Are Indian markets prepared to deal with increasing global stress to the economy?

A falling rupee indicates a clear and present danger for India from increasing global stress. The local currency has fallen 7% versus the US dollar since the beginning of January.

External risks at present form the soft underbelly of the Indian economy. Rising crude oil prices, a worsening current account deficit, and a slowdown in foreign investment inflows threaten to upend the economic recovery. In its 7 June statement, the Reserve Bank of India’s rate setting panel highlighted “geo-political risks, global financial market volatility and the threat of trade protectionism” as key threats. These pressures have emerged to the fore in recent months as can be seen from the depreciation in emerging market currencies.

As the US and EU end a decade of easy monetary policy and the former pursues an expansionary fiscal policy at the same time, some of the risks are expected to worsen. Indeed, in its review of the US economy presented on 14 June, the International Monetary Fund said that “a rapid rise in inflationary pressures would force the Federal Reserve to move at a faster pace than is currently priced in by markets.” The US Fed has already increased rates twice this year and signaled that two more are coming.

Any more rate increases could increase global volatility, reverse capital flows to emerging market and worsen global imbalances. Indeed, some of this is already happening. RBI governor Urjit Patel wrote in a 3 June op-ed in the Financial Times last week, the outflows from emerging markets exceeded $5 billion a week over the past few weeks. India has been no stranger to these outflows. Foreign investors have net bought around half a billion dollars’ worth of equities so far in 2018; but withdrawn about $5 billion from bonds during the same period.

This is happening at a time, when rising crude oil prices are putting more pressure on the current account deficit. JP Morgan estimates that if oil prices were to sustain at $75 a barrel this financial year, current account deficit would hit $80 billion or close to 3% of gross domestic product (GDP). Already trade deficit in the first two months of this fiscal year has climbed to $28.3 billion. In theory, a depreciating rupee is supposed to help exports, but may not be enough to boost overseas sales and reduce the trade deficit.

Not only is there a danger of the deficit widening, funding it is going to be a challenge. Foreign direct investment (FDI) was not enough to cover financial year 2017-18’s current account gap of $48.7 billion, and nor  is it likely to do so in the current fiscal. The United Nations Conference on Trade and Development (UNCTAD) in a 6 June report has projected FDI inflows into south Asia to remain stagnant or decline in 2018. So, there will be an increasing reliance on fickle portfolio flows at a time of increasing US rates.

The good news is that India is in a much stronger position than it was during the so-called “taper tantrum” of 2013 when the rupee crashed after the US Fed signaled its intent to wind down bond purchases. Indicators such as the current account deficit, foreign exchange reserves, fiscal deficit and inflation are all better than at the time of the taper tantrum.

But policymakers would do well to monitor the increasing risks. Inflation is already on the upswing leading the RBI to hike rates for the first time in four years last week. A depreciating rupee will feed into inflation, but there is no alternative other than letting the currency weaken, and to hike rates.