Cracks in the citadel: Financial Express: May 17, 2011

The mood in the economy after the presentation of the monetary policy is quite a contrast to that when the Union Budget was announced. There is a hint of despondency as we discuss economic numbers today compared with March and the mood has shifted from optimism to caution. How serious is this loss of confidence?

GDP growth expectations for the year have been rolled back from 9% to 7.5-8%. This means that the three sectors will not be able to measure up to expectations. Agricultural production peaked in FY11 and retaining the momentum of 5%-plus in the coming year will be a challenge, considering that we have, so far, not had two successive high growth rates in this sector in the last decade. Therefore, moderate growth can be expected, provided the monsoon is normal and well-distributed across geographies and crops, besides its normal ‘arrival and departure’.

Industrial growth for the year has been lower in FY11, at 7.8% (10.5% in FY10), which can be partly explained by the high base year effect. Can this number be bettered in FY12? High interest rates have been fairly neutral for most of FY11 but may impact growth in the coming year. RBI is willing to sacrifice growth for inflation control, which may be interpreted as the possibility of there being further increases in interest rates that, in turn, will impact investment decisions. Interest rates have a bearing not just on investment and cost of working capital but also on retail loans in the housing and consumer goods segments. This would have a bearing on the production of capital goods, metals, construction, etc. Therefore, a number of 8% or so in the coming year would be an optimistic call, aided partly by the relatively low base year effect.

Next, government balances looked well under control in February. Lower growth in industry will have a bearing on production as well as imports, thus posing a potential loss of revenue in indirect tax collections that will pressurise the deficit. The government has to take a call on taxes/duties on oil products, given the volatile nature of crude prices globally. Therefore, the number of 4.6% for the fiscal deficit will have an upward bias if any of the assumptions made at the time of its drafting change. Also, in this environment, a decision that has to be taken is on government expenditure, as it is the only entity that can provide demand stimulus as higher interest rates do not impact them significantly. But, it has withdrawn this stimulus quite drastically in FY12 with overall expenditure to grow by just 3.4%. With lower spending, the component of services sector, i.e., community and social services, will show a modest increase.

Inflation is a phenomenon that no one has been able to grasp. It appears that we have entered a high cost economy, which is hard to reverse and at best can be stabilised at these levels. MSPs have risen, as has the cost of cultivation. Protection of farm incomes has meant that prices have to increase to preserve real consumption levels. Prices have become sticky in the downward direction. Global prices have provided cues to domestic prices and this linkage is becoming stronger. They, in turn, have been driven of late by speculative forces and may be expected to remain volatile. While a high base should bring down prices, the same did not happen last year, notwithstanding the high base.

The stock market has been largely stable in the 18,000 to 20,000 region, reflecting caution. FII funds have not exactly given the thumbs down signal but have been vacillating in the last few months. June to November 2010 was a boom phase after which flows ebbed for 3 months before turning positive again. FDI has also slowed down for several reasons. Besides, the global economy would be recovering and interest rates could move up, thus re-diverting funds to the developed economies. All this means that there could be pressure on the balance of payments.

The exports story has been impressive in FY11 even if looked at in absolute terms and not just growth rates. Surpassing the mark of $200 billion was an achievement but maintaining this tempo will receive a shoulder shrug, as growing exports by even 20% over a base of $245 billion is a challenge. Imports growth will be linked to industrial production and would tend to slow down if industrial growth is lukewarm. However, higher commodity prices, in particular oil, can spoil the party. While we have been talking of a manageable current account deficit at 2.5% of GDP for FY11, the FY12 outcome could be different.

While it may not be proper to predict doomsday, there is definitely a circle of apprehension over all the economic numbers that defied global gravity in FY10 and only stumbled a bit in FY11. FY12 may still be better than what is happening in the rest of the world, but certainly the inflation impact has distorted images that were constructed at the beginning of the year. The 10% terminal year growth target is obviously ruled out and the five-year average will now be lower than 9%, as was envisaged by the Planning Commission.