Moderate risks seen emerging on account of wider deficits: Derrick Kam of Morgan Stanley

Private capital expenditure (capex) in India is set to recover in 2018 on account of three factors—asynchronous recovery in exports and consumption for the first time in four years, improvement in corporate balance sheet fundamentals, important steps taken by policymakers towards strengthening the financial system, Derrick Kam, India economist at Morgan Stanley, said in an interview.

“As private capex recovers, it will revive job creation, thus ensuring that the economy will be heading towards the “productive growth” phase, which is characterized as a period of improving growth while macro stability remains in check—typically setting the stage for a sustained growth cycle,” he added. Edited excerpts:

In March, the US Federal Reserve raised rates by another 25 basis points (bps), and we could be having three more hikes this year. Do you see India being among the most vulnerable Asian economies in an environment of rising interest rates in the US? With rising rates, do you see capital outflows from emerging economies as investors search for better yields in the US? (One basis point is one-hundredth of a percentage point.)

India’s macro stability indicators are now in a much better shape, compared with the taper tantrum episode of 2013. Real interest rates are now 250 bps higher as compared to the US, relative to just a gap of -210 bps during the taper tantrum episode. Moreover, the current account deficit (CAD) of 2.2% in the December 2017 quarter has also narrowed than the peak of 6.8% in December 2012. Even as growth accelerates over the forecast horizon, we are confident that macro stability risks will be contained. The most important driver to this view is that policymakers are pursuing a policy mix which is supporting the productivity dynamic and, hence, reducing the misallocation risks. Key macro stability indicators like inflation and the current account balance will remain broadly within RBI’s (Reserve Bank of India’s) target range and comfort zone. Specifically, we are forecasting headline CPI (Consumer Price Index) inflation of 4.6% for FY19 as compared with RBI’s inflation target range of 4% +/-2%—while CAD would widen to 1.7% of GDP (gross domestic product) in FY19, as compared with RBI’s comfort zone of 2.5% of GDP. Moreover, with India’s growth differential projected to improve vis-à-vis the rest of the world, this environment could prove to be conducive for capital inflows, which could help mitigate the pressures from higher yields in the US.

You are of the view that India has been staying on the recovery path in 2018. Can you explain this in detail? India’s macro numbers—last 2-3 years—always have been good, and can we sustain this recovery, as we transition from the macro to micro story? And for the transition to micro, earnings need to come back and private capex needs to pick up—when do you see this happening? What makes you confident that a private capex recovery is on?

For 2018, we are expecting economic growth to accelerate to 7.5% from 6.4% in 2017. More importantly, we expect recovery would become full-fledged, with private capex recovering for the first time in six years.

From a broad perspective, since 2014, the recovery in India has been gradual and un-synchronized. As consumption began to recover from 2014, post the taper tantrum shock, the fall in commodity prices resulted in weak EM growth, which affected India’s exports. Then, as exports began to recover from 2H16, the twin idiosyncratic factors of the currency replacement programme in November 2016 and the implementation of the goods and services tax (GST) in July 2017 affected consumption and production activity. Since late 2017, as headwinds from both the currency replacement programme and implementation of GST have abated, the economy has experienced a strong acceleration in growth, supported by a synchronous recovery in both consumption and external demand. The strength in the recovery has been sustained into early 2018, suggesting the economy is still on a recovery path.

We see three key reasons why private capex will recover in 2018.

First, asynchronous recovery in exports and consumption for the first time in four years against a backdrop of global growth recovery and dissipating idiosyncratic headwinds in India should help lift capacity utilization and corporate revenue growth. This would help improve corporate return expectations.

Second, corporate balance sheet fundamentals have improved. Corporate balance sheets have delivered for the past two years, while free cash flows have reached an all-time high level. Moreover, the growth and interest rates dynamic should turn more favourable, with real interest rates projected to drop below real GDP growth for industry. The corporate sector should be better positioned to take up capex as demand improves.

Third, policymakers have taken important steps towards strengthening the financial system, which should improve the ability of the financial system to extend credit and provide support to the private capex recovery. This has included instituting new insolvency and bankruptcy code and granting RBI powers to address the issue of slow non-performing loans resolution. The government has also infused capital into state-owned banks.

