India has come under siege this summer. The rupee has depreciated sharply since late July, and foreign exchange reserves dropped significantly. The pressure has been triggered by market concerns on the Fed’s intention to ‘taper’ its quantitative easing, against the background of a growth slowdown in China.
India’s currency suffered a first bout of depreciation starting in early May, right after Fed Chairman Bernanke gave the first hint that the Fed might start reducing its asset purchases. Concern that global liquidity might become less plentiful has made investors wary of emerging markets, triggering capital outflows. India is not alone here. The chart below shows that other emerging markets have had a rough summer. South Africa suffered a deeper depreciation than India year-to-date, as did Brazil before its central bank stepped in announcing a new foreign exchange intervention program (Figure 1).
Figure 1. FX depreciation v US$ (January 1, 2013 = 100)
Market reactions linked to fundamentals
The market reaction has not been indiscriminate. Countries with larger funding needs, poorer fundamentals and weaker policies have been hit harder:
- For example, Mexico – with low government debt, a small current-account deficit and a major wave of reforms underway – fared much better than the rest.
- Conversely, India is paying for its domestic weaknesses.
As economic reforms lost momentum, economic growth slowed to about 5%, a far cry from the 9% enjoyed in the three years before the Lehman crisis. And as growth decelerated, the current-account deficit widened rapidly to about 5% of GDP (Figure 2). In other words, India is a victim of deteriorating external circumstances, but not an innocent victim (see Chan 2012). Deteriorating domestic fundamentals have placed the country in a relatively higher-risk bracket, making it more exposed to a turn in market sentiment.
Figure 2. India: Current-account balance (% of GDP and US$ billions)
The marked worsening in India’s economic growth and external accounts underscores the need to step up reforms and critical infrastructure investment. Accelerating liberalisation, opening up larger portions of the economy to foreign investment, upgrading the infrastructure for power generation and distribution, and simplifying the business environment would open the way for faster growth in industry, manufacturing and exports.
India’s inability to make progress in these areas has caused exports to stagnate in dollar terms over the past two and half years (see Figure 3), and has left underutilised and underemployed India’s vast reserve of labour. Without an acceleration in economic reforms, liberalisation and investment in infrastructure, India might even slip back to the infamous ‘Hindu rate of growth’, the 3-4% which prevailed before the first wave of economic reforms in the early 1990s (see Ghani 2012).
Figure 3. India: Exports and imports (monthly, US$ billions)
The need to step up investment takes us back to the issue of funding:
- Between 2000 and 2007, India’s Investment to GDP ratio rose from 23% to 38%, supported by a commensurate rise in domestic savings.
- Since then, however, domestic savings have declined significantly – so that attracting foreign investment becomes even more important.
In an interesting recent discussion of savings and investments in advanced and emerging economies, Daniel Gros (2013) notes that it makes sense for India to run a current-account deficit and absorb foreign investment, given its lower capital to output ratio compared to many advanced economies. I concur. The recent bout of volatility, however, reminds us that a good business environment and sound fiscal policy are crucial to support the sustainability of foreign capital inflows.
Against this background, Indian policymakers have adopted a pragmatic response to the recent market pressure. They have initially focused on ‘tactical’ measures to help the current account and capital account:
- Higher duties and excises on gold and silver.
- A lower ceiling for remittances by resident individuals.
- A lower ceiling to overseas direct investments by Indian companies.
- Measures to raise short-term rates and tighten credit.
These measures have had limited success on the foreign exchange front, while the tightening of credit conditions presented a new risk to growth.
Pragmatically, the Reserve Bank of India has then taken a step back, announcing purchases of long-dated government bonds via open market operations as well as measures aimed at giving banks some more breathing space on reserve requirements, to alleviate the liquidity crunch.
The pressure is likely to persist. Uncertainty on how the Fed’s policy normalisation process will play out could persist for several months at least. The rupee therefore remains vulnerable to further depreciation. There are two ways in which policymakers could stem the pressure:
- One is to quickly revamp economic reforms.
- The other would be to issue bonds for Non-Resident Indians, which in past occasions has proved to be an effective way of bolstering foreign exchange reserves.
And the latter has been highlighted by a number of market analysts.
Growth is also likely to suffer. Consumer and business sentiment have weakened, credit conditions have been tightening, and the foreign exchange depreciation will boost import costs and reduce purchasing power as it feeds through to inflation. With the pipeline of infrastructure projects already reduced, a further slowdown in growth is a likely scenario, though specific sectors will continue to perform.
Things are not that bad
It is important to keep things in perspective, however, and realise that India’s macro vulnerabilities are not extreme – though they compare unfavorably to other major emerging markets. For instance:
- External debt is low.
- Public debt is fully sustainable.
- India has not experienced the kind of massive credit boom that could imperil the banking system.
- The stock of reserves is still well above danger levels, even though the recent loss of International reserves has made markets nervous.
The same holds for emerging markets. The alarm and pessimism which has begun to permeate the debate on emerging markets appears to have run well ahead of the deterioration in the countries’ performance and fundamentals. Any talk of an ‘emerging markets crisis’ seems at best premature.
Overall, emerging markets fundamentals are still healthy. Public debt levels in most cases compare favorably to those in advanced economies (yes, that applies to India as well), and even more so if one considers contingent liabilities on pension and health care spending. Credit growth and corporate debt issuance have risen in the last few years, but overall emerging market policymakers have done a good job at managing the combined pressure of fast economic growth and buoyant capital inflows. Finally, most emerging markets today have flexible exchange rates, which provide a more immediate adjustment mechanism – different, for example, from the fixed exchange rates that prevailed in Asia at the time of the 1997-98 financial crisis.
Momentum has weakened, but this is not a systematic emerging market crisis
There is no doubt that in some emerging market countries over the last few years, reform momentum has weakened and fiscal or external balances have deteriorated; but this weakening has been neither deep nor widespread enough to set the stage for a systemic emerging market crisis. Rather, it points to the importance of assessing the health of macro fundamentals on a country-by -basis.
Similarly, it is true that many emerging markets are experiencing a cyclical slowdown in GDP growth – this should not be surprising given the coordinated sprint with which these markets helped pull the global economy out of the 2009 recession. But it is a stretch to argue that emerging markets are being replaced by advanced economies as the engine of growth. Again, the key is to look at fundamentals to distinguish those emerging markets which are just experiencing a cyclical deceleration from those who might be set for a more structural slowdown.
I still believe that the concern for the impact of Fed tapering on emerging markets should not be overdone. Global liquidity will keep expanding for some time. The Bank of Japan is stepping up its quantitative easing while the Fed has no plans to withdraw liquidity anytime soon. More importantly, the Fed’s taper is predicated on a strengthening of US growth, which would be positive for emerging markets.
As we move towards the end of 2013 and into 2014, I expect global growth will take a firmer tone, and better sentiment on emerging markets will stabilise capital flows. Together with softer growth and a weaker rupee, this will also lead India’s exports to recover a bit of ground, and help India’s current-account balance reverse its widening trend.
Chan, S (2012), “Is India’s current economic slowdown due to cyclical or structural factors? ”, VoxEU.org, 15 September.