BackOpinion | Reduced volatility in India augurs well for the future
With greater economic stability, the cost of credit as well as equity reduces over a period of time
PremiumScreaming matches on prime-time television belie a quiet revolution that has been going on in the country. India has become less volatile over the last few years, and this reduced volatility has many positive effects for our overall economic outlook.
For the purpose of this conversation, I am defining volatility rather classically, as the liability to change rapidly and unpredictably. Numerically, it is often measured by the dispersion around some average value, but it can also be a subjective notion of stability. Before we discuss the implications, here is a look at the sources of reduced volatility.
Inflation volatility: In 2016, the government, in consultation with the Reserve Bank of India (RBI), put in place a Monetary Policy Committee (MPC) framework. The MPC is mandated to target inflation directly, and is expected to maintain it within a band. In the nearly three years since the MPC began, both core and headline inflation have come down and, more importantly, inflation volatility has reduced. The other shoe will drop when the level and volatility of inflation expectations also reduce.
Currency volatility: With inflation being targeted and contained, the remaining source of currency volatility is a shock induced by the balance of payments (BoP). India is a major crude oil importer and is likely to become an even bigger importer in the years to come. The price of crude oil, over which India certainly has no control, remains a major source of volatility of the currency. But there are mitigating factors: India’s portfolio flows have converted to foreign direct investment (FDI), so much so that India now receives more FDI than China, and India’s diaspora remittances remain rock solid at over $75 billion for this fiscal year. Taken together with a foreign exchange war chest that now exceeds $405 billion, India can expect a period of relative real currency stability.
Political system volatility: We are in the midst of election fever in India and speculation is rife about the number of seats the contending parties will win, whether the ruling party will return with a (near complete) majority, and whether the alliance in Uttar Pradesh can make a serious dent in the fortunes of the ruling party. One thing is treated as a given, however—whichever set of parties wins, the others will accept the winner in the electoral contest. With each passing Lok Sabha election (this one being the 17th), the political system of democratic handover in India has only gotten stronger. The party in power may come and go, but this system-wide stability augurs well for electoral democracy and predictability in the country. India’s Constitution remains the guiding framework within which the country operates.
While we have had a reduction in volatility in the above areas , there are some areas where the situation is still mixed.
Fiscal volatility: India’s fiscal balance has shown some stability over the last few years. However, India still runs both, a revenue deficit as well as a primary deficit. Parties on both sides of the political aisle are vying to “out-populist" the other with loan waivers and basic income grants. A fiscal prudence wave would reduce economic volatility, but as of now, this is more hope than reality.
Policy volatility: While monetary and currency policy have contributed to a reduction in volatility, sector-specific policies are a mixed bag. Sector policies are important because stability in policy attracts FDI and domestic investments, while instability engenders the opposite. The recent Press Note 2 for e-commerce is an example of a hastily enforced policy that was arrived at without warning, and had a dramatic impact on the competitive landscape. Similarly, demonetization in 2016 was a major negative surprise and has had numerous first and second order effects.
Policy consistency and implementation must improve so that businesses are able to make long-term investment decisions without the fear of arbitrary policy changes, reversals and haphazardly imposed rules.
Others: Some may argue that the constitution and electoral system cannot be taken for granted and that institutions have been undermined, particularly during the term of the current government. While institutions have indeed been impacted, a greater stability has been maintained in the country, because a free press, an active civil society and other institutions have stepped in to reset the balance. While the press and civil society must remain ever vigilant against slippage, we are in the midst of structural maturity, and the benefits of that maturity will likely become more visible over time.
If true, what does lower volatility imply for India?
In the economic sphere, the most important transmission of this is through a structurally lower real interest rate. This means that, the cost of credit in real terms—adjusted for inflation—is likely to favour investment for the future. This sets in place a virtuous cycle. The recognition of lower currency volatility and greater political system stability means that the risk premium for projects funded from abroad through the FDI route will reduce and, therefore, more projects become viable. So, the cost of credit as well as equity reduces over a period of time. This augurs well for India’s economic prospects. Of course, it requires that we keep up the good work.
P.S: “When stability becomes a habit, maturity and clarity follow," said the legendary yoga teacher B. K. S. Iyengar.
Narayan Ramachandran is chairman, InKlude Labs. Read Narayan’s Mint columns
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