Never mind emerging, India’s economy over the past year has shown worrying signs of growing up too fast: surging inflation and capital inflows have put pressure on both the rupee and interest rates, casting a pall over growth. What’s become alarmingly clear is that the economy cannot sustain a higher pace of growth until its productive capacity is enlarged. As early elections next year become increasingly likely, chances are that interest rates, if anything, won’t rise and could even fall, while the fiscal deficit in the run-up to polls may suffer from inevitable pressure to increase spending on oil or food subsidies.
Global turmoil
Reserve Bank of India governor YV Reddy is juggling an impossible trinity faced by a select group of emerging markets still in a certain phase of economic transition – an independent monetary policy, an open capital account and a managed exchanged rate.
But the global picture makes matters more complex. Late in September, just as worries over Indian consumer prices were beginning to recede, the US Federal Reserve cut interest rates by 50 basis points, unleashing a surge of foreign portfolio investment into India. Foreign investors rushed into Indian stocks once again, investing $2 billion in just five days, pushing the benchmark Sensex up almost 17% by October 9.The rupee shot up rapidly and urged prompt action from the central bank, for the second time this year, to let capital out quickly. The resulting move was as swift as it was bold – the overseas investment limit for local companies was raised from three to four times their net worth, refinancing limits on foreign currency loans were also tightened, and investment restrictions on domestic mutual funds and individual savers were eased. It seems unlikely that these measures will be enough to keep the rupee down.
By the end of September, the rupee had risen more than 10% against the dollar year-to-date – moving through the psychologically important Rs40 to the dollar level – prompting the central bank to buy the greenback aggressively to keep the rupee in check.
Back in May, Reddy told Emerging Markets that monetary tightening in developed economies might be able to curb the flow of capital – a key source of domestic inflation – into India. But by September, following the Fed rate cut and the surge in Indian stocks, the situation had become more problematic, made worse by the constant spectre of inflation. Although wholesale prices had fallen from a worrying 6.3% in April to 3.2% by late September, the threat from rising prices has not been entirely tamed – consumer prices have not fallen by much. “If one takes out fuel, power, lighting, the drop in wholesale prices is not considerable,” Reddy told Emerging Markets in an interview mid-September. New pressures could be emerging because of hardening oil and food prices, he added. The RBI would stick to its target of keeping the price rise under 5%, while it expects the economy to grow by 8.5% this fiscal, lower than the 9.4% last year.
In an interview with Emerging Markets in mid-September, Reddy said that turmoil in international credit markets had created a “sort of disconnect” because, despite “underlying inflationary pressures in most economies, which require a withdrawal of monetary accommodation, current financial market conditions require an injection of liquidity.” He added, in an interview hours before the Fed rate cut and shortly after the UK government’s bailout of distressed mortgage lender Northern Rock, that while India is not immune to the impact of a possible US economic slowdown, “India’s direct link to the US economy is low relative to other emerging economies.”
Challenge
Still, with a general election looming, India’s political class is becoming increasingly impatient with even a temporary spike in the rupee. This is despite the lack of evidence that the rupee’s rise against the dollar will make India’s IT industry uncompetitive, points out former IMF chief economist Raghuram Rajan. Short-term fixes – like a Rs15 billion package the government handed out to exporters in July – may be politically appealing, Rajan says, but politicians should focus instead on investing more in roads, power and setting up colleges – the things that actually make exporters more productive.
Earlier this year, there was widespread approval of a move to restrict foreign borrowings by Indian companies to keep capital inflows in check – backing that appears to have strengthened the Indian central bank’s case for managing the capital account. Nevertheless, Rajan points out that, as India’s trade integrates globally, capital controls become less effective. The reason for this is that current account transactions grow in size and start to more closely resemble capital account ones: “Once the current account is open, stuff leaks out. As soon as you plug one leak, another one springs up,” Rajan points out. For instance, accounts payable on a company’s imports can often turn out to be a foreign loan. As it is not possible to ‘fix’ the real exchange rate in those circumstances, a better way to manage it is to remove the constraints on supply in the economy, Rajan adds.
International trade makes up nearly 50% of India’s GDP. But India’s policy-makers argue that opening the capital account only gradually has served the country well. Reddy says that capital account management in an emerging economy may be defended on two counts: international financial markets treat the macroeconomic fundamentals of an industrialized economy differently from those of an emerging market economy, and also, because good macroeconomic management demands that an emerging market’s foreign exchange reserves must cover up to one year’s short-term liabilities. “How can we be expected to follow that rule unless we manage the capital account?” Reddy asks.
More importantly, capital account management becomes necessary when the real economy may not be flexible enough and the fiscal space available to policy-makers is tight. On both these counts, India’s economy has some way to go.
What slowdown?
By the end of June, there was little sign of a slowdown as India’s economy clocked an impressive 9.3% growth. In early September, Goldman Sachs raised its forecast on India’s GDP growth this year from 8% to 8.7%, citing the continued strength in investment demand and a better-than-anticipated monsoon. Still, the impact of a sharp fall in loan growth is expected later this year while consumption demand for homes, consumer durables and cars is dropping off.
At the same time, slower exports and the higher cost of crude oil imports are expected to widen India’s current account deficit. JP Morgan Chase reckons the deficit will hit $13.6 billion (1.2% of GDP) in the year to March 2008, up from $9.6 billion (1.1% of GDP) in the same period one year earlier. Yet, policy-makers appear unconcerned. Reddy says he expects net capital inflows into India this year will “most likely” take care of the current account deficit; there’s no evidence of capital inflows drying up or a “flight to safety”, he argues.
Chanda Kochchar, deputy managing director at ICICI Bank, India’s second-largest commercial bank, believes the large investment plans of Indian companies are credible because they have sizable cash flows, are not highly leveraged and have kept the cost of capital low. “The challenge for Indian banks is to be able to support the big ambitions of Indian companies while also being able to serve the small retail customer,” she told a Mumbai conference of global bankers in September.
“Recent monetary tightening will only moderate, not derail, investment spending,” concurs Rajeev Malik, head of Asia Economic Research at JP Morgan Chase. He reckons that, like last year, fixed investment will contribute more to 2007 GDP growth than private consumption. Bankers are eager to see interest rates fall when the RBI announces its monetary policy in October so that companies continue to invest.
Most analysts put their hopes in the prospect of a stronger coalition government emerging from next year’s elections, perhaps led by the Congress Party with a large regional ally in tow, rather than the fractious support it now has from leftist parties. This, it is hoped, will give the new government the right amount of traction to focus on more urgent issues – quick movement on policy reforms to bolster electricity generation and construct more roads, ports, airports and schools – all key ingredients to sustain economic growth.