The past year has seen major global shocks—the Russia-Ukraine war, aggressive rate hikes by major central banks, and the recent banking turmoil in the US, to name a few. However, India has largely held onto its land. The rupee has stabilized over the past few months, equity and debt markets have avoided any sharp downside, and bank credit remains at a decade high.
This is very different from a decade ago—the 2013 taper tantrum—when news of the US Federal Reserve tapering off quantitative easing measures caused the rupee to depreciate sharply, and financial conditions in India tightened significantly. To be sure, many emerging markets have done well amid the current round of global shocks, riding on low macroeconomic vulnerabilities and a prudent and timely policy response.
India, which was part of the ‘Fragile Five’ in 2013, has long been out of that club. In fact, in terms of its worst performance during the market turmoil, the rupee depreciated only 2.6% against the US dollar in October 2022 as against 6.3% as the taper tantrums. This is despite the fact that the Fed has not only pulled out of quantitative easing but raised interest rates by 500 basis points (bps) within 15 months – a pace not seen since the 1980s – to 5-5.25%. , the highest level since 2007. The unusually fast pace of rate hikes has increased the risk of market crashes, as evidenced by the collapse of small regional banks in the US in 2023. Risk is transmitted to emerging markets through interconnected institutions and the trust of fracking investors.
So how is India managing such global headwinds? To be sure, capital inflows into India have weakened over the past year. Foreign portfolio investors (FPIs) were net sellers in the Indian equity and debt markets for the second consecutive year in 2022-23. Foreign direct investment (FDI) also fell to a nine-year low. On the other hand, India’s dependence on external funding has reduced. The Current Account Deficit (CAD) has been narrowing since the second half of last year. Even at its peak of 3.8% of gross domestic product (GDP) in the second quarter of 2022-23, the CAD was lower than in the taper tantrum period.
The fall in crude oil prices has helped lower the CAD, along with factors such as growth in service exports and increase in remittances abroad by Indian workers. Furthermore, India’s external debt has remained stable at around 19% of GDP, which is lower than most BRICS peers (except China).
The Reserve Bank of India’s (RBI) intervention in the forex market helped prevent rupee depreciation during the worst months in 2022-23. Nevertheless, the central bank’s foreign exchange reserves remain sufficient to cover any major emergency. The quantum of reserves is higher than India’s overall short-term liabilities, led by CAD and short-term external debt, as the buffer has increased materially since 2013.
All these factors have contained the volatility of the rupee and promoted the stability of other market segments. Furthermore, these factors prompted monetary policy to focus on domestic growth. Even as the Fed and the European Central Bank continued to raise rates till May, the RBI’s monetary policy committee halted rate hikes in April. Over the past few months, inflation in Western advanced economies has remained within the RBI’s target range despite being above the central bank’s targets. Back in 2013, inflation had touched double digits in India, while advanced economies remained muted.
India’s growth premium over advanced economies is high and is expected to improve further. Between 2023-24 and 2026-27, CRISIL expects India to grow at 6.7% per annum. During this period, S&P Global expects an average growth of 1.4% in the US and 1.2% in the Eurozone. Based on these estimates, India’s growth margin over these economies would be 170 basis points higher than the average over the past decade. In the medium term, it will attract capital inflows, especially sustainable flows like FDI.
FDI has already become the dominant form of capital inflow and has been broadly on an increasing trend over the past decade, accounting for 57% of net financial inflows in 2021-22 as compared to 22.2% in 2012-13 (Forex excluding stores). While they narrowed to 40.5% of overall inflows in the first three quarters of 2022-23, they were double that of 2012-13. FDI inflows support the resilience of a country’s external profile as they are generally less affected by FPI inflows in a rising interest rate scenario.
Meanwhile, the after-effects of increased interest rates are unfolding, even as major central banks near the end of the rate hike cycle. Risks of market crashes remain high, especially as segments that have benefited from ultra-low rates and surplus liquidity over the past decade struggle to weather the impact of higher interest rates. However, India is well prepared to deal with such global volatility. The fall in crude oil prices should bring down the CAD to around 2% in 2023-24.
Structurally too, India’s external profile looks better, as FDI stabilizes capital inflows, promising prospects for services exports, strong remittances, and improving overall growth prospects. In the environment, we expect the RBI interest rate to be held steady in June as inflation continues to decline, while the West, especially Europe, has some way to go before hitting the pause button on policy rates.
Dharmakirti Joshi and Pankhuri Tandon are Chief Economist and Senior Economist, CRISIL respectively.
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Updated: June 07, 2023, 11:35 PM IST