Brent crude has averaged $63 per barrel in 2019 so far, compared with $71 in 2018. This has helped ease India’s current account deficit (CAD) and inflation. And three rate cuts by the US Federal Reserve in 2019 eased global financial conditions, and gave a big breather to slowing emerging markets. Had the scenario been similar to 2018—when the Fed had hiked rates four times and emerging markets got battered in the ensuing risk-off—India would have had it far worse.
Low global interest rates have helped India attract $18.6 billion from foreign portfolio investors (FPIs) in 2019 so far. In contrast, FPIs pulled out $11.3 billion as the Fed began tightening. Not surprisingly, the rupee depreciated a mere 2.1% in 2019, compared with 9.6% in 2018.
These tail winds gave the Reserve Bank of India (RBI) the latitude to cut rates by 135 basis points in 2019, at a time of limited fiscal space. However, the US easing cycle appears to be halting, if not ending. And the Fed is unlikely to change rates in 2020, according to S&P Global.
How would this affect India? A flashback would be in order here. The Fed has triggered waves of easing and tightening since the global financial crisis. In its easing cycle of 2008 to 2012, it pared rates to the zero bound and made massive asset purchases in three phases of quantitative easing (QE), which caused a liquidity surfeit globally.
And when the Fed hinted at tapering QE in 2013, it sent global markets into a tizzy. “Normalization" of monetary policy went on till 2018, which included nine rate hikes and a reduction in the Fed’s balance sheet. However, the easing resumed again in 2019, as US-China trade tensions weighed on growth.
India, in general, wasn’t too adversely impacted in this “tightening" cycle (2013-18) compared with the easing period. Sure, FPI inflows contracted, but they remained net positive. Foreign direct investment (FDI), on the other hand, surged. Even more striking was that the rupee depreciated at a slower rate and was less volatile on average during the tightening, compared with the easing period. However, significant exceptions were 2013 and 2018, when all these variables were adversely impacted.
What explains this? India’s own vulnerability to external shocks. Crisil measures this using indicators of the quantum of external liabilities (current account deficit, or CAD, and external debt), ability to finance these liabilities (through our foreign exchange reserves), and domestic macroeconomic health (growth-inflation mix and fiscal health).
Most of these indicators were improving since 2013. Given a fortuitous turn in crude oil prices, the CAD dropped below 2% of gross domestic product (GDP), the fiscal deficit was tamed, GDP growth crossed 8%, and inflation fell from double-digits to the RBI target range for most of this period. Improving domestic fundamentals helped attract capital inflows and offset the Fed tightening.
Conversely, 2013 and 2018, when the shocks were bigger, were also the years when vulnerability indicators weakened. In 2018, for instance, the CAD crossed 2% of GDP for the first time in five years. The rupee, hit by the double whammy of a higher CAD as well as weaker capital inflows in a risk-off scenario, suffered the worst depreciation since the 2013 taper tantrum. RBI was forced to raise rates and switch stance to calibrated tightening, despite domestic inflation staying low.
Changes in crude oil prices also impacted India’s vulnerability. Besides directly affecting the CAD, these prices affect growth, inflation, and fiscal metrics. A sharp fall in crude prices played a big role in improving these metrics between 2014 and 2017. So, given this history, how do we view the interplay of domestic vulnerability and external shocks in the coming year?
While the risk of rising global interest rates remains low in 2020, uncertainty over geopolitical developments remains high. The US-China trade spat still needs to be resolved. Brexit still needs to attain closure. Fresh risks could also arise from a surge in global debt, a concern recently highlighted by a World Bank report. According to the report, a debt surge in emerging and developing economies over the past eight years has been the largest in nearly five decades. Such uncertainties can continue to affect investor sentiment—as they did in 2019—and keep capital flows, especially of short-term nature such as FPIs, volatile.
Risks to domestic vulnerability from the CAD are expected to stay low in 2020, as crude prices are likely to remain benign. However, risks are rising from other economic fundamentals, most importantly GDP growth—which has fallen to a six-year low. In the absence of fiscal stimulus and slow monetary transmission, growth could see only a mild pick up. Slowing growth is also putting stress on India’s fiscal health through lacklustre tax collections. Even inflation has risen, albeit due to a transient surge in vegetable prices. These factors could also influence investor sentiment in the near-term.
In short, while external flux would persist, vulnerability from new pain-points could emerge. In such an environment, it would remain critical to maintain macroeconomic prudence, for this would mitigate the impact of a global shock.
As received wisdom tells us, fragile economies fall harder in a risk-off scenario.
Dharmakirti Joshi & Pankhuri Tandon are, respectively, chief economist, and junior economist, at Crisil Ltd