Simply Economics

India, post independence, has been a capital importing economy (current account deficit). While the intent at most times has been to use this to create productive assets, there has been a significant shift to import for consumption. The spend by the government in social schemes has further increased this trend.

The global environment prior to the 2008 crises was very conducive in the form of easy monetary policies and high consumption in developed economies (encouraging imports). But the vulnerabilities have exacerbated since.

The Indian government and the central bank reacted to the crises with expansionary policies - reducing excise duties, lower interest rates, flexible restructuring terms for bad loans, while the global central banks created ultra loose policies. This combination supported the sharp cyclical upturn of 2010 and 2011.

These measures made no change to the productive capacity of the economy in the long-run. The private sector had not recovered from the the jolt of 2008 when the governance issues played out in full. Mega-corruption scandals and activism of Supreme Court / CAG created a stand-still in the government.

The social schemes and rural sector transfers (higher procurement, higher minimum support prices for grains) continued as the government fought to remain in favor resulting in high fiscal deficits. These measures kept the consumption engine in the economy firing while more capital was directed towards real estate and gold by households to protect from inflation (implication of negative interest rates).

Fast forward to today, we have the following issues:

• a profligate and corrupt government unable to act;
• consumption slowing down as employment generation contracts;
• corporate India facing a slowing revenue and profit growth;
• massive non-performing loans (we have a fully levered banking sector running at 75% + loan-deposit ratio);
• very high current account deficit, resulting in the rupee problem.

International monetary regime will no longer be supportive to allow for such failings in the economy. 

Before I come to the implications, in economics savings (domestic plus imported) is equal to investments. Domestic savings rate which was 37% in 2008 is expected to dip below 30% this fiscal. International imports of savings has been in the form of FII flows to debt and equity, which has seen significant outflows in the last 2 months. If savings decline, so will investments and this is the primary determinant of the level of GDP growth in India.

The rise in international rates primarily dollar rates will put significant pressure on capital flows. We have seen a brief trailer in the last few weeks. This has happened when the dollar index has barely moved. 

The dollar is likely to see its 3rd significant rally since Bretton Woods (when it came off the gold standard in 1968) as the Fed increases interest rates and shale gas creates greater productivity in the economy. The first rally in the early 1980s driven by Volcker interest rate regime caused the Latam crises, the second was in the mid-1990s when the Asian Financial Crises played out. These crises were caused by over-dependence on foreign capital.

The implication of above changes are already playing out and these trends will deepen. Banks, real estate, consumption related and import dependent businesses and the rupee will suffer. External demand sectors like pharma, IT and MNC linked export businesses will gain. Metal related business will continue to feel the heat of the Chinese slowdown. As the above pressures correct the saving imbalance in the economy in the next 3-4 years capex linked sectors will recover.