India well placed to weather some risks to export outlook: Economist Shilan Shah


Indian stock valuations looks relatively stretched in comparison to most Asian peers, and gains from hereon will unlikely be as impressive as they have been since the start of 2017, says Shilan Shah, Singapore-based economist at Capital Economics. Edited excerpts from an interview:

The Indian government has come under severe criticism from various quarters for estimating 7% gross domestic product (GDP) growth in the quarter to December, discounting the effect of demonetisation. What is your take?

There are widespread doubts about the accuracy of the national accounts numbers, and the unexpected strength of the recent GDP data will do nothing to allay these concerns. A host of monthly data, including for vehicle production and rail passenger volumes, suggest economic activity fell sharply towards the end of last year as a direct result of the government’s demonetisation measures. The cash shortage probably kept activity subdued in the very early stages of 2017, although whether or not this shows up in the official GDP figures when the next set of national accounts data are due is a different matter. This being said, the most acute impact from demonetisation on economic activity has now passed. Indeed, cash in circulation has risen by almost 50% since the start of 2017. Meanwhile, the PMIs (purchasing managers’ indices) have rebounded, and vehicle sales have continued to recover after plummeting at the end of 2016.

In all, we expect growth to accelerate in the coming months. In particular, consumption should pick up as new banknotes become more widely available, and there has also been evidence of a substantial move towards greater digital and cashless payments. Indeed, spending could bounce back strongly as households make purchases of non-essential items that they had earlier put on hold.

Beyond the domestic outlook, after declining for almost two straight years, Indian exports are exhibiting a recovery of sorts. Will this provide the economy with a crucial tailwind? And does it mean the government is on track to meet its long-term export target?

Export growth in US dollar terms was positive for the sixth consecutive month in February following a prolonged slump in the preceding two years. In volumes term, export growth has also picked up, which has undoubtedly helped cushion some of the impact on domestic demand from demonetisation.

The government, meanwhile, is aiming to raise annual exports of goods and services to $900 billion by FY20/21. In the 12 months to February, total export value stood at around $450 billion, meaning that exports need to double in value over the next three years for the target to be reached.

Looking ahead, there are reasons to think that export growth in US dollar terms will gradually accelerate. The recent rise in oil prices is one factor. After all, refined petroleum products account for around 15% of total goods exports. India also appears well-placed to weather some of the risks to the export outlook affecting many EMs (emerging markets). One concern is the protectionist rhetoric of (US) President (Donald) Trump. But it should be some reassurance for India that, at less than 2% of GDP, its exports to the US are relatively small.

Nevertheless, the prospects for export growth over the longer term are likely to be hampered by continued structural constraints. Most notably, India’s restrictive land acquisition and labour laws are holding back the development of a thriving manufacturing sector. Unfortunately, signs of reform in these areas haven’t been encouraging. The upshot is that even if exports do stage a firmer recovery in the coming months, the government’s export targets still look far too optimistic.

What about the outlook for imports? Does a pick-up present a risk to the external position?

Imports of key commodities should remain in check over the coming months. There was, admittedly, a rise in gold imports in February. This was always likely, given that consumption has rebounded from demonetisation. Indeed, other indicators such as vehicle sales also show a recovery. But local premiums on gold prices remain low, suggesting underlying demand isn’t particularly strong. What’s more, efforts to increase transparency in the gold market—which will in all likelihood be stepped up following the Bharatiya Janata Party’s (BJP’s) state election successes based in part on promises to clamp down on corruption—is likely to curtail demand further.

Oil imports should remain comfortable too. We are forecasting the price of Brent crude to rise to around $60 per barrel by end 2017. If this proves the case, it wouldn’t imply a sharp jump in import values. Only if oil prices reach $80-90 per barrel for a sustained period will we be concerned about the trade balance.

For now at least, the overall current account position doesn’t appear to be a major vulnerability. This means India’s economy is relatively well-placed if risk aversion returns to financial markets in the coming months. Whereas India was one of the most exposed emerging markets at the time of the taper tantrum in 2013, due to its large current account deficit, it is now looking fairly secure.

There has been plenty of talk about the potential setting up of a bad bank to deal with the growing bad loan problem. What do you think of the potential impact of a bad bank?

