The outcome of the US Federal Reserve meeting was in line with most market expectation and even mine. Fed did not lift the rates from zero. However, what I was shocked to see was their communication post policy, right from the short minutes to the more detailed press conference which followed. US Fed seemed confused, lost as well as little scared. Just consider this, in the whole message they had major conflicting pieces like (i) mention of negative rates in US (ii) dissent by one of the members, who wanted a 25 bps hike (iii) that Fed remains ready to ease further, if situation demands. The wide range of outlook proves how unsure US Fed is about the economic situation. Financial markets tumbled within 24 hours of US Fed sounding like the way it did. Financial traders seek clarity from regulators, and when they get such a garbled message from the world’s most followed central banker, it is quite natural if they decide to panic.
I have said it before and saying it again. Lifting of rates is not the only important event for financial markets, but a more important phenomenon is how indecisive global central bankers are about the same. The question remains, why after 8 years of trillions and trillions dollars of stimulus (both fiscal and monetary) from major world policy makers, what have we achieved as an economy. A healthy economy needs little or no crutches of stimulus, leave aside the possibility of a monetary ventilator like a QE. After nearly a decade, just two years short, of these rounds of booster shots, the world’s most powerful central banker cannot even muster the courage to normalize policy rates, and that too by just 25 bps. This is a loud and clear confirmation of the weak of the world economy. I have written at length about it over past one year and hence not surprised to see it occur.
It seems US Fed has decided to now meeting to meeting about when to hike rates, as they have little or no medium to long term goal posts in front of them. They know that they have missed the window of opportunity long time back. Though in an ideal world, policy normalization should not be an economic breaker in itself, but when you are midst of a major global deleveraging cycle, you are wary of triggering rounds of vicious loops of crumbling asset prices and economic shocks. Hence, we may continue to see more central bank mis-steps in the future.
In a recent speech Dr. Raghuram Rajan (https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=976), titled, Sustainable Growth in the Financial Sector, talked about the following, “ No country succeeds without believing in itself – I do not mean the unwarranted belief that we are intrinsically better than everyone else but the confidence that given our population, our demographics, our massive infrastructure investment opportunities, and the wide range of capabilities in our people, the arc of history is turning towards us.” I believe has hit the nail on its head. You must have come across the near delusional and a bit motherhood statement, that we are immune to world economy. However, the truth, time and again has shown how wrong those assertions are. Yes we are better-off in relative terms in some aspects but we are also equally vulnerable in many.
Emerging economies are capital starved and full of economic potential. However, having potential does not mean that it is realizable. Weak institutions create hurdles along the way. Hence, inspite of being a gold mine for opportunities, emerging economies remain emerging and only a handful, more as an exception finally emerge to become a developed nation. DR. Rajan has talked about Brazil as an example but one can see the EM space littered with many such fallen angels, over the century and even now. Therefore, saying that invest in Indian financial assets because it has so much potential, ignoring the risks associated with it, is like telling somebody that if ones stays in Africa, one must be rich, because there are so many diamond mines around. Hence, in EMs it always caveat emptor, buyer beware.
Indian economy too is going through a phase of economic transition, where government is doing its bit of building strong institutions and processes and also removing bottlenecks. Transition periods are always painful, if it is a trade-off between long term over short term. Government is working to remove red tape, eliminate corrupt practices and improve accessibility to resources. Ease of doing business comes with an economy which offers equal opportunity to all kinds of players in a corruption free and transparent manner. An efficient and impartial bureaucracy and judiciary can go a long way in enabling that. Remember, the role of the government is more an enabler and it is up to the private enterprise to make full use that conducive environment to become successful.
Over the short to medium term, Indian economy has to grapple with following issues, which I have written about at length over the past 18 months:
Rural economy is ravaged by structural forces of commodity bust and real estate down turn
For the last three seasons, last year Kharif, this year Rabi and the ongoing Kharif season, rural economy had the face the brunt of uneven rainfall
Construction and real estate sector provides significant employment to skilled, semi-skilled and unskilled workforce. With the industry facing an end to decade old boom, which one can say became a bubble, is now hurting employment situation
Natural resource extraction and processing industry is also facing crunch
Exporters, from precious metals and diamond industry to garment manufacturers are also under stress
A sharp economic slowdown in India has hurt government’s tax revenues. Government’s ability to spend and grow is limited. Remember, the state and the central government has limited fiscal deficit room, with central bank and rating agencies watching like a hawk. At the same time, there is clamor for more spending. Yes, a deregulation of petroleum sector and fall in fertilizer subsidy has created a fiscal room. However, that room remains is inadequate if the government has to offset the private sector downturn. Government has increased spending on roads and railways but please do not expect miracles due to that at the aggregate level. Therefore, it is quite natural that government has had to raise taxes in a contractionary economy. They have raised service tax, rolled back various sops and also had to raise excise duty on gold and petroleum products. Remember, government also faces a loss of revenue (state as well as central) on account of 60% drop in petroleum prices, as their taxes are ad valorem.
Housing and building construction activities have powerful multiplier effects on the economy. In India, it is estimated that around 270 industries are directly or indirectly related to the housing and real estate industry. Therefore, when such an important industry faces downturn, debt deleveraging and bust, it is bound to have significant economic implications. One can easily gauge the impact of real estate on financial institutions too and also on corporate balance sheets. I continue to keep a close watch on this sector as it remains a major driver of the economic activity. Additionally, state governments earn revenues from this sector through taxes. (http://www.firstpost.com/business/money/the-real-estate-crisis-will-devastate-state-finances-time-to-prick-the-price-bubble-1962899.html)
Government’s drive to root out corrupt practices in government, bureaucracy and corporate India is very laudable. I see it as a major long term positive for the nation. However, it comes at a short to medium cost. As the parallel economy or cash economy shrinks it can slowdown economic growth even more. However, that should not deter us from pursuing it, as it is will a single biggest reform in post-Independence India.
Global economy and Indian economy is changing, we are witnessing the next industrial revolution. Now the opportunities are moving away from the skilled/unskilled routine workers towards skilled non-routine workers. A knowledge economy is greatly rewarding as far as productivity improvement goes. India is making progress in leaps and bounds in that aspect. With little or no involvement of politics, we are seeing the economy sectors flourish. However, the middle or lower sections of the employment pyramid is also at risk. The large sections of people who do skilled/ unskilled or semi-skilled routine jobs are facing the axe. This means skilling India has become imperative. Demand for quality education and flexible forms of education like vocational courses are the need of the hour. In that regard, GOI’s skill India mission is a good start.
To conclude I would say, that the transition phase will continue to ensure that disconnect that exists between financial asset prices and economy will gradually diminish, through episodes of risk-offs. In that scenario, we may continue to see EMs, including India, go through a long period of sub-optimal return and volatile phases. Indian Rupee, remains better placed till now, thanks to RBI. Though we may continue to see relative outperformance from Rupee but on an absolute basis, Rupee may face gradual depreciation pressure. We expect a range of 65/65.50-67.00 over the near term. In case, of a blow-out in global risk aversion, the range can expand upward towards 67.50/80 levels. Indian 10 year can remain well supported as expectation for rate reduction remains in play ahead of the RBI policy.