India sucked into a downward spiral

published 31 May 2012

Little more than a year ago, India was flying high and analysts were hoping growth in Asia's third-biggest economy could accelerate into double-digits. But now everything seems to have gone wrong, with the slumping rupee the most visible distress signal. It has lost 25% of its value in the past year and fallen to record lows of around 56 to the US dollar. In three months it has fallen by over 10%.

What's gone wrong?

The country is beset by both external and internal problems. The cooling global economy and the euro crisis have dampened global risk appetite, so many emerging-market currencies have suffered setbacks. Higher recent commodity prices have hampered growth. But much of the malaise is self-inflicted. Inflation was not "brought properly under control" in the latest upswing despite successive interest-rate hikes, says the FT. It is back up to almost 7% now, so interest rates may need to rise again after a recent cut.

"Tainted by corruption scandals" and split into factions, the government has looked "asleep at the wheel", adds the FT. Structural reforms have been held up and foreign firms have been rattled by inconsistent and opaque regulations. Neither has the government had the guts to reduce fuel subsidies, which would have lowered the fiscal deficit.

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Along with high interest rates and global uncertainty, the political backdrop has hampered growth by repelling foreign firms and crimping local investment. But the main problem is the gaping current-account deficit of 4% of GDP, a three-decade high.

India is among the few countries in the region to have an external deficit. Its shortfall with the rest of the world has been increased mainly by high energy prices, as oil comprises two-thirds of the import bill. A current-account deficit tends to be corrected by a fall in the currency, which makes exports cheaper. But any boost to export competitiveness has so far been offset by oil becoming more expensive due to the weak rupee.

Why the rupee is vulnerable

The current-account deficit has to be plugged with foreign capital. India's problem is that it relies more than most on foreign investments in stocks and bonds to plug the gap. Such portfolio inflows, unlike foreign direct investment (in equipment and companies), are short-term and flighty. They "help India fund its deficit when investors are bullish, but can just as easily go in reverse if attitudes sour", says Wayne Arnold on Breakingviews.

With the current-account deficit rising, India is all the more beholden to short-term investors. But they are heading in the opposite direction due to governmental mismanagement and the growth slowdown. The falling currency itself reinforces the problem. "Without steady capital inflows, the currency will collapse. But without a steady currency, it is hard to attract foreign capital," says Jeff Glekin, also on Breakingviews.

What next?

The worst-case scenario, then, is a run on the currency as confidence tumbles. This would feed on itself as it would rattle investors by damaging the economy further. A plunging currency would send inflation higher, implying higher interest rates; it would also add to the fiscal deficit by boosting the cost of oil. "The currency's fall threatens a negative spiral," says Glekin. Even if this can be avoided, it may be some time before investors return en masse, given the darkening domestic and international outlooks. Far from overtaking China's growth rate in the near future, India is going backwards.