Thursday, February 23, 2012

Precipice Ahoy!

The fundamentals of the economy paint a nice picture of where we are headed in the immediate future. Though the 7.1% growth estimate (by PMEAC) for FY12 takes us above our comfort threshold and many would have heaved a sigh of relief, projection for the next year comes with a list of contingencies attached to it. This is not surprising at all.

A quick look at a few statistics reveals where we are headed. Despite boasting a high rate of growth over past several years, India is one of the few economies globally that still posts a 10%+ rate of unemployment, which means there is a meaningful section of the economy that is not getting any benefit from the growth. Farm sector still accounts for 50% jobs in India. This sector has not benefitted from either growth or from global commodity price boom (due to policies that don’t allow farmers to move produce from one state to the other, let alone export it). With extent of poverty not declining and inflation eating away at the purchasing power of a significant section of the population, the Indian consumption story is seriously at risk.
The rest of the story is equally depressing. We have ongoing stalemate in many sectors which are critical to growth. This includes power, where the government coal monopoly cannot get its supply act together. Growth being a power intensive business, it is bound to have repercussions. Infrastructure continues to be in doldrums, despite fancy numbers like $1 trillion being thrown around. Telecom, aviation, textiles, capital goods, consumer durables…, the story is not very encouraging.

If we start adding the center and state’s fiscal woes to it, we get a fairly bleak picture of it all. The point is, how did we manage to dig ourselves into such a hole despite almost a decade of growth, and despite a global economy that has been essentially benign (though the financial crisis did look like dampening growth, the liquidity flood that ensued more than offset the disadvantage). Even today, if you ask yourself the question, what is it in the external environment that creates a big threat to Indian growth, I am sure you will struggle for a cogent answer. The best we can do is probably ‘high oil prices’. Unlike the rest of Asia, we are not export dependent to keep the growth engine humming. If we had our house in order, there is nothing in the environment to derail the economy.

The truth of the matter is, most of our problems are of our own making. Fiscal mismanagement means we have allowed inflation to get out of control (though the global flood of money has played its role) and it is seriously hurting. Large fiscal deficits always hold monetary policy hostage. Either the government prints money for filling the gap (which would be inflationary), or the central bank has to keep the system flooded with money to allow the government to borrow at reasonable rates. The same goes for the oil mess. The government never bothered to decontrol prices when oil prices were low (the government was making a good surplus out of it, of course). Now it is politically unacceptable to raise petroleum product prices. The same applies to other areas where subsidies are hurting. If you start adding policy paralysis, corruption scandals, fractious politics, etc., to the mix, it is wonderful recipe for concentrating the mind.

The outcome is a situation where everyone is hurting and everyone is looking to the government to sort out this mess. There are high hopes from the budget. Almost every sector is hoping for a duty cut, and almost everyone is looking for a dollop. It is anyone’s guess where these hopefuls are likely to end up.

The current stock market boom is probably a combination of copious amounts of money and some wishful thinking.  This may continue till the budget comes out. Chances are the budget will try to make everyone happy and end up pleasing none. Going by the track record of past 8 years, it is not likely that someone will stand up and say, ‘we need to make some hard choices, and we will throw everything behind these three (or four or whatever number you prefer) top priorities’.

In absence of any real measures taken to put the economy on the growth path, stock market is likely to see the reality quickly enough. The current levels may be sustained till the budget day, but reality is likely to sink in fairly quickly post budget (if it does not happen before then). A surprise may be in waiting for those banking on wishful thinking to continue the good run.

Tuesday, February 21, 2012

Riding on Fizz...

Indian stock market has outperformed practically every other market in the world in 2012. This is not very surprising. India was among the worst performing markets in 2011 and relief rally has seen many beaten sectors/stocks recover some of the lost ground.

The surprising part is the speed of the rally, failure of most of the big players to spot it well in time and the relative paucity of good explanations on why India is suddenly booming. Most of the people I speak to are just dumbfounded. Barely 8 weeks ago, the India story had gone bust, the infrastructure sector had caved in, power plants did not have fuel, policy didn’t have direction and government didn’t have the tenacity needed to stand up and deliver. The question is, what has changed in a month or two?

The sad part is, nothing. Fundamentally, we are exactly where we used to be. To the extent that behind the veneer of a booming stock market and a massive inflow of portfolio dollars, even the liquidity situation is as tight as November, prompting hints from the RBI on another CRR cut. Falling car sales, slowing tractor and durable goods sales in the rural sector, ballooning real estate inventory; all the elements are the same as before.

