The combination of India’s economic structure and recent dynamics positions it as a unique global risk on-off trade. Thus, when global risk-on is in play, as is the case now, all appears deceptively OK for India. Portfolio inflows are on a roll, equity markets are heading higher and there is general optimism in the air. There is, of course, ample reflexivity in play as well — investors are feeling better because equity prices are higher rather than the other way round. However, all hell breaks loose the moment risk-off emerges.
India is a largely consumption-based, domestic-driven economy that has lopsided global integration while her politics is becoming more inward-looking, and is stuck with a populism-addicted federal government that is the weakest link in the growth story. It runs a sizeable current account (CA) deficit that is largely financed by volatile capital inflows and a fiscal deficit that is heavily facilitated by financial repression. The sizeable invisible surplus, which includes remittances from Indians working overseas and software service exports, substantially offsets the impact of Asia’s largest merchandise trade deficit on the CA deficit. The economy is significantly exposed to swings in crude oil prices that affect its twin deficits and inflation, and India’s central bank in the last couple of years (until its desperate actions in late 2011) preferred a hands-off currency policy.
The above does not take away the favourable structural drivers that can raise the speed limit on non-inflationary economic growth even if the unlocking remains uncertain and uneven. But shifting global risk appetite affects both commodity prices and capital inflows, and these are also impacted by the domestic economic and political dynamics. Thus, global risk-on typically boosts commodity prices that play out as a negative terms-of-trade shock for India. But it also often facilitates more volatile capital inflows that aid the financing of the CA deficit. Admittedly, there can be periods, such as late last year, when capital inflows dry up even as crude oil prices remain high — worsening the balance of payments, which in turn causes currency-related palpitations.
Other countries also show symptoms of political inertia, CA and fiscal deficits, and dependence on volatile capital inflows, but no one matches the susceptible severity of India’s combination. Indeed, India must be the only country with the current distressing combination of a dysfunctional executive that has resulted in a supercharged judiciary. We have a prime minister who is in office but not in power; and, apparently, Cabinet ministers can do what they want even if the action is against public interest and the government will still be devoid of any collective moral and political responsibility.
In the current cycle, India has ended up with three undesirable outcomes that are a result of myopic government policies, and these accentuate the impact of the swings from global risk on/off: first, inflation is more than just cyclical in nature and has been adversely affected by some of the government’s own policies; second, economic growth is more reliant on consumption than investment; and third, the fiscal-monetary mix is out of whack. The investment collapse is due more to a combination of government inaction, policy drift and a general fear psychosis following the corruption scandals than high interest rates alone. That is why the anticipated limited easing by the Reserve Bank of India (RBI) will be insufficient for investment recovery.
Each of the three undesirable outcomes mentioned above has fiscal irresponsibility as a key contributor. This also compromised the effectiveness of the RBI’s tightening. Setting the fiscal house in order is also critical for boosting investor confidence and positioning for a sustained long-term growth upturn, which in turn will also partly help cushion the impact of the wild risk on-off swings for India.
The Budget for 2012-13 to be announced in mid-March will be the last opportunity for the government to do something sensible, as the Budget in February 2013 will likely be constrained by the general elections due by May 2014. Already, local media reports suggest that the government has postponed bringing out a new Fiscal Responsibility and Budget Management legislation since it is not sure of meeting the proposed targets. This tells us a lot about the seriousness of government’s fiscal discipline – it is to be followed only when it thinks it can meet the targets!
While the global risk-on trade fuels equity markets for now, there is a necessary painful adjustment ahead for the economy that should not be ignored by investors. The upcoming Budget will have to cut the fiscal deficit by raising some indirect taxes, broadening the coverage of service tax, and possibly targeting the rich. The key issue will be whether the government has the political muscle to restrain spending, especially the ballooning subsidy bill.
Now, food subsidy will actually increase in 2012-13 due to the partial launch of the food security Bill, leaving the burden of the subsidy cuts on fertiliser and fuel subsidies. Reduction in subsidy has a greater and quicker impact on aggregate consumption than higher interest rates. Thus, any upward price revisions – even if gradual – will have implications for both growth and inflation, especially core inflation. In turn, this will limit the ability of the RBI to ease significantly, despite the below-trend growth. Unfortunately, there is no epidural analgesia available for the government to avoid this painful adjustment, which is necessary but could prolong the combination of sub-par growth and still-high core inflation.
The recovery in the rupee is not really natural or necessarily sustainable; it is driven by a combination of the RBI’s desperate measures and global risk-on that has boosted portfolio inflows. The RBI should now consider changing tactic and intervene in the foreign exchange market to increase its foreign exchange reserves. This, in turn, will enhance its ability to better manage potential wild rupee swings. The merits of the hands-off exchange rate management notwithstanding, the RBI’s preference for this approach while also struggling with the combination of a large CA deficit and dependence on volatile capital inflows actually worsens to the very currency swings that the RBI reportedly tries to check.
Indian policy makers have their work cut out for them, despite the current breather from higher global risk appetite. But even the policy makers appear unsure whether they can rise to the challenge.
The writer is senior economist at CLSA, Singapore.
These views are personal
