India's Chinese takeaway: Turning adversity into opportunity
The RBI must loosen monetary policy to spur both consumer demand and corporate investment.
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How seriously will China's economic slowdown affect the global economy? Stock markets around the world, including India's, have reacted with deep panic.
China's GDP growth in 2015-16 could dip to as low as five per cent - the lowest in decades. The yuan has so far fallen by less than four per cent but the housing and banking bubble in China could drive it down further. The Shanghai Composite index continued to skid on Tuesday (August 25), falling below the crucial 3,000 mark.
With Chinese demand slowing, steel, cement, auto and other Indian exports could face a domino effect as China cuts down on imports. The governor of the Reserve Bank of India (RBI), Dr Raghuram Rajan, is not a naturally grim man. But his prescription for the Indian economy has often been grim. However, after Monday's global stock market crash, he said India was in "a good condition" compared to other economies. He added that the RBI would not hesitate to defend a falling rupee.
Dr Rajan, chief economist at the International Monetary Fund from 2003 to 2007, made his global reputation by predicting the financial meltdown of 2008. To turn adversity into opportunity, both the RBI and the finance ministry must now think out of the box. India's economy, as finance minister Arun Jaitley said on Black Monday, remains robust. Tax collections are up 37 per cent and industrial production is rising steadily. Cheaper global commodity prices will help reduce input costs of finished Indian products though a weak rupee will neutralise some of that advantage.
Dr Rajan's term, which ends in September 2016, has been controversial. His singleminded focus has been to control inflation. By keeping monetary policy tight and interest rates high, Dr Rajan has squeezed consumer inflation down to below four per cent and wholesale inflation into negative territory: (-) four per cent.
The RBI has cut rates thrice in the past year by a parsimonious 25 basis points (0.25 per cent) each. That's clearly too little, too late. An impetus to Indian GDP growth needs at least two factors: one, more corporate investment; and two, higher consumer consumption.
Lower interest rates would cut corporate debt and interest outgo. Company profits would rise. Corporate investment across sectors - from infrastructure to health - would increase sharply, setting off a virtuous cycle of economic growth.
Simultaneously, lower interest rates would cut EMIs on home, car, scooter, tractor and consumer loans, putting more money into peoples' hands. Consumption would get a boost. Fast moving consumer goods (FMCG) companies complain of subdued demand. The automotive industry too has shown slow growth. Lower interest rates would catalyse demand across urban and rural India.
Once consumer demand picks up though, some economists warn, inflation could again rise. Not, however, if the supply-side is taken care of - ie, increased output in manufacturing and services following lower corporate debt and interest outgo. Lower interest rates would strengthen company balance sheets, enabling them to borrow from banks (which are shortly to be recapitalised). A combination of higher consumer demand and increased corporate investment will lead to a spike in manufacturing and get the economy back to an eight per cent growth trajectory.
Moody's has lowered its India growth forecast to seven per cent from the earlier 7.5 per cent. It cities uncertain global conditions and lack of economic reforms. By pursuing a more balanced monetary policy that places equal importance on controlling inflation and spurring economic growth, India can escape a deflationary cycle - low inflation, low growth - which Japan and much of Europe are battling.
The United States Federal Reserve has used low interest rates for several years to spur growth and jobs, create new manufacturing assets and keep inflation down. As a result, the US economy today is in the best shape it has been in seven years - low unemployment, steady GDP growth and moderate inflation.
Obviously, with the dollar as the world's reserve currency the US can print money at will. However, the Federal Reserve has consistently shown toughness, flexibility and pragmatism in getting the US economy back on its feet after the financial meltdown of 2008.
India's foreign exchange reserves are at a comfortable $355 billion, covering nine months of imports. Companies with dollar debt, however, will face a crunch: the rupee has depreciated by 13.9 per cent against the dollar in 2015-16. This makes lower interest rates to cut corporate debt even more imperative.
This is a crucial time for the Indian economy. With exports falling for eight consecutive months, largely due to global demand contraction, the trade deficit has remained stubbornly over $100 billion. Oil prices are trending below $40 per barrel. Once extra Iranian crude (an estimated 5,00,000 barrels per day) comes into the market following the gradual withdrawal of Western sanctions, oil prices could remain at these depressed levels for at least two years till global demand increases.
