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Tuesday, September 9, 2008

Is India Riding Out The Storm?

by Edward Hugh: Barcelona

India's growth rate fell back in the second calendar quarter of 2008 (and the first quarter of the 2008/09 financial year), expanding at the slowest rate recorded in three years, as the Reserve Bank of India struggles to control record high inflation by applying tight credit conditions. Annual growth slowed to 7.9 per cent in the quarter of 2008 which ended on June 30, significantly lower than the 8.8 per cent rate reported for the January to March quarter.

Growth momentum has obviously been slowing on tighter monetary policy and the adverse global environment. Higher interest rates, slower bank credit growth and higher oil and commodity prices are evidently now having a marked effect on activity levels in the Indian economy. However, in spite of the slowdown, the growth rate of Asia’s third largest economy remains strong, and there are very positive signs of resilience in the face of what is now a global economic slowdown. China’s economic growth also slowed in the second quarter dropping to a 10.1 per cent year on year rate, from 10.6 per cent in the first quarter.

Despite this slowing growth the Reserve Bank of India is very likely to maintain its tight policy stance until it succeeds in bringing inflation down significantly from the current double digits level. Inflation fell back slightly in mid-August but it may well tick up again before the year is out.

Growth in the services sector, which includes banking, transport and leisure, came in at a healthy 10%, while the construction sector remained strong, clocking up an annual 11.4 per cent expansion. It was the manufacturing sector which suffered the sharpest fall as it grew only 5.8 per cent compared to 10.9 per cent in the same period in 2007. Obviously the impact of a higher rupee and rising internal prices have been having a significant effect of export competitiveness.

Inflation Still A Big Problem

India's inflation remained well above the central bank's comfort level for the sixth straight month in the second half of August, increasing the likelihood that incoming Governor Duvvuri Subbarao will continue to raise interest rates. Wholesale prices were up by an annual 12.34 percent in the week ended August 23, according to the latest data from the Indian commerce ministry in New Delhi. That compared with a 12.4 percent gain in the previous week.

Subbarao, whose three-year term at the Reserve Bank of India starts this weekend is under some pressure to show that he is independent and no less concerned about inflation than his predecessor, and is quoted as saying that the "obvious" answer to surging prices is tighter monetary policy. Outgoing Governor Yaga Venugopal Reddy increased the central bank's benchmark rate three times between June and the end of August, giving a higher priority in the short term to the battle against inflation rather than to economic growth. In the mid-term these both amount to the same thing, since unless India gets inflation under control a whole battery of other macro economic indicators will become misaligned, and then it will be near impossible for India to realise its full growth potential, which I personally consider to be a couple of percentage points higher than consensus opinion would have it.

The Reserve Bank last raised its benchmark interest rate on July 29 - on that occassion by a half point to take the rate to a seven-year high of 9 percent. The central bank's next policy announcement is due Oct. 24.

High energy, commodity and food prices remain the main concern, and these have forced the central bank in July to raise its inflation forecast for the year to March 31 2009 to 7 percent from its earlier target of between 5 percent and 5.5 percent.

Consumer-price inflation for agricultural and rural workers accelerated to 9.41 percent in July, compared with 8.77 percent for farm workers and 8.75 percent for rural workers in June, according to government data. India releases separate indexes for consumer prices paid by industrial, agricultural and rural workers, and as we can see, these come out with a significant time lag, hence the most widely tracked measure of inflation in the Indian context is the wholesale-price index.

But The Tide Could Turn Sooner Than Many Think

There are, however, indications that the tide may already be turning. Prices of fruits, spices, sugar, tea and eggs all continued to rise in the week to August 23, but prices for vegetables, pulses, edible oil and cereals fell. Manufactured price inflation on the other hand continued to move up, rising 11.28 percent, compared with 11.02 percent in the previous week.

One big part of the issue about when inflation drops back revolves around what happens to agricultural output this year. The June-September monsoon season, which accounts for four-fifths of India's annual rainfall, has been more or less "normal" this year, according to data up to the 3 September supplied by the India Meteorological Department (the chart really is worth a look if you are at all interested in seeing where food prices may move).

Most sources seem mildly optimistic on the agriculture front. India, which is the world's biggest producer of rice after China, partly lifted a six-month old ban on the export of some premium quality rice grain last week as we seem set to see a bumper crop for a second year running. Overseas sales of Pusa-1121, a strain of rice grown in north Indian states, will now be permitted as of October 15. Global rice prices have fallen 25 percent from their April high as Thailand and Vietnam, the leading global suppliers, lifted export forecasts following increased plantings. Vijay Setia, president of the New Delhi-based All India Rice Exporters Association estimates that India may export most of the 1.4 million ton output of Pusa-1121 variety forecast for this year. Sowing of paddy in India is up by 5 percent on the year to August 28, and reached  to 34.5 million hectares, according to data from the Indian ministry of agriculture. Setia estimates that output may be some 10% above last year's record of 96.43 million tons, and Mangala Rai, director general of the Indian Council of Agricultural Research, holds a similar view.

