The recession decision

True, there are global imbalances. Some developing countries have become exporters of capital, and without this inflow the US current account deficit will be unsustainable. Nearly 7 per cent of GDP is the US current account deficit (fiscal deficit is 4 per cent), a mind-boggling 800 billion US dollars. If one adds US investment outflows abroad, the US must attract 4 billion dollars of foreign capital inflows every day. Otherwise, the system will collapse. Arguments that high productivity growth in US has led to higher returns on US assets don’t neutralise the thrust of the diagnosis that there must be dollar depreciation, higher savings, lower consumption, higher interest rates and higher inflation in the US. If these changes are big bang, the consequences can be disastrous. But they must be incremental and they must happen.

Compounding the problem, US expenditure has been reallocated towards security concerns. There is also the sub-prime lending crisis, with more revelations surfacing. Neither President Bush’s tax incentive package nor the Federal Reserve’s 0.75 per cent interest rate cut addresses these medium-term issues. They are short-term reactions. And in both cases, the question remains — how long will it take for these changes to have effect? In case of the interest rate cut (the highest in 23 years and announced ahead of schedule), there is a second question. Has this cut been large enough?

In July 2007, this is what the PM’s Economic Advisory Council had to say. “The Council assesses that the Indian economy will grow by 9.0 per cent during 2007/08 assuming reasonably benign monsoon and other external conditions… Global economic conditions do not seem to contain potential of adverse developments during the current fiscal year. Rising crude oil prices and supply disruptions do pose a potential downside risk, although this has become a somewhat familiar part of the landscape during the past several years.” In January 2008, 9.0 per cent became 8.9 per cent (because of lower manufacturing and energy growth) and for 2008-09, we were looking at 8.5 per cent. All this based on a ‘mild’ recession (read slowdown) in US, with adverse effects on both trade and capital inflows. In Q1 and Q2 of 2007-08, we had real GDP growth of 9.3 per cent and 8.9 per cent respectively, though manufacturing slowed from 11.9 per cent growth to 8.6 per cent. (Index of industrial production reinforces the manufacturing slowdown story.) Independent of the US story, higher interest rates and rupee appreciation were hurting. With the US story factored in, we are probably looking at 8.5 per cent growth rather than 9 per cent-plus. That’s hardly reason for panic. Inflation rate of 4.5 per cent means 13 per cent nominal growth. Purely as an average indicator, there is no reason why corporate profitability shouldn’t increase by almost 20 per cent.

Therefore, India is still a good market to invest in. Where else will one get these returns? But as we all know, stock markets mirror macro fundamentals with a longer time horizon, not short-term changes. We also refuse to often accept that equity is inherently risky, especially individual stocks and high returns are inevitably associated with high risks, a point reinforced if you bring in futures and options and factor in the greed of retail investors who lack expertise and treat the capital market as a gambling option. Asian economies may no longer catch a cold when the US sneezes. But that’s not true of stock markets, though one should recognise that the hyped Sensex represents only one segment of the market. So fears of a US recession triggered a bloodbath, aided by foreign institutional investments (FII) booking profits and pulling out so that losses incurred in sub-prime lending could be glossed over. The market is still narrow and sensitive to foreign inflows and any substantial FII outflow is bound to hurt.

Not just India, but the rest of Asia had a mini bloodbath and have rallied after the Fed rate cuts. But consider the two completely different interpretations of stock market experts. Does the Fed cut mean the recession spectre has gone away? Or does the cut ahead of schedule mean a recession is around the corner? The answer is probably simple — a slowdown (India, US, global) is likely, but nothing to get paranoid about.

The more interesting poser is for the RBI. Normally, it would have announced its review a day before the Federal Reserve. Now it has the advantage of prior information and knows a greater interest rate differential can create capital inflow and rupee appreciation problems. By any indicator, inflation is under control and earlier, the RBI made an error in judgement by contributing to the hardening of interest rates. It is time to accept culpability and soften rates (CRR or repo rate changes), not maintain the status quo. But as we unfortunately know, the RBI isn’t independent of North Block and no one wants it to be. Consequently, decisions aren’t going to be economic, but political. With elections pushed back a bit, inflation is less of a political concern and nothing seems to be happening on petroleum product prices. Therefore, one is justified in betting on a softening of interest rates.

The writer is a noted economist bdebroy@gmail.com