Analysis on the current state of the Indian economy, and the government’s monetary policy to control inflation.
The unremitting despair of the young orphan Oliver when he asks for more gruel in the Dickensian tale Oliver Twist is an uncannily apt allegory for the situation Indian businesses are in today. The recent union budget and policy announcements by the central bank have not mollified fears of possible economic slowdown. All quarters of the economy, yes sir, are hoping for more – more in terms of measures to ensure long term inflation stabilization, reduction of the fiscal deficit, and a drop in interest rates.
All is not well in the Workhouse
The Indian economy has, for the last several months, been torn between controlling inflation and maintaining robust economic growth. In order to control skyrocketing inflation, the central bank chose to sacrifice growth in order to rein in inflation. The 20-month period, till October 2011, of rising interest rates has slowly but surely put the brakes on economic growth.
Industry is understandably worried about the high cost of capital, and the manufacturing sector is showing signs of stagnation. GDP growth in the third quarter of the current fiscal came in at a woeful 6.1%, marking a sharp drop from 7.7% in the first quarter, and 6.9% growth in the second quarter. Manufacturing growth slipped to 0.4% compared to 7.2% and 2.7% in the first and second quarters respectively. The seventh successive quarterly slowdown, and the slowest growth in three years, has not only triggered fears that the economy will slow down further in the last quarter of the current fiscal (January – March 2012), but also that overall growth for the fiscal year could fall short of the downwardly revised target of about 7%. Furthermore, despite the finance minister’s exhortation that the economy will grow at about 8% in the next fiscal, it is possible that growth will stagnate at a ‘new normal’ of about 6% unless significant efforts are made towards improving credit conditions and resurrecting investments in the coming months.
Growth data from India's eight core infrastructure sectors, although showing improvement in February after a dismal January, are no cause for cheer. The core sectors expanded 6.8% in February, compared to January’s growth of just 0.5%. Growth in the factory sector slowed down for the third month in a row in March as new orders continue to fall and raw material prices headed north. The HSBC manufacturing Purchasing Managers’ Index (PMI) fell to 54.7 in March from 56.6 in February and 57.5 in January.
India’s exports grew 4.2% in February, the slowest pace of growth in three months. Imports, on the other hand, grew 20.6%, translating into a trade deficit of $15bn. The Commerce Secretary recently expressed his concern over the burgeoning trade deficit as weak demand from Western markets and global political developments are likely to exert a drag on exports in 2012. Some market analysts are so spooked by the current account deficit that they do believe India could be headed for a crisis of sorts – this, however, currently seems only a remote possibility.
Inflation – The Artful Dodger
And although inflation dropped to a 26-month low in January, it seems unlikely that inflation will stabilize at the current level, casting doubts on whether the central bank can really afford to reduce interest rates at this point in time. Headline inflation accelerated in February after five months to about 7%. Core inflation, or inflation less the effects of food and fuel prices, fell to 5.8% in February. While this does mean that demand driven inflation is falling, it could also imply that demand for manufactured goods is actually on the decline, adding credence to fears that the manufacturing sector is heading towards stagnation. Conversely, the fall in core inflation also implies a rise in food and fuel prices. After hitting near zero inflation in January, food prices rose about 6% in February.
Recent announcements by meteorologists predict a below average rainfall this year, and absent any removal of supply-side bottlenecks in the agriculture sector, food inflation could spiral upwards 2012, taking overall inflation well above the government’s target level of about 7% inflation for the rest of the year.
The fiscal deficit continues to be a cause for concern. Notwithstanding last financial year’s fiscal deficit of 5.9% of GDP as against a planned level of 4.6%, the government has set a ‘realistic’ target of 5.1% for the current fiscal in the recently unveiled budget. Not only is the target possibly unsustainably high, but the credibility of the target for the current fiscal has already been called into question by market commentators. A large fiscal deficit surely does not bode well for inflation.
Policy Fears – Speak out, boy!
The government stressed that reining in ‘fiscal, revenue and current account deficits while controlling inflation’ were the main aims of the recently unveiled budget. The proposed debt to GDP ratio is 45.5%, down from last year's 50.1%. The finance minister has also proposed to reduce outlay on subsidies to below 2% of GDP from the current level of 2.5%. However, skeptics believe that the targets and measures proposed are neither spectacular nor credible. It has been argued that the government does not have the political will or support to reduce subsidies on food, fuel, and fertilizers, and also push through important policy reforms that are important for fostering growth. Further, the Goods and Service Tax, the much vaunted plan for fiscal consolidation, is unlikely to see the light of implementation pending resolution of key issues regarding the division of revenues between the center and the states.
In the run up to the budget, foreign investors had looked to the government for policies that would aid investment in India. However, post budget, there is increasing worry that recent government stances on foreign investment may not be countenanced by foreign investors. The government has tabled a proposal that will allow tax authorities to ‘crack down’ on companies that may have structured deals in ways just to avoid taxes. Firms, Indian and foreign, that have routed their investment in India through Mauritius are potentially under scrutiny. Another proposal to tax cross-border deals involving the transfer of Indian assets, with retrospective effect stretching back till 1962, is giving current and potential investors the jitters as well. At a time when the government can ill afford deterioration in its current account deficit, recent policy proposals seem, at the very least, ill-timed.
Few policy options
Inflation, the barb that had threatened to derail India’s growth for several months, had been on the decline over the last several weeks. Inflation dropped to a 26-month low of 6.55% in January after remaining above 9% for much of 2011. However, inflation is on the rise again, and is likely to stay in the 7-9% range in the coming months. The central bank can far from afford to conclude that the inflation will stabilize in the medium term. In fact, the central bank has announced that it would be ‘premature’ for it so start reducing interest rates without seeing any abatement of inflationary threats exerted by the high fiscal deficit and global energy prices.
Thus far in 2012, the central bank has already eased the reserve requirements for banks, infusing liquidity into the economy. It is likely that further liquidity could be infused into the economy in the coming months. Measures to ease liquidity may however not be enough to provide a much needed fillip to the economy. Growth is slowing down, investment is falling, and business sentiment is on the decline. Absent any credible government action, the central bank may not be able to stave off calls for reducing the interest rate for too long. Much of India’s economic fortunes in the medium term could well hinge on the monsoons as well. If the rain gods should play truant, runaway food inflation will almost surely force the central bank to hold interest rates at current levels. If however the rains do fall and if inflation can be contained, it is more a question of how much rates will be cut rather than whether they will be cut at all.
The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.
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