India’s resilience has been saved
Cover image by: Jaime Austin
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The global recovery has been fueling inflation across the world. This has led to rising speculations about whether industrial nations will reverse their monetary policy stance. Over the past decade, the central banks of the United States, European Union, and Japan, among others, have embarked on ultralow interest rates and have been rapidly expanding their balance sheets, more so after the pandemic, to inject liquidity and stimulate their economies. Consequently, global liquidity is at an all-time high (figure 1). Low bond yields have compelled global investors to turn toward emerging nations with stronger economic prospects, including India.
The reversal of easy monetary policies is inevitable; if not this year, industrial nations will reduce the stimulus and raise policy rates in the coming years. Emerging markets with high debt could witness a reversal of capital flows as investors seek safer havens during market volatility. As echoed by International Monetary Fund (IMF) chief economist, the pandemic has led to a sharp increase in public and private sector debt, which can create financial risks and have macroprudential implications.
Back in the summer of 2013, markets in emerging economies went on a rollercoaster ride as investors worldwide started selling risky assets from emerging markets, including India. What led to a “sky is falling” reaction among investors was an indication by the US Federal Reserve (Fed) of a possible reduction in its monetary policy stimulus.1
The question then is, will history repeat itself or is India fundamentally strong enough to deal with the uncertainty associated with the Fed’s actual tapering that starts later in November?
What we know from past experiences is that the extent of vulnerability varies across emerging economies depending on investors’ risk perception. That, in turn, is influenced by nations’ relative economic performances and fundamentals. During 2013, the economies that belonged to the weaker end of the performance spectrum, including India, were punished the most by investors.2
However, the situation is much different today. A comparison of economic parameters suggests that India’s fundamentals are now relatively strong.
At a time when pandemic uncertainties linger, it won’t be a surprise if investors get ahead of themselves, anticipating with confidence that the taper of bond-buying programs will result in higher borrowing costs, impacting asset valuations. A possible consequence could be that investors worldwide start pulling money back to the United States by selling risky assets, mostly from the emerging markets, in favor of US securities and cash. Emerging markets that have grown accustomed to unprecedented flows of short-term capital from abroad will have to be prepared for the potential impact of liquidity shortages and uncertainties once the central banks decide to turn the liquidity tap off.
The impact across emerging nations will, however, differ based on the strength of their underlying economic fundamentals. We analyzed the movements in key economic parameters of emerging economies during the most vulnerable periods in 2020 when the world was reeling under the first few waves of the pandemic, as well as any ensuing recovery to date.
Figure 2 shows that while local currencies in all these economies depreciated against the US dollar in 2020, most economies have gained some of the lost ground since then, with India’s currency being among the better-performing ones. Extreme currency volatilities compelled the policy authorities of these economies to urgently intervene to correct the course of depreciation. China and Vietnam are exceptions—their currencies appreciated against the US dollar in 2020.
Even though high demand for US treasuries drove down bond rates at the peak of the crisis in 2020, only a few economies witnessed a sharp widening of the interest rate spread with respect to the 10-year benchmark rate of the United States, suggesting rising risks associated with holding sovereign assets of those few nations (figure 3a). As a result, not all economies saw a rapid sovereign sell-off.3 India was the only nation whose yield spread (vis-à-vis the United States) did not deteriorate after February 2020. India is also the only nation that has seen its 10-year sovereign yield decline since January 2020, despite pandemic-related uncertainties (figure 3b).
The trajectory of the yield suggests that risks associated with sovereign borrowings have declined and India’s creditworthiness has improved despite the deep economic recession and uncertainties. This may be an outcome of a relatively stronger economic outlook and stable domestic currency, all of which have improved investor confidence for India.
Capital markets across the world were badly hit post the onset of the pandemic, although the steepest decline was in February 2020, except in Turkey. Fierce asset sell-off and a sudden outflow of portfolio investment led to a sharp fall in equity prices. The markets have stabilized since, but the improvement has varied significantly across nations. Many emerging nations have not been able to reverse the stock market trends yet.
