Seven months after receiving a rare sovereign ratings upgrade from Moody’s Investors Service, the Indian economy has been hit by an exodus of foreign investors. This has led to a fall in the rupee. With rising global uncertainties, coupled with a fluid political situation ahead of the general elections in 2019, the crisis of confidence poses a tough challenge for policymakers.

However, India is not the only emerging market to have been affected by capital outflows. All emerging markets have witnessed capital outflows ever since expectations of US interest rate hikes strengthened, and returns or yields from US Treasury bills rose in mid-April.

However, India has been the worst affected, data from the Institute of International Finance (IIF) shows. Between mid-April and now, foreign investors have sold assets worth about $10 billion.

Not only portfolio flows, even foreign direct investment (FDI) flows, which are often deemed to be more stable, have been tapering.

FDI inflows to India declined in 2017 after having risen in each of the previous four years. Moreover, repatriation or capital by long-term foreign investors has also increased in recent quarters.

Rising repatriation might suggest waning investor interest and possible “disenchantment" with the experience of investing in India, Mahesh Vyas, chief executive of the Centre for Monitoring Indian Economy (CMIE), argued in a recent note. The crisis of confidence also stems from India’s extra-ordinary sensitivity to global commodity prices, especially oil, which tops the list of concerns for the Indian economy.

Even if the price of crude oil falls to $70 per barrel, India’s current account deficit would still reach a six-year high at 2.5% of India’s gross domestic product (GDP) in fiscal 2019. If crude oil prices touch $90 per barrel, this could push up the current account deficit to 3.6% of GDP. Oil prices at $90 could also force the government to cut excise duties to absorb at least part of the price shock. This alone could push up the fiscal deficit to 4.6% of GDP, 130 basis points higher than the budgeted estimate, assuming other spending remains at the 2017-18 levels as a percent of GDP.

Thus, the fear of the ‘twin deficits’ is back,five years after similar fears had spooked markets and led to a mini-currency-crisis. At that time, India’s balance-sheet was in a far more precarious position, and it had far less fire-power in the form of forex reserves to defend the currency. Things are in a better shape today. Yet, the nature of the global shock is different. In 2013, the expectations of an unwinding of monetary easing by the US Fed had brought emerging markets, such as India, to their knees. This time, the rate hike cycle is already on track, and both the US Fed and the European Central Bank are expected to tighten monetary policy.

The yield advantage India enjoyed over the US has already shrunk, impacting portfolio flows in the debt segment. The inflation-adjusted differential has narrowed since mid-2017 and is likely to remain compressed for the rest of 2018, as the US Federal Reserve looks poised to raise interest rates by another 50 basis points (bps) by end-2018.

Not surprisingly, FIIs have gradually turned net sellers in the debt segment, besides also selling equities. The sell-off has put pressure on the rupee.

The fear of rising trade-related disruptions, globally, and the risk of populist spending locally ahead of elections also dampen the outlook for the rupee. Even a limited skirmish with the US could impact India’s trade and current account deficit, by jeopardising India’s sizeable trade surplus of around $30 billion with the US.

The risk of fiscal slippage is also high, given India’s past history of rising spending ahead of elections. Of the three past general elections, the incumbent managed to return to power only once: and that was when spending spiked up ahead of elections. The government faces a stark choice between good economics and good politics today. It can tighten its belt, limit expenditures, and win back the confidence of investors in the Indian economy, at the cost of alienating a significant chunk of voters.

Alternatively, it can please voters by raising government spending, risk the ire of disenchanted investors, and jeopardise its macro-economic legacy.

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