Global sentiment has soured against emerging markets in recent weeks. With Europe’s growth hitting a pothole, the global economic recovery has suddenly become asynchronous, inducing a stronger dollar, tighter financial conditions, and a “sudden slowing" of capital flows to emerging markets. Meanwhile, oil prices, despite recent relief, are still 50% up over the last nine months.

With India particularly sensitive to oil, the combination of higher oil and global turbulence has inevitably raised questions about India’s preparedness to deal with global stress. How much more insulated is India compared to the taper tantrum episode? Is there any risk of a 2013 repeat, when India was part of the “Fragile Five"?

Emerging pressures

To be sure, some pressures have emerged over the last year. India’s current account deficit (CAD) is on course to tripling to 2% of gross domestic product (GDP) in 2017-18—even though crude prices averaged just $57 per barrel last fiscal—spurred by underperforming exports and over-performing imports. Now, if crude prices were to average $75 per barrel in 2018-19, we estimate the CAD would widen towards 3% of GDP or $80 billion. This won’t be trivial to finance in a turbulent world. Last year, 50% of India’s capital inflows were “interest rate sensitive". With global rates likely to go up faster than Indian rates this year, will India be able to attract a large quantum of interest-sensitive flows?

In addition, the consolidated fiscal deficit continues to remain elevated, keeping the bond market nervous. Over the last five years, even as oil prices collapsed and India’s fiscal reaped a large windfall, the consolidated deficit has not witnessed any meaningful reduction. While the Centre has reduced its deficit, states have increased theirs, such that the consolidated deficit has only inched down from 6.9% to 6.5% over the last five years. The concern, therefore, is familiar: will the twin deficits feed into each other? Will concerns of fiscal slippage later this year further spook bond markets, precipitate foreign debt outflows, pressure the rupee, which, in turn, will further spook bond markets, creating a vicious spiral like in 2013?

Palpable Buffers

While some of these concerns are understandable, it’s important to put things in perspective. Comparisons with the taper tantrum are unwarranted, both because India’s starting points have markedly improved and India possesses significantly higher buffers than in 2013. Consider this:

•India’s twin deficits (fiscal and current account) increased last year but are still materially below 2013-levels (9.5% of GDP in 2018-19 versus 11.7% in 2012-13).

•India now has an institutionalized inflation-targeting framework. Consumer price index inflation has averaged less than 4% over the last year with positive real rates versus almost 10% before the taper tantrum with negative real rates. Fundamentally, the commitment to an inflation target also anchors medium-term currency expectations, conspicuously absent in 2013.

•Foreign exchange buffers have increased sharply. India’s reserves as a function of annual gross financial requirements (CAD and amortization of short-term debt) has jumped from 100% in 2013 to 140% today. More importantly, the Reserve Bank of India (RBI) is perceived to have a war-chest that it is willing to use.

•Even though the twin deficits are still elevated compared to the fragile five, India has witnessed the largest decline of the twin deficits and inflation in the last five years amongst the fragile five.

Hidden Fissures

By all accounts, therefore, India is more fortified than in 2013. But the real story lies below the radar: that India’s underlying external imbalances have markedly deteriorated in recent years. If one excludes net-oil and gold imports, India runs a sizeable current account surplus. But that current account surplus has seen a sustained deterioration over the last three years, declining from 4.6% of GDP in the second half of 2014 to 2.2 % of GDP in the second half of 2017.

All this is despite India’s growth differentials with the rest of the world narrowing in recent years. Prima facie, that should improve external imbalances, right? Exactly, the opposite has happened. Underlying external imbalances have widened to the highest level in at least 14 years.

What this reveals is that the improvement in headline CAD is exclusively because of lower oil prices and reduced gold imports. Think of the counterfactual, if India’s gold imports were as high as they were in 2013, and oil was above $100 per barrel as it was then, India’s CAD would have been close to 6% of GDP—much higher than the 4.8% witnessed in 2013. While gold imports are unlikely to surge to 2013 levels, the larger point is that underlying vulnerabilities have increased, and we remain hostage to oil prices. If oil jumps back up to $100, the CAD would widen back to above 4% of GDP.