It is no surprise that the idea of setting up a bad bank in India has gained attention, given the deep malaise that the banking sector has been in over the past few years. Bad banks have been effective tools in cleaning up financial sectors in a number of countries over the past few decades, from Sweden to Nigeria. In India specifically, the formation of a bad bank could be particularly beneficial given that, according to the Reserve Bank of India, just 50 companies account for 30% of stressed assets.

These companies have debt spread across many banks. If the debts were consolidated in one place by a bad bank, their resolution would be easier to coordinate, and this would have a significant impact on the overall non-performing loan (NPL) burden. What’s more, the fact that the vast majority of the banking sector is state-owned—public banks hold nearly 90% of NPLs in the system—should also make it easier to reach agreements, for instance on how much of a haircut banks take on their NPLs.

The problem, however, is that the government is not currently in a position to commit the fiscal resources to set up an effective bad bank. Banks need an estimated $40 billion of capital by FY18/19 to meet global capital requirements. But due to fiscal constraints, the government has only pledged around $10 billion of infusions for the next three years. The cost of setting up a state-owned bad bank would not be any different, as it would require financing from the government to purchase NPLs. The other option would be to have greater private participation in the formation of a bad bank. But this would make it harder to reach agreements on the price of loans. A privately-owned bad bank would only purchase NPLs at discounted values, meaning that a capital injection would still be required.

It is clear, therefore, that while the creation of a bad bank could help with the process of resolving the NPL problem, its creation on its own wouldn’t fix bank balance sheets and encourage new lending. Alongside setting up a bad bank, the best option for the government would be to announce larger-scale recapitalizations, but offset the cost by privatizing state-owned banks. This process would not only lead to significantly larger capital injections, but it would also mean there is no lasting damage to the government’s own finances. What’s more, it would ensure greater competition and also reduce political influence in the banking sector, which would trim the likelihood that banks make the poor lending decisions that created the current NPL problem in the first place.

Indian stocks have hit record highs after Modi’s resounding victory in state elections. The markets appear to have seen this as a referendum on his economic policies, including demonetisation. The rally also takes India above Japan as the most expensive in the region. Where do you see the markets headed?

The benchmark Sensex stock index is up nearly 10% in local-currency terms since the start of the year. This has pushed it close to its all-time high reached in early 2015. Most major EM equity markets have also risen recently, but local factors have certainly given the Sensex an extra boost. In particular, the government’s ability to push through wide-ranging economic reform has strengthened following the ruling BJP’s strong performances in recent state elections.

However, looking ahead, although the government’s political capital has increased, there is no clear indication that Prime Minister Modi actually has the conviction to push ahead with necessary but unpopular reforms. What’s more, valuations look relatively stretched in comparison to most other Asian equity markets. Valuations are also higher now than they have been over the past five years based on the price/12-month forward earnings ratio, which suggests that upside is now limited. Given all of this, we expect the Sensex to strengthen a little further, but gains are unlikely to be as impressive as they have been since the start of 2017.

RBI is scheduled to hold a policy meeting next week. Where do you see policy rates heading over the course of 2017?

In light of the RBI signalling the end of the loosening cycle in its most recent policy meeting in February, most analysts are expecting the central bank to keep rates on prolonged hold, including in next week’s announcement.

We, too, agree that the most likely course of action next week will be the repo and reverse repo rate being kept on hold at 6.25% and 5.75%, respectively. This is, as mentioned above, due in large part to the fact that the economy appears to be on a firmer footing following the initial negative impact from demonetisation.

But while the outcome of next week’s meeting appears to be a foregone conclusion, the picture is less clear beyond that, due in large part to the outlook for inflation. RBI sounded notably less dovish in February than it had done during the previous two meetings that have been held with a voting monetary policy committee in place. Since then, the latest data show inflation has accelerated, and there are reasons to think it will rise further. We expect food inflation to accelerate later this year, while core inflation will also remain elevated.

Our judgement therefore is RBI will soon consider monetary tightening. We expect the repo and reverse repo rates to be hiked before 2017 end. This is not the consensus view. Most analysts are expecting rates to be kept on hold for a prolonged period, with a handful still forecasting some more loosening in the near term.

But we remain comfortable being out on a limb. We were ahead of the pack in expecting the loosening cycle to come to an end prior to RBI’s move in February. We think market expectations of policy tightening have fallen behind once more.