Jahangir Aziz, chief economist at JP Morgan, believes that if the government does not move in the next three to six months, S&P will find it very difficult not to pull the trigger. A downgrade to junk status, Aziz points out, would send borrowing costs for Indian corporates sky-rocketing non-linearly. On the positive side, Aziz tells Shobhana Subramanian that the shift from imported equipment to domestic capital goods, driven by the sharp depreciation of the rupee, will create some momentum locally.

What are the chances of a further slippage from the current GDP estimates?

There is a fair chance of slippage but high frequency data like the PMI or auto sales, or even exports, show the bottom seems to have happened. So growth seems to have troughed out somewhere in April?June as the month-on-month numbers indicate. While things don?t look as though they?re going to recover strongly, it doesn?t also look as bad as it did in April. For Q1 GDP, we?re looking at somewhere around 5.3%, maybe even 5.1%, but for the year we could hit 6% if the global economy doesn?t completely collapse around us. But to reach 6%, when we are starting from somewhere near 5.3%, there?s an actual upturn required. In this environment, this is a large recovery that we?re expecting because we have to cross 6% at some point. There?s no stagflation in India. We have really only one stagflation story, which was the US in the late seventies.

Consumption has slowed and could slow further with a weak monsoon…

The biggest problem, as we see it, is the power grid failure, since farmers depend crucially on power; the last time around when the monsoon was weak, at least they had free electricity. This time, crops like oilseeds could get affected because there?s less ground water and Karnataka doesn?t give as much free electricity as other states. We are more or less comfortable that rural consumption won?t get affected because there?s MSP and there?s MGNREGA which are tied to inflation. What we?re really concerned about is urban consumption because there?s no social safety net and wages haven?t kept up with the rise in prices. Auto sales, after plunging last year, seem to be picking up. But, we believe, core inflation could trend up even if commodity prices soften.

How then are you seeing a recovery?

We remain negative on investments, but there is going to be a large shift resulting from import compression, from foreign-sourced imports to domestic equipment. The total amount of investment in the economy isn?t really going to move up too much. In fact, it?s probably going to decline, but there will be shift in the composition of investment. That shift to onshore will probably help you get to 6%, though the capacity in the economy will remain strained. Related to this is our view that even though growth is slowing down, trend growth or potential growth has slowed even more. So potential growth is now down at 7.5% from 8%. The near-permanent depreciation of the rupee is going to have benefits. Currently, the J curve is happening because of a massive compression in imports rather than a massive increase in exports and, in this respect, India is pretty much like the rest of the world.

Is the output gap small?

The output gap is small. The very high inflation of 2010 and 2011 was caused because the economy was running much higher than capacity. Now capacity has come down, or rather is not growing any more at the same pace, but demand has slowed down. The total output gap or the excess use of capacity that existed in 2011 hasn?t been worn out. You need many more quarters of the economy growing at a slower pace than 7.5%, for the massive excess capacity usage that took place or the lack of spare capacity to come down. For inflation not to move up, you require the economy to be running at 80-85% but we really have no measure of where it is now. With growth being lower than potential, the output gap has been reduced and that means the pace at which core inflation is going to rise is slower. If core had been 4% then we could, more or less, say the output gap could turn negative very quickly in the next one or two quarters. In which case there would be enormous disinflationary pressures in the economy simply because growth had slowed down to a miserable level.

So what is India?s potential growth now?

Our concern is that RBI?s wrong about the 7.5% and our calculations suggests trend growth is around 6-6.5% and not 7-7.5% for two reasons. The first is that investment in India has fallen off sharply in the area of equipment because investment by corporates has plummeted. Because of this, corporates haven?t been able to improve productivity. Higher productivity comes from better policies, reorganisation or new IT platforms, but there are limits to what these can deliver today and what really delivers productivity is much more efficient equipment. The decline in equipment investment not only has a direct impact as it reduces the potential of the economy, it also lowers the productivity of the economy.

The sharp fall in the rupee, you say, has resulted in monetary easing of about 150 basis points?

Absolutely. Unless, in the same breath, we say that a 9-10 month depreciation of 25% has not changed the behaviour of importers and exporters. What RBI has done is to tie future rate cuts to government actions, though it is very clear that RBI is concerned about lower growth. But it?s up to Delhi now because RBI moved in April perhaps more than it should have. What we need is a diesel price hike because that would ensure demand comes down, but we also need to be sure supply constraints will ease. RBI needs to be sure infrastructure will be in place, that there will not be another grid failure. Once that happens, even if inflation is high, RBI will cut rates because potential inflationary pressures will be lower.

So a tight monetary policy has been effective?

Yes, of course. Aggregate demand has come off and we have seen a quietening of core inflation from 7% levels. But we are concerned about the FY14 Budget and its impact on the economy and what S&P will do. My sense is that the government has resigned itself to the fact that growth is going to be 5-6%, inflation 7-8% and if it can survive the next couple of years, it will be reasonably happy. When you base policies on trying to muddle through, almost invariably, in any economy that I have seen, the market loses patience and punishes you severely. And the S&P downgrade will trigger it. If the government does not move in the next three to six months, S&P will find it very difficult not to pull the trigger. And the cost of borrowings for corporates will sky-rocket non-linearly because this will mean a movement from investment status to junk status and a large number of investors will simply not invest. Muddling through cannot be an option.

What do you make of the 100 basis points SLR cut?

RBI believes that overall liquidity could be in short supply because deposits are growing at a slower pace, so it is de-burdening banks by cutting the SLR. There is a near-term rhetoric that RBI uses and there is an actual or an implicit rhetoric that is not being articulated but is probably closer to the truth. RBI has persistently, in the last two or three years, cut SLR every time there?s been an opportunity. Their medium-term goal is to bring down SLR and that?s a good thing to do because that?s the only way it can discipline the government. It?s also a fact that banks are scared about not having permanent liquidity.

How do banks cope with the slowdown?

We have to accept the fact that RBI will have to go through a period of extended forbearance in order for a large amount of loans that will turn bad. If we don?t do that, we will have a problem where our regulator is doing one thing on the regulating side and another thing on the monetary policy side and the two are inconsistent. If I have serious questions about your creditworthiness, you can cut rates to zero, but banks will not lend. Look at the US; every corporate is sitting on cash large enough to buy small economies?Google?s cash for instance. The regulator did step in in 2008 and say it would give an extended period of forbearance and ultimately the government will have to be willing to accept a write-off on debts. SMEs should be allowed to restructure and loans can be treated as non-sub-standard. But it has to be done systematically and RBI must do it.

Do you see a QE3?

Yes, and, almost surely, the money will flow into commodities. My guess is that you will see an LTRO soon in the eurozone and the Fed may have to do another round of QE because growth is trending down. So, I think you will see a wall of money coming in to emerging markets and commodities. But, in India, we haven?t created the space for capital flows in that we haven?t raised the limits for gilts. Money hasn?t come into our markets because of the 20% witholding tax, so we need to rationalise the rates like we have done for infrastructure or corporate bonds where it is 5%. The tenure doesn?t really matter. As for equities, money will come into specific companies.