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India will have to deal with fallout of Iraq crisis

By Puneet Wadhwa
June 27, 2014 13:20 IST
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For India, which is set to record a deficient monsoon this year, the crisis in Iraq and its toll on global markets could be a double whammy.

Sanjay Mathur, managing director and head of economics research for Asia-Pacific (ex-Japan), Royal Bank of Scotland, tells Puneet Wadhwa for every $10/barrel rise in crude oil prices, India’s current account balance deteriorates by 0.5 per cent of gross domestic product (GDP). However, he adds the environment is still favourable for equities. Excerpts:  

What do you think of the geopolitical crises in Iraq and Ukraine and their implications on the global economy? 

The implications aren’t too significant, given the size of Ukraine and its role in the global economy.

But I think the bigger issue is with Iraq, as it has a direct impact on oil prices.

And, an increase in oil prices could come at a time when the global growth is just recovering. As the Asian region outside of Malaysia is a net importer of oil, that is a concern.

Where are oil prices headed in the next six months?  

Right now, our assumption is the Iraq conflict will not escalate further and, therefore, oil prices will remain in a range of $110-$115 a barrel.

However, if the conflict intensifies, it is difficult to say where oil prices will stand. A lot of countries have reduced their oil purchases from Iran.

Therefore, to rework that model will entail a number of processes.  

Is it a good time to invest in the Indian equity market, given the run-up and the road ahead for the economy?  

The macro backdrop seems favourable, considering yields have adjusted well across the fixed income spectrum; major global central banks have clearly indicated tightening will be slow to come by and there is modest growth in net imports. So, overall, the environment is favourable for equities.  

What could go wrong for India?  

The immediate risk is higher crude oil prices arising from the internal conflict in Iraq. Rising crude oil prices have always been problematic for the Indian economy and the recent weakness in the rupee can be attributed to concern about oil prices.

In fact, we estimate India’s current account balance deteriorates by 0.5 per cent of GDP for every $10 a barrel rise in crude oil prices.

Also, it will be inflationary at a time when the government is attempting to reduce energy subsidies. A secondary and medium-term risk is policy complacency.

Once growth recovers, it is possible the reform process slows. But it is too early to tell.  

Have you tweaked the outlook for key macros such as inflation and GDP growth, considering the recent releases relating to the monsoon and oil prices?  

It is too early to incorporate the impact of oil prices, as we don’t know the duration of the conflict. In any case, we have a mild growth outlook for FY15 — 5.3 per cent.

The downside risk is how the monsoon pans out, which could be a bigger shock.

However, based on the government’s agenda, we expect growth for FY16 to rise to about seven per cent.

Do you think rates are too high in India for investment to revive?

Nominal interest rates are undoubtedly high. Nor does the Reserve Bank of India (RBI) seem to be in hurry to lower them.

In fact, we expect only a 25 bps (basis point) cut in the policy rate in FY15 (fiscal year ending March 2015).

But several studies, including those of the IMF, point out that interest rates are only a minor part of a larger problem.

The dominant hurdle to investment has been policy uncertainty. If policy uncertainty is removed or reduced, a revival in investment should be possible.  

Your USD/INR forecasts of 57 and 53 and end-FY15 and FY16 seem too aggressive. What is the rationale?

We think India's investment cycle appears promising. Add to it that the RBI has explicitly shifted to inflation targeting.

The experience of countries where inflation targeting has been successful and investment has strengthened has proven to be currency supportive, at least in the initial few years.  

India's own experience is also telling. The combination of strong industrial activity and low inflation in 2005-06 was also a favourable period for the INR.

It is also important to note that this period coincided with rising FDI (Foreign Direct Investment) into the country.

Finally, we think it fair to say that the performance of the INR over the last three years is not a particularly appropriate guide for the future.  

Could gold be back in the reckoning in this macro-economic backdrop? What is the road ahead for gold prices?

Though the Iraq conflict is important and can have a bearing on how the gold prices pan out, I think that the gold prices are likely to remain soft.

The slow hike in interest rates and monetary easing exits has been fully discounted in the prices.

There has been some positive shift towards competing asset classes like equity. Gold as an asset class is not as charming as it was two years ago.  

The Modi government will present its maiden Union Budget in July. What are your expectations? Will we ever see a consolidation of public finances?

We think so. The FY15 budget is due shortly and a reduction in the fiscal deficit to 4.1 per cent of GDP from 4.5 per cent last year is on the cards. What will be of greater importance, however, is the overall orientation of fiscal policy.

Here we expect a rationalisation of fuel and fertiliser subsidies - the objective is to reduce subsidies from 2.3 per cent of GDP (FY14) to around 1.7-1.9 per cent in this fiscal year on our estimates.  

We also expect the government to lay out a definite timetable for the implementation of a goods and services tax (GST) and the direct tax code. The direct tax code seeks to lower tax rates but also to minimise tax exemptions. These two measures should allow for the tax-GDP ratio to improve by at least two per cent of GDP. India's current tax ratio is low at around 10 per cent of GDP.

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Puneet Wadhwa
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