Aziz tells Shobhana Subramanian this is why India is overheating. Hiking rates by 50 bps is the only way to beat inflationary expectations

It?s been a great earnings season so far in the US?

In the initial phases of a recovery, you see profit share starting to rise and with a lag you see unemployment going down as firms start expanding. We haven?t seen the second part in this recovery, although profitability has been going up since Q3 2009. In this phase, we?ve seen six quarters of the phase without the market correcting, and unemployment is correcting very slowly. It?s not a good sign because when you see sustained divergence between profit share and employment, and the market not correcting it, then the politicians correct it either through regulatory changes, subsidies, protectionist measures or taxes.

Why is the stock market not seeing this? The S&P?s still rising.

The stock market is, in some sense, seeing this because many of the stocks that have done well have a high share of global revenue, say, an Apple or an Intel or a GE.

Nonetheless, that means the world economy is doing well?

Yes. What it shows is that we have stronger faith in the global recovery than we did six months ago. Portugal is probably the only country where the growth hasn?t been strong.

So is there going to be a QE3?

My guess is that we are done with QE (quantitative easing) temporarily.

Would this result in some pullback in commodity prices?

No. Commodity prices were being driven by excess liquidity?the amount of liquidity there is in the world today is significantly large, Japan is going to add to it. Beyond that, demand for commodities was being driven by growth in the emerging economies. And that remains?the rebuilding in Japan could add to the demand. The third reason why commodity prices could stay elevated is because this was a hedge against US inflation.

But once QE2 ends, the dollar would strengthen…

The dollar won?t strengthen because there are serious questions arising on how long the infighting between the Democrats and Republicans will go on and how long it will take for an agreement on fiscal consolidation. If that remains an uncertainty, then the 10-year rate doesn?t get support from inflows and that means the dollar remains weak. Although the Fed has said it doesn?t have a view on the dollar, the entire mechanism of the QE2 was meant to weaken the dollar in order to provide stimulus and to create the impression that an inflationary process is on the way. If there is some news from Washington that the Democrats and Republicans are not going to end up fighting forever, then you will have support for the dollar. But if not, it?s difficult to see how the dollar is going to be supported.

The ECB has started tightening; the Bank of England (BoE) meets in May. Most of the world is tightening. What about the US?

I don?t think the US will start to tighten till the middle of 2012. The BoE could tighten by 25 basis points and the ECB could tighten by another 25 basis points between now and the rest of the year.

Where do you see inflation?

Everybody?s inflation forecast peaks more or less in Q3; this is true for analysts and central bankers. And all of us have a tightening that reverses only a very small portion of the cuts during the crisis. The one that leads all of this is Asia?by the end of 2011 it would have reversed 60% of the cuts, followed by Latin America though Brazil would have reversed just half of what it cut. Europe may have done 10-12 %, and the US nothing. At the end of 2011, you will still have a loose monetary policy. None of the countries will be back to the point where they were in 2008. The big consensus is that the global commodity price hike is going to peter out and that after Q3 we?ll live happily ever after. It can happen but that seems unlikely given the monetary policy stance.

Is it too late then for a 50 basis hike in policy rates at home?

Even if it is too late and doesn?t have an impact, it needs to be done. There?s no other way to bring down expectations. If you don?t do that, it?s going to be almost impossible to keep inflationary expectations in the market under control.

Do high interest rates in India hurt consumption?

Yes, they do. People argue that they don?t and say that interest rates have gone up by 250 basis points but I?m still consuming the same amount. That?s not the way to look at it. The argument to make is that what would they have done if there wasn?t a 250 basis rate hike.

But there?s no cut in consumption.

The cut in consumption doesn?t happen because banks do not increase lending rates in an environment where credit is falling. The only way they can pass on the higher costs is if credit is rising.

Banks would rather take a hit on margins than pass it on to consumers.

So how do you read policy rates?is a hike of 75 to 100 basis points likely this year?

That depends almost entirely on how aggressively RBI restarts its tightening. If RBI does 50 basis points on Tuesday, it may get away with doing 100 basis points altogether this year. If it keeps on doing 25 basis points, then a time will come, Q3 probably, when India will start looking much like it did in July when RBI was forced to do a 50 basis points in the middle of the night and do another 50 basis points a week later, alongside CRR hikes.

Where does that leave growth?

Growth necessarily needs to be brought down appreciably, by a minimum of 50 basis points. I think if India gets away with 8% this year, we will be lucky.

Are you saying India?s overheated?

Yes, we?ve been overheated for a long time. Part of the reason is that we?ve gotten used to the idea that 9% is the potential growth rate. It may be. If you look at the last two years, there has been almost no investments outside of infrastructure. Nothing. Not a single corporate has done any expansion between 2008 October and now. So capital today is smaller and, therefore, the potential of this country has to be lower because the amount that it can supply is lower. The potential to supply can probably keep the economy growing at 7.75% but we?re pushing the economy through monetary and fiscal policy to grow at 8.5- 9%.

How do you read fund flows into India?

The fiscal deficit of the developed markets (DMs) is going to be large for the next 10 years, more so given the ageing population. But you can?t have negative savings in equilibrium, it has to be financed. The only countries that can finance this are emerging markets (EMs). So ultimately, flows have to go back to DMs from EMs. But the private sector will seek yields and take out money from DMs to put it in EMs. So the public sector or central banks will have to be the ones who will take money out of EMs and put it in DMs and their task will become difficult since the private sector will be doing the opposite. But the dollar remains the reserve currency because it is convertible. Global imbalances can be brought down by targeting growth globally?EMs should allow currencies to appreciate significantly.