Evan Soltas
Apr 17, 2012

Could India Implode?

Slowdown now, and the specter of financial crisis

For the last decade, the story out of emerging markets, and particularly countries like China and India, has been of rip-roaring real growth, at rates of 8, 9, or even 10 percent year-over-year, and year after year. It has powered the consistent over-performance of investments in emerging markets relative to those in the US and in other developed economies; and much more importantly, it has lifted hundreds of millions out of poverty, particularly in Asia, representing the greatest improvement in quality of life in the history of mankind.

Yet will these trends continue -- a rapid, ever-forward march to better lives? What is going on in India today, disturbingly, says -- or at least raises the possibility of -- no. India transformed from an unproductive socialist economy shackled by the license raj to a liberalized, dynamic, and fast-growing marketplace, and this rivals any for the most inspiring success-story of the last two decades. And yet now, all this seems to be on the edge.

Real growth is collapsing. Industrial production is stagnant. Inflation is soaring, and expectations are unanchored. Foreign investment is drying up. Gross fixed capital formation is dead. The current account deficit is soaring. The exchange rate is under pressure. In essence, all heck is breaking loose.

Let's start with real growth to capture a view of the Indian economy at 60,000 feet. Since 2002, trend RGDP growth was near 10 percent year over year from official statistics [blue line in first graph], and I've projected back even further an estimate of RGDP growth derived from NGDP and CPI [red line in first graph]. It's not perfect, but it gives us a larger dataset to say that India clearly as a real growth problem. To confirm this, we can also look at the year-over-year change in industrial production, aggregated by quarters [yellow line]. 1.3 percent, the weakest quarter on record, and much of the collapse coming in manufacturing. That's not what you should see from a country like India, and I read it as "flashing red light" that may point to binding constraints on growth that are microeconomic and not macro-based.India's central bank, the Reserve Bank of India, has also definitely lost control over inflation. Although they chose to let it rise in 2009 to accommodate sagging real growth -- not a bad idea -- they were caught flat-footed as inflationary pressures built up post-2009, thanks to wages, food, and gasoline. Now expectations appear to have leaped up from 5 percent, and with a weakening real economy, the RBI finds itself in the unenviable position of having to choose between restoring credible inflation expectations or growth. Given this morning's announcement of a 50 basis rate cut in the main policy rate, which is implemented through repurchase agreements.

I hinted earlier at the possibility that some of India's newfound challenges may go beyond the power of the central bank to fix. This view is perhaps bolstered by what's going on in capital formation and foreign direct investment -- two ingredients which have been key to India's rise and high rate of growth. Both are in collapse.
You might think of the trend rate of capital formation has more or less equivalent to the maximum sustainable output growth rate for an economy, plus a few percentage points for other factors in productivity. What this graph makes me worry about is the fact that India's soaring growth may be gone, and its return may be out of the hands of the central bank. There appear to be "deep" factors here which are restraining the trend of capital investment -- perhaps the level of infrastructure, or health and education, or the quality of rule of law, from what I know about India. The Economist also blames fiscal profligacy, which has kept interest rates high, thus depressing investment, and the money which the national government does spend appears largely wasted:

No one doubts that India’s economy will keep getting bigger. But the angle of its economic trajectory has dropped. Growth slowed to 6.1% in the past quarter. Even if, as the government hopes, it bounces back, plenty of people worry that trend growth is now unlikely to be much above 7%...

India’s politicians point out that growth of 6% or 7% is far faster than most other countries. But that is complacent. Just as China is said to need 8% growth in order to maintain social stability, India probably needs to grow at 6% or more to maintain financial stability. Lower growth than that would make the public debt harder to bear and scare off the foreign capital that India needs to fund its current-account deficit and pay for its imported energy. And whereas for a rich country, failing to fulfil its potential is a disappointment, for India, so full of poor people and so badly in need of jobs, it is a tragedy.

Note that The Economist also worries about India's "financial stability" and the sustainability of its fiscal and current-account deficits.

The sharp changes in India's financial account [in the graph above] should also raise concerns of hot money creating financial and monetary instability -- the RBI's interest rate policy has been high and variable, which encourages such maneuvering on the part of foreign-exchange markets.

The sudden expansion of India's current account deficit, which when reported by the Financial Times, first prompted my research into India for this post. The consensus is that the balance-of-payments situation here stems from increases in the prices of oil and gold, two commodities which India imports, and to whose prices the country is unusually sensitive, and naturally also as a predictable consequence of the government's fiscal stance.There's a really ugly worst-case scenario of what could happen in India if current trends continue: a 1997-style financial crisis. The key ingredients are there: a "sudden stop" in growth, flighty investors, increasing pressure on the Indian rupee, low foreign exchange reserves, a large current account deficit, a fiscal deficit on the part of the Indian government. Now let me be careful, waving the bloody shirt of the 1997 financial crisis -- to be precise, I'm saying that these conditions are historically favorable to the adversely cascading sort of financial crisis, and that their presence should be an "early warning," certainly not a prediction, but something we ought not to dismiss as merely a slowdown and forget, lest the very worst occur. We should also note that many of these conditions also appeared in 1991 in India, when it experienced a severe crisis of confidence in the rupee.

It is this comparison in particular which seems to haunt the minds of Indian monetary policymakers, to quote an article in India's Economic Times:

RBI governor D Subbarao, speaking at a panel discussion in Delhi recently, said the situation was not as alarming as in 1991. "That is quite disturbing picture. Nevertheless, I would still argue that in 1991, an implosion was imminent. In 2012, an implosion is not imminent," he said.
I would agree with Governor Subbarao that an implosion is not "imminent," but that the proper distance from cataclysm, when we can breathe easy, is significantly further away than not "imminent." Nor should any central banker be throwing around the word implosion -- policymakers in the US and abroad avoid the "r-word," recession, before the NBER has officially deemed it one.

The trend I worry most about, perhaps, is the proximate cause of any 1997- or 1991-style financial crisis: the foreign exchange reserves of the central bank. When a currency depreciates due to inflation and a large current account deficit, the first line of response by central banks is often to directly intervene in foreign exchange markets to maintain the value of their currency. This, however, expends reserves, and when these reserves are depleting or depleted, it reduces the credibility of this approach -- raising the risk of such a crisis of confidence in the currency, which makes foreign direct investment dangerous. There have been initial warning signs that this is happening now in India -- there has been an intervention in the market for rupee, despite a 14-percent fall in the value of the currency against the dollar, and foreign exchange reserves are down, although not nearly to the levels seen immediately before the 1991 crisis in India. (The Indian government's dependence on short-maturity debt compounds the issue.) The bank has sold $20 billion in forex reserves, or roughly 10 percent of its total holdings; they may be compelled to resume their intervention, as the rupee's slide has continued after a brief reversal in January 2012. And as the current account deficit persists, the RBI will be forced to sell off reserves to maintain the balance-of-payments.

Lest anyone walk away from this thinking that I have predicted economic apocalypse in India, here's a brief restatement. (1) India's trend growth rate appears to be slowing. (2) A cyclical slowdown also seems likely, despite central bank easing. (3) India has severe problems, in any event, to confront in terms of inflation, investment, real growth, fiscal policy, and in microeconomic issues. (4) Warning signs suggest that risk of financial crisis has increased.