India’s cup of macro challenges remains full and the brew is becoming more potent. Unfortunately, the country also suffers from tragic local politics. The original task of dealing with inflation has turned into a more complicated problem with multiple but related macro imbalances. The government shows little fiscal responsibility, growth has been crippled, and inflation is firmly entrenched and has affected the rupee as well. And now the drought will add insult to injury.
A key saving grace for India has been exceptionally easy global liquidity. All said and done, net foreign institutions investor equity inflows so far in the current calendar year have hit $10.6 billion, despite the plethora of local negatives. Still, we shouldn’t overlook that India is benefitting because many others are worse off, not because we are doing the right things to make the India story more attractive.
India’s economic evolution is following a path distinctly different from that of other Asian economies, but there is nothing preordained about its rise. It is also a good example of how policy makers in an economy with favourable structural drivers can mess up. For now, India remains stuck in a combination of below-trend growth and above-trend inflation (often incorrectly described as stagflation).
There is still considerable variation in expectations across different economic parameters. Most economists and investors have capitulated on economic growth, reconciling to five to six per cent annual growth over the next couple of years, depending on whether the government undertakes constructive action. But expectations about the outlook for inflation and interest rates appear to be, at best, work-in-progress, although considerable shift has occurred. Recall that the consensus forecast was for a dramatic fall in inflation, which, in turn, would facilitate aggressive easing by the Reserve Bank of India (RBI).
Expectations about rate cuts have undergone a dramatic shift, especially after the recent guidance by the RBI. The concerns are understandable given that Brent crude oil price has surged since bottoming in June. Also, the government is pussyfooting on the anticipated fuel price adjustment and the overdue fiscal correction. Finally, the impact of the poor monsoon will be much more relevant to inflation than growth.
The fight against inflation remains weaker than it should be. The risk here is that politics will again trump sensible economics and the government will attempt to boost growth without addressing the underlying ills. The worrying decline in the domestic savings rate and policy makers’ new-found sustainable current account deficit ceiling of two to 2.5 per cent of GDP mean that a strong investment upturn is unlikely. Low inflation and higher savings rates are key prerequisites for a lasting strong upturn in economic growth.
The fiscal situation will worsen given the political objectives of a government that is already on the defensive and the need to respond to the poor monsoon. The GDP assumption in the 2012-13 Budget always appeared to be from la-la land; actual growth could now be roughly two per cent lower than the 7.6 per cent it assumed. The new finance minister, P Chidambaram, has so far said all the right things. But talk is cheap, and actions, including those that require political blessing, will matter more than words. Hopefully, he won’t again resort to the sleight of hand of off-budget subsidy bonds.
Unfortunately, the one area where investors’ expectations have still not adequately adjusted is the medium-term outlook for the rupee. The rupee’s fortune began to change in 2002, but owing to temporary current account surpluses that lasted until early 2004. Often viewed as a sign of strength, they actually reflected weak domestic demand conditions that contributed to the narrowing of the merchandise trade deficit. The current account balance reverted to a deficit from 2004-05 onwards, as a new multi-year acceleration in growth began.
There were strong grounds for the rupee’s appreciation between 2002-2007, including higher growth differential, manageable twin deficits and inflation. Of course, easy global liquidity provided ample capital to finance the current account deficit. But these favourable drivers reversed course in recent years and the rupee became overvalued in real effective exchange rate (REER) terms. Indeed, its 20 per cent depreciation against the dollar is largely to correct this overvaluation.
In the very near-term, global risk-on could be positive for the rupee. But the rupee’s future beyond the next few months will be a function of: (1) India’s balance of payments (BoP); (2) outlook for the dollar; (3) global risk appetite; and (4) India’s inflation differential with trading partners. A narrower – but still large at three to 3.5 per cent of GDP – current account deficit doesn’t necessarily mean that capital inflows will be sufficient to comfortably finance it. Capital inflows matter. Recall that between 2003 and 2007, the rupee was under pressure to appreciate despite a wider current account deficit.
It is a common practice to have a view on the rupee without a view on the US dollar or the euro. Exchange rate is one of the most sensitive relative prices and the rupee will not be able to dodge the impact of the movements in the US dollar, the euro, and the related global risk-on/off.
Still, even if we assume that India will post an overall BoP surplus (capital inflows will more than finance the current account deficit), how long will the RBI continue with its hands-off approach? This is relevant in the context of India’s higher inflation relative to that of its trading partners. High inflation economies generally don’t have sustained appreciation of their currencies. In fact, more often than not, such countries have to favour currency depreciation to prevent them from becoming overvalued in REER terms.
Of course, there could always be a flood of reforms that will again justify appreciation of the real exchange rate. But this remains wishful thinking rather than a likely outcome. The rupee-has-to-appreciate view is partly because people are wedded to thinking of 2002-07 as the new normal. In fact, that period was an exception, not a new normal that would hold despite government incompetence. India’s higher relative inflation threatens a return to the almost forgotten pre-2002 days of annual rupee depreciation.
Given the painful nature of the anticipated adjustment and the likely political cross-currents, the actual corrective path will, at best, be sub-optimal, uncertain and uneven. The current economic challenges are not insurmountable. However, fixing them requires a government that is awake, willing to use some political capital and avoids more own-goals. Unfortunately, sensible economics doesn’t make good myopic politics that some bigwigs in the Congress party mistakenly think can win them elections.
The writer is senior economist at CLSA, Singapore.
These views are personal