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No beating about the bush.
Morgan Stanley isn’t exactly bullish on the Indian macro economic outlook due to stagflation and has drawn up three distinctive scenarios, none of which are too optimistic
In their new report titled ‘Where Are We in the Boom-Bust-Adjustment (BBA) Cycle?’, Morgan Stanley Asia/Pacific Research (MS) notes out that India is stuck in the threatening stagflation stage, caused due to weak productivity, high inflation and policy inaction. It also believes that the consolidation will take time as India is in the “early stages” of the readjustment cycle, which can only be helped by an “aggressive” actions whoever takes hold of the next government post-elections.
However, MS are also on a look out for external facts such as the US dollar and US 10-year yields. If the latter moves up, it could be trouble for India. The report said, “On the external front, we would be watchful of any sharp upward movement in the US dollar and US 10Y bond yields while we remain concerned about the potential negative effects of a sudden stop in capital flows.”
Reasons for stagflation and decline in GDP
According to Morgan Stanley, there are four reasons to explain for loss of productivity, resulting in stagflation, and weak productivity over the past three years.
Fiscal deficit: Firstly, India’s fiscal deficit remains in grave danger of breaching the double digit mark. If it does, it will put a severe dent to India’s growth prospects. According to MS, “the fiscal deficit was lifted from 4.8% of GDP in F2008 to 9.9% in F2009 and has remained above 7.5% for the past four years.” It is likely that double digit figures could be achieved if the National Food Security Bill is implemented.
Rural wages and NREGA: Secondly, there is a mismatch between rural wages and productivity. While rural wages have shot up, productivity hasn’t, thanks to the NREGA programme which has been beset with poor implementation and misuse. According to MS, “We believe the national rural employment scheme (NREGA) has been one of the key factors pushing rural wages without matching gains in productivity.”
Low capex: Thirdly, an “Unfavourable business environment resulting in deterioration in productivity of corporate sector, as well as, declining private investment to GDP” caused by global factors caused corporate confidence to decline, thereby reducing investments. This chart shows how capex has plummeted.
Negative real rates: Lastly, Morgan Stanley feels that negative real rates are the cause for India’s widening current account deficit which caused funding problems. The report said, “We believe that discouraging financial saving by maintaining negative real rates has only exacerbated the macro stability risks and has been instrumental in widening the current account deficit further, exposing India to external funding risks.”
All the four reasons collectively led to macro-economic stability issues, including persistently high inflation, widening current account deficit and a bad-loans crisis. The three graphs below are self explanatory:
Inflation: Even though inflation remains elevated, MS expects food inflation to worsen even as headline inflation hovers around the 8% levels, till April-May, during election time. The report said, “Even as we expect further deceleration in food prices, we expect CPI inflation to remain elevated around 8.5%-9% over the next 4-5 months.
Non-performing loans: Moneylife had predicted this way back in 2012, with a cover story on how the public sector squandered public resources leading to grave situation of bad debts. The same story can be accessed here: . MS expects bad loans to rise. “As per estimates from our Financials team, impaired loan ratio could rise to 11.1% by March 2014,” according to the MS team.
Current account deficit: Current account deficit widened from 2.7% of GDP in F2011 to 4.2% of GDP in F2012 and an all-time high of 4.8% of GDP in F2013.
Three possible scenarios
MS has drawn up three distinct scenarios: moderate, bad, and worse.
Benign scenario (medium): This would be helped by “strong policy actions” of the next government. MS believes that this could not only reduce fiscal deficit, but also moderate wages and keep headline inflation to 6.5%-7% levels by March 2015.
Sub-optimal (bad): Interestingly, MS thinks that if the government is unable to do anything (i.e. if the government is weak, without a mandate), then the RBI will do something. The report says, “if the outcome of the general election were to produce a weak coalition government, it could hamper the pace of implementing the required policy reforms... the central bank will have to tighten monetary policy further, potentially in an aggressive manner to bring about a more credible and quicker adjustment in inflation expectations.”
Disruptive (worse): The worse case scenario is forced market adjustment. Such a scenario is described as “the persistence of high inflation and inflation expectations keeps real rates in negative territory and brings about a widening in the current account deficit all over again, exacerbating the macro stability risks... the central bank would need to tighten monetary policy in a potentially disruptive manner... and could entail a sharper deceleration in growth rates.”