Suyash Choudhary

Half Way to Everywhere

By: Punam Sharma

India’s perception amongst global investors has seen a remarkable turnaround over the past few months. This is evidenced in the remarkable stability in the rupee even amidst emerging market (EM) rumblings and recent Ukraine related geo-political risks. Indeed with geo-political risks stabilizing, the rupee has rallied smartly backed by robust foreign portfolio flows. So far in 2014, the rupee ranks amidst the top 5 emerging market currencies in terms of performance. Commentary from global researchers for the most part also expects the currency to retain its new found resilience. There have been 3 factors that have contributed to this turnaround. First, our current account deficit has seen a remarkable compression owing to policy intervention. FY14 current account deficit is now expected at less than USD 40 billion from USD 88 billion last year. Second, the FCNR initiative has yielded a staggering USD 34 billion in dollar flows. Third, with a clearer policy focus, the RBI’s credibility has strengthened with international investors. Besides these, temporary factors like expectations with respect to the upcoming elections may have also created a tailwind to flows and hence the rupee. While the adjustment so far is indeed commendable, it must also be remembered that with expectations of diminishing incremental global liquidity (that is, with Fed expected to continue taper) the standards for assessment have also become harsher for global capital. Macro-economic vulnerabilities that were being comfortably overlooked between 2009 – 13 when expectations were of almost perpetual global liquidity expansion, are no longer being forgiven. Indeed, an almost 5% current account deficit and 10% CPI did not deter foreign investors from putting in USD 31 billion in India over FY 13. However, these vulnerabilities in the current context would not be taken kindly at all by investors. We assess here India’s preparedness on key macro-economic parameters in this new global context of diminishing incremental liquidity expectations.

1. Current account deficit: As mentioned before, our adjustment on this count has been timely and impressive. However, what is also true is that some of the factors helping the process may diminish in intensity going forward. The most obvious is the reprieve that gold import restrictions have brought. But such restrictions cannot constitute a permanent solution given the burden they place on local employment-intensive gems and jewelry industry as well as the smuggling that gets inadvertently encouraged. Secondly, non gold imports may also see some revival should we see some growth rebound. Thirdly, whether the export rebound witnessed so far sustains or not is a question. Indeed, most of Asia is not experiencing strength in exports as seen in last numbers as well as recently released PMIs. Nevertheless, while the sequential current account deficit may widen going forward, the overall deficit for the year ahead may be much better contained compared to what was the case in the past few years. While continued vigilance is definitely required, we no longer stand out in terms of fragility on this count when compared with EM peers.

2. Inflation: As is well documented, India has struggled with a persistent inflation problem, with CPI averaging about 10% over the past few years. This has been despite a significant growth slowdown. While the headline has been influenced by highly volatile primary articles’ prices, the so-called core inflation has also remained very sticky at 8 – 8.5% for almost 2 years now. As far as inflation is concerned, we still stand out amidst peer countries and a move towards 6% on CPI will bring us in line with more stable EM peers. In our view, the RBI’s resolve to bring CPI down to 6% by January 2016 should be looked at in this context, since India can ill-afford to be extra-fragile on any macro-economic parameter given the new paradigm with respect to global liquidity expectations. In fact, if extra motivation is needed to fix our problems, the current consensus expects the US Fed would have completely stopped QE and in fact may have started to raise rates by the time 2016 comes. While the task of inflation adjustment ahead is substantial, what is also true is that the new RBI has already geared up well for it. Well begun being half done, we would tend to believe that Rajan is unlikely to let this macro-economic parameter go out of hand.

3. Fiscal Deficit: In our view, this remains the parameter on which we are potentially the most susceptible. The large saving grace, of course, is that the deficit is almost wholly domestically funded given the limited FII participation so far in our total outstanding government bonds. Nevertheless, India stands out on this parameter when compared with many global peers. Also, while the finance minister has thus far done a commendable job in delivering to steadily reducing deficit targets, the quality of this compression remains the weak point. The format lately has become quite familiar:

1. The budget presents assumptions that seem ambitious,

2. Fiscal situation deteriorates through the year thereby generating concerns of slippage,

3. Finance minister tightens purse-strings towards year end with savings on plan expenditure and rolling forward of subsidies; apart from aggressively garnering ‘other receipts’,

4. Fiscal deficit target is met or even bettered at year end.

The anomaly here is quite straightforward:

1. The government’s entitlement based approach is keeping non-plan expenditures elevated,

2. Revenue growth has slowed substantially with GDP growth,

3. And yet the finance minister has to deliver upon progressively smaller fiscal deficit targets year after year.

Given these, quality of compression has to be the collateral damage. The concern is that unlike on current account where substantial progress has been made and to some extent even inflation where willingness is showing the way for hope ahead, we are still some-way from achieving quality fiscal consolidation with due outlay for productive capital expenditure. In summary while India has undergone substantial adjustments already, the fruits of which are evident in the remarkable currency stability lately and resumption of capital flows, we still have some way to go before we are macro-economically ready for normalized monetary policy from the West. Specifically, current account requires maintenance, inflation vigilance, and fiscal deficit still hard work. The first of these was the most critical given that it involves dependence on foreign capital for its funding, and we have picked the right order of things to have addressed it first. Nevertheless, to purchase lasting stability the rest need fixing as well. Assuming the pace of policy normalization follows the broad global consensus currently, we have the next year or so to be well into the rest of our adjustment.

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