The rupee factor
The slowdown in China is the critical factor. The steep fall in Chinese stocks and the four per cent devaluation of the yuan have sparked calls for controlled devaluation of the rupee to keep Indian exports competitive. But the link between a weak rupee and strong exports is tenuous at best. As Swaminathan Anklesaria Aiyar wrote recently in a business daily:
"Some Indian analysts want steep rupee devaluation. But studies by C Rangarajan, Prachi Mishra, Sajjid Chinoy and Jehangir Aziz suggest that Indian export growth is not strongly linked to the exchange rate, and depends much more on global growth.
"So, steep devaluation may not revive Indian exports, given gloomy global trends. Real rupee appreciation should be avoided. But a more aggressive approach than that could simply fuel a currency race to the bottom. That is a bigger danger by far. India needs to sound alarm bells on this, and get the IMF on board to stop any currency war. Slowing Chinese growth alone may not cause a world recession. But competitive devaluation surely will."
With the rupee at 66.50 a dollar after Black Monday, some of the gains from low crude prices have been lost. India's oil import bill has declined from $180 billion in June 2014 (when crude was $115 a barrel) to $110 billion this year (net of re-export of refined petroproducts and rupee depreciation). The saving of $70 billion (Rs. 4.60 lakh crore) has reduced the current account deficit (CAD) to 1.3 per cent of GDP. If the rupee had not fallen steeply since the Modi government took office, CAD could have been even lower, nearer one per cent of GDP. With strong FII/FDI inflows and NRI remittances, the overall balance of payments (BOP) remains strongly positive.
So is a weak rupee good for India as Dr Rajan and chief economic advisor Arvind Subramanian have hinted? I cited the weak link between a depreciating rupee and export growth:
"Votaries of a weak rupee point to the example of China which - to the rest of the world's annoyance - has deliberately kept the yuan undervalued, forcing US legislators to consider officially declaring Beijing a 'currency manipulator'. The comparison with India though is not valid. China is the manufacturing workshop of the world. Exports comprise nearly 30% of its GDP. Last year it displaced Germany as the world's largest exporter (with annual exports of $2 trillion). In contrast, exports account for only 18 per cent of India's GDP. A weak rupee does not help the other 82 per cent of India's economy. Quite the contrary: an annual import bill of $470 billion pushes up inflation and lowers competitiveness.
"A stronger rupee will not only trim our trade and current account deficits and temper inflation, it will attract more FDI and FII. Today foreign investors factor in an historical 4 per cent annual depreciation of the rupee when computing their return on investment (RoI). Were the rupee to strenghten, dollar returns would rise concomitantly. Average central bank lending rates in the west and Japan are between 0.25 per cent and three per cent. In India, the RBI's repo rate, at which it lends funds to banks, has averaged 7-8.50 per cent in the recent past. The gap mirrors precisely the historical annual depreciation of the rupee against the dollar. A stronger rupee would reduce that gap and bring India in line with advanced economies.
"Most crucially, a stronger rupee would bring down India's oil and gas import bill. A failure of our oil and gas exploration effort over the past two decades has led to India importing 80% of its crude oil requirement.
"Wouldn't Indian services - especially IT software - suffer if the rupee hardens? Service exports sell increasingly on quality, not price. Many (especially refined petroproducts and polished diamonds) have high import content. The biggest long-term beneficiaries of a stronger rupee would be India's manfacturing productivity. Cheaper imports would allow companies to ramp up foreign technology and build infrastructural and manufacturing assets. These in turn would lead to a spike in competitveness, boosting exports based on quality, not marked-down dollar prices. This would create a virtuous cycle of high productivity and quality allied with low inflation and deficits."
India needs to urgently ramp up broad-based economic reforms. Key among these are land, GST, labour, administrative and tax. In the meantime, the RBI must loosen monetary policy to spur both consumer demand and corporate investment. With the global economy in turmoil, time is running out.