Turning of the cycle

The US and Gulf recovery will have the power to pull up emerging economies and trigger an era of high growth and inflation

By Mohan Sule

The latest policy initiative by the Reserve Bank of India evoked two kinds of reactions. Industry and investors welcomed the unanimous decision of the new Monetary Policy Committee to cut the lending rate by 0.25% to the lowest level in five years. It is unlikely that banks, groaning under the burden of bad loans, will transmit the measure as the earlier downward revisions are yet to be fully passed on to the borrowers. Yet, the step is a sentiment booster. The message is that the central bank is shifting focus to growth from the obsession with inflation, noting the sluggishness in industrial output and weakness is prices of food, metals and manufactured items. Armchair economists, meanwhile, fretted about the unwarranted adventurism. The responses from either side of the aisle have as much basis as contradiction. The decision by oil producing and exporting countries to cap output to stem the sliding crude prices poses a threat to the benign inflation environment. Recovery in rural buying post a normal southwest monsoon could be another tripping point. On the other side is the wave of low interest rates and bond-buying in ex-US developed economies. The US Federal Reserve has been displaying extreme restrain despite falling unemployment in continuing its rate hike cycle that was started December last year. China, too, is loosening its monetary policy to bolster capacity utilization. The depreciation of the yuan means   emerging markets have to weaken their currencies to stay competitive. The plunge in the value of the pound against the dollar following the Brexit poll is another challenge for Indian exporters. The rupee has been gaining of late due to the inflow of foreign portfolio and direct investment. The success of the Make-in-India campaign hinges on a soft currency.

Apart from the slump in economic indicators capturing output and prices, an important reason why the RBI could not have taken a pause in paring rates is the momentum of the US recovery that makes a second rate hike in a year by the Fed increasingly inevitable. Post December, there is a possibility of net outflow of foreign portfolio investment. India’s comfortable reserves could deplete rapidly if capital flight were to gather momentum and oil prices rule higher than the levels in 2015.  The glut in food grains is likely to result in pressure on the government for  higher support prices to farmers. All these developments will strain the balance sheet of the government and fuel inflation, complicating any move to ease interest rates further. Balancing the adverse effect of the Fed’s action will be the bounce-back of the Chinese economy. China is the largest exporter to the US. A healthy American market is bound to revive the appetite for commodities. If not the US due to its sufficiency in energy on the back of the domestic shale gas industry, Chinese consumption will lend support to fossil fuels. The revival in spending by Gulf countries on back of higher crude prices will be a powerful booster dose for India’s services and merchandise exports.

The reluctance of the market to break from its range-bound movement indicates that the coming Fed rate action has been factored by equities. As such, there might not be a plunge of the magnitude that would take stocks to the post-September 2008 level. Some industries seem to have priced in the recovery of the Indian economy post southwest monsoon of 2016. These are mainly the consumption sectors such as automobiles, apparels and housing-related products, whose purchases had been differed due to the two years of drought. Some others, primarily in the core and infrastructure space, will benefit from low base on private sector investment. In fact, booming US and Chinese economies will do more to wipe out Indian banks’ bad loan problem than any amount of relaxation in income recognition norms. Discretionary sectors might continue to report flat margins as the rise in demand could be accompanied by a spurt in the cost of raw materials. A muscular dollar will push up exports to the US and at the same time ensure that the Fed ramps up its discount rate in driblets and the exuberance in commodity prices is capped. If foreign funds maintain the inflow momentum to buy cheap Indian assets, a strengthening rupee, essential to keep a lid on inflation, is likely to blunt the salutary effect on the margins. Revival of IPOs in the US might see a repeat of history, with profit booked going to emerging economies. So much so that some countries might have to impose capital controls. Investors will have to reconcile that the era of cheap money might be coming to an end by the second half of the next fiscal due to increase in risk-taking in the US, India and China. As such, higher Fed rates and oil prices could be the liquidity injection by the US and the Gulf region to pull up global economies.