Column : It wont be all smooth in 2010

Written by Indranil Pan | Updated: Jan 5 2010, 02:49am hrs
It would be nave to accept that global economic conditions have recovered just by looking at the financial market parameters, especially the race-up in the equity markets. But from an economic fundamentals standpoint, India appears in good shape, even compared to China. Unlike China, the growth model in India leant towards fostering domestic demand and not towards the export market. And this is possibly one reason why the slowdown was not as deep as was initially expected, and also did not permeate much beyond the initial fear psychosis that was unleashed in October 2008. Here India was a bit lucky in the sense that the two biggest stimulus packages that worked on the demand side, namely the 6th Pay Commission awards and the Farm Loan Waiver, were instituted long before the crisis erupted and the first tranche of arrears under the Pay Commission awards were also doled out in October 2008. Perfect timing! These and the enhancement of NREGA programme and some tax cuts formed Indias fiscal focus to fight the crisis.

Indias rural demand has also proved to be rather resilient in the face of severe drought. While its true that even today 60% of Indias population lives in villages, much of the rise in income and consumption of rural India did not have much to do with agriculture. Over the years, better rural roads, electricity connectivity and penetration of communication services have enabled the ancillary services industry and export-oriented industries to flourish in rural areas.

There is no hesitation in indicating that there is little risk for India so far as economic fundamentals are concerned. Growth will stay strong, but will not climb to 9-9.5% immediately. India should be happy achieving 7-7.5% growth for the next year. Inflation is still mainly supply-side and we expect it to come off on the back of base effects. However, it is not the time to relax and my sense is that consumption demand has yet not recovered adequately to supplement withdrawal of fiscal and monetary policies.

On the other hand, financial markets in India this year could be quite volatile with price actions largely dependent on global financial market conditions. For interest rates, I think there will be core pressure to move higher. Even as we talk of fiscal consolidation, not much loosening has happened with the crisis of October 2008 in mind and, therefore, there is not much that gets rolled back anyway. And so far as the 6th Pay Commission awards are concerned, there is a permanent factor of an increase in the salaries of government employees. Next fiscal will also be a period of high redemption pressure for the Central government, given the de-sequestering of MSS bonds that happened in this fiscal. And the high borrowings of the last couple of fiscals would lead to the interest burden going up by Rs 25,000 crore at the minimum in future fiscals.

But, it would probably be wrong to assume significant large capital inflows into India throughout 2010. History suggests that any attempt by the US Fed to reverse its easy monetary policy is likely to lead to dips in the prices of risk assets, including equity. Further, risk aversion could rear its head once again if any of the earlier mentioned risks such as sovereign defaults were to emerge. I am not sure if the already fragile banking system globally could take another hit soon and before all problems have been mended. And as the US signals an interest rate increase, carry trades in dollar will be unwound, leading to large-scale flows of capital back to US.

Thus, the risk is that equity markets globally and also in India will remain largely volatile in 2010, also leading to volatile trends in the currency markets. And reduction of foreign flows in 2010coupled with the governments high borrowing programmecould potentially lead us back to the old days of crowding out, higher inflation and higher interest rates. Unfortunately, in such a situation, funding infrastructure growth would become difficult and would also limit the long-term growth prospects for the Indian economy. Added to this would be consistent fears of policy rate hikes in India.

Overall, it may not be prudent to rest on the laurels of 2009 and hope for an ever-improving economic scenario and asset market momentum in 2010. The challenges of 2010 would be significant and caution needs to be exercised as we discuss the pace of normalisation of fiscal and monetary policies.

The author is chief economist, Kotak Mahindra Bank. These are his personal views