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Growth Moderation

IMA’s recently concluded Human Resource Survey reveals rapidly rising salaries and therefore perceptions of an upbeat business environment. Whilst our own forecasts propose economic growth close to 8.6 percent in this fiscal year, I fear that going forward things may turn out rather differently. Rising imbalances in some economic and financial parameters throw up risks. If they played out, they could spoil the plot. This paper will seek to explain.

The Treasury has forecast a fiscal deficit of 4.6% of GDP in the coming year, down from the current 5.1%. On the face of it, the target does not appear particularly hard to achieve judging by a favourably downward trend in the past few years. However, its calculations assume a net rise in borrowings of only 2% and disregard the windfall profits from the sale of 3G spectrum. Effectively, the reduction in deficit amounts to approximately Rs 1 trillion. To make things worse the estimated subsidy on oil, which adds up to Rs 230 billion, is Rs 150 billion less than the amount provided for in the current year. Political disruptions in the Gulf have given punters sufficient reasons to panic and consequently oil prices have abruptly jumped from USD 90 in December 2010 to USD 115 a barrel in March 2011. We do not have the data which provides the basis on which the Treasury determined its subsidy estimates, but my hunch is that the Finance Minister may have generously assumed Brent crude valued at around USD 95 a barrel. This is unlikely to stick, with some forecasters predicting further rises.

A larger deficit would lead to higher borrowings by the government, crowding out funding sources for the private sector. Money would become both scarce and expensive, capex spends would be chopped and personal loans would take a batter, affecting both consumption and investment.

The second imbalance is in the current account which relates to trade in goods and services. This deficit continues to widen and will amount to approximately USD 60 billion in this fiscal year – 3% of GDP. Not too long ago, in 2005, this was USD 2.5 billion or 0.4% of GDP. Such deficits are hard to sustain without a consequential rise in interest rates and inflation. Usually they are accompanied by a proportionate depreciation in the value of the currency; but in India the deficit has been adequately funded by foreign capital inflows. This sort of money is finicky, unreliable and can quite easily reverse in its flow – as it did in 2008, following the global financial crisis. Indian stock markets are over-valued and given the slightest of considerations, foreign fund managers could begin to panic and issue sell instructions. Both the markets and the rupee would then be hit by a bear hammering.

Such an event would be catastrophic, undermining both consumer confidence (as personal fortunes are destroyed) and creating a liquidity crisis (through the withdrawal of foreign capital) in an already stretched market. The rupee too would slide in value.

And this leads me to the twin issues of liquidity and price instability. With a view to managing inflationary expectations, the Reserve Bank tightened monetary policy, and overnight interest rates have risen from 3.25% to 6.25% within the period of a few months. The Cash Reserve Ratio, which determines the extent of cash deposits commercial banks are obliged to park with the RBI, increased by 1%. Domestic liquidity remains scarce as the growth in credit has been much higher than the increase in new deposits within the banking system. And the RBI is not yet done with monetary tightening. Analysts expect another hike of 25-50 basis points in the coming months. Effectively, the yield curve is flattening as the gap between 1 and 10 year G-Sec has begun to narrow. Economists believe this is frequently a precursor to moderation in growth.

Some signs of this trend have been glaringly obvious for a few months. Both the Index of Industrial Production and the growth in capital goods, despite monthly variances, have fallen since January 2010. IMA’s own headline Business Confidence Index dropped from 78.7 (in Q4 2009/10) to 65.2 (in Q4 2010/11). Large capital goods producers and engineering contractors are appalled about a drop in orders – a reversal from no more than eighteen months ago when they were quite nearly refusing work, citing capacity constraints.

Going forward, I remain apprehensive about an upward shift in business confidence any time soon or an increase in capital spends, given tight monetary conditions and economic uncertainties.

It is hard to say how some of these risks will play out. But industry should be prepared for tougher quarters ahead and the generous salary hikes not withstanding, keep one eye focused on costs and consolidation and the other on liquidity.


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