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Growth challenges ahead: Will the current circumstances be a repeat of 2019-20?

This time around, economic recovery appeared robust and gained momentum in Q4 FY22.

Growth challenges ahead: Will the current circumstances be a repeat of 2019-20?
A recession in the advanced economies could set back exports as in 2019. Despite higher capacity utilisation, credit off-take by large industries remains weak (1.9% nominal and deeply negative in real terms).

Financial markets have been awash with uncertainties, leading to extreme volatility over the past several months. The sources are multiple, but ironically, central banks of many advanced economies have been major contributors. Their actions and communications have been tangential to their public commitment to attack inflation unflinchingly under their respective inflation targeting regimes, especially when the price rise is at a 3-4-decade high and still mounting. They are all traveling on a narrow path, in trying to achieve the pious act of controlling inflation without prompting any recession. This alibi to protect growth and employment, i.e., manoeuvering the softest landing possible, has turned them into extreme risk-takers and unwittingly emerge as the source of greater uncertainties for emerging market economies (EMEs) like India.

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What could be its fallout for India’s economy? Spillovers to EMEs travel through three channels, viz., capital flows, trade, and sentiment or confidence channels. Most commentators are notably focused on the first two—one, the rising US interest rate and the hardening dollar would trigger capital outflow, tightening domestic monetary conditions; and two, a slowing global economy would hurt export demand. The two channels could combine to pressurise the exchange rate resulting in higher pass-through of international prices and damaging corporate balance sheets with unhedged forex exposure. Few, if any, have impressed upon the third channel—a protracted uncertainty that could dent business sentiments and confidence, thus delaying investment.

Consider the US Federal Reserve, the fulcrum of world financial markets. It has been wide off the mark with inflation projections, unsure about its policy communications, and ambivalent with forward guidance. Its inflation prognosis since chairman Powell’s Jackson Hole speech last August has moved from fully supply-induced to a largely supply-driven one, hence the reluctance in decisively raising the interest rate. It’s been professing nimbleness in response but remains clumsy in actions. Such indeterminacy would mean the first two channels would fluctuate with incoming data—each time actual inflation goes against the consensus, the market would be forced to change its views on monetary policy actions, thereby injecting more uncertainties.

Uncertainty is well known to be the biggest enemy of investment. Unfortunately, markets across the globe have joined these central banks to aggravate it further. Many market participants engage in recession “fear-mongering”—displaying extreme nervousness at the slightest hint of aggressive tightening. Why? The underlying fear is that any sharp increases in the interest rate could result in huge mark-to-market losses and a potential debt meltdown. Therefore, avoid a hard landing at any cost! That’s why the US yield curve has inverted—the 10-year yield has remained below the two-year one, feigning a future recession. Some even go to the extent of saying the US might already be in an early phase of recession! Such expectations are based on the hope that inflation will self-correct with diminishing consumer purchasing power and a gradual drop in excess savings accumulated during Covid. But this could be an uncharted path as the real interest rate remains hugely negative!

How badly could it hit India’s economy? Unlike the 2013 taper tantrum, which was purely an announcement effect that fizzled out as soon as the Fed changed its views, this one is being driven by real economic factors that are adjusting in an unmapped path; therefore, it could drag on much longer. Persistent uncertainties like the above could test Indian policymakers, who’ve been careful in calibrating interest rate increases and liquidity removal to support early growth recovery. The biggest challenge would be retaining the autonomy of policy actions to address domestic objectives. However, their initial assessment—that foreign exchange reserves (including RBI’s net forward purchases) exceeding $680 billion could see them through this uncertain period—turned out to be short-lived. Elements of external sector vulnerabilities—like a widening current account deficit and sustained capital outflow—have prompted market concerns, forcing the RBI to announce fresh measures to reverse the trend.

What could the future hold? Some believe that improving global supply-chains and recession fears have already corrected international oil and commodity prices; this could cool domestic inflation, helping RBI to decouple from the world interest rate cycle. This could be optimistic, though. It must be flagged that capital outflows from debt markets have been fairly subdued so far; any large difference in interest rates could activate this channel as well, pressurising the exchange rate. We also do not know if Covid has significantly impacted India’s potential growth. If so, core inflation will remain firm despite headline falling below 6%.

More important, though, is the fact if these uncertainties endure or further amplify. In that case, domestic business sentiment could deteriorate much faster than currently anticipated, transmit to real variables much sooner as investment decisions get delayed, and envelop consumer sentiments with it, reminiscent of the early months in 2019. Some early indicators are conspicuous—for example, business sentiments were already down to a 27-month low in June’s Manufacturing-PMI. In early 2019, economic conditions were looking up as RBI projected GDP growth at 7.2% in FY2019-20. But then, something gave way. Growth decelerated every succeeding quarter—it fell from 4.9% in Q1 to 4.2% in Q2, to 3.2% in Q3, and to 2.8% in Q4 (the last 10 days were impacted by the Covid lockdown).

This time around, economic recovery appeared robust and gained momentum in Q4 FY22. But it showed signs of fatigue in Q1FY23. It is still very weak relative to 2019-20, a low base itself. For example, IIP grew only 1.7% in May 2022 over May 2019. Recent research (Nikhil Gupta, Indian export figures are not as impressive as they may appear, Mint, June 27, 2022) estimates that real exports contracted 1.9% in May 2022. A recession in the advanced economies could set back exports as in 2019. Despite higher capacity utilisation, credit off-take by large industries remains weak (1.9% nominal and deeply negative in real terms). CMIE’s data shows sharp fall in new project announcements to Rs 3.71 trillion in June 2022 quarter from Rs 5.83 trillion in the March 2022 quarter.

It is true that several other indicators reflect healthy recovery in contact-based services, although indicators like GST revenues are hard to interpret given high WPI inflation. But the intent here is to flag that it wouldn’t take much time for sentiments to plunge and economic activities to turn risky as in 2019. If the uncertainties originating from the advanced economies endure, the current phase of optimism may turn out to be a story so far, but no further! Eternal vigilance is called for.

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