How RBI misread the global economic scenario to take India back to the Hindu rate of growth

I have been a strident critic of RBI’s monetary policy stance over the last several months and most economists have been critical of this stance as they have focused on the ‘Inflation Bogey” to support RBI’s growth destroying monetary policy. Although RBI has historically had a good track record in terms of maintaining macroeconomic stability their track record on creating situations for strong growth have been clearly suspect. In the midst of global growth uncertainty as well as various issues related to Euro zone RBI has been only focused on one variable i.e. “Inflation”.

We have seen that inflation has been above the targeted range across large number of economies including the troubled Western Economies mainly due to the elevated commodity prices that have been driven up by excessive speculation driven by the supposedly growth supportive “Quantitative Easing (QE)” policies. We have seen that some central banks like the BOE as well as the US Fed have clearly seen this spike in inflation as temporary and have seen the risk of “Deflation” in the longer run as the bigger risk. It is a reality that without underlying demand being strong the price of an asset can be taken up in the short run through leveraging and speculation, but it cannot sustain over a period of time. We are now seeing this situation playing out in the commodity markets globally where crude oil prices have corrected by over $ 30 per barrel in a period of several weeks and most other commodities like Thermal Coal, Copper & other metals etc have corrected sharply. As I had pointed out in several of my earlier articles the price of oil was clearly in a speculative bubble in the midst of slowing demand and increasing supply. As I had written earlier the topping pattern in Brent indicated a correction, first down to the $ 98-102 per barrel and eventually possibly down to $ 85 levels. Most major correction in Brent crude have seen a correction in prices by nearly 35% from the top which indicates a correction to the $83-87 range.

Central banks like the US Fed, BOE and lately the ECB have recognized that their economies actually risk deflation over the long run in the midst of the severe deleveraging cycle both from the governments in terms of reduction in Fiscal Deficits and the banks in terms of shoring up their capital adequacy ratio’s after taking into account severe losses from bad debts. This combined with high unemployment and adequate capacities create a situation for low inflation over the long run. Greater oversight means that these banks will keep on shrinking their balance sheets over a period of time before things stabilize.

It was clear to every one that a global deleveraging cycle is on and this is the reason why the Western Central banks have kept policy rates at the absolute minimum and kept the system awash with liquidity while printing money via QE’s. The first impact of the QE cycle was to take asset prices up as ample liquidity at no or very low cost was available for speculation. However I have always believed that in the long run unless and until there is underlying demand these prices cannot sustain. Indian monetary policy authorities took this rise to be permanent without evaluating the global uncertainties and kept on hiking policy rates & squeezing liquidity without realizing that in a globalized economy where India is just around 3% of the global GDP and where more than $ 4-5 trillion of fresh money has been either printed or shoved into the system through QE’s & LTRO’s there is very little that the Indian monetary policy could do to control inflation. Infact I had put out an entire analysis of India’s WPI basket a few months back to show the complete ineffectiveness of Indian monetary policy on controlling inflation.

The reality is that the “Policy Paralysis” of the central government has got exaggerated by monetary tightness. The biggest failure of the policy environment seems to be on the agricultural reforms front where despite knowing the reasons for huge food wastages due to transportation and storage nothing much has happened on this front. Despite overflowing granaries we have a situation of double digit food inflation at a time when we have had strong agricultural growth for the last couple of years. It is clear to most people that food inflation falls outside the gambit of monetary policy in any case.

As such by assuming the global commodity inflation cycle to be permanent & not taking into account global factors the tight monetary policy domestically has taken growth back to where the boom started in the year 2003. Slower growth has resulted in deterioration in the governments tax collections, which combined with a complete lack of fiscal discipline from the government has led to a further increase in Fiscal Deficit. The logic given for a tight monetary policy has also been the high Fiscal Deficit which has resulted in crowding out of private investments. However the reality is that the poor investment cycle is more due to policy paralysis and the tight monetary policy rather than crowding out. Slowing growth and a perceived lack of macro economic stability has resulted in a severe fall in the value of the rupee also. This in my view is not necessarily bad as it improve India’s terms of trade over the long run despite its negative impact in terms of increasing inflation in the short run. The reality is that if INR had not depreciated by nearly 25% the inflation at this point of time would be more near 4% rather than the headline 7% that we see today. As such the high headline inflation that we see today is more due to the high food inflation and the inflation induced by INR depreciation rather than any strong demand in the economy.

