While the Indian economy continues to gather momentum, there are concerns relating to rising crude oil prices, inflation and the country?s current account deficit. Rajeev MalikR, senior economist, CLSA Singapore, believes growth could moderate in 2011-12 before rebounding the next year. He tells Shobhana Subramanian that while it is legitimate to worry about whether the ongoing investment cycle is slowing, investment should gain traction due to spends on infrastructure.
What is the 2011-12 outlook?
Growth will moderate slightly to 8-8.3% due to subdued global growth but will rebound to 8.5-9% in 2012-13. India?s lower export-GDP ratio makes it less exposed to global demand but this ratio rose from 7% in 1989-90 to 21% in 2009-10. Also, RBI?s tightening should moderate domestic demand to a more sustainable but still-elevated pace. Since equity markets are significantly more open to foreign flows, shifts in global financial conditions are quickly transmitted via markets, and can sometimes have a major effect on the real economy.
There are risks, including any lasting fallout from the recent corruption scandals that increases policy uncertainty and adversely affects the investment cycle. GDP grew at a stronger-than-expected 8.9%YoY in the first half of the current fiscal year. Domestic demand remains the inherent strength with gross fixed capital formation increasing 14.9%YoY in April-September, while private consumption and government consumption rose 8.6% and 9.1%, respectively.
Private spending is expected to remain robust, while the ongoing investment upturn is poised to become more palpable. Higher prices for agricultural produce and the government?s active social and infrastructure programmes will also boost spending by rural consumers.
Is the investment upturn for real?
The worry over whether the ongoing investment cycle will lose steam could be ascribed to a still-cautious corporate sector, political fallout from the recent corruption-related scandals, and/or slower pace of loan approvals by public sector banks following the recent bribery scandal. But we believe that the investment upturn will gain more traction in 2011-12 due to higher infrastructure spending and an increase in private capex. It is hard to imagine that India can grow at 8-9% but not have to add any capacity.
Indeed, India remains in a virtuous cycle of higher saving and investment-driven growth that will be favourably affected by the emerging demographic dividend. But the government needs to get its act together to facilitate an enduring investment upturn.
Headline inflation is coming off. Will it stay that course?
Unfortunately, no. WPI inflation has been easing, partly owing to a combination of softening food inflation and last year?s base effect. Non-food manufactured goods inflation will likely start reversing soon to head higher as the impact of higher global commodity prices, especially crude, is fully captured in local prices.
India is also a country with ?suppressed? inflation, with several structural rigidities that accentuate cyclical inflationary pressures. What I mean by ?suppressed? is that prices of several categories need to be adjusted upwards, but that can only happen gradually. Or it can happen in a big bang manner if we are forced by a crisis.
What about food inflation that is becoming structural?
This is the result of several factors, including improving affordability, stagnant output in some categories and the government?s move to increase minimum support prices. The recent bout of food inflation hitting around 20% was the first time that there were no street riots and violent protests.
India is not the first country that is undergoing an increase in affordability across different cross-sections of the population, which have increasing demand for protein-rich foods. But food inflation never became a structural issue anywhere else. Why? That was because there was a supply response that kept prices in check. Talking about a part of food inflation in India being structural in nature is really confirming the deficiencies in boosting food output, including protein-rich food. Indeed, it is worrying that the government is likely to go ahead with a food security Bill without having first done anything to secure the supplies.
What is the outlook for interest rates?
RBI operates with very few degrees of freedom. Some of the constraints include large government borrowing, embarrassingly slow pace of action on infrastructure, and lack of skill enhancement of large sections of the labour force. Monetary policy alone cannot solve all the structural rigidities and it also cannot be a replacement for government inaction.
2011-12 will be an even more challenging year for RBI. The current year was all about policy normalisation, but from now on RBI will have to take a call on the magnitude of the monetary tightening without overdoing it. While slower growth will soften demand-driven inflationary pressures, supply-side pressures from higher global commodity prices will remain a challenge. Global crude oil prices of $100-110/bbl could cause WPI inflation to jump to 7.5-8%, depending partly on the government?s ability to hike retail fuel prices.
More importantly, RBI will need to take a call on which drivers of inflation it can actually affect with its policy. Monetary policy can only affect non-food manufactured inflation and that too via moderating demand. Even here it is debatable how much RBI can actually check higher inflation in non-food manufactured goods, especially since global commodity prices are partly because of excess global liquidity. If the government does not want to sacrifice growth in the near term, then inflation will be higher for longer.
Unfortunately, RBI makes things difficult for itself by focusing on WPI as a measure of inflation. This is partly understandable as India doesn?t have a reliable CPI, despite having four such measures. But the WPI is inherently more sensitive than the CPI to changes in global commodity prices. Thus, during the spike in crude oil prices in 2008, WPI/PPI inflation in most other Asian countries was higher than in India. But many investors concluded that India was much worse off on inflation because we were advertising WPI inflation, while others were focusing on CPI inflation, which was lower than their respective WPI inflation. It is like comparing apples and oranges, and has anchored market expectations in a counter-productive manner.
What about capital inflows?
The biggest surprise this year has been the surge in the magnitude of overall capital, especially portfolio, inflows. The key issues with the current account (CA) deficit are its size and the nature of financing. Since India is growing faster than the rest of the world, it will post a higher CA deficit during this phase. But the growth differential in India?s favour is also the reason why foreign savings are being recycled into India. Also, the wider CA deficit has played an important role in offsetting the appreciation pressure on the rupee, thereby allowing RBI to have a generally hands-off approach on the rupee. Still, the widening CA deficit will need to be checked, as India cannot have a CA deficit of 3% of GDP on a sustained basis. Nothing can beat policy initiatives to enhance the competitiveness of the export sector but precious little is being done in that area. It is a concern that India has a high reliance on portfolio inflows, which, to be fair, are also needed for the divestment programme to be successful. India needs to diversify the channels of capital inflows rather than being too reliant on equity inflows.