Farmers in India, which is the world's second-biggest wheat producer, may also increase planting from October because of favourable rainfall, possibly helping India garner a record harvest of this crop for a second year. Wheat, which is the country's biggest winter food grain, is planted from October through December. Harvesting starts in March and continues through April. Again the agriculture ministry estimates that India harvested a record 78.4 million metric tons of wheat in the year ended June 30, up 3.4 percent from the year to June 2007.

A bigger harvest will obviously help reduce the problems of food shortages that have stoked inflation and lead India to import 1.79 million tons of wheat since July 2007 to build up stockpiles. These imports from India are among the factors which helped fuel last year's 77 percent gain in wheat prices on the Chicago Board of Trade index.

Energy prices also seem to be easing, and rapidly.

Oil prices fell to their lowest level in five months last Friday as investors worried that an economic slowdown could chip away at the demand for energy. Light, sweet crude for October delivery closed down $1.66 to $106.23, capping off a week of declines that totaled $9.23. It was the lowest settlement price since April 3, when crude settled at $103.83 a barrel.Oil prices have fallen more than $40 from the record high of $147.27 a barrel on July 11, two months ago, as a struggling global economy has cut into demand for energy. The US is leading the way in the decline in demand for oil, and the US Energy Information Administration reported Thursday that imports of crude in August were 200,000 barrels a day below the same four-week period last year. This pattern is repeated to some degree or another in economy after economy across the globe.

Now this downward movement in oil prices will eventually find a floor, but where exactly will that floor lie? My own view is that the decline will continue for some time yet, but that we may hit bottom around $80, since at some point the inflation situation will ease back, and growth will rebound, and then of course the price will head up again.

My feeling is also that we could then see quite a quick turnaround in inflation in emerging economies like India (from 13% to say 7%) and this will then mean the negative "lose-lose" dynamic of rising inflation, rising trade deficits, rising interest rates, falling currencies and falling growth can transform itself into the "win-win" dynamic of falling inflation, falling trade deficits, slightly lower (but still very yield differential attractive) interest rates, rising currencies and rising growth.

The interesting question is when will we hit the inflection point? Well, if we look at the NYMEX chart below, we will see that oil prices really started to take off in October 2007, and that at current rates of decline in oil prices the two curves should cross (ie 2008 prices should be below 2007 ones) sometime between October and November. Now this will be quite an important event in the emerging market economies, since given the weight which has been attached to energy and food rises in the total inflation picture, once these (for so called base effect reasons) start to clock negative readings, headline inflation should start to sink back.

Within six months of this cross-over we should see the Indian economy really start to pick up speed again, and in particular we should see a strong rebound in industrial output. India, remember, is still growing at a 7.5% annual rate, but this could easily change as the Indian economy starts to "break sweat" and heads upwards again towards 10% (and even beyond). Depending on the future evolution in energy prices I see trend growth in India in the 2010 - 2015 window of between 10% and 12%.

Foreign Exchange Reserves Fall Again

India's foreign exchange reserves dropped back again in the week to 29 August, falling by $1.98 billion (Rs8,791 crore) to $295.3 billion, according to Reserve Bank of India data. Foreign currency assets declined $932 million to $286.11 billion during the week, while gold reserves dropped by $1.04 billion to $8.7 billion,and reserves with the International Monetary Fund (IMF) decreased $2 million to $496 million. India’s special drawing rights with IMF were unchanged at $4 million.

There are various explanations for this continuing fall. One of them is the purchase of dollars by India's oil importers, another is intervention by the Reserve Bank of India (to stop the weakening in the rupee, which to some extent is welcome as it helps exporters, but beyond a certain point becomes most damaging as it only adds more wood to the domestic inflation bonfire) and a third is the selling of Indian equities by overseas investment funds.

All three of these could reverse as oil prices drop and inflation comes under control, since importers will need less dollars, the RBI will not need to intervene since the rupee will be rising, and both of these factors will make India's stock markets once more an attractive proposition for the overseas funds. This is what I mean by "win-win".


In the meantime, the rupee slumped back for a fourth successive week on speculation economic slowdown in the U.S. and Europe will prompt global funds to shun emerging-market assets. The rupee dropped to a 21-month low versus the dollar, sliding in tandem with currencies across Asia, as regional stocks tumbled. In this context I very much agree with the view expressed in a recent research note by Kotak Institutional Equities:

"The current USD rally was prompted by technical factors and fears that the US slowdown would lower growth globally sparking flight to dollar as a perceived safe heaven. We feel this argument is overstretched. 1QCY08 COEFER data reveals continued slow movement away from USD and into Euro in reserves. Share of EUR in reserves has increased to 27% in 2008 from 18% in 2000, while that of the USD has dropped to 63% from 71%. We consider it a paradox that the USD continues to be considered a safe heaven despite US credit markets being the epicenter of the current global economic turmoil.......... In real terms, returns on USD assets continue to be negative, making the current USD rally unsustainable"

Basically, the move into the US and Japan as safe havens, seems to be more of a "herd like" knee-jerk response, especially when looked at over a weekend where the US government may well move in and temporarily take over FannyMae and FreddyMac, and as Japan seems to be sliding steadily downwards into its next recession. I also agree with Kotak that the weakening in the rupee is now starting to look decidedly overdone and may well move into reverse gear in the not too distant future.

