India: still need the weatherman to know which way the wind blows ::JPMorgan,

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India: still need the weatherman to know which way the wind blows

India wasn’t spared from last week’s financial market mayhem. But the asset market sell-off neither reflects the economic data flow nor the likely policy response. A broad range of data prints points to an economy that while moderating is it still quite strong. Meanwhile policy remains firmly focused on further slowing demand to bring inflation down. In the coming weeks asset markets could be surprised both by the strength of the economy and the continued policy tightening. Caught in a squall Last week’s mayhem in global asset markets did not spare India. Equities tumbled and bonds rallied, perhaps less viciously but directionally the same as elsewhere. The shock originated in the developed markets and reflects not just a reassessment that global growth could disappoint sorely but also that there is little policy space to provide any meaningful support. While there are marked differences between the US and Europe in terms of economic conditions, policy options, and balance sheet positions, the general growth and policy concerns are broadly the same. Looming over these worries is the added anxiety that elections next year in the US and France could make policy making even more difficult. The riots in Britain may be just isolated expressions of frustration, but they are disconcerting nonetheless. Taken together these have heightened uncertainty and tail risks and not just a ratcheting down of growth expectations. As often in the past EM economies were caught in this storm and so was India. The big question is whether last week’s sell off was just a temporary spillover effect or a more ominous sign of a drawn out DM recession that will more permanently damage economic prospects in the EM world and India. More specifically there are concerns that India isn’t really positioned to provide much policy support caught between a stubbornly high inflation and a high fiscal deficit, both results of the significant policy stimulus provided in the aftermath of the 2008 global crisis Which way does the wind blow? What is economic data telling us? It is undeniable that global growth will be slower than one had expected few months back (growth in almost all economies, including the US, China, Euro area, and India have been downgraded recently). But recent data flow from the jobs reports in the US to the IP and exports prints in China and India do not suggest that we are at the verge of an impending collapse. True these are all backward looking indicators and asset markets are forward looking, but for activity to cave in from here on one really needs the increased uncertainty and heightened tail risks—reflected in last week’s asset price tumble—to scare households and corporates back into a post-Lehman style retrenchment. The negative impact from the loss in asset value is likely to be muted as the rise in wealth after QE2 did not materially boost consumption and investment. In India signs of slowing have been surfacing for some time and the equity market had been pricing this since the start of the year. Indeed Indian stocks had underperformed relative to US equities and had been on a downward trend for most of 2011. Equity prices have also underperformed against India’s US$ GDP growth, which it broadly tracks. This is consistent with our own view that growth would slow in the rest of the year bottoming around 7% in 4Q11. Part of the moderation reflects the global slowdown. The other part is by design through tighter monetary and fiscal policies to curb inflation. Indeed, with signs (albeit still weak) that the hitherto languishing private investment cycle may have restarted we believe that if the RBI can engineer a soft landing by 4Q11, to eliminate the uncertainty surrounding the amplitude and timing of the bottom of the domestic economic cycle, 1Q12 could see quite strong private investment growth. This would raise GDP growth back towards the 8% mark. Have you seen what’s happening to IP … Recent data flow in fact suggests that activity may be tighter than what we had thought and much more than what the market is currently pricing. After slowing for a couple of months due to inventory destocking, June IP grew 8.8 % significantly higher than consensus expectations of 5.5%, with capital goods rebounding sharply. Even consumer durables that had been on the decline since the start of the year appear to be stabilizing.   … exports … But this is not an isolated data point. Exports surged in May and June and preliminary data indicates it held up rather well in July. In fact on a year-ago basis it grew over 80% in July but that’s misleading given the very low base of last year. In dollar terms it rose to its highest level ever to $29.3bn. (In recent weeks suspicions have been raised over the veracity of these export numbers. In a later note we’ll go into these allegations. For now consider this. If truly these exports numbers are fudged and in reality the export flows are much less than the official numbers suggest then shouldn’t we have seen this in the exchange rate? But instead of depreciating, as one would expect, USD/INR appreciated from 45 at the end-Dec 10 to 44 at end-Jul 11.) But won’t exports fall off if growth in developed market stutters. Surely it would. But the question is by how much. The structure of India’s exports has changed substantially over the past few years both in terms of the goods it exports as well as their destinations. Much of the export growth over the last decade has come from non-traditional sectors such as engineering, auto parts, pharmaceuticals, and chemicals with the share of traditional export items such as textiles, gems and jewelry, and agricultural products shrinking steadily. At the same time, India’s most rapidly expanding export market has been EM Asia. Thus, while the impact of a slowdown in the US and Europe will be felt, if growth in EM Asia holds up, and all indications so far is that it will, the moderation in export growth will be muted. … non-oil imports … Non-oil imports too have rebounded very strongly in recent months with the momentum continuing into July. The sharp pick-up in non-oil imports could well be due to Indian corporates substituting more expensive domestic goods, given India’s higher inflation, with cheaper foreign imports, but the fact that IP rose strongly in June suggests that the substitution effect is only part of the story. The import buoyancy does reflect stronger-than-expected final demand and a return of investment. Skeptics point to gold imports as the main cause for the import surge. For their benefit gold imports fell in July!   … project announcements and FDI … Beyond the growth in capital goods production and non-oil imports, there are other indications too that the investment cycle has resumed. New projects announcements, which had been on a steep decline since the Lehman crisis, have begun to rise once again. The upturn isn’t anything to write home about, but it is no longer sliding. FDI, which had dropped off since the second half of last year has rebounded quite smartly averaging over $3.5bn in the last three months. … and tax collections? More indirect indicators also corroborate this narrative. Indirect tax collections continue to come much higher than expected. For the first four months of this fiscal year (April-July), excise tax collections rose 22%, customs duties 30% and services taxes 30%, all well above the budgeted targets for this year. While some of this buoyancy is undoubtedly due to the higher inflation, it also indicates that activity has not slowed as much as feared. And then there is the question of policy stance How will the authorities take all this? Our conversations with policymakers in Delhi and Mumbai even as the asset market mayhem was unfolding suggest a distinct shift in their attitude towards growth and inflation. While the RBI reiterated its new-found aggressiveness in combating inflation as policy priority, there was surprising unanimity in Delhi that the current inflation rate was unacceptably high and needed to be brought down even if it meant slowing growth. The coalescing of views on how to tackle inflation should put to rest doubts formed in some parts of the market that the 50bps rate hike in July may have been just RBI adventurism. Our sense is that the authorities will take the slower global growth and lower commodity prices as a bit of good fortune in helping to contain domestic inflation and oil subsidies, but not much more than that. They remain unconvinced that commodity prices will be subdued for long especially if the Fed unleashes another round of monetary easing. It is likely that inflation in July and August could rise past 11% when the estimates are finalized. A lot of market attention was focused on the July PMI print falling to the low 50s. But what got missed in the din was that output prices rose very sharply and outpaced the rise in input costs. And so monetary tightening will continue—as the RBI has repeatedly underscored—until there is visible evidence that domestic activity has slowed sufficiently and producers no longer have pricing power to keep fueling core inflation. By the look of things we are far from that stage. Ending the macroeconomic uncertainty needs more not less tightening Among the myriad of factors that have held back private investment since the 2008 crisis one of the key cause has been the rise in macroeconomic uncertainty. With inflation showing little sign of waning, it is unclear when inflation will peak and correspondingly when growth will trough. And importantly how high inflation will rise and how low growth will fall. And this makes it difficult to assess how wages and interest rates will evolve. So with both demand and costs uncertain it is not surprising investment hasn’t restarted in earnest despite tight capacity. The RBI can help to resolve this uncertainty by engineering an early soft landing. This requires the RBI to move aggressively again in September to bring the tightening cycle to a quick end rather than prolonging it. But despite its new found audacity the central bank is unlikely to make a big move (read 50 bps hike or pause) in its September mid-quarter review. Instead, it will likely raise rates another 25bps in September and wait till October to think big. Markets might be in for another policy surprise But the market appears poised to be rudely shocked, again. Even before last week, the front end of the swap curve had been falling from its post July policy high of 8.4% and now stands nearly 50bps below the current policy rate. A 50bps rate cut in the next 12 months can happen, but growth needs to collapse and inflation drop from its current double digit run rate to the 5% norm. It is one thing for activity to slow and global commodity prices to soften and quite another thing for them to slow enough to bring down inflation in a sustained manner. It is the latter that is needed before the RBI starts thinking of reversing its monetary stance. And so far this looks like a stretch on current data flow. On the fiscal front, the government after providing unprecedented fiscal stimulus over the last two years is on a consolidation phase. This is likely to continue. The lower oil prices will help to reduce the government’s subsidies and with revenue running higher than budgeted, the FY12 deficit is likely to print below 5% of GDP, above the targeted 4.6% but significantly below market expectations. The space to provide support to the economy is limited and the government neither feels the need nor has the intention to do so at present. So while the recent decline in the 10Y yield may have been overdone, a massive sell-off looks unlikely in the absence of a surge in bank credit demand which so far has remained subdued. Growth in India will undeniably slow, partly by design and partly because of slower global demand. But a growth collapse as mirrored in last week’s price action looks very unlikely. Instead recent data flow point to activity stronger than expected a few months back. So rather than any loosening, policy will continue to be tightened in the near term.