Rate hike, inflation set the stage for fire test

It has already been an interesting month. Financial markets globally—especially equities—are in a tizzy. Bond yields are rising and equity yields too. While it’s not clear exactly why US stock investors are panicking, it may be a concern that the Federal Reserve will either raise interest rates enough to cause the US inflation rate to fall, or not do so. , thereby increasing inflation.

Real economic growth in China fell to around 4% in the last quarter of calendar year 2021, and its growth rate for the full year was around 8%. The low-bass effect played its part there. China was seen as one of the very few economies to register positive economic growth in 2020. Other countries widely copied its Covid management template – still being followed by Beijing – to their detriment. The long-term cost will be even more significant. Note that the German economy has entered recession.

While many central banks around the world are talking about raising interest rates, China has had to start the year with some interest rate cuts. The People’s Bank of China (PBOC) has also supported the Chinese economy with liquidity provisions. Rebutting his message from the start of the year, GMO veteran investor Jeremy Grantham said: “In China, real estate has played an unusually important and unique role in the expanding boom and thus poses an equally unique risk The economy and therefore the rest of the world if its real estate market loses air exactly as we sit.” (“Let the Wild Rumpus Begin”, 20 January 2022).

More interestingly, Chinese President Xi Jinping, using the occasion in his address to the World Economic Forum in Davos, encouraged central banks in the West to raise interest rates gradually, not excessively. Higher US interest rates increase funding costs for Chinese corporations in dollars. Too much Chinese dollar debt is due for repayment. If the US decides to deal with its high inflation rate, refinancing costs will increase. This appeal from China in the West for moderation in rate hikes gives us an indication of the extent to which the Fed’s liberal monetary policy has served Chinese interests over the past 15 years.

In fact, it underscores the limits of China’s ability to pursue structural reforms compared to the “decline West”, as many say. The reality is far more nuanced. China’s economic model is also built on leverage and monetary adjustment. The level of accumulated debt, the ability of many economies around the world – China, the US, the Eurozone and many others – to withstand high interest rates has diminished significantly.

The US is also not in a position to allow further increases in interest rates, not only because debt levels are high, but also because its economy is facing a recession. The monthly survey of small businesses in the US, conducted by the National Federation of Independent Businesses, is widely seen as a key barometer of underlying economic conditions. “Owners expecting better business conditions over the next six months rose three points to a net negative 35%,” the latest report said. Owners remain pessimistic about future economic conditions as this indicator increased over the past six months. There has been a drop of 23 points.

As far as India’s economy is concerned, it appears that the average real gross domestic product (GDP) growth rate for the financial years 2021-22 and 2022-23 can be assumed to be around 9.0%. In its January 2022 monthly bulletin, the RBI noted that omicron infections in India have been more of a flash-flood than a wave. The central bank is right. Therefore, it should not leave any permanent damage to the economy. What is more heartening to read in the monthly assessment is that the capital expenditure by the state governments has increased by 67.6% in the period April-November 2021.

Looking ahead, a steady-state average real GDP growth rate of around 6.7% to 7.0% may be a reasonably conservative assumption for India for the rest of the decade. Replicating recent export performance could be a challenge, as the world economy could face a number of growth constraints, not least from the risk of a significant recovery in asset prices.

I take Jeremy Grantham’s view seriously here: “If valuations in all of these asset classes return even two-thirds of historical norms, total asset losses alone would be on the order of US$35 trillion. If it were negative. If the wealth and income effect is exacerbated by inflationary pressures from energy, food, and other shortages, we will have serious economic problems.”

The second major risk facing the Indian economy is one of rising import bills for crude, brought about by a combination of a chaotic global green transition, reduced upstream investment in oil extraction and geopolitical conflicts. Globally, this oil-price risk is not being taken seriously because it is barely understood. So in India too. In the coming years, our public policy should be more innovative and flexible in managing that risk.

V. Ananth Nageswaran is visiting Distinguished Professor of Economics at Kriya University. These are personal views of the author.