The Next Surge

Sajjid Z Chinoy is Chief India Economist at JP Morgan. All views are personal
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A fine balance between creativity and caution

ONE MONTH INTO the year, it is now a truism that 2017 is going to be a roller-coaster ride for emerging markets. Not just because the United States’ Federal Reserve is expected to continue raising interest rates this year. Yes, that will inevitably tighten financial conditions around the world and likely induce more capital outflows from emerging markets. But ordinarily, that by itself should not be a cause of concern. That’s because—barring a negative supply shock like a surge in oil prices that pushes up inflation and forces the Fed to tighten—interest rate increases in the US would be the clearest admission yet that growth remains on solid footing there. Stronger growth in the US—in conjunction with positive growth surprises in Europe and Japan—should typically have a salutary effect on exports from emerging markets and therefore boost growth around the world. A rising tide should lift all boats, right?

Except, this time, it may not. One of the most documented phenomena of late has been that global trade, which powered growth in the 1990s and 2000s, has slowed sharply in recent years. Yet, as well documented as this phenomenon is, we don’t quite know what’s behind it. In all likelihood, it’s a confluence of factors: the fact that ageing populations have moved away from consuming goods to services that are less import intensive, the fact that capital expenditure (which is more import intensive) has been sluggish in advanced economies, and the fact that some commodity exporting emerging markets—which came under significant pressure when commodity prices collapsed from 2014 onwards—had to disproportionately slash capital expenditure and therefore imports. Whatever be the cause, the outcome is that it effectively breaks the umbilical cord between developed markets and emerging markets. Indeed, a percentage point of stronger growth in developed markets (DM) has a much lower impact on emerging market (EM) growth than it did in the pre-Lehman era.

This, of course, should not be a surprise because it has been playing out for some years. What’s different in 2017 is that the increased threat of protectionism from advanced economies is likely to accentuate this ‘de-globalisation’. Think of the Border Adjustment Tax that has been proposed in the United States, for example. This is tantamount to an import tariff and an export subsidy for firms based in the United States, and, if implemented, is likely to make exports from other countries more expensive and thereby put downward pressure on their currencies, creating its own set of macroeconomic challenges.

Therein lies the nub of the problem: the unprecedented monetary support in the US has already taken the economy close to full employment. If that is now compounded by a Trump fiscal stimulus, US growth is likely to be pushed above potential. This, in turn, is likely to push up wages and price inflation and elicit a faster pace of tightening by the Fed. The financial market spillover to the rest of the world is likely to be swift. Forward-looking yield curves in the United States and the rest of the world have already priced in a tightening of monetary conditions around the world. In turn, higher interest rates in emerging markets could depress growth on the demand side and interfere with much-needed deleveraging— the lowering of debt burdens—on the supply side. So while all this represents the ‘cost’ of US rates going up, the commensurate ‘benefit’ through higher exports is unlikely to materialise if protectionism rises in tandem with growth. No wonder then that emerging markets will have to brace for a turbulent 2017.

One of the most documented phenomena has been that global trade, which powered growth in the 1990s and 2000s, has slowed sharply in recent years. Yet, we don’t quite know what’s behind it

So what are the implications for emerging markets and Indian policymakers? First, don’t trade off macro-stability for growth in this global environment. In the case of India, that means don’t overreact to any growth slowdown by over stimulating monetary or fiscal policy. Think back to the Lehman crisis. Worried about the repercussions to growth, fiscal and monetary policy was relaxed dramatically and in tandem. That was perhaps understandable because of the quantum of uncertainty at the time. But what was harder to fathom was why the fiscal stimulus took so long to be rolled back, for instance. By end-March 2012, more than three years after the Lehman crisis, the Centre’s fiscal deficit, at 5.9 per cent of GDP, was still more than twice the level before the global financial crisis.

What all this did was put pressure on external imbalances. The current account deficit surged, in part because of higher oil prices, because negative real rates increased the demand for gold imports, policy bottlenecks increased the need for imported coal, but also because stimulative fiscal and monetary policy boosted non-oil, non-gold imports. As a consequence, the current account deficit had surged to an unsustainable $88 billion dollars or 4.8 per cent of GDP by 2012-13 from 2.7 per cent of GDP in 2010-11. With a third of that ($27 billion) being financed by portfolio inflows—which was inevitable given the total quantum that had to be financed externally— it was an accident waiting to happen.

