Devangshu Datta: Tough choices

BEATING THE STREET

There are some saving graces to the progression of rising dollar interest rates, higher domestic inflation and inevitably, higher rupee interest rates; the vise is tightening gently. The US rate hike has been moderate "" just 25 basis points in the key Fed fund rate.

Indian inflation is still low in historic terms. If bond market movements are indicators, Indian rates will rise gradually. One silver lining is the dollar's strength against the rupee. This should enable export growth.

Globally, things remain confused. It's anyone's guess whether Iraqi oil will come onstream in this fiscal or the next. The instant Iraqi supplies stabilise at significant levels, Indian inflation will ease along with lower crude prices.

The US economy seems to be in recovery mode "" hence the rate hike. But the Chinese economy has overheated and the PRC's planners are choking off money supply as a counter-measure. Will US recovery counter-balance a drop in PRC activity and thus keep global GDP ticking over?

While trying to cool the domestic economy, the Chinese could set off major repercussions. The Renminbi (Rmb) is pegged artificially low at 8.3 to the dollar "" a rate unchanged for over 4 years. This mercantilist approach works because the US is China's biggest market, by far.

But the Chinese may be on the verge of delinking and a floating Rmb will have unpredictable consequences. If China must cool off, just as the US is heating up, it will have to delink. Given US growth, a Chinese exports boom is guaranteed at current exchange rates. A soft-landing for China involves handicapping exports through deliberate Rmb appreciation.

Anyway, a moderate rupee rate hike won't do the Indian economy too much harm. For one thing, it will make mandated provident fund rates less of a freebie! If higher rates are associated with market-related petro prices, it would structurally improve the economy.

Real yields and rates have been low or negative for a while. If crude prices hadn't been forcibly tamped down, rates would have definitely gone negative after January, 2004.

The hit to refiner and producer margins is visible in Jan-March, 2004 results; benchmark crude prices rose from $29/ barrel to over $33 in that period. In April-June 2004, crude moved from $33 to above $40.

Any economic recovery is liable to incorporate low or negative rates at some stage. But it is time to end the free lunch at the expense of the energy sector.

India will continue to be an energy-inefficient economy with large structural problems until petro prices are decontrolled. Given inherent energy-deficiency, a "free lunch & inefficient energy use" paradigm places brakes on long-term growth.

As to the Budget here's my simplistic analysis. The FM can't cut mandated rates or subsidies. He is committed to increases in social spending. He cannot raise revenues through disinvestment. If he does produce something visionary within these parameters, wonderful!

Maybe he'll implement tax-reforms. Or perhaps, he will compose a VDIS reprise. He can certainly offer tax-breaks to education and healthcare. These would all be brave measures. If he lets things drift, be resigned to "only" 6 per cent growth this year. Most countries would kill for that.