As private capex recovers, it will revive job creation, thus ensuring that the economy will be heading towards the “productive growth” phase, which is characterized as a period of improving growth while macro stability remains in check—typically setting the stage for a sustained growth cycle.

Where does the Modi-led government stand on near-term and medium-term reforms? How would you rate its performance here?

First, on ensuring macro stability, we believe the root cause of the challenging macro environment in India prior to 2013 was a sharp deterioration in the productivity dynamic. In this context, we have been closely tracking the government’s ongoing efforts to correct the four key factors that we think caused deterioration in the productivity dynamic.

These four factors are to stay on the path of fiscal consolidation, moderate rural wage growth, maintain positive real rates, faster implementation and increased transparency of government policies for investment approvals. We believe the government’s policy action has helped to complete the macro adjustment cycle and reverse productivity-weakening policies. This makes us more confident that the economy can sustain higher growth without a deterioration of macro stability factors.

We believe that in order to sustain growth at 7-8% levels, the government will need to focus on addressing issues related to land, labour tax, the policy regime related to infrastructure, and overall ease of doing business. Progress has been made on all these fronts, which has bolstered our confidence that the economy can sustain higher rates of growth over the medium term.

Second, on improving ease of doing business and liberalization, policymakers have focused on improving the ease of doing business, taken steps to streamline the investment approval process and liberalize the economy. The focus on improving ease of doing business has been reflected in a significant improvement in India’s ranking on the World Bank’s ease of doing business index to 100, from 130 previously. Improvements were made in six out of the 10 sub-components.

Over the years, FDI (foreign direct investment) limits have also been progressively lifted, resulting in a significant increase in FDI inflows. India is attracting FDI inflows amounting to 2.4% of its GDP on a 12-month trailing basis. India accounts for 2.5% of total global FDI flows—as of 2016—and is the 11th largest recipient of global FDI inflows. This is up from 0.8% of global FDI flows in 2005, when India was the 32nd largest recipient of global FDI inflows.

A related query—so far, the global investor community had largely assumed that political stability was given. Are worries creeping that we may perhaps see political instability, and that 2019 is not a given deal as was once assumed? Considering recent developments, is the political narrative slipping out of Modi’s hands? Do you also see any form of policy paralysis leading up to 2019 elections?

There is a current debate on the issue of a lack of job creation, which we would attribute to the weak private capex cycle. If the economic growth momentum continues and private capex picks up as we expect, we do expect employment growth would pick up, which would help alleviate concerns on this front. Policymakers have continued to take steps in the right direction such as a continued focus on public capex and improving ease of doing business. This will help facilitate economic growth and nurture recovery.

Big picture, what are your clients asking you about India? What are their concerns?

Investors’ concerns on India are centred around, first, the strength of the growth recovery, and second, impact of higher oil prices, and third, the outlook for fiscal policy and its implications.

On the growth cycle, we are more confident on the strength and composition of the recovery as we think strong global growth will support exports growth and that consumption recovery will also remain strong. This will then support a rise in capacity utilization and coupled with the improving corporate balance sheets and banking system, will help support a recovery in private capex.

Given India’s role as a net oil importer, higher oil prices will lead to higher inflation and will negatively impact the fiscal and current account deficits. However, this rise in oil prices is probably driven more by strong global demand rather than supply-related issues and, hence, India will get a corresponding offset in the form of better external demand conditions. As a case in point, commodity prices rose significantly in the 2003-07 cycle and given that there was productive growth in the economy then, the economy was able to absorb the impact of higher commodity prices.

We forecast a central government fiscal deficit of 3.4% for FY19, which is slightly higher than the government’s target of 3.3%. The key anchor to our expectations for a higher-than-target fiscal deficit is our view that policymakers will seek to lift expenditure-to-GDP ratios, particularly in the year before elections, as compared to the budget estimate of a reduction.

As regards the impact of fiscal spending on macro stability, the key to watch for would be the mix of public spending—share of capital expenditure has fallen in FY18—and also for any potential distortions to the productivity dynamic. The starting point of core inflation and current account deficit is providing some buffer, but we do think moderate risks are emerging on account of the wider-than-targeted fiscal deficits and, hence, would monitor this closely.