Real sector globalization has given rise to increased cross-border financial interlinkages. Recent evidence suggests that Indian financial markets are increasingly getting integrated with the world markets. Rising financial integration has provided positive spillovers in the form of financial efficiencies, rising asset returns, improved corporate performance and strengthening of domestic market infrastructure.
The metamorphosis in the financial world has been rapid and is generating investment and trading opportunities at an equivalent pace. Indian markets are no more seen as an isolated play, with global dynamics impacting all markets - exchange rate, interest rate and equity.
Macro economic conditions
India has emerged as one of the fastest growing countries among the emerging market economies. Resurgence in economic growth has been broad based with industrial and services sector showing remarkable performance. Over the last decade, the Indian growth engine has been fuelled by the fast growing services sector, which grew at an annual average rate of 7.5% in 1990s against 5.8% and 3.1% growth rate of industry and agriculture respectively. Various studies reveal that the growth in services sector has been less cyclical and more stable.
In the recent times India has seen resurgence in the industrial growth at 7-8% and has been backed by revival in investment demand. Capital goods segment for instance has been experiencing above 10% growth over the past two years. Capacity utilization in the industrial segment has increased significantly and this has resulted in several capacity expansion plans. According to ICICI Bank's estimates, the expected capex spending over the next few years is to the tune of Rs 200bn. Availability of external capital and a surplus current account has been helping the rising growth momentum by providing sufficient external saving to meet the investment demand. India has posted surplus in the current account for three consecutive years ending FY2004.
However, the agriculture sector performance remains very volatile as it continues to be exposed to the vagaries of nature. Indian agriculture continues to be rain fed with over two-thirds of the cultivated area lacking access to irrigation. The agriculture sector growth bounced sharply to 9.1% in FY2004 following a fall of 5.2% in the previous year. Fiscal constraints arising from large revenue spending has resulted in the decline in capital allocation for the agriculture sector and hence, impacted productivity.
Interest rates in India
As a result of the deregulation of interest rates structure over the past decade, interest rates are determined competitively in the market. There has been a downward trend in the interest rate in the economy with both the short-term and long-term rates falling. The overnight call money rates have fallen from about 13% in August 2000 to the current levels of 4.5%. The yield on 10-Year government securities has declined from 11% in August 2000 to the current levels of about 6.2%. Similarly, interest rates on corporate paper have fallen significantly. The interest rate on 5-Year AAA rated corporate paper declined from 12% in August 2000 to about 6.7% currently.
This fall in the interest rates in the recent period has been in consonance with the monetary policy stance of a soft and a flexible interest rate regime. The Reserve Bank of India (RBI) has progressively eased its monetary policy stance in the last few years to revive growth. The cash reserve ratio (CRR) was reduced from 5.5% to 5.0% in June 2002 and further to 4.75% in November 2002. The bank rate and repo rate have emerged as important tools signaling the policy intentions of the central bank in India. In October 2002 the Bank Rate was lowered to 6.25% and further to 6% in April 2003. The repo rate was also reduced to 5.75% in June 2002 and further cuts were effected in three stages, reducing it to the current rate of 4.50%.
Monetary conditions have continued to remain easy, driven by persistent capital inflows.
Despite sterilisation operations, the sheer volume of accumulation of the RBI's net foreign assets expanded reserve money at the rate of 18.3% in year 2003-04, which is the highest since 1994-95. India experienced an unprecedented accreation to its forex reserves in the last year with reserves increasing by USD 36.5 billion over the last year, the largest increase ever recorded in a single year.