Dutch Disease?

What’s driving the worsening of underlying external balances? Various factors are likely at play. Over the last year, for example, we have argued that external imbalances have widened on account of a temporary adverse supply shock emanating from demonetization and goods and services tax. But underlying external imbalances began to deteriorate much before 2017, suggesting competitiveness has been under pressure for a while. Are India’s infrastructure bottlenecks becoming an increasingly binding constraint? Is India’s conspicuous absence in global value chains beginning to hurt us progressively more?

Are exchange rate dynamics also contributing to trade pressures? Between the start of 2014 and the end of 2017, India’s broad trade-weighted real exchange rate appreciated almost 20%. Some of this was inevitable. The collapse in oil prices in 2014 served as a large, positive terms- of-trade shock for India. Economic theory would argue that a positive terms-of-trade shock should manifest in a more appreciated real exchange rate. The intuition is straightforward. To the extent that windfall gains from a positive terms-of-trade shock are spent, the price of non-tradables should rise vis-à-vis the price of tradables and drive real appreciation. India witnessed large windfall gains from the collapse in oil prices (3.1% of GDP across two years, of which two thirds was estimated to have been spent). So the collapse in oil prices should have put upward pressure on actual and equilibrium real exchange rates. The only choice policymakers had was whether to accommodate this real appreciation through nominal appreciation or relatively higher inflation. Operationally, this manifested itself in a collapse of the CAD (because of oil) and therefore a larger balance of payments surplus that was putting upward pressure on the rupee. This was compounded by foreign direct investment flows almost doubling after this government came to the power. All this exacerbated the rupee appreciation pressures.

The question, therefore, is whether the 20% real appreciation between 2014 and 2017— reflecting this positive terms-of-trade shock—has impinged on the competitiveness of India’s manufacturing sector (exports and import competitors) and therefore contributed to the deterioration of underlying balances? If so, India likely caught the “Dutch disease"—a term that describes the Netherlands in the 1960s where a discovery of gas deposits in the North Sea, and the income boom that followed, led to a real appreciation of the exchange rate that crowded out manufacturing exports. In India’s case, the analogy is the collapse in oil prices resulted in a large, positive terms-of-trade shock that was largely spent, drove up the actual and equilibrium real exchange rate which, in turn, has impinged on the competitiveness of India’s tradable sector.

Policy Implications

Several policy implications flow from this.

First, the 50% increase in crude prices over the last nine months is partially reversing the earlier positive terms of trade shock and will, by similar logic, induce some actual and equilibrium real exchange rate depreciation. This should help mitigate pressures on India’s tradable sector. Policymakers should not fight this real depreciation since it’s an equilibrium phenomenon, but simply use reserves to ensure the new equilibrium is reached in a gradual manner, so as to avoid self-fulfilling panic and overshooting. The RBI seems to be doing exactly this. Already between January and April, the broad real exchange rate has depreciated almost 6%.

Second, there are bound to be inflationary consequences of the rupee depreciation. Under the new inflation-targeting framework, this will need to be countered by monetary tightening. So, external stress will need to be buffered through a weaker currency and higher rates, as is being witnessed all around the world. There is no escaping this.

Third, it is crucial that fiscal policy (at the Central and states) does not slip again. The more expansive the fiscal policy, the more it will offset the real depreciation that will occur from the positive terms-of-trade shock reversing, and thereby hurt the competitiveness of the tradable sector.

Fourth, policymakers need to continue working on improving underlying trade competitiveness, apart from exchange rate, by boosting infrastructure, total factor productivity and assimilating into global value chains.

All told, India is much more fortified than in 2013, but that should not mask the fact that underlying, external imbalances have widened. The recent rise in crude prices and the real depreciation that it will induce may well be a blessing in disguise, because it may help improve underlying competitiveness. But the scale of what needs to be done to improve trade competitiveness, more fundamentally, remains daunting, and should be underestimated only at our own peril.

Sajjid Z. Chinoy is chief India economist at JP Morgan.

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