Which way will the Indian economy recover and its impact on the markets

Part II

The Indian economy has slowed down in growth from over 9% a year back to the current levels in the region of 5%. The fall in growth has been contributed by various factors like the global economic crisis which has led to a severe fall in confidence as well as availability of liquidity; high interest rates domestically due to RBI’s aggressive monetary tightening till September 2008 fall in exports and import etc. In my view the biggest factor which impacts growth in India is inflation, if inflation remains under control the interest rates also remain low and given the fact that India needs significant investments all around for its development a low interest rate regime is in my view the Panacea for high sustainable growth. Since we are not very export dependant and have sound financial institutions that have been able to skip the global turmoil in the financial sector, all we need is lower interest rates to boost both consumption and investment demand.
China had a golden period in the decade of the 1990’s where it could grow rapidly with low inflation as the global commodity cycle, after the big boom of the 1980’s remained subdued and led to a regime of low interest rates. Low interest rates not only boost consumption but also make more projects viable. Under the circumstances the most important thing for all of us to try to predict is the direction of inflation over the next few years. The reason is that while China got nearly 15 years of low inflation to grow, when India finally started to grow rapidly in the year 2003 it was in the midst of a global economic boom which finally led to high commodity prices and high inflation. Easy liquidity also led to a big asset bubble globally which finally burst in early 2008.
There are going to be two pulls for inflation over the next few years. The biggest fear is that the huge wave of liquidity that has been unleashed by central bankers globally will lead to money flow into risky assets and cause another bubble there. On the other hand the size of the global economy of USD 50 trillion and the fact that nearly 70% plus of this is constituted by Developed economies of the West and Japan. These countries are facing a severe structural problem with their financial systems and their economies. Under the circumstances growth is unlikely to pick up to any great extent in these countries over the nest 3-5 years. Under the circumstances demand is likely to remain subdued from these countries for this time period. As such inflationary pressures will be under check. The key is that although commodity prices can move up due to slush in liquidity they cannot sustain at very high levels unless they are backed by actual demand. Moreover the investments that have happened in capacity expansion over the last few years have led to an overcapacity in lot of commodity industries which is unlikely to correct in the near term. Under the circumstances where 70% of the global economy will growth at 0-2% it is highly unlikely that inflation will pick up to any great extent. Record high unemployment in these countries will also lead to lower inflationary pressures due to wage increases. Jobs are still getting cut in these countries and creation of unemployment is still far off.
One of the ex RBI governors has recently commented that there are inherent inflationary pressures in the Indian economy. However the reality in my view is that inflation in India has and will be largely a global phenomenon (ex of food). As such neither Indian monetary policy led to a rise in inflation and nor has it led to its fall. The biggest contribution of Monetary policy and various other credit parameters that the RBI set up have actually been in
-Controlling asset bubbles, especially in the real estate segment
-Prevented high increase in NPA’s in the financial sector due to conservative lending guidelines and exposure to various kinds of derivatives.
-Preventing exposure of banks into equity markets and thus lower losses due to capital market investments.

So finally how will the economy grow? For this let’s evaluate the composition of the India economy and how each segment will grow.
Agriculture – approx 15% of economy– This has become the least important part in terms of economy growth but still remain an important segment from the rural income point of view. Given the rally in agriculture commodities over the last few years and improving productivity in some segments like Cotton, agricultural incomes have grown at a much faster rate than the growth numbers of 1-3% we read of. This part of the economy still remain dependant on monsoons to a great extent. Government policies also have an impact, like in the sugar segment excessive intervention has led to a complete disarray of sugarcane production. Here growth should continue in the 1-3% range.
Industrial /Manufacturing – approx 25% of the economy – This segment has got affected the most due to the global slowdown, liquidity crisis, high interest rates and fall in confidence. The growth of this segment in the last six months has been between -2-2%. This is as compared to the range of 9-15% over the two years preceding August/September 2008. Given the improvement in liquidity, lowering of interest rates and the ending of political uncertainty in the near term we should see activity in lot of segments picking up going forward. The first signs of revival in this segment has come from the consumer side where Automobiles growth has picked up significantly over the last three months and consumer durable and non durable growth has gone upto double digit levels. Cement sector has a growth of 10-13% over the last two months. Steel companies are reporting record production volumes and growth of 20-30%. Construction spending has picked up and likely to accelerate post elections.
The most important thing here is also the fact that various core industries are likely to do much much better in the current year vis a vis last year. Given higher production of gas, start of oil production from Cairn energy fields and the start of the new Reliance industries refinery the incremental growth in these industries is likely to be in double digits. Higher power plants commissioning and better electricity production due to better availability of gas is likely to see electricity production growth in the current year at double digits. Also the severe fall off in exports is likely to stabilize over the next three months.
Under the circumstances I expect industrial production numbers to come in the range of 3-4% average growth for the first half of the year and 10-12% for the second half of the year. Average growth for the year should be in the region of 7-8%.
Services – approx 60% of the economy – The services segment which includes huge number of services like telecom, IT, government services, construction, transportation, hotels, banking, insurance etc. etc. has been growth at the rate of 8-10% continuously over the last may years. This segment has also seen some stress in the near term and growth has come to around 8% levels currently. Some segments like IT, hotels, transportation etc. will be under pressure here, however given the momentum of growth in a large number of other segments growth of this segment is likely to remain at between 8-10% for the current year itself. Due to greater government focus on reviving the economy government services should recover strongly. The long term growth is also sustainable at these levels given the demographics of India.
As such the overall growth of the Indian economy is likely to bounce back to 7.5-9% by the second half of the current financial year and go back to a sustainable level of 8-10% over the next few years. It is likely to sustain at these high levels as long as inflation does not rear its ugly head.
Given the fact that economy is likely to recover faster than most prediction my guess is that we are already in a new bull market.

Leave a Reply

Your email address will not be published. Required fields are marked *