After Shock Within, Comes External Shock Wave

Apart from demonetisation worries, Donald Trump’s victory in the US has added new risk variables for equity, bond and currency markets

The government’s demonetization contretemps has focused attention on the short-term havoc it will inflict on the domestic economy. There’s another worrisome front opening up which could exert additional pressure on the stressed economy: the external sector.

Donald Trump’s unanticipated election victory in the US and his scattergun statements on trade, visa control and general economic policymaking have added new risk variables for equity, bond and currency markets.

In addition, markets sense that the Federal Reserve might be on track to increasing interest rates in December. Consequently, investors are headed for dollar-denominated assets which, in turn, has adversely affected emerging market assets.

In India, foreign portfolio investors sold close to Rs32,000 crore of securities in November (till 25 November) alone. Predictably, the Indian rupee also depreciated by over 2% in November.

It also raises questions about the Reserve Bank of India’s (RBI) surgical strike: There’s speculation that the sudden and inexplicable 100% incremental cash reserve ratio announcement is aimed at stopping the deposits deluge from bringing down bond yields further and staunching outflow of foreign exchange.

But, that’s not the main problem; it only adds to the underlying weakness. The problem lies on the current account front.

The mainstay of India’s export basket— services—is slowing down. According to RBI data, services exports between April-September 2016 increased only 2% over the same period in 2015, while services imports are up 7%. And, though India enjoys a positive trade balance in services exports, slowing export growth has shrunk the surplus trade balance by 50%.

There’s more. The performance of software and IT-related services exports, the largest contributor to services exports, is expected to deteriorate progressively. Leading infotech companies are revising their FY2017 estimates downwards.

For example, Infosys has marked down its top-line growth expectation to 8-9% for FY17; the lowered guidance comes a second time this year.

Nasscom, the industry association for the information technology and business process management companies, expects IT industry’s exports to grow at 8-10% for the financial year ending March 2017, against its earlier estimate of 10-12%: from $119-121 billion estimated earlier to $116-118 billion now.

The drop in the IT sector’s revenue generation is a direct fallout from US-based companies holding back, or deferring, their spending till the political drift becomes clearer. Trump is expected to take over in January; meanwhile he has revealed his business agenda which, if followed through, is likely to spell trouble for India’s IT sector.

For example, he has promised to review the US visa programme and reform “abuses of visa programmes that undercut the American worker”. Read that as targeting the H1B visa programme, a non-immigrant visa that allows US companies to hire foreign workers in specialized roles for short periods. In IT-speak, it’s a special window which allows Indian software coders to work on client sites in the US.

Trump seems to be following through on his promise: his pick for advocate general, Alabama senator Jeff Sessions, is a long-time H1B opponent who has tried to legislate a reduction in H1B annual quotas and sought federal investigations into alleged H1B visa frauds.

So, till the picture gets clearer, most US companies have put their IT spends on hold. This hurts because the US accounts for about 60% of India’s software exports. Add to this Brexit and the uncertainty caused earlier in year, and that’s another negative mark against the rupee. Expect further changes over the next few months as the picture becomes clearer.

There’s additional pressure on the horizon. Goods exports have been in steady decline, affected by a mix of cyclical and structural factors. Merchandise exports between April-October 2016, in dollar terms, were stagnant (actually marginally down by 0.17%) over the same period in 2015.

The trade balance might look redeeming, with the negative spread between imports and exports having narrowed but hides another source of worry: goods imports during April-October contracted 10.85% in dollar terms.

Apart from the impact of lower oil prices, this reflects two trends: waning global demand squeezes items imported for re-export (such as precious stones, or other jewellery inputs), and decline in domestic demand affects imports of raw materials or intermediate goods.

The bad news doesn’t end there. One of the pillars of India’s current account— remittances sent by Indian workers overseas—has also been steadily coming down. Net remittances during April-June 2016 amounted to $8.82 billion, down 3% from $9.1 billion in the same period of 2015.

It can be argued that the external economy has been under stress for a while. What’s changed is the effect of demonetization on the economy.

The sudden liquidity withdrawal will have a shock effect on the economy, disrupting supply chains, dampening an imminent consumer-led economic revival, deterring capex impulses and lowering overall GDP growth.

How long that will last is still uncertain. But what is certain is that the added burden of a shrinking external economy—gripped by a decade-long slowdown and buffeted by systemic shocks like Brexit or unexpected sharp turns in US economic policy—will only aggravate the systemic shock.

This article originally appeared in Mint newspaper on November 30, 2016, and can be also be read here

Investment Must Lead The Way For Economic Revival

The Reserve Bank of India was once again at the center of a expectations led rally -- that it would cut repo rates on October 30, while announcing its second quarter review of the 2012-13 monetary policy. Instead, RBI cut the cash reserve ratio (CRR). Here is my op-ed piece in The Economic Times, carried the next day:

The rate cut lobby should be worried for two reasons. The first one is obvious: despite their high-decibel clamour, RBI governor D Subbarao has not relented an inch. He is steadfast about holding interest rates till the rate of inflation blinks first.

In short, his message remains unchanged: interest rates won't budge till inflation does. But the second reason is far more worrisome. It depicts a state of economic stagnation that even deep rate cuts cannot remedy. The pointers lie in the second quarter review of the 2012-13 monetary policy.

Subbarao once again cut the cash reserve ratio (CRR, a mandatory provision that requires banks to maintain a fixed portion of their deposits with RBI) by 25 basis points, down to 4.25%, releasing an additional Rs 17,500 crore of funds into the system, which the central bank fondly hopes will result in credit growth to productive sectors.

This is the fourth time in the last one year that RBI has cut CRR; in fact, in the last 12 months, CRR has been pared down by 175 basis points. That is not all. Further, the central bank has cut statutory liquidity ratio, another mandated reserve that requires banks to invest a portion of their deposits in government securities, cut the benchmark repo rate by 50 bps in April and made liquidity available through export refinance schemes. Outside the policy framework, the central bank has been conducting open-market operations regularly and daily liquidity adjustment exercises.

It is, therefore, a bit surprising that despite the RBI's repeated emphasis on pumping additional rupees into the economy, attention seems to be still focused on petitioning for a cut in the repo rate, rather than worrying about drying up liquidity. And, significantly, this recurring deficit in liquidity is symptomatic of another economic crisis: slowing down of economic growth.

Apologists will argue that cutting rates is probably the only elixir for reviving growth. If that is indeed true, then the economies of US, Europe and Japan should have been growing at supersonic speeds, given their near-zero nominal interest rates. Look at the malady — the liquidity shortage — first.

The policy document of Tuesday states, "The wedge between deposit growth and credit growth, in conjunction with the build up of the Centre's cash balances from mid-September and the drainage of liquidity on account of festival-related step up in currency demand, have kept the systemlevel liquidity deficit high, with adverse implications for the flow of credit to productive sectors and for the overall growth of the economy going forward."

Data released by RBI on October 26 shows that aggregate deposits with the banking system has grown (on a year-on-year basis) by only 13.9%, compared to 17.5% growth in the previous comparable period. However, credit has grown by 15.9% (against 19.5% in the previous period).

While the wedge between deposit and credit growth seems to have narrowed during Q2 2012-13, compared to the wide gap that existed during Q1, the difference is still cause for worry. For one, the slowing down deposits growth is a direct manifestation of the slowing down savings rate in the economy. The continuing high inflation rates have dampened real interest rates, making financial instruments (such as fixed deposits) relatively unattractive compared to physical assets (such as gold).

Alower savings rate is bound to translate into a lower investment rate. It is by now common knowledge that one of the ways to kick-start growth in the economy is to rejuvenate the investment climate. In fact, some of the government's recent policy pronouncements have focused on improving the pace of investments in the economy. And, without the investment rate looking up, the savings rate is unlikely to improve, thereby worsening the feedback loop.

Therefore, the RBI policy document makes it clear that the recent spurt of feel-good announcements is not enough to warrant a cut in interest rates. The statement does not mince words, "...recent policy announcements...that have positively impacted sentiment, need to be translated into effective action to convert sentiment into concrete investment decisions."

In the meantime, the CRR cut is not only expected to boost liquidity but is also likely to have some salutary effect on lending rates as well. While the RBI is loath to directly signal lower interest rates in the system right away, lest they rekindle inflationary expectations once again, the CRR cut is an apt signalling tool: it might still induce some banks to lower their lending rates, depending on each individual bank's balance sheet. This way, Governor Subbarao can still tick both the inflation and growth boxes on his to-do list.

Rx: Start With Consumption, Start Small

The trick to jump-starting the economy might lie in creating demand for basic goods, besides increasing liquidity and other revival measures

IN THE movie Batman & Robin, arch-villain Freeze gate-crashes into an antiquities exhibition and announces: “In this universe, there is only one absolute. Everything…freezes.” Credit markets across the world have frozen over, and though there’s no nasty piece of work yet (at least not on the scale of Freeze), there are no early signs of thawing. Spring may still be far away, but attempts by regulators and governments from across the world to end the economic chill don’t seem to be working. In India too, the government and the central bank, Reserve Bank of India, seem to be working hard to loosen winter’s cold grip over the Indian economy, but with little success.

