Indian Economy 2011 Overview: Challenges For The Global Economy Surfaced After Recent Sovereign Debt Crisis.

Everyday is bringing the new challenges to the global economy and this time around, the massive public debt of a country is creating a three-ring circus on the streets and the possibility of disagreement over debt ceiling in the United States could set off the fresh concerns of the global economic recession – VMW Research Team brings you the latest update on the global economy and would address all your concerns related to the Indian economy in particular.

 

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Global Economy in Brief – Consternation of Sovereign Debt!

Once again, the default on debt repayment haunting the economies around the world after the tragic incident in Argentina in the early 2000s, when hyperinflation undermined the Argentine’s export competitiveness and triggered the chronic deficit in current account of the Balance of Payment (BoP). The 1998 Asian Financial Crisis also played a greater role in Argentine’s hyperinflation and bank run, which ultimately led to default in debt’s payment, as the major chunk of current account deficit financed by borrowings, that gradually dragged the economy in 4-year of depression. Greece is the latest case of a defaulter in debt repayment and subsequent to this, Standard & Poor’s or S&P has downgraded Greece’s debt to CCC rating (Junk or extremely high risk), the lowest in the world. Greece is not the only country in Europe to get support from the EU and the IMF. Iceland and Portugal have already bailed-out. It is expected that the other European countries might be getting snared into the sovereign debt crisis such as Italy, Spain and Russia. Why such type of instances unfolding after two years of the global economic recovery? Greece was one of the fastest growing economies in the region with expanding areas like tourism, port infrastructure and transportation. Robust economic growth and lower interest rates put the Greece’s economy on structural weaknesses as the country borrowed exceptional amount of money and hid the exact borrowing numbers. Subsequent to the economic crisis in 2008, countries like Greece, Spain, Ireland, Poland  are having a slower economic growth, lower foreign investment inflows and tremendous amount of overspending (fiscal deficit). Such kind of problems has a material impact on an economy, and these countries will take several years to recover their credibility. Another nerve-racking concern is that the creditors of these countries are mostly foreign holders and this is making a panic situation to overcome from this crisis. Is the European Union going to be transformed with all these dire economic developments at the time when the economy like Greece and Portugal have implemented an austerity plans to cut down on their annual spending?

 

Economic circumstances of the United States is somewhat, but not completely due to economic structure and positioning, similar to the European economy having the forebode public debt estimates, even assumed double the size of the US economy by year 2035. This is something, which cannot be accounted for the current-year’s economic outlook as yet. Now, let’s discuss the US’ military operations, since the largest spending after healthcare is “Defense”. According to the US Department of Defense or DOD, War in Afghanistan costs the United States about $6.5 billion a month, increased by 50% from year 2010 (about $4.4 billion) while the cost of war in Iraq is about $7.9 billion a month but seeing a reduction in spending followed by the contraction of boots number on the ground. So far, since the US invasion in Iraq and Afghanistan after the 9/11, US spent more than $1.414 trillion. The positive point is, after the reduction of boots in Iraq, the US’ spending has been reduced to half of the total spending in FY09 owing to the withdrawal of the large amount of troops from the country. Now the United States has started an exercise to reduce the number of troops in Afghanistan, which could make a positive development for the US economy going forward as the country can curb its swelling deficit over the years. Thus, the US President’s ambitious plan to cut overspending by FY15 will be feasible. However, the VMW is not certain about the cut in fiscal deficit as the economic output in the subsequent years  is also expected to remain under pressure and the revenue side of the US budget would not increase. According to the report of Congressional Budget Office (CBO), there is a wide gap of revenue between the baseline projection of CBO and the US President’s budget. This could boost the fiscal deficit and rise in interest cost for the government. The recent debate on the US debt ceiling has unearthed the risk of US economic growth and questions the capability to meet the obligation. In early 2009, VMW had posted an update on Twitter, quoted as “US have to prove its solvency followed by massive government’s support to the banking sector by spending trillions of dollars of taxpayers’ money.” The debt crisis in the EU region and the United States could reverberate across the world, since this could lead to fresh inefficiency of the banking system after normalization. All-embracing, the United States has to make an economic friendly defense and healthcare spending policies to reduce the ratio of public debt to the GDP and combat the expected rise in interest cost to alleviate the risk of prolonged stagnant economic development and sovereign debt crisis.

