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Economics: India
Economics – Markets – Strategy
Even if India
produced all its oil
and operated as a
closed economy,
domestic oil prices
might have risen
due to oil demand
We expect another
25bp rate hike by
Sep08
So again the question to ask is who and what is ultimately responsible for the
rising global commodity price inflation? According to our analysis, (see section
“On a clear day”), in 2006, India and China together accounted for two-thirds of
the incremental petroleum demand and India alone accounted for about 15%
of the incremental demand. In other words, even if India produced all its oil
and operated as a closed economy, oil prices would have likely risen and fuelled
inflation. Fuel subsidies are also shielding India’s demand from higher oil prices,
so strong demand from India clearly plays a role in driving oil prices higher. It is
for this reason that we think that India should not ignore fuel price led inflation.
It is imperative in the long-run to cut subsidies, let the price mechanism work
and avoid “suppressed” inflation.
Interest rate: not yet peaked from a longer-run perspective
It is clear that the rising headline inflation rates should not be ignored. Rising
inflation pushes down real interest rates and increases wage hike demands creating
a risk of wage-price spiral. Indeed, the RBI’s 25bp repo rate hike late on June 11
was aimed at controlling inflation expectations. In India, fuel subsidies also
suppress inflation and widen the fiscal and current account deficits. Therefore,
we believe that policy rates have not peaked in India. At some point, the economy
would have to factor in rising oil prices and raise rates. At that point, oil prices
may also moderate as the “price mechanism” that is clogged right now by subsidies
in emerging markets begins to work. Nonetheless, our sense is that rates may
yet go up in 2009. In the near-term, however, we expect only one more 25bp
rate hike in 3Q08.
Twin deficit scare and implications for ratings
India’s current account deficit is likely to widen sharply to 2.7% of GDP in FY2008
(and 1.8% of GDP estimated in FY2007) from around 1%-1.2% of GDP in preceeding
years. The central government’s fiscal deficit might exceed the budgeted 2.5%
of GDP by as much as 1.5%-pts on account of expenses related to central government
pay revisions, farm loan waiver and duty cuts to control inflation. This calculation
doesn’t include off-budget oil bonds issued to oil companies which amounts to
another 1.7% of GDP. However, unlike South East Asian countries, deficits are
funded with domestic savings in India. India’s external debt stands at only 17%
of GDP. The banking sector is also a captive market for government bonds as
banks are required to hold 25% of their assets in cash or government bonds as
part of the statutory liquidity reserve requirement. Therefore, the higher fiscal
deficit, by itself, should not materially hurt the balance of payments, leading to
a spiral of weaker currency and higher deficits. India also has the scope to raise
corporate taxes in the short-term to fund higher subsidies - a bad move from a
policy perspective but one that will help the ruling Congress-led coalition reach
general elections in mid-2009 without virtually ensuring its doom. As long as oil
prices do not rise further, we think ratings agencies are likely to give India the
benefit of the doubt, seeing the present fiscal slippage as a temporary setback.
Note:
Annual and quarterly forecasts / references in the text and the table refer to
calendar year forecasts unless specified as fiscal year (FY).
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