India: Losing its way

India: Losing its way

India: Losing its way

Global Economic Outlook Q3 2012

The economic slowdown in India has been worse than many analysts expected. Uncomfortably high inflation and a steady depreciation of the rupee are inhibiting a quick recovery.

While the global macroeconomic environment is contributing to India’s decelerating growth, everyone knows that Indian GDP woes are at least partly self-inflicted. The economy has been badly hurt by a dearth of market-friendly economic policies. Moreover, bureaucratic reluctance to make key decisions amid fears of graft charges is resulting in a state of policy inertia. In fact, some of the government’s policy actions may have done more harm than good. For example, the proposal to tax cross-border transactions involving the transfer of Indian assets resulted in widespread concern among investors and pushed the government into damage-control mode.

Slipping away

There is little doubt that the pace of economic expansion has slowed significantly. India’s economy grew at 5.3 percent in the quarter that ended in March 2012, its lowest rate in seven years. The growth rate for the 2011–2012 fiscal year came in at 6.5 percent, substantially lower than the 8.5 percent achieved a year earlier in 2010–2011. Agriculture, the single largest employer in the country, grew at a dismal 1.7 percent in the last quarter of 2011–2012. Poor growth in the agriculture sector will likely impact the entire economy because rural consumption is a major contributor to GDP growth. Less money in the hands of the rural consumers will significantly constrain their purchasing power.

In addition, growth in the industries and the services sector was lower than expected. In the last quarter of the 2011–2012 fiscal year, the industries and the services sector grew at 1.7 and 7.9 percent respectively compared to 7.0 and 10.6 percent during the same period in the previous year. The manufacturing sector contracted 0.3 percent after a 7.3 percent expansion over the same period a year ago. Furthermore, the corporate sector experienced one of its worst decelerations in recent times. Declining external demand added to the woes of export-oriented industries. Lower demand for Indian goods abroad and domestic weakness are weighing heavily on business sentiment.

Meanwhile, interest rates are high, and borrowing costs remain elevated, resulting in a drag on business investment. However, the Reserve Bank of India’s (RBI’s) mid-quarter monetary policy review suggests that the effective lending rate remains lower than levels seen between 2003 and 2008 when India managed robust growth. This suggests that India’s high interest rates are not the only drag on the country’s GDP.

Government proposes, and opposition disposes

One of most anticipated policy reforms pertaining to India’s $450 billion retail market has been marred by roadblocks. The government decided to allow 51 percent foreign direct investment (FDI) in multi-brand retail, which would have paved the way for global retail giants to enter the Indian market. However, stiff opposition and widespread protests forced the government to backtrack. Meanwhile, the government has allowed 100 percent FDI in single-brand retail. Similarly, the government was forced to defer the Pension Fund Regulatory and Development Bill. With little support from the other parties that form the coalition and a vociferous opposition, proposals for allowing higher FDI in insurance, defense, and aviation may be further delayed. Other key reforms are unlikely to see the light of day anytime soon.


Figure 1: Rupee-Dollar exchange rate

A rock and a hard place

In its monetary policy review meeting in June 2012, the RBI kept its policy rates unchanged even though the markets expected a rate cut. Clearly, the RBI is more concerned about high inflation than lackluster GDP growth. There could be two reasons for the current stance. First, the RBI surprised the market with a larger-than-expected rate cut in April, so it held back this time around. Second, the RBI believes that the role of interest rates in holding back investment is relatively small in the current environment. As such, a reduction in interest rates could heighten inflationary pressure, which is lingering at fairly elevated levels.

The RBI will continue to closely monitor both external and domestic factors, and it will likely focus on reining in inflation and managing liquidity. The choices before the RBI are limited, and its policy decisions will likely be heavily influenced by the growth-inflation dynamic.

When will it stop?

The Indian rupee (INR) has been one of the worst performers among the BRIC currencies, setting record lows almost every other week. The rupee experienced significant volatility, alternating between periods of rapid decline and mild recoveries. Between April 1, 2012, and June 20, 2012, the rupee fluctuated between $51.19 and $56.49—a decline of over 10.3 percent—before recovering to $55.86. On June 19, the value of the rupee against the U.S. dollar fell 1.1 percent in a single day. As of this writing, the rupee has once again embarked on a depreciating path (see figure 1).

The Indian rupee (INR) has been one of the worst performers among the BRIC currencies, setting record lows almost every other week.

There are several reasons why the rupee has been under pressure over the past few months. Amid uncertain global macroeconomic conditions, investors tend to flock to safer assets. This predisposition resulted in a huge outflow of funds from India. Furthermore, European banks will likely continue to deleverage, exerting pressure on the rupee. India’s widening trade deficit is another factor that contributes to the slide of the rupee as importers demand more foreign currency to pay for their purchases, resulting in a downward spiral. In addition, India runs a deficit on its current account and requires external capital flows to bridge the gap. Dismal economic performance and the possibility of weak exports while the Eurozone’s crisis deepens and Chinese growth decelerates are chipping away at investor confidence. As a result, India is unable to attract sufficient FDI inflows. Finally, India’s foreign exchange reserves, although sufficient to pay for over six months of imports, are not large enough to allow the reserve bank to frequently intervene in the foreign exchange market. In times of excessive volatility, the reserve bank has intervened in the foreign exchange market, but its ability to stem the slide has been compromised.

Instead, the RBI initiated measures to restrict the rupee’s declining value. First, the RBI relaxed the interest rate ceiling on foreign currency non-resident (FCNR) deposits. Second, it allowed higher limits on intraday trading. Third, on May 10, 2012, the RBI instructed exporters to liquidate 50 percent of the dollars in their accounts within two weeks to help release greenbacks into the market. Furthermore, exporters were mandated to exhaust the available dollar balance in their accounts before tapping markets. Finally, the government deferred a controversial set of tax proposals, which brought some relief to the rupee by stemming the flight of capital. Improving investor sentiment—either because of a favorable development in Europe or breakthrough policy decisions in India—could potentially reverse the rupee’s downward trend against the dollar. The others measures will, at best, have a temporary impact.

Not surprisingly, rating agencies made downward revisions to their outlooks on India and suggested that the country’s sovereign credit rating faces the prospect of being downgraded to “junk” status. Markets did not respond negatively to the news, but India is likely to confront a spate of challenges in the coming months. Owing to a huge subsidy bill, the government is finding it extremely difficult to bridge the fiscal gap. Furthermore, a rising import bill further exacerbated its current account deficit. Additionally, ongoing inflation suggests that India may need to address structural macroeconomic factors rather than simply relying on monetary policy. Moreover, the political situation does not bode well for the country’s growth prospects. India will experience slower GDP growth in the coming quarters, and growth forecasts for the 2012–2013 fiscal year range between 6.0 and 6.5 percent.


Pralhad Burli

Pralhad Burli is a senior analyst at Deloitte Research, Deloitte Services LP.

India: Losing its way