Recovery to begin in second quarter of 2014:: Business Line

Crystal-ball gazing on the economy

Excerpts from an exclusive interview with Business Line.

WHERE IS GDP GROWTH HEADED?

Growth has remained very weak over the last three quarters and we expect growth to remain below 5 per cent for the next three quarters as well. Domestic demand will remain constrained by interest rate tightening by the RBI. Although we do expect an improvement in domestic demand in the US and Europe over the next six months, supporting a gradual recovery in external demand, we believe that a meaningful recovery in private capex or consumption in the next six months will be difficult, considering the recent tightening in monetary policy.

In this context, we believe that recovery in growth will not be led by a quick rise in consumption or investment to GDP. We believe that the first stage for stabilisation in growth will be through improvement in macro stability indicators (such as inflation, interest rates, and government surplus/deficit). We expect a gradual recovery in growth to begin in the second quarter of 2014 helped by export growth and stabilisation in private capex. We expect overall GDP growth to improve to about 5 per cent by September 2014 from an expected 4 per cent level in December 2013.

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RUPEE’S ROUTE

We believe the problem at hand is that India has its savings decline faster than investments and has been running a persistently high current account deficit. In this context the sharp and quick rise in US real rates (interest rates adjusted for inflation) has exposed the economy to funding risks (risk of reduction in foreign investment flows) with pressure on the currency. Indeed, the recent sharp depreciation has taken the rupee below its 10-year mean of CPI-based real effective exchange rate or the REER. Based on this model, we see current fair value of the rupee-dollar exchange rate at about 60. In the context of reducing fund flows, increase in short-term real rates (though part of it is rolled back post the RBI’s monetary policy) and opening of the window allowing banks to swap NRI dollar deposits at a lower cost are the most meaningful measures taken. Moreover, the decisions to postpone QE taper by the US Fed has also mitigated the risk of foreign fund outflows to some extent in the near term.

However, we believe that a systematic reduction in funding (flows) risks would require an increase in real interest rates. In this context, the reduction in effective short term rate by 75 basis points in the RBI monetary policy on September 20 has reduced the real rates (on CPI) to zero. Indeed this has increased the risk to currency stability all over again considering that US 10-year bond yield is still at 2.74 per cent compared with 2.53 per cent on July 15.

Over the next six to twelve months US real rates and dollar trend will continue to be the key drivers of domestic real rates and currency.

INFLATIONARY PRESSURE

We expect WPI inflation to remain at around 6 per cent in the near term with some upside risks on account of rupee depreciation and higher oil prices. While food inflation will decelerate over the coming months as weather-related distortions reverse and higher crop output help, the depreciation of the rupee and consequent pressure from global commodity prices could lead to higher non-food inflation pressures.

However, the CPI inflation is the better measure to assess inflation expectations. While WPI inflation has decelerated from the peak, CPI inflation still remains high. We expect it to moderate over the next four-six months helped by lower food prices because of better farm output and lower increases in minimum support prices (MSP), deceleration in rural wages and slower growth in domestic demand. We expect CPI inflation to decelerate to around 7 per cent by September 2014.

POLICY ON RATES

We believe that the present situation in India is similar to the 1990s when rise in US real rates and the strength of the US dollar forced India and other emerging markets to lift their real interest rates. So in this context India will need to allow for build-up of positive real rates on CPI-adjusted basis to increase saving and reduce the CAD.

We believe that the RBI will have to keep real rates (based on CPI inflation) positive and indeed increase it over the next 12 months as US real rates on 10-year rise steadily. With the reduction in MSF rate by 75 basis points, real short-term rates are now close to zero and this implies that bulk of the build-up in real rates needs to be achieved with deceleration in CPI inflation.We were expecting deceleration in CPI inflation over the next two-three months to enable lowering of nominal short-term rates from Dec-Jan 2014. However, the cut in MSF rate has front-loaded a 75 basis point reduction in short-term nominal rates. We expect CPI inflation to decelerate by 250 bps to 7 per cent by September 2014 from the current 9.5 per cent and we believe that should allow short-term nominal rates to decline by an additional 75-100 bps in this period. For a sharper decline in nominal short-term rates, CPI inflation will need to decelerate much faster than our forecast.

REVIVAL IN INDUSTRIAL OUTPUT

We expect recent pro-cyclical tightening by the RBI to weigh on domestic demand. While the latest industrial production (IP) data showed a positive growth in July, IP data tends to be volatile. We do not expect capital good output growth to sustain at these high levels which mainly led IP to positive growth in July. We expect IP growth to remain weak over the next two quarters. We think surprise in IP could arise if exports growth turns out to be much stronger.