The following are the Key Takeaways from our economy and markets outlook for 2010.

1. Gradual recovery in US / global economies
   
2. High unemployment in US to be focus of policy action there
   
3. US policy to remain highly accommodative / supportive well into 2010 ( at least till November 2010 when mid-term Congressional elections are due) to support jobs growth even as the economy recovers
   
4. In other words, policy focus will be to prevent or minimise the occurrence of 'jobless growth'
   
5. Impetus to global liquidity to remain strong
   
6. All asset markets - stocks, commodities, real estate - to remain supported on the back of this liquidity
   
7. Indian stocks, particularly, could rise sharply in New Year first quarter
   
8. Indian rupee may rise sharply - say to the 40 / 41 levels - in New year first quarter
   
9. Persistent rupee strength, though, could be a drag on Indian stocks
   
10. But sharp rise in rupee may enable RBI to be moderate in monetary tightening
    
11. Local liquidity / interest rates may not be under much pressure under Scenario 10
    
12. Range bound rupee - between 44 to 47 - is also possible
    
13. If rupee is kept range-bound, then RBI may have to undertake fairly severe monetary tightening
    
14. Local liquidity may have to be squeezed; and, interest rates may rise by 3 or 4 percentage points under Scenario 13. This rise may happen over the course of 6 to 8 months.
    
15. An inflation / food price/ political crisis and capital outflows driven by risk aversion could be the trigger for a fall in the rupee to the 50+ levels also. This cannot be completely ruled out, though the probability of this scenario panning out currently appears quite low. Indian stocks could have a significant downward correction in this scenario.
    
16. Scenario 15 also could result in local liquidity getting squeezed and interest rates going up some 3 or 4 percentage points, though much faster than in 6 or 8 months as under scenario 14.
    
17. On balance, we feel there are greater chances (some 60 / 70 per cent) of the rupee ranging between the 43/44 to 47 levels over the next 6 to 8 months.
    
18. We would assign about a 10 per cent probability to the rupee falling to the 50 levels.
    
19. There is about a 20 / 30 per cent chance that the rupee sharply rises to the 40 / 41 levels.

To summarize:
Over the next 6 to 8 months
a. Chances of the rupee being in the 43 /44 to 47 range: 60 / 70 per cent
b. Chances of the rupee rising to the 40 / 41 levels: 20 / 30 per cent
c. Chances of the rupee falling to the 50+ levels: 10 per cent

Readers may wonder why we are placing so much emphasis on the level of the rupee as a factor influencing domestic financial markets - be it stocks, banking sector liquidity, interest rates, real estate and commodity markets, etc.

That is simply because of the high (and increasing) level of our integration with global financial flows and how India deals with such flows. The interaction between global capital flows and India's policy takes place in the foreign exchange market.

What we attempt here is the following:
a. Assessment of economic conditions in the key global economies - particularly the US, Euro zone, Japan and China
b. What those conditions imply for economic policy in those countries; here, we will specifically look at the policy scenario in the US
c. What will be the implications of those policy decisions for India given the current state of the Indian economy / markets, the current Indian policy set up and how RBI / Government react to the policy moves in the key economies viz. the US and the Euro zone.

As we shall try to explain presently, Indian policy makers do have some choices about how they can respond to the developments originating abroad. How our policy makers respond could have a significant impact on how things shape up here.

Economic scenario in the US, Euro zone, Japan

Our study will for the most part focus on the US economy. The simple reason is that the US continues to be the chief locomotive for the global economy. A strong revival in the US will be a solid booster for the entire global economy - quite similar in impact (in absolute terms) to the downturn which the crash in the US has caused.

While EMEs such as China and India have performed relatively better despite the deep recession in the US, a robust pick up in US economic activity would still be relevant for them.

For one, it could provide a major boost to commodities (industrial and consumption commodities) prices from their current levels. Most commodities, even now, are already up strongly from their lows of late 2008 /early 2009 on the back of strengthening demand from the Asian zone, primarily China, and heightened speculative activity aided by cheap liquidity (You can borrow for 3 months in dollars at less than 0.5 per cent).

Further increases in commodities prices may not be that much welcome for countries such as India which are already seeing a pick-up in manufacturing inflation from the lows of the last several months.

See the latest manufacturing sector inflation in India for November 2009. Manufactured product prices rose at an annualised rate of nearly 15 per cent in November from October 2009. They were either declining outright or rising at a measly 1 or 2 per cent rate earlier in this year.

For another, important export sectors, for instance, textile, could benefit significantly from a revival in US consumption.

High unemployment

Among the key defining features of the major global economies now is the high level of un-employment. Unemploy-ment is in double digits, at the close of 2009, in the US.

