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Surjit S Bhalla: Financial crisis - Getting facts right - II

Why GDP growth and the rupee should do better in 2009/10

Surjit S Bhalla  |  New Delhi 

Many reasons suggest that GDP growth and the rupee will do better in 2009/10 than in the horrific 2008/9.

 Just when one thought it was relatively safe to wade back into Indian equity, one got attacked by the Does this change the outlook for the Indian economy, or markets for 2009? Not after the immediate short term.

The world witnessed possibly the largest trade shock ever when trade credit froze post-Lehman in October 2008. Both exporters and importers were forced to cancel orders and this most likely led to the steepest drop in the shortest possible time of world trade, and therefore production. This chain of events affected economists and policy makers thinking around the world. This led to a chain reaction of counter-cyclical policy in the form of easier monetary and easier fiscal policy. Yesterday, England reduced its overnight (repo) rates to 1.5 percent, the lowest in its 400 year history. Even in India, the government has moved faster than anyone expected, though still considerably slower than governments elsewhere in the world. With this background, herewith some forecasts/reality checks for the for the 2009/10 fiscal year.

Reality Check 1: Trade not to stay at Oct-Dec lows: How realistic is the possibility that world trade would remain in a deep funk? Small. Even without the additional stimulus, it would be a fair bet that world trade would bounce back from panic lows. So the prospects for Indian trade in the next fiscal year will be considerably better than the second half of 2008/9.

Reality Check 2: Fiscal space in India: There has been a lot of comment on the fact that India does not have any room for fiscal expansion. Double-digit, and historically the highest fiscal deficits are staring us in the face — so warn the fiscal watchers. A lot of the alarm, and calculation, is based on the large fiscal deficits that have already occurred due to the oil and fertilizer price hike. But what the fiscal hawks fail to take into account is the steep fall in the price of oil and fertilizer. Given that nine months of this fiscal year are over, it is a simple matter to calculate what the fiscal impact of oil and fertilizer subsidies is likely to be. This is shown in the table. The result — there is zero net impact, or at best a half percent of GDP. One way to appreciate this result is that the average oil price in fiscal year 2008/9 will most likely average the same as the last fiscal year — $72/barrel (Indian basket) or $80/barrel (WTI crude). The rupee is 10 percent cheaper in 2008/9 so the net fiscal cost cannot be more than 10 percent of last year. And last year the petroleum sector was approximately in balance, in terms of the net fiscal impact (subsidies and taxes included).

Is there fiscal space in India?
Oil related
Domestic Price
(Rs / litre)
Item Subsidy
(Rs / litre)
(‘000 crore)
Kerosene 15 19 8.9 -13.7 -26.2
LPG 17 31 11.9 -10.7 -33.4
Oil 12 17 50.0 27.4 46.6
Diesel 48 56 36.0 13.4 74.5
Fertilizer 45  



Other subsidies
Farm Loan waiver         -20.0
Pay Commission         -22.0
Additional fiscal deficit         -33.7
(% of GDP)         -0.7
1. MMT is million metric tons
2. The average oil price for Apr-Dec was $92/barrel, for Jan-Mar 2009 assumed to be $41/barrel; (WTI crude price is approximately 10 percent higher); corresponding values for Rupee/$ are Rs 44.6/$ and  Rs 48/$ (assumed).
3. This yields the following averages for fiscal year 2008/9: crude oil: $79/barrel; $/rupee: 45.5, or Rs. 3,594 a barrel. Oil industry conversions have 1,177 litres per metric ton for gasoline, and 7.41 barrels per metric ton. This yields an average international price of oil at Rs. 22.6/litre for 2008/9, the figure used in the above table to derive the subsidy.
4. The average price of oil in 2007/8 was $75/barrel.

The exercise reported in the table is a reality check on the fiscal critics and is not meant to be a forecast for the 2008/9 fiscal deficit. The decline in domestic activity, and the reduction in indirect taxes will, and should, add to the fiscal deficit. Given that at 5.4 percent (consolidated, centre, state and off-budget) the 2007/8 fiscal deficit was the lowest in the last thirty years, an extra 3 to 4 percent fiscal deficit should be the target!

Reality Check 3: No scope for interest rate reduction: This mantra is repeated so often by the RBI and the fiscal hawks that it has attained the status of an out-of-reality broken record. At 5.5 percent repo rate, interest rates are still about 2 percentage points too high — especially in comparison to all the nations in the world. The real problem that policymakers are facing around the world is the danger of deflation overstaying its welcome. Yet in India the ‘money supply causes inflation’ hawks still reign supreme.

Also read: Surjit S Bhalla: Financial Crisis - Getting Facts Right - I

They have several lines of defence, though each is collapsing first. Recall that the first objection was that money supply growth was too high. This was shown to be both false logic and false economics. The next line of defence is that interest rates cannot be cut because the fiscal deficit is too high, and too expansionary. The table nails this defence. The next line of defence argument is that interest rates cannot be cut because the rupee could be in trouble.

Reality Check 4: Exchange rates respond to growth, not interest rates. A not-so-appreciated empirical reality is that exchange rates respond much more to growth prospects and very little to interest rate differentials. Most government and RBI officials were (pleasantly) surprised to see the rupee appreciate every time the repo rate was cut. Last year the rupee appreciated not because of interest rate increases but because Indian growth was strong.

Reality check 5: India to revert to pre-2003 growth: Many are making the point that India will revert, on a sustained basis, to pre-2003 levels of 5 to 6 percent GDP growth. For this to be true, investment rates will have to fall to pre-2003 levels. This would imply a decline of 14 percentage points of GDP, from 38 at present to 24 percent before. No non-oil economy, and certainly no high growth economy, has ever witnessed this fall. A fall of about 5-7 percentage points is reasonable. Assuming this permanent fall, the decline in potential growth rate is about 1 percent, ie, an 8 percent long-term growth rate.

Growth forecasts: For the second half of fiscal 2008/9, an average growth of 6 percent can be expected, which yields growth for the fiscal year to be close to 7 percent. For 2009/10, there is some argument — given the worldwide stimulus, given the trade freeze in Oct-Dec 2008 that analysts are using as a (false) benchmark for forecasts, and assuming that there are no more major shocks, man or God-made — that the growth will exceed that of 2008/9. So my forecast for 2009/10: higher than 2008/9 and in the range 7.5-8 percent.

The author is Chairman, Oxus Investments, a New Delhi-based asset management company. The views expressed are personal.  

First Published: Sat, January 10 2009. 00:00 IST