While India has grown faster than the world average for many years now, even through the financial crisis, there is now a combination of factors both external and internal that pose new risks to the country’s economic performance going ahead. Expect to see worsening balance of payments and erosion of the foreign exchange reserves in 2011.
VII. INFLATION AND INTEREST RATES
The relationship between inflation and interest rates is an important one in any economy. This relationship has played a large role in India in 2010 and is of great importance to economic outcomes in 2011 because inflation has been very volatile for over a year now. High inflation caused real interest rates to dip as low as -7% in 2010. Negative real interest rates have important economic consequences including a slowdown or even reversal in bank deposits, the formation of bubbles in various asset markets, speculation in sectors like real estate, and higher consumption patterns that create even more inflation.
Falling bank deposits pose a real risk to growth by creating a situation where credit can become a constraint to growth. Recognizing the risk of this happening, the Reserve Bank of India began raising interest rates in late 2010. The good monsoon rains have also helped by lowering inflation. However, real interest rates while positive for now remain low. With interest rates very low or even negative in many countries, financial markets have seen resurgence, and India has been no exception. The Indian stock market is at a high in early January and it will be interesting to see whether these levels are sustainable in 2011.
Inflation increased to alarming levels in 2010. Increasing consumer demand, growth in rural consumption spurred by government social programs, high economic growth, and bad rainfall the previous year contributed to rising prices. The inflation rate was enough to cause real interest rates to turn negative for most of the year, catching policy-makers by surprise.
Inflation remains a concern given the large salary increases especially among the urban middle class, continued increases in consumer demand, fuel price increases, and the possibility of some demand constraints. Inflation is not expected to come down too drastically in 2011, due to which real interest rates will remain low and even possibly turn negative from time to time. Low real rates of interest could then cause a deterioration of commercial bank deposits leading to slowing down of credit. Hence, while low interest rates could spur growth in the short-term, too much of a good thing could actually lead to slower growth. It is encouraging to know that the Reserve Bank has made it clear that it will do whatever it can to prevent negative real interest rates.
VIII. EXCHANGE RATES
With low interest rates and high inflation all year long in 2010, one would have expected to see a weakening Indian rupee. The rupee actually strengthened during the year. The Indian currency has managed to maintain its stability for the past few years even though current account deficits have been climbing, interest rates have been for the most part low, and inflation has been high. The rupee strengthened towards the end of 2007 and in the first few months of 2008 (Table 8). It then progressively weakened by almost 20 percent by the end of 2008 which was the year when the global financial crisis was at its peak. Since the beginning of 2009 the Indian rupee has progressively strengthened.
The period of March 2007 to April 2008 (which is the 2007-08 fiscal year) is the year of maximum strengthening of the Indian rupee and is also the period in which foreign portfolio investment quadrupled to U.S. $27.4 billion. During the following fiscal period from April 2008 through March 2009 there was a net outflow of portfolio investment to the tune of U.S. $14.03 billion. Not surprisingly, this was also the period when the Indian rupee lost 25% of its value. The last two fiscal years have been good for foreign portfolio investment in India. The huge net inflows of foreign capital have helped to keep the Indian rupee strong even though other economic indicators point to a weaker currency.
TABLE 9 – Indian Rupees per U.S. Dollar (monthly averages)
It is going to be very difficult for the Indian rupee to maintain strength while interest rates are low, inflation is high, and the current account deficit is ever-increasing. Add to the mix the nervousness about the fiscal deficit; the ratings companies like Moody’s and Fitch will be happy to press the panic button. There is a high probability that there will be a stock market correction due to a rating downgrade, disappointing corporate earnings, or a financial crisis elsewhere in the world. Be ready for rupee depreciation at least to the same magnitude as the one in 2008-09.
IX. CONCLUSION & OVERALL OUTLOOK
India enters 2011 facing many of the same risks from early 2008. The equity market has entered territory that it occupied exactly two years ago; and in similar fashion the level of the stock market (the Bombay Sensitive Index or SENSEX) is close to 21,000. The business fundamentals, however, do not support these valuations. The stock market is very often a barometer of business confidence and a sharp fall has immediate implications.
Similar to 2008, western economies are on shaky ground, although all indications are that a recovery is taking shape in the United States. Should there be a retreat into recession in the wealthy economies; India will be once again a victim of the collateral damage. This time around though, there are several endogenous factors at work as well.
Persistent inflation fueled by high demand and more than a few supply constraints could make policy choices in 2011 tricky. As discussed in the section on manufacturing, growth in this sector has been slowing down progressively. Raising interest rates too much might negatively impact demand for credit hurting demand for manufactured goods, as well as reducing demand for industrial credit. On the other hand, allowing interest rates to be too low or even negative could create credit supply constraints.
If the agricultural sector continues to show improvement in 2011 with normal rainfall then food inflation would be well under control taking the pressure off government to implement costly social programs. Good agricultural performance would also strengthen rural consumption helping the manufacturing sector greatly. It is important to note, though, that agriculture now comprises less than 15% of GDP while still employing the most numbers of people. It is quite likely that agriculture will grow by 6.5-7.5%.
Manufacturing in India is in danger of stagnation with month-to-month plots of industrial production yielding flat or negative trends. There is no easy explanation for a manufacturing slowdown in a time when urban salaries are rising fast and domestic private consumption is rising by all indications. The sectors that are doing well are the automotive and machinery sectors. It could be that cheaper Chinese imports are eating into the market shares of some of the manufacturing segments in India. This might explain the falling levels of output in some segments of the manufacturing sector while overall consumption expenditure is rising. Manufacturing will quite surely end the 2010-11 fiscal year in March 2011 at roughly the same level or lower than what it was in April 2010. For the calendar year 2011, I expect manufacturing to either be flat or grow at 2-3% for the year.
The good news for the services sector in India is that the U.S. economy is showing signs of recovery. American companies are also very cash rich right now. These factors could end up helping the Indian service sector grow boosting overall confidence and compensating for the weaker manufacturing sector. Expect services to grow by about 6-8% in 2011.
When it comes to GDP growth, I do not share the government’s optimism on the outlook for 2011. A slow recovery is taking shape in some countries in the west which make up the largest export markets for Indian goods and services and supply the bulk of the portfolio capital that has taken the Indian stock market to highs that are similar to the ones preceding the collapse in early 2008.
India’s finances on the other hand are now in dangerous territory. With the national debt getting close to 80% of GDP once again, a large fiscal deficit, and gross corruption at all levels of the government, the Indian government might find that it has painted itself into a corner. The likelihood of a stock market correction is high and so are the chances of ratings downgrades. In both these situations capital flight and a fall in the value of the rupee are highly likely.
Given the trends in the major components of GDP and the likelihood of a correction in the financial markets, I predict GDP growth will be 6% to 7% in calendar year 2011. This is lower than the 8-9% that the world has got used to for the past few years.