In the last 3-4 years, India's growth acceleration trend has benefited
more from the globalization of capital markets than from the
globalization of trade. The inflexion point for the current growth
cycle was April 2003, which signaled the beginning of the synchronous
rise in emerging market equities. We believe that a favourable
sustained global risk appetite trend has been at the heart of India's
current growth acceleration cycle: Average GDP growth accelerated to
9.2% during F2006 and F2007 from an average of 6.1% in F2003 and
F2004. If the current global risk aversion trend continues for more
than three months, we believe that India could face a significant
deceleration in growth.
Appreciating the global link to India's growth story
A positive global risk appetite environment and consequent rise in
capital inflows into EMs has been a key pillar of stronger growth in
India. The risk-appetite growth linkage is as follows: rise in risk
appetite - rise in non-FDI capital inflows - lower real rates - strong
credit-driven growth. Indeed, India has increased its outstanding bank
credit stock to US$480 billion from US$162 billion in April 2003.
However, the trigger for reversal - just like the rise of this growth
cycle - will be the global risk appetite trend, and not domestic
fundamentals per se.
We believe that market participants arguing for serious decoupling of
India's growth do not fully appreciate that India is excessively
reliant on external sources of risk capital and that these suppliers
of risk capital tend to be indiscriminate in their behavior at times
of turbulence. Unfortunately, the sub-prime problem is threatening to
paralyze risk capital, which was supporting risky assets. In addition
to direct linkages through global capital markets, we believe that any
sustained risk aversion in financial market conditions to global
growth will weigh on external demand, adding to the overall growth
concerns in India.
A repeat of the 1993-96 cycle?
The current domestic and global macro conditions remind us of the
1993-1996 cycle. Like in this cycle, unusually low global interest
rates and large capital inflows into India (and emerging markets in
general) have allowed an expansionary monetary policy. In the current
cycle, the capital inflows have been even larger, resulting in a much
higher growth push. During the 1990s cycle, the capex cycle recovered
sharply from lows with the support of positive sentiment for emerging
markets. However, it was soon constrained by tightening monetary
policy triggered by signs of overheating. A simultaneous reversal in
risk appetite for emerging markets and reduced capital inflows caused
further tightening in interest rates and affected the corporate
sector's ability to raise risk capital, unveiling a significant
deceleration in GDP growth.
We believe that, in the current cycle too, the direction of the global
financial markets will be critical to the growth outlook. Indeed, in
this cycle India has witnessed both leveraged consumption as well as a
capex cycle. Our base-case forecast assumes a soft-landing in
consumption and the capex cycle. Domestic overheating problems like
those during 1993-96 have already forced the central bank to lift
borrowing rates by around 400-450bp from the bottom to the current
eight-year-highs. However, if the recent sell-off of risky assets were
to represent the beginning of a reversal in global risk-appetite for
trade, it could reduce the access to external sources of risk capital
and result in a further rise in the cost of capital in the domestic
market, causing deceleration in GDP growth below our conservative
estimates.
Why India may be more exposed than the rest of Asia?
We believe that, in the event of a sharp risk aversion in the global
financial markets and/or a global hard landing, India's growth cycle
is far more vulnerable than the rest of Asia. To assess exposure, we
compare India's macro balance sheet with Asia Ex-Japan (ROAXJ)
economies on the following parameters:
Inflationary pressures: A high level of aggregate demand growth in
India's case is already reflected in inflationary pressure. While the
headline inflation rate already corrected to 4.4% as of July 2007
(average) (below the RBI's comfort level of 5%), inflation ex-food and
energy is still at 5.2%. Both headline and core inflation in India are
some of the highest in the region. Sharp appreciation in the exchange
rate since early March 2007 has helped to reduce the inflation
pressure. Any major reversal in global risk appetite could result in
depreciation of the exchange rate, adding to inflation concerns.
Credit cycle: India is the only country in the region that has
witnessed a strong credit growth trend in the current cycle. A
sustained slowdown in capital inflows will cause a hard landing in the
credit cycle. It will also increase the risk of the credit quality
problem. Until recently, banks had not only been lending more to
riskier segments but had also been mis-pricing credit. At the peak of
the credit cycle in 1Q06, banks were making little distinction in
pricing credit risk for various types of loan assets. Almost all loans
were being priced in a narrow range of around 7.5-8%, similar to the
10-year bond yields at that time. Indeed, banks' lending behavior
implied that the risk of lending to a low-income-bracket borrower (for
whom there is little credit history available) for the purchase of a
two-wheeler was not meaningfully different from the risk of investing
in government bonds. A significant part of the fresh lending of US$318
billion over the last four years has come at a time when banks have
been inadequately pricing credit risk.
Fiscal deficit: India's headline combined fiscal deficit (central plus
state governments' deficit) is estimated at 7.1% of GDP for F2007.
Including off-budget items such as oil subsidies and state electricity
board losses totaling about 1.1% of GDP, the deficit estimate rises to
8.2% of GDP for F2007. India's deficit (excluding off-budget items) is
the highest among the major emerging markets and about two-to-three
times the levels seen in major developed economies on a percentage-of-
GDP basis. Although there has been a significant improvement in the
fiscal deficit trend at the margin, there is little evidence that the
government is implementing any major structural reforms to reduce
revenue expenditure, which we believe is critical to achieving a
sustainable reduction in the deficit. Most of the improvement in the
deficit is due to the rise in corporate tax to GDP, in line with the
corporate profit cycle. In our view, India is running a pro-cyclical
fiscal policy. In the event of a sharp slowdown in growth due to
global factors, the condition of India's public finances provides
little flexibility to increase public debt aggressively and offset
such global pressures.
Current account balance: The most important differentiation between
India and the Rest of Non-Japan Asia (ROAXJ) is that while India runs
a current account deficit, ROAXJ runs a current account surplus. In
India, aggregate demand being higher than supply (domestic capacity
creation) is also reflected in the current account balance and
inflationary pressure. This makes India more reliant on capital
inflows than ROAXJ.
Composition of capital inflows: Unlike other emerging markets, India's
balance of payments surplus (a key source of liquidity supply) has
been driven by capital inflows. Almost 82% of the total US$98 billion
of capital flows that India has received over the past four years has
been in the form of non-FDI flows. As a result, India is more exposed
than other emerging countries to a potential sharp reversal in global
risk appetite. Non-FDI capital inflows account for only 25% of the
total in emerging countries (excluding India).
But there is good news...
While we see the risk of significant deceleration in India's growth in
the event of sustained risk aversion in the global financial markets,
we also do not agree with the view that India's current growth cycle
resembles South East Asian countries prior to the Asian crisis. We
believe that the levels of excesses are much lower and India's growth
model has inbuilt stabilizing aspects. Some of the differentiating
factors are: (a) the exchange rate regime (India has a flexible
exchange rate regime unlike in SE Asia prior to the Asian crisis); (b)
a significant part of non-FDI inflows have been denominated equity
inflows. These liabilities will get marked down in line with asset
market corrections (in SE Asia there was excessive reliance on short-
term debt); (c) the current account deficit in India is still under 2%
of GDP, versus 5-8% in SE Asia (d) the Indian corporate sector balance
sheet is in reasonably good shape, with an average debt-equity ratio
(for companies under Morgan Stanley coverage) at only 0.3% as of F2007
(debt-equity ratios were unusually high in SE Asia).
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