India: Twin crises bode ill for the economic outlook
- On 15 June, Indian and Chinese soldiers clashed near the so-called Line of Actual Control (LAC), which resulted in 20 Indian casualties and an unknown number of fatalities on the Chinese side
- We expect that New Delhi and Beijing will try to solve the Sino-Indian border dispute diplomatically
- However, the border clash has definitely soured the already fragile Sino-Indian relationship and might drive India into the arms of the United States as far as geopolitical matters are concerned
- Economic decoupling between the two nuclear powers will prove cumbersome, as India is dependent on key materials and imports from China for its electrical and chemical industry. Moreover, China is India’s third most important export partner
- Besides the border dispute with China, India continues to struggle to keep a lid on COVID-19. The twin crises has an adverse impact on India’s attractiveness as an investment destination, which might explain why the Indian rupee (INR) has barely been able to benefit from the global financial markets rally
- We expect another cut of the repo rate in third quarter by 50bps in Q3 of 2020, but we also foresee that unfavourable inflation dynamics might force the RBI to start hiking rates as soon as early next year
Sino-Indian border clash
On 15 June, Indian and Chinese soldiers clashed near the so-called Line of Actual Control (LAC). The confrontation resulted in 20 Indian fatalities, whereas the number of casualties on the Chinese side remains unclear. Although both sides put the cause of the clash down to the other party violating agreements, the Chinese Minister of Foreign Affairs Wang Yi and Indian Minister of External Affairs Jaishankar have been in close contact in order to prevent further escalation.
The nuclear neighbours have been at loggerheads at the 3,500 km border since the Sino-Indian war of 1962. Although there have been several skirmishes at the border ever since, there have been no actual fatalities since 1975, when the Second Sino-Indian war was fought. Although we expect that both New Delhi and Beijing will continue to try and resolve matters diplomatically, the border clash has definitely soured the already fragile Sino-Indian relationship and significantly increased the risk of renewed escalation and even war. In the past India has often refrained from choosing sides in geopolitical disputes, but the current political crisis might just be the straw that breaks the camel’s back and drive India into the arms of the United States.
The border clash will certainly have economic ramifications. There are already accounts that India is delaying imports from China, resulting in supply-chain issues in its electronics industry. Moreover, anti-dumping tariffs on steel from China have been imposed and the Ministry of Electronics and IT has banned 59 Chinese apps over privacy concerns. The question is how far the Modi government can go in pushing further sanctions without infuriating Beijing. Retaliatory measures by China would definitely hurt the Indian economy, which is going through its worst economic crisis since the late 70s due to COVID-19. Many Indian industries are currently dependent on intermediate inputs and investment from China, ranging from machinery manufacturing (telecommunication, semi-conductors, integrated circuits and computers) to inputs for the chemical industry (Figure 1). Prime Minister Modi has stated before that India’s dependence on China for key components might pose a security risk. Moreover, it is India’s third most important export destination, with 5.6% of all goods being shipped to China (see Figure 2). When Indian goods that are shipped to Hong Kong are taken into account, China is even on a par with the UAE. In contrast, India is only China’s seventh export destination, responsible for 3% of all goods being shipped from Chinese shores to other parts of the globe. All in all, we expect that economic decoupling will be difficult and not something that can be realized overnight.
No relief for the rupee
Besides the border dispute with China, India continues to struggle to keep a lid on COVID-19. India currently has 550,000 confirmed COVID-19 cases, compared to ‘only’ 190,000 at the beginning of June. On the upside, the death toll (16,500 people) is still very low in India, which we discussed extensively in this report. The twin crises might explain why the Indian rupee (INR) has barely been able to benefit from the global financial markets rally (Figure 3). Although we feel markets are currently sedated by the vast amount of monetary stimulus and are pretty much out of touch with reality, the fact is that many EM currencies have witnessed a remarkable recovery on the back of financial markets optimism; but there’s been no relief for the INR.
Another parameter that needs close monitoring is inflation, as we expect a volatile trajectory going forward. The government has not released inflation data for April and May due to a lack of information during the hard lockdown phase. Although we know that food inflation has remained elevated in these months at around 8%, we think core inflation leveled off substantially, leading to an expected sharp decrease in headline inflation to 2.8% (y-o-y) in June (Figure 4). Our expectations differ substantially from median expectations in the June Bloomberg survey among 34 economists, where inflation is expected to bottom out in the first quarter of 2021. Based on our own estimates with a new improved inflation model, we expect a rapid pickup of inflation by that time, caused by weak y-o-y currency dynamics propping up import inflation and by high real money growth. And although we expect another cut of the repo rate by 50bps in Q3 2020, unfavorable inflation dynamics might force the RBI to start hiking rates as soon as early next year.