October 20, 2016 7:00 am JST
Singh and Sharma

Rupee stability looks fragile

A money lender counts Indian rupee currency notes at his shop in Ahmedabad, India.

In many ways, India's economy is on a roll. Its current account deficit fell to 0.1% of gross domestic product in the April-June quarter; foreign exchange reserves are rising -- to $371.99 billion as of Sept. 30; and retail inflation dipped to 4.31% year on year in September. Inflation is likely to remain under control following a good monsoon and forecasts of improved food production.

Lower inflation and the postponement of an impending interest rate hike by the U.S. Federal Reserve made room for the reserve Bank of India, the central bank, to reduce policy rates by 25 basis points on Oct. 4 -- a move that is widely expected to support demand and encourage businesses to add new capacity. Foreign direct investment also continues to flow in. Most forecasters say the economy is likely to grow by an impressive 7.6% in the financial year to March.

However, the country faces a number of downside risks. Investment, exports and foreign remittances are all weak. Corporate investment is stagnant, as is job creation. GDP growth is being driven mainly by consumption, which will not be sufficient to sustain growth momentum.

Given global macroeconomic realities, even a small unforeseen disturbance could cause an upheaval in financial markets and lead to outflows of foreign capital, or at least turn off the tap of cheap foreign money for India. The rupee and the stock markets have already shown signs of volatility; a rate increase by the U.S. Fed in December could provide a trigger for more and greater uncertainty.

At present, India's negligible current account deficit poses no threat to macroeconomic stability. However, the major factor responsible for the reduction in the deficit is a decline in the import bill caused by low commodity prices, especially for crude oil. This could change in light of a recent agreement on production cuts by the Organization of Petroleum Exporting Countries, especially if Russia also reduces output.

The value of Indian merchandise exports rose 4.6% year on year in September in dollar terms, but that followed a near two-year period of disappointing export performance, and looks unsustainable in the current global economic environment. Exports were down 1.74% by value over the six months to September, compared with the equivalent period a year earlier. Services exports rose 4.7% in August, according to the latest available data from the Ministry of Commerce and Industry, but were down by 4.57% for the five months from April to August.

Foreign remittances, which have been a steady source of funds, amounted to $70 billion in 2014. However, the total is likely to fall to $65 billion in 2016, with just $14 billion arriving in the second quarter to June -- a fall of 12.5% compared with the same period in 2015, according to the World Bank.

There are plenty of other danger signs. Continued lower oil prices and a shift to employing indigenous labor in Saudi Arabia will further reduce the flow of remittances into India, while the high cost of transferring funds through the formal money transfer system is pushing emigrant workers toward greater use of informal hawala channels. Such remittance dollars escape official records and often do not reach Indian shores.

FDI inflows have been declining since the quarter ending in December 2015. Net inflows fell from $14 billion in the October to December quarter of 2015 to $11.38 billion in the quarter to March 2016 and then to $5.25 billion in the three months from April to June, the first quarter of the 2016-2017 fiscal year. That compared with $9.43 billion in the comparable quarter a year earlier -- a decline of more than 40%. That is not a good sign.

Capital outflows

The Fed has postponed its planned rate hike, but looks as though it will go ahead in December. If that happens it is likely to induce capital outflows, given the frailties of the Indian economy, which include a banking system saddled with an unsustainable and rising level of bad loans. The manufacturing sector is operating below 75% of capacity, on average, and that is pulling down the growth of dependent services such as logistics, transportation, and banking and financial services. Credit uptake, which grew at 20% a year on average until 2012 -- and was still growing at an annual rate of more than 10% in July 2014 -- posted a decline of 0.2% in August 2016. That was the first monthly fall in a decade.

Optimists argue that the Fed is not likely to raise rates by more than 25 basis points, and that it may defer a rate hike again in the face of poor U.S. GDP numbers and low inflation. By contrast, they say, India's fundamentals are strong -- the economy is growing at around 8% a year, with inflation below 5% and likely to fall further, and comfortable foreign exchange reserves. On this view, India's economy is strong enough to view a small rise in U.S. rates with equanimity.

However, these optimists are forgetting that the initial U.S. move in rates will not be the last. On top of that, the Indian corporate lobby is increasing pressure on the RBI to cut Indian rates again, which would further decrease the relative interest rate gap between India and the developed world. That would probably cause debt market outflows, or at least create a risk that bond market inflows would dry up.

India also needs to bear in mind that a change in sentiment can happen overnight, giving the economy little time to adjust. On Oct. 13 India's benchmark stock index fell by 439 points (1.6%) and the rupee shed 0.62% against the dollar on the mere hint of support for a rate hike in the minutes of the Fed's Open Market Committee, combined with an unexpected fall of 10% year on year in China's September exports numbers. This is an indication of things to come.

The decline in the rupee was a surprise -- the currency has been stable since mid-June against the dollar, while the yuan, the euro and the pound have fallen. But this could be a sign of a currency market mismatch, implying an elevated risk of depreciation to come. That could trigger renewed inflation, reduce economic activity (because of the higher costs of inputs, especially energy) and seriously embarrass India's corporate sector, which is sitting on a foreign debt pile of $182 billion. No more than 40% of that is hedged.

India cannot afford to be complacent, in spite of the hype over its strong fundamentals. Eight years of looser monetary policies in developed markets has overheated asset markets in India more than it has fuelled growth in the real economy. A U.S. rate hike in December could be the start of a series of problems for India, and the first signal could well be a fall in the rupee.

Ritesh Kumar Singh is a corporate economist and former assistant director of the Finance Commission of India. Prerna Sharma is vice president and head of agriculture, food and retail at Biznomics Consulting, a research and policy advocacy specialist in Mumbai.

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