The capital markets of two nations have stood out in reversing the trend and are growing aggressively—India and Vietnam. This probably indicates that a portion of capital withdrawn from all other nations flowed into these two economies as global corporations explored alternate investment destinations to diversify the supply chain.
Robust foreign investment inflows resulted in strong growth in the Indian capital market as investors’ risk perception of India as an alternate investment destination improved. India was among the very few nations that witnessed strong foreign direct investment (FDI) in 2020 and the momentum has continued in 2021. Recent reforms and policies to further liberalize FDI in a few sectors such as insurance, agriculture, telecommunications services, and defense have attracted global investors. Schemes such as the production-linked incentive (PLI) and labor reforms have increased foreign interest in several investable. Besides, the national monetization pipeline of brownfield assets is likely to generate investment interests and attract foreign capital.
One of the key concerns for policymakers in emerging economies is the probable impact of capital outflows on the current account balances of the nations. This is because foreign inflows—both direct and portfolio—aid in bridging the deficit gap, if any, and capital outflows can put the external balance at risk. While the pandemic has led to a significant improvement in the current account balance of almost all emerging countries, India’s improvement since 2013 is noticeable. Even though improving economic activity and higher commodity prices will result in a rising deficit, it will likely remain range-bound, given the strong growth in the country’s exports. Besides, India’s foreign exchange reserves have increased 2.3 times since 2013, and the country’s import cover of more than 18 months provides a cushion against unforeseen external shocks.4
In other words, India’s current account position will not be challenged in case there is an outflow of capital because of the global liquidity squeeze.
The improved economic fundamentals are a reflection of India’s underlying structural changes addressed since 2013. India is one of the few economies that has improved its global competitiveness index significantly. Over the last two decades, India has successfully moved away from agriculture and leapfrogged into the services sector, which now contributes close to 55% of its GDP. That said, the recent emphasis on manufacturing and reforms are enabling the business environment and the ecosystem to boost the sector’s contribution to income and employment.5
Can India maintain its solid economic fundamentals vis-à-vis its peers in the medium term as the world emerges out of the pandemic’s shadow? This question is important because, barring any surprise, advanced economies have tailored their communication about closing the liquidity tap gradually over the next few years. This will, inevitably, lead to capital outflows and India will need stronger economic parameters to withstand the impending pressure.
The most important criteria for risk assessment of an economy as an investment destination are its growth outlook and stability. Economies with high growth and low inflation are usually deemed as low-risk and high-return investment destinations. Strong growth increases the probability of higher returns on investment, while low inflation prevents erosion of the value of their investment returns in the long run.
India is projected to be one of the world’s fastest-growing economies and is well-positioned relative to its peers based on their real economic growth in 2022. However, growth is likely to be lopsided as the contact-intensive services sector will bounce back with a lag. Inflation has been a persistent concern in India throughout the pandemic and is likely to remain so owing to a strong recovery, continued supply disruptions and constraints, and high commodity prices. Besides, it will face stiff competition for foreign capital resources from its Asian peers, where high growth is expected to be associated with low inflation (figure 8).
The other challenge is the high fiscal deficit incurred by the Indian government during the pandemic and its impact on the rising debt (figure 9). The pressure on the fiscal side in the absence of counterbalancing measures may impact sovereign ratings, and lead to higher yields and borrowing costs. Rising debt servicing costs could be a potential problem for the government and financial sector. Thankfully, India is well-positioned with respect to reserves as well as the share of external debt and debt denominated in dollars is low, which bolsters the country’s standing.
As the US Fed begins to taper the pace of its asset purchases, it has hinted it will be patient in reversing its monetary policy, and so would be the European Central Bank (ECB).6 However, it will be naïve to believe that risks in the global financial system won’t impact India in case there is a surprise. What we know is that the Fed’s “taper tantrum” episode in 2013 has played an important role in correcting the very economic fundamentals that had whirled the economy into a rollercoaster ride.
The influx of foreign capital and its impact on assets pricing has been recognized by policymakers, and they are vigilant. The Reserve Bank of India is more prudent and will be proactive to respond to capital outflows. However, the government will have to put the pedal to the metal on reforms and asset monetization to ensure a stronger rebound.
Cover image by: Jaime Austin