In his brief reign at the Reserve Bank of India (RBI), he has already delivered several surprises. First, he found an unusual way to prevent a run on the rupee by swapping dollar exposures of oil importers. Then, he refused to raise the policy rate in December, and he did raise rates in January. He has also shown determination to move to a new paradigm in targeting the retail inflation rate as reflected in the Consumer Price Indices (CPI).
Rajan said RBI will not raise the repo rate again, unless CPI spikes out of its expected glide-path. It's unlikely, however, that RBI can achieve the targets it has announced, within the time frame it wants. It hopes to pull the CPI (running at 9.9 per cent year-on-year in December 2013) down to eight per cent by January 2015, and to six per cent by January 2016. The year-on-year rate of change has not been below eight per cent since a three-month period ending February 2012, and it has not been below six per cent since the period, October 2007-February 2008. (Click for charts)
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If we go by history, the CPI will spike through summer for two reasons. One is that food (which has 48 per cent weight) will inevitably get more expensive. Note that food prices have run at above 20 per cent for many items despite a bumper agricultural performance in 2013-14. The other reason is that political parties will flood the informal economy with trainloads of cash as the general election gets closer. This means a repo hike early into 2014-15 is odds-on, unless RBI has actually anticipated the impact of these events and plugged them into whatever models it uses to calculate expectations.
Growth prospects have not improved much going by latest projections. FY 2013-14 will see sub-five per cent gross domestic product growth at around 4.9 per cent. This would be the first time since 1988 that India has suffered two years of sub-five per cent growth in succession.
Manufacturing and mining will both contract, with only good agro performance and average services expansion keeping the economy afloat. On the consumer front, the auto-industry has registered lower unit sales for the time in 12 years and expects the slowdown to continue until September 2015.
In FY 2014-15, if inflation slows, growth may accelerate to around six per cent. A lot hangs on the shape of the next government. If it cannot deliver, there are fair chances of India's credit rating being downgraded to junk.
A higher rebound would be possible only if the next government can unclog the large number of infrastructure projects, which are currently in limbo. M Veerappa Moily has made desperate attempts to get things moving after taking charge of environment. However, although Moily has cleared stalled projects worth some $24 billion, there is fear that everything might be put under review all over again.
So, actual investment won't be forthcoming until the next government is in place and its attitudes can be assessed. To add to the natural uncertainty of electoral outcomes, there is now a belated attempt to put together a Third Front, which could mean even more fragile coalitions. The winter session of Parliament was wasted with little legislative work done, amid rows about Telangana. None of this inspires much confidence in the political process and where it will lead.
In the meantime, it appears as though emerging markets (EMs) are increasingly out of favour with the investment community. The global economy might turn the corner this year, with growth expected to exceed three per cent. But most gains will come from bounces in the US, Europe and Japan.
EMs will contribute less, given a slowdown in China and India. There have already been huge portfolio outflows from EMs - money has moved out for 15 weeks in succession. India has also been hit and it's likely that foreign direct investment (FDI) flows won't be very strong in 2014-15 either. Given the certainty of a continuing US taper, portfolio flows are unlikely to improve a great deal.
To add to the problems, the US-India relationship appears to be getting worse on several fronts and a chilly relationship could also translate into lower FDI inflows. It started with the Khobragade affair and now, the US seems ready to tighten visa controls in ways that may affect tech businesses adversely. There is also ongoing unhappiness on the pharma front with global majors complaining that Indian pharma companies are copying patent drugs. Plus, of course, Indian pharma exports have been hit by the US Food and Drug Administration's tightening inspections.
On domestic debt markets, treasury yields are holding steady or falling slightly despite the repo hike. Corporate debt yields have risen, however. On the overseas front, confidence in the rupee seems reasonable since credit-default swaps on the State Bank of India's overseas bonds are trading lower. The drastic drop in the current account deficit is at least partly responsible for this.
On the stock market, major indices have dropped due to the continuing foreign institutional investor pullout. However, it seems retail investors are net positive in attitude since trading volumes are up in small and mid-cap counters. The Nifty has tested support near its own 200 Day Moving Average through most of the past two weeks. The support has held, thus far. If it does break, the market could correct five per cent very quickly. If it holds, we're likely to see an extended period of range-trading.