Parts Of India’s Economic Slowdown Are ‘Transient & Idiosyncratic’, Says JPMorgan’s Sajjid Chinoy

The recent batch of the data has been very soft. You be alluded to the Purchasing Managers’ Index in the last couple of months, softening meaningfully. Auto sales have been weak for several months now. IIP numbers have been a little bit soft. But it’s simplistic to say that India is in the midst of a broad-based slowing, because a lot of this is on the account of both transient and idiosyncratic factors.

We know, for example, in the auto market, the emission norms have had some impact. The shock from the non-banking financial sector late last year is feeling its way through the system. It is also that global uncertainty keeps rearing its ugly head. The third risk, as we saw in the last month PMI, as we get close to any election around the world, political uncertainty increases and investment decisions are typically postponed till those political uncertainties are resolved. You are seeing a combination of those factors—the elections are coming up in a couple of months, the global uncertainty is reappearing from time to time, and the aftereffects of the NBFC retrenching.

And also, let’s not forget the fact that the terms of the trade have moved so adversely against agriculture. Food inflation this year has been less than a percent—last year, it was less than a percent. And the core inflation has been at 5 percent, which hurts the purchasing power of the rural economy.

Undoubtedly, there are some headwinds and drags here, but if you take a more forward-looking perspective, over the next three to four quarters it’s not all gloom and doom. The elections will come and go and, hopefully, once that uncertainty is resolved, you will see some pick-up in the investments in the next four to six quarters because two things are happening. One is capacity utilisation in India today is the highest in six years. Second, despite the fact that the NBFC growth has slowed, you see bank credit growth pick up very sharply. It’s running at 13 percent year-over-year for the last 12 months.

The Reserve Bank of India’s Monetary Policy Report, a few weeks ago, had said that the total flow of funds in 2018-19, adding up bank and NBFC lending, was actually higher than the year before. The fact is that the deleveraging process has moved on and much more can be done, but also that the utilisation rates are picking up. The banks lending again does augur well for some investments in four to six quarters down the line.

Globally, there have been some event risks around Iran, and particularly around the U.S.-China trade war. But if you strip that out, the underlying fundamentals are still very good. Especially in the U.S., the labour market is doing very well, financial conditions in the U.S. and in the rest of the world have eased, Europe has had some positive data flow in the last few weeks and China’s stimulus is clearly kicking in. So, we are going through a soft patch currently. Some of these are idiosyncratic like the auto market, but some of these may be transient like politics. If you take a three- to four-quarter view, then the growth is not as weak as it is feared.

The one area that we need to address more systematically is the NBFC sector and some more structural solutions are required in that area. Asset quality review is at some point post-elections desperately needed, because every time there is a large repayment that is due in the next few months, you will have these uncertainties again.

Over the last two to three years, it was only urban consumption that was driving overall consumption. Apart from the fact that the government consumption growth has also been quite strong in the last two to three years—and it’s been a tailwind towards the growth—it was largely urban consumption that was driving consumption. This was manifested in the fact that the NBFC growth—whether it’s in auto, the housing market which was growing very rapidly, or even banks lending quite strongly to personal households. So, it was urban consumption that was leading consumption growth.

Rural consumption was soft precisely because there has been some agrarian distress. The terms of trade have moved against agriculture and rural real wages have softened. If you look closely at month-on-month seasonally-adjusted real rural wage data in the last four to five months, there is good news. It seems that deceleration stopped, and things have bottomed out and there is some modest acceleration in sequential wages.

Post elections, it will become almost inevitable for the next government to deliver on some of these promises. The current government has promised the cash transfer of Pradhan Mantri Kisan Samman Nidhi and that will play out incoming quarters. Opposition parties have promised even more expansive transfers. So political economy of the rural India won’t allow the rural economy to be in distress for another one or two years. So, our sense is that in next few quarters there will be enough support for the rural consumption to pick up a little bit sharply.

Urban consumption has slowed because of some slowdown in the NBFC growth and idiosyncratic issues related to auto emissions, because there are multiplier effects from it. Core inflation has been running around 5.5 percent for the last 12 months which is a much bigger fraction of the urban consumption basket than the rural consumption basket; it therefore hurts the purchasing power. So there have been a number of drivers that are causing urban consumption to slow.

It won’t be surprising, especially since NBFC resolution takes some time to play out. A year from now it will be the rural economy which will be supporting consumption more than the urban, and these lines would be eventually crossed.

I am really puzzled by the phenomenon that there is no liquidity. First, currency in circulation has gone down as the percent of Gross Domestic Product, that has hurt cash transactions. But that has been rising every quarter as a share of GDP rising, until the existing quarter it’s back up to 11.4 percent of the GDP. It used to be 11.8 percent before demonetisation. So the rate of growth of the currency in circulation has exceeded the normal GDP growth from the last two years comfortably. The rate of growth has slowed down, but we expect that after demonetisation got over and after the fact that when the GST was introduced, there were some transactions being conducted in cash to evade the GST. Once those effects are normalised, you expect this to be slow.

Core liquidity was tight a few months ago. The RBI made a concerted effort to bring that down. Core liquidity is now in surplus and we expect the headline may also head to surplus in the coming months, as the government starts spending post elections. Some people have alluded to M3 [money supply] to GDP going down in the last few years, where from 85 percent it has gone to 80 percent. This should not be a surprise. M3 is going down because credit growth has been weak in the last few years, which is an inevitable consequences of deleveraging. When any emerging market undergoes a deleveraging process of its banking system, M3 to GDP is bound to go down. New information is that over the last six to eight months, credit growth is now at 13 percent to 14 percent and as the RBI believes that total flow of funds of banks and NBFC’S has actually accelerated over last year. I would expect in coming quarters M3 to GDP to also start rising again.