The RBI has been infusing the economy regularly with large doses of liquidity ever since the system was beset with worries of money drying up. The RBI tried everything in the book — cut cash reserve ratio, freed up part of the statutory liquidity ratio, opened a special lending facility for banks to on-lend to NBFCs, housing finance companies and mutual funds, created a special refinance window from where banks could borrow without providing any collateral. Additional liquidity was pumped in by buying back bonds issued under the market stabilisation scheme. In all, since mid-September, the RBI pumped in Rs 300,000 crore through the sluice gates.

But, even that did not help hydrate the financial system. When banks were swamped with liquidity, they took the cash and dumped it with the RBI for a 6% return, even when lending it to prime borrowers might have fetched better returns. The central bank even cut its benchmark repo rate by 150 basis points (bps) to 7.5% on October 19 in an attempt to get some of that money moving out of the bank vaults. Still no go.

The RBI recently turned up the thermostat once more, this time to prod banks to start lending at reduced interest rates. It cut its benchmark repo and reverse rate by 100 bps. But, again, there’s hardly any movement. The banks are still carting their surplus cash over to the RBI and dumping it there for safe-keeping, for even as a low a return as 5%. Take a look at the money being tipped over at the RBI window.

For the first five days of the month, till the RBI cut the rates, banks plonked Rs 243,310 crore with the Reserve Bank, for a return of only 6%. Then on December 6 — a Saturday — it cut rates again. Over the next three working days, banks again deposited Rs 84,635 crore with the central bank, for a return of just 5%. The total — for just eight days — works out to over Rs 327,000 crore! In fact, the RBI was forced to comment, while announcing the new rate cuts, that the liquidity adjustment facility operated by the central bank, “has largely been in an absorption mode.”

In effect, this means banks are still wary of lending to corporates, despite the sea of liquidity and rate cuts unleashed by the central bank. This also then conveys how banks are still uncertain about the future and that they are doubtful about the ability of their corporate clients to pay up in time. In short, the vital glue of financial system — trust — seems to be missing and the authorities designing the various economic packages are unable to supply it in sufficient quantities.

Here's an example — a public sector unit was able to issue five-year bonds to banks with a coupon of 9.33%. Around the same time, one of the Top five India Inc companies also borrowed three-year money, but at 10.10%. Clearly, banks are willing to take a risk on the government, even if it is a subsumed sovereign guarantee, but not on even AAA-rated private companies. Banks have not forgotten the nightmares of the early 1990s, when bank NPAs ruled around 10-14%. This time, despite the prodding from the government and the central bank, they are unwilling to stick their necks out. The RBI has allowed banks to restructure loans — a euphemism for looking the other way when a loan turns bad — that might in ordinary times have been called for stricter treatment. But, the banks are still not biting.

The problem also seems to be in the system’s liquidity absorption capacity. Whatever steps the government takes at the moment — such as, providing cheap cash to corporates through a variety of refinance windows — not only are banks reluctant to lend, even corporates are loath to load up their balance sheets with fresh debt. Many of them are drawing down their existing credit lines with banks — emboldened somewhat by the new restructuring space — to finish existing projects but are unwilling to bet on new projects. With aggregate demand having fallen, India Inc is also contending with reduced topline and bottom line projections. In such a scenario, they may not be in a mood to pile up additional debt.

Therefore, the key to the current economic impasse might lie on the demand side. The government has tried addressing the issue by spending on infrastructure and by cutting taxes to boost demand. These are also not without their associated problems. Any investment in infrastructure will yield results only after a long lag, and the nature of improved technology does not allow for the higher employment generation that one saw a few years ago. Plus, to get an infrastructure project started is also time-consuming — financial closure in these days of clammy credit markets is a tough call.

Some economists say that the production orientation of the economy has changed in favour of expensive consumer products, a sector that might be slow off the blocks in reviving. In such a situation, reviving demand for wage goods might just do the trick. Even this hypothesis needs to be tested. The occasion might present itself soon — with experts forecasting a better-than-average winter crop, the government should facilitate hassle-free movement of the harvest to the markets and consumables to centres where the ensuing agricultural income can be spent. This may sound simplistic, but sorting the physical, infrastructural infirmities could be one of the first achievable steps on the long road to recovery.

Published as an Op-Ed in The Economic Times (December 15, 2008)

RBI’s Priorities And Concerns

The pressure on the RBI to cut rates will intensify now because of two immediate reasons — G8 central banks are re-hydrating their economies to keep the credit lines lubricated and China has cut its rates

IN LESS than a week of taking over his new assignment, Reserve Bank governor Duvvuri Subbarao decided to hold a press conference and talk about some macro issues. This is unusual. Typically, a central banker takes some time to settle down before speaking out about the problems of the day. But, given that he chose to address the media so soon after taking over, it is perhaps an indication of the troubled times we live in. Or, perhaps, it’s symptomatic of the confusion roiling the asset markets, making them swing between the two extremes of heightened expectations and mounting uncertainties.

