The recent spate of weaker than expected data has triggered the next round of forecast cuts for the Indian economy; with estimates trending towards 5% real GVA for the current financial year. The intensity of our slowdown is now somewhat comparable to the 2008 – 09 period at least in some aspects, but with added complications: One, unlike that period there are domestic aspects to the current slowdown (sustained income slowdown in run up, and impaired lenders’ balance sheets). Two, both domestically and globally the kind of firepower available is nothing like 2008; thereby arguing against any sort of a V shaped recovery from this cycle.
The objective below is to highlight some big picture points that are very notable in the current cycle:
- The Global Industrial Slowdown
Source: CEIC, Netherlands Bureau for Economic Policy Analysis, IDFC MF Research. Note: 1) China M1 comprises currency in circulation plus demand deposits in national currency of resident non-bank non-government sectors with the People’s Bank of China (PBoC) and banking institutions. Currency in circulation refers to notes and coins by the PBoC less the amount held by banking institutions. 2) Real numbers refer to nominal numbers deflated by y/y of Consumer Price Index (CPI)
The chart above shows that the intensity of the current global industrial slowdown is similar to the one around the period of the surprise devaluation of the Chinese yuan in late 2015. However, the noteworthy aspect is the size of the Chinese stimulus in response to the slowdown (as denoted by real M1 growth above), which helped stabilized the industrial cycle. By contrast, Chinese response so far has been quite muted with inclination so far around targeted easing rather than any big-bang approach. This argues against any robust recovery in the global industrial cycle in the near term.
- The Size of the Indian Credit Freeze
The above chart quantifies the size of the credit freeze that has hit India’s financial system. Thus fund flow to commercial sector for first half of current financial year has collapsed by 88% versus the same time last year (INR 90,995 crs vs INR 7,36,087 crs)! There is food for thought here on what this liquidity collapse may do to asset quality at many lenders and how, given the scale, it may be too early to call the all-clear in the financial system.
- India’s Exceptional Fiscal Constraints
It is well documented by now that in order to get a correct picture on India’s effective fiscal deficit one has to look at total public sector deficit (which includes centre, states, and public sector enterprises). This has been around 8 – 8.5% of GDP for the last few years. Thus not only is the effective public sector deficit quite large, but it hasn’t seen much effective consolidation. A bigger problem is when one compares this with the net financial savings of households, which is a proxy for resources available to finance this deficit (assuming corporate savings are left alone to finance private sector investments). As the chart shows, this ratio has been steadily climbed over the past few years and now stands close to its highest in recent history (at least the last 19 years). There are a few important takeaways here:
a. While there is nothing wrong ideologically to launch a counter-cyclical fiscal stimulus, the fact remains that we have run out of savings to finance this. All other things remaining constant, this will further accentuate crowding out and further impede transmission of rates.
b. Comparing with 2008, public sector deficit more than doubled from 5.2% of GDP in FY08 to 11% in FY10. This represents the magnitude of the government response to that slowdown.
c. Furthermore, even after this expansion public sector deficit as a % of net household financial savings was less adverse that it is today! This is because total savings were much higher than that they are now.
The above shows the futility of keeping pushing at the fiscal string. Not only does it risk further crowding out, but the magnitude of incremental response can never match up, given the constraints on financing.
- The State of Balance Sheets
The charts above show the level of impairment of Indian banks’ balance sheets both versus the 2008 – 09 cycle as well versus some other emerging markets. Note that although the pick-up in bad assets for us may be on account of truer recognitions, the focus here is on capital absorption and risk-appetite destruction that NPAs bring. Thus the ability of the banking system to substantially ramp up lending (as they did from 2010) is severely curtailed.
- The Very High Real Lending Rates
Source: CEIC, IDFC MF Research. Note: For real weighted average lending rate deflated using the Consumer Price Index (CPI), All-India-CPI is used from 2012 before which CPI-Industrial-Workers is used
While the issue of transmission is not new in this cycle, it is noteworthy that real lending rates collapsed sharply by 2010. While that was clearly an extreme, it is also hard to envisage a broad based capital formation cycle kick-starting basis the current prohibitively high real lending rates,
Conclusions
It is well documented that the size of monetary and fiscal response launched by India post 2008 crisis was probably exaggerated and policy makers were certainly too slow in pulling it back. Indeed, many of the balance sheet problems and macro-imbalances that subsequently surfaced could probably have been avoided had the response been more measured and its durability curtailed appropriately. Comparisons here with that cycle are certainly not to advocate that India should be repeating any of that. However, the comparison does serve to underscore just how limited space is both from the standpoint of the government and the banks. This is especially true as global policy space is also limited. The following conclusions are in order, in our view:
1. One shouldn’t look for a V or U shaped recovery out of the current slowdown. Both global and local policy space is much more limited and the marginal utility of incremental monetary easing has diminished globally. Also, large policy movers like China seem to be more nuanced in response this time around.
2. India has no incremental fiscal space when one compares effective deficit with the savings pool available to finance it. Minor tinkering on the margin will make no real impact to the growth narrative but will constantly keep our fiscal intentions in doubt. Notably the issue is not of ideology but of hard numbers. Rather than continually pushing at this string, we should think about bettering this adverse ratio of deficit to savings (large scale asset monetization and rule based offshore placement of sovereign bonds).
3. Transmission is impaired owing to both higher credit spreads and higher term spreads. The former is a function of balance sheet impairments and the latter of the adverse deficit to savings ratio. Both these are slow moving and corrections have to happen over a period of time, if left to happen naturally. Policy can decide to intervene selectively and depending upon where the space available is the most. To us, the RBI can easily play a role in compressing term spreads via stepping in with quantum purchases of government bonds. The macro justification for this could be an intent to step up reserve money creation to compensate for a diminished money multiplier. Critics calling this backdoor monetisaton will probably need to rest their high horses for now since if there is an inflationary impact of this exercise, then it is a welcome outcome in the near term. Further, RBI can have a private understanding with the government against incremental fiscal activism against this bond-buying. Finally, RBI should redraft their inflation objective from 4% to 2 – 6% and say that so long as one year expected average inflation falls within the range, focus of policy will be conclusively on growth. Indeed, this redrafting will provide the necessary policy framework to then step up money creation via bond purchases.
4. A conceptual fallacy, in our view, that we often find in arguments today is the failure to differentiate a ‘necessary’ condition from a ‘necessary and sufficient condition’. Thus when we earlier used to argue for a positive liquidity stance from RBI, the counter was whether this will fix lending to perception hit borrowers. The above recommendation may be met with a similar view as well, or with an arbitrary universal classification of the problem being a demand rather than a supply side one and so on. The clear answer is that this will not solve everything. However, so long as there exists a somewhat normal shaped demand curve for at least a segment of borrowers, a 75 – 100 bps fall in lending rates backed by actual collapse in term spreads can probably loosen some demand in the system. Addressing the elevated credit spread embedded in lending rates is probably the trickier aspect and may only come back over a period of time with more stable asset quality perceptions.
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