India’s Growth Slowdown

December 8, 2019

Hot topic of discussion in economic and industry circles currently is the fall in India’s GDP growth rate. In the Quarter ending September 2019 GDP growth rate fell to 4.5%. Questions are being raised whether this is a recession. Scientifically speaking, if an economy contracts for consecutive two quarters, then it is said to be in recession. This means, if economic growth turns negative, then it fits into this definition. According to IMF projections, in the year 2019 global economic growth rate is 3%. Growth rates for developed economies like America, Europe, Japan are projected at 1.7% and of emerging economies are projected on an average at 3.9%. Compared to this India’s 4.5% growth rate is more than average. Hence, one cannot term this as a “Recession”. Average growth rate in India over last 5 years was 7.32%. In comparison, the current fall in growth rates gives a recession-like feeling and it is hard to ignore. What is the reason behind this fall? What are probable solutions? Who has power to correct this? These are some of the questions in peoples’ mind. Is any remedial action being taken? Whether it is effective? When will the actual results be visible? Many will have their own doubts. Fall in auto sales, lower consumption of diesel and electricity, daily news items of this sort increase anxiety for sure.

Monetary and Fiscal Policy

Two main tools to keep maneuver and balance growth and inflation are Monetary and Fiscal Policies. These policies are managed by Reserve Bank and Government respectively. Reserve Bank is an independent institution. How and at what level current rates (Repo rates, CRR, SLR etc.) are to be kept and how money supply is to be maintained is decided by Monetary Policy of the Reserve Bank. In 2016, after changing RBI Act, Monetary policy setting is assigned to Monetary Policy Committee (MPC). MPC consists of 6 members; 3 are Reserve Bank’s officials and remaining 3 are appointed by Government. RBI’s Governor is the Chairman of this committee. This committee was formed based on a report presented by Dr. Urjit Patel. Before Monetary Policy committee’s mandate, the nature of Monetary policy was multidimensional. Along with Inflation control, maintaining growth rates, stability in currency and Forex markets were also part of Monetary policy. After the committee came into existence, Inflation Targeting was kept as the single point agenda. There are 2 indices which are commonly used for tracking inflation. Wholesale Price Index (WPI) and Consumer Price Index (CPI). Committee has been given the mandate to maintain CPI within the desired level. To achieve this, Monetary Policy projects inflation range for coming 12 months and then it decides the level at which interest rates are to be kept and how money supply should be maintained to keep inflation under check. If you reduce interest rates and increase supply of money, then inflation is likely to go up. As a corollary to that, if you increase interest rates and make money supply tight, it helps in reducing inflation. As aim of the monetary policy is to maintain Inflation, maintaining growth rates is not MPC’s responsibility.

Growth Rate and Fiscal Deficit.

Fiscal Policy is an instrument in the Central Government’s hand. Government’s income comes from Tax collections and Capital receipts. Governments spends these for revenue expenses and capital expenditure. If expense is more than income, then that is termed as Fiscal deficit. Government needs to fund this deficit by borrowing money. Globally, government budgets are usually in the deficit. More spending leads to improved growth rates. Hence spending more than earnings is the rule rather than an exception. If growth rate keeps on increasing, it adds to government’s popularity. Hence, elected members have more emphasis on improving growth rates than on keeping inflation in check. Widening Fiscal deficit is likely to result in rising inflation. If fiscal deficit increases beyond control, then hyperinflation like scenario can occur. Because of this, the currency depreciates, imports become dearer and inflation goes out of hand. For exactly this reason, to keep Fiscal deficit under check the Fiscal Responsibility and Budget Management Act (FRBM act) was passed. According to this law, till 2021 Fiscal deficit is to be reduced at 3% of India’s GDP. Government’s attempts to stimulate growth are constrained by this responsibility of keeping Fiscal deficit in check.

It is clear that GDP growth and inflation control are conflicting goals. In balancing such conflicting goals, standoffs often take place between RBI and Government. But this is completely natural and not specific to India. We can see this tug-of-war happening in may developing and developed countries across the world. Due to media limelight, these skirmishes now a days reach the common man. In India, RBI Governor Dr. Raghuram Rajan declining an extension and his successor Dr. Urjit Patel stepping down before his term has given media enough sensational material.

