Come rain or shine

India has survived the global stress test. But policy-makers must now tread with caution as they look to peel back policy stimuli – or risk choking off a nascent recovery

  • By Sid Verma
  • 03 Oct 2009
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When India’s newly re-installed Congress-led administration unveiled its first budget in July, the stock market responded by plummeting 6% on fears a fragile economic recovery was in jeopardy.

Welcome to the tug-of-war between market expectations and political reality.

Markets assumed the decisive re-election of reformist prime minister Manmohan Singh would spark a spate of reforms and spending restraints hitherto blocked by the Communist party. Instead, finance minister Pranab Mukherjee announced the federal deficit would widen to 6.8% in a “calculated risk” to boost growth, and hailed the “wise and visionary” decision to nationalize the banking industry 40 years ago.

The government continues to prime the fiscal pump by further expanding welfare programmes and slashing key taxes. Over the past two years, the central bank has injected further liquidity by reducing interest rates and aiding the government’s borrowing programme.

This fiscal and monetary stimulus aims to soften the slowdown in the business cycle. Weak consumer and market confidence, destocking by firms and the poor external demand have checked India’s growth rate. Industrial production fell to 0.1% between January and March, from 7% a year earlier, and it remains at its weakest level since 2002. Domestic consumption has fallen from 8.5% in 2007 to 2.9% in 2008, and still stands at just 1.6% in the second quarter of the year.

Nevertheless, there are signs the economy is improving. The country grew by 6.1% annually in the second quarter of the year compared with 5.8% in the previous quarter. Foreign capital is pouring in, businesses are slowly re-investing, and consumers are returning to the shops.


But there is now a dispute over which strategies to pursue to make the recovery sustainable. Conservative economists want the government to curb its spending while the central bank concentrates on inflation. Meanwhile, the government is focusing on public investment in the near term as the virtuous growth cycle – of domestic consumption fuelling investment via surplus savings – remains weak. This strategy will generate enough revenues to soak up the deficit in the medium term, it argues.

But ratings agencies are concerned about India’s public finances. They say that without timely consolidation the country’s BBB- rating is in jeopardy. The budget deficit has jumped from 3.3% in the 2007 and 2008 fiscal year to an 18-year high of 8% the following year, including off-budget outlays such as oil subsidies.

This makes India’s fiscal burden one of the largest in the emerging world and the highest in Asia. While China entered the crisis with a low level of public debt at 40% of GDP, and the US at 40%, India faces an 80% public debt burden. “This fiscal deficit will endanger sovereign borrowings... and has implications for interest rate structures,” says Rupa Rege Nitsure, chief economist in Mumbai at Gujarat-based Bank of Baroda.

But the massive upturn in emerging market risk appetite in March – which helped Indian asset prices rebound and the currency strengthen – has meant that some analysts are now arguing that the government’s plan to contain the deficit to 6.8% this year and 5.5% next are achievable. But the situation has been complicated by an unforgiving drought: farmers have suffered a record delay in the summer monsoon rains, causing drought in 177 districts.

While government grain stocks will avert famine, there is disagreement over the economic impact. Optimists say agriculture only contributes 20% of GDP, and the affected districts account for a mere 3%, so real growth will only be reduced by a sliver: at a maximum of 0.5%.

Others say the impact could be far-reaching. Two-thirds of India’s population lives in rural areas and higher food prices will erode rural and urban purchasing power. This will depress consumption, says Samiran Chakraborty, head of India research at Standard Chartered in Mumbai.

The Planning Commission expects the economy to grow 6.3% this fiscal year and 8% in the next, but it has yet to revise its forecast until the full effects of the drought are clearer.

The government is expected to play it safe and maintain its fiscal expansion. China’s growth-at-all-costs philosophy is well known by the mantra ‘protect 8%’; India has a similar growth bias under the Congress party led by Sonia Gandhi.

It has placed rural growth at the heart of its populist development agenda. Over the past few years, the government has cancelled small farmers’ debts, expanded a rural employment scheme and increased wages for state employees. This was key to ensuring its unexpected re-election in May and is vital to retaining its popularity.


As a result, the battle to fight the drought could consume yet more fiscal resources, which has sparked fears that unbridled government borrowing could hike market interest rates, choke off private investment and “so derail the economic recovery”, says Chakraborty. Meanwhile, as the central bank targets inflation, government borrowing costs will jump, which will further exacerbate the crowding out of the private sector.

“When the government borrows as much as it has, it is inevitably going to put pressure on interest rates, and therefore there is need for coordination between monetary and fiscal authorities,” says Reserve Bank of India (RBI) governor Duvvuri Subbarao, in an interview with Emerging Markets in the RBI headquarters in Mumbai.

The government 10-year benchmark bond has remained between 7.0% and 7.5% over the past few months and stands at the wide end of the range, in anticipation of new supply. The government is likely to raise around Rs4 trillion through net market borrowing in the 2010 fiscal year compared with Rs2.6 trillion last year, according to JP Morgan.

Many banks are close to their 25% limit for government bond purchases – which are guaranteed under the held-to-maturity category – as a percentage of their net demand and time liabilities. As a result, if banks buy paper above this limit, they have to be marked to market and will, thus, expose them to potential losses if yields widen. This may disincline some banks from buying government paper.

Nevertheless, analysts say the banking system still has excess liquidity, while credit growth is likely to remain comfortably below deposit growth in the coming months as “demand for new loans remains weak,” says Siddhartha Sanyal, economist at Edelweiss Capital, one of India’s largest investment banks.

The government is banking on yields on sovereign paper remaining stable. “Bond yields have risen in the recent past, but I don’t see a sharp hardening of the rates in the near future because there is enough liquidity in the system and private-sector demand remains stable,” says C Rangarajan, chairman of the prime minister’s Economic Advisory Council, in an interview with Emerging Markets in New Delhi.

