Rajeev Malik: Time to roll up your sleeves

A confluence of economic factors not witnessed recently will make the policy maker's job exceptionally challenging.

India's economic outlook remains encouraging, what with both domestic demand and exports driving the current economic expansion. The economy is likely to grow by 7 per cent in 2005-06, positioning it as the second fastest-growing economy after China.

Consumer and business confidence remains upbeat, with palpable indications of investment recovery taking hold, though, admittedly, rising oil prices could be a spoilsport.

The year 2005-06 is poised to post several multiyear "firsts", including the fact that India's expected GDP growth of 7 per cent in 2005-06 will be the fastest pace in nine years, excluding the monsoon-driven surge in GDP growth in 2003-04.

Fiscal 2005-06 will be the first year in almost a decade in which the investment upturn will gain a stronger footing, and for the first time in several years, the government is likely to undertake its estimated full-year net market borrowing of Rs 1.1trillion ($25.2 billion) in an environment of rising local interest rates over the course of the year.

And, the current account deficit-to-GDP ratio this year is to be the widest in eight years.

Unlike in the past, this time, consumer spending has been boosted by both structural and cyclical factors and business expectations are more realistic.

It is also quite striking that having suffered in the mid-1990s, businesses appear to be somewhat guarded in their capex plans, leaving open the possibility of upside surprises.

The gradual build-up of the investment recovery this time also suggests that the capex upturn is likely to be more sustainable, sharply contrasting with the euphoric build-up in the two years starting in 1994, and the subsequent collapse.

There are three principal risks that policy makers and investors need to be prepared for in 2005-06. All of them have their seeds in the strength of the current economic upturn, and at least one is also affected by the end of easy global money.

These risks are: demand-driven inflation surprising on the upside, prompting greater monetary tightening; deterioration in the balance of payments that hits the currency; and a wider-than-expected fiscal deficit that pushes up long-term rates more than currently expected.

One area where market expectations appear to be somewhat complacent "" and, therefore, could be adversely impacted "" is the inflation outlook, especially owing to demand-driven factors.

A combination of higher commodity prices and return of pricing power are bound to feed through to higher demand-driven inflation later in the year.

Last year's high base will flatter over-year-ago comparisons, but central banks normally look through such volatility to concentrate on more sustainable drivers of inflationary pressure.

The Reserve Bank of India (RBI) is expected to maintain a hawkish stance in 2005-06, and will also be wary of narrowing interest rate differentials, particularly with the US. Also, tactically, the RBI would probably gauge this year's outcome for monsoon season rainfall before hiking interest rates.

Finally, last year's high base will somewhat depress the over-year-ago inflation rate in the coming months, though a likely hike in local fuel prices could slow the pace.

However, even a normal monsoon season rainfall would complement the current economic momentum, further boosting domestic demand and prompting the RBI to hike again in October, when it will announce its midyear policy review.

If the monsoon rainfall disappoints, the RBI would be vindicated in staying on hold later this month.

Investors appear to be under-appreciating the ongoing change in India's balance of payments dynamics. India's current account balance is poised to slip deeper into the red in 2005-06 after posting surpluses in recent years.

The deterioration in the current account is driven by substantially wider trade deficit owing to higher oil import bill and large gains in non-oil imports fuelled by strong domestic demand.

As the current account deficit widens, the importance of capital flows in maintaining a strong rupee will be amplified.

While foreign equity investors will remain interested in the India story, the likely completion of the US dollar's weakening cycle and the steadily rising global cost of capital complicates the picture, and could slow the pace of capital inflow in coming months.

With a wider current account deficit this year, slower capital flows may lead to a weaker rupee.

The surge in India's forex reserves suggests heavy RBI intervention in the currency markets in recent weeks. This may have been motivated partly by the need to restrain the real trade-weighted rupee to within its historical band.

But the RBI is probably also concerned that India's deteriorating current account balance and the country's reliance on volatile portfolio inflows, especially as this is happening in the backdrop of narrower rate differentials with the US, and tighter global liquidity.

This concern may predispose the central bank to persist with its dollar bid. In this regard, at its April policy announcement, the RBI may choose to raise the cap on rates offered on non-resident deposits to encourage a relatively more stable source of capital inflows.

Finally, the key fiscal focus for the 2005-06 will be on the government's ability to contain the fiscal deficit at the projected 4.3 per cent of GDP.

The government should be forewarned about a higher-than-planned Budget deficit, as it would indicate that the "pause" announced in the Budget for 2005-06 in meeting the targets of the Fiscal Responsibility and Budget Management (FRBM) Act has probably turned into a reversal.

A Budget deficit outcome that exceeds the official forecast would severely compromise government's credibility about fiscal consolidation, and could also prompt unfavourable reactions from rating agencies.

Equally importantly, given the interest rate outlook, banks and retail portfolios will rotate further away from government bonds, and the recently announced large government issuance plan could collide with the ongoing revival of private investment demand.

With the government constrained to concentrating its issuance to longer maturities in the backdrop of an adverse rate outlook, the yield curve is set to shift higher and become steeper.

Indeed, the 10-year bond yield is likely to rise to 7.5 per cent by December, a level last seen in June 2002.

India's favourable, though gradual, structural changes will further solidify in 2005-06, even as the current economic upturn strengthens. Indian policy makers have navigated the economy impressively in the last few years, though dollar weakness, sharply lower US interest rates, India's low domestic inflation and current account surpluses made their task easier.

Now, however, the policy makers will have to roll up their sleeves in order to repeat their success in a much more challenging environment. And there is no margin for error this time.

The writer is vice president and senior economist at JPMorgan Chase Bank, Singapore

(The views expressed are his own)