India's economic woes

India's Economic Decline Is One Of The Most Under-Reported Stories This Year

School students make a formation depicting the new symbol of the Indian Rupee in Chennai

Business Insider,

5 December, 2011

Economist Tyler Cowen tweeted, "the current economic deterioration of India is the single most important under-reported story these days…".

We've been tracking India's inflation and stock market woes for some time, so we went digging.

The Bombay Stock Exchange has been one of the world's worst performing stock markets this year. The BSE 30-share index is off 18.06% year-to-date, worse than the stock markets of other BRIC economies. 

Foreign investors have been pulling out of the country all year as India continues to struggle with inflation, and investors continue to pick safe havens.

The Indian economy which gained 6.9% in the second quarter, is expected to grow 7.5% this year, according to Indian finance minister Pranab Mukherjee, against previous estimates of 9% growth. And the Indian Rupee is off 13.14% year-to-date (YTD) against the U.S. dollar, and 13.72% against the euro. The currency has been declining as inflation remains consistently high, driven up by food costs.

Inflation and capital flight are two clear factors that have hurt the Indian economy. First, inflation has stayed over 9% since December 2010, and wage inflation is also on the rise. The Reserve Bank of India (RBI), the country's central bank has been hiking interest rates since March 2010 to curb inflation. India's finance ministry released a statement showing that rising interest rates in part caused industrial growth to drop to 5% from April-September in the fiscal year 2011 - 2012, from 8.8% a year ago.

The higher interest rates have tightened liquidity in the Indian market over the year, and the central bank has now promised to inject liquidity through debt repurchases. Moody's recently cut India's banking sector outlook to negative, from stable:

"India's economic momentum is slowing because of high inflation, monetary tightening, and rapidly rising interest rates. At the same time, concerns have emerged over the sustainability of the recovery in the US and Europe, and the rise in the borrowing program of the Indian government, which could drain funds away from the private credit market.

…"With asset quality, given the tightening environment, we anticipate that it will deteriorate over the next 12-18 months, thereby causing an increase in provisioning needs for the banks in FY2012 and FY2013."

Secondly, capital flight in the wake of the European debt crisis and India's corruption scandals have landed another massive blow to the economy. Foreign investors looking to cut risk have pulled their money out of India which counts on foreign funds to keep its current account gap in check. Foreign investors have only $530 million in Indian equities this year, compared with $28.9 billion a year ago, according to the Securities and Exchange Board of India (SEBI).

Dr. Subir Gokarn, deputy governor of the RBI explains the impact of the European debt crisis and skittish foreign investors on the Indian economy: 

“The impact of this recent global instability on India has been enormous. India is a structurally current account deficit economy. This deficit is, in turn, financed by capital inflows, which over the past several years, had been large and stable enough to more than offset the current account deficit.

“…India has large reserves, of course, over $300 billion, but because we have a current account deficit, the reserves are essentially counterbalanced against our external liability position. In an extreme scenario, if there is a large outflow of capital, the adequacy of reserves will be judged by the economy's ability to finance the current account deficit and, over and above that, meet short?term claims without any disruption or loss of confidence”.

India runs a trade deficit, and last month it was reported that Indian companies have raised about $30 billion in foreign debt in 2011. This would cost $5.4 billion more to repay because of the weakness in the rupee.

Unlike export nations like China, Indian exports only account for 10% of GDP. While a global economic slowdown will impact India's growth, the weaker currency-cheaper exports rule shouldn't be a driving factor, rather, the country needs to strengthen the rupee in an effort to make imports cheaper and attract foreign investment.

The RBI indicated in its last monetary policy review meeting that the likelihood of another rate action was low. And Mukherjee has said that the Indian economy which already focuses on domestic-demand growth, needs to push that strategy more.

Meanwhile, here is a chart that shows how the BSE has performed against the S&P 500 and the DOW: