India can’t rest on its laurels

Despite improving macro-economic fundamentals, growth has been, and will be, slow to pick up

The UK has voted to leave the European Union of which it was a part from 1975. Theresa May, Britain’s new PM, has her task cut out to provide her country with the best solutions, post its separation from the EU. The process of separation is likely to be a slowburn and the jury is still out on the extent of hit that could be taken by the UK, the EU and the rest of the world.

Effect on India

The immediate direct impact on India could be limited from the trade channel. India’s goods and services imports from the UK are 0.7 per cent of GDP while exports to the UK are 0.8 per cent of GDP. But, if global growth slows, the implications for India’s exports will be stronger. The impact could be more from the financial markets side as global markets remain volatile. There could be a bias for dollar to appreciate; implying EM currencies, including India’s, will have to depreciate.

There may also be bouts of volatility due to rising Euro-scepticism across the EU and fringe political parties gaining importance. India, as a standalone, has, to a large extent, achieved macro-economic stability. This is partly due to sharp corrections in commodity prices that helped it stay on course for fiscal correction and also lowered the current account deficit to levels much better than the RBI's comfort zone (2.5 per cent of GDP). This, and the RBI’s relatively tight monetary policy have led to a decline in headline CPI levels. The government and the RBI have initiated measures to clean bank balance sheets and infuse capital that will enable banks to restart lending.

Growth dynamics

Despite improving macro-economic fundamentals, growth has been, and will be, slow to pick up.  Most corporates have high debt and with industrial capacity utilisation running at 70-72 per cent, private investment is unlikely to pick up soon. The government’s infrastructure-related expenditure is expected to help, though. However, the key reliance will be on reviving consumption demand. On the urban side this is expected via rise in government employee wages through the 7th Pay Commission awards, on the rural side, the expectation is that incomes will increase due to good monsoon.

This is hardly a good time for India to rest on its laurels. Even as growth is expected to be muted, there does not appear a significant chance for oil prices to again race to the bottom. And if oil prices do plummet, this would be indicative of severe risk-off behaviour, implying that the rupee will have to depreciate faster. We will again be following a consumption-led growth model that was also followed in the post-Lehman period, with known disastrous results.

This will need to be avoided by policy makers. Calculations show that if oil tends to go up to $60 per barrel, India’s current account deficit could inch back very close to the red mark of 2.5 per cent of GDP. Further, fiscal policy could come under stress as oil products’ excise collectionspad up the revenue and might have to be given up if global oil prices increase. Further, it could add to inflation.

Monetary policy

In this context, monetary policy also needs to be carefully calibrated. Market expectations are again building over another rate cut by the RBI, especially in the likelihood of further easing of global monetary policy and postponement of further rate rises in the US. However, over the last three months, headline CPI inflation has increased and actually moved closer to the upper threshold level of 4+2 per cent. The outgoing RBI governor has explained that if inflation is closer to the threshold it is more likely to breach the threshold and hamper growth. So, there isn't any logic for an immediate rate cut. The final mantra? India must continue to employ structural reform. Slow and steady progress will win the race.

The writer is Chief Economist, IDFC Bank

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