The Indian economy today presents an ambivalent picture. There is the real economy, which is looking quite good, with signs of acceleration. On the other hand, the financial side, or rather the monetary picture, is different with inflation concerns and other global economic developments presenting several concerns. What is one to make of it?
April and May have, probably, been the most difficult months from the point of view of the war in Ukraine as the repercussions have been felt due to disruption in the demand-supply equilibrium for several commodities. Yet, the Indian economy has performed admirably. The PMI for manufacturing and services show improvement and stability. These indicators are significant because they indicate month-on-month progress and, if May is better than April, which is better than March, clearly things are fitting well.
The same comes from the IIP and core sector growth numbers for April. In fact, the core sector data is significant because, contrary to the problem the nation faced in the area of power, both coal and electricity have done well this month. Add to this buoyant GST collections and high eWay bill issuances and the picture is quite sanguine. The trade deficit has widened in first two months, but exports have grown well and high imports are reflective of industrial activity.
No bed of roses
However, on the financial side there appear to be challenges. Inflation is the Achilles heel for the government and the RBI as even though it has been triggered by supply-side dislocations, the solution is in their realm. Therefore, there is pressure on the RBI to raise rates and the government to address issues on taxes. Some steps have already been taken.
Further, as a result of the repo rate hikes and expectations of more aggressive steps, the bond yields have started climbing upwards. In this muddle, there is the Federal Reserve, which has been backing up talk with action (75 bps in the last policy) and has raised interest rates relentlessly, thus spooking the markets. The reverberations have been felt in the forex market, where a strong dollar has damaged EM (emerging market) currencies. Also, investment flows have been reversed and just like how the EMs benefited from the QE (quantitative easing) programmes, the backlash is being felt today as the reversal of liquidity infusion has started.
How will the rest of the year be? The financial side of the market will hold clues here. The RBI is expected to raise the repo rate. Here there are different expectations. The first set revolve around the RBI bringing the repo rate back to the pre-Covid level of 5.15 per cent as the reduction to 4 per cent was part of the extraordinary support provided.
The second set of expectations are betting at another 50-75 bps increase. The third is a market view where it is widely believed that the 9-12 months OIS (Overnight Index Swap) rate is a good indication of what to expect, and this is in the region of 5.9-6.2 per cent. Therefore, high interest rates are here to stay.
Cost of borrowing
This means in turn that cost of borrowing will go up and will affect retail and SME (small and medium enterprise) loans perceptibly as they are linked to the repo rate. The MCLRs (marginal cost of funds-based lending rates) will move gradually, and may not be significant for the larger companies. With property prices also reversing, thanks to the higher input costs being passed on to the consumer, the housing sector will see a slowdown along with SMEs, which may not be in position to invest and would continue to face pressures on financing working capital. Hence, overall growth momentum will slow down, albeit marginally. The GDP growth number of 7.2 per cent for the year looks reasonable under these conditions.
Another battle for the RBI will be with the currency as a call has to be taken on the quantum to which the rupee must be defended. There are two reinforcing forces that will be in operation for the next nine months or so. The dollar is going to strengthen further, and while the ECB is expected to also start increasing their interest rates, the Fed would be well ahead providing the fillip. The dollar is close to parity level with the euro and this has meant that most currencies will continue to decline. This is a conundrum for central banks, which have to take a tough call on how to balance depreciation with retention of export competitiveness.
In parallel, a strong dollar also deters capital flows which, in turn, affect the fundamentals and cause the rupee to fall further. Therefore, it is hard to guess the quantum of depreciation though the rupee for sure will keep going down, step by step. It has already been observed that just before the Fed meet the rupee falters by 25-50 paise to a dollar.
And finally inflation will be the ‘unknown’ as the geopolitical situation appears to be as gloomy and uncertain as ever. With the war proceeding quite endlessly, the oil situation appears to be shaky. China’s comeback will also mean some upward pressure on demand, though admittedly the supplies from within would also increase, thus correcting the demand-supply links for various commodities.
While further sharp price increases may not be expected, stability is what could prevail in the coming months. To this extent the effect of global commodity prices would be muted.
Input price hikes
A call has to be taken by Indian manufacturers on the second round of price increases due to higher raw material costs. This will be tough because one round did take place from Q3 FY22 onwards. Right now, most are protecting the price but reducing the content. The new round of input price hikes will at some time have to be passed on and this is why inflation will continue to remain elevated at over 6.5 per cent for the year.
Therefore, the current scenario will most likely be carried along for the rest of the year. Stable but lower GDP growth (mainly due to high inflation affecting consumption), higher interest rates, stubborn inflation and a volatile rupee will characterise the economic landscape.