Like the moon pulls the waters from one part of the world to another as it moves, so too are the changes to America’s economy pulling investments from other parts of the world toward American shores. And none has been left as high and dry as India.
For some five months now, as American bond yields have improved, investment money has been exiting India and other emerging markets toward U.S. Treasuries, corporate bonds, and equities. With its foreign investments slowly draining away, the repercussions are being felt clear across the Indian economy, especially in consumers’ wallets, as inflation soars nearly 2% in four months.
Can India’s central bank maintain the delicate balance among inflation, currency stability and economic growth to once again attract the foreign investor? Or are investors wiser to stay clear in favor of other markets?
India’s Inflation Fears
Since U.S. bond yields started rising in May, investments have been returning to America from the emerging markets where they once enjoyed substantial returns, leaving behind a wasteland of sunken currencies and washed-up economies.
The Indian rupee had plummeted as much as 21% versus the USD from May to the end of August, eroding the buying power of Indian households. Inflation rose by nearly 2% in four months, from 4.58% in June to 6.46% this week, on its way to an expected 7.5% by January.
India’s government has been struggling to keep up with changes in subsidies of essential imported items – such as fuel, fertilizer, and cooking oil – while food prices have risen 18.4% over the past year, triple China’s 6.1% increase. Core inflation excluding fuel and food has also risen, to 2.1%.
“Rising input costs have again pushed up core inflation on a month-on-month basis,” Rupa Rege Nitsure, chief economist at Bank of Baroda in Mumbai, informed Reuters. “While CAD (current account deficit) worries have faded, inflation continues to remain the major macro risk.”
While current inflation is not terribly out of line with normal levels this century as noted in the graph above (click to enlarge), it is the consequences of the recent spike in prices that is troubling economists as they are forced to choose between two courses of action – one more damaging than the other.
Harming One to Save the Other
To strengthen the rupee and keep inflation hemmed in, the Reserve Bank of India begrudgingly raised interest rates in September for the first time in two years, from 7.25 to 7.5%, with a second rate hike to 7.75% expected before this month is out. As a result, almost half of the currency’s losses since May have been reclaimed, though it is still down some 12.5%.
Although the rate hike managed to stop the recent exodus out of the Indian 10-year bond – stabilizing its yield at about 8.58% – the cost of borrowing money in India has now grown some 1.5% in the last three months, which is expected to put a dent in economic activity going forward. Industrial output in August has already grown slower than expected, at just 0.6%, impacted by weak investment and consumer demand.
The RBI had been trying to avoid raising rates as the nation’s GDP growth has already been declining for over three years. As noted in the graph below (click to enlarge), since climbing out of its own 2008-09 recession, India’s GDP annual growth rate ballooned from 5.8% in late 2009 to 9.4% in early 2010.
That growth, however, has steadily declined to levels lower than they were in the thick of the last crisis, currently at 4.4%. While this rate by itself may be envied by many other nations, the skyrocketing inflation rate is undermining its benefit.
“Markets are disappointed,” Deven Choksey, managing director of KR Choksey Securities Ltd, assessed to BBC News, “as traders have been expecting the Reserve Bank of India to go on a rate reduction programme, and that is where low inflation would have helped.”
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It was a choice of the lesser of two evils – keep rates low to promote growth at the cost of inflation, or raise rates to stop inflation at the cost of growth. After four months of procrastination, the Indian central bank finally made a decision, opting for the latter.
As a result, the International Monetary Fund’s World Economic Outlook has projected India’s growth rate to continue falling to 3.8% before edging higher next year.
But India’s Finance Minister P. Chidambaram sounded more optimistic to India’s Economic Times. “We expect these measures to show their impact from the second half of the current fiscal and believe that the Indian economy will grow at over 5.0 per cent and perhaps closer to 5.5 per cent in 2013-14,” he affirms.
Investors Slow to Return
Another Indian paper, Business Today, reports that Indian “equities firmed up amid sustained capital inflows… a forex dealer said.”
It stands to reason that more attractive bond yields on the rise since June have been once again attracting back some of the investment capital lost when investors pulled their funds out amidst one of the worst routs in the Indian rupee’s history.
But inflation seems too rampant to be easily controlled by just one or two small 25 basis-point interest rate hikes. Look for further tightening over coming months, the effect of which will slow GDP growth all the more. And given India’s dependence on foreign oil and fuel – which are still at multi-year highs – the nation’s ailing current account deficit will continue to hemorrhage money. As with any emerging economy these days, investors should cherry-pick their investment vehicles.
Remember too that much of the growth enjoyed by emerging markets since the 2008-09 crisis had come on the back of abundant monetary stimulus in America, which weakened the USD and gave foreign economies and currencies a competitive edge.
But since yields stared rising in the U.S. in May, that whole premise has changed. As the U.S. Federal Reserve’s monthly bond purchasing program is to be slowly reduced to nothing over the course of the next year or so, the dollar will strengthen, weakening foreign currencies even further. As inflation spreads throughout emerging markets, interest rates will have to continue to rise, and economies will consequently continue to slow.
Over the near future, then, as investment money ebbs and flows out of bays of foreign markets and onto America’s shores, investors might do well to adopt the Dorothy Gale-style of investing: “There’s no place like home.”
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