But this possibility, for now, lies out in the future, and in the present the rupee fell a further 1.7 percent against the dollar this week reaching 44.66 per dollar as of the 5 p.m. close in Mumbai: This was the lowest level since Dec. 20, 2006, and the rupee is now down 11.8 percent against the dollar so far this year as equity sales by global investors exceeded their purchases by $7.1 billion.

Heavy demand for dollars from corporates, and especially oil companies, coupled with anticipated losses in the local equity market had a significant effect on market sentiment. The currency fell to a low of 44.75 at one point — its lowest in over 20 months, before the central bank intervened to halt the fall.

If the central bank had not stepped in, then the rupee could even have breached the psychologically important 45 threshold already on Friday. In the view of some market participants, sentiment for the rupee is extremely bearish at the moment, over concerns over capital outflows, the falling stock market and a rising fiscal deficit. The latter of these is important, but I do think the first two are being overdone, and reflect a rather old fashioned mindset, since as Kotak point out, it a paradox that the USD continues to be considered a safe heaven despite US credit markets being the epicenter of the current global economic turmoil.

External Borrowing

India’s external debt went up sharply - by over $50 billion, according to Finance Ministry data - during the financial year ended March 2008, the highest year-on-year increase ever. A fall in the value of the dollar against the Indian rupee and other international currencies, along with increased overseas borrowings by companies seem to be the main reasons for the increase. External debt, both government and non-government, stood at $221.2 billion as on March 2008, representing an increase of over 30 per cent in one year.

External commercial borrowings (ECB), used by corporates to borrow money from abroad at a cheaper interest rate, were up more than 40 per cent, and reached $70.6 billion in 2007-08, as compared to $48.52 billion a year earlier. The share of such overseas borrowings in the total debt has risen to nearly 32 per cent now from under 24 per cent two years back.

Two concerns dominate the views of foreign inflows through ECBs. First, the influx of borrowings from abroad will increase the domestic money supply that has potential to accelerate the inflation rate.Second, flow of money to sectors like real estate — which is classified as ‘sensitive’ by the government — was feared to cause price inflation. The weakening of the US dollar against other currencies accounted for 20 per cent of the increment in India’s external debt, said the report titled “India’s External Debt- A status report 2007-08”. As nearly 57 per cent of India’s debt is denominated in US dollar, any decrease in the value of the US dollar against the Indian rupee and other international currencies means that stock of external debt as measured in rupees increases. In 2007-08, Indian rupee appreciated against US dollar by as much as 13 per cent, as per data available with Reserve Bank of India.

Despite the increase, the ratio of government debt to total debt has declined by 2.8 percentage points to 25.6 per cent as on March 2008, reflecting the higher share of private borrowings. Key external debt indictors like ratio of total external debt to GDP, ratio of short-term debt to foreign exchange reserves and ratio of short-term debt to total debt have shown an increase in the financial year 2007-08. For example, ratio of external debt to GDP is now at 18.8, an increase of 1 percentage point and ratio of short-term debt to total debt stood at 20 per cent — an increase of 6 percentage points in one-year.

Because of larger borrowing by corporates, government’s debt as a proportion of total external debt declined from 28.4% to 25.6%. As a percentage of gross domestic product (GDP), sovereign debt dropped from 5.3% to 4.8%.

The ratio of short-term debt to foreign exchange reserves stood at 14.3% at the end of the year against 13.2% at the end of March 2007. The ratio of short-term debt to total external debt was 20% at the end of March this year against 15.5% in the year before.

Trade Deficit Rises In July

India’s trade deficit widened to $10.79 billion in July, up 83 per cent from $5.87 billion in the year-ago month, as the growth in imports far outstripped exports. But perhaps the big news here is the growth in exports, which in July were up a very healthy 31.2 per cent year on year to reach $16.34 billion. Imports registered an even sharper annual rise of 48 per cent to $27.14 billion, mainly due, of course, to the increase in the value of crude oil imports, the price of which touched an all-time high in July. Oil imports expanded 70 per cent and stood at $9.5 billion as against $5.6 billion in July 2007. Non-oil imports in July stood at $17.66 billion, which is still an increase of 38.7 per cent over the $12.73 billion registered the year before.

Of course the oil factor isn't entirely a one way street, and high crude oil prices also mean that domestic refiners like Reliance Industries sell their products at a higher rate in overseas markets, adding to the export increase, and, with a 40 per cent increase in steel prices, the value of engineering goods’ exports also increased accordingly.

Bottom Line

Basically the Indian economy looks set to slow, possibly hitting its bottom level of around 7.5% year on year during the winter, but after next spring we could well see a rebound, and in all probability a quite healthy one. It would not surprise me at all to see the double digit growth barrier broken in 2010, at least in one or two quarters.