It is now almost five years since the taper tantrum that pushed India into the fragile sorority with others such as Brazil, Turkey, South Africa and Indonesia. The rupee tumbled after the US Federal Reserve indicated in May 2013 that it would soon begin to cut back on monetary expansion. India was then hobbled with an overvalued exchange rate, inadequate foreign exchange reserves, a record current account deficit, runaway inflation, and a massive fiscal deficit.
Such economic fragility is not in the room right now. However, macroeconomic instability is like a genie in a loosely capped bottle which can be unleashed at the slightest opportunity. As a recent report from investment bank Nomura noted, India is now not fragile but still vulnerable.
The global economy recently has been full of surprises. There are three main risks to economic stability right now. First is interest rate normalization in the US. Quantitative tightening would send US bond yields shooting up. US monetary tightening usually reduces capital flows into emerging markets, at a time when the Indian current account deficit has begun to widen. However, given the uncertainty surrounding the Donald Trump administration, the dollar still seems to be in the doldrums.
Second are the headwinds from China’s slowing growth. The clampdown on smoke, and the move towards clean energy, is hampering the Chinese manufacturing sector. Institutional changes after the top leadership consolidated power may disturb the incentive mechanism for local government officials, thereby hurting growth. According to a recent report by Nomura, the upsurge in producer price inflation that bolstered the profits of state-owned enterprises last year is deteriorating. Countries exposed to a China growth slowdown (through exports) may face a huge blow.
Third is the escalating trade war. “Trade wars are good, and easy to win," declared Donald Trump while announcing higher tariffs on steel and aluminium. However, they are rarely good. Retaliatory moves by big countries could hurt the exports of countries that participate in the sophisticated system of global value chains.
At first glance, India seems to be less at risk, if not immune, from these global tremors. To begin with increased US trade protectionism, the US accounts for only around 10% of India’s steel and aluminium exports, which limits the material impact of such a tariff on India’s trade—with the caveat that downward pressure on global prices owing to the diversion of steel and aluminium meant for the US could leave Indian producers in some strife. Further, exports from India to China and Hong Kong constitute about 10% of the total Indian exports, so India may not see a drastic impact despite the sputtering of China’s growth engines. In fact, it could make some room for India’s exports to cater to the global market.
Moreover, the macro situation looks far better than it did in 2013. India has a lower current account deficit, moderate inflation and better fiscal numbers. The Reserve Bank of India (RBI), thanks to record foreign exchange reserves built through several years of intervention in the currency market, is sitting on greater firepower to defend the rupee in case there is a run on the Indian currency.
However, there are four worries as well. First is the spectre of a current account deficit that is likely to widen up to 2% of gross domestic product (GDP) in 2018, from 1.7% in 2017. Despite being below the 5% mark reached in 2012, a higher current account deficit could make the economy vulnerable to sudden capital stops.
Second, the banking crisis that the Indian economy is undergoing. The sluggish pace of bad debt resolution and the growing cases of bank frauds make the economy susceptible to confidence loops. The assets of the State Bank of India (the country’s largest bank by assets) which turned into non-performing assets (NPAs) in the third quarter were three times more than those in the second quarter. India could be entering a freshly brewed cycle of NPAs. This would necessitate larger-than-earmarked capital infusion, consequently leading to a further pushing back of fiscal consolidation goals.
Third, a recent note from investment bank DBS says that foreign liabilities are also increasing (around $472 billion in March 2017). Most of the rise in long-term external debt is because of the increase in external commercial borrowings by companies. There are limits to how much the Indian central bank can intervene to absorb these capital flows, given the risks that India could then be tagged a currency manipulator by the US. India already runs a trade surplus in excess of $20 billion with the US, one of the three criteria that put an economy in the black list. Heavy currency intervention could increase the risk of trade sanctions from the US.
Fourth, political risks could come to the fore thanks to the cycle of important state elections in 2018 followed by a national election that is scheduled for next year. There could be strong incentives to abandon macro stability in favour of spending programmes that lead to a deterioration in public finances.
The Indian economy seems to be better placed to deal with global shocks than it was in July 2013. There may be no reason to panic. But there is enough reason for policymakers to stay on guard.
What are the safeguards policymakers should take in light of global risks? Tells us at email@example.com