Monday, November 10

“Sail with the tide” is the apt phrase for those who talk about the economy, markets you name it. Except for those who did not invest in India, every one talked about the fundamentals and the growth rate projections for India’s GDP went as high as 15% by some eminent global analysts. Now when the markets have come down, every one has become an astrologer in retrospect. Every one is saying that India was overvalued and this downfall was obvious et al.

India’s GDP growth accelerated to an average of 9.3% during the three years ending March 2008 compared with an average of 6.6% and 6.0% in the preceding three and five years, respectively. “The most important driver for this acceleration in growth above potential was the sharp rise in capital inflows” – believes Chetan Ahya, Managing Director, Morgan Stanley.

Capital inflows have risen dramatically over the past five years. India received an average of $10 billion per annum between 2000 and 2002. During 2003-2005, capital inflows jumped more than two times to an average of $21.3 billion, followed by an increase to $38.5 billion in 2006 and to $98.3 billion in 2007.

Contrary to general belief, the direction and magnitude of capital inflows have been highly influenced by global macro environment rather than emerging markets’ long-term fundamentals. Very often we hear the argument from investors that capital inflows were drawn into India because of attractive growth opportunities and, therefore, this trend will continue unabated. However, trend for capital inflows into emerging markets have been dependent on global risk appetite, which has been driven by liquidity and growth environment in the developed economies.

During 12 months ending March 2008, India received $108 billion in capital inflows. Of this, $29 billion were portfolio equity inflows, $42 billion were debt borrowings, $15.5 billion were net FDI, and the balance was other inflows. Over the last few months, with the reversal in global risk appetite, we are seeing a sharp fall in capital inflows into India and emerging markets. As estimates of Morgan Stanley, capital inflows into India have on an annualised basis slowed to $30-35 billion in April-August 2008. India has seen portfolio equity outflows of $4.3 billion from April to August 2008, in line with the emerging markets.

It has been observed in the past that FDI inflows into emerging markets and India tend to lag the portfolio inflows by a year. A large part of the rise in FDI inflows into India was in the form of private equity inflows, real estate, and acquisition of stakes in Indian companies by multinationals. There has not been any significant increase in FDI into green-field manufacturing activities in India. Hence, a large part of the FDI inflows will likely follow the mood of the capital markets.

“In the current global financial market environment, countries with the twin macro-problems of high current account deficit and tight banking sector liquidity is likely to suffer a major deceleration in growth”, says Chetan. He believes India will be the most affected after Australia. First, unlike the rest of the region, India runs a large current account deficit, and its balance of payments surplus has been driven by capital inflows. Most other countries in the region have large current account surpluses. Second, India has had a strong credit cycle over the last four years. It has been a beneficiary of a virtuous cycle of large capital inflows — major liquidity infusion — pushing up domestic demand. India’s credit growth has averaged 28% over the last three years.

There is not much scope for a quick policy response to a further slowdown in domestic demand. The government has already been running a pro-cyclical fiscal policy stance. Indeed the burden of higher oil prices, the government’s announcement of a wage hike for its employees, and write-off of farm loans have pushed government’s deficit, including off-budget items to 10.2% of GDP in year ended March 2009.

Analysts don’t expect a quick monetary policy response either. It is believed the RBI is unlikely to cut policy rate again until the March-April 2009. The RBI will hesitate to cut policy rate until we see deceleration in WPI inflation closer to RBI’s comfort levels of 5% from the current double digit levels. Moreover, the RBI’s policy rate decision is also likely to be weighed against the weakening exchange rate.

Further domestic demand growth deceleration is inevitable. Over the last 12 months, aggressive tightening in India’s monetary conditions has already slowed credit-funded consumption significantly. The increased tightening in the global and domestic financial markets is expected to further slow investment growth sharply.

With nothing going well for the global economy, one can just sit and watch what the global leaders do to rescue the global economies from the ongoing crisis.

References: The Economic Times Nov 10, 08 [Interview with Chetan Ahya, Managing Director, Morgan Stanley]

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