By the Blouin News Business staff

India’s economic fears – and optimism

by in Asia-Pacific.

BJP leader Narendra Modi gestures to supporters. AFP/Getty Images

BJP leader Narendra Modi gestures to supporters. AFP/Getty Images

India’s newly elected pro-business prime minister Narendra Modi has assured a number of times he will take the necessary measures to boost the country’s economic growth. The task is a major one and the Reserve Bank of India, the central bank, has just reminded him why. The RBI published its biyearly financial stability report in which it expressed concerns over the public sector banks, the state-run banks: “India’s financial system remains stable, though the banking sector is facing some major challenges, mainly relating to public sector banks (PSBs),” said the central bank. The reason is that the amount of bad loans that they hold is still considerably higher than the ones the private-sector banks have on their books.

Although there has been some improvement in the asset quality of scheduled commercial banks (SCBs) since September 2013, the level of gross non-performing advances as percentage of total gross advances (GNPA ratio) of PSBs was significantly higher as compared to the other bank groups. While the ownership pattern and recapitalization of PSBs are contingent upon government policy and the fiscal situation, there is a case for reviewing the governance structures of PSBs, with a greater emphasis on market discipline.

However, the RBI report also looks at the domestic scenario and jumps on the optimism wave that Modi’s election, and the majority of his Bharatiya Janata Party, has brought. As the graph below shows the balance of concerns have changed during the first quarter of this year. The central banks believe that the return to political stability has “provided impetus to the outlook and the capital markets reflect the expectations on policy measures to address the adverse growth-inflation dynamics and saving-investment balance as also efficient implementation of policies and programs.” It goes on to add:

Formation of a stable government at the centre has ameliorated political risk and has led to expectations of better policy coordination and implementation which has had a positive impact on the markets. Going forward, in general the risks that the Indian economy is facing are expected to fall. However, in comparison to the recent past, there could be some deterioration on the current account and fiscal deficit fronts.

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Yet there is a big fear that quickly cools the economic hype down: the toxic mix low growth-high inflation. The growth-inflation setting in India was adverse for seven of the last eight quarters with below 5% gross domestic product growth and high consumer price index inflation, which has an adverse effect on saving-investment dynamics.

Persistent high inflation can alter inflation expectations permanently and may lead to disintermediation in the economy with resultant adverse effects on financial savings, investment and growth. High inflation can also interfere with the financial sector’s ability to allocate resources effectively as price uncertainty can alter inflation expectations, which can significantly increase risk premia in financial transactions.

The challenge is on to stabilize the economy. It it’s going to be through monetary policy interventions, it needs to be complimented by appropriate fiscal policy measures, warns the central bank. Modi might be able to tackle Asia’s third biggest economy’s problems, though policy reforms must arrive as soon as possible.