Despite the fact that India is a relatively closed economy, it
has not escaped the global financial meltdown. The flow of gloomy
economic data continues. Both exports and industrial production
contracted in the third quarter of India's 2009 fiscal year,
covering October-December 2008. The third-quarter gross domestic
product (GDP) was 5.3 percent, down from 7.3 percent from a year
earlier. This also was the lowest growth in six years. Insufficient
availability of capital, fragile confidence, and uncertainty about
the economic outlook are making growth more difficult. Many expect
the GDP growth to remain moderate for 2009 and 2010 until lower
domestic interest rates translate into higher consumption and the
weaker currency provides support to export demand.
In an attempt to spur growth, the Reserve Bank of India has
aggressively reduced interest rates. This past April, the central
bank surprised many by another cut in interest rates. The
repurchase rate (an overnight charge to banks for borrowing cash)
and reverse repurchase rates are now at 4.75 percent and 3.25
percent respectively. The cash reserve ratio (CRR), the amount of
money banks need to set aside in reserves, has also been reduced
aggressively from 9 percent to 5 percent to ensure ample liquidity.
The rate cuts are possible as it appears inflation does not seem to
be a problem. Wholesale price inflation for February was only 2.43
percent, and there may be patches of negative inflation in Q2 and
Q3 of fiscal year 2009 on weak demand. So the focus will clearly
remain on growth. Many expect the Reserve Bank of India to reduce
rates even further. Interest rate and the CRR will likely bottom
out near 4 percent, and 3.5 percent respectively by this June or
July. Although this move by the RBI will provide some temporary
relief, there is a concern that long bond yields will likely push
higher given the large government borrowing.
Internal Factors
While India has many challenges, its domestic demand remains
relatively untapped. The fundamental outlook for India remains
bright compared to the rest of the region. The International
Monetary Fund sees GDP growing at 4.5 percent for the remainder of
this year. One key driver to growth in 2009 and beyond is the rural
consumer. India has an estimated 800 million consumers. These are
for the most part citizens removed from any credit crunch or high
leverage. They are also benefiting from a decent agricultural crop,
substantial government assistance by way of agricultural loan
waivers, employment guarantees, and large investments in rural
infrastructure. According to a recent RBI analysis, the past five
years of rural consumption "reveals strong growth in durable goods,
as well as in health, education, and transport services. We also
think that the telecom sector will be a major beneficiary of rural
spending." In addition, the increasing aspirations of India's
growing educated middle class will continue to pump demand. Demand
for consumer goods seems to have stabilized and car sales and some
other durable goods have actually increased. At the same time, the
nation's high savings and investment rates provide a comfortable
cushion and should allow the growth story to continue once the
current turmoil subsides.
External Factors
India's current account deficit rose to a record this past
quarter. Exports have shrunk for the seventh consecutive month,
extending the longest streak of declines in a decade. In May 2009,
shipments fell 33 percent from a year earlier, while imports
slipped into negative territory, further reflecting the slowdown at
home. The trend is expected to continue in the near term, with some
projecting a 17 percent year-on-year decline in exports and a 16
percent drop in imports for fiscal year 2010. Given that India
remains a net importer, the trade balance should benefit. The
Reserve Bank of India expects the current account deficit to narrow
to 1.2 percent of GDP in fiscal year 2010, down from 2.8 percent in
fiscal year 2009. However, I do expect overseas investment inflows
to resume once risk appetite stabilizes and investors start
favoring countries with sound economies, such as India. According
to the Securities and Exchange Board of India, foreign investors
bought more Indian stocks than they sold in April, the biggest net
purchase since 2007. The largest indices on the Bombay Stock
Exchange are up over 50 percent since its low on March 6,
2009.
Politics
India's 15th month-long Lok Sabha (House of the People) general
elections - in which final votes will be counted on May 16 - may
have little consequences on the short-term direction of the
economy. Given the lack of any clear outcome in state elections,
the national elections are likely to be close, with the possibility
of a hung parliament, reducing the chances of any single party
taking power. Some small regional and caste-based parties seem to
be gaining ground at the expense of the two biggest parties, the
Congress Party and the Bharatiya Janata Party (Indian People's
Party). So it may be the post-election negotiations that determine
who rules India. The longer-term impact of the election may also be
muted as it appears none of the parties are arguing to cut spending
or stop India's much-needed reforms. However, two major dangers
remain. Most of the political parties are promising large subsidies
and loads of spending (sounds familiar). The Congress Party is
trying to sway voters by promising every poor family 55 pounds of
grain per month at a cost of only 75 rupees, while the Bharatiya
Janata Party is promising 75 pounds at only 70 rupees (about a buck
and half). Who would you vote for? The problem is the deficit is
already 11 percent of GDP, and will continue to be high for at
least two years. The question is, how much more can they
spend?
The Future
Since this time last year, the Indian rupee (INR) has steadily
weakened. Since April 2008, the currency is nearly 25 percent
weaker against the USD, and just this past February, traded at a
historic low of just above 52 to the USD. The reason was primarily
that increased global risk aversion created demand for Indian
equities and the INR. The correlation between the India stock
market and the value of the INR can be confirmed by the adjacent
graph.
Source: Bloomberg
However, given that economic expectations have yet to fully
pan out, risk appetite should remain on a weaker footing, meaning
the INR should remain on a historically weaker note for the near
term. In addition, the Reserve Bank of India (RBI) seems to
tolerate a weaker currency, most probably due to competitive
concerns.
However, the INR is finding some stability. While I can never rule
out the possibility of another run-up in USD-INR in the near-term,
I believe any such gains would be short-lived. The fundamental
outlook for India remains bright compared to the rest of the
region, supported by increased overseas holding of equities and
further signs that the global recession may be winding down.
Expansive fiscal and monetary policies, smaller exposure to global
growth, a narrowing trade deficit on lower oil prices, and a
growing investment demand, should help stem any more INR losses.
This year's GDP growth is predicted to only drop modestly. As such,
India will still out-perform most Asian economies, only surpassed
by China. Strong growth and portfolio adjustments should support
capital inflows into India. Given the long-term positive outlook
for India, I suspect the INR to outperform the USD on a longer term
basis. INR trading at 47 to 45 per USD by this December is not out
of the question. Bloomberg surveys many institutions (including
Silicon Valley Bank) for forecasted exchange rates over various
time periods. The median forecasted rate for the end of 2010 has
the INR near 45. The forward exchange rate for INR for the same
time period is still above 51 per USD. If the "experts" are
correct, it may make sense for USD-based corporations that fund
Indian operations to raise hedge percentages by selling USD-INR non
deliverable forwards, particularly beyond six months.