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Is India Immune To Global Tightening?


Emerging markets gained significantly from the pandemic-induced quantitative easing that the advanced economies, especially the U.S., and the opportunities created. Fallout: The monumental fiscal stimulus and acute supply shortages led to strong domestic demand and contraction in their exports. 

As a side effect, these created new export opportunities for the EMs, especially China and India, which saw disproportionate surge in their export volume and value.

The unleashing of ultra-accommodative monetary policy by the advanced economies also stimulated significant capital flows, collectively leading to forex reserves bulging in the emerging markets (RBI’s forex reserves peaked at $642 billion in September 2021, expanding by $167 billion since April 2020). The massive quantitative easing led by the U.S. Federal Reserve resulted in EM Asia forex reserves bulging by $600 billion, of which 30% came to India and 24% to China. 

The role of global trade rebound in India’s recovery is reflected in the stupendous rise in the share of external trade (goods and services exported plus imported) in GDP to a seven-year high of 50% in the June 2022 quarter from the pre-pandemic levels of 36%.  

However, the ratcheting-up of inflation is compelling a quick transition to an increasingly restrictive and synchronous monetary tightening by central bankers, particularly the U.S. Fed and Europe’s ECB. This is quickly eroding the episodic post-pandemic gains as reflected in the pervasive decline in forex reserves of EM and Asia.

The combined forex reserves for the major Asian countries have declined by $560 billion, out of which China, India and Japan have contributed 35%, 16% and 23% respectively. This spillover impact of monetary tightening by the advanced economies have transmitted growth dampeners into the EMs, through declining exports, price realisation on exports and tighter financial conditions. 

The big picture is that the synchronous monetary tightening, fiscal drag, and inward relocation of global sourcing by AEs would considerably narrow the external surpluses to EM Asia, thereby reversing the episodic post-pandemic gains.

Our estimates suggest that India’s growth sensitivity to global trade volume growth has risen to 1.73x since 2017, compared with 0.73x for China, revealing the large multiplier impact of external trade on domestic recovery. Thus, as exports slow and interest rates tighten, we expect India’s growth to slow to 5.0-5.5% in FY23E from 8.7% in FY22, aligning with the structural trajectory at 4-4.5%. 

But this moderation in growth projections is common across EMs, particularly Asia, which could be trending towards an average of 3.5-4.0% for 2022-26. Hence, the average growth differential between EM Asia and AE is expected to decline further to just 2% from the pre-Covid average of 4% and 8% in 2008, respectively.

Rate tightening and the balance sheet contraction by the Fed have led to U.S. dollar index of AE currencies appreciating more sharply (DXY rose 18% YoY) compared to those of Asian currencies, notably the Chinese yuan, Indian rupee, Malaysian ringgit, and Thai baht (8-10%), despite slowing growth and dwindling external balance surplus or widening deficit (as in the case of India).

This outperformance of Asian currencies resulted from aggressive currency interventions, as central banks ran down forex reserves, hoarded since post-Covid QE4. 

As the Fed embarked upon tightening and capital flows waned since October 2021, our measures indicate that the RBI has adopted extreme levels of currency inflexibility to limit INR/USD depreciation.

China, too, has stepped up currency controls. Hence, the rundown of forex reserves by RBI ($91 billion) and People’s Bank of China ($145 billion) cannot be attributed just to the worsening current account balances. 

Our framework of exchange rate (function of domestic growth and capital flows) shows that the depreciation impact of widening current account deficit (CAD/GDP) comes as a peripheral variable, relevant only after controlling for growth.

Thus, if India’s inherent growth is strong, the rupee appreciates despite widening CAD as growth attracts capital flows. But if CAD widens with weak growth, the currency depreciates. Also, there is generally a positive relation between the value of Indian rupee and global crude oil prices (commodity prices rise with better growth); it turns negative only when it hurts growth (typically crude price over $100/bbl). 

In the current context, we have structurally low growth (three-year CAGR for real GDP at 3%), capital flows are inadequate to fund the CAD/GDP, and domestic inflation is high (7%). This is a clear case for sharper depreciation if RBI interventions recede. 

RBI’s currency interventions could get increasingly untenable as a) forex reserve/monthly imports have declined to eight months, b) aggressive interventions have resulted in the tightening of domestic liquidity, and c) significant gap between our estimated optimal forex reserves (~$740 billion), and the actual balance with RBI at $551 billion. 

Thus, as global liquidity tightens further, receding interventions could imply a sharp depreciation in INR/USD. The trend depreciation in INR/USD is expected to rise from the current 3.4% per year to over 7%, mimicking the low growth phases of 1997-99 and 2012-13. 

Since currency depreciation will have a second order impact on inflation, which is already high, the RBI will likely need to continue raising rates to a) moderate demand and increase domestic savings, b) attract external capital flows, and c) narrow external deficit.

Our analysis suggests significant upside to RBI repo rate; 7.0-7.5% looks plausible, if the Fed hikes rates to 4.5% and maintains at that level to achieve a desirable real rate of +1%. 

Overall, the Indian growth outlook will likely need to negotiate the dominant withdrawal symptoms of global slowdown and tightening financial conditions against the incipient post-Covid revival in domestic urban demand to a sub-trend level. 





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