Jahangir Aziz, chief economist at JP Morgan, believes there?s room for further tightening of monetary policy even after the Reserve Bank of India upped the key policy rate by 50 basis points to 8% on Tuesday and sees the repo closer to 9%. In a conversation with Shobhana Subramanian, Aziz says RBI needs to rein in inflation to about 6-7% by March next year and needs to keep it at a sustainable level so that companies can assess their costs and have the confidence to make investments.
The 8% growth number put out by RBI is perplexing…
Yes, they?re talking about the global economy slowing and they?re pulling down credit growth and they?re raising inflation forecasts. So, that?s clearly an anomaly because most of us are looking at growth between 7% and 8%. My sense is that they are far more pessimistic about the government?s ability to rein in the fiscal deficit. However, I think the consolidation will be surprisingly strong and, in the last month or so, the UPA government has shifted gears significantly pushing through rather difficult reforms.
Are you referring to the Committee of Secretaries? clearance of FDI in multi-brand retail?
In any country, FDI in retail is a tough legislation to push through because there are always fears of mom & pop stores closing down, of the back-end becoming a monopsonistic world. In the US, if you?re a family firm you can?t get a bank loan unless you have a three or four year contract with any of the four major supply chain wholesalers. Also roping in Sushil Modi to spearhead the GST shows they?re rethinking the process and pushing for reforms. There?s probably a new found confidence, and part of this is RBI?s much greater aggression; I also believe that the government will consolidate on the fiscal front and slippage of the fiscal deficit will not be 1% or 1.5% of GDP, as people are saying. If there is a slippage, it?s going to be 0.2% or 0.3%. The food subsidy will kick in only at the end of the year and it?s not clear that it?s going to be an additional subsidy. Also, NREGA, because of the indexation, will remain within the budget and, at the same time, revenues are increasing more rapidly than was budgeted. So there could be a positive surprise.
So, will industry be hit by the higher interest rates?
In real terms, rates have just turned about positive for borrowers with the current inflation of 10.5%. But, if you compare it with rates that prevailed between, say, 2004 and 2008, real rates are significantly lower. If you look at any proxy for profitability?nominal GDP minus nominal interest rates?nominal GDP would be around 17%, while interest rates are nowhere close to 17%, they?re much below that. The spread even now is higher than it has been between 2005 and 2008, and corporates were investing at much lower rates of profitability. So, it is undeniable that investment hasn?t risen as fast as one had hoped and credit isn?t picking up, but high interest costs are just a bogey.
So, do you think investment will pick up?
I think what you?re seeing is a return of investment. These are still green shoots but at least the bottom seems to have been reached; CMIE data shows that projects bottomed out sometime in February-March and while the pick-up isn?t huge, it?s picking up. So I think IIP this year would come in at around 7% or thereabouts and I think the view that IIP is going to keep slowing down is an overstatement of reality. If you look at the last two or three months, exports are growing well and while they will taper off, even if you halve the growth, we?ll still be at 20%. Also, non-oil imports are going up, which is a good sign. I?m much more comfortable now on the growth front especially because RBI has decided it needs to be the manager of macroeconomic stability and not leave it to the market to decide. This was an important move and with this new-found aggression things look much better.
Will high interest rates hurt consumption?
We tend to underplay the impact of interest rate increases on consumption saying that people are earning enough. But, at the end of the day, an increase in costs is an increase in costs. If people are not consuming less it only means the increase in interest rates is not sufficient and the tightening is not working. I think the repo should be closer to 9% by March next year.
There?s a feeling that growth in 2012-13, too, will probably not be up to scratch …
Absolutely, and what people are not seeing is that if inflation is not brought down to 7% by March and if you get a sense that the government does not have control over macroeconomic stability, then no one invests in a country with macroeconomic instability. The problem is that if I am to make an investment, I need to know my cost structure, including wages and capital, which make up 50% of the cost of a company. If inflation is so volatile, I won?t be able to assess costs. Today, there is pricing power because the economy hasn?t slowed enough and that?s why we needed the 50 basis point hike. If inflation isn?t controlled, capital costs would have been even higher; inflation needs to be reined in within a target, that?s what investors want to see. So, if RBI can bring it down to 6-7% and keep it there, next year and 2013-14 look better.
Would a QE3 upset the equation?
I think a QE3, if it happens, will be much more sedate than a QE2 and so it?s hard to see the commodity boom of the vicious nature that we saw last time, largely because people have been burnt. Also, QE3 may not see a direct injection of liquidity because that isn?t going to work any more; no one?s complaining about liquidity in the US, corporates have massive amounts of cash. If there is a debt shock in the US, all bets across the world are off because the shock will be larger than Lehman. All assets are ultimately collateralised against the US treasury and you will no longer have any certainty on that, because you can?t price any assets. The cost of all borrowing will shoot up.
How do you read flows into the emerging markets?
There are a couple of key risks for the emerging markets; one is a short-lived risk, which is the Greece package. If the Greece package doesn?t convince investors that it will resolve the Eurozone problem for some period of time, then you will see money going back to the US. People still use US treasuries as a safe haven; treasuries have rallied almost 25% in the last one and a half months simply because of the Euro problem, even though they have one of the worst debt outlooks among all G3 countries. If Europe is sorted out, risk comes back into the system, and money moves back into emerging markets. The bigger risk for emerging markets is a very sharp recovery in the US in which case you have two major hits; US equities will pull resources and US treasury rates will go up so the cost of funding EM investments goes up.
Money will go back to the US even if India grows at 7%?
Of course. Just because we are growing at 7.5% or 8% isn?t enough, all the other parts such as government reforms and so on have to be in place. However, the chances of a strong recovery in the US are slim in Q3 and Q4. So, as long as the government here gets its act together, as it seems to be doing, the market should see the entire change in overall policy reform as ensuring medium term sustainability rather than be obsessed by the earnings of the next quarter. I?m much more bullish today than I was three months ago when things looked very uncertain.