The West’s ultra-loose monetary policy is causing repercussions across the emerging world. 600+ basis point interest rate and GDP growth differentials, and increasingly consensus thinking around “buy emerging markets”, have driven a flow of money that is threatening to become a flood, causing currency appreciation and risking asset price bubbles. India has received $30bn of FII into equities YTD and another $10bn into fixed income. The RBI has risen to the challenge so far, but its resolve will be severely tested in the face of a further flood of money.
Cocktail of factors driving flows into emerging markets
$825bn net of private capital has flown into emerging markets in 2010, with India already receiving $55bn (including net FII, FDI, ADRs, ECBs). This is hardly surprising. India’s GDP growth rate is likely to be 650bps higher than the developed world average for several years, whilst its 600bp interest rate differential incentivises a carry trade. Add to this historic underrepresentation of emerging markets in investors’ portfolios, and you have a heady cocktail of factors driving capital flows.
A problem of plenty
These flows are welcomed up to a point, but beyond that they can have destabilizing effects, on currency, inflation, and planting the seeds of the next bubble. India has the biggest inflation problem of the major emerging markets, at 8.6% in October 2010, the Rupee has appreciated 15% since early 2009 and the Sensex is trading at 19x 2011 earnings.
Can you keep your head when all about you are losing theirs…
The concern is how India copes with a further flood of foreign capital. In contrast to their peers in other emerging economies, Indian policymakers have remained sanguine so far, stressing the increased absorptive capacity of the Indian economy; higher domestic growth simmers up in the form of the Current Account Deficit, which increases the capacity to absorb foreign capital.
But an unfettered reliance on domestic absorption to solve the problem of copious capital flows undermines the importance that should be attached to the undesirable effects of these flows - asset inflation and currency appreciation with its consequences on the labour intensive export sectors.
What is more if oil prices rise, then a commensurately bigger deficit may undermine this approach (a $10/bbl increase in oil prices results in an increase of about $7 bn in the deficit).
We investigate alternate scenarios of intervention as part of India’s preferred policy path that tends to balance appreciation, intervention and sterilization costs. Indian policy makers have made clear in public statements that they don’t favour capital controls. But can this middle path be maintained in the face of unabated inflows, increasing global currency frictions and adoption of very different policy paths in other emerging economies such as Brazil?
There are no easy answers to these complex and interconnected challenges, but we highlight to investors the limitations of relying on absorptive capacity, amidst a weak arsenal of policy choices, and would recommend closely watching the space, lest the menu of choices turns unpalatable.
Whether the tryst with plenty will play out also depends on the prospects for the US and other developed economies – if their prospects improve, then the pressure of capital flows into emerging economies will ease.
But if they stagnate, then an extended period of high growth and interest rate differentials, driving more and more flows into emerging markets, will severely test the interplay between inflation, currency and asset price rises.
India in a global policy quagmire
Highly accommodative Western monetary policy, reinforced by QE2; interest rate and GDP growth differentials; and the increasingly consensus view that emerging markets represent the best prospects for investors– together have driven $825bn of net private flows inflows into Emerging Markets YTD in 2010, according to International Institute of Finance. Already $55bn has flown into India YTD in 2010 (including net foreign institutional investment, foreign direct investment, ADRs, ECBs and NRI deposits). The concern is how India copes with this flood of foreign capital.
Quantitative Easing Reloaded meets a frosty response
Whilst the RBI remained relatively sanguine on the subject, the Federal Reserve’s November 3rd announcement that it will launch a second round of quantitative easing met with screeches of protest from across emerging economies about the distortive effects on global economic policy. Coming on the back of already turbocharged developed world monetary policy, the Fed’s purchase of $600bn of longer-term Treasury securities by the end of the second quarter of 2011, provides further stimulus to already record flows, with the potential currency appreciation foremost in policy maker’s minds.
Cocktail of factors driving flows into emerging markets
The problem is that the flows and currency moves in several emerging economies are essentially soundly based – their stronger prospects and GDP growth differential attracts capital from a developed world with anaemic growth, whilst relative interest rate differentials incentivize a “carry trade” as cheap money encourages investors to borrow and chase higher yields in emerging markets.
The differential between the GDP growth rate in Advanced Economies and India is forecast to be 600 bps in CY2010 and should persist at around 650 bps over the next five years given the IMF’s average growth forecast of 2.4% for Advanced Economies over CY10-15. Meanwhile the interest rate differential between India and Advanced Economies (as proxied by the repo are and the Fed Funds Rate) respectively is 600 bps.
On top of this investors are needing to play catch up in Emerging Markets allocation, due to historic under representation in portfolios, and there is increasingly consensus thinking around “buy emerging markets” – no prizes for guessing the three markets presenting the “best opportunities for investors” in 2011 in Bloomberg’s November poll of 1,030 investors, analysts and traders (1. China 33%, 2. Brazil 31%, 3. India 29%).
