India faces DIRE risks amidst slowing growth

CRISIL Research recently lowered India’s GDP growth forecast for 2011-12 from 7.6 per cent to 7 per cent. While we had anticipated the adverse impact of rising interest rates and sluggish growth in advanced countries on India, forecasts by several agencies now suggest that Euro-zone growth is not only slowing, but the region is already in a recession or will slip into it by early 2012. This will pose a risk to the recovery of the United States and Japan, and also cloud the outlook for the Asian region.

As a result, the global  economic situation will remain unfavourable to our growth throughout 2012-13. In this scenario, acceleration in India’s growth will depend largely on the performance of domestic demand, especially investment. However, creation of a favourable
investment climate depends on the manner in which India will manage the DIRE risks over the next year –

D – Deficits (fiscal, current account, governance, reform policy)
I – Inflation
R – Recession (spreading beyond Euro-zone)
E – Exchange rate

D – Deficits
Prior to the 2008 economic crisis,public finances were in a relatively good shape, and hence, the government could augment expenditure quickly when private demand slowed down. However, the fiscal stimulus was largely aimed at reviving household consumption, and failed to boost investments in key areas, which would have enhanced the economy’s supply potential. Since then, India’s fiscal position has worsened further.

In view of the mounting oil and the fertiliser subsidies that have raised government expenditure, coupled with weak revenue growth, CRISIL has revised its fiscal deficit forecast to 5.5% of the GDP for 2011-12 from the previous estimate of 5.2% and the government’s estimate of 4.6%. Clearly, India has little fiscal room to counter another global crisis. In any case, rather than pushing through fiscal stimulus, even if the global economy falters again, India needs to re-structure government finances in favour of capital expenditure, and move back to the path of fiscal responsibility and budget management (FRBM). A clear commitment towards fiscal consolidation and stability would improve investors’ confidence in India’s medium-term growth story.

Another area of concern is the current account deficit – the disparity between India’s exports and imports. CRISIL Research has revised its forecast for the current account deficit to GDP to around 2.9% this year from the previous estimate of 2.6%. This is because the global slowdown will hinder India’s export growth going forward, but its import bill will remain high given the firm international oil prices. However, for a developing economy like India, a current account deficit of about 3% of the GDP is not a pressing concern by itself, but the way it is financed is a major concern surely is. In recent years, India has become more dependent on portfolio flows and commercial loans, which are volatile in nature and render the country’s economy vulnerable to a global slowdown. While foreign direct investment (FDI), a more stable and productive way to finance current account deficit, has remained relatively robust, we need to attract even more FDI into India.

To regain the confidence of foreign as well as domestic investors and to improve the investment climate, India needs to enhance its image in terms of governance and initiate key reforms on many fronts, including the land acquisition policy, environmental clearances
policy, the mining sector, skill development as well as the Goods and Services Tax (GST). While some reforms are in sight, such as implementation of the National Manufacturing Policy, India now faces a visible deficit on the policy agenda after the fiasco of relaxing FDI limits in the retail sector. Policy actions and their quick implementation are critical to mitigate risks to growth arising from global turbulence. Past developments suggest that reforms take time to translate into sustained growth, since the economy needs time to adjust to the new structure.

I – Inflation
Inflation risk depends on external as well as internal factors. India is a price-taker in international commodity and oil prices, and cannot  directly control inflation in the fuel group. However, it is in our hands to rein in food inflation and prevent the spread of second-round effects of fuel and food inflation to manufactured goods. While food inflation may have begun to come down in recent weeks, unless public investment in agriculture raises productivity and augments production dramatically, it will not be possible to
contain food inflation on a sustained basis, especially if the Food Security Bill is implemented. Continued pressure on food prices leads to greater demand for wage hikes, resulting in a wage-price spiral.

To lower inflation, and therefore create an environment conducive to high growth, government policy must work towards expanding the supply potential of the economy, which could complement the central bank’s efforts to contain excess demand and inflation. While agriculture continues to await a big push in terms of investments, rising wages and income transfers to the rural poor under the NMREGA (which are not linked to productivity in practice) would continue to result in demand persistently exceeding supply. This has also raised the cost of labour in rural India as well as reduced the availability of labour. In the urban areas as well, skill shortage in sectors such as financial services and IT/ITES will push up wage growth as soon as there are signs of a recovery, and will make inflation control difficult.

R – Recession
The Euro-zone crisis and recession are posing a significant risk to the global economy. If the Euro-zone problems deepen, the US and UK economies could slip into recession again. This time around, there is little room for either a monetary or a fiscal policy push. In the developed countries, interest rates are typically close to zero, and central banks have limited policy instruments to fight another recession. Also, there is almost no fiscal bandwidth for these countries to stimulate the economies in case of another recession. These concerns continue to weigh on the risk appetite of foreign investors, leading to muted capital flows to emerging countries, including India. If growth in advanced countries comes to a halt, our future will largely depend on our ability to stimulate domestic drivers of growth, especially investment.

E – Exchange Rate
Exchange rate, or the value of a country’s currency, depends on its supply and demand. Between August and November 2011, the rupee depreciated by 12.2%, almost by the same extent witnessed during August-November 2008. However, while the diminishing risk appetite of foreign investors has caused sharp outflows on certain days, the net outflow of portfolio capital during August-November 2011 stands at just USD 0.5 billion vis-à-vis USD 5.1 billion during the same period in 2008. In contrast, the demand for US dollars has been much stronger this year as compared to 2008, owing to firm oil prices and repayment pressures on corporate India.

In the last few years, the foreign borrowings of Indian corporates have not only increased, but have also increasingly become short term in nature. Repayment of FCCBs, ECBs and related interest payments add up to nearly USD 22.9 billion for 2011-12; it is expected to hover at this level in 2012-13 as well, as per the govt.’s estimate. In an uncertain global environment, the rollover of short-term debt will be difficult. Therefore, if the rupee remains weak, Indian corporates will continue to face repayment pressures. It is necessary for Indian corproates with a large foreign exchange exposure to manage it via appropriate hedging strategies.

What Next?
Another global economic slowdown is looming large, this time led by the Euro-zone instability. In this scenario, domestic policy reforms are imperative to mitigate the DIRE risks and raise India’s growth potential. If we take appropriate actions now, once the world economy recovers, India might be able to regain the pre-crisis growth trajectory of 9%.