political stability post the elections.

To be sure, a stable governmentof whichever partywill be good for sentiment and markets. But the current market euphoria is pricing in a series of assumptions that must all hold. For starters that opinion polls have it right. Given the patchy record of pollsters in the last two elections, one cannot necessarily take that for granted. Second, that there is a fundamental economic pivot post elections. Given that the reform and welfare philosophies of the two national parties are not that radically differentlike, say, the Republicans and Democrats in the USits hard to imagine a massive economic pivot. And thats a good thingbecause both major parties broadly agree on the need for a GST, need for fiscal discipline, need for boosting infrastructure and clearing stalled projects. So if there is political consensus on key reformseven if parties disagree on certain specificsit suggests that reform in India is invariant to political formulation, a critical development. But it also suggests that we may not get the pivot that markets may be pricing in. Third, markets are assuming that the next government steps up implementation. But, if you look at the top 50 projects that are stalled (which account for nearly 70% of the value of all stalled projects), you will find that 60% of the stalled projects, in terms of value, are stuck because of state related issuesland acquisition and state contractsover which the central government has no jurisdiction. Another 25% are stuck because of fuel linkages which ultimately relate to state electricity board financinganother area over which the Centre may have more limited efficacy. Only 8% are stuck because of environmental clearanceswhich, in theory, the Centre can grant on day one.

All this poses the risk that markets may be running ahead of themselves, and some caution is warranted. If expectations grow relentlessly and markets ignore the writing on the wall, disappointment is inevitable. Yesterdays RBI policy is a classic case in point. There was an ever increasing belief that the central bank would stay on hold. And, expectedly, it did. Yet bank stocks sold off sharply because the tone and tenor of the statement revealed that the space for any rate cuts down the linewhich growing sections of the market had surprisingly come to expectlikely does not exist. The fact that the bank index fell by more than a percent suggests that some in the market were still holding out hope that policy rates would be cut in the near future.

Instead, RBI revealed it will be firmly focused on keeping the economy on a disinflationary glide path to meet its 8% and 6% targets by January 2015 and 2016, respectively. Why is this reaffirmation important Because some market participants believe that if inflation dips below 8% for any length of time in 2014, it will open up space for rate cuts. It is important to emphasise that 8% is an intermediate target for RBIa milestone on the way to the central banks eventual goal of 6%. Almost nobody believes that CPI is expected to dip and stay below 6% for any length of time this year. Even RBIs fan chart has a 90% confidence interval wherein the lower bound stays above 6% for most of the year. So, even assuming inflation were to fall below 8% for any length of time but remain above the central banks eventual target of 6%, its hard to see a central bank cutting rates!

Second, what are the chances of the 8% target being met in January 2015 without further tightening Some commentators have pointed to how the momentum of headline inflation has plunged in recent months. But this is only on account of the plunge in vegetable prices which have now plateaued. Already, prices of other foods have begun to tick-up. Its important to remember that there is a clear structural element to food inflation which has averaged 10% over the last 10 years. So, food inflation is unlikely to sustain at current levels of 8% and is eventually likely to mean revert. Thats because nothing fundamental or structural has changed about agricultural productivity, allocative efficiency or the supply chain to suggest a regime change. Yes, MSPs have grown at a much lower pace last yearbut the problem was never rice or wheat inflation, per se. It was the allocative inefficiency of farmers not responding to non-cereal price signals because of sustained MSP increases. That process will not reverse in one year.

Furthermore, core inflation is stuck at the 8% mark for more than a year. And, more ominously, its sequential momentum (quarter on quarter, seasonally adjusted and annualised) is even higher at 8.3%. So if core is sticky at the bottom of the economic cycle, what happens to it if growth accelerates in the second half of the year Given the extent to which corporate margins have been compressed, any sustainable rise in aggregate demand is expected to be met with corporates rushing to normalise margins and raising final prices. So, the outlook for core inflation looks far from rosy. No wonder then that RBI signalled there are upside risks to its forecasted inflation trajectory.

All this suggests that monetary policy is likely to be tight for the foreseeable future and any future action is likely to be a hike, not a cut! Add to this the fact that fiscal policy will be forced to remain tightif next years 4.1% of GDP deficit target is to be met and a ratings threat kept at bay. All this suggests that the challenge for the next government to boost growth through industrial policywithout reliance on stimulative fiscal and monetary policywill be significant to say the least.

RBIs actions and guidance yesterday were understandable and expected. But markets had chosen not to read the writing on the wall, and bank stocks fell. Lets therefore hope that even as market expectations are rising relentlessly, the tyranny of economic reality is not ignored.

The author is chief India economist at JP Morgan