2012 will be a year of austerity for India - so be prepared

One prediction that one can confidently make for calendar 2012 is that “austerity” will be the key word for nations, corporations and common people.

Nations will adopt austerity measures to bring down debt, corporations will make austerity the theme to cut costs while the common people will be forced to adopt austerity on the lack of availability of debt and uncertainty over incomes. Unfortunately, no one has a choice in adopting austerity measures given the fact that debt is considered a four-letter word in the current market environment.

Austerity has its positives and negatives, with positives outweighing the negatives in the long run. The lack of freedom to borrow and spend by all sections of the economy results in falling demand for non-essential goods and services. This fall in demand will reflect in falling inflation levels as the demand-supply factor tilts in favour of supply.

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Inflation, which trended at over 9 percent for most of the calendar year 2011, will fall faster than expected in 2012 on the back of the fall in demand.

[caption id=“attachment_168134” align=“alignleft” width=“380” caption=“Inflation, which trended at over 9 percent for most of the calendar year 2011, will fall faster than expected in 2012 on the back of the fall in demand. Andrew Middleton/Flickr”]  [/caption]

The Indian government is facing a huge pressure on its finances due to economic mismanagement. The government will exceed its budgeted fiscal deficit of 4.6 percent of GDP by more than half a percentage point due to the rising subsidy bill on fuel and fertilisers. The subsidy bill for 2011-12 is likely to exceed budget estimates by more than Rs 100,000 crore.

Higher than expected government borrowing is placing pressure on borrowing costs, with the cost going higher by over 1 percent from 2010-11 to 2011-12. The government will be forced to adopt austerity measures to bring down its borrowing costs and, if the government can contain its fiscal deficit, it will be positive for interest rates, which will trend down.

Falling inflation coupled with less pressure on government bond supply (if the government can actually control its finances) will lead to falling bond yields and lower interest rates across the economy as the Reserve Bank starts cutting policy rates. The RBI has a lot of leeway on its policy rates with the CRR (cash reserve ratio) at 6 percent and the repo at 8.5 percent. India can go into a lower interest rate regime, leading to better growth prospects.

Austerity brings around a fundamental change in economies. Over-investment and over-consumption will become under-investment and under-consumption. Once interest rates are sufficiently low for investment and consumption to take place, there will be an uptick in demand, leading to strong economic growth.

India is going from a phase of over-investment and over-consumption to under-investment and under-consumption, as seen by the fall in IIP (Index of Industrial Production) growth numbers. IIP growth for April-October 2011 was 3.5 percent against 8.7 percent seen last year. India has to see interest rates come off in 2012 for it to get back a balance on investment and consumption.

Austerity is not taken well by markets in the short term. Equity markets do not like to see growth rates fall as it leads to earnings downgrades. However, the fact that austerity is the result of bond markets making borrowers pay for high debt levels in the economy is overlooked by most.

The sharp rise in the borrowing costs of seemingly strong countries in the eurozone is a case in point. The markets forced countries such as Italy, Spain and France to adopt austerity measures by taking up bond yields on the sovereign debt of these nations. Bond yields rose by 150-400 bps (1.5-4 percent) across eurozone nations as bond markets gave a thumbs down on high debt levels carried by eurozone nations.

The Sensex and Nifty are down over 20 percent in the calendar year to date as the markets fretted about rising inflation, rising interest rates, global debt issues and slowing domestic growth. Austerity will keep equity markets down until the outlook for inflation and interest rates become highly positive.

Once the markets start factoring in better economic prospects on the back of low interest rates, equity markets will see a sharp uptrend.

Investors should start playing for a market revival in 2012 as austerity measures start working on inflation and interest rates.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.