Whatever happened to the India story? As stories go, it was quite a simple one. India is the second-fastest growing large economy, the Western economies have been blighted by the financial crisis and, since Western central banks have no option but to keep their interest rates low, the money had no choice but to come to the Indian market. The problem is that at the moment that story looks a lot like a fairy tale.
What went wrong? It wasn’t, as so many pundits were fond of saying, the contagion from a fiscal crisis in the European periphery. It wasn’t that old bogey, the double dip. What happened was that, contrary to most expectations, the US economy started to pick up steam. Even Europe is not doing quite so terribly. Instead, the combination of rapid growth in the emerging economies, together with loose monetary policy in the advanced economies and a revival in growth in the West, has led to the re-emergence of inflation in emerging markets.
India has been hit particularly hard. Food inflation has proved to be remarkably persistent and almost everyone now says the reasons are at least partially structural. The implication is that it’s going to be tough to bring down inflation.
That’s not all. Interest rates are already at levels seen at the top of the last business cycle and the latest advance estimates of gross domestic product for the current fiscal show that investment demand has been affected. And if firms do not expand capacity, that will restrict supply, adding to inflationary pressures. High input prices have already squeezed corporate profitability and a spate of earnings downgrades is likely to follow. Also, it isn’t just interest rates that are a problem—the hope that the government will deliver economic reform, a hope that sent the markets rocketing when they came to power—has been completely belied.
Apart from these “fundamental” factors, the fall in the markets has also been prompted by a shift in the flow of funds to the US and other developed markets, as their economies show signs of improvement, and to export-oriented economies that stand to gain more from a global upswing. It doesn’t help the Indian market that it still quotes at a premium to its peers.
The implications are clear. For the India story to regain its lustre, the government will have to show that it means business. It will have to deliver on reform. It will have to move resources from government consumption to investment. It can no longer coast along on a rising tide of global liquidity. It’s time for it to take some hard decisions.
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