India's H2FY14 recovery at mercy of rupee, monsoon: ADB

Asian Development Bank (ADB) recently downgraded India's FY14 growth forecast from 6 to 5.8 percent. Stalled projects, low industrial output and slowdown in import economies, like Europe are responsible for India's muted economy says ADB’s economist, Abhijit Sen Gupta.

ADB could relook at this growth forecast as it has not factored in the recent measures taken by the Reserve Bank of India (RBI) which aimed at curbing rupee’s fall. Gupta also cautioned that asset quality would worsen going into FY14 as well.

He further told CNBC-TV18 that India’s recovery in the second of FY14 would depend on the rupee and monsoon.

Below is the edited transcript of Gupta's interview to CNBC-TV18.

Q: Take us through the primary drivers of the downgrades that you have notched up over the last couple of days?

A: We have reduced our forecast for India’s growth from 6 percent for this year, which we had forecasted in April 2013, to about 5.8 percent. The main reason for this downturn was a continued weakness in fixed capital formation.

We still see that the trend of decline in announcement of new projects is continuing. There has also been some uptick in the number of stalled projects and these have been driven by the traditional drivers. There is limited progress in dealing with some of the policy and execution related challenges whether they pertain to a land acquisition, environmental clearance, fuel supply linkages.

In addition, we have also seen that the industrial output continues to be quite weak especially for the capital goods, which does not bode well for future investment prospects. Finally, the tepid recovery in Europe, which is a major destination market for Indian exports would mean that Indian exports will continue to be hit for some more time. So, all these factors together have combined us to reduce our forecast to 5.8 percent for this year.

Q: Some economists brought down their growth targets further after the recent decisions by the RBI that seemed like an indirect rate hike for the system, have you factored that in or do you think there might have to be more tweaks to your target if these changes remain for a longer while?

A: These decisions came out only a couple of days before. So our forecast was made before that so we haven’t factored those in. Going forward, one has to look at it from two prospects.

The first aspect is that these measures were primarily undertaken to help strengthen the rupee, which has weakened considerably and the way it was targeted was that a tightened liquidity would allow short-term rates to rise. That would widened the interest rate differential and therefore attract more debt flows.

However, they can have unintended consequences. For example, India’s growth continues to be quite weak. So, a domestic tightening would mean that the financial conditions for banks and corporate sector would worsen. There could be some worsening of asset quality and growth outlook might take a hit. If that happens, then we will have to come and see our forecast again because what that would do would also mean that the growth sensitive equity flows could also take a hit.

Q: In the kind of forecasts that we are seeing in most economists including you, the premise seems to be that the current quarter and the next quarter would be relatively weak closer to that 5 percent mark and then in the second half we will see a fairly significant acceleration. What are the risks that that second half acceleration disappoints and does not play along expected lines?

A: One of the risks is the rupee weakening because if the rupee was to weaken further,  then it would hit us on inflation, it would hit us on the fiscal side. If that was associated with further monetary tightening then that would lead to the second half recovery getting stalled. Additional factor is the monsoons. Till now the monsoon has been quite well but the latter part of the monsoon is very critical for the winter crop. If that again is not according to plans then the agricultural output might take a hit in Q3 and Q4 of the year.

Q: To go back to monetary policy expectations as well, what did you tie-in in terms of what you expected to see from RBI along with this 5.8 percent growth, were you factoring in more rate hikes and what kind quantum were you looking at?

A: In April, when we made our projections, we were expecting around 50-75 percent drop in policy rates. Now, this latest policy does point out that the prospects of future rate cuts are limited at best. That would definitely have an impact on the GDP growth and we will be looking at that in the next round when we do our forecast.

Q: What about macroeconomic stability factors for the Asian region because some of these countries like India which run large deficits are fairly vulnerable to or dependent on global flows. In the light of what is going on in the western world now, do you fear that some of the stability factors are also beginning to worsen along with growth?

A: If one looks at the overall forecast that we have made for the Asian region, we have toned it down also. That is precisely because of the fact that capital flows, which is a very important requirement for this region, could slow down due to the tapering fears. If that was to happen, a number of countries, which run not as high a current account deficit (CAD) as India but still a large CAD, would get hit.

The problem with India is that apart from just the sheer quantum of CAD, it is the way the CAD is being financed, which is making us more and more vulnerable to short-term and portfolio flows, which is not that much the case with other economists. So, India is particularly vulnerable at this point in time.

Q: Equity fund managers at this point believe that emerging markets are probably the most vulnerable spot in financial markets. Would you agree that within Asia which is where some of these emerging markets reside, this is probably the most vulnerable spot in terms of global macro growth as well? Last year it was Europe but do you think now it is Asia and emerging markets that are at the bottom of the ranking?

A: There are two things to that. What these countries do depend a lot on are external capital flows but external capital flows has been volatile for some time since the collapse of the Lehman Brothers. Growth in this region has been fairly robust compared to other countries. So, there is an inherent trend of stable growth. Also, a lot of these countries including China are looking inward and within the region to get more drivers of growth. Hence, that would reduce their vulnerability to the risks of capital flows slowing down.