The MPC will hold as budget proposals sink in

We are at the intersection of a series of data and policy releases. Globally, a crucial policy meet of the European Central Bank (ECB) was followed by the last meeting chaired by the US Federal Reserve’s (Fed) Janet Yellen, preparatory to the transition to the new Chairman, and in all likelihood, a more hawkish Fed in 2018. Global financial markets have now begun to believe that the Fed’s intention is of hiking its policy interest rates three times, and pricing US interest rates accordingly. Given the big surprise of the Eurozone’s recovery in 2017, the ECB has also become sanguine about tapering its loose policy to avoid a financial bubble building up again.  

In India, we’ve had the Economic Survey, the FY17 GDP growth update (6.8%), an assessment of the impact of the November ’17 demonetisation, the Union Budget for FY19, and now we await the first Monetary Policy Committee meeting post the Budget.

Other than higher oil imports, the Current Account Deficit is also at risk from lower remittances. Although the Survey is sanguine about this, political uncertainty and fiscal tightening in the Middle East might adversely impact migrant incomes and remittances.

First, the assumptions on the macroeconomic scenario, used for the FY19 Budget, hinge on a 115% nominal GDP growth. The 7 – 7.5% real GDP growth forecast in the Survey is eminently feasible, given that indirect tax collections contribute to the difference between GDP and the underlying Gross Value Added (GVA). The green shoots of economic recovery now increasingly evident is at risk of being buffeted by financial sector headwinds, mostly global.

The most biting of these is the rise in crude oil prices, whose rise has defied the predictions of the best experts. The Survey estimates that a $10 / barrel increase in oil cuts 0.2 – 0.3% of GDP growth and raises the oil import bill by $9 – 10 bn, and the forecast for FY19 is an average $68 / barrel (vs $57 in FY18). Other than higher oil imports, the Current Account Deficit is also at risk from lower remittances. Although the Survey is sanguine about this, political uncertainty and fiscal tightening in the Middle East might adversely impact migrant incomes and remittances. On the whole, it is probably advisable to be conservative on economic forecasts, given rising global risks.

The good news in this is that the synchronised global recovery and the lag in the conservative monetary policy response is likely to make the “risk-on” investor sentiment persist, thereby keeping capital flows to the most attractive global destinations active, and providing risk capital, ie. portfolio flows to stock markets robust. Foreign Direct Investment (FDI) flows to India have remained consistently high and are likely to rise with the progressive relaxations across sectors.

The most disruptive and disturbing trend change has been a progressively rapid rise in interest rates over the past four months. This rise, widely reported on the move of the benchmark 10 year Govt bond from 6.45% in August ’17 to the current 7.56%, has much wider ramifications. Costs of state government and corporate borrowings have risen in tandem.

The FY19 budget was a modest stimulus, with a “pause” in the fiscal consolidation timeline deemed justifiable in the light of the deep structural changes which have been effected in the underlying transaction and reporting systems. India’s economy is in the process of adjusting to many fundamental structural reforms, while facing global headwinds. The Budget’s approach was guided by the Government’s “mission to especially strengthen agriculture, rural development, health, education, employment, MSME and infrastructure sectors”. The measures to increase credit flows to MSMEs using the significant formalisation, MSPs for farmers of 1.5x cost of production, mega food park schemes will gradually begin to have an impact on growth impulses from these segments. The moderate slippages in the overall and revenue deficits will not be deemed overly worrying, having been mostly factored in due to the disruptions of the massive transitional frictions of the move to GST.

The most disruptive and disturbing trend change has been a progressively rapid rise in interest rates over the past four months. This rise, widely reported on the move of the benchmark 10 year Govt bond from 6.45% in August ’17 to the current 7.56%, has much wider ramifications. Costs of state government and corporate borrowings have risen in tandem. In a fragile growth recovery, this rise in borrowing costs imposes significant costs to private sector borrowing.

Given this environment, the forthcoming thinking, stance, reaction and communication of the Monetary Policy Committee (MPC) on February 07 is likely to be moderately restrictive, citing the pressures of the looser fisc (for whatever reason) adding to the effects of the sharply higher global commodity prices.  The substantive concerns on inflation have, if anything, exacerbated. Adding to inflation worries are the effects of a fiscal slippage, particularly if this is progressively followed by states on their own fiscal trajectories. The effects of the new MSP formula, 1.5x of “cost” in the absence of a cost definition, remain uncertain. It is unlikely that there will be any significant change on the monetary policy stance, let alone a rate hike, till greater clarity emerges on the details of the Budget.

For the near future, the main growth drivers will presumably be Govt expenditure and, to a limited extent, exports. The revenue component of Govt spending will have a secondary effect on household consumption, but the magnitude will be more contained.

Albeit a bit technical, a view on the likely liquidity conditions in FY19 will be important for much of the corporate decisions on funding working capital requirements, which will remain relevant in the near future, given the persisting adjustments to an equilibrium in the GST  environment.

How does fiscal, monetary, industrial, trade and employment policy coordinate in this environment to put growth on a sustained recovery? How do actions and policies converge? Consider the four engines of India’s growth: household consumption, government expenditures, private sector investment and exports. For the near future, the main growth drivers will presumably be Govt expenditure and, to a limited extent, exports. The revenue component of Govt spending will have a secondary effect on household consumption, but the magnitude will be more contained. Leveraging the improvement in global trade, India’s exports should begin to contribute to growth, but the process is likely to be gradual.

To summarise, India has largely turned around from the short term adverse effects of the deep structural transformations. The Budget has sought a targeted allocation of funds to help some key sectors, but implementation of these measures will require coordinated actions between various policy authorities, and more importantly between the Centre and states. 

(The writer is Senior Vice President and Chief Economist, Axis Bank. Views are personal)