A whiff of danger in the financial markets

Tuesday brought a bout of nervousness to the Indian financial markets—stocks fell, the 10-year bond yield moved above 8% and the rupee crossed the 71.50 to a dollar level. The question uppermost on investors’ minds is: will other emerging markets catch the contagion emanating from Turkey and Argentina? To be more specific, is India vulnerable?

The answer to that question lies in the accompanying chart, which compares India’s macro parameters with those of some of the most vulnerable countries. It shows that while the rupee has depreciated sharply this year, its fall is nowhere near that of the Argentine or Turkish currencies.

The closest parallel is the Indonesian rupiah.

That, however, does not mean there is no reason for concern. According to projections by the International Monetary Fund (IMF), India’s current account deficit this year is going to be worse than that of Indonesia, as well as Brazil. India’s fiscal deficit is one of the worst. Inflation in India will likely be higher than in Brazil, Indonesia and South Africa. The silver lining is that India’s growth is far higher and we have a large foreign exchange reserve.

In June, this column wrote about the increasing risks to financing India’s current account deficit.

In 2017-18, much of the current account deficit was financed by external short-term credit and foreign portfolio inflows into the debt markets. These are fair-weather flows and can reverse any time, particularly when external conditions worsen, as they are doing now—what with rising protectionism and a hint of liquidity tightening.

The Reserve Bank of India’s recently published annual report says, “The share of India’s exports in world exports has been constant at around 1.7% of world exports in the last five years, possibly pointing to a protracted stagnation in competitiveness.”

Exports are unlikely to prove a saviour, especially in these protectionist times. Some economists have suggested a sovereign bond issue.

The problem is that the current account deficit is already wide, even though investment demand in the country is tepid. If capital formation picks up, as it is widely expected to do, the deficit will widen further.

Indeed, Kotak Securities economists quoted in our June column said that assuming Brent crude prices at an average of $72.5 a barrel—well below the current level—the current account deficit would go up to 2.9% of gross domestic product (GDP), which is higher than the IMF forecast.

Simply put, if we have higher growth, we will have a higher current account deficit, which will weaken the currency further, stoke inflation and lead to higher bond yields.

A falling rupee may also deter portfolio inflows in both stocks and bonds.

As JP Morgan’s Jahangir Aziz said to CNBC- TV18 on Tuesday: “In a situation like this, there is no other option but to bring down the current account deficit by the old fashioned method, which is by reducing growth.”

Unfortunately, the stock markets are currently pricing in very high growth.