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India: Decoupling Emerging Economy?

Pramit Pal Chaudhuri March 8, 2012

Emerging economies are fretting. All that money being printed by the US Fed and its ilk is pouring into their economies, causing speculation, inflation and financial indigestion. They are being forced to buy up the foreign exchange to stop their currencies from appreciating, their reserves are growing, and their domestic money supply is getting out of hand. Largely true, but not in the case of India.

A recent UBS Investment Research comment, “India Does Whatever It Likes,” makes the point that India is among the emerging economies where this pattern does not fit. Yes, there is a lot of financial institutional investment (FII) flowing in. But the rupee is appreciating very gradually and reserves are at a standstill.

The Reserve Bank of India is, if anything, injecting money into the system, due to a purely domestic phenomenon: the growth rate of Indians putting money into their savings accounts is less than the growth rate of Indians borrowing money from their banks. Forget the FII flows — they don’t matter. India has problems, but FIIs aren’t one of them. As the UBS report notes, “India is one of the very few countries in the emerging market universe that has the luxury of setting monetary policy as if the rest of the world didn’t exist.”

On this front, at least, India is an emerging economy that has decoupled from the rest.

The problem at home is acute. As of early December, year on year, deposit growth rose 15%, but bank loans grew 23%. This has “liquidity problem” written all over it. Which is why the RBI has been easing statutory liquidity levels on banks. It has also been raising deposit interest rates gently to incentivise Indians to save more.

But inflation is the key problem. Indians won’t save more if prices rise as rapidly as they are today. Its officials continue to express concern about inflation, which is why commercial interest rates are floating upwards. “Tightening by stealth,” as Chetan Arya of Morgan Stanley calls it.

There is plenty of debate as to what is causing this inflation. Sources seem to be hydra-headed. Supply and demand for certain foodstuffs is clearly part of the problem. Massively increased borrowing to pay for the various welfare schemes of the United Progressive Alliance is another, but less than one would think, CARE rating agency economist Madan Sabnavis argues. Sabnavis notes that despite rising red ink, the government’s sovereign yields have actually fallen.

So the Indian paradigm will be higher interest rates to improve savings and thus overall liquidity. The higher interest rates will also help keep inflation down, a perennial problem as India’s growing economy struggles with the bottlenecks in supply, infrastructure, etc., that bedevil its system. The comparative story with other emerging economies couldn’t be more different, though China is taking a similar path.

This does raise the question of where all these FII billions flowing into India are going. Presumably, some is going to pay off the government’s fiscal deficit via the indirect method of FIIs buying up divested shares in state-owned enterprises like Coal India and Power Grid Corporation. But a lot seems to be flowing back and forth between FIIs as they buy and sell Indian shares to each other.

My general impression is that Indian investors are slowly pulling out of the stock markets here, wary of the levels that share markets have reached. Business Line’s Research Bureau seems to bare this out. They have calculated that Indian institutions pulled out Rs 210 billion from the stock market by December this year even as FIIs put in Rs 610 billion. This would explain why, as the UBS note comments, “for India there has been no net foreign contribution to base money growth at all over the past year.” But it does lead to a concern about a bubble. In which case, India may not be as decoupled from global quantitative easing as it would like.