Indian Economy: A Macro shock may be closer than we believe

It is difficult to understand the causes for extreme bullishness among investors about the prospects of the Indian economy –at least over the past two years. It was not very long ago that investors, analysts and policy makers were promising that India was insulated from the economic problems in different parts of the world. The steady drum beat that India would grow at 8-10% for the next decade seemed to be so obvious that it was almost the patriotic duty of Indians to accept what seemed a fiat accompli. Any questioning of the supposed Eternal India Boom story was considered sacrilege. One idiot actually claimed that i'f the Prime Minister, Manmohan Singh assured us that high growth was going to take place, then it was good enough to accept it because he was a good man and a brilliant economist'. The PM is no doubt a brilliant economist, but unfortunately being the PM comes with its set of constraints. The rulers always get to see and hear only what they would like to hear.

At the outset, I think, India should consider itself lucky if it is able to grow at 6% in the financial year 2012-13. and 7% for the 2011-12. The Prime Minister seems to have, at last, realised that it may be more prudent to be candid in 2012 than he was in 2011. For the record: through out the first half of 2011, it was common for policy makers to claim that India would grow at 9% or at least 8.5%. The Prime Minister thinks that this figure is now likely to be 7%. In the normal course, one cannot fault the Prime Minister for that statement. The only problem: last month he promised that growth would be close to 7.5% (for the fiscal year 2011-12). It is difficult to believe that a reputed economist and former Governor of the Reserve Bank of India, could not have foreseen the magnitude of the problems facing the Global Economy, unless he was fed with wrong data from his subordinates. It is imperative that policy makers, especially at the higher echelons realise that the present crisis in the global economy is not a standard text book type of crisis and it is more deep rooted. But, for that realisation to occur we need our policy makers to first shake the education system, where mediocrity is the norm rather than the exception. In my experience that will never happen so best not to worry too much about that aspect.

There is an urgent need to clean the banking sector. Goldman Sachs claims that the problematic loans (including rescheduled + non-performing assets) may reach about Rs.235,000 crores. I would think that will be understatement. If the banks stop the practice of ‘ever-greening’ of loans, I believe it could be 2-3 times the figure that Goldman has given. India and China will do well to remember that historically, an economy has never had a 'soft landing' after the bursting of a real estate bubble or a credit bubble. This time the global economy as well as these countries had both.

Factoring in these loses would require huge capital. Interestingly, unlike the lack of direction in the past, RBI seems to be the only stakeholder who seems to understand the magnitude (or to be candid about it). The rising NPAs invariably will pressurise future ability of the banking sector to fund various projects in India. Unfortunately, this slowdown is affecting India at a time of the year when the government finances itself are under strain. A conventional view seems to believe that the Indian economy should pick up steam as the interest rates have peaked. The role of monetary policy as a counter cyclical measure may be limited, especially when there is a debt overhang. The example of USA is illustrative: the economy has deteriorated even as interest rates have declined from nearly 5% in 2007 to about 0.25% presently. It would be a mistake to believe that India is better off because the country is relatively less leveraged and because the savings are high, especially when compared to their counterparts in the highly indebted countries of Europe.

We have pointed out continuously since early 2008 (even before the blog was established and ever since), that the recent boom was facilitated by a large assumption of debt. Private sector debt doubled over the past decade. This is borne by recent statistics. The table below clearly illustrates the precarious nature of our economy:

Year (Financial Year)	Public Debt as % of GDP	Pvt Debt as % of GDP	Total Debt as a % of GDP
2000	73.8	32.5	106.30
2001	77.1	35.4	112.50
2002	82	36.1	118.10
2003	85.5	40.2	125.70
2004	85.4	40.1	125.50
2005	85.2	45.9	131.10
2006	83	52	135
2007	79.3	57.9	137.20
2008	76.1	60.8	136.90
2009	76.7	63.6	140.30
2010	74	63.6	137.60
2011	69.4	63.2	132.60

Source: Citi

In other words, the ‘great India story’ is essentially built on debt with the supposed thinking that the boom will continue for another 20 years at least. I Remember the euphoria that greeted the oldman Sachs’ BRICs  Report, despite what seems be a clear case of the authors probably  forgetting to factor-in the impact of economic and business cycles!

A Slowing economy creates a number of problems: reduces revenues for the government thereby forcing it cut down on expenditure thereby aggravating the slowdown and as a natural corollary forces the government to borrow more. Even if the government does not borrow more, the burden of debt keeps increasing as the output in the economy declines. Hence, the above percentages will look worse, rather than the other way round once the slowdown becomes more pronounced. Interestingly, any country with a current account deficit of more than 3% has run aground with the global bond investors. India has very rarely run a current account surplus and has rarely balanced its budget. Morover, India's imports are rather inelastic due to dependence on oil imports. Any rise in oil prices will be nothing short of a disaster.

Unlike the troubled countries of Europe, India’s problems are likely to emanate first from the foreign exchange market and the problems are likely to be transmitted from the heavily indebted corporate sector to banking sector. Since the government will forced to bailout the corporate sector, the government finances will only get worse. Indian corporate sector needs to repay nearly US$18 billion of foreign borrowing in 2012. This liquidity squeeze comes at a time when the banks themselves are forced to borrow at least US$20 to 30 billion from the RBI on a daily basis.

This comes in complete contrast to the global scenario, where traders and investors do not seem to believe that the global economy recovering in the foreseeable future. Hence, they seem to have lost faith in measures that will increase demand. Instead they believe that manufactures should slash production and manage supply in order to keep prices firm. That strategy of price fixing and supply management is bound to be disastrous in the long-term. A rising prices in times of debt deleveraging will destroy any little demand that exists over the medium term rather than provide greater profits.

At a personal level, I would be more amenable to believe that the ‘Great’ India boom is over, at least for the next couple of years. Talk to any business and they will never agree that this is possible: nearly two decades in the markets convince me that it is exactly at such times that the cycle turns. As an ardent believer in economic and business cycles, I would speculate that based on my very limited reading of the Jugular Cycle, India may have seen the best. However, I understand that others may provide an alternative theory that claims that based on other interpretations of cycles, the boom is likely to continue.

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