There are signs of ambiguity everywhere — whether it’s in the inflation numbers or growth impulses, whether it’s in the drag effect of a global slowdown or the intense volatility experienced by the markets. Therefore, it was a welcome sign that Subbarao decided to break with convention and spelt out his priorities. While Subbarao has taken to his new role (and its obligatory nuanced statements) with surprising agility, he did outline, rather pointedly, some of the RBI’s concerns and priorities.

But many other concerns remain unspoken and there are any number of surprises (“known unknowns”, as Subbarao calls them) strewn along the central bank’s path to attaining economic growth with price stability. The global sell-off arising out of the collapse of three Wall Street icons — Lehman Brothers, Merrill Lynch and AIG — are the latest “known unknowns”. Much of the advice dished out for the governor so far focuses on obvious concerns, some unfinished agenda and a few minor issues. The obvious ones are: unease over the rate of inflation and speculation over the future course of monetary tightening. The incomplete tasks include financial sector reforms and addressing the capital deficit in PSU banks. The minor issues involve tinkering with products and processes in the currency and interest rate markets. But, Subbarao still has to keep his guard up for a host of wide-ranging issues, including the aftermath of the global credit squeeze.

Elections are round the corner and the governor is bound to be inundated with demands to loosen the monetary taps, some of which were quite presciently tightened by his predecessor. With crude prices having now dipped below $100, the requests to ease interest rates have acquired a new force. Add to that the latest WPI numbers — which dropped to 12.1% for the week ended August 30, from 12.34% the week before — and the clamours for an interest rate cut are already getting louder. Subbarao needs to watch out. Crude prices are still higher than the prices charged by oil marketing companies. But, more importantly, Opec recently decided to undertake a production cut. Although this has so far failed to rattle markets — primarily because of the global economic slowdown — the danger of further production cuts or sudden disruptions in oil production cannot be ruled out.

Also, the slowing down of the inflation rate might be slightly misleading. For one, the inflation index is still growing above the RBI’s comfort levels. But, beyond that, on a disaggregated basis, there are some essential products and manufactured items that are still showing rising prices. There are also two other factors that can’t be overlooked — the base effect might be finally wearing off and, therefore, it is important to look at the week-on-week growth in the index, which clocked 0.2% for August 30, after rising marginally in the previous week. In fact, the September 12 report by the Goldman Sachs Asia economics research team forecasts inflation peaking to 13.5% by November before beginning to cool off. Plus, the rupee’s continuous depreciation against the dollar over the past few days, despite the RBI’s attempts at intervention, could complicate attempts to tamp down inflationary expectations. The rupee will continue to be under pressure as foreign investors rush to sell their equity holdings and buy dollars.

The pressure to cut rates will also intensify now because of two immediate reasons — G-8 central banks are re-hydrating their economies to keep the credit lines lubricated and China has cut its rates. But, developed country banks are caught in an asset blow-out and need additional liquidity to keep their heads above water which Indian banks, thankfully, don’t. Export-driven China, on the other hand, sees large parts of its economy affected by the US developments and has therefore opted to chase growth. India has a strong domestic market and even the consensus growth forecast of 7-7.5% is pretty good by international standards.

The monetary tightening was conducted to squeeze out excess demand, a partial reason for the build-up of inflationary expectations. This is what Subbarao said at his maiden press conference: “The current high level of domestic inflation reflects a combination of supply-side pressures as well as demand-side factors… Though demand is not the main problem, in the absence of further flexibility on the supply side, demand management has to be part of the solution. Dampening demand and anchoring inflation expectations has been the logic behind Reserve Bank’s monetary stance.” One of the methods used was increasing cash reserve ratio (CRR) and the repo rate. This was to ensure a slowdown in the runaway growth in bank credit. Former governor Y V Reddy pressed the panic buttons when credit-deposit ratio crossed 80%, indicating that banks were borrowing short term to finance long-term assets.

Subbarao’s observation about systemic rigidities — “absence of further flexibility…” — is unlikely to be set right any time soon. Plus, as the RBI’s annual report points out, the fisc is expected to come under increasing stress from, among other things, implementation of the sixth pay commission, lower petro-product duties, higher fertiliser subsidies and farm debt waivers. Therefore, perforce, demand-side management will have to remain the focus of the RBI’s strategy. But, the expectations of monetary easing are also unlikely to fade away soon. The market will be looking at the governor pretty closely — to see whether he can indeed walk the lonely path reserved for central bank governors, insulated from the influence of markets and, most importantly, from the fiscal side across the fence.

Publilshed as an Op-Ed in The Economic Times (September 17, 2008)