The relentless selling by foreign investors in the Indian market continues. As on 18 January, the US MSCI index was up 9.6% three months-to-date, while MSCI India was down 8.2%. The usual explanation is that money is flowing back to the US equity markets, thanks to higher than expected growth there.
But not all Asian markets have been affected. The MSCI equity indices for both Korea and Taiwan are up 15.5% in the last three months. Is it merely some profit-taking then, a rotation away from the more expensive markets? Also, it’s not that money is flowing back only to the US—MSCI Japan is up 11.5% over the last three months.
While higher US growth is providing the pull, inflation in emerging markets is providing the push to the funds flow. Inflation fears have started to weigh heavily on emerging markets and the worry is that growth will slow as central banks across the region start tightening policy and raising interest rates.
India is at the forefront of these worries, with food inflation shooting up again. Money markets have remained stubbornly tight. Both deposit and lending rates have moved up. Oil prices are rising, widening the current account deficit. Economists have rediscovered the fact that India is a supply-constrained economy.
Inflation projections are being revised upward while growth forecasts are being revised down. When global growth was low, we tom-tommed the relative insularity of our economy, but now that world growth is recovering, it is the more export-oriented economies that are poised to benefit more from it. And all these headwinds are occurring in a market that trades at premium valuations. Investors are now saying that part of that premium is unjustified.
The nightmare scenario, of course, is a repeat of 2008. At that time, the combination of loose monetary policy in the developed world and strong growth in developing countries, which had earlier led to a sharp rise in emerging market equities, finally led to liquidity spilling over into commodity prices. Inflation in the asset markets gave way to price inflation, valuations soared, central banks tightened policy and the bull market turned into a bear.
How different is it today? Monetary policy in the West continues to be easy. Commodity and oil prices are rising. The World Bank’s Global Economic Prospects, released recently, says global real gross domestic product (GDP) growth for 2011 will be 3.3%, down from 3.9% in 2010. In 2007, global GDP growth was 3.7%, after 4% growth in 2006, so overall demand pressures are currently not as strong as in 2008.
But what’s the forecast for Chinese growth? 8.7% in 2011, according to the World Bank, after 10% growth in 2010. That’s well below 2006 growth of 11.6% and 2007’s 11.9%. Even in 2008, China’s GDP growth was 9.4%, higher than forecast today. And it’s difficult to reconcile higher commodity prices with a slowdown in Chinese growth. Also, the dollar has been rather strong recently, while it’s a weaker dollar that is good for commodities.
That’s why the World Bank is forecasting a comforting 7.6% increase in oil prices after a 28% rise in 2010. The forecast is for oil at $85 a barrel on average in 2011. The price is already above that average, but then prices may fall as economies such as India and China slow.
Turning to India, the World Bank forecasts real GDP at market prices to be 8.5% in calendar 2011, lower than its estimate of 9.2% growth in 2010. While the Bank doesn’t provide a separate inflation indicator for India, it forecasts inflation (using the GDP deflator) at a high 8.7% in 2011 for South Asia, on top of 11.5% inflation in 2010.
In other words, inflation is going to be a hard nut to crack in India, not least because it has steadily crept higher since 2000, leading to heightened inflationary expectations. Add the fact that the fiscal deficit is exacerbated when food and oil prices rise because of higher food, fuel and fertilizer subsidies and that this year’s windfall from the telecom auction won’t be repeated.
Add what’s mentioned in the annexure to the World Economic Prospects pointing out that in India industrial activity is 6.1% above full capacity utilization, which means pricing power is back. It’s no wonder then that RBI is concerned about inflation and will certainly increase policy rates all through 2011.
The problem is that interest rates are already at levels seen in 2008. For instance, deposit rates with banks have already reached the levels they were at during that time, in spite of RBI’s policy rates being much lower. Real interest rates for bank deposits are now in positive territory.
Bank credit growth is currently at 24.4% year-on-year, as on 31 December 2010. At the end of December 2007, bank credit growth was lower, at 21.4%. The credit-deposit ratio for banks is currently at 75.7%—it was a much lower 72.75% at the end of 2007.
These are the fears that have dragged the Indian market down. Is there a silver lining? Well, the World Bank estimates that net portfolio equity flows to South Asia—most of it to India—will be $39 billion this year, compared with $43 billion last year. That’s not so bad.
Also, the Bank of America-Merrill Lynch survey of fund managers for January says that India, at -35%, was a big underweight for emerging market investors as well as for Asia Pacific investors (-21% underweight). Taken as a contrarian indicator, that should cushion the downside.
To read all of Manas Chakravarty’s earlier columns, go to www.livemint.com/capitalaccount
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org