BackIndia’s next big leap is a bit farther down the road: Frederic Neumann
The co-head of Asian economic research at HSBC says poor monsoon rains could cut India's GDP growth this fiscal by about half a percentage point, slow consumer spending, drive up food prices
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Singapore: Poor monsoon rains could cut India’s gross domestic product (GDP) growth this fiscal by about half a percentage point, slow consumer spending and drive up food prices, says Frederic Neumann, co-head of Asian economic research at HSBC Holdings Plc. A drought, or even sub-normal precipitation, will put the brakes on rural demand that has sustained sectors such as consumer staples, telecommunications and construction, among others, Neumann said in an interview.
Edited excerpts:
According to weather experts, India may face a dry summer, with rainfall expected to be much below normal—if there is a drought, or even a semi-drought, what will be the impact on the economy?
Despite India’s huge strides in development over the past two decades, the economy remains sensitive to rainfall conditions. A drought, or even sub-normal precipitation, weighs on rural demand especially, but its effect is felt more broadly as well. Lower crop yields reduce rural incomes, even if higher prices for food and other agricultural products offer some compensation for lower output. In turn, consumer spending slows. Urban residents as well have to contend with higher food prices, reducing the disposable income for other items and services. It is difficult to assess the precise impact of rainfall conditions on economic growth. Much depends, for example, where the shortfall occurs geographically, whether it is temporary or drawn-out, and whether the government has scope to cushion the blow on demand through various support measures. This year we estimate that a significant shortfall in rain during the monsoon period could have about 0.5 percentage point off GDP growth, with the impact felt the most in the third quarter of the current fiscal.
Can you detail the impact of a poor monsoon on inflation in India? Indian government granaries are well stocked, which could help augment market supply, but how much effect will the new right to food law have in constraining the government from drawing down its reserves?
The biggest risk for India at the moment is that a poor monsoon drives up food inflation. Even if broader economic growth is still lacklustre, food prices could quickly accelerate, posing challenges for the inflation outlook more broadly, not least since price pressures are already elevated. The government has some scope to counteract this by releasing excess food from its reserves. At the margin, this will certainly help; but under a severe drought, there is a limit to which the government can release its reserves. The right to food programme, for example, requires that state granaries hold a certain quantity in reserve for future use. Possibly, this stipulation could be suspended in an emergency, but it would still leave the government with the costly task of rebuilding reserves quickly, possibly through imports. Other challenges abound as well, including the distribution of excess reserves and the quality of existing stocks. It is, therefore, by no means assured that state granaries offer a complete solution to the potential challenge of a drought.
What are the policy changes that the new government may have to take if the monsoons are poor, and also on the increasing possibility of the El Niño weather phenomenon? What can the Reserve Bank of India (RBI) do?
In the short-term, the options for the new government are limited. The distribution of extra fertilizer could help, as well as irrigation equipment and expertise. But if drought sets in, crop yield is almost inevitably likely to decline. The real task for the new government is to strengthen the resilience of the agricultural sector over time. This will require reform of the minimum support price system to rationalize incentives for farmers, a better rural transportation infrastructure, improved irrigation systems, and more active crop and seed management for better yield under challenging conditions. All of this will take time but is essential to finally overcome the scourge of volatile monsoon rains.
The task for RBI is less clear cut. On the one hand, the new inflation objective requires that the central bank tighten whenever its goal drifts out of reach. On the other hand, if food prices spike because of a drought, it is not clear higher interest rates will do much to rein this in and may, in fact, be inflicting even more pain. In the past, RBI has rarely hiked interest rates purely in response to a drought. This is also warranted by the fact that growth tends to slow after a dry monsoon, reducing broader price pressures in the economy outside of food. Still, the challenge this year is that inflation is already at a fairly elevated level, to begin with, and RBI has firmly committed itself to bringing headline inflation down to 8% by January. So if it looks like the central bank is likely to miss its goal, doing nothing is not an option as well. The trouble—or, some would say, the advantage—of an inflation target is that it in many ways ties the hands of central bankers: central bankers under such a regime cannot afford to be seen to sit idly by as inflation accelerates away from their target. In the event, RBI may opt for the middle path, hiking once, but not more, should inflation pick up. A 25 bps (basis points) hike would be enough to send a signal that officials are serious about inflation targeting, but not so large a move as to risk critically undermining growth.
The rural sector has been one bright spot in an otherwise gloomy demand scenario for Indian industry. If poor monsoons lead to a rural slowdown, what are the sectors that could be affected?
Rising rural incomes in recent years have sustained sectors like consumer staples, which could tap into an emerging clientele in the countryside. Even telecommunications found increasing growth opportunities in rural areas, given the higher disposable incomes and increasing saturation in urban centres. Construction is another sector that could see a slowdown due to a hit to rural incomes, although here the proposed acceleration of infrastructure spending should help offset this. By and large, however, Indian industry should benefit from a “rebalancing" of economic growth back to urban clusters in the coming years; so the rural demand disruption from a weaker monsoon should prove temporary. In fact, Indian industry is likely to be a firm winner over the coming years as disposable income recovers, investment picks up and exports continue their stride as well.
