Fiscal 2015 was a good year from the point of view of economic risk being minimised due to a combination of factors. Call it serendipity, but somehow all numbers ended up looking better, with external factors remaining benign for most of the year, and the base effect keeping several parameters look healthier. The icing on the cake was provided by the new GDP methodology which has projected growth of 7.4% for FY15. The government was hence able to do some serious housekeeping without having to worry about these extraneous factors that have the potential of diverting attention. The moot question, however, is whether this scenario will persist in FY16?
There are several risks that lie in suspension this year too, which can go either way and hence pose a threat for the economy and come in the way of a more definite recovery. The dismal science can point at six major risks that can surface, which may not be directly under the control of the government.
The first is the performance of agriculture. A sub-normal monsoon has become a norm of late, as even last year rainfall was 88% of normal, leading to farm output falling across almost all crops. While the inflationary impact was minimal and localised, the impact on industry was more discernible as rural spending was muted on consumer goods including white goods, electronics, two-wheelers and tractors. This year, the IMD has provided a preliminary reading of 93% of normal monsoon, and while other factors such as arrival, progress and departure of monsoon as well as geographical spread are important, a sub-normal monsoon is a sufficient condition for inflation and growth worries. Besides, there has to be a contingency plan in place to react to a monsoon failure, which has to include alternative employment as well as measures to address rural indebtedness.
The second threat pertains to food inflation, which has been the dark spot in the inflation profile all through the year.
A second successive year of low farm output will most definitely be inflationary, which was not the case in FY15. Currently, overall inflation has been below the RBI comfort zone of 6%, though food inflation has strayed at a higher level. This is a risk that has to be borne in mind as it can be compounded further in case crude prices start moving up. There are reports that there has been limited new investment undertaken in oil exploration and that the US oil capacity has been almost exhausted, in which case prices could move upwards when demand increases. Currently, it looks like that as long as prices remain within the $60-70 per barrel range, the economy should be able to absorb price changes.
Third, with inflation being a threat, monetary policy is bound to be affected. While RBI can, and will, probably not hold back on rate cuts merely because there is a fair chance of higher inflation in the future, it does reserve the right to even increase rates in case inflation moves up beyond the 6% target. Hence, while another 50 bps cut in the repo rate may be expected, it would be under ceteris paribus conditions only. Interest rate is one major factor that affects future investment, and while there are other enabling factors also that have to be addressed, high rates can spoil the party. Today, several projects are stalled and are waiting for lower interest costs to get back on stream. If RBI starts increasing rates, it will push back the recovery process.
Fourth, fiscal deficit has been delicately balanced, premised as it is, on a steady growth in the economy and oil prices remaining neutral at a low level. Any deviation could necessitate expenditure cuts, which will repeat the process that we have been through in over the last three years or so. Upstream oil companies have already been freed from sharing the subsidy burden with the government, which means that fiscal balances are going to be that much tighter.
Therefore, it is a good sign that the government has started looking at the disinvestment process early in the year as the target of R69,000 crore is high and slippages will mean cuts in other expense items, especially since we are committed to the 3.9% fiscal deficit ratio.
Fifth, the increase in rates by the Federal Reserve, which has been taken as fait accompli, will happen at some point of time when the central bank is convinced that inflation can be a concern. This will mean a certain modicum of reverse migration of funds from the emerging markets to the US, especially in the debt segment. The risk for us is that since we do get between $10-20 billion of FPI flows into the debt segment, overall flows would be in jeopardy that will affect the exchange rate to begin with and subsequently the current account deficit. Also, the stock markets can be affected sharply as they rebalance their portfolios across both debt and equity and across countries.
This leads to the sixth risk of rupee stability. The recent volatility in the rupee has opened the door for arguments on the future of the rupee. FIIs have a very important role to play in affecting the value of the rupee. We have seen in the past that the 2013 run on emerging markets currencies was a global phenomenon that was not always related to fundamentals. The Fed factor dominated even at that time, which can repeat.
These risks are not really exceptional and exist at all times, but the ‘dismal’ possibility is of all of them fructifying at the same time. This would be opposite to FY15 when all these conditions were benign, which provided a major cushion to the economy on all fronts so that government attention was primarily on policy and its implementation.
We are on the precipice of a recovery, especially in investment and industry, and stable extraneous conditions are necessary. Any or some of these six risks emerging with strength will cause policy stance to change, which can then disturb equilibrium. It is hence necessary to be watchful of these developments and take prompt pre-emptive action to the extent possible so that the negative effects are less potent.
The author is chief economist, CARE Ratings. Views are personal