In the period from 2009 to 2014, CPI inflation rate on average was around 9.95%. In the period 2014-2019 it has declined to 4.97%. This may tempt us to conclude that monetary policy has been successful in controlling Inflation. In this context, we should acknowledge that, in our country we cannot control inflation, only by maneuvering monetary policy. Close to 70 % of our energy needs are met by importing Crude oil. If oil prices go up in international markets, then inflation in India heats up. In the year 2013 oil prices had reached level of $111/barrel; but in last 5 years on an average oil prices have remained close to $60/barrel. This has been one of the biggest reasons in maintaining inflation within desired range. Repo rate considered as a proxy for interest rates in India. In last 5 years RBI has changed Repo rate several times. Since the beginning of 2019, Repo rate has been lowered from 6.50% to 5.15%. In every Bi-monthly policy repo rate was reduced by 25 bps, but in October policy repo rate was reduced by 35 bps. In the December 5 MPC meeting, status quo was maintained. At a time when GDP growth rate has hit a low of 4.5%, the decision not to cut rate stating the rising food price inflation took everyone by surprise.  This year, because of excess rains kharif crops were washed out. Hence the MPC has taken a cautious stance. They have also considered the fact that this year Rabbi production will touch an all-time high, and inflation is projected around 4.7-5.1%. This decision reiterates that the single point agenda for Monetary policy is only inflation control.

In a country like India, whether it is right to prepare monetary policy with Inflation being single point agenda is something which being getting increasing attention. There are experts who argue that rather than copying template from Developed countries, we should design more balanced and practical policies. Maintaining a delicate balance between growth and Inflation is required. Sole focus on CPI is also being questioned. In CPI, food, fuel and housing have close to 70% weight. In WPI, industrial produce has higher exposure. WPI has been consistently close to 2% and currently it is close to 0%.

Impact on Consumers?

Do interest rates really have impact on consumers? Do consumers really tend to buy more, if interest rates are reduced? These are some of the questions currently being asked. Impact of interest rates on buying some goods is undisputed. For instance, if you were to avail a housing mortgage loan of Rs.20 Lakhs, and the interest rate is 10%, monthly instalment would be about Rs. 19,300. If interest rate falls by 3%, the EMI falls to Rs. 15,506. This creates the room for an extra Rs. 3,694 for other spending. This can lead to a demand for other items of consumption. But there are some other important factors as well which one needs to consider. Whether consumer income is growing and there is job security, will impact consumption. A lack of confidence about these factors is bound to hamper it. If we consider the last 10 years data, the increment in salary in white collar jobs in the private sector has consistently lagged inflation rate. Even with this, why did we see consumer spending increasing? One reason could be falling savings rate. India’s savings rate has come down from 38% to 30%. Individuals savings rate has dropped from 23% to 18%. This means, while salaries were not growing incremental spending was taking place at the cost of savings. In recessionary environment there is less confidence about jobs. In small and medium enterprises also, events like demonetization, GST and prolonged time for recovery of debtors has shook confidence. This leads to a tightening of the belt and the tendency to save money in every possible manner.

On the other hand, low cost of finance and easily available money supply was also one of the reasons. CIBIL has enabled credit rating for Individuals. Like companies have “Credit Rating”, because of CIBIL score, giving loan to individuals has also became less risky. Taking wholesale discounts from manufacturers and offering optically attractive “0%” interest (But actually high rate schemes) gave encouragement to individuals for spending. Private banks were able to grow their business on such schemes. NBFCs also entered in this competition. NBFC financing was one of the main pillars of this individual spending. In August 2018 IL&FS ran into problems. This company was mainly engaged in Infrastructure financing. It defaulted on interest and principal. This episode exposed weak links in NBFCs.  NBFCs were borrowing for short term (typically 1 year) and lending for long term (typically 10 years).This is called asset-liability mismatch. As panic set in, investors refused to renew short term deposits and many NBFCs were “Run-Out”. This funding squeeze affected many businesses. Many Small and Medium enterprises borrowed from NBFCs despite having higher interest rates because of convenience. It was simpler compared to borrowing from corporate banks. Those companies faced a liquidity crunch and interest rates also went up. These developments had negative impact on business as well on personal spending. When similar situation happened in the USA, Federal reserve drastically cut interest rates, bought stressed bonds and infused liquidity under its TARP program. In India, Repo rate had been hiked 2 times In June and August 2018. In hindsight, this action shows lack of sensitivity. In current year’s budget, it was announced that banks will provide liquidity to NBFCs to the tune of  Rs. 1 Lakh Crore. 5 months have passed since, but how much money has been provided is still not clear. There are also question marks on whether, the recapitalization package worth Rs. 70,000 Crore declared for public sector banks and Rs.25,000 Crore package for Real estate sector have made any progress on ground or are still stuck in red tape.

