Building buffers and using them

Letting the rupee weaken may be the least bad option; raising interest rates to slow imports is too blunt an instrument

There is turmoil in the global economy. First Covid and then a war have curtailed global capacity, forcing prices up as buyers (some boosted by fiscal stimuli) compete for limited resources, until the weakest buyer drops out. While recovery from supply-chain bottlenecks was a procedural challenge, and one hopes the current disruptions in China do not last long, the drop in energy availability globally is difficult to offset quickly. A shortfall in affordable energy is almost certain to hurt global economic output. The current high inventory of goods due to a yearlong logjam in global shipping exacerbates the downward lash of the supply-chain bullwhip, potentially forcing order flows for factories well below what end-demand warrants.

Governments desperate to protect their economies are using fiscal tools to cushion the energy price impact. This will only affect the global distribution of available energy, not pull growth from the future as fiscal interventions normally do. This, together with the substantial reset in the flow of money due to trade (the amount energy buyers pay to energy sellers is higher by several per cent of global GDP) and capital flows (rise in risk aversion among global investors), is also driving volatility in currency markets.

Similar to a household that has saved for a rainy day, some conservative macroeconomic policies of the past few years have created buffers that have saved India thus far from significant volatility. The Reserve Bank of India prudently sequestering excess dollar inflows in the last two years into foreign currency reserves has meant that the rupee has been one of the most stable currencies globally in the past few months. Similarly, eschewing fiscal profligacy despite strong tax inflows left room for extension of the food subsidy programme and an expansion in fertiliser subsidies in response to surging global prices of food and fertiliser.

Gross taxes in FY2021-22 (FY22) were higher by nearly Rs 2 trillion than in the central government’s revised estimates (RE has nine months of actual data and three months of estimates, implying all positive surprise came over just three months); strong goods and services tax collections in April 2022 show this continues. This also means that budget estimates for tax collections in FY23 are now just 2 per cent higher than what was collected in FY22. As a share of GDP, both direct and indirect taxes (excluding excise on fuels) are now back to 2018 levels. That is, before corporate tax rate cuts and the pre-Covid economic slowdown had driven a dip. If nominal growth in the economy is 11 per cent (again a conservative assumption), gross taxes in FY23 can be over Rs 2 trillion more than currently budgeted.

While inflation is definitely boosting taxes, there are several drivers of strength in the economy. First, as schools and offices restart and borders reopen, jobs in personal services, education, travel and tourism are coming back: These accounted for most of the services job losses until late last year.

Illustration: Binay Sinha

Second, state governments, among the worst affected by activity restrictions, are now beginning to spend. Government cash balances with the RBI have fallen over the past three months, partly due to lower borrowing, but also due to higher expenditure. Dug up roads are a sign — one hopes there is some purpose behind the digging, but it is a form of fiscal stimulus in any case, and creates jobs.

Third, a dwelling construction up-cycle is underway. As discussed in an earlier Tessellatum (“The Shovel Returns”, December 13, 2021), despite structurally steady demand growth for housing, construction had slowed for nearly a decade due to excess inventories. The sudden rise in cement and steel prices in the last two months has likely slowed some construction currently, but growing demand means it will start.

Fourth, there is growing evidence of India gaining share of global manufacturing exports in several sectors, which should help offset some of the impact of a global slowdown and inventory correction. Fifth, the terms-of-trade changes on software developers are in India’s favour. The surge in hiring/wages are supportive of current growth.

However, a large macroeconomic adjustment is necessary going forward, particularly as energy prices may remain elevated for a while, implying that India needs to address the resultant large balance-of-payments (BoP) deficit. Some believe that the RBI should use forex reserves to keep the rupee stable against the dollar. This would be unwise, in our view. Unlike the “earned” foreign currency reserves of, say, China or Korea, India “borrows” its reserves. That is, they are not a result of trading surpluses, but an excess of capital inflows. Not only does the capital already in India incur a cost ($42 billion annually, and growing), in theory, it can also go back. Perhaps more importantly, such an approach assumes that uncertainty will end soon; it may not. Thus, using reserves to fund a large BoP deficit is unsustainable.

In a slowing global economy, to bridge a BoP deficit one can rely neither on strong growth in exports, nor on higher capital inflows at a time of rising rates and high uncertainty. Imports therefore need to fall. Higher interest rates may be too blunt an instrument to drive that, potentially slowing down activities that have low import dependency (like housing); India’s capital inflows are also less rate dependent.

Thus, letting the rupee weaken may be the least bad option (there are no good options). A valid concern is that the exchange rate against the dollar moving out of the current band could trigger currency volatility: Importers may increase hedging, and exporters, fearing a steeper fall in the rupee, may delay bringing back dollars, exacerbating BoP pressures.

However, these would be temporary by definition, and use of reserves to dampen such volatility is prudent, particularly as any excess outflows during such volatility would return. Another concern is the rise in inflation if the rupee depreciates. Given that import volumes would not fall until there is a price increase; undesirable as it is, such inflation is inevitable. This is likely to cause a step jump in prices rather than a sustained inflation that requires monetary policy action. As external demand weakens incrementally, and global uncertainty remains high, prudent use of fiscal resources (shunning freebies, but continuing to spend on infrastructure —it is remarkable how quickly rail network shortages have returned) to sustain economic momentum and keep the fiscal wheel turning also become important.

The writer is co-head of APAC Strategy and India Strategist for Credit Suisse