Indian stock markets have been boosted by the recent change of guard at the finance ministry and subsequent policy decisions. From extreme pessimism in June 2012, markets have moved to optimism in October. Indian markets are supported by the global markets, which have also moved up after the decision by the US Federal Reserve to infuse liquidity and the resolve of the European Central Bank to tackle the Euro zone crisis.
While hopes are still alive, let’s conduct a reality check. India’s gross domestic product (GDP) growth has been reset at lower levels, with best estimates suggesting growth of less than six per cent in FY13. The fiscal and current account deficits (CAD), key indicators of the health of the economy, have not improved. We expect the fiscal deficit for FY13 at 5.5-5.8 per cent and the CAD near four per cent. Short-term measures of expenditure control or revenue maximisation like spectrum auction or divestment may not change the structural fiscal deficit problems. Broader expenditure reforms are a must to bring down the fiscal deficit meaningfully. Inflation has refused to fall below 7.5 per cent, despite a high interest rate maintained by the Reserve Bank of India (RBI) leading to slowing growth. Loose fiscal policy is forcing RBI not to cut rates to boost growth. In the upcoming monetary policy, we expect RBI to address the problem of liquidity deficit, which has again shot up to over Rs 100,000 crore, by cutting the cash reserve ratio (CRR) but do not think it would cut the repo rate.
Markets are excited about reforms initiated in the last two months. But under the current political set-up, legislative reforms would be difficult due to lack of political consensus, though the government can always take decisions held up so far because of lack of political leadership.
The global economic situation is equally challenging. The situation in the Middle East remains a concern, leading to high crude oil prices despite slowing growth. The ‘fiscal cliff’ in the US could become a reality if a political consensus is not evolved on spending cuts and tax increase. In a ‘base case’ of Barack Obama being re-elected and Congress becoming more Republican, an agreement may take time. Depending on the quantum of spending cuts and tax increases, economic growth in the US may be impacted by 1.5 per cent to 4.5 per cent.
EU economies have adopted the right approach of austerity and political will. However, public support is necessary for it to succeed. In the near term, we may not see green shoots of economic recovery, though a mix of austerity and growth supporting measures may bear fruit in the long term.
China is growing through a painful transformation, from being an investment and export-driven economy to one led by consumption. There is hope that growth slowdown is bottoming out and once the new politbureau is in place, growth supporting measures would be initiated. China is reaching to peak to a favourable demographic position. We assume, China has structurally shifted to a lower growth trajectory.
The Indian political scenario is becoming murky. The market might wait for some improvement in the political environment and real economy to move ahead. However, markets would react negatively if these hopes are belied. We expect markets to trade at a discount to long-term valuation averages. Hence, the upside may remain capped in the near term at 19,500 levels, unless we see more meaningful initiatives and cut in interest rates by RBI.
The author is chief investment officer, IDBI Federal Life Insurance