India: Battered but not beaten
The market anticipation of Fed QE tapering has sent the Indian rupee to record lows. However, India is not a blameless victim. It struggles with fundamental issues constraining economic growth; large twin deficits and a declining investor confidence on the back of inadequate reforms.
Twin deficits put India on top of the hit list
In May, the US Fed Chairman suggested that the Fed will start to lower the pace of asset purchases. In response, investors started selling off assets in high risk markets. Countries with large current account and fiscal deficits have been particularly vulnerable, including India. The Indian rupee has lost 20% of its value against the US dollar since May. The government’s response has so far been rather weak and at times confusing. However, what is needed to calm markets are reforms to boost the potential growth rate, curb inflation and reduce the twin deficits.
Despite the expectation that the twin deficit will persist and that sweeping reforms are unlikely given the elections next year, India does not seem to be heading for a repeat of the 1991 balance-of-payments (BoP) crisis. While several factors look familiar, the economy is stronger today in comparison and the currency is no longer fixed. The foreign exchange (FX) reserves are still at reasonable levels. The FX reserves decreased from USD 288bn end-May to USD 275bn end-August, a 4% decline. Reserves currently cover about five months of imports and over 300% of India’s short-term debt. Although a BoP crisis is not near, India has become more vulnerable. An unexpected spike in oil prices, for example, could put the country at risk.
Economic growth is slowing
The meager 4.4% y-o-y GDP growth in the first quarter (April-June) of the fiscal year (FY) 2013-14 dashed the hope of a good start to the fiscal year. The economy slowed from 4.8% in the fourth quarter of FY2012-13 (Jan-Mar). The slowdown was broad based with most sectors performing weaker than in the previous quarter. The weak performance of manufacturing (-1.2% y-o-y) and mining (-2.8% y-o-y) reflects poor investor confidence. The financial and business services sector continued to grow at 8.9%, but this was lower than the 9.1% in the previous quarter. The agricultural sector recorded a small uptick (2.7%, up from 1.4% in the previous quarter) as it recovered from an erratic and delayed 2012 monsoon.
A strong recovery in the remainder of the fiscal year is not expected given the string of bad news. The HSBC composite PMI was below the 50-point threshold for the second consecutive month in August (47.6). The sub-indicator for manufacturing was 48.5, thereby dropping below the neutral level for the first time since March 2009. The manufacturing PMI had been surprisingly strong in the past months, but reality now seems to have caught up with the Indian producers. Overall, GDP growth is expected to slow further from 5.0% in FY2012-13 to 4-5% in FY2013-14.
Inflation remains a concern
Despite slowing economic growth, inflationary pressures have been on the rise lately. The wholesale price index (WPI), India’s main inflation gauge, increased from 4.6% in May to 5.8% in July, driven by rising food and fuel prices. The former is expected to ease in the coming months, as the monsoon is progressing rather well. However, fuel prices are unlikely to decrease much. In January 2013, the government allowed the oil companies to adjust their prices to reflect input costs. As India has to import most of its oil, the rupee depreciation is putting upward pressure on fuel prices.
After cutting the policy rate three times at the start of 2013 amid declining inflation, the Reserve Bank of India (RBI) has left its policy rate on hold (7.25%) since early May. In August, the RBI took several measures in response to the sliding rupee that resulted in a tightening of monetary policy. While the monetary authorities stated that these measures are only temporary, a quick return to the easing cycle is unlikely given the current volatility of the rupee. Stimulating economic growth through loose monetary policy is therefore not expected.