Limitations on Fiscal Stimulus

Finance Minister has done efforts through Fiscal policy to stimulate GDP growth. Promise made by previous finance minister to reduce corporate tax rate from 35% to 22% was fulfilled by bringing in an amendment. The tax cut means stimulus of Rs. 1,45,000 Cr. For the economy every year. Tax rate for new manufacturing unit is now set at 15% to give boost to manufacturing and the government is hoping to attract large Foreign Direct Investment due to the most competitive tax rate in the region. This tax cut, however, might lead to slippage in Fiscal deficit to the tune of 50 bps to 3.8%. GST collections have remained below Rs. 1 lakh Cr., but they inched up above that mark in the last month. As GST collections are weak due to the sluggishness in the economy, the limitations on inducing growth in the economy through fiscal measures are clearly there.

Interest rate and Growth rate

While discussing about Interest rate and growth rate it is important to understand the “Real Interest Rate” as a concept. When the borrower repays its loan, reduction in purchasing power of rupee because of price rise acts in its favor. For example, if inflation rate is 5%, then value of Rs.100 after 1 year (100/1.05) becomes 95.23. i.e. value is reduced by Rs. 4.77. Suppose if I pay 8% interest, then in real terms, I am paying (8-4.77) only 3.23 out of my pocket. This means, if inflation is higher, I will be more tempted to borrow. In period, 2009-2014, average inflation rate was 9.95%, and deposit rates was on average 8.33%. This effectively means that banks were not required to pay “Real” interest. Today, inflation rate is around 3% and deposit rate is around 6.5%. This means banks now have to pay “real” interest of 3.5%. Governments Small Savings schemes are offering 8% interest so real rate is close to 5%. Individual running a business is facing a bigger problem. If we assume wholesale inflation around 2%, then their product selling price is rising merely by 2%. Interest cost for him is close to 12%.  His loan is growing at “Real rate” of 10%. Today, real interest rates in India are one of the highest globally and that is hurting businesses and impacting growth rates. 

Will reducing Repo rate solve the problem?

Only reduction in Repo rates will not solve this problem. There are two reasons for this. First reason is that the Interest rates on Small Savings schemes, PPF, Provident Fund are in the range of 8-8.65%. Hence, even if Repo Rate comes down, banks cannot cut deposit rates and effectively interest rates on loan. Along with that, if they reduce interest rates on Small savings schemes, then senior citizens and middleclass retirees will find the situation tough. Second reason is, as savings rates have come down. There is a shortfall of funds and it makes it difficult to cut interest rates.

There are possibly other reasons also for current recession-like scenario. Take the Auto industry, for example. Pollution in cities, traffic jams, implementation of BS6 standards, improvement in efficiency of commercial vehicles and the resultant reduction in time because of GST, preference for ride hailing services such as Ola and Uber by younger generation, expectations regarding electric vehicles could be some additional reasons for current slowdown.. Having said that, high “Real” interest rates and low capital availability are undisputed factors in the slowdown.

Global Paradox

The total value of Bonds outstanding globally is close to $23 trillion, out of which, almost $15 trillion worth of Bonds are trading at a yield of 0% or negative rates. India at the same time has a big requirement of funds for building its infrastructure. This could be an opportunity for global investors, who are unable to find productive avenues. Union Budget 2019 had proposed to raise funds through issue of Indian Sovereign Bonds abroad. This was bitterly criticized by taking a myopic view. Instances of countries like Argentina, Venezuela, Zimbabwe were quoted, which had indiscriminately piled up foreign debt. We need to think this through openly. With proper communication, co-ordination and necessary controls in place, this could be one great window of opportunity. India can become a part of the global emerging market bond index; large allocations can come from pension funds and endowments. If we can restrict this Bond program to, say, 0.5% or 1% of GDP, we can raise 15 to 30 billion dollars and we would not be playing with fire. The cost of the funds will not be zero, but will be governed by India’s credit rating and currency depreciation. When we allow Foreign Direct Investment through the equity route, profit perpetually go to foreign countries. Bonds have a maturity and the liability extinguishes on repayment. Our country runs a Current Account Deficit and we need to be cautious in borrowing abroad, but this can be put in place with proper checks and balances. The world is flooded with funds and we face a drought of capital. This is one “River Joining Project” that can create a Win-Win and reignite growth.   

bharat@wealthmanagers.co.in

Fifth Bi-monthly Monetary Policy Statement, 2019-20

Wait and Watch for now.

