Download 1 MACROECONOMIC RISKS IN THE INDIAN ECONOMY Dun and

MACROECONOMIC RISKS IN THE INDIAN ECONOMY*
Dun and Bradstreet have provided yeoman service by once again focusing attention on
issues of “Risk Management”. There are many facets of risk management and we have a
number of erudite speakers at this Congress in the Technical Sessions wherein, I am sure,
there would be in depth discussions. The Reserve Bank of India (RBI) Report on
Currency and Finance 2006-08 provides a comprehensive review, which can be described
as the most authentic document on Managing Capital and Risks. It would be no
exaggeration to say that this Report is a Collector’s Item.
2. In this talk I propose to discuss the macroeconomic risks in the Indian economy
which, I am aware, would point to the dangers of a self-fulfilling prophecy. Accordingly,
I would first briefly refer to key macroeconomic strengths.
Macroeconomic Strengths
3. The Indian economy has greater economic resilience than hitherto. The unprecedented
overall average growth rate of 9.3 per cent over the past three years is expected to slow
down in 2008-09 to 8 per cent, as set out in the RBI July 2008 quarterly review nut even
this lower growth would imply that India is one of the fastest growing countries in the
world.
4. There is no doubt the danger of the recent mayhem in the international financial
markets and the internal propagation of inflation through escalation of commodity prices.
The crude oil shock and escalation of prices of other commodities which we import could
put a pressure on our international payments. The Prime Minister’s Economic Advisory
Council (EAC) has projected the balance of payments current account deficit (CAD) in
2008-09 at 3.2 per cent of GDP. This CAD can be easily financed by modest capital
inflows and if necessary a small drawdown of the US$ 289 billion foreign exchange
reserves.
5. The foreign debt-service ratio was only 5.4 per cent in 2008-09, while the foreign
liability-service ratio was 6.5 per cent and these are perhaps the lowest in the emerging
market economies. The outstanding international liabilities at the end of December 2007
amounted to US$ 405.6 billion against assets of US$ 331.7 billion. Given that of these
assets the foreign exchange reserves amount to US$ 289 billion, India has the
wherewithal to easily meet any exodus of portfolio capital; this should be of great
assurance to foreign investors.
Risk of Imprudent Policies
6. As the Currency and Finance Report 2006-08 puts it, risk is the danger of an adverse
deviation in the actual result from an expected result. While there are many types of risks,
the most relevant macroeconomic risk is the reputation risk which refers to the potential
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Talk at the Inaugural Session of the Dun and Bradstreet, Second Annual Risk Management Congress, by
S.S.Tarapore, Tuesday September 23, 2008, Mumbai.
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adverse effects of the reputation deviating negatively from its expected level. The
reputation refers to the image in the eyes of the public with regard to competence,
integrity and reliability.
7. The biggest macroeconomic risk comes from faulty policies which are invariability
advocated with seductive zeal and there is a temptation for the polity to accept such
policies. To ensure against such risks, policies should not sacrifice fundamental
principles at the altar of expediency. Quite often there is a temptation to go in for soft
policies which appear to resolve the immediate problem, but in the medium-term
irrevocably damage the economy.
Real Sector Cycles and the Timing of Policy Measures
8. With the greater integration of the Indian economy with the international economy, the
Indian economy is now subject to international real sector cycles. Overheating of the
economy, when the actual growth exceeds the potential, is relevant and our macho
spirits need to be curbed and we should no longer hum and haw when signs of
overheating emerge. Monetary-fiscal tightening has to be undertaken during the uptrend
of the cycle and not the downtrend. Thus macroeconomic policies should be anticipatory
and proactive and not delayed and reactive.
Control of Inflation
9. The current inflation rate of 12 per cent, based on the wholesale price index, is clearly
unacceptable to the Indian polity. The major risk here is wonky analysis which results in
inappropriate policies. It is often argued that the present inflation is a supply side
problem, notwithstanding the fact that the inflation is generalized. Taking the supply side
argument to its logical end, what this implies is that if only we had more goods and
services there would be no inflation!
10. It is sometimes argued that we have imported inflation, which results in an income
terms of trade loss and that there is nothing that can be done by domestic policies and all
that we can do is to helplessly wait for the imported inflation to abate. It needs to be
recognized that irrespective of the cause of generalized inflation the answer lies in
tightening of macro policies. The authorities would know that that the true inflation rate,
based on anecdotal evidence, points to an inflation rate of 16-17 per cent. Such a high
rate of inflation has serious economic, political and social repercussions and, therefore,
control of inflation must be given overriding priority. Policies should aim to squelch the
current inflation as also inflationary expectations. Inappropriate policies to tackle
inflation would be a major macroeconomic risk.
11. While the global meltdown has rightly excited the media to focus total attention to
this phenomenon and the meltdown would have some repercussions on India we need to
realize that inflation control should remain our central objective and any weakening of
the anti-inflationary policies would be hazardous.
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Fiscal Policy
12. There is erroneous thinking that the fiscal situation is well under control and,
therefore, “fiscal bashing” is no longer fashionable. The problem is that the fisc is
expansionary during the uptrend as well as the downtrend of the real sector cycle and,
therefore, fiscal policy cannot be a stabilizer. The fisc is the biggest risk and this is a
subject that needs separate dedicated analysis.