  

Japan’s economy after the earthquake disaster continues to see downward pressure due to supply side effect, lowering the production. Although, after four months, the Japan’s economy has shown some sign of picking-up as the production and domestic demand is improving. The consumer prices have also changed slightly positive. VMW has analyzed that the Japanese economy could gain some momentum going forward amid high uncertainty in the other industrialized economies since it is an exporting economy. In the meanwhile, Japan is currently working out to impede the greater  downside risk to the economy followed by series of disaster ranging from the leak of nuclear radioactive material to reconstruction in order to restore supply chain. The immediate step of the Japanese central bank was to add liquidity in the banking system to keep up the short-term requirements faced by the tragic incident.

 

 

Economy of India

 

High Inflation – “Temporary But Unsustainable”

Most important area of this VMW research. Let’s start with “inflation”. Is inflation really going to indent the economy and undermine the real economic growth? Per our empirical findings, inflation is expected to peak between 10-percent and 11-per cent and would fall down to 5.5 per cent in the second-half of FY2013. Why? VMW believes that the good monsoon rains this year, persevering high interest rates  amid tighter monetary policy, stable crude oil prices throughout the fiscal and controlled global food prices amid high volatility could be the reason of falling inflation back to 6.0 per cent. Look at the inflation chart. VMW Research Team has worked on the inflation to build this chart, which shows that the inflation is expected to peak-out at nearly 11.00 per cent and will come down to 6.0 per cent by the second half of fiscal year 2013. However, interest rates are expected to remain high to support the sustainable and materialistic economic growth with consistent risk of high inflation as the higher economic growth means an uncomfortable inflation rate (mildly higher than the RBI’s comfort zone viz 5.0 percent). It is apparent that the Reserve Bank of India will continue to monitor the supply side effect on the economy, which could keep the inflation rate at the attentive level even after falling back to 6-per cent.

 

 

After a series of measures to curb the overspending by the federal government, the recent price hike in petroleum products will spur the price rise, to some extent, which is to be limited for certain months. This could be the possible reason of a double-digit inflation rate which the VMW is expecting in the Indian economy. To elaborate the inflation issue further, we need to discuss the most important factor such as oil prices and food prices. Although, VMW is not seeing any immediate appreciation in oil prices due to bleak economic output, intervention of the west and the International Energy Agency (IEA) in oil markets. But the risk remains owing to the arab spring and instability in the northern parts of Africa. As per the IEA report, the economic growth engines – China and India will drive the global energy demand higher. What matters the most is the policy implementation of the respective governments since crude oil is predominantly the largest imported product for the economy like India, and it is unclear, by when the oil production will peak? The latest shock to the energy sector was given by Japan’s nuclear disaster followed by earthquake and tsunami, questions the safety of nuclear energy and reducing the demand, which just accounts for 6% of the total energy consumption. However, contrary to our assumption, the IEA believes that the nuclear energy will account for 8% of the total energy demand by 2035, which is still much lesser and slower in terms of growth due to safety and security concerns. Government has to act and respond to the oil consumption and the growing cost of supply by improving the viability of the alternates to the oil. It could ease the demand for the oil, and we can see the peak of output even before 2020.

 

After discussing  the future of crude oil price and demand, there is another phobia, which needs attention, viz Food Prices. According to the available data, wheat production is not impressive due to continuous dryness in EU-27 nations including Germany, France and the UK. But the lower consumption is Russia would yield the wheat exports higher and offsets the EU-27 and Canada decline in trade. Interestingly, Pakistan this year has a surplus amount of wheat output and plans to export 0.3 million tons, for which Bangladesh is an immediate consumer. On the other side, Rice production has largely been affected by bad weather in the United States, China, Cuba and many other nations in the western hemisphere dragging down the projection of rice production. However, projections for Egypt and Guyana have been raised. Many other commodities like oilseeds, corn and wheat are witnessing the downward pressure in the Ending Stocks threatening the volatility in global food prices. Combining all the factors, food prices is expected to remain volatile since market drivers are pointing towards the instability in production and ending stocks, as the major crop producing nations are facing the bad weather, which imbalances the global production under higher costs.