This leaves few explanations for the ongoing rally. One of the plausible few is the fresh glut of liquidity in the wake of the Greece crisis. Equities worldwide have gone up as a result and India has received a good chunk of the money. The precipitous fall of the rupee last year provided an added incentive. Strong defense of the currency by RBI and past experience would have convinced many that rupee weakness was unlikely to last for a long time. Stocks looking doubly cheap on a dollar basis would have added to the temptation. Indeed, if you invested in dollar terms in December, you would have already made a 16% on the stocks and another 16 on the currency, quite an unbeatable package.

But where do we go from here?  The answer is not very clear. Once again, my bet is on commodities. Stock markets across the world may be rising, but their ability to absorb the excess liquidity is going to be limited due to poor fundamentals. Bond yields are also likely to continue to stay low globally (and high in India, more on that later). It is very likely that a good chunk of liquidity will flood commodities, causing an upward spiral all over again.

This does not augur well for the Indian market. High commodity prices, particularly oil, will further worsen the fundamentals. Coupled with Government’s inability to implement policy reforms (we have not even been able to sort out whether luxury cars should get a fat diesel subsidy or should finally bear the cost of fiscal and environmental damage they do), this will only worsen the pressures the economy is facing. The market is currently riding on fizz and it is hard to tell how long the fizz will last.

Monday, February 20, 2012

Government Debt and the Role of RBI… Back to the Future?

Governor D Subbarao’s musings about government debt and need for a cap on borrowing hark back to an era that we have almost forgotten in India. Not so long ago (say, till late 1990s), the primary role RBI played in balancing monetary policy was managing the government’s borrowing needs against the monetary needs of the economy.

Government borrowing in India has historically crowded out the private sector, there is nothing new about it. Till late 1990s, the traditional monetary policy tools were more or less ineffective due to this. For the banking sector, the primary tool RBI deployed was 90 and 180 day T-bills. Banks were more or less relying on their T-bill purchases to meet their reserve requirements on every reporting Friday. The catch? RBI used to measure their reserve adequacy only on reporting Fridays and the bills could be discounted freely by the banks. The highlight of this policy setting was that more than 99% of the T-bills bought by banks were discounted the following Monday. In essence, banks were keeping their funds in T-bills for only a few hours over the entire fortnight for which the reserves supposed to be maintained.

Bank rate, similarly, continued to be totally ineffective tool for a long period of time. Banks could technically borrow from RBI at the bank rate, but only to the extent of a small fraction of their incremental deposits, in effect making the bank rate practically useless for managing monetary policy or interest rates in the economy.

This situation prevailed primarily because the RBI was tasked with managing government’s debt requirements. Thus, whatever deposits the banks raised, a large chunk of that went into government bonds as the SLR component. In a cash starved economy, it meant that there was little liquidity left in the system for the private sector and banks. The result, a farcical situation in which banks needed to game the system to meet the liquidity needs and RBI did not have choice but to turn a blind eye to it.

The situation changed dramatically in the 2000’s. Falling fiscal deficit, rising growth rates and flood of global money meant that India was suddenly had a deluge of liquidity. Private sector could access capital internationally at far more competitive rates. Liquidity started chasing yields, which meant government bonds became attractive and banks started keeping more money in gilts than SLR required. With this flexibility, RBI, perhaps for the first time, gained true control of monetary policy and its tools gained a true bite.

All this can change dramatically again, if the government allows the current fiscal mess to continue and its borrowing needs start crowding out the private sector. And many signs are pointing in that direction. International money is no longer flooding India the way it was in the middle of the decade, borrowing internationally is becoming more difficult and costly, and RBI is forced to tighten domestic liquidity due to inflation concerns. Though the situation has eased somewhat with January inflow of portfolio dollars, it is the only source of liquidity at the moment and its drying up could suddenly lead to a drought of money.

In this situation, RBI could find itself in the same dilemma again. In a tight liquidity situation, government borrowing will start crowding out the private sector. Interest rates, in that case, would be driven more by the ‘going rate’, rather than tightly controlled by the RBI. Hence, the comment by the governor assumes significance.  

What does it mean for the markets? One key factor to keep in mind is that if liquidity starts drying up again, the assumption that interest rates will fall no longer holds true. RBI will be hard pressed to inject liquidity into the system but will be constrained by inflation rearing its head again. Token rates may fall, but with no money available at those rates, private sector will be forced to borrow at whatever rates money is available. Not a great situation when most of the sectors are reeling under less than stellar outlook and growth has started hurting. The only hope lies in the government being able to manage its finances better and letting the economy be.
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