Monetary Policy
13. The current monetary expansion (M3) of 20 per cent, on a year-on-year basis, is
reflective of an accommodative monetary policy. Furthermore, the credit expansion of a
little less than 26 per cent (on a year-on-year basis) is irresponsible as it reflects an
untenable credit-deposit ratio of 86 per cent. If this pace of credit expansion is allowed to
continue, the RBI would have to inject massive liquidity or there would be a sudden
cessation of credit. At the present juncture, it is not the central task of monetary policy to
tilt its policy towards growth. Its central task is to bring about a quick and enduring
reduction in the inflation rate. Monetary policy has to have blinkers on so that it does not
deviate from its central task. The RBI should not be swayed by the doves who advocate a
replication of the monetary policy in the industrial countries and China. There would no
doubt be howls from the critics, but the RBI must be true to its Dharma of rapidly
crushing both current inflation as well as inflationary expectations. In the absence of a
strong monetary policy, the economy will face serious risks in 12-24 months.
14. In the context of the global meltdown, the RBI has rightly taken quick action on
September 16, 2008 to stabilize frayed nerves by reversing gears on monetary policy.
Rather than the convoluted measure of temporarily dropping the statutory liquidity ratio
the authorities would have done well to liquidate a part of the Market Stabilization
Scheme bonds which are essentially at the short-end of the maturity structure. While the
RBI has adopted one set of measures, the global meltdown should not be the excuse to
cascade the softening of monetary policy on an enduring basis. There should be no
question, of any lowering of the RBI signaling interest rates .The RBI should quickly get
back to its policy path of tightening monetary policy with inflation control as its central
objective.
Exchange Rate Policy
15. Critics of the RBI argue that its major fault has been intervening in the forex market.
In the absence of RBI intervention, earlier in the current year, the exchange rate would
have fluctuated widely, affecting the wheels of production.
16. More recent discussion of exchange rate policy turns fundamental principles up side
down. Advocates of a hands-off policy argue that the market knows best. But in markets
which are not developed, markets are unlikely to reflect maturity and hence intervention
becomes inevitable. In a county with a sizeable CAD, an appreciation would be against
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fundamentals. The hands-off approach is a major risk which could dislocate the economy.
It would be best if the RBI continues with its time-tested exchange rate policy and not
resort to an adventurous policy which goes against fundamentals. It would be extremely
risky if the authorities flirt with dangerous ideas.
Capital Flows
17. The experience, the world over, is that in the aftermath of large capital inflows, there
are episodes of large capital outflows. While the Indian authorities have deftly managed
the capital inflows, the question really is whether the authorities have a contingency plan
for dealing with large outflows. Some analysts argue that since large capital outflows
shrinks domestic liquidity the RBI should inject liquidity and aggressively sell in the
forex market to stem the depreciation. It is here that great finesse is required. The RBI
would need to raise interest rates and tighten liquidity well before the exodus of capital.
Furthermore, it is recognized that some injection of liquidity is necessary to avoid a total
dislocation of the credit delivery system and the RBI should be willing to sell in the forex
market to obviate a stampede at the exit door. When outflows start, the RBI should let a
gradual depreciation to take place.
Impact of the Global Sub-Prime Crisis
18. I am conscious of the fact that I have stretched your patience by holding back
discussion of the global sub-prime crisis. Central banks the world over have reportedly
pumped in a total of US$ 800 billion to enable banks to meet their liabilities. In the
initial stages of the sub-prime crisis the Indian authorities went into denial mode. It is to
the credit of the RBI that it took preemptive regulatory action quite some time back to
curb lending to sectors which appeared vulnerable. While, initially the RBI came under
heavy criticism, it is now appreciated that the rearguard action by the RBI has enabled
India to minimize the contagion effect.
19. As Percy Mistry has explained we are being hit by four exogenous shocks of varying
intensity and amplitude: (i) The financial shock triggering a global slowdown. (ii)The oil
and commodity shock. (iii) The inflation shock. (iv) The coming stagflation shock.
(Percy S.Mistry, Global Turbulence: Its Unfolding Trajectory and the Likely Implications
for India, Open Lecture at the Administrative Staff College of India, Hyderabad, on
August 26, 2008 ).Percy Mistry argues that the stagflation shock would be the combined
impact of the first three shocks and we have no idea of how exactly things will unfold.
The biggest risk that the macro economy can take would be to dismiss these risks as not
applicable to India, till we are faced with a fait accompli. If we are to risk-proof the
economy it is necessary to take anticipatory action across a broad front and accept the
ground realities that international developments could have drastic repercussions on
India. A major risk to the Indian economy would be if we were to merely ape the
industrial countries and flood the market with liquidity. We need to appreciate that
inflation is our central concern and that injecting liquidity carries macro risks.
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India’s Home Grown Sub-Prime Crisis
19. In recent years we, in India, have believed that the Indian banking system has
undergone a paradigm shift in the deployment of credit with enhanced credit for housing,
consumer loans, personal loans auto loans and credit card loans and such loans were
rising by leaps and bounds. While the non-performing ratios of banks, at present are at a
historical low, it would be a serious error to believe that these sectors are immune from
non-performing assets. We need to recall the old adage that bad loans are sown in good
times. The cheer squads at the sidelines would encourage banks to continue lending to
these sectors but the ground realities are that the Indian banking system is extremely
vulnerable and non-performing assets are going to pile up in the ensuing few years. The
question that remains unanswered is are we prepared? The answer, unfortunately, is in
the negative. Before time fully runs out the authorities need to devise strategies for
handling this difficult problem looming on the horizon. Can we risk not attending to it?
September 23, 2008
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