The reasons for the rupee fall, besides the deterioration in the Current Account has also been due to a view that Indian policy makers have lost the way in managing the economy. There have hardly been any capital outflows to which this fall can be attributed. There are a lot of economists who have suddenly discovered the inflation differential argument between the USA and Indiain order to explain the INR fall which is good in theory but not necessarily practically true.

The worst hit due to the tight monetary policy have been the exporters who have not only had to face the brunt of global downturn which has cut demand but have also got squeezed due to high cost of credit at a time where competing countries are are providing the same at costs 5-7% below Indian interest rates which is providing an extreme disadvantage as margins are in any case squeezed. There is need to provide export credit at global rates in some way or the other in order to boost exports at this time.

This is the ideal time for India to do a sovereign bond issue. There is enough liquidity available globally and benchmark US10 yr bond yields are trading at levels of 1.5%. Most people arguing against this give the logic of the exchange rate risk and whether the government should take that risk. I am not sure what kind of premium the government will need to pay for the borrowing in USD, however it should be in the 4% range. Assuming that the Indian economy grows at a rate of around 13-14% in nominal terms over the next 10 years (7% real +6% inflation) the Indian economy should be of the size of around $ 7  trillion at the end of 10 years. As such even if the government takes the risk of a $ 20 billion bond issue at this point of time at the time of the repayment of the bonds the entire repayment amount assuming it’s a deep d
iscount bond will be $ 30 billion i.e. just 0.4% of India’s GDP at that time. A bet, worth taking in my view. The impact of such an action will be two fold, one it will stabilize the INR & secondly it will eliminate the severe tightness in the domestic liquidity scenario which is much needed.

We have seen the phenomenon of China’s growth in the 1990’s which was accompanied by extremely low inflation mainly due to the fact that the global commodity cycle was subdued. Low commodity prices meant that huge investments could be made without increasing inflation. Indiacould also see this opportunity over the next decade; however domestic policies have to be supportive. RBI needs to boost liquidity and reduce policy rates immediately and sharply in order to bring confidence back in the mind of investors and consumers. Policy action cycles by the government are clearly cyclical with times where they are supportive of the economy and times when they do nothing. This is not new and has been seen several times in the past. The worst of policy inaction seems to be behind us, however how much above the worst we will move needs to be seen. Prohibitively high interest rates have distorted the entire investment project viability cycle. Poor capital markets have also meant that equity fund raising has become very difficult. On top of that high cost of debt funds are ruining corporate balance sheets as well as that of banks where NPA’s are moving up.

Growth supportive policies from the RBI and hopefully some FDI reforms from the government will stabilize the rupee & should lead to a move to the 52-53 levels. The average cost of Brent last year was $ 114 and current prices are nearly 15-20% cheaper. This will improve the governments’ fiscal situation substantially due to a lower subsidy burden. Since commodities in USD terms are already down 25% yoy the full impact of the same will be seen on India’s headline inflation over the next few months. Lot of armchair economist argue that higher policy rates are supportive for the INR. This is an extremely fallacious argument, especially for a country like India where there is only partial capital account convertibility. High growth is the actual long term support for the rupee.

The downside risks for the Indian economy have reduced substantially with the risks on both Fiscal & Current account deficits as well as inflation coming down. Markets are positioned cheap on both in terms of valuation as well as long term growth prospects. Markets are back to the 15800-16000 range which I believed should be a good support. Most global and domestic concerns seem to be factored in to a great extent into the markets. The only risk that remains is the contagion impact of a Greek exit which is difficult to evaluate as it can result in a selloff in the short run, without impacting long term prospects. Given the extreme oversold situation of global equity markets the Greek exit seems to have already been factored in to the extent of above 50%. Declining domestic macro economic risks have made the long term risk reward payoff extremely attractive for investors into Indian equities that are trading much below long term valuations. The current downturn, like most downturns test the patience of investors but will always be followed by strong up cycles which will playout over the next few years. Apathy towards equities, low leveraged positions, cheap valuations & a peaking interest rate cycle are creating the situation for the upturn for the 2003-07 kinds that will create sustainable wealth and take the markets away from the value destroying trading range.