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Silver Linings in 2012

Though there is a lot of ground for pessimism about the economy’s prospects in 2012, a closer look reveals a few silver linings

As 2011 draws to a close, the economic outlook appears gloomy. Growth is slowing down: with luck the economy may clock a growth rate of 7 per cent in FY12, quite a comedown from the 8.5 per cent rate notched up in FY11. Manufacturing has been badly hit, as the lIP (index of industrial production) figure of -5.1 per cent for October brought home starkly. Private investment has been on the decline ever since the 2008 crisis. Now private consumption too is faltering, owing to high inflation (that reduces purchasing power), high interest rates, and a weak job market in urban areas. Government spending, the mainstay of GDP growth since the credit crisis, is also bound to decline in future, since the government’s revenues have taken a knocking amid slowing growth. Moreover, it will perforce have to curtail spending in order to rein in its fiscal deficit. Against such a backdrop, to get dispirited about the economy’s prospects would be natural. However, a closer look reveals a few silver linings.

High inflation has been the economy’s biggest bugbear for the last two years (last 21-month WPI average: 9.7 per cent). But December onwards inflation is expected to begin softening. The Reserve Bank of India (RBI) expects it to abate to 7 per cent by March 2012, while economists at Goldman Sachs expect it to average 5 per cent in FY13. Several factors will contribute to this softening: the high base of 2011; softening of commodity prices due to weak global growth; lower food inflation due to a good monsoon in 2011, and lower inflation in protein-based foods due to a cyclical improvement in supply.

If inflation softens, can interest-rate cuts be far behind? With growth decelerating rapidly, the central bank will be forced to reverse its policy stance. Rate cuts could commence as early as January or latest by the middle of 2012. How early rate cuts begin, and how aggressively they are undertaken will determine how quickly the Indian economy shakes off its growth blues. Falling interest rates will provide a fillip both to private consumption and private investment (though in case of the latter, policy initiatives and improvement in economic outlook will also be called for). Even equity markets could rally in anticipation of a reversal in the interest-rate cycle.

The Indian rupee has depreciated sharply in recent months owing to India’s current account deficit, capital outflows, and lack of fresh inflows. While the rupee’s depreciation will make imports more expensive, it will also enhance India’s export competitiveness, which the country will be able to capitalise on once global demand revives.

Among the two major international trouble spots, US and Europe, economic data from the former indicates that its economy has stabilised to some degree in recent months. In Q3 2011 its GDP grew 2 per cent (revised downward from the initial 2.5 per cent), an improvement over the 1.3 per cent growth in Q2 and 0.4 per cent in Q1. The consumer confidence index is up, the unemployment rate has tapered downward to 8.6 per cent (from 9.2 per cent in July 2011), and jobless claims have also fallen.

On the policy front, the Indian government has indeed disappointed. Sectors like mining, infrastructure and capital goods have borne the brunt of delays in project approvals. After the government’s decision to hold in abeyance its decision to open up the retail sector further to FDI, doubts have arisen about its willingness and ability to push through long-pending reforms. Will the Goods and Services Tax (GST) and the Direct Tax Code (DTC) be implemented in 2012? Will the Land Acquisition Bill, the Mineral and Mining Bill, and the Company Amendment Bill receive Parliament’s approval? Noone can vouch for these reforms. In view of the xenophobic outpourings of the political class in the debate on FDI in retail, it is doubtful if proposals to raise the FDI limit in insurance or to allow foreign players into the education sector will receive the Parliament’s approval anytime soon. However, even on the reforms front there is room for optimism. Though the centre’s record will at best remain patchy, states like Gujarat, Tamil Nadu and Bihar have initiated their own reforms. This is cause for celebration.

Overall, in 2012 (or FY13), the economy may not fare much worse than in 2011 (unless new risks appear), so undue pessimism about its prospects is unwarranted. But it is unlikely to fare much better either. Which raises the question: will the around 7 per cent growth rate (the current estimate by private-sector economists for both FY12 and FY13) suffice to meet the aspirations of an increasingly ambitious middle class that has tasted 8 per cent trend growth and knows it is achievable, if only the quality of governance were to improve?

Misplaced ardour
Indians’ excessive lust for gold is neither in their nor the country’s interest

John Maynard Keynes, the economist who revolutionised his subject with the idea that governments should undertake counter-cyclical spending to pull economies out of recession, once referred to Indians’ fondness for gold as the “the ruinous love of a barbaric relic”. His words ring true even today.

India remains the world’s largest consumer of gold. Indian households hold a cumulative 18,000 tonnes, which amount to 11 per cent of the total global stock. In 2010 India’s volume of gold consumed rose 72 per cent year-on-year. And despite prices reining high, consumption is up 5 per cent in the first three quarters of 2011.

In normal circumstances, Indians’ lust for the yellow metal would evoke neither comment nor worry. But these are not ordinary times. India, which consistently runs a current account deficit, depends on capital flows from abroad to fund the deficit. The ongoing crisis in the developed world has heightened risk aversion and led to capital outflows. How to fund a current account deficit of the order of 2.6 per cent of GDP (the figure for FY11, which could escalate to 3 per cent plus in FY12) has now become a source of worry.

Gold is India’s third-largest import item after crude oil and engineering goods. Remove gold from its list of imports and its current account remains negative, but shrinks to a much less intimidating -1.2 per cent of GDP (for FY11). By raising the country’s dollar needs, India’s gold lust is one of the factors responsible for the recent sharp depreciation of the rupee.

Even from a personal finance point of view, excessive allocation to gold in a portfolio is not wise. Most financial planners suggest limiting exposure to 5-8 per cent. It may be argued that over the last 10 years the cumulative returns from gold have topped 500 per cent. Over the past five years returns from gold have beaten equity returns handsomely. But that’s because global growth has been wobbly since 2008, and central banks have been printing money to jumpstart growth. Gold does well in such circumstances – when the economic climate is adverse, inflation reins high, and faith in paper currencies is low.

Like all asset classes gold too witnesses booms and busts. The only difference is that commodity cycles are much longer lasting than those of equities. Granted that gold may continue to outperform equities in the near future, given the likelihood of sluggish global growth for a couple of years or more. But gold’s already long bull run suggests that it may now be closer to the peak of its cycle than the bottom. Being overweight on the yellow metal at this stage is fraught with risk.

Furthermore, investments made in physical gold rather than in a financial instrument can’t be channelled into productive uses, say, for investment by either the government or a corporate. And all that an investor earns from this inert metal is capital gains; it pays no dividends.

So while gold may be a good investment for diversifying a portfolio and for providing a hedge against inflation, carrying this lust too far is neither in investors’ nor this country’s long-term interest.