How is it that commodity markets don’t yet reflect any panic about the monsoon yet?
One thing to remember is that all the predictions about the monsoon, or lack thereof, are really just that: predictions. Even the India Meteorological Department (IMD), which has a good track record in these matters, has got predictions wrong in the past. So, from a market perspective, it remains to be seen to what extent crops will be impacted by the potential lack of rain. In the food sector, it is also not always easy to make big directional bets about local agricultural markets. Many items, for example, are perishable or costly to store. Traders, therefore, may well be worried about the potential for poor rains, but not quite in a position to place big bets on a future rise in prices. When it comes to food price disruptions caused by poor monsoon, facts will drive prices, not a hunch about what these might potentially look like.
Do you think that another rate hike may well be warranted, especially if the government doesn’t tighten the fiscal reins as promised?
Fiscal and monetary policy go hand in hand. The current budget trajectory implies ongoing consolidation for this year and the next. If this is delivered, it should remove pressure on RBI to hike rates further this fall. However, if a slippage occurs, a hike would become a real possibility. In effect, the economy is in a tough spot: trend growth has declined in recent years as productivity gains have stalled. This means that any artificial boost to growth would result in an uptick to inflation. Loosening the fiscal reins could well be such a trigger. Given RBI’s commitment to its new inflation objective, growing price pressures may well elicit a hike. It is, therefore, critical that fiscal and monetary policy are closely coordinated.
Can RBI meet its target of bringing headline Consumer Price Index (CPI) inflation to 8% in January and 6% by early 2016. For this to happen, what are the steps the government should address in the upcoming budget?
In principle, yes. RBI’s inflation target is within grasp. But the trajectory of fiscal policy in the coming quarters, as well as a potential drought, might yet put it beyond reach. The government, therefore, has a key role to play. Primarily, it needs to keep a lid on spending, continuing with consolidation efforts undertaken over the previous two years. Any expansion of fiscal policy could reignite price pressures. Apart from the overall budget stance, the composition of fiscal spending matters as well for the inflation outlook. For example, a cut in subsidies, while desirable from the point of view of long-term fiscal prudence, would fan price pressures in the short-term. One option, therefore, is to leave these largely in place for now and push reform into next year when price pressures are better anchored and some of the productivity-enhancing measures that the government is proposing have had time to get some traction.
Your view on the rupee—do you agree that it has done well of late—what are the risks?
The rupee has performed impressively, of late. India is in a far better place today than a year ago, when it was gripped by financial volatility. However, risks remain in the short-term. One is that a disappointment on growth or economic reforms, as well as a spike in inflation, could lead to a pull-back in the stock market. This would lead to equity portfolio outflows as foreign investors take money off the table, adding pressure on the rupee. The second risk is that the gradual recovery in local demand and higher oil prices could push out the trade deficit again. By and large, these risks are manageable, but they could still interrupt the one-way trend in the rupee towards greater strength that we have seen in recent months.
You are of the view that Modi’s victory will lead to a significant increase in commodities demand and also prices. For now, China has a huge say in global commodity prices, but in the future, can India influence or have a say in global prices? Also, India is a large producer of commodities, and so, when do you see it becoming a net importer?
For the time being, China remains by far the biggest player in global commodity markets. But the resource intensity of Chinese growth should gradually decline over the coming decade, not least because the government has shifted focus to less construction-centric sectors. In India, we expect growth to recover in the coming years, primarily driven by investment, especially construction. This means India will become more natural resource-intensive in its growth over time. Admittedly, India will not be in a position to overtake China’s share in global commodity markets any time soon. But the trend is unmistakable: India will become a more and more important player in the sector. This will likely become apparent in three to five years’ time, assuming that the Modi government presses ahead with its construction-centric growth strategy. Meanwhile, while India possesses substantial resources of its own, such as in iron ore or coal; these may not be retrievable at international commercial rates in all instances and a full exploitation could also be restricted by local regulations and environmental considerations. So some of India’s demand will likely be met by imports, giving the country incrementally greater sway over global commodity prices.
By when will the improving domestic sentiment and firming external demand translate into a pick-up in India’s growth numbers?
In the near-term, growth may well fall short of investors’ expectations. After all, Modi faces almost an impossible task: turning India around is like steering a supertanker into a new direction. Some of the far-reaching reforms proposed, such as regarding the labour market or the tax system, will take deft political handling to pass through the various legislative hurdles. Even if passed, these measures will need time to have the desired effect on economic growth. We remain optimistic about India’s growth prospects under a Modi-led government, but patience is required, and the real gains will likely only materialize in two to three years’ time. This is not to say that growth will not gradually improve over the coming year or so, but India’s next big leap is still a bit farther down the road.
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