I was a little surprised by the stock market's initial adverse reaction to the monetary policy. Though a quarter-percentage point cut in the repo rate was certainly anticipated by the markets, the cut in the cash reserve ratio wasn't. So it couldn't entirely have been a case of "it's all in the price, so let's sell off after the event". Perhaps the selling came on the back of anxiety about a sticky path for inflation and the possible macroeconomic instability that could follow a bloated current account deficit. These were two risks that the Reserve Bank of India (RBI) emphasised considerably, and might have goaded the markets to do some much-needed soul-searching about where the economy is headed and what valuations stocks and other assets should ideally fetch.
But first things first. Both the equity and currency markets in January felt the effects of a surge in global liquidity. The Fed increased its liquidity infusion from $40 billion to $85 billion from January, and the Bank of Japan pumped in about Yen 5 trillion of additional liquidity. A number of markets across emerging economies popped up as a result: bonds, equities and currencies. Indian markets built on this liquidity support, surging a little more than others in response to local policy announcements and benign macro data. Thus, it wasn't just the perception of a turn in the India story that drove the markets up; there was a global component as well.
The second and somewhat obvious issue that markets should focus on is how quickly the current "reform drive" will reflect in improved fundamentals for the economy. The state of the investment cycle is critical to this since any significant uptick in our business cycle has to be backed by expansion in the productive capacities of enterprises as well as in infrastructure.
One has to fall back on anecdotal evidence for this. (The capital goods component of the index of industrial production that goes up and down like a yo-yo is notoriously misleading.) A small and extremely informal survey of companies by HDFC Bank's economics research unit that I run could not identify a single manufacturing sector that was planning to ramp up capacity. Companies seem content to finish existing expansion projects and then go easy. The slew of reform measures that seemed to have pleased the markets do not seem to have gone down as well with Indian companies.
This difference in response from the financial markets and corporate India to the government's initiatives is neither new nor too difficult to explain. Take the case of fiscal consolidation. While lower deficits and debt are an unqualified positive in financial investors' scheme of things, for Indian producers it also implies an immediate increase in costs. (The benefits of fiscal compression in terms of reduced inflationary pressure and hence costs are far too abstract and distant to enter their profit and loss calculation immediately.) Some of the cost increases are both immediate and sharp.
Take the increase in the price of diesel. I live and work in Gurgaon where diesel generators provide , on average, half the power supply in offices. Electricity bills are likely to go through the ceiling over the next few months - especially if diesel is bought in bulk since bulk diesel prices have been completely deregulated. The railway passenger fare hikes announced early last month add, in our estimates, close to a percentage and a half to consumer price inflation, and are likely to show up in rising wage demands sooner rather than later.
While costs threaten to rise further, the problems that have vitiated the investment climate for the past few years linger. Land acquisition remains a problem. Even if legislation were to be passed over the next few months to address this, the cost of acquiring land under the new Act seems all set to rise by a significant margin. A number of sectors, such as plantations and construction, continue to complain of massive labour shortage. Rural wages in November were up by 18 per cent over the previous year's level.
However, the biggest problem companies across the board seem to complain about is the "go-slow" approach adopted by the bureaucracy and regulatory agencies. This has meant a sharp slowdown in clearance and approval processes. Scarred and scared by the accusations of malfeasance by some senior officials and the exemplary punishment that followed, the government machinery seemed to have retreated into a shell.
Then there is the issue of capacity utilisation. HDFC Bank's extrapolations of capacity utilisation indicators like the RBI's OBICUS index suggest average capacity utilisation of a little over 70 per cent currently. Thus, there is really no compelling case to expand capacity to support top lines.
The only bit of good news seems to be coming from the information technology (IT) sector. There seems to be growing evidence that the prolonged slowdown in the West is goading companies to look for cost savings through outsourcing. This is incidentally particularly true of Europe, which is worst hit by a recession. The same phenomenon could, hopefully, spill over to exports of goods as well, if sluggish incomes translate into "down-trading" by slowing economies. This could help both the balance of payments and aggregate demand, if only at the margin.
The RBI has cut the policy rate and infused some liquidity in the economy. It has, however, been cautious about promising much more. Companies that face an immediate escalation in costs, thanks to higher fuel prices and rising wages, know that a small reduction in borrowing rates will not compensate for this. Nor will it goad Indian bureaucrats to take decisions faster.
The central bank has emphasised "non-monetary" factors as the key constraint to growth and I doubt if any Indian entrepreneur will disagree with this prognosis. These non-monetary factors aren't likely to disappear in a hurry, and so a full-blown boom might remain elusive in 2013. Investors need to think about what they should pay for a half-hearted recovery.