 "Chetan Ahya")
The recent economic data from the US has reinforced belief that the US Federal Reserve will stick to its plans of gradual withdrawal of quantitative easing. This has had a repercussion on the emerging markets, especially India that is also grappling with twin problems of rupee weakness and a burgeoning current account deficit.
Chetan Ahya, Asia – Pacific Economist at Morgan Stanley tells Puneet Wadhwa in an interview that the challenge to meet the fiscal deficit target and prolonged duration of growth slowdown raises the risk of a sovereign rating downgrade. GDP growth can touch 3.5-4%, he points out. Edited excerpts:
Do you think that the concerns regarding tapering off of US Federal Reserve's (US Fed) bond-buying programme have been overdone?
We believe that the Federal Reserve has been actively communicating their intention to taper off the quantitative easing (QE) purchases and have also announced their framework on what they and other market participants would be watching to assess if they would be on track to taper off.
Our US economics team’s view is that the US Fed will start the process of trimming its assets purchases in September, unless the August employment report weakens relative to the July report or if there is a further shortfall in inflation between now and September.
There have been divergent views on China and how its economy is likely to shape up going ahead. What is your interpretation of how the economic powerhouse is placed within BRIC nations?
Our view is that China’s potential growth has been slowing and will likely slow further as a result of three factors.
Firstly, demographic trends are weakening and will pose a headwind to overall GDP growth. These weakening demographic trends will pose a challenge for pace of economic growth as they determine the productive labour input toward the production process.
Secondly, rising per capita incomes meant that the economy was approaching the technology frontier, limiting the pace of further catch-up in growth. While there is still room for improvement in productivity levels, the pace of productivity gains will likely slow given the huge progress China has already made on the path to the technological frontier with the help of first generation reforms and imported technologies.
Thirdly, export demand is likely to remain structurally weak. Given the headwinds from the deleveraging cycle in the developed markets, export growth is likely to remain structurally weaker in this current environment as compared to the period pre-credit crisis.
We believe that policy makers are cognizant of these challenges and have already indicated their preference for reforms and quality of growth over speed of growth. Reforms are required to bring forth a new China – one that features a more balanced growth model and lower but sustainable growth rates.
How much emphasis should one lay on deflation as a risk?
Considering that China’s working age population growth was slowing significantly and that export demand was likely to remain structurally weak, the rise in leverage for investment in the aftermath of the global financial crisis was unwarranted in many ways.
We believe that as China proceeds with its deleveraging cycle and slows down the pace of investment growth, it could aggravate the issue of producer price index (PPI) deflation. Any slowdown in growth will only exacerbate the problem of deflation in producers’ prices, and pose a challenge regarding the management of real interest rates.
How do you see economies within Asia shaping up?
We believe that Asia will face the twin challenges of a potential slowdown in China and the trend of a rising US dollar and rates. We believe that every country in the region will be exposed to at least one of these two trends, if not both, which could pose downside risks to the region’s growth outlook.
A slowdown in China’s domestic demand will slow import growth and will have an attendant impact on the export growth of its trading partners, in particular Hong Kong, Korea and Taiwan, which count China as its top trading partner. Moreover, China’s strong investment growth trend has played a key role in the trend for industrial commodity prices.
Slower growth in China will imply a slower rate of consumption of commodities, putting downward pressures on prices. In this context, the net commodity exporters in the region such as Australia, Indonesia and Malaysia will be most impacted as their terms of trade would be negatively impacted.
In addition to the challenge of slowing growth in China, we believe that the region is facing another challenge in the form of the rise in the US dollar and real rates. We believe that rising US interest rates and US dollar strength, coupled with the narrower current account surpluses in Asia that have prevailed post credit crisis, will mean that Asia will now face currency depreciation pressures alongside upward pressures on its real interest rates.
Are all Asian economies, according to you, staring at a tough economic phase then?
We believe that each and every country in the region will face the headwinds from a rising US dollar with two key implications. Firstly, a rise in real interest rates will slow down the pace of credit growth across the region which will constrain domestic demand growth.
Second, a higher real rate environment without a meaningful rise in real GDP will imply an increase in the debt servicing burden for the borrowers. We see this rise in real rates relative to real GDP growth as a challenge across the region.
In addition to these two challenges, the region is having an independent challenge of weakening demographics. The demographic trends in China, Korea, Taiwan, Singapore, Hong Kong and to some extent Thailand, are reaching an inflection point. These weakening demographic trends will pose a challenge for economic growth as they determine the productive labour input towards the production process.
In this backdrop, where does India stand? Do you think that the policy-makers have failed to deliver?
The macro environment in India has been challenging since the credit crisis. The stretched macro stability situation can be attributed to poor policy choices on both the fiscal and monetary policy front, with policies kept too loose for too long.
Like most other Asian countries, India pursued an expansionary fiscal policy to push domestic demand (through consumption) in the face of weaker export income. While running a high fiscal deficit for a short period of a year or so post the credit crisis in order to support growth confidence was justified, continuing with it for four years in a row has left the economy in an unhealthy state.
We believe policy makers' decision to pursue the bad mix of growth since the credit crisis is at the heart of the problems facing the economy leading to macro stability risks and slower growth.
Secondly, RBI has been managing interest rates at levels lower than warranted all through this cycle. Moreover, the easing in the current cycle has already moved at a much faster pace than warranted, keeping real rates on WPI very low.
As we have argued previously, the way out of the stagflation type environment is to change the bad growth mix by first reducing the fiscal deficit and moderating the pace of rural wage growth while also carrying out policy reforms to improve investment spending. This would help to improve the growth mix and productivity dynamic.
Is more pain in store for the Rupee?
With the US Fed clearly indicating its intentions to taper quantitative easing depreciation pressures on the rupee have increased significantly. The increase in pace of currency weakness in May and June was leading to a risk of one-sided bearishness on the rupee taking it below fair value on our metric of CPI based real effective exchange rate, REER.
We believe this forced policy makers to intervene to slow the pace of currency depreciation. We believe that to prevent a vicious loop of currency confidence the RBI was forced to initiate explicit monetary tightening to push up short term rates.
However, these measures will at best help to reduce the volatility in FX markets and will not be able to alter the rupee’s trajectory. RBI’s policy actions, including whether and how quickly they will be able to reverse the quantitative tightening measures will depend on the external funding and currency depreciation pressures and in turn will depend on the US economic data surprises.
We believe that India will remain exposed to the trend of the US dollar and real interest rates as long as India’s current account deficit remains higher than a more sustainable level of 2.5% of GDP and CPI inflation remains higher than 7%.
In the next six months, while we do expect some moderation in CPI (consumer price index) inflation and current account deficit, it will still remain high. During this period, the rupee and interest rate environment in India will remain highly dependent on the expectations of Fed’s monetary policy action.
How much worse can the growth rates get for India, going ahead? Can a sovereign rating downgrade become reality?
GDP growth has already been below 5% during the quarters ending Dec-2012 and Mar-2013 and is unlikely to be any better during the quarter ending June 2013. The recent external macro developments coupled with weak domestic fundamentals mean growth could remain weak for at least two more quarters.
A weak growth trend lasting for four-five quarters will increase the risk of a vicious cycle, putting India into an extremely vulnerable position and increasing the risk of GDP growth touching 3.5-4%. The challenge to meet the fiscal deficit target and prolonged duration of growth slowdown raises the risk of a sovereign rating downgrade.