From a macro perspective, there are 3 critical objectives of economic policy in all countries. These are:
a. Employment (or its corollary, unemployment)
b. Inflation (price level increase at the level of the consumer)
c. Output growth (GDP growth)

It is well-known that consumer level inflation is almost non-existent currently in the major global economies. The fear is of even outright declines in prices given the high level of resources slack - meaning low utilization of available resources, be it labor or capital equipment / productive capacity. Industrial capacity utilization in the US is now running at around 65 per cent compared to long-term averages of around 85 per cent. The high unemployment, of course, points to excess labour supply.
The third quarter in CY 2009 appears to have seen a bottoming out and output growth seems to have resumed in the major economies. The US, for instance, grew 0.7 per cent in 3 Q 2009 over 2 Q 2009 - this gives an annualized growth rate of close to 3 per cent. Compare that with the heavy losses in output in the earlier quarters. The US economy does appear to have turned the corner on output growth.

With inflation quiescent and output growth gradually recovering, the entire focus of policy is now on ensuring that jobs creation takes off in a big way.

Broadly

a. The RBI can allow the rupee to appreciate sharply in which scenario local liquidity will not expand much (in fact, may even get constricted). This will be a dampener on local economic activity and could help cool asset markets such as stocks and real estate. There could be a softening in the overall general price levels also. Though there could be some immediate pressure on local liquidity / interest rates, this policy course will, over a period of time, provide leeway for the RBI to cut local interest rates.

More broadly, this policy stance does not make the local economy hostage to the whims of foreign capital flows and, therefore, could be more sustainable in the long run. It is also likely to produce more stable economic and market conditions.
Greater fluctuations could be witnessed in the rupee's exchange rate as it may adjust up and down in tune with the underlying fundamentals and without the overwhelming presence of RBI intervention. But, as pointed out above, the domestic economy could be more stable and there could be enduring reductions in local interest rates.

Such stability would be reflected in various ways...

For instance, we may not have our stock markets exhibiting high fluctuations as has been the norm in the past 8 or 9 years. A rough measure of the variability (the risk element) in our stock markets is as high as 35 per cent for average annual returns of around 15 per cent. This means that in any year, Indian stocks could either rise 50 per cent (15+35) or fall 20 per cent (15 -35). More importantly, there is approximately a 30 per cent chance that the rise or fall is more than 50 / 20 per cent.

Such stability would also be reflected in a more healthy real economy where businesses can plan and invest with confidence. We have had many examples in the past few years of manufacturing companies (in steel, engineering ancillaries, textiles among others) expanding capacities aggressively on the expectation of continued high demand. But when the 'bust' happens as explained below under 'b' and demand collapses, many of these industries are stuck with excess capacity. Financial distress sure follows such excess capacity build-up. The fact that the RBI / banks have been forced to announce a general scheme of corporate debt restructuring (CDR) is a clear pointer to this.

b. An alternative course of action is to intervene heavily in the foreign exchange markets. This could keep the rupee's exchange rate in a range. But, the impact will be felt in asset markets and in the goods and services markets where there could be large price increases.

Though liquidity and local interest rates could remain comfortable / soft as an immediate sequel to this policy course, this policy stance will, in course of time, compel the policy maker to tighten liquidity and push local interest rates up.

How much liquidity gets pressured and how local interest rates go up in this scenario will be dependent on how much of froth has built up in the asset markets and in the markets for goods & services. In other words, policy choice 'b' will provide temporary comfort and create a 'feel good environment' but hold the potential for severe medium / long term economic pain. ('Temporary' here could be a few years).

c. A modified version of 'b' is also possible. In this, the central bank floods the local economy with liquidity (by purchasing domestic assets instead of foreign exchange as in 'b' above). This again will provide immediate relief and comfort but hold the potential for longer term damage. Indian policy in the period since October / November 2008 is reflective of 'c'.
In our assessment, we are currently in the scenario depicted in 'b' above. The markets and industry are now all convinced that liquidity tightening and higher interest rates are on the cards. Perceptional differences are only about the extent of tightening that is going to come about.

In our assessment, policy choices 'b' and 'c' are the perfect recipes for creating boom and bust situations in the economy - in our stock, real estate and commodity markets and in the markets for goods & services.

If inflation goes out of control generally (it has so far happened in the case of food prices and in a range of other goods & services - be it education costs, medical costs, transport costs etc), only a bust in the overall economy may be enough to quell it. At that point, there could be distress in various asset markets such as stocks, real estate and commodities. The situation will also be marked by risk aversion induced capital outflows and heavy downward pressure on the local currency (the rupee). More importantly, business sentiments and confidence also would be severely undermined as the underlying economic environment is rendered very weak.

As of now, it does not seem like RBI / Government are going to put through any radical shift in their policies. We expect more of 'b' (and if necessary 'c') in the period ahead.

This is the basis for the various scenarios we have depicted in the Key Takeaways section of this report.