Indian markets did not escape the wrath of foreign investors in the second half of last year, as they pulled money out of emerging markets in response to the beginning of Federal Reserve monetary tapering.
Emerging market investors panicked after then-Fed Chairman Ben Bernanke suggested in congressional testimony last May that U.S. monetary officials could taper bond purchases later in the year (aEURoeTaper Tantrum 1aEUR?). When the Fed unexpectedly did not taper in September, and Bernanke said in December that the zero interest rate policy would continue even if unemployment fell below the FedaEUR(TM)s 6.5 percent threshold, the markets partially recovered. The respite proved temporary, as the Fed tapered in January for the second successive month, once again putting pressure on emerging equities (aEURoeTaper Tantrum 2aEUR?).
The Indian economy was promptly named a member of the aEURoeFragile FiveaEUR? countries that would be most affected by Fed policy changes. (The others are Brazil, Indonesia, South Africa and Turkey.) Interestingly, though, Indian financial markets have fared much better this year than during Taper Tantrum 1. Equity prices, measured by the Bombay Sensex Index, dropped from a 2014 high of 21,374 on January 23 to a low of 20,193 on February 13, a decline of less than 6 percent (chart below).
The relative stability of equity markets was also reflected in the performance of the rupee. The indian currency had been battered by massive capital outflows last summer, weakening to almost 70 per dollar in late August, compared with 53 six months earlier. The rupee has been relatively resilient this year, even as emerging markets worldwide reacted badly to Taper Tantrum 2. The most recent exchange rate of 61.90 per dollar was little changed from where it started the year.
Why have IndiaaEUR(TM)s reactions diverged from those of six months ago aEUR" and been milder than the corrections in some other emerging countries? With nationwide elections set for April or May, and with the ruling party expected to lose big, political uncertainty had been expected to worsen the market correction. But what I heard during my recent trip to India and meetings with private sector and senior government representatives suggests that both domestic and external factors played into the favorable turn of events.
First, the deficit in the current account of the balance of payments increased to more than 5 percent of GDP last year, putting pressure on the currency. After all, such a deficit must be financed through capital inflows or a rundown of reserves. This measure has improved markedly in recent months because two variables responsible for the prior deterioration have likewise improved. Gold imports have come down sharply in reaction to higher import tariffs and other restrictions the Indian government imposed last year. Also, the fuel import bill shrank with the fall in global oil prices.
Indian Current Account Balance as % of GDP
Second, a key driver of domestic inflation is food prices, which fell 1.4 percent month-on-month in January, helping to lower overall inflation, demonstrated by the move from an annual reading of 9.9 percent in December to 8.8 percent the following month. That progress, in turn, incentivizes Indians to channel their savings into financial instruments instead of accumulating gold as an inflation hedge, as has been their habit.
A third factor responsible for the improved investor sentiment toward India aEUR" perhaps the most important development over the medium term aEUR" is a shift in monetary policy. While criticizing the Federal Reserve for failing to consider the needs of emerging markets, Raghuram Rajan, head of the Reserve Bank of India, has continued to hike rates in his own country despite howls of protest from the business sector. The highly regarded Rajan, formerly chief economist at the IMF, has set an inflation target for monetary policy, a novel development for an emerging economy such as IndiaaEUR(TM)s. He calls inflation the main enemy of growth and therefore argues that a restrictive policy that lowers inflationary expectations would actually help long-term growth. This policy shift has gone a long way to boost investor confidence.
This is not to say that the Indian economy is out of the woods. The Fed seems likely to continue to taper bond purchases unless continued poor U.S. jobs numbers cause it to pause. And markets will see those moves as leading to an eventual rise in U.S. interest rates, prompting additional capital to flow out of emerging markets such as India and toward U.S. and related fixed-income assets. But a diligent economic policy, such as the one pursued by the RBI, is the best insurance policy against volatility.