India: Taking stock of macro stability risks
What Really Caused Stretch Marks Early in the Current Recovery Cycle?
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
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
2) Aggressive Deposit Rate Hikes Should Help to Improve Interbank Liquidity
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
Key reasons for raising our food inflation estimates are:
(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
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
Source: Chetan Ahya, Morgan Stanley, January 5, 2010.
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