Key Points

  • Policy repo rate unchanged at 5.15%, reverse repo at 4.90% and MSF at 5.40%
  • Monetary Policy stance remains “Accommodative – As long as it is necessary to revive growth, while ensuring that inflation remains within target”.
  • CPI inflation projected at 5.1-4.7% for H2:FY20 and 4-3.8% for H1:FY21, with risks evenly balanced.
  • GDP growth forecast reduced to 5% from 6.1% in FY 19-20, and in the range of 4.9-5.5% for H2:2019-20 and 5.9-6.3% for H1:2020-21 with risks evenly balanced.
  • Liquidity to be Positive.

Inflation:

  • CPI increased sharply to 4.6% in October, propelled by surge in food prices.

Factors shaping inflation path- 

  • Upsurge in prices of Vegetables likely to continue. However, RBI expects pick-up in arrivals from the late Kharif season and imports by government should soften food inflation.
  • Incipient price pressures seen in other food items such as milk, pulses and sugar are likely to be sustained.
  • Both 3-month and 1-year ahead inflation expectations of household have risen.
  • Domestic demand has slowed down, which is being reflected by softening of Core inflation.
  • Increase in telecom tariffs can have some impact on core inflation.
  • Crude oil prices are expected to remain range bound barring any disruption due to geo-political tensions

Liquidity

  • Liquidity in the system was in surplus in October-November 2019 despite expansion of currency in circulation due to festive demand.
  • Reflecting easy liquidity conditions, the weighted average call rate (WACR) traded below the policy repo rate (on an average) by 8 bps in October and by 10 bps in November.

Current Account Deficit and Forex

  • Trade deficit narrowed during September-October 2019.Imports contracted faster than exports.
  • On the financing side, net FDI rose to US$ 20.9 bn in H1:2019-20 from US$ 17 bn a year ago.
  • India’s foreign exchange reserves were at US$ 451.7 billion on December 3, 2019 – an increase of US$ 38.8 billion over end-March 2019.

Domestic Growth outlook cut to 5%

  • Growth in GDP moderated to 4.5% in Q2:2019-20, extending a sequential deceleration to the 6th consecutive quarter.
  • Real GDP growth for 2019-20 is revised downwards from 6.1% in the October policy to 5% – in the range of 4.9-5.5% in H2 and in the range of 5.9-6.3% for H1:2020-21 with risks evenly balanced.

Factors that will influence growth

  • Various high frequency indicators suggest that domestic demand conditions have remained weak.
  • RBI expects several measures initiated by the Government and monetary easing undertaken since February 2019 to revive sentiment and spur demand.
  • The business expectations index of the Reserve Bank’s industrial outlook survey shows marginal pickup in business sentiments in Q4.
  • Quick resolution of global trade tensions.
  • Further slowdown in global economic activity and geo-political tensions

Assessment of Global Growth

  • Since the meeting of the MPC in October 2019, global economic activity has remained subdued, though some signs of resilience are becoming visible.
  • GDP growth in the US picked up in Q3, in Euro area GDP growth remained stable. Japanese economy lost momentum in Q3 while economic activity in the UK accelerated.
  • Among Emerging economies growth in China, South Africa, India decelerated in Q3 whereas growth in Russia and Brazil accelerated.
  • Crude oil prices have remained range bound.
  • Gold prices traded sideways before falling in early November as a revival of risk appetite eased safe haven demand.

All members of the MPC voted in favour of the decision.

Other Key Announcement

  • Draft circular on exposure limits and priority sector lending by primary urban cooperative banks to be released soon
  • Urban cooperative banks with assets of Rs 500 Crs and above to be bought under the Central Repository of Information on Large Credits (CRILC)
  • Facilitation of setting up a self-regulatory body towards development of the secondary market loans

Debt Market View  

  • With growth faltering to 4.5% in the last quarter, it was widely expected that RBI will cut rate in this monetary policy, in absence of that bond markets reacted negatively with Benchmark 10-year paper gaining 14 bps.
  • RBI in its commentary has indicated that economic activity has weakened further and the output gap, which is the difference between actual output and potential output, remains negative and RBI will “Wait and watch” effect of monetary and fiscal measures already taken.  
  • High Real rates continue to make debt an attractive asset class
  • We suggest products having maturity close to investment horizon having highest credit quality and lowest expense for investors having less than 1-year time horizon.
  • For a 3-year investor, we recommend allocation in 1-5-year average maturity segment with high credit quality portfolios mainly focused on accrual. The high-quality PSU and corporate bond spread over G-Sec is attractive