Singapore: India has survived the current economic turmoil better than other emerging economies, but it is part of a globalized world and cannot remain insulated forever, said Sanjeev Sanyal, global strategist and managing director, Deutsche Bank. 

Sanyal said the current slowdown has provided India with automatic stabilizers as the falling cost of commodity imports have compensated for weak exports. The real test would be of the country’s ability to use this period of cheap capital to build its infrastructure and create internationally competitive capacities, Sanyal added in an interview.

Edited excerpts:

Were you surprised by the non-committal Federal Reserve after the latest hold? Will we see a US rate hike by December or will we remain in a long-term pause?

I was not at all surprised by the decision of the Federal Reserve to stay on hold, given the uncertainty over the trajectory of the global economy. Even if the US Fed does increase rates by December, it will not be the start of an aggressive tightening cycle. Indeed, as I have been arguing for some time, the long-term cost of capital will remain low for years even if major central banks begin to tighten because China will keep flooding the world with cheap capital. This is not a cyclical problem but part of a long-term structural shift away from China’s investment-driven growth model. It’s the reflection of China’s transformation from being the world’s factory to becoming the world’s investor.

When will we see the global economy return to sustained expansion? 

China currently generates a quarter of the world’s investment. However, it cannot sustain this pace with a shrinking workforce and dwindling domestic investment opportunities. Therefore, as China’s growth slows, it will keep flooding the world with excess savings that it cannot absorb internally. This is not a “hard landing”, as happens with typical emerging market crises. 

China is a net creditor country with large external and internal resources. It will be more in the nature of a steady unwinding of the investment-driven growth engine. In order to maintain global growth, the rest of the world will have to find ways to deploy this cheap capital. As things stand, Europe is not in a position to absorb this capital and will do well to not add to the problem. 

India could potentially absorb some of the excess capital, but it is still too small to make a dent on the larger landscape. 

So, it will ultimately boil down to the willingness of the US to take this capital and invest it. Interestingly, the awful state of American infrastructure provides many good opportunities for deploying capital, but it will require a willingness to take risks and again run up debt.

In other words, we will have to accept a return to large global imbalances if we want to see sustained growth in the world economy. 

After the Fed decision, can some stability emerge now in the overall liquidity situation in emerging markets, particularly India? 

As I said, the US Fed is unlikely to embark on an aggressive tightening cycle in the foreseeable future and, in any case, long-term international capital will remain cheap for a long time. The problem is that this will cause a large amount of liquidity to slosh around the world markets and, unless it is usefully deployed, it could cause bubbles and misallocations. This is a recipe for volatility. Central banks in emerging markets need to use the accumulation of reserves to cushion against the swings as well as closely monitor how their financial systems allocate international flows. 

India is so dependent on portfolio flows. Whatever steps and safeguards it puts in place, can India ever really be prepared for all eventualities? Alternatively, what are the defence mechanisms India needs to put in place against all eventualities? 

One of the lessons of economic history is that one cannot be prepared for every eventuality. The trick is to have enough degrees of flexibility in order to be able to react to the unexpected. This could be in the form of fiscal breathing space or sizeable foreign exchange reserves that provide a cushion against random shocks. This means that the authorities have to “lean against the wind” during the bountiful periods in order to be able to unwind them during the outflows. However, structural and institutional flexibility is even more important in the medium term—a smooth bankruptcy process, efficient labour markets, a well-capitalized banking sector, transparent secondary markets for real estate and so on. These do not only encourage more permanent forms of capital inflows but, when things go wrong, they allow the economy to unwind the excesses. In other words, good economic management is not about planning with perfect foresight, but about the ability to react to the unforeseen and correct for mistakes. 

Amid the current crisis, India’s foreign exchange reserves have risen sharply, current account deficit has declined and macro-fundamentals have generally improved. So, can India remain insulated from ongoing adverse global developments?

India has survived the current economic trends better than other emerging economies but it is part of a globalized world and cannot remain insulated forever. Moreover, the circumstances of the current slowdown have provided India with automatic stabilizers—the falling cost of commodity imports has compensated for weak exports. The real test will be (of) India’s ability to use this period of cheap capital to build its infrastructure and create internationally competitive capacities. I would like to emphasize that it is risky if the public and private sector simply build up external debt. This is why foreign direct investment should be the preferred way to leverage the domestic market in order to build globally competitive capacities. This is not so different from what East Asian countries did during their “take-off” stage. 

Will the Reserve Bank of India (RBI) cut rates in September and beyond?

Wholesale price inflation had been negative for a while and consumer price inflation is also well behaved. Therefore, RBI has the space to make significant reductions in benchmark interest rates—perhaps in the range of 100-125 bps (basis points) by the year-end, although it’s likely that governor (Raghuram) Rajan will be a lot more cautious.

Moreover, I am of the view that one cannot take a mechanical inflation-targeting approach—one needs to take account of the fact that industrial growth, job creation and credit expansion remain very weak. I share governor Rajan’s concern that a sharp reduction in rates could feed a credit bubble and perpetuate the old sins of evergreening bad debt. However, these issues are perhaps better dealt (with) through tighter supervision of banks rather than starving the whole economy of capital. 

In my view, the restructuring of the banks would be much quicker and less painful if easier liquidity conditions were allowed to lubricate the transition. In this context, I am pleased that a new bankruptcy code is being brought in. I hope that the process will be quick so that bad investments can be constantly liquefied and not allowed to clog the financial system.

Structural tailwinds to India’s recovery by way of crucial reforms don’t seem to be happening, or have not kept pace—progress on the goods and services tax (GST), land acquisition and labour reforms have been delayed at least until the winter session of Parliament.

Many critical reforms have indeed been delayed by the logjam in Parliament and there is no way to guess if the winter session will be any better. Nonetheless, there are many things that can still be done administratively by the central government or be implemented by the states. Moreover, the government’s majority in the lower House allows it to pass money bills. For instance, the government could opt for a radical simplification of the direct tax system in the next budget. Just as an illustration, the finance minister could remove all exemptions for personal income tax and then opt for a standard deduction of Rs.7.5 lakh followed by three simple slabs of 10%, 15% and 25%. This would not only reduce inefficiencies and corruption but dramatically increase compliance by re-orienting the tax collecting machinery towards widening the tax net rather than squeezing the few existing tax payers. 

Where do you see the rupee—near and long-term?

I think the Indian rupee is broadly fairly valued. Its weakness against the US dollar this year is more a reflection of dollar strength rather than a reflection on the rupee. 

I think RBI should continue with the long established strategy of smoothening sudden exchange rate moves while generally letting it drift within a real effective exchange rate comfort zone in the medium term. It’s more art than science, but it has served India well since the 1990s and there is no need to change this approach. Nonetheless, with so much global liquidity sloshing around, the authorities need to be wary of a sudden wave of inflows. Foreign exchange reserves are now at $350 billion but it would be no big deal for a country of India’s size to hold $500 billion. There is a price to be paid for holding such large reserves, but this can be reduced by narrowing the interest rate differential.