The RBI has an unenviable task. Due to policy paralysis, the central bank has been forced to go beyond its mandate. But its attempts to shore up the economy have also made it obvious that the high-inflation-and-lower-growth cycle cannot be cured merely by monetary tools.
The consequences of three wasted years are clear. Inflation has not corrected down while the GDP growth rate has dropped from 9.2 per cent to 5.3 per cent. It’s likely that growth will slow down further before inflation drops to acceptable levels.
Core inflation (the inflation basket minus food and energy) has eased. It was below 5 per cent in May. However, food and energy inflation remains high, driving up overall inflation. The problems in these sectors are supply side driven.
Demand is relatively invariant with respect to price in the food and energy baskets. The government has to find ways to tackle the issues that prevent supply expansion. This is not something monetary policy can handle.
Another key fiscal problem is likely to correct naturally only through a trend of lower GDP growth. India has a big current account deficit along with a huge fiscal deficit. The CAD is about 4 per cent of GDP.
Domestic savings plus CAD represents investment. The ICOR (incremental capital output ratio) is a measure of output per unit of investment – the lower the ICOR, the better. GDP growth can be calculated by dividing the sum of domestic savings plus current account deficit (both taken as percentages of GDP) by ICOR.
ICOR is rising. Large investments are stuck in incomplete infrastructure projects. New infrastructure capacity translates to lower ICOR. But projects are long-gestation. So the initial impact of infrastructure investment is usually a higher ICOR. Since many projects across India are stuck in an endless loop of delayed clearances or land acquisition problems, ICOR may rise even further.
The domestic savings rate is 33-34 per cent. The CAD is about 4 per cent. The savings rate is unlikely to fall much. The CAD will drop if GDP growth drops (reducing import demand). Since GDP growth shows a southern trend, ergo the CAD is likely to ease down.
However, reducing the CAD this way (and not addressing the broader problem of fiscal deficits) is not ideal. It means the trend rate of growth is lowered. A combination of high ICOR, low CAD, and flat savings rate implies that GDP growth rates will drop well below the target of 9 per cent over the Twelfth Plan period (2012-17). A difference of even 1 per cent compounded over a five fiscal periods is considerable. Strong linkages between the corporate economy and GDP imply earnings projections will also be pared down.
However, few investors look five fiscals ahead. Politicians don’t plan beyond the next election. So corrective measures are unlikely. The government would have to make huge efforts to cut subsidies, and to speed up infrastructure investments. Both involve taking politically sensitive actions. So don’t hold your breath waiting for it to happen.
Long-term investors probably need to pare down expectations in terms of growth. The good side of things is that as inflation declines, interest rates will come down. That will tend to boost or at least, support valuations.
Although the RBI held the rates and CRR steady in its latest policy review, it is unlikely to hike rates again, unless something unforeseen occurs. If this is the top of the interest rate cycle, the market will rise as and when the RBI finally starts easing in sustained fashion.
Regardless of lower growth projections, a rule of thumb suggests that a drop of 1 per cent in interest rates equates to a rise in fair-value of between 1.5-2 PE for the broad market indices. So, if fair value is say, 12.5PE at an interest rate of 8 per cent, it would be about 14 PE at a rate of 7 per cent. Of course, financial stocks get larger benefits when rates cuts occur and liquidity eases. Putting a timeframe to easing liquidity is difficult. On the external front, the Eurozone is unstable and the RBI will also have to watch both China and the US for significant policy moves. If things go normally, rates and liquidity will remain easy in all three regions.
There are two dangerous factors. If the situation in Syria, Libya, Egypt or Iran explodes, crude prices will spike.
That will force inflation up again. It will also increase the quantum of government borrowings pushing up the fiscal deficit. The other danger is a sub-par monsoon with pressure on food prices.