 

 

Core Economic Developments

 

 

In the last two years, India’s public debt has been limited to a range of 75 percent to 80 per cent of the total economy and the annual growth in public debt has also come down to below 10.0 per cent. To discuss the issue of public debt, VMW has gone through the 11th five-year plan, a document which is a facet of the government’s action plan. Perhaps, none of the five-year plans have been accomplished so far and this time around the government is still not able to meet the infrastructure goal due to funding deficit. According to the Planning commission, 8.37 per cent of the total GDP is supposed to be invested in the infrastructure development. However, the government has proposed to invest only 4.0 per cent of the total GDP. Based on these assumptions, the government borrowing is expected to continue to rise amid shortfall of investments in the required sectors of the economy. Apparently, the infrastructure in India is a bottleneck to the economic growth and the local firms are not able to realize the economy of scale.

 

 

If we talk about the physical infrastructure, in particular, about 95 per cent of the total traffic generated through railways and road. In contrast, several parts of the country are still not connected even by road. Nevertheless, the situation of a road getting deteriorated even in those cities and villages which are connected by road due to short funding to maintain the condition. Most of the government’s efforts are going futile because of the shortage of funds with the highway authorities and local state bodies such as municipal. Furthermore, several states are facing the supply-side constraint such as the absence of fair deal and federal law to acquire land for highways, expressways and road transportation. In addition to this, inadequate institutional capacities, shortage of a raw material due to poor connectivity in areas such as North-East states of India. The institutional implementation is necessary and for that, the adequate funding assistance from the Central Government is important. VMW-RT analyzed that, going forward, to meet the targets of the five-year plan and to sustain our ambition of expanding the economy with structural growth – government is in desperate need to continue with its plan to borrow money. Thereby, the fiscal deficit is an important indicator to watch-out for in the next couple fiscal years. In the figure given below, VMW has discussed the federal government’s finances and where the government does spend the taxpayers’ money.

 

 

 

Although, we have projected the higher growth on the spending side and government’s borrowing plan. The revenue side is not expected to outpace as fast as the expenditure is growing since the direct tax income to the government will see a moderate growth and the non-tax revenue this time around is likely to be marginal, which could make a significant gap in income and expenditures. Although, the Indian government is taking measures to cut down it spending on subsidy, however the subsidy part accounts for 12.0 per cent of the total expenditures and the major pie of the government’s revenue goes to the planned expenditures. What is plan expenditures? Of course, the recommendation of spending by the Planning Commission of India – which is absolutely required. On the other side, the “Interest” cost burden on the government is also rising with a significant portion of the expenditures is going in the payment of interest on the outstanding debt. Since, we have projected the rising government borrowings; the interest payment burden on the government is also expected to rise, which could undermine the government spending in planned expenditures. To offset the fiscal imbalances, government should oversee the non-plan expenditures carefully such as the interest payments, transfers to the Federal State governments and the Union Territories, Subsidy and Defense. The federal government has already started the exercise by gradually reducing the subsidy burden. However, it would not make a significant difference in the government’s balance sheet and the proper management of the “other government expenses” is necessary. Above all, the inflationary pressure must be subdued to balance all the finances and to contain the rise in cost of funds in the country.

 

On the monetary side, by taking certain inputs from one of our earlier research done on the RBI’s monetary policy dated back in May, 2011. We have projected that the interest rates will remain moderately high for the next couple of fiscal years to freeze the wild rise in prices. To counter the rising inflation, Reserve Bank of India has  revised its policy rates for more than 10 times in the last 14 months and its stance on the Monetary Policy is somewhat having a mute effect on the commercial bank’s lending power. Banks are not expedite in responding to the RBI’s increase in policy rates and credit growth is quite high, fairly above the baseline projections of RBI to meet the economic needs due to accommodative financial environment and solid inflows into the country.

By concluding our analysis on the Indian Economy and the Global Economy, the slower growth in global economic expansion is temporary – due to policy action by the central banks around the world by raising interest rates and subdued commodity prices. India, in particular, the economic output is expected to see some sluggishness due to inflationary effect on raw material and expected slowdown in demand-side due to higher cost of credit. However, balancing the government finances by cutting down on unnecessary spending and focus on the planned expenditures to improve physical infrastructure in the country so that the long-term foreign inflows could be sustainable to finance the current account deficit will make a greater positive impact on the Indian economy over the long-term.

 

© Copyright 2011 VMW, a division of UNIDOW Financial Intelligence Services, unless otherwise noted. This data/information may only be used internally for classroom/business purposes and shall not be used for any unlawful or unauthorized purposes. Dissemination, distribution or reproduction of this data/information in any form is strictly prohibited except with prior written permission from the VMW. Please contact VMW Blog! at sift@unidow.com for any licensing issue.

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