The elephant in the room is the NBFC sector.  Are there more systemic issues with it? Will an AQR be done? If an AQR results in question marks about underline asset quality, will there be some kind of deleveraging in the NBFC sector? We have to take that risk because, as we learned from the banking system, the more you push that out, the more you become subject to what is happening currently. This is asymmetric information—because you cannot separate the good apples from the bad apples, you stop lending to everybody. So, that is one risk in terms of M3. Otherwise, I am hard pressed to figure out the argument that there is no liquidity in the market.

The reason credit growth was down was not because the public sector banks have no liquidity. It was because they had serious issues on asset quality on non-performing asset resolution. We have seen in the last couple of years that as a resolution process has started and begun to work its way out, and as those banks have been recapitalised by the government, credit growth has picked up quite meaningfully.

If this continues, there are two to three implications that flow from this. One is that most of the capital to public sector banks is resolution capital and so they will be unable to sustain this rate of growth without more infusion of capital. Second, incremental credit deposit ratios have gone up for these banks and that is hurting monetary transmissions. There are implications for monetary policy as well. For example, if you were to cut interest rates much more and credit growth picks up even further, then that is unlikely to transmit because banks will be more disinclined to cut deposit rates at that time. The third implication is that we need to know very carefully what we want. It’s very well to say that let banks start lending again, especially those banks which graduated from prompt corrective action, but what we don’t want is the repeat of what happened 10 years ago. Governance structures have to improve commensurately, so that three years down the line, we don’t start with another NPA problem. So I think, we should not be too eager to push up credit growth or M3. It has to be a more organic process.

Some things need to be done. One is to recapitalise public sector banks when they need to. Second is the government structures need to be improved. We need to be careful about how much monitory easing is feasible and viable at a time credit growth is picking up, incremental credit deposit ratios are high and we may have an investment-savings gap in the economy at some point of time.

It is a combination of both these factors. You had idiosyncratic episodes and you have got large redemptions in the last few months. I don’t want to draw a parallel here. But if you go back to the 2008 in financial crisis, what happened then was the low-end, sub-prime mortgages were a very small fraction of total outstanding mortgages. That’s why regulators were not worried so much. Once you have a confidence crisis or there’s any kind of panic, then just the word mortgage was enough for everybody to ration out.

In the NBFC sector, they may be a few bad apples. But because investors and mutual funds are unable to determine the good apples from the bad apples, they have a lot of risk aversion and everybody gets rationed out.

We need to go back to the first principle—post-elections, there has to be systematic asset quality review. It needs some stress test. Confidence has to return in that market so that those NBFCs which have sound portfolios, don’t have much leverage, are exposed largely to retail more than wholesale, and don’t have developer exposure are not rationed out. Some of the best names are receiving liquidity. It is the second tier that may have sound portfolios, but is unable to signal that, and is not receiving that liquidity.

We need to be careful about what NBFCs are borrowing from abroad. Forward premium came down after the buy-sell swaps. We need to ensure that there is enough potential here, so that whatever borrowing happens from abroad is hedged. Lots of NBFCs who don’t have dollar revenue streams are suddenly having dollar liabilities, which are not hedged. That will be not good from the macro prudential perspective.

This is manifested in how steep the yield curve is. The overnight policy rate is running at 6 percent now. There are some expectations in some parts of the market that there could be more easing to come and yet the 10-year bond yield is 7.5 percent. There is a very steep yield curve.

The fiscal overhang, whether it is borrowed by state governments or central governments or public sector undertakings. Everyone is drawing from the same pool of households financial savings. It is reflecting in the investment-savings gap that total public sector borrowings is close to 9 percent of GDP. Household financial savings is close 7 to 8 percent of the GDP and there is pressure at the long end. The biggest risk for investment recovery four quarters from now is going to be how this will be financed. Either a pick-up in investments will result in higher interest rates at the long end and, therefore, some crowding out or domestic investments have to be financed from foreign savings and commensurately larger current account deficit, which could be worrying because it exposes us and makes us hostage to a global shock.

The priority of new government in July will have to be political stability. There would be too much pressure on the July budget to go back and ensure that the revenue assumptions for the next year are more credible. We were worried about the February budget that the revenue assumptions for the remaining months of 2018-19 were aggressive, as they are for the next year. This will involve tightening GST compliance. It needs to entail tax rate increases and discipline on the expenditure side. It is very important for the new government to stick to the fiscal path, deliver what was promised in February in a credible way. Even if you end up meeting that number in March, the uncertainty or whether you will meet it or not starts from September and risk premium gets priced into government bond yields in six months. It is very important for the the July budget to have very credible revenue targets and have a discipline on the expenditure side.

Perhaps, we had a positive fiscal impulse in 2018-19. With consolidated deficit of 6.5 percent of the GDP and public sector borrowings requirement close to 9 percent of the GDP. There is no scope for positive fiscal impulse going forward. We are now at a point where enough work has been done and underpinnings of a private investment cycle is emerging. You are seeing utilisation rates go up. You are seeing banks lending again. If global growth holds up this year, we will see a private investment cycle for six quarters down the line.

The best thing the government can do to enable that cycle is to retreat a little bit and create fiscal and financial space that will be needed to finance that cycle. If the government were to again try and drive growth over the next year, then we run the risk of prematurely extinguishing the cycle. We need strong, sustained and job-creating growth. The sustained part can happen if it is led by a private investment cycle. The job-creating path happens when along with a capital-expenditure cycle, when the government consciously works to make labour a more attractive part of the production function. We have seen capital intensity in India over the last two to three decades, which is worrying as it hurts job creation in a labour-abundant economy.