Will the recovery be a lopsided W?

Remember the discussion we used to have whether the recovery would be V-shaped, or L-shaped, or W-shaped? Now that we’re in the fifth year of the financial crisis, with the benefit of 20/20 hindsight we now know the recovery wasn’t a V. The global economy did recover smartly in 2010, but then it decelerated again last year, though the fall was certainly not as sharp as the recovery. The year 2012 is expected to be even worse than last year for the global economy, with the recovery coming in 2013, according to the recent update to the International Monetary Fund’s (IMF) World Economic Outlook. And there’s a fair chance it could get even worse, what with all those “downside risks”. All that we can hope for, at this point of time, is that it’s going to be a W of sorts and the final upward stroke of the W is going to start in 2013. The good news is the IMF’s record in soothsaying has been rather disastrous, with revisions to forecasts being both large and frequent.

What about India? Now that we’ve had a cut in the cash reserve ratio and the Reserve Bank of India (RBI) has signalled the next step will be a rate cut, the all-important question is: When will we see a return to growth? We have just a couple of months left in the current fiscal, but how much better will 2012-13 be?

In other words, the recovery is going to be slow. This is not a repeat of 2010, when fiscal and monetary stimulus resulted in a swift bounce from the depths plumbed by the markets in 2008 and 2009. Government finances are in no shape for another stimulus and RBI is itself uncertain about the scope for a decline in inflation. The recent monetary policy statement has pointed out several “upside risks” to inflation.

Their lack of conviction doesn’t seem to be echoed by the markets, though. They’ve been having a party this year as investors flock into equities. A steady flow of better-than- expected data has stemmed the panic and the relief is palpable. The numbers out of the US have been getting better, the Markit Flash Eurozone Composite PMI—for both manufacturing and services—is at a five-month high for January 2012. In China, growth is slowing, but at a pace that avoids a hard landing, while allowing the central bank to loosen monetary policy.

There’s a disconnect at the moment between the improvement in the data and the World Bank and IMF’s view that global growth in 2012 will be lower than in 2011. What is even more interesting, from the point of view of the markets, is that while the World Bank believes that real GDP growth in developing countries will drop this year to 5.4% from 6% in 2011, net portfolio flows to developing countries will go up, from $51 billion last year to $62 billion. That’s still much lower than the $133 billion that went to developing countries in 2007 or the $128 billion in 2010, but the assumption seems to be a slow return of risk appetite, despite the many uncertainties that still linger and through which the world will, at best, muddle through.

The World Bank also forecasts net portfolio inflows of $13 billion to South Asia this year, paltry compared to the $39 billion we received in 2010, but better than 2011’s $9 billion. The assumption is even though the economy may not do better than last year, the markets will do well, because risk appetite will be higher.

But there’s also another very important factor that RBI pointed out in its monetary policy statement. It clearly said that its hands were tied by loose fiscal policy and the government has no alternative but to cut consumption and boost investment. The question is: Will the government do what is needed? Consider the hurdles: 1) Lower growth will mean lower tax revenue; 2) Oil prices remain high, so subsidies will continue to be high; 3) Government spending next fiscal will include the effect of the Right to Food legislation. And if the fiscal consolidation doesn’t happen, as RBI says, it’ll be “a significant threat to both inflation management and, more broadly, to macroeconomic stability”.

Manas Chakravarty looks at trends and issues in the financial markets. Comment at capitalaccount@livemint.com

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