Political stability is the key to macroeconomic stability and growth: Jahangir Aziz, JPMorgan

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In a conversation with ET Now, Jahangir Aziz, Head-Emerging Asia Economics, JPMorgan, talks about the importance of stable government to the economy as well as India’s potential GDP growth and the rupee. Excerpts:

ET Now: With the outcome of this week’s election, how important is a stable government to the Center for the Economy?

Jahangir Aziz: Political stability is the key to macroeconomic stability and growth, and everyone is looking forward to that. That said, if we go back and look at Indian history – the elections and their results – and compare it to the economic performance that followed these administrations, the results are never conclusive. Although political stability is important, it is not really the driver of economic policy changes or the driver of good policies. We often see that stable governments become too complacent and you end up with results that are not necessarily what you originally expected. So I would say it’s important, but not critical. To come back to your question on what we expect from this new government, it is clear that the return to growth is everyone’s priority and that is where there are binding constraints.

The binding constraints in India are twofold. First, there are physical implementation constraints, such as land acquisition, which are unfortunately in the hands of local governments and state governments, not in the hands of the central government. The central government will therefore have to get the states to start tackling these problems. In addition, some financial constraints have increased, particularly in overleveraged infrastructure-related companies. How you handle this over-indebtedness becomes important. If they answer these two questions, you could start a meaningful investment cycle in the coming months and that should be able to propel growth significantly.

ET Now: What is your view on India’s GDP growth potential and what will be driving India’s GDP growth in FY15 and FY16? What are the main upside and downside risks for you?

Jahangir Aziz: One thing we haven’t noticed in this severe decline in growth: from 9% in 2010-2011 or even 10% in 2010-2011 to 4-5% currently. If you measure the gap between potential growth and trend growth, between the productive capacity of this economy and what is produced, this gap is not small. In fact, that’s one of the reasons why you notice core inflation, despite everything that’s happened to headline inflation, is back. Core inflation remained virtually unchanged at 8%, showing that there is very little excess capacity in India, despite the decline in overall growth. India hasn’t really made any corporate investments since mid-2008. It’s been five years now. That’s why we have a situation like this where you have low growth and at the same time you have high underlying inflation. The trick is to get companies to invest in equipment and invest in new technology. This will bring back productivity growth in India. Now whether or not that happens again depends on the government’s ability to remove the binding constraints.

ET Now: Do you think the perception of India could really change if we get a stable government? Do you think that the tapering of US QE and the possible rise in interest rates can still pose a great threat to foreign flows?

Jahangir Aziz: Both are important issues. But if you look at the streams that have come into India, say, from December last year until today, there are two sets of streams that have come in. One is for equity flows and the other is for debt flows. Debt flows into India have been significantly larger than equity flows. The debt flows came basically to reward the existing government for the macroeconomic stability it has brought to India since the massive disruption that took place when the QE rumor started in May last year. Credit goes to the current government for actually succeeding in reducing the budget deficit by keeping the current account deficit under control and to the Reserve Bank of India for implementing a very prudent macroeconomic monetary policy regime. Speaking of equity flows, equity investors, on the other hand, have been flooding in on hopes that growth will be propelled once a stable new government returns to power this month. and, therefore, the two driving forces of these two streams are very different.

The important thing for the new government is to continue to balance the two. It cannot allow macroeconomic instability, in which case you will see debt exits, and it needs to start delivering on the promises the stock market has made over the past few months that growth will pick up. Coming to the question of the impact of the global economy on the global interest, this is very important for India. We saw that in May last year, even the rumor of QE completely disrupted the Indian economy. This is where the credit goes to the RBI and the current government. They have successfully demonstrated that they can withstand the pain. So if you look at January when there was a selloff in equities or emerging assets, you didn’t see the diminishing impact on India and Indonesia. India has shown that it is no longer one of the fragile five. Now, of course, it depends on whether or not macroeconomic stability has been intact. The impact of a US interest rate hike is obviously going to be hard on India, but not as disruptive as long as they continue to demonstrate that they can take the pain and take the necessary steps to ensure that the macroeconomy is kept in good condition.

ET Now: How serious is the risk of a below normal monsoon? What impact do you think this could have on food inflation and therefore on GDP data?

Jahangir Aziz: This is always a difficult question to answer. We weren’t really able to predict the weather very well. But by all indications, this is an El Niño year. The severity of the El Niño impact depends on a) its intensity and b) the geographical distribution of its impact. More importantly, does the impact of El Nino have a greater impact on places in India that already have irrigation or places in India that do not have irrigation? If it affects states that have irrigation, then the impact will be much less. I think if you look at drought situations over the last few years, droughts don’t really have that big of an impact on real GDP. It has an impact, but it’s not that big. The biggest impact is on inflation and the reason it affects inflation so badly is because it changes people’s expectations. As soon as we have bad weather, as soon as you have an agricultural surprise, you start to have food inflation. It’s a really big problem because once you have expectations that go up, that again feeds underlying inflation, headline inflation. So I would say much more disconcerting is the impact this could have on inflation rather than growth.

ET Now: Currency appears to be a somewhat helping factor in the stock move. We saw the best gains since March 6 and then broke through the 60 mark. What do you think is the fair value of the currency and where do you think the RBI might be comfortable with the currency in order to maintain its export competitiveness?

Jahangir Aziz: It takes a brave man to say something about the fair value of the rupee. It’s not about what’s going to happen over the next month, but over a period of one to two years. The fair value of the rupee is generally determined by the growth differential and the inflation differential that India has with its trading partners. The growth differential tends to appreciate the rupee and the inflation differential tends to depreciate the rupee. Now if you look at the growth differential, India’s growth differential has gone from 9% to 4%. Therefore, this push towards currency appreciation has disappeared and the inflation differential, on the other hand, has increased. Even though India’s inflation has come down, its trading partners’ inflation has fallen even faster, largely because there is currently a global trend of disinflation. Therefore, we believe that going forward, downward pressures, again from a one- to two-year perspective, will outweigh appreciation pressures. We believe that given the current growth in the inflation differential, 59-60 seems like a reasonable assumption. This is where the fair value of the rupee lies.

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