India Macroeconomic Snapshot 2011

 

For almost 2 years, India’s Central Bank has been busy battling Inflation, even at the cost of Economic Growth. However, instead of being commended on their efforts to tame this stubbornly sticky inflation (which is clearly a product of Supply Constraints and Fiscal Mismanagement), the RBI has been heavily criticized for the slowdown in GDP growth.

In response to the slowdown, the RBI cut the Cash Reserve Ratio – the percentage of deposits that banks must keep with the central bank – by 50 bps (0.5%) in its review on Jan 24, a move that would release Rs. 32,000 Cr ($ 6.5 billion) into financial system. In his policy statement, RBI governor D. Subharao said, “the growth-inflation balance of the monetary policy stance has now shifted to growth, while at the same time ensuring that inflationary pressures remain contained”.

Slowing GDP Growth

According to the official estimates, the GDP grew at a mere 6.9%, compared to 8.4% in the previous year. The slowdown was mainly driven by the manufacturing sector, where growth slowed down from 7.8% last fiscal to a meager 2.7%. Other sectors have fared poorly as well with the Industrial output slipping into negative territory at -5.1% in October before bouncing back to 6.8% in November, mostly on account of a large base-effect. Strapped for funds, core infrastructure sector too saw dismal growth at 0.3%, owing to poor execution of projects.

Inflationary Pressures

Averaging around 9%, throughout the year 2011, headline inflation has been well above the comfort levels of the Government and RBI. While their desired range for headline inflation is 5 – 5.5 %, that range has continuously been breached every year since 2005 – 2006. However, much to everybody’s relief, Food inflation declined to lowest in 6 years (6 years – what a coincidence) albeit thanks to a strong base-effect, and seasonal impact. Since monetary actions take about 4-6 months to show results in the economy, there is some respite for 2012 for inflation to be contained. However, considering the risk of oil prices spiking up, the Central Bank will have to be extremely careful and ensure that inflationary headwinds have genuinely subsided before adopting any stimulus measures throughout 2012.

Burgeoning Fiscal and Current Account Deficits

Another alarming issue for the economy has been its mounting fiscal deficit. The previous Union Budget (FY 2011-2012) had set a target of the fiscal deficit at 4.6% of GDP. However, the fiscal deficit during the first half the fiscal alone was 85.6% of the full-year target. Hence, it is quite clear that the government is set to miss the target, and the deficit is more likely to be around the 5.2% mark, or perhaps more if oil prices rise and/or tax revenues decline (I believe that both events are highly likely, and a deficit of around 5.6% or more should not come as a surprise). With tax collections sluggish, and divestment ambitions foiled by poor market conditions, the government has no option but to borrow more to pay for its ever-growing subsidies bill. In doing so, it essentially mopped up most of the funds in the market, and crowded out private sector investments (i.e. increased interest rates by excess borrowing in the money markets). Rising oil and fertilizer prices and the implementation of the Food Security Bill are all going to further increase the subsidy burden for the government. With a tax base of less than 10% of the GDP, the picture doesn’t look very bright.

To make matters worse, high interest rates, big-ticket scandals, and the government’s reform-inertia had dampened the business environment to such an extent that manufacturing and industrial production plummeted. Exports growth was very trivial (due to economic slowdown in major export destinations), and was merely a fraction of the sharp growth in imports (thanks to robust domestic consumption demand), thereby worsening the trade balance. In addition to the worsening trade-balance, imports of Oil and a huge appetite for Gold (India imported 969 Tons in 2011) dented the Current Account Deficit even further. In fact, Oil and Gold together account for about 70% of the nation’s Current Account Deficit. Furthermore, high interest rates dampened corporate investments, and foreign capital inflows dried up too. All this put pressure on the nation’s foreign exchange reserves, which reflected on the Indian Rupee.

Currency Woes

2011 was a challenging year for the Indian Rupee, which depreciated 16% in 2011 (its biggest annual fall since 2008) and was the worst performing Asian currency of the year. Concerns about the rising fiscal and current account deficits amidst an uncertain global environment, loss of confidence in the Indian reform process, doubts over its growth momentum and stubbornly high inflation led foreign institutions (FIIs) to sell the Indian currency, pushing it to an all-time low of 54.30 against the US Dollar in the December.

The RBI refused to deploy India’s foreign exchange reserves to curtail this slide, as it was not a phenomenon that monetary action could fix alone. So RBI used alternative methods to curb speculation on the Rupee. It banned firms to enter multiple forward contracts to cover a single foreign currency transaction, and also eased rules for companies to raise offshore debt. It also raised the interest rates payable on deposits made by Non-Resident Indians. Also in December, India and Japan signed a $ 15 billion currency swap agreement. The RBI has pledged to keep a close eye on Rupee levels throughout 2012 as a weak rupee would further hurt imports, and on the flipside, exports won’t benefit much either owing to a global slowdown. In fact, firms that had resorted to foreign-currency debt in the form of External Commercial Borrowings, or ECBs (against a backdrop of rising interest rates in India), had to face tremendous pressure servicing that debt with the Rupee at such depressed levels. All in all, a weak currency would hence only add more inflationary pressure on the Indian economy.

Dominated by negative news-flow, such as the FDI in Retail debacle, or missed Divestment targets, criticisms of Policy Paralysis, failure of introducing GST, etc., 2011 was a year to forget for several investors, business leaders, and parliamentarians alike. So as we enter 2012, many “experts” will be hoping for the Union Budget in March to introduce crucial economic reforms. However, the challenges now are more complicated than they have been in recent years. Too much emphasis has been given to the role of RBI’s monetary policy, discounting the importance of the Finance Ministry (Fiscal Policy) in driving the economy. Personally, I expect FY13 to be much choppier than last year, and expect things to get much worse before getting any better. Considering the nature of coalition politics in India, any reform announced during the budget would come as a surprise, albeit a positive one.