However, after being one of the most aggressive in loosening monetary policy in Asia, the RBI is faced with the difficult task of ensuring monetary conditions remain calm and loose. After dipping into negative territory, the wholesale price index is now positive while the consumer price index is in double digits. The threat of supply-side price shocks looms large.

In a bid to anchor inflation expectations, Subbarao is quick to sound a hawkish note: “If the supply shocks tend to fuel inflation expectations – as indeed they will in a country like India, where food takes up the majority of the consumption basket – then monetary policy inevitably becomes the first line of defence.”


The difficulty for market players is that unlike his predecessor, YV Reddy, who was seen – and liked to be seen – as an inflation hawk, the jury is still out on Subbarao’s views on the relative emphasis of growth versus price stability. “I have not really thought in terms of establishing a reputation for a particular stance,” he says.

Subbarao says the RBI is attentive to the balancing act of establishing price stability without destabilizing markets or choking off the emerging engines of growth. “I am hoping to get the balance right and that the market will interpret it to be the right balance,” he says. “It is very important for the central bank to be transparent – to tell the market what we know.”

Analysts say that, in the coming months, the RBI may hike the cash reserve ratio – the percentage of cash commercial banks must keep in reserve – rather than make a rate hike in the near term. This would not fundamentally restrict the presently ample liquidity conditions. Instead, the policy and its timing risk spooking markets if there are concerns about the future supply of credit, and could bring the recent spate of interest-rate cutting by commercial banks to an abrupt end.

While the central bank is independent, it still faces opposition to any move to tighten rates while the government embarks on its deficit-financed spending spree. Its ability to function is complicated by the RBI’s mandate for growth and role as government debt manager. Finance minister Mukherjee said in mid-September, “At this point of time I cannot accept dear money policy or credit curbs as it will have an adverse impact on growth.”

Subbarao says he will maintain loose credit conditions to stimulate private-sector expansion. “We are hoping that private demand for credit will pick up in the second half of the year, and we will continue to provide liquidity to get banks to lend,” he says.

But he is calling for the government to commit to medium-term fiscal consolidation to boost market confidence. The government aims to bring it down to 5.5% next fiscal year and 4.4% in 2011–12. For now, it is awaiting the 13th Finance Commission report in December that will advise on a plan to implement this fiscal consolidation. “Everyone knows this fiscal deficit is not sustainable, and I don’t think the country can afford this year after year,” says Rangarajan. “But as the economy recovers and private demand picks up, the government will put in place a programme to bring it down over the next two to three years,” he says.

For now, the government argues revenue buoyancy – once high growth kicks in – combined with the sale of government stakes in state-controlled companies will help rein in the deficit. But given the failure of the first Fiscal Responsibility and Budget Management Bill, which legislated a 3% deficit target, there is scepticism that a medium-term programme of deficit reduction will be met. “The way the government is going with its large borrowings has left me with the impression that it will shy away from fiscal reforms and other necessary liberal policies,” says Nitsure at Bank of Baroda.

The lessons Indian policy-makers draw from the crisis will be crucial in determining the pace and composition of any reform process. The left in the ruling Congress party have less appetite to make tough spending decisions or accept the virtues of the market in driving rural development: premised on the idea that India’s macroeconomic policy mix is sound.

The country is decoupled from the global economy as it can grow by 7% purely from activating domestic demand. “But it is coupled with global business cycles if India wants to grow at 9%,” says Sanyal at Edelweiss Capital.

India’s healthy fundamentals have helped pull the economy out of the global crisis. It is less trade dependent than its rival China. And, over the past year, the private sector has still been able to turn to Indian state banks, which control 70% of the sector, for credit. The banks are flush with liquidity thanks to laws forbidding investments in risky products and overseas markets.

Analysts say the government needs to remove costly oil subsidies, reform labour laws and modify the rural development programme to optimize productive investment. Most controversially, India’s increasingly complex market-orientated economy necessitates a deeper and more liberalized financial sector, say some analysts.

Last year, India’s Planning Commission was advised by the High Level Committee on Financial Sector Reforms to privatize India’s banks. This would channel investment into more productive sectors, lower the cost of capital through competition and bring the underbanked into the economy, argued the report authors Raghuram Rajan and Eswar Prasad, who are (perhaps unsurprisingly) ex-IMF economists.

However, “real financial reforms conflict with the soul of the Congress party,” says Saugata Bhattacharya, chief economist at Mumbai-based Axis Bank. And while the government has huge borrowing needs, radical reforms are even more unlikely. Thankfully for India, real reform is not a prerequisite for strong growth in the near term.

  • By Sid Verma
  • 03 Oct 2009

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Jul 2017
1 Citi 244,235.70 910 8.87%
2 JPMorgan 223,767.95 1021 8.13%
3 Bank of America Merrill Lynch 211,276.97 750 7.68%
4 Barclays 166,062.82 634 6.03%
5 Goldman Sachs 162,877.27 537 5.92%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Jul 2017
1 HSBC 25,202.67 100 7.14%
2 Deutsche Bank 25,125.19 81 7.12%
3 Bank of America Merrill Lynch 21,836.07 58 6.18%
4 BNP Paribas 18,395.95 105 5.21%
5 Credit Agricole CIB 18,048.72 104 5.11%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Jul 2017
1 JPMorgan 12,578.87 55 8.17%
2 Citi 11,338.07 71 7.36%
3 UBS 10,682.06 44 6.93%
4 Goldman Sachs 10,419.53 53 6.76%
5 Morgan Stanley 10,194.88 57 6.62%