India’s real gross domestic product (GDP) growth has declined from 10.1% in the first quarter of FY07 to 7.9% in the fourth quarter of FY08, and in the process, the country has gone from being a much loved investment destination to one that the global investing community has accepted is slowing. How did we get here: Was India’s expansion just a consequence of a strong global economy? Is India going to be a pariah here on? Or should we expect a return of the glory days?
Current account deficit economies such as India will always have exaggerated reactions to the upside when global liquidity is on their side, and an exaggerated reaction to the downside when the liquidity spigot gets turned off. We love a chart that the India strategy team at Morgan Stanley puts out —Indian corporate earnings divided by India’s nominal GDP, overlaid with the US counterpart metric. This chart shows that the business cycle took off for both India and the US at the same time in 2003. There’s no denying that India has benefited from global liquidity between 2003 and 2007, but has it just been a strong global wave lifting India’s boat?
We don’t think so.
Consumption led the growth from 2003 to late 2006. The Indian consumer’s new found addiction to debt undeniably boosted the consumptative growth until the Reserve Bank of India’s (RBI) rate hikes caused this growth engine to sag. Capital investment took over the growth mantle from late 2006 onwards; however, as capital now becomes a scarce commodity for even India’s corporates with their strong balance sheets, investment growth itself is slowing, as evidenced by the declining growth of capital goods production.
On a very related note, we have long felt that the much talked about inflation scare will prove to be just that—a scare. For inflation to prove sticky, one needs a wage spiral; without one, the demand side cannot hold up and consequently, prices can’t either. The developed nations, especially the US, are poster children of this. In India, too, inflation’s bark will prove to be worse than its bite, as already evident by stripping out the effect of global commodities from the Wholesale Price Index (WPI). While rampant wage increases did seem to pose a problem, the dynamics of the labour markets in India have shifted to a more flexible model and will help put a lid on spiralling inflation. The “core” measure of inflation while admittedly outside RBI’s comfort zone, nevertheless, is just a lagging indicator of an overheated business cycle that’s already correcting itself.
We do think the Indian economy is very likely to slow further, and this recognition isn’t necessarily ingrained among global investors. Consumption growth is unlikely to revive soon as wages moderate, nominal interest rates stay high and financial savings in the equity market as well as the property market suffer. Private corporate investment is already contributing heavily to GDP growth and has way surpassed the previous capital investment cycle, measured as a percentage of GDP. Further, this high level of capital investment is not because of any sort of a secular trend—i.e. significant proportion of the investment going towards infrastructure. Infrastructure investments as a percentage of GDP have grown less than 1.5% between fiscal 2003 and 2007; on the other hand private corporate investment has grown by more than 10% in the same period. Meanwhile, like in any emerging economy, with high levels of productivity growth, one would expect the same capital investments to go a longer way.
Access to capital is not going to be abundant globally for sometime to come, as we have no faith in the global credit crisis resolving itself quickly, since repairing of financial institution balance sheets and deleveraging tends to be a long, painful process. Of course, India’s dependence on volatile capital market (from foreign institutional investors, or FIIs) flows rather than FDI (foreign direct investment) doesn’t help either. Exports, too, spurred by a declining rupee, are unlikely to save the day as global demand peters out. Also, going back to what we had talked about in our article dated 17 July, exports though a much larger part of the Indian economy post liberalization, India still really hasn’t achieved its export potential. The woeful fiscal management by the government means that we shouldn’t be banking on government spending boosting growth either.
The slowdown is for real, but when the global economy revives, investors will once again revisit the reasons that made India emerge as an attractive investment destination—a young demographic which ensures that India has a growing labour force, gradual but consistent path of reforms that have continued independent of the governing political ideology and a high consumer and private sector savings rate. All these make India a phenomenal domestic-driven story; for those of us not terribly enthralled with export-driven economies, India will always be something to keep an eye on.
Meanwhile, it’s not as awful when the excessive froth, be it in wages, easy credit, stock prices or property prices, corrects itself, leaving a more fundamentally strong economy behind.
To read all of Rajeshree Varangaonkar and Bharat Indurkar’s earlier columns, go to www.livemint.com/globalbeat
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They will write every other Friday. Send your comments to firstname.lastname@example.org