To recap, the causes lie in the combination of persistently high inflation, rooted in both demand and supply-side pressures, coupled with a complete logjam in the legislative process delaying urgent infrastructure reform. All of this has been overshadowed by high-profile corruption-related scandals, leading to substantial falls in the equity market.
However, the principal cause of India’s underperformance against its peers is that inflation has been higher and stickier than in other economies. It exists as a consequence of insufficient capacity in the economy constraining higher levels of growth.
Since early 2010 the central bank has not flinched in its mandate and has inflicted 500 basis points of aggregate monetary tightening on the economy in order to prevent longer-term inflationary pressure embedding itself in the system. Certainly it has been painful in the short term but it is a big plus to the investment case for India that the Reserve Bank is staying the course.
The economy has reacted accordingly with clear evidence of slower growth across all sectors. Currently the market is grappling with a situation of elevated inflation and lower growth, and, in addition, a deteriorating fiscal situation is forcing bond yields higher.
Contagion risk
India’s economic performance is not decoupled from other markets. The risk-off trade has taken hold and tightened its grip on the market. However, unlike other export-driven Asian models, India is an inward-facing economy which is why it is perceived as being more defensive when global macro concerns come to the fore. Defensive yes, but immune it is not.
There are a few reasons why India remains integrated into global events. Like other risk assets, when markets are rising Indian equities benefit from the carry trade, whereby low-yielding currencies (normally the dollar or yen) fund higher-yielding trades in emerging economies. When the appetite for risk reduces the carry trades reverse and funds are repatriated, thus causing the market to fall and the currency to weaken.
Secondly, the twin deficits – fiscal and current account shortfalls – need to be funded. The fiscal deficit is largely funded domestically, but because of growth in the economy being below expectations, the government has failed to meet its revenue targets for full year 2012, and thus bond yields rise further crowding out the private sector.
Slow start
The current account deficit is not unmanageable, but becomes more of a problem in times of market stress. As it is funded broadly by foreign equity inflows, when investors flee the market it puts additional funding pressure on the current account with an immediate knock on effect on the currency.
In spite of the bleak state of affairs, in a short-term relative context India has started to outperform its peer group meaningfully and we anticipate this continuing. India’s GDP growth has a relatively lower correlation to export growth than other Asian economies whose economic outlook is predicated on a healthy export market, and this is a real positive.
India is also a beneficiary of weaker oil prices as it reduces the cost of imports (providing the currency does not weaken in tandem), and although the Reserve Bank of India is expected to keep monetary policy tight in the near term the inflation alarm is hopefully over. Currently, however, it looks as if the market is ignoring this point as all attention is on the unfolding drama in Europe.
