India: Taking stock of macro stability risks

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This post is a guest contribution by Chetan Ahya of Morgan Stanley.

What Really Caused Stretch Marks Early in the Current Recovery Cycle?
We believe the ideal outcome would have been to manage GDP growth closer to potential of 7.5-8% for the first 12 months immediately following the credit crisis – and then to gradually push growth higher as investment growth accelerated, lifting potential growth.

However, since the credit crisis unfolded, India’s policy-makers have been aggressively pushing growth back to pre-crisis levels as fast as possible. Unusually low real interest rates, loose fiscal policy and faster-than-expected global recovery have brought growth in India back close to pre-crisis levels. The credit crisis had a significant impact on investment in India. India’s investment trends tend to be highly influenced by the capital market environment. As the global credit crisis impaired capital markets, private corporate capex declined from 16.1% of GDP in F2008 to 12.7% in F2009 and further to 12.6% (our estimate) in F2010. On the other hand, the quick recovery in domestic demand from April 2009, driven by the government’s aggressive fiscal and monetary policy as well as an improvement in global and local sentiment, resulted in a capacity stretch much earlier in the cycle than was normal.

The good news is that GDP growth in F2011 could potentially be even higher than our forecast of 8.5%. However, this approach by policy-makers to maximize the growth opportunity came at the cost of rise in macro stability risks in the form of higher inflation, a wider current account deficit and tighter interbank liquidity – we have been highlighting this for some time now (see India EcoView: Inflation Risks Rising Fast, March 15, 2010 and India EcoView: Policy Support Maximizing Growth Opportunity but Macro Stability Risks Emerge, June 16, 2010). Moreover, a major crop failure due to drought in summer 2009 only added to the inflation management challenge.

Worst of the Macro Stability Risks May Be Behind
We see three key factors supporting this gradual improvement in some of the macro stability risks:

1) A steady rise in private corporate capex: Private sector capex has been accelerating over the last 10 months. We believe that it will soon begin to reflect in the form of commissioned capacity. The revival in capital markets as well as capital inflows and increased corporate confidence have fueled a significant pick-up in capex. For instance, as per the RBI data, aggregate resources raised by the commercial sector had risen by 47%Y as of September 2010. In this context, the key risk to our view of a continued steady rise in investments is potential risk-aversion among public sector banks due to recent corruption-related investigations. Similarly, we see the risk that contract awards for infrastructure and commodity-related projects might slow because of similar issues and a delay in mining approvals.

2) The tightening of short-term interest rates: We expect that this should start checking aggregate demand growth, reducing the non-food inflation pressures.

3) Recovery in G3 domestic demand and consequent rise in India’s exports: This is helping to reduce the trade and current account deficits.

Note, the risk to our view that the worst may be behind us is that oil prices quickly shoot up above US$100/bbl on a sustained basis and/or capital inflows into EM and India decline sharply. Under either of these conditions, the short-term cost of capital will spike up – hurting growth.

Tracking the Macro Stability Risks

1) Trade and Current Account Deficit Narrowing for Now
After widening for a sustained period from 2H09 when the recovery began, the trade deficit has shown a clear trend of moderating over the last three months. The monthly trade deficit stood at US$8.9 billion (7.1% of GDP annualized) in November. This is down from the peak deficit of US$13 billion (10.8% of GDP annualized) in August 2010. On a three-month trailing basis, the trade deficit narrowed to 7.3% of GDP, annualized as of November 2010, from 8.6% in October and the peak of 10.1% in August 2010. The improvement in the deficit has been supported by a faster rise in exports while imports have been steady. Over the last six months, seasonally adjusted exports have risen by 26.1%, whereas imports have increased by only 4.8%. We expect the trade and current account deficits to narrow over the next six months as rising investments help to build capacity and a steady reversal in monetary and fiscal policy contains demand growth. The key risk to our view would be a sustained rise in crude oil prices above US$100/bbl.

2) Aggressive Deposit Rate Hikes Should Help to Improve Interbank Liquidity
The persistent lag in policy rate hikes had meant that real deposit rates were unattractive. While bank loan growth is accelerating, deposit growth is decelerating. The gap between credit growth (23.7%Y as of the fortnight ending December 17, 2010) and deposit growth (14.7%Y during the same period) has remained high. Currently, the banking system loan-deposit ratio is already high at 75.8% as of as of the fortnight ending December 17, 2010. Similarly, the 12-month trailing banking system loan-deposit ratio is already tracking above 100%. Considering that the statutory liquidity ratio is 24% and the cash reserve ratio is 6%, we believe that there is a need to significantly accelerate deposit growth so that the system has adequate liquidity to support this rising credit demand.

