Policy makers need to be vigilant and ensure that India can withstand any shock to the global economy.
The International Monetary Fund’s latest review of the global economy and financial stability paints a rather sombre picture of the future. The World Economic Outlook maintains that expansion seen since mid-2016 would continue this year and the next, but also warns of growth becoming less balanced and rising downside risks. The global economy is expected to clock 3.7 percent growth in 2018 and 2019, which itself is little lower than the IMF’s April assessment. Rising trade tensions, reversal of capital flows from emerging markets, tightening financial conditions led by the US Federal Reserve and overall policy uncertainty are key risks.
The Global Financial Stability Report (GSFR) further cautions about heightened near term risks to financial stability on worsening external financial conditions and trade tensions with elevated medium term risks from high global debt levels and stretched asset valuations. For emerging markets, the GSFR warns of growing concerns about their resilience and policy credibility, which could trigger more capital outflows and lead to sharp asset market corrections.
Given this global backdrop, the Indian economy, which already is in the midst of pressure on the external front, may have to face more turbulence ahead. The impact of tightening global liquidity and capital flow reversal is already being felt and some steps have been taken to address that vulnerability. The rupee has already depreciated this year by over 13 percent against the dollar and by over 11 percent against a basket of currencies (based on the RBI’s 36-country trade weighted REER index).
A widening current account deficit and net portfolio outflows have turned the balance of payments (BoP) into a deficit. The RBI’s foreign exchange reserves fell by $11.3 billion in the Q1 FY19 as a result. In Q2 too, the BoP is likely to be in deficit on the back of an increase in merchandise trade deficit, even though the BoP deficit would have been smaller than in the first quarter.
Trade deficit in July-September widened to $49.4 billion from $45 billion in the previous quarter on the back of the higher oil prices and a broad-based increase in non-oil imports. Foreign exchange reserves during that period fell by about $5.5 billion (including valuation losses), indicating that the BoP would have been in a deficit in Q2 as well.
It is quite likely that we will see a BoP deficit for the whole of FY19, the first FY12, on higher oil prices and portfolio capital outflows. That in turn means foreign exchange reserves this fiscal are likely to be drawn down.
Adequate foreign exchange reserves are a critical macro-economic buffer for weathering adverse external shocks like the ongoing monetary policy normalisation in the US. Between FY14 to FY18, the RBI added $160 billion to these reserves on the back of robust capital inflows.
Despite the drawdown on reserves in the current fiscal, their level is adequate to cover all debt obligations maturing in the next one year. India’s external debt with residual maturity of one year stood at $220.5 billion at the end of June, with reserves at $404 billion more than adequately covering this debt. Of course not all of this debt is at risk of reversal, as NRI deposits at $88.8 billion and short term trade debt at $96.9 billion tend to get rolled over. This forex buffer offers resilience against capital outflows on account of portfolio outflows or repayment of commercial borrowings. While a flexible exchange rate allows for a narrowing of the current account gap, adequate levels of foreign exchange reserves allow for dealing with sustained capital outflows and help contain undue volatility.
Low and stable inflation is another desirable policy goal for macro-stability, which is being pursued by the RBI and the monetary policy committee, under the new flexible inflation targeting regime. Recent inflation prints have largely surprised on the positive side, despite rising fuel inflation and sticky core inflation as food inflation has remained benign. In fact, with the latest reading of headline CPI inflation at 3.77 percent for September, the average for Q2 was below RBI’s revised forecast of 4 percent. Although core inflation eased during September, it remains sticky in the range of 5-6 percent.
This points to the fact that the headline inflation is holding below the CPI inflation target of 4 percent, mainly on account of benign food inflation. That can continue until January 2019 aided by a favourable statistical base effect and seasonal softening in food prices.
That said, upside risks to inflation are becoming more pronounced in the form of higher oil prices and a weaker rupee. However, as long as food inflation remains soft, the Monetary Policy Committee could look to raise rates gradually. A third consecutive year where summer foodgrain production has risen to new record levels would help manage upside pressures that may have been built on account of higher minimum support prices (MSPs) and the government’s new procurement policy. Monetary policy is however, in a calibrated tightening mode now, with more rate hikes on the cards, to ensure that inflation remains stable around the 4 percent target.
The domestic orientation of India’s growth is another buffer which allows the economy to tackle global challenges. Growth has been accelerating, with the surge to a nine-quarter high of 8.2 percent in Q1. On the demand side, this pick-up was driven by private consumption and capital formation.
Q2 PMI data suggests that economic activity may have slowed down to some extent as compared to Q1, but in all likelihood growth this fiscal year will be higher than FY18. The IMF estimates that real GDP growth this fiscal and next would be around 7.3-7.4 percent, closer to its potential level, despite the challenges being faced the economy. Private consumption is being supported by the 7th Pay Commission driven salary increases by state governments, robust personal loan growth and fillip to rural incomes from record foodgrain production, farm loan waivers and now higher MSPs. Public spending by Centre and states — another key driver of both consumption and investment — also remains supportive, though the likelihood of fiscal slippage has increased, making that a risk.
For instance, GST collections are running below their monthly target of Rs 1 lakh crore and that can lead to an overall shortfall in tax revenues. Fiscal pressures can also increase in case of another round of excise duty cuts or a significant pick-up in food procurement, in order to support farm prices. However, a tighter control may be required on fiscal policy to contain the pressure on current account deficit and inflation over this year and next from fiscal slippages.
In nutshell, greater vigilance is required going forward, especially on the policy front, to ensure that if the global environment takes a turn for the worse, the Indian economy can withstand that shock without a significant growth slowdown, large capital outflows and severe asset price correction.
(Gaurav Kapur is the Chief Economist of IndusInd Bank. Views are personal.)For more Opinion pieces, click here.