This is the second of two parts. See Part 1
GOVERNMENT DEFICITS AND DEBT
India has a long history of running high fiscal deficits. The political imperatives that arise from widespread poverty combined with massive leakage of resources due to corruption have resulted in a string of deficits over the years. The persistently high deficits are partly the result of the need for coalition governments to accede to the demands of a variety of constituencies. The second obvious reason is the extremely high level of corruption in India. Unofficial reports state that upwards of 50% of all government spending is lost to corruption and theft.
That said, many economists have brought into question the sustainability of high Indian fiscal deficits. The more common complaints about high deficits are the usual arguments that deficit spending crowds out private investment, increases the cost of money, and is wasteful when spent on salaries, subsidies, and debt waivers. The arguments against deficits notwithstanding, the high level of deficit spending and the resultant upward pressure on public debt are causes for concern.
From 2005-06 through 2007-08, the fiscal deficit ratio (Table 5) fell to reach its lowest level of the decade at 4.2% of GDP. Since then the ratio doubled in 2008-09 and reached 10.2% of GDP in 2009-10. The debt ratio has also been rising in similar fashion. While most of India’s debt has been funded domestically, making interest payments might prove to be a challenge in a recession. In this instance, the government could theoretically inflate its way out of the problem. In reality this would be a political nightmare. Increasing debt while economic growth is good makes it much harder to ramp up spending when it is needed during periods of slow or negative growth.
TABLE 6 – Consolidated Fiscal Deficit Ratio, Debt Ratio, and Interest Payments as % of GDP
(Click charts to enlarge)
FIGURE 3 – Consolidated Deficit Ratio 2001-02 to 2009-10
The estimates for the 2010-11 deficit ratio range from 8.5% to 10.5% of GDP. The government hasn’t performed well in keeping spending under control. Widespread corruption at the highest levels of government has only made matters worse. The year 2010 will be remembered as one in which financial scandal after financial scandal rocked the government and gridlocked parliament. Because of the financial shenanigans public finances have been deprived of tens of billions of dollars in revenue.
The year ahead will be one where the government will be forced to pull back from excessive spending especially since high fiscal deficits and increasing national debt have attracted the attention of international investors. Considering that debt repayments will become more difficult especially if there is a new recession, I believe that the Indian government will take new (and unpopular) steps to control the fiscal deficit.
VI. BALANCE OF PAYMENTS
India’s current account turned negative in fiscal 2004-05 and has remained so ever since. This has been offset by capital account surpluses with the exception of fiscal 2008-09 during which the balance of payments (BOP) actually turned negative (Table 6). Even though the BOP has once again turned positive, the global financial crisis has exposed vulnerabilities in India’s foreign currency position and prospects for future growth.
TABLE 7 – Balance of Payments from 2005-06 through 2009-10, 2010-11 estimates, and April-September 2010 Semiannual Results
Merchandise imports have been increasing year after year and 2010 has been no exception. The semi-annual data shows that invisibles have been stagnant making the projected current account deficit increase by almost 50%. The demand increases for imported goods continues to outstrip demand for Indian goods and services abroad. The trade imbalance poses a threat to the BOP position of the country and to its foreign exchange reserve position. Foreign exchange reserves were US$ 295 billion on December 24, 2010 according to Reserve Bank of India data released on 31st December, 2010. This amount is enough to just about cover imports for 10 months.
FIGURE 4 – Current Account Trends with Estimate for 2010-11
Invisibles, which are comprised of services such as transportation, insurance, travel, software, and business & finance services, and private and government currency transfers, have remained stagnant for the past three years. The expanding merchandise deficit and the stagnant invisibles surplus mean ballooning current account deficits. The lack of demand in the west, which is the principle market for Indian software and business services, has made the situation worse.
The capital account too has seen some erosion in terms of falling foreign direct investment (FDI) inflows. By all indications, FDI inflows in the current fiscal year are set to fall by more than 40%. The decline in FDI means manufacturing, which was already facing falling growth rates in 2010, will face additional headwinds in 2011.
At the same time, portfolio investment inflows have set new records in the period from April-September 2010 with more than US$ 23 billion net inflow. The huge increase in portfolio investment has offset the drastic fall in FDI, propping up the capital account. Portfolio investment flows are volatile and have heightened the risk of bubbles in Indian financial markets. There are now increased risks to Indian financial markets and balance of payments in 2011
FIGURE 5 – From 2005-06 through 2010-11 (projected)
It is virtually impossible to predict the movement of portfolio capital. Going out on a limb, however, I expect that the year ahead will most probably bring slower inflows of portfolio capital with a great risk of portfolio capital outflow due to a combination of factors: volatility in the Eurozone, faltering recovery in the US, slower manufacturing growth in India, reduced demand for Indian software and services, a rating downgrade of India, and deterioration in public finances. The outflow of portfolio capital will result in a sharp fall in the Indian stock market.
Energy imports are the single largest category of items in India’s import basket. The US Energy Information Administration estimates that India imports about 70% of its total crude oil requirements. Energy in the form of crude oil and petroleum products make up 25% to 32% of India’s total import bill (Table 7). With oil prices on the rise again, the current account could take another large hit in 2011. But if the nascent recovery in the US and other countries falters, oil prices may not be a problem.
TABLE 8 – Energy Imports
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.