Worries only on policy front

Based on the experiences from the past, global economic developments were always going to be important in shaping the future of policy formulation in the country. The guess of late was however restricted more to the Federal Reserve and its stance on interest rates. However, the dynamics have changed in the last couple of weeks on two fronts. The first is the devaluation of the Yuan by China which came unexpectedly, followed by the shakeout in the stock market which has had reverberations across all global markets. Both of them indicate an expected palpable slowdown in the Chinese economy. What does this mean for us?

The most important factor that would guide the future is the permanency of what is happening around us. Will the Yuan depreciate further or will it stabilise? Will the Chinese economy continue moving downwards or will growth stabilise soon? There are evidently no easy answers here as the stock market crash came just after the devaluation. In fact China has followed it up by cutting interest rates too which means that the government does recognize that the economy is slipping and that it would work on all fronts to restore growth through export advantage and domestic demand.

To answer the questions put forth earlier, the currency decline could be considered to be more transient as the Yuan has been around 6.40 to a dollar which was the expected target rate to begin with. However the lower growth puzzle for the country will be deeper and it will take time to reverse the same. It may be expected that the 7 plus growth rate would take between one and two years to achieve on a sustained basis.

A Chinese slowdown is negative for all countries which have strong trade relations with the nation as imports will slow down thus affecting exports of countries especially in Latin America and East Asia which are dependent on this market. At the same time low growth in China will affect its own imports and demand for commodities and the cycle will remain in the downward direction for another year for sure. China is the largest consumer of metals and the declining prices have affected the profitability of all companies across the worlds which have confronted declining incomes. India has not been immune to this phenomenon.

Putting these facts together, the feeling one gets is that the Chinese slowdown will retard growth in the world economy especially in export oriented countries and given that other regions are tied to growth in this geography or have their own problems like the Euro region, all eyes will be on the US to be the engine to growth and hence the Fed to take a call on interest rates. The picture today is positive though there are few signs to show any kind of acceleration is in place.

India is relatively a more domestic oriented economy where growth emanates from within the country and exports are more of a secondary support. However, the economy will not be insulated as it will get affected in two ways. The first is the exchange rate route where the rupee has also been falling continuously to new lows. The second is the interest rate action of the Fed will also have a bearing on RBI’s decision on interest rates.

The rupee depreciation this time is different from the 2013 episode as the earlier one was based on the combination of an external shock and weak fundamentals. This time, the balance of payments looks robust and the only shock is external. Ironically there are limited policy options for the RBI which will have to think of direct intervention to bring about any correction. The fact that we have reserves of $ 355 billion is a comfort here.   Therefore a lot will depend on the stance taken by the central bank and its level of comfort. More importantly the RBI will be observing if the current round of depreciation in the rupee is temporary or of a permanent nature. Also given that there has been a call by the market to allow the rupee to depreciate before this event took place, the central bank may probably be comfortable with the present turn of events.

But from the monetary policy standpoint, the rupee depreciation and volatility may not be too satisfactory. It has been agreed that the RBI will target inflation, but a weak rupee will have a tendency to increase imported inflation which will become a monetary concern. Presently inflation is low and the concern is only the kharif crop. With the rupee falling by almost 5% in the last month, there will be some upward pressure on prices. At another level, with the rupee being where it is, the RBI may have a strong reason not to touch interest rates at this point because the window for FPI in debt should be kept open at a time when the trade balance is already shaky and the rupee weakening.

In fact there is a strong reason for the Fed to defer its rate hike as it would be keen to ensure that US does not lose its export competitive edge by letting the Yuan fall. With inflation being marginally positive and its own target at 2 per cent, the US is far from an inflationary situation to warrant a rate hike. This can be another factor supporting a deferment of rate cut by the RBI.

To conclude it can be said that the Chinese devaluation and stock market crash has had repercussions on these two markets all over the world. India has not escaped this contagion as these two markets are well interconnected globally given the preponderance of foreign investors in the stock markets and the rupee being linked to the dollar. Therefore, adjustments by the central bank are inescapable. The comfort however lies in the fact that the economy is growing positively and is more dependent on domestic demand. In fact growth in exports is in the negative territory and yet, GDP growth looks quite positive. Hence while we would be concerned on these developments from the policy standpoint, we can feel somewhat reassured on growth and employment to a large extent.

(Author is chief economist, CARE Ratings. Views are personal.)