Bad growth mix at the heart of the macro challenges: The macro environment in India has been challenging since the credit crisis,
with slowing growth and stretched macro stability indicators (persistently high inflation, widening current account deficit and weak
deposit growth). As we have been highlighting, we believe poor policy choices on both the fiscal and monetary fronts (sustaining high
fiscal deficit for longer, maintaining high rural wage growth and keeping real interest rates lower for longer) have led to the challenging
macro environment.
Policy makers have taken efforts to change the bad growth mix since September 2012…: Since mid-September, the government
has initiated measures to achieve fiscal consolidation in F2013 and has also initiated some policy reforms, such as liberalizing FDI
limits, reduction in fuel subsidies, setting up a Cabinet Committee on Investment to accelerate the investment approval process to
improve the growth mix.
… But rapid rise of US real rates and US dollar since May 2013 have adversely impacted India: Despite the measures taken by
the government, the growth and inflation data indicates that more time was needed for the economy to heal and come out of the
stagflation-type environment. However, the rapid pace at which US interest rates and the US dollar have risen since early May has
taken away the luxury of time for policy makers to improve the macro stability indicators and correct the growth mix effectively. Given its
high current account deficit, India is significantly exposed to the trend of a rising US dollar and real rates to funding risks.
RBI thus had to tighten monetary policy in a pro-cyclical manner…: The increase in the pace of currency weakness since May 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 (CPI adjusted implied fair value of the rupee is about 60). We believe that to prevent a vicious loop of currency confidence,
the RBI was forced to initiate explicit monetary tightening in July 2013 pushing up short term rates by 300bps.
… leading to even more downward pressures on growth…: The pro-cyclical tightening has meant that real rates in India will
continue to rise even while GDP growth has remained below 5% for the past three quarters. Although we do expect an improvement in
domestic demand in the US in the second half of 2013, supporting a gradual recovery in external demand, we believe that a meaningful
recovery in private capex in the next six months will be difficult considering the recent pro-cyclical tightening in monetary policy. While
we expect strong growth in farm output during the quarter ending September and December (of about 5.5%), we believe the weakness
in non-farm output will mean GDP will remain below 5% until QE Jun-14.
…extending the duration of the growth slowdown which will increase the viciousness of this cycle: The longer duration of the
growth slowdown will likely lead to: (1) an increased stress on the banking sector as non-performing assets rise; (2) make it difficult to
achieve the fiscal deficit target as revenue growth slows and divestment targets become harder to meet in the context of weak capital
market environment; and (3) reduce foreign investor’s confidence in India and thus exacerbating the funding risks
��
with slowing growth and stretched macro stability indicators (persistently high inflation, widening current account deficit and weak
deposit growth). As we have been highlighting, we believe poor policy choices on both the fiscal and monetary fronts (sustaining high
fiscal deficit for longer, maintaining high rural wage growth and keeping real interest rates lower for longer) have led to the challenging
macro environment.
Policy makers have taken efforts to change the bad growth mix since September 2012…: Since mid-September, the government
has initiated measures to achieve fiscal consolidation in F2013 and has also initiated some policy reforms, such as liberalizing FDI
limits, reduction in fuel subsidies, setting up a Cabinet Committee on Investment to accelerate the investment approval process to
improve the growth mix.
… But rapid rise of US real rates and US dollar since May 2013 have adversely impacted India: Despite the measures taken by
the government, the growth and inflation data indicates that more time was needed for the economy to heal and come out of the
stagflation-type environment. However, the rapid pace at which US interest rates and the US dollar have risen since early May has
taken away the luxury of time for policy makers to improve the macro stability indicators and correct the growth mix effectively. Given its
high current account deficit, India is significantly exposed to the trend of a rising US dollar and real rates to funding risks.
RBI thus had to tighten monetary policy in a pro-cyclical manner…: The increase in the pace of currency weakness since May 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 (CPI adjusted implied fair value of the rupee is about 60). We believe that to prevent a vicious loop of currency confidence,
the RBI was forced to initiate explicit monetary tightening in July 2013 pushing up short term rates by 300bps.
… leading to even more downward pressures on growth…: The pro-cyclical tightening has meant that real rates in India will
continue to rise even while GDP growth has remained below 5% for the past three quarters. Although we do expect an improvement in
domestic demand in the US in the second half of 2013, supporting a gradual recovery in external demand, we believe that a meaningful
recovery in private capex in the next six months will be difficult considering the recent pro-cyclical tightening in monetary policy. While
we expect strong growth in farm output during the quarter ending September and December (of about 5.5%), we believe the weakness
in non-farm output will mean GDP will remain below 5% until QE Jun-14.
…extending the duration of the growth slowdown which will increase the viciousness of this cycle: The longer duration of the
growth slowdown will likely lead to: (1) an increased stress on the banking sector as non-performing assets rise; (2) make it difficult to
achieve the fiscal deficit target as revenue growth slows and divestment targets become harder to meet in the context of weak capital
market environment; and (3) reduce foreign investor’s confidence in India and thus exacerbating the funding risks
Risks to the growth outlook still skewed towards the downside: We believe that significant uncertainties still cloud the growth
outlook. Failure to take corrective policy measures, a sharper rise in US bond yields and the prospect of an unstable coalition
government post the elections due in May 2014 could cause growth to dip to 3.25% in CY 2014.
What is the way out?
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 near term
(within six months), while we do expect some moderation in CPI 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 the Fed’s monetary policy
action.
We believe India will need to allow for build up of positive real rates on CPI adjusted basis to increase saving and reduce the
CAD. Given our trajectory for CPI, we expect it to fall to around 7% by September 2014, and similarly we expect current account deficit
to narrow to around 3% of GDP on a 12-month forward basis. In this scenario we believe that nominal rates will remain at the current
elevated levels until year end and then gradually reduce as CPI moderates and CAD narrows. However the reduction in nominal rates
will be of lesser magnitude to keep real rates positive. We expect that nominal 91-day T-Bill yield to decline by 150bps by December
2014 from current levels of 11% even though CPI inflation will likely decelerate significantly.
In the near term if currency weakness emerges again we believe that policy makers could pursue the following options to help
cushion the pace of weakening in the currency: (a) augment capital inflows most likely through non-resident Indian deposit scheme; (b)
announce a one-time increase in diesel prices; and (c) hike repo rate.
More importantly, a sustainable solution to put India on a recovery growth path will be to accelerate implementation of
structural reforms that in turn will help to correct the imbalances in the economy and put it back on a positive productivity dynamic.
Policy makers will need correct the distortions to cost of labour and capital to fix the incentive structure for recovery to take hold.
Although policy makers have moved in the right direction on this front since September 2012, we believe that the pace at which these
external developments have unfolded have only increased the urgency for an accelerated pace of policy reforms.
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