Toeing the trendline

Summary

Due to reduced fiscal flex, the economic expansion is going to be of shorter duration with more frequent contraction. The medium term growth outlook for global economy in general and India in particular is going to be below the previous trend line growth due to various structural changes in economy. Prolonged period of slow growth is going to be new normal.    

The shadow of economic and financial crisis of 2008 has prolonged, casting a serious doubt on trend of industrial growth. The aftermath of political logjam in a fatal mixture of high debt and low growth regime has made it clear that global recovery is going to be very slow. The extremely poor performance of H1 2011 goes beyond the effect of temporary factors related to the Japanese earthquake and MENA unrest. We might have reached where we were before the crisis, but getting on the trend line might take much longer.

The US conundrum

In 1980, the US federal receipt was 19% of GDP and debt was 0.9 trillion. Today share of federal receipt to GDP is 5% lower and debt is 15 time higher. US is on a debt steroid. This mixture of fiscal stress and weak economic growth is a painful potion. “Halting the downward spiral of foreclosure, falling housing prices and dwindling household spending” is the key to halting another recession. US has to grow its economy at a pace fast enough to pay its expenses, by raising taxes and cutting expenditure. In an over leveraged economy with log gammed political system, this seems like a farfetched assumption.

It looks like an accepted norm to assume 6-7 years of expansion followed by 1-2 years of contraction as normal business cycle. The followers of Keynesian school of thought would argue that contraction is caused by slump in aggregate demand and it can be spurred up by deficit spending. The followers of Friedman would say that contractions can be fought by increasing the money stock. Fisher says that major contractions are caused by excessive build up of debt to GDP ratio. Symptoms of the excessive indebtedness are: weakness in aggregate demand, slow money growth, falling velocity and sustained underperformance of the labour markets. Fischer was of opinion that government spending of borrowed funds was counterproductive to stimulating economic growth, a phenomenon observed in 2008.

Reduced fiscal flex to manipulate economic cycle

We can also observe from the chart that post 1980’s the expansions became longer and contraction shorter. This coincides with the increasing level of debt. Most economists are of the view that the economy starts un-stabilizing as level of debt touches 80% of GDP. Going forward, the option to borrow more to elongate the expansion cycle may not be viable.

The other economy of the size of USA (14 trillion UDS) is European Union. In Europe, the problem of liquidity is becoming the problem of solvency. Many of the peripheral European economies are finding it difficult to raise money from market. The large amount of sovereign debt holdings of European banks has to be written off at some point of time, if the peripheral economies have to grow at a faster pace. That would result in losses and recapitalisation needs. The restructuring of Europe is going to be painful. Making sacrifices to save the monetary union is going to be less painful and costly than doing away with the euro. The coordination in a monetary union without strong fiscal oversight would be difficult. “They are going through some truly horrible times. I am very worried about the whole southern European fringe, not just on a 10 month to 2 year view but looking out a decade or longer,” said Philip Whyte from Centre for European Reform, a London think tank.

New normal in the world

The other major economy, China has done massive investment during downturn in real estate sector to boost up economy. The massive overcapacity and its inability to boost up domestic demand can result in hard landing of the economy, which can be a shocker to the world economy. Already the HSBC Purchasing Managers Index is hovering around 51 mark, with below 50 an indication of contraction. Japan is already deep into high debt and slow growth for decades. Is it the beginning of “Japanisation” of the world? Spanish GDP growth has touched 0.1%, from 0.4% two quarters earlier. The CDS spread, a measure to insure against default, of many peripheral European countries is higher than several corporations in those countries.

These structural changes in the global economy would have a profound effect on Indian economy. Exports have a rising share of Indian GDP (~14% in 2011), side lining the decoupling theory of Indian economy from world affairs. The imports in advanced countries are growing marginally in 2011 on a quarter on quarter basis. So India can’t export its way out of trouble.

Structural changes in Indian economy

The medium term growth outlook of Indian economy is based on strong domestic consumption, and thrust on infrastructure development backed by strong banking system. The change in the factors underlying these have more than a cyclical variation, they have gone a structural change due to lower savings, expected higher inflation environment and volatile fund flow.

Household financial savings as percentage of GDP is less than 10% now from 12.1 per cent in 2009-10. It was this savings in banks which was a cheap source of finance for huge government bond purchase by banks (through high SLR requirement of RBI). Some of that financing of India’s growth is not going to be readily available. High inflation environment has resulted into rising prices and more liabilities as higher interest outgo. The fear of downturn and rising gold prices has pushed Indians to buy more gold purging bank investment. Gold purchase in Q2 2011 rose by 60% vis a vis last year and is only second to crude in value of Indian imports. Slower adjustment to bank deposit rates has not helped either. This has resulted in slower deposit growth rate last year.

Government savings and corporate sector savings are also coming down sharply post-recession. Various measures of investment show how national savings and investment rates are around 2-3 percentage points below the pre-crisis highs. That alone can pull down the rate of economic growth by around 0.75-1 percentage point, says Prime Minister’s Economic Advisory Council in its recent report. How much the trend reverses, once the prices of essential items are down, is a thing to watch out for.

Inflationary pangs in Indian economy

The other inhibitor, inflation has to be looked from both supply side and demand side. RBI’s tighter monetary policy attempts to depress demand side effects. However the supply side constraints remain un-tackled due to policy impasse, structural shift, broad macroeconomic scenario and capacity constraints. The food inflation is fuelled by severe draught in 2009, reduced acreage to pulses, weak monsoon, wastage of food grains during transportation, lack of storage capacity with FCI and paucity of private sector warehouses. Indian farm productivity is among the lowest in the world. About 40% of fruits and vegetable perish in storage and transit, mostly because farmers have to rely on middleman and trade associations instead of direct market access.

Crude prices, a major factor of inflation, remain north bound and volatile due to supply side issues arising out of contagious unrest near middle-east, despite opening up of world reserves. The situation in Libya and other Middle East countries would take a lot of time to come back to pre-crisis level. Fiscal consolidation along with targeted policy action especially in manufacturing and infrastructure reforms has definite potential to ease off inflation.

In its latest monetary policy statement, the Reserve Bank of India has already pointed out that its battle against inflation would be a limited success unless the government acted to increase the productive potential of the economy. Inflation may come down if slowing global growth brings down commodity prices. That may also increase the chances of QE3 and chances of that fund flowing in shallow equity and commodity markets of emerging countries, creating asset bubbles.

As policy paralysis dampens investor sentiments, the foreign fund flow, both FDI and FII is going to slow down in India, although it is increasing in Asian markets. Infrastructure projects are clearly going to bear the burnt. Planning Commission of India’s target of $500 Billion investment in infrastructure sector in 12th plan period of 2012 to 2017 is going to be a challenge. Banking sector has regularly been hitting sectorial targets in infrastructure sector, thus making it difficult for them to sustain the momentum alone unless massive increase in asset base.

Financial sector stress

Banking sector is going to be hit with higher capital to risk asset ratio of Basel II as financial inclusion programs, increase in loan requirements of credit intensive manufacturing and infrastructure sector build up. The counter cyclical reserve measure of RBI does not help either. As Joshef Acramana, CEO of Deutsche Bank said at Frankfurt’s annual banks in transition conference “Prospect for the financial sector overall…are rather limited. The outlook for the future growth of revenues is limited by both the current situation and structurally.”

These factors have already started playing out in the economy. June 2011 quarter results of Indian Inc. shows that although top line grew, bottom line is under pressure due to mounting operating and non-operating costs. In a rising inflationary scenario, it may not be possible to pass on these costs to consumers. So the growth in bottom line may not trend the top line numbers. A Credit Suisse report also highlights the increasing trend of leverage in Indian companies. “While world over balance sheet of companies seems to have improved since the last crisis, the same has not happened in India. In fact, the number of companies with high leverage is now higher than it was in FY08.”

Gearing up

Growth is going to be slower and with longer periods of down cycles, taking some points off country’s GDP numbers. The usual bounce back in GDP post-recession is not going to happen. Growth would follow the average normal trend. With options in fiscal and monetary side limited, India needs to take appropriate policy action to stimulate supply and limit the impact. The fear is of it being too little and too late. Firms need to tweak there business model and possibly rejig there portfolio to take advantage of these changes. The winners in the new world order would be the ones who understand the market and love the way it is. As Marilyn Monroe said

“If you can't handle me at my worst, then you sure as hell don't deserve me at my best.