There was a lag (relative to strength of growth and inflation) in deposit rate hikes as the RBI was slow in moving policy rates up – but the banks have finally moved deposit rates now. The State Bank of India (SBI, India’s largest public sector bank) recently raised deposit rates by 50-150bp across maturities. In the 1-2 year bucket (using the 555-day deposit rate as benchmark), SBI increased rates by 150bp to 9%. Indeed, over the last 12 months, short-term rates have moved up significantly. 91-day T-bill yields have risen by close to 310bp to 7.1% over the last eight months. The three-month commercial paper rate has risen by 480bp during the same period to 9.5% currently. We believe that these hikes in deposit rates should start improving deposit growth and reduce tightness in interbank liquidity over the next 2-3 months if the inflation rate does not spike up again.

3) Inflation Stays Too High for Policy-Makers’ Comfort
Headline inflation has moderated to 7.5%Y in November 2010 from the peak of 11%Y in April 2010, primarily due to high base effect in food prices. While non-food inflation remains high at 7.9%Y in November 2010 (versus the peak of 8.9%Y in April 2010), food inflation (primary and manufactured) has moderated to 6.6%Y in November from the peak of 19.2%Y in February 2010. We were earlier expecting the headline and food inflation (WPI) rates to moderate further to 6-6.5%Y and 5.5-6%Y by March 2011 – but we now raise our headline and food inflation forecast to 7%Y and 7.3%Y, respectively.

Key reasons for raising our food inflation estimates are:
(a) Unseasonal rains damaged the onion crop, pushing up prices of other vegetables: The onion crop in Maharashtra and Gujarat has been significantly damaged by unseasonal rains. These two states combined contribute about 40% of the country’s onion output. The sharp rise in onion prices has also had an impact on other vegetable prices. During the week ended December 18, 2010, higher vegetable prices pushed headline primary food inflation further upwards to 14.4%Y from 12.1%Y and 9.5%Y in the previous two weeks. Indeed, the weekly primary food articles index has risen by 3.5% over the last three weeks cumulatively. Typically, the primary food index declines MoM in December. However, the recent rise in vegetable prices is likely to push December primary food inflation index over the November number. We believe that vegetable prices could moderate when the next onion crop arrives in February-March 2011.

(b) Rise in edible oil and other soft commodity prices: Over the last three months, international prices of crude palm oil and other edible oils have jumped by 30%. Domestic edible oil prices are highly influenced by international prices as India is a big importer of edible oils. Edible oils have a weighting of 3% in the WPI. Edible oil prices as reflected in WPI always tend to lag the international prices. We believe that over the next three months the WPI edible oil component inflation will likely spike up. Similarly, other soft commodity prices have also been rising. For products where India is self-sufficient, the international prices don’t reflect one-to-one – but some pass-through is inevitable.

Rise in Oil Prices Could Compound the Inflation Problem
We currently expect non-food inflation (WPI) at 6.8% by March 2011, assuming that oil prices remain close to US$100/bbl. Hence, any upside surprise in G3 domestic demand could push crude oil prices to increase to US$110-120/bbl.

In this context, the recent announcement in the US of a potentially large fiscal stimulus in 2011 has increased the probability of such an outcome. If crude oil prices reach US$110-120/bbl for a sustained period of six months or more, we believe that headline inflation (WPI) could spike to 8-9%. This would increase the risk of disruptive policy actions to manage inflation pressures and thus would eventually hurt growth. Indeed, this could remind us of the macro environment in mid-2008.

Fiscal Deficit Reduction in F2012 Will Be Key
We believe that fiscal policy has to lift most of the burden of tightening. While short-term interest rates have moved up aggressively over the last 12 months, the government has delayed reduction in the core deficit (excluding one-off receipts like divestments and 3G license fees), supporting strong aggregate demand growth. The government is currently indicating its determination to cut the central fiscal deficit to 4.8% of GDP in F2012 from 5.5% in F2011 (7% excluding 3G revenues). We believe that this is a difficult target to achieve but, in order to manage the inflation risks, we think it will be critical that the government abides by this earlier stated target.

Source: Chetan Ahya, Morgan Stanley, January 5, 2010.

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