The Hindu Business Line : Macroeconomic scene laced with challenges

The ongoing phase of rate hikes, which is likely to continue for at least one more year, will have a bearing on growth in fiscal 2009 and early 2010. The worrying aspect is that the situation on current-account deficit and the government’s finances may require a tighter policy bias for a longer period.

Higher prices of oil and other commodities are likely to slow down the economy for much of 2009 as well.

Equities have ended June with one of the more value-draining first six months of a calendar year ever. This is true of India as well as several other emerging and developed markets. Fixed-income securities also had an eventful month with a repo rate hike and multiple increases in the Cash Reserve Ratio (CRR) — the share of savings and fixed deposits that banks have to maintain as cash balance with the Reserve Bank of India.

Concerns, more local than global

Interest rates are firmly headed for higher levels, even as stocks have headed south, a rare period when textbook-like behaviour panned out across the two major asset classes.

Local factors appear to be playing a more dominant role now unlike in the first quarter of 2008 when global triggers held centre-stage. Global-event risks are, however, by no means history, and lurk with the potential to inflict more damage on sentiment, risk appetite and liquidity.

The credit-crisis centred in the US with ramifications across geographies, also now has company in crude prices at historic peak levels, high and rising inflation across the globe, trend towards higher interest rates and slowing growth in developed and emerging markets.

This is the global picture with relative pockets of comfort only in the Middle East (this region, too, has not escaped inflation due to its dependence on food imports), Brazil and Russia.

Oil and inflation have been in the limelight. Both are here to stay, with inflation probably set to linger longer than higher oil prices.

Even as rising crude price is the focal point on the world stage, the local picture in India has further stress points in trade deficit, a consequently higher current-account deficit and a gradually deteriorating state of the government’s finances.

The deterioration may take far longer to correct, even from the time pressures from rising crude prices recede as a key variable.

The external balance or lack of it

India is one of the few countries of note in the emerging markets’ space that has a current-account deficit (a growing one at that).

The deficit has not yet reached a level that makes for a high degree of concern, but the journey towards such a stage is well and truly under way now. If crude prices take longer to reach price points at which a corrective phase will be triggered, the pressures on the trade deficit and current-account deficit can acquire a more challenging hue for the economy in India.

Over the past couple of years, strong flows on account of remittances, borrowing, FII and FDI neutralised the impact of rising imports (non-oil and oil) and kept the deficit under check as well as at acceptable levels for a high-growth economy. The position is likely to be different this year as well as in at least the early part of 2009.

Remittances may stay at robust levels. This may not, however, be the case with FII flows and FDI as a result of low-risk appetite at the global level. Overseas borrowings are also likely to be more moderate due to rising interest rates across the world economy with the exception of the US, a lack of willingness to lend in a big way that is prevalent even between global banks and the depreciation in the value of the rupee.

As far as oil is concerned, our interaction with global experts indicates that the possibility of further increase till there is a permanent destruction of demand to ensure better balance with supply. Even in such an eventuality, it does appear unlikely that oil will recede much below $100 a barrel in the next year or two. These aspects could push the current-account deficit to a level that is distinctly uncomfortable for the macro-economy.

As a consequence, the rupee is likely to remain under pressure and could depreciate further against a trade-weighted basket of currencies, even if the dollar changes tack.

This situation on the external balances front may also constrain the RBI’s ability to moderate rates, even if inflation starts to recede in the latter part of the year as a result of a correction in global commodity prices.

From a longer-term perspective, after the expected corrective phase, oil is likely to embark on an upward trend, aided by robust demand growth in emerging economies and lack of adequate new sources of supply.

What this essentially means is that the window to get the external deficit to manageable levels may be short.

A significant source of comfort could emerge if gas and oil production from domestic sources is in line with expectations in terms of magnitude and timing of commencement of production. This may be crucial in getting the deficit under reasonable check.

Focus on RBI

Given the supply constraints, the policy approach appears to be structured to curb demand (growth) in a bid to rein-in inflation, and hence the recent emphasis on monetary tools. After a few fiscal initiatives a couple of months ago, the Government now appears to have left the job of battling high inflation to the RBI.

The central bank has responded with aggressive hikes and the prospect of more does exist. The ongoing phase of rate hikes will have a bearing on likely growth in FY 2009 and early FY 2010. The worrying aspect is that the situation on current-account deficit and the government’s finances may require a tighter policy bias for a longer period.

The option of letting the currency appreciate to act as defence against rising inflation — as the RBI did in early 2007 — neither exists now nor will the leeway be available next year. These aspects only mean that we may have to endure higher interest for at least over the next year. This amalgam of factors also has the potential to make FIIs cautious on India despite the still-intact long-term growth story.

Equity-market outlook

We maintain our cautious stance on the outlook for the economy and stock markets over the next few months. In terms of damage to equity values, we believe a significant part is already in the price and downside from present levels may be limited. What appears a fairly certain outcome is that a swift and sustainable recovery of the kind witnessed in 2004, 2006 and 2007 may not be on the cards.

The macroeconomic environment is laced with several challenges that may cast an overhang on the trends in equity markets. What we have now is a period of consolidation in the market and a slowdown in the economy to adjust to the reality of higher prices of oil as well as other commodities. We expect this year and much of 2009 to be marked by this phase of slower growth in the economy.

The growth momentum may pick up subsequently, led by commencement of gas and oil production, easing of capacity constraints and possibility of interest rates peaking in the ongoing renewed journey to higher levels.

(Source: Market Outlook, Sundaram BNP Paribas Asset Management.)