The accident did happen in the summer of 2013 at the first hint that the Fed’s asset purchases would be tapered later that year. The resulting ‘taper tantrum’ meant that there was a ‘sudden stop’ of capital flows to emerging markets, and India’s macroeconomic vulnerabilities came to the fore. The resulting pressure on the balance of payments meant that the rupee was easily the worst performing currency in the emerging market universe. All this was less than four years ago.

Much water has passed under the bridge since then. Indian policymakers deserve to be complimented for restoring macro stability. Successive governments have chipped away at the central fiscal deficit, and the current Government and RBI deserve kudos for institutionalising a new monetary policy framework, which will ensure than never again will Indian households have to endure six years of double-digit Consumer Price Index inflation. The global perception has therefore been turned on its head: India is now seen as a relative ‘safe haven’ in the emerging market universe.

As the French economist Jean-Baptiste Say once said, supply creates its own demand. If Indian policymakers double down on infrastructure creation, it will generate demand of its own, while addressing a key bottleneck in the economy and improving productivity. This must be the policy antidote to trade pessimism

However, policy resolve will be tested if growth continues to stay under pressure. The demand-shock from demonetisation is expected to be temporary and one that policymakers need to look through. And, if growth slows more organically—as was the case even before the decision of 8th November last year—we must accept the new reality that potential growth around the world has fallen meaningfully, and India may not be able to completely buck that trend. Over-reaching with a monetary/fiscal stimulus is simply likely to cause output gaps to close more quickly, and to spill over into a larger current account deficit. The collapse in oil and commodities—and generally tepid growth—has meant that the current account deficit has narrowed sharply to less than 1 per cent of GDP in 2016-17. But with oil prices likely to average $55 in 2017-18, commodities firming up, and exports likely to be under pressure if the long shadow of protectionism casts itself, the current account deficit could inevitably widen. Over-stimulating growth—that spills over into higher imports—will simply increase the pressure precisely when portfolio flows are likely to take a hit. In the last three months, for example, India has witnessed $10 billion of outflows. We are nowhere near the vulnerabilities of 2013, but we’ve all seen this movie before. And we know how it ends. So policy must be even more careful to ensure external imbalances stay contained in this global environment. The broader lesson: don’t trade off macro stability for growth.

The second implication is that, in this global environment, we have to start looking for other sources of growth. The inconvenient truth is that much of India’s growth in the decade of the 2000s was on the back of surging global trade. Between 2003 to 2008, GDP growth averaged 8.8 per cent, but this was on the back of exports growing at a scorching pace of 17.8 per cent in those years.

In the last few years, however, for the reasons laid out above, export growth has slowed to a miserly 1.4 per cent. So if we cannot bank on external demand driving exports and investment, we must look for other ways to perk up the economy. The obvious driver is infrastructure, both physical and human. This entails at least three parts. First, we need to significantly ramp up public investment in the Budget—and pay for it through disinvestment—thereby effectively engineering an asset swap on the Government’s balance sheet. But public investment is not just about the finances. We need to increase and improve state capacity to spend the resources. Second, policymakers must continue chipping away at reducing implementation bottlenecks (example: land acquisition) on the ground and quickly operationalise the bankruptcy law, so as to improve project viability, reduce the balance sheet stress in the infrastructure sector and improve the demand side of credit. Third, we need to continue cleaning up and re-capitalising our banks—and broadening available sources of finance—to work on the supply side of credit.

Only a combination of these policies will ensure that any public investment has correspondingly higher multipliers and jump-starts private infrastructure investment. Remember, as the French economist Jean-Baptiste Say once said, supply creates its own demand. If Indian policymakers double down on infrastructure creation, it will generate demand of its own, while simultaneously addressing a key bottleneck in the economy and improving productivity. Just think back to what the golden quadrilateral or rural infrastructure did to boosting asset prices, rural and urban, and, most of all, firm productivity and competitiveness. This must be the policy antidote to trade pessimism.

As the fast moving events in the global economy in recent months have demonstrated, we live in dangerous times. This requires both caution and creativity from policymakers in emerging markets.