Until recently, there appeared to be only two views on the Indian economy: bullish and super bullish, with the former labelled as the pessimistic view. But the recent inflation scare and the resulting aggressive monetary tightening by the RBI to check the gung-ho growth approach have defused some of the near-term hype.
GDP growth is likely to moderate in the current year but still remain impressive at around 8%. Slightly slower growth will likely be posted by service and industry sectors, with interest rate sensitive areas, such as consumer spending, being impacted more than the ongoing spending on capital expenditure and infrastructure.
Since early 2003, Indian equities and real estate prices have benefited from flush global liquidity and increased risk appetite, India’s powerful growth acceleration and a multiyear string of impressive corporate profits. These factors will now be more mixed, with the growth in corporate earnings likely to moderate owing to a combination of slower top-line growth and increased pressure on margins.
There is a price for all financial assets, and the Indian equity markets were until recently priced for perfection. All positives have been factored in but delivery is unlikely to match expectations.
Still, the recent macro risks that had depressed sentiment will likely recede, as inflation is rolling over and will likely stay the RBI’s hand from further hikes in policy interest rates. Concern over corporate earnings still has to run its full course, and the upcoming pipeline of equity issuance will be an overhang.
Finally, liquidity management will remain challenging for the RBI, and might prompt more measures to siphon off liquidity. The RBI’s recent hands-off approach toward the rupee is unlikely to be sustainable. Indeed, in the absence of strong intervention by the central bank, the rupee could strengthen to around Rs 38-39 against the dollar if sizeable FII inflows materialise in June.
Beyond that, poor export data, more noise from exporters and softening inflation could prompt the RBI to intervene to partly reverse the sharp appreciation in real effective exchange rate that could in turn push the rupee back to the Rs 40-42 range. Investors will just have to live with more currency volatility.
The medium-term outlook for the rupee remains bullish, as productivity gains, healthier fiscal dynamics and strong capital inflows will justify greater appreciation of the real exchange rate. To their credit, exporters have been improving productivity. But it is ironic that the government cannot deliver on its promises of removing the impediments (e.g. physical infrastructure) that hold back export competitiveness.
At the start of the calendar year, I felt 2007 was poised to be a make-or-break year owing to the macro policy challenges of inflation and capital inflows that the policymakers were expected to be faced with.
Undoubtedly, there have been some hiccups but the RBI has navigated well despite the inordinate number of constraints and conflicting objectives it has been saddled with, and despite a government that is unable to deliver on reforms.
The biggest risk to the unfolding India economic story is that politicians remain slow in embracing economic reforms.
(By Rajeev Malik, Executive Director, JPMorgan Chase Bank, Singapore)
