India facing key structural risk of stagflation

India faces numerous headwinds to growth, and the Reserve Bank of India (RBI) and the central government are at odds over economic policy. While RBI has room to stimulate the economy by cutting rates, we fear that profligate government spending will make it very hard for RBI to act decisively. Further, India remains closely tied to the problems in Europe and the continued deleveraging in the US because India's stagnant domestic savings make it reliant on capital from abroad, which could dry up.

Capital expenditure has slowed to nearly zero and savings have stagnated in India recently. As such, India has been unable to generate the efficiency gains necessary to provide growth while avoiding inflation. Inflation in India is primarily supply-side driven, as businesses are reluctant or unable to make investments in increased capacity and/or efficiency. Conditions are ripe for stagflation. Any attempt to stimulate demand will drive up inflation, without providing compensating economic growth. This is a key structural risk at this time. While the cyclical elements of inflation could recede and provide some relief (lower crude prices, for instance) these structural inflationary pressures must be addressed before India can get back on its prior growth trajectory.

It is evident that the crisis in the Eurozone has already impacted emerging markets in general and India in particular. As global investors seek safe havens (such as US Treasuries), liquidity has been removed from emerging markets. Many emerging markets, and especially India, are dependent on this liquidity to finance the current account deficit and provide capital for investment. India is particularly vulnerable due to its large current account deficit, which is financed to a large degree by shorter-term portfolio flows. As these have dried up, the equity markets have struggled and the rupee has depreciated sharply. Given abysmal government policy, limited action by RBI and high dependence on foreign capital, India has revealed itself as a weaker link than many investors suspected.


It is evident that the crisis in the Eurozone has already impacted emerging markets in general and India in particular. As global investors seek safe havens (such as US Treasuries), liquidity has been removed from emerging markets. Many emerging markets, and especially India, are dependent on this liquidity to finance the current account deficit and provide capital for investment. India is particularly vulnerable due to its large current account deficit, which is financed to a large degree by shorter-term portfolio flows. As these have dried up, the equity markets have struggled and the rupee has depreciated sharply. Given abysmal government policy, limited action by RBI and high dependence on foreign capital, India has revealed itself as a weaker link than many investors suspected.


The government has implemented a number of capital account actions that should provide some support to the rupee. However, a spike in oil prices or a continued slowdown in growth could undermine this support. Also, the recent RBI regulations forcing exporters to convert half of their dollar holdings into rupees could well backfire, as it will be perceived as a last-ditch effort to support the rupee. The rupee will also continue to be buffeted by global risk sentiment and developments in Europe.