A lacklustre performance of the economy in
the April-June quarter created a sense of unease amongst industry watchers.
More recently, the media was abuzz with news about the Government’s intent to
pump prime the economy with a spending binge in the hope that private capital
would follow. Quite expectedly the markets panicked on the premise that the
treasury would exceed its fiscal targets. Equities fell 2.5%, bond yields
spiked 10 basis points and the Rupee dropped by about 1% to 64.8 to the dollar.
Subsequently, the Finance Minister took pains to clarify that Government
incentives would take a form where targets on deficits would remain sacrosanct.
The fact is that private investment has
been feeble and consumption remains the main driver to economic growth. The
Government has been pressing ahead with infrastructure projects but clearly on
their own they lack the ability to drive economic output. At the time of
writing this note it was not particularly clear as to what form the
Government’s intervention was likely to take. There is talk about subsidised
loans for small industry, sops to exporters, higher funding for infrastructure
and even more capital for banks. There is no doubt that going forward, the IMF
and other forecasters will revise India’s growth outlook. I suspect growth in
this fiscal year will be below 7%.
Another worry is a change in the policy
stance by the United States Federal Reserve. The Fed announced on the 20th
September its intent to shrink its bloated balance sheet through redemptions of
bond purchases previously made. As a matter of interest, in September 2008, at
the time when Lehman Brothers went belly up, the Federal Reserve’s asset book
was a little under USD 1 trillion. By 2015, this figure had touched USD 4.5
trillion. The Fed has made clear that it will not dump bonds in the market,
which might result in an evaporation of liquidity and a spike in bond yields. It
will simply allow its bond holdings to mature in their natural course, at the
same time refraining from making new purchases. This will play out over a
period of 5-6 years and therefore not create unnerving ruffles in the near
term. What the Fed does not want to do is create a panic in the markets, such
as the taper tantrum had done a few years ago, which neither advanced economies
nor emerging markets can afford at this time.
Be that as it may, a shift in the Fed’s
policy stance will come with consequences and the most glaring amongst them
would be the reversal of the dollar carry trade affecting, specifically,
emerging markets including India. Liquidity going forward may therefore begin
to tighten amongst capital starved economies. Fortunately for India, both
equity and bond markets are no longer at the mercy of foreign institutional investors
(FIIs). As I explained at a recent briefing at IMA’s CFO Strategy Roundtable, an
important outcome of the demonetisation exercise has been the shift in investor
preferences from fixed assets such as real estate to fungible ones such as the
equity and debt markets. As a result, domestic mutual funds now account for a
larger share of investments. For instance, during the period April-July 2017,
mutual funds invested Rs 415 billion in the equity market against Rs 188
billion by FIIs.
Going forward financial markets will remain
jittery and certainly volatile. As a combination of domestic developments and
the actions of the Fed, analysts expect further corrections in the weeks ahead.
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