Wednesday, May 6, 2009

Indian economy - glimmers of hope may be misplaced?

The Sensex breaching the 12000 mark and the improved fourth quarter profitablity of corporate India may gave the impression that a V shaped recovery may already be on its way. However, such anecdotes gloss over important areas of concern, giving ground to the impression that these "glimmers of hope" will remain just that!

In fact, far from being a positive development, the increased profitability may be the result of actions that may end up doing more harm to the economy as a whole. As Businessline points out, corporate India have focussed on cutting costs - both in employee costs and other expenditures - which have the effect of depressing aggregate demand. The lower commodity prices and easing interest rates too have helped boost bottomlines. Importantly, even as profits rose 23%, sales declined by 1.4%, lending credence to this view. Further, the fortunate coincidence of quarterly profit announcements and "green shoots" and other developments in the US, may have fed back into boosting the equity markets.

The exports are anemic, tumbling by 33% in March, widening the current account deficit to alarming levels. Even the substantial depreciation of the rupee has had limited effect on propping up the exports in the face of slack global demand. In any case, given the weak global demand, it may be futile to rely on the external sector to stimulate the Indian economy.

Despite all talk of the relative insulation of the Indian economy from the global economy, there is atleast one dimension in which the Indian economy is increasingly coupled with the the fortunes of the world economy. External sources have been contributing a sharply increasing share of the domestic investments, reaching a third of the investments. In fact, India took up the largest share of external financing - through bonds, equity and syndicated loans - among Asian emerging economies, rising from a share of just 8.7% in 2004 to 20.2% in 2008. Even within this inflow, the share of bonds and equity have been declining rapidly, being replaced with syndicated loans, in stark rversal of the picture since 2004 and in contrast to China and South Korea's external inflows today.

The IMF in its World Economic Outlook 2009 has estimated growth to decline sharply to 4.5% in 2009, primarily due to the weaker investment, resulting from the double whammy of decline in external financing and tight domestic credit markets, both underpinned by the weak expectations about the global economy.

The only alternative is for the government to step in with its fiscal stimulus spending to keep investments flowing and boost aggregate demand. However, as the graphic below indicates, here too India is on bad wicket, given the limited fiscal space available. Its overall fiscal deficit is set to worsen to 10.2% in 2009, more than double the other major emerging economies. And of bigger concern is the fact that despite the substantial worsening of the fiscal balance, the discretionary spending on fiscal stimulus have the lowest among all emerging economies, a reflection of the oil bonds and other handouts in the run-up to the elections.

In the circumstances, the one area where there still remains considerable room for easing is in the monetary policy. For all the repo and reverse repo cuts, the real rates remain among the highest among emerging economies, especially with inflation falling precipitously. The IMF too has commented on the need for substantial monetary easing. Faced with the credit squeeze, the RBI has been more sure-footed with its credit policy responses, by way of lowering SLR and CRR and keeping open liquidity auction windows, than in aggresively lowering rates. Though this has eased the liquidity availability for banks, it has not been passed on to the corporate borrowers.

Given the deep slump facing the global and domestic economy, the RBI's actions will need to demonstrate a commitment to keeping interest rates low for atleast the medium term, so as to anchor interest rate expectations. The recent, half-hearted rate cut of 25 basis points, did little to convey such clear commitment.

Lower interest rates will slowly but surely translate into lower yields on long term G-Secs, as is happening now with the yields on 10 year Treasuries. This downward trend is important in the face of the upward pressure exerted due to the expectations about the borrowing commitments of the Central Government. Lower rates will also have the effect of dis-incentivizing banks from parking a large portion of their funds with the RBI under the reverse repo window in the Liquidity Adjustment Facility (LAF) and in short term Treasuries. All this will in turn have a positive effect on the considerable debt servicing burden of the Government.

Further, the reductions in interest rates since September 2008 are beginning to show an impact, with the banks lowering their rates and the commercial paper market easing slowly. As the banks get over their high cost deposits, a legacy of the brief monetary tightening in the first half of 2008, and their margin pressures ease, lending rates are likely to come down further.

The same tight-fistedness by the RBI that saved the Indian financial system from the excesses of the sub-prime bubble, may ironically enough be now coming in the way of Indian economy when unprecedented monetary easing is the need of the hour.

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