Increased capital account openness and exchange rate interventions during the US rate easing cycle has led to a large buildup in domestic liquidity over the past three years. While the monetary authorities stepped up sterilization to curb excess liquidity, it was only partial, and the domestic interest rates exhibited strong co-movement with US rates. Hence, in our view the gradual pull out of the accommodative US monetary policy could have a significant influence on the Indian interest rate scenario. The prolonged period of excess liquidity could be one of the reasons for a lagged inflationary impact and this is attaining greater focus within the monetary policy framework. The Reserve Bank of India has recently announced a 50bps hike in the cash reserve ratio as a measure to curb inflationary pressure. There is increased absorption of excess liquidity and this is evident in the pickup in imports and domestic credit. A combination of rising global rates, inflationary pressures and a surge in demand for funds contribute to a rising interest rate cycle. While the central bank is yet to announce policy interest rate changes to suggest that, the market yields and lending rates for housing finance have already increased.
Efforts towards debt market related infrastructure have also been stepped up in the recent years with the central bank taking up measures towards establishment of an integrated payment and settlement system. This includes establishing the Negotiated Dealing System (NDS), which provides for an electronic platform for facilitating trading in government securities and money market instruments. CCIL has established itself as a central counterparty and is presently extending guaranteed settlement for trades done in the government securities market. The Real Time Gross Settlement System (RTGS), as a settlement process, minimizes settlement risks by settling individual payments in real time in the books of account, held at the central bank. Evolution of the debt market has seen emergence of the interest rate swap which has been actively utilized for risk mitigation and trading.
Exchange rate scenario
Liberalization and greater global integration of the economy has underlined the need for the efficient exchange rate markets in India. India moved from a fixed to a freely floating exchange rate regime in 1993. Since then Indian exchange rates have been a managed float and the central bank has attempted to make the Rupee more market driven albeit intervening to curb volatility.
The Indian forex market is predominantly a transaction-based market with the existence of underlying forex exposure being a prerequisite for market players. Similarly, regulations in most cases require end-users to repatriate and surrender foreign exchange in the Indian forex market. The forex market is made up of Authorized Dealers (generally banks), some intermediaries with limited authorization and end users, which includes, individuals, corporates, institutional investors and others.
Growing volumes and wide participation have made the Indian forex markets extremely liquid and the average monthly total turnover has increased sharply over time, clocking USD 174.7 billion in 2003-2004. The inter-bank to merchant turnover ratio hovered in the range of 2.9 to 3.9 during the year. Market making banks (generally foreign banks and new private sector banks) account for a significant percentage of the overall turnover in the market. Beyond the spot market, the central bank has also developed the cross- currency derivative market for players to hedge their forex risk. Eligible market players are allowed to enter into a forward contract and use foreign currency options and swap markets to hedge the foreign currency risk.
Post liberalization, the Rupee depreciated broadly against the Dollar, however, this trend reversed in 2002 to appreciation. After a net 2.57% appreciation of INR in FY 2003, Rupee strengthened further by 8.17% in FY 2004. The current account turned into surplus in FY 2002 due to a surge in software exports and remittances, and this has resulted in a reduction in the trade deficit. We believe that the rapid growth in software and BPO service exports would ensure that India's current account would stay in surplus in the years to come. However an oil shock and large-scale capital expansion would test the above expectations.
On the capital account front, we observed a huge surplus last year, due to strong capital inflows, including foreign portfolio investments and NRE deposits. The growth differentials vis-à-vis the rest of the world and global income redistribution and rebalancing is expected to ensure positive capital flows into India over the medium term. But this would require a continued rigor and momentum in the economic and administrative reform process.
Globally, the US twin deficits and low savings rate are putting a downward pressure on the Dollar. Indian Rupee has been a mirror image of the Dollar cycle and we expect Dollar to weaken further. Overall, we believe that Indian Rupee will continue on its medium term strengthening cycle. However, realization of any of the risk factors stated above could weaken the Indian currency.
Financial and real sector globalization is likely to bring about solutions to ease the structural constraints, which are impeding India from attaining the envisaged 8% growth rate on a sustainable basis. The developments in the financial markets and greater global integration of Indian goods and asset markets would enhance the efficiency in allocation of limited resources. Such developments would also reduce the transaction costs and would improve overall economic efficiency. Indian financial markets will play a pivotal role in the investment led Indian growth vision.