The 2017 Annual Report of the Reserve Bank of India (RBI), declaring 99% of demonetised notes as having returned to the banking system, kicked off the ongoing economy debate for real. This discourse reached its inflexion point last week when the former Finance Minister Yashwant Sinha penned a harsh critique blaming the Modi regime in general and the present Finance Minister in particular for all that is wrong. The nearly constant media coverage that followed, can in most cases be accused of either cherry-picking data or painting the picture with too broad a brush.
India’s GDP growth has been consistently falling over the last six quarters, touching an alarmingly low level of 5.7% in the quarter ending June. The Gross Domestic Capital Formation (GDCF), indicating private investments in the economy, has stooped down to 27% of GDP in 2016 from 33% in 2012, only moderately recovering in Q1.
The issue of non-performing assets (NPAs), especially for Public Sector Banks (PSBs) has reached unsustainable levels of close to 12% of gross advances. The twin balance sheet problem of over-leveraged debtors and bad-loan-encumbered creditors is also likely to stay due to high-interest burden, low capacity utilisation and weak earnings of the former and poor asset quality of the latter. It is no surprise that bank credit which grew at c.18% per year during 2011–14 has come down to a historic low of 6% in 2017.
The Index of Industrial Production (IIP) grew by a mere 1.7% in Q1FY17–18 with manufacturing IIP growing at an even lower 1.3%. On the external front, recently released data suggest that exports dropped to 19.4% of the GDP, a 14-year low. As per latest RBI data, India’s external debt has increased by 3% to $485 billion in June vs. the previous quarter. Current account deficit (CAD) has quadrupled from 0.6% to 2.4% of the GDP.
Political affiliations aside, the economic parameters speak loud and clear. The disruptive policies of the present dispensation, owing to either strategic fallacies or implementation gaps have allowed this reality to transpire, ironically in an era when global crude oil prices were at an all-time low.
An easy solution may be to kick-start growth by spiking government spending. But considering the frontloading of government expenditure in 2017–18 having already touched 96% of planned spend, any attempt to push for a stimulus will only move us away from the 3.2% fiscal deficit target as set in the Budget. A breach of the target has its own cost in the form of fresh inflationary pressures and predictable capital flight.
Recapitalisation of PSBs is the single most important task at hand to revive credit growth. With limited fiscal space, the focus should be on other means at disposal such as decreasing government stakes and carefully planned mergers. Issuing Sovereign International Bonds will also help in mobilising capital at a cheaper rate. Besides that, a strict application of the Insolvency and Bankruptcy Code and wide-scale governance reforms in management boards of PSBs will expedite NPA resolutions. Despite the setup of the Banks Board Bureau (BBB), mandated to reform PSB governance, ground realities have not changed due to continued bypassing in decision making by the government. Former RBI Governor Raghuram Rajan recently suggested to empower the BBB in real terms and remove any functional overlap by discontinuing the Department of Financial Services.
Moving on to the Monetary Policy front, we know that the RBI targets inflation under its Monetary Policy Framework by viewing price rise through the Headline Consumer Price Index (CPI). The argument given in favour of Headline CPI (which includes food items), that it is more representative of a consumer’s day-today purchasing activity has its own merit. But policy rates have either no control or weak indirect control over food inflation. Food prices rise mostly due to supply shocks which in turn pushes the CPI, making the RBI keep interest rates high and hurting already dim growth prospects, as evident by the recent unchanged rate environment.
It is time to balance the stand taken over inflation targeting by giving some weight to the Wholesale Price Index (WPI), representative of industrial buying rather than consumer buying, along with the existing CPI framework. A similar argument applies to the RBI’s approach of targeting “forecast” inflation while giving no weight to current inflation. Just due to forecast error on inflation (many over the past few quarters), the inflation-adjusted repo rate has gone up from 50 basis points in 2014 to 600 basis points in 2017 as the actual inflation recorded was much lower than the estimated one. The real repo rate, as a result, kept on increasing, and so did the cost of capital.
Talking about capital markets, the long-standing and much-talked-about paradox of weak macroeconomic indicators vs. a soaring Sensex recently broke down with stock market indices falling for 2 weeks straight due to foreign investor exit.
Let us first understand the dynamics of foreign portfolio investment (FPI), the USP of Modi government. FPI investors are basically concerned with fiscal conservatism, low rate of inflation, a real interest rate differential and a stable exchange rate. Indian economy was earlier performing well on these parameters causing a heavy inflow of foreign investments. FPI comes under two segments, Debt or Equity. The foreign inflows in debt are primarily driven by a favourable and stable exchange rate and the existence of an interest rate differential, mostly with respect to US Treasuries. A 6.5%+ yield on 10-year Government of India (GOI) securities is way more than the 2.5% one makes from US Treasuries of the same tenure which explains the foreign investors’ interest in the Indian markets. The rupee has appreciated against the dollar about 15–20% in real terms in the tenure of this government and stayed stable at those levels until now. This is the reason that 2017 alone has seen FPI’s pump of $20.50 billion into the Indian debt market. On the equity front, foreign portfolio investors were betting on the expectations of better corporate earnings in the coming quarters. But low private consumption and continued distress in corporate balance sheets have significantly eroded that possibility. After infrastructure, IT, Pharma and Banking, Telecom is the new entrant to the list of financially distressed sectors.
Any deviation from fiscal prudence or a monetary stimulus in form of a rate cut is going to create inflationary pressure and volatility in the exchange rate market. This accompanied with the possible reduction in interest rates differential due to much-anticipated US Fed hikes would cause heavy capital outflow. So FPI may no more be the engine on which Indian economy could be run now.
On the external front, the four-fold rise in CAD is due to sharp rise in the import of manufactured articles and gold. 70% of the rise in CAD has come from an increase in merchandise imports. This suggests that either domestic goods are losing out to imported ones due to a stronger rupee or there has been a supply shock situation due to wide-scale disruption by demonetization and a hastily implemented GST reform. We need to continue improving the regulatory and business environment for SME’s and resolve glitches in the GST. The first step towards this iterative process was concluded on Friday when return filing for 90% of tax assesses was made quarterly vs monthly as before (read GST Council Meeting on Oct 6th).
The possibility of a fiscal stimulus measure is challenged by the fear of inflation, capital flight and volatility. The dynamics of economics suggest that increasing government spending is the only way out but a multi-pronged strategy to balance the challenges that may arise needs to be adopted.
The fear of inflationary pressure and thereby an interest rate rise due to fiscal expansion could be contained by RBI redefining its Monetary Policy Framework through inclusion of WPI and a current inflation rate reference. High priority should be given to the resolution of stressed assets to revive private investment through lower cost of funding and adequate supply of capital. With $400 billion reserves in RBI coffers, possible FPI outflows should be ignored. The depreciating rupee as a consequence of capital flight should anyways help our exports.
The revived Economic Advisory Council under the chairmanship of Bibek Debroy is a step in right direction. The committee would hopefully come up with recommendations for fiscal expansion particularly in capital and social expenditure which would aid job growth prospects along with the intended revival of the economy. Enough of the Past & Politics. It should be just Economics now!!
The article was originally published at Transfin.