India’s Stagflation Problem: Are Monetary Tools Enough?

 

In the wake of India’s high inflation and slow growth, analysts say the country is witnessing classic signs of stagflation, which is not only destroying the current growth but corroding the future growth as well.

 

In the wake of India’s high inflation and slow growth, analysts say the country is witnessing classic signs of stagflation, which is not only destroying the current growth but corroding the Future growth as well, Indian stock market news today.

Currently, inflation is driven through cost-push and supply limitations. High inflation reflecting higher interest rates has further slowed down the economic activity. Stock selection in such a scenario has become complex on account of elevated inflation and sluggishness in growth. In such a situation, experts balance sectoral mix with stocks having least sensitivity to inflation (such as export oriented sectors) and which offer limited downside in case of higher inflation trajectory (quality cyclicals).

Analysts believe using only monetary tools currently is not likely to ease down the inflation, but is only likely to be detrimental to the growth. In the current scenario, even though the core inflation remains at the lower ebb, demand conditions are weak due to destruction in savings and disposable income. Elevated interest rates are adversely Impacting manufacturing activity.

Inflation needs to be tackled addressing the supply restraints; even if they are implemented now their impact will be with a considerable lag. There is an urgent requirement for non-monetary measures such as greater regulation in commodity trading, increasing the investment in warehousing and reducing the intermediaries etc. to control inflation.

Market Outlook

Analysts expect slow pick up in earnings growth, largely driven by outperformance in export driven sectors (currency benefit and global recovery).  Late cycle domestic earnings recovery is largely contingent on strong political mandate post elections. Though the US is witnessing strong economic recovery and showing resilience, QE tapering and subsequent Emerging markets flows reversals remain key overhang. Sensex now trades 7.6% higher than the lower end of the range and 7% lower than the higher end, offering 7.5% upside over the 1-yr period.

The top picks comprise of a mix of low inflation sensitivity and limited downside risks. Whilst Indian markets continue to witness high inflationary volatility, likely revival on policy front, pickup in investment post elections and bottoming out of industrial growth may not provide sufficient tailwind for sharp recovery.
Market experts expect inflation to persist (until supply side get addressed) and hence believe that India would continue to be a more bottoms up stock picker’s market. Their top picks are a mix of export oriented stocks with low sensitivity to domestic inflation and quality cyclical with strong pricing power and operating in a high demand pull segment.

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The Coppers Are Thinning

Forex Reserves depleted by $10.4bn in Q2FY14, sharpest decline in last seven quarters, mainly due to decline in capital account balance. Capital account balance declined by $5.4 bn primarily driven by sharp FII outflow, outflows in foreign loans by commercial banks and decline of $6.9 bn in other capital. FII outflows increased sharply from Jun’13 onwards, after Fed indicated high possibility of tapering of quantitative easing. FII outflows augmented further in Q2FY14 which amounted to $6.6 bn within which significant proportion of it was debt investment.

 
Outflow in other capital is indicating that exports receipts are received with significant lag. Strong FDI investment and increase in net overseas borrowing by banks aided in stalling the further decline in Capital Account Balance. Net trade credit outflow increased to $1.9 bn in Q2FY14 from inflow of $2.5 bn in Q2FY14 and $4.1 bn inflow in Q2FY13; with drop in imports in ensuing months, analysts expect trade credit to further shrink in subsequent quarters.

 
On the other hand, merchandise deficit narrowed down to 10 quarter low of $33.3 bn to 7.9% of GDP. Sharp growth in exports of 11.6% Y/Y in Q2FY14 as against 1.2% de-growth in previous quarter aided in driving the moderation of deficit. Export growth augmented on back of favorable currency and signs of improvement in global economy contributed largely by textiles and agricultural product exports.

 
On the other hand, imports declined sharply on account of fall in gold imports and machinery imports. Strong action taken by government and RBI to curb gold imports has led to such a sharp correction in imports. Sharp depreciation in the currency, improvement in global conditions and actions taken by government is likely to maintain favorable merchandise deficit for rest of the year.

 
Import as a ratio to foreign exchange reserves has further fallen to 6.6 months from a peak of 17 months in Jun’04; this is mainly driven by sharper depletion in foreign exchange reserves despite substantial slowing down of imports. Increasing external vulnerability is indicated by falling import cover ratio. Software services exports increased to $16.3 bn due to favorable currency which pushed the overall services net exports to 4.3% of GDP. Net investment income declined by $6.4 bn in Q2FY14 on increasing servicing of rising external liabilities.

 
Higher reliance on short term inflows to finance CAD is likely to adversely affect net investment income and continue to pressurize CAD. While depreciating currency not only aided in increasing the inflow in private transfers but also augmented the growth in NRI deposits. To know more visit theFinapolis.com

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