Together all this represents a powerful mix driving flows into emerging markets. India, because of its particularly favourable growth and interest differential, has received a significant portion of capital flows in 2010. In particular, it has been a key recipient of FII equity flows into Asia, with $30bn of net FII flowing into Indian equities this year, and another $10bn inflow into rupee debt.
What happens if a flow becomes a flood?
The question is when a healthy flow of capital becomes a flood, with the risks of runaway currency appreciation, loss of export competitiveness, inflationary effects, and sharp rises in asset prices.
Exchange rate pressure
Whilst the last fortnight has seen the rupee coming off against the dollar, driven by short-term factors, October and November saw levels of Rs 44 per dollar, from Rs 52 in early 2009. When these levels were hit in May it prompted comments from Kaushik Basu, Chief Economic Adviser to the Finance Ministry about both capital controls (not in favour) and open market action (in favour).
Inflationary pressures
The rub for the RBI is that if it uses open market action too extensively to curb exchange rate appreciation, the extra rupees released in the market further stoke India’s bigger problem; inflation. India faces a situation where headline inflation is already above the Central Bank’s comfort level. While the Central Bank is comfortable with a medium term range of 3-4% WPI Inflation and estimates the current headline to settle at 6% by March 11, the figure remains stubbornly high at 8.6% for October 10.
The seeds of an asset bubble?
Property prices are another key indicator of asset price bubble risk. While monetary tightening and macro prudential measures have led to softening of property prices in the rest of Asia, property prices remain firm in India. The National Housing Board residex indicates that residential property price indices have actually gone up in 11 of the 15 cities surveyed, with a 16% average rise in the metropolitan cities. Indian equity markets also trade at rich valuations relative to history, and relative to other emerging markets, on the back of Foreign Institutional Investor inflows (domestic institutions have been net sellers in most months this year).
Can you keep your head when all about you are losing theirs…
So far Indian policy makers have been remarkably sanguine about these pressures, in contrast to their peers elsewhere, most notably Brazil. Indian policy makers are confident about accommodating inflows to the tune of $70 bn for FY11 (this includes Foreign Direct Investment, Foreign institutional investment, Loans, Banking capital etc.).
For its part, India’s Central Bank has risen to the challenge so far, letting the exchange rate float, but faces a real challenge if capital flows continue unabated. At what point does this become destabilizing in India? What level of flows, currency appreciation, and inflation can be coped with? What is the likely policy response?
Below we look at the absorptive capacity of the Indian economy, and risks of a run up of the rupee exchange rate, with consequences for export competitiveness, asset prices and upward inflationary pressures. We also look at the impact of rapid flows in 2007. What happens if there is no response and the rupee continues to appreciate? How far will the policymakers resist capital controls? And what form might they take? What has been the cross country experience with capital controls?
The Indian experience with capital measures
Capital measures in India have taken the form of;
• Allowing /disallowing external commercial borrowings in sectors like
infrastructure and real estate
• Revising the maturity and interest rate for all in cost ceiling on ECBs (External
Commercial Borrowings) to a mark-up above or below LIBOR
• Raising/lowering the interest rates on Non residential Indian deposits
Even so, sterilization costs for India in the face of copious capital inflows have been
among the upper echelons in the region.
Capital measures for India going ahead
• The possible roadmap for Capital Measures in India to combat copious flows will be in the direction of lowering the all in cost ceilings on External Commercial Borrowings, altering the maturity profile of External Commercial Borrowings and a close watch on the end use of ECBs in sectors like real estate. ECBs for rupee expenditure have latent inflationary potential and
could also be actively controlled.
• Decreasing the interest rate on Non Resident Indian deposits in the range of 125-175 bps, could also figure in the range of options.
How far this becomes destabilizing depends on Western recovery
While not claiming to answer all the complex and intertwined questions on this broad topic, we do drive home the point that policy confidence has to be predicated on more than just a reliance on the absorptive capacity of the current account deficit.
After all, the current account deficit could be easily thrown into disequilibrium by extraneous factors like the (escalating) price of crude oil in the wake of QE2. We flag to investors the reliance on absorptive capacity as a key risk in a weak array of policy choices, and would advise closely monitoring this space.
We have highlighted the inflationary potential of copious capital flows and, given tight domestic labour supply, this inflation becoming more generalised through wage inflation is a very real threat. Also, given a large tradable sector in the Indian economy, pecuniary externalities like a strengthening currency may have far reaching implications for and employment generation and domestic demand.
Of course, how far the destabilisation plays out depends also on the prospects for the US and other Advanced Economies – if the prospects for these economies improve, then so the pressure of capital flows into emerging markets will ease. But if as seems likely they stagnate then we could face an extended period of growth and interest rate differentials driving more and more flows into emerging economies, with all the associated risks.
(Nick Paulson-Ellis is the country head, Research for Execution Noble.)
