MORGAN STANLEY / Chetan Ahya : India - How Global Funding Environment Influences India's Growth Trend?

[arthur garbayo]

 

India How Global Funding Environment Influences India's Growth Trend? February 08, 2012  By Chetan Ahya | Hong Kong & Upasana Chachra | Mumbai Over the last few months, we have been highlighting that India's growth outlook will be influenced by two key macro factors: (a) the global funding environment and its impact on capital inflows into India; and (b) domestic challenges in the form of (i) weak domestic macro stability, which reduces the room for aggressive counter-cyclical monetary or fiscal policy, and (ii) a weak macro environment, which is not conducive for quick revival in the investment cycle. In this note, we are reiterating our framework on how and why the global funding environment influences India's growth trend. Capital Inflows - A Critical Macro Link: #1 Funding the Current Account Deficit Since the credit crisis, India's current account deficit has widened and moved to a range of 2.5-3% of GDP from 1-1.5% of GDP earlier. We believe that the government's desire to stimulate domestic demand (with expansionary fiscal policy) at a time when external demand has been relatively slow has been the most important factor behind the wider current account deficit. Indeed, India is the only country in the region running a current account deficit. During the 12 months ending December 2011, we estimate that India will run a current account deficit of US$53 billion, -2.8% of GDP. Moreover, India's dependence on less stable non-FDI inflows to fund its current account is high. For the three years ending F2012 (year ending March 2012), we estimate that about 76% of the total capital inflows of US$184 billion have been from non-FDI inflows, including commercial loans, trade credit and portfolio equity inflows. Indeed, the dependence on debt-creating inflows has been much higher in recent years, given that the share of debt-creating inflows averaged only 44% in the 10-year period of F2001-10. While India manages to fund its current account deficit with ease when global financial markets are relatively benign, in times of uncertainty, the high reliance on capital inflows to fund its current account deficit will bring the challenges of managing balance of payments and exchange rate volatility.     #2 Large Net FX Outflows or Inflows Affect Domestic Liquidity Conditions As the current account is in deficit, a slowdown in capital inflows will result in net foreign exchange (FX) outflows. The net FX outflows will cause a deceleration in reserve money growth. Moreover, any intervention in the FX market (selling dollars) to prevent excessive currency depreciation will result in tightening in domestic liquidity conditions. Indeed, as capital inflows slowed during August-December, reserve money growth has suffered. While there has been a rise in the money multiplier (which has helped to offset part of the deceleration in money supply), the growth in money supply (M3) decelerated from 17.3% in August to 15.8% currently. This deceleration in money supply growth has kept interbank liquidity conditions tight. Over the last few months, interbank liquidity has been persistently higher than the central bank's comfort limit of US$12 billion (about 1% of net time and demand liabilities). Although the RBI could have injected liquidity through open market operations and a reduction in the cash reserve ratio, the trailing inflation problem has meant that the RBI has had to err on the side of being conservative and was not able to pre-emptively inject liquidity in an aggressive manner. #3 Commercial Sector Funding Is Highly Dependent on Capital Inflows Foreign capital has been a key contributor to overall commercial sector funding in India. The direct contribution of various sources of capital inflows including portfolio equity inflows, foreign debt and FDI has been about 26% in F2012 (up to December) as per the RBI. Hence, the trend in capital inflows weighs heavily on the trend of investment growth in the country. Moreover, portfolio equity inflows and global capital market movement also influence the risk capital allocation behaviour in the domestic market. A high share of foreign ownership has meant that domestic stock market movements have been highly linked to the trend in global risk appetite and portfolio equity flows. This, in turn, influences the corporate sentiment for risk capital allocation behaviour and investment sentiment. Great Monetary Easing Part 2 (GME2) to Reduce Funding Risks? As our Co-Head of Global Economics, Joachim Fels, highlights, we are entering a second round of monetary easing which "will be aimed at minimising recession risks, preventing deflation and helping governments to stabilise debts and deficits" (for more details, see Sunday Start, What Next in the Global Economy, January 22, 2012). Indeed, we have already begun to see signs of this monetary easing around the world. On November 30, 2011, to ease the dollar funding problems of European banks, the Federal Reserve, along with the ECB, Bank of Japan, Bank of England, Swiss National Bank and Bank of Canada "agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points". Moreover, our colleagues in Europe believe that the first Long-Term Refinancing Operations (LTRO) conducted by the ECB has significantly reduced the risk of a systemic banking crisis (for more details, see Don't Underestimate the Impact of the LTROs, January 18, 2012). Looking ahead, our global economics team expects meaningful easing measures from both the ECB and the Fed in the near term. In Europe, our colleagues expect that the second round of LTRO (due in February) could add an incremental €200-450 billion of additional funding into the banking system (for more details, see LTROs Underestimated, but Great Deleveraging Ongoing, February 2, 2012). This would then be followed up by a further 50bp policy rate cuts by the ECB in 1Q12 and eventually culminate in "broad-based asset purchases across countries and maturities only if it had exhausted its standard policy tools and still saw downside risks to price stability". In the US, our economics team expects the Fed to announce a third round of quantitative easing (QE3) of roughly US$500-750 billion in April-May 2012. The measures taken by the central banks in the developed world so far are beginning to reduce the global funding risks. This stabilisation in funding risks has been manifested in a narrowing of the Libor-OIS spreads to 42bp from the peak of 50bp on January 6, 2012. Spreads of Italian and Spanish two-year government bonds over German two-year government bonds have also declined to 284bp and 238bp, respectively, from 602bp and 448bp as of December 1, 2011. This improvement in the global funding environment has, in turn, resulted in a revival of capital inflows into EM and India. If the revival in capital inflows is sustained, it will start reducing the pressure on commercial sector funding and help to ease the tightness in interbank liquidity to some extent. Bottom line: As we mentioned in our regional economics note (see Asia Pacific Economics: Downside Risks to AXJ Growth Reducing but Not Totally Out of the Way, January 24, 2012), the systemic risks in the funding environment have been reduced and have given us some comfort that the probability of downside risks to the region's growth have been reduced. The reduction of the funding stresses is particularly important for India, given the importance of capital flows. While the funding environment (and therefore capital inflow) improves and becomes less of a drag, we believe that the challenging domestic environment will mean that it will still be difficult to achieve a V-shaped recovery in growth. We will address the issue regarding domestic challenges in a follow-up note.

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