Indian markets walk over fire

India is in trouble.

A currency free-fall amid huge capital outflows saw the Reserve Bank of India hike two key interest rates by 200 basis points as it worked to arrest the decline in the rupee. Bank borrowing costs under the so-called Marginal Standing Facility rose to 10.25 per cent. The rupee, which had fallen 12 per cent over the past two months to a record low of 61 to the US dollar, did lift marginally. This morning it is trading at 59.3.

The Indian stock market, the SENSEX, fell sharply yesterday dropping 1 per cent against a positive lead from global markets. The Indian 10-year government bond yield spiked to 8.05 per cent from 7.55 per cent as markets took fright about a credit rating downgrade to junk status from the ratings agencies and India struggled to address some significant structural issues in its economy.

The markets were reacting to not only the lift in interest rates, but Reserve Bank of India Governor Duvvuri Subbarao also announced his intention to withdraw 120 billion rupees ($US2 billion) from the banking system through the sale of bonds. This is designed to soak up excess liquidity, which in turn should tighten monetary conditions and spark demand for the Indian rupee.

The policy action from the Indian Reserve Bank followed a decision last week to ban banks and currency dealers from trading rupee futures and options for speculative purposes, and only allowed such transactions for client related business.

The outflow of funds from India followed confirmation that the current account deficit widened to 7.3 per cent of GDP and economic growth slowed to a 10 year low of 5 per cent. The recent inflation data confirmed a worrying acceleration in price pressures with the annual CPI rising 9.9 per cent, while producer prices rose by 4.9 per cent. Earlier news that industrial production actually declined in the year to May reinforced concerns about the growth outlook.

The Times of India quoted Prasanna Ananthasubramanian, an economist with ICICI Securities in Mumbai saying, “These moves will not only push up interest rates but also lead to tightened liquidity conditions.” Ananthasubramanian also highlighted “it’s quite surprising that the central bank has used these measures to support the rupee at a time when the economy is in such a bad state”.

In announcing the policy action, the Reserve Bank of India said, "The market perception of a likely tapering of US quantitative easing has triggered outflows of portfolio investment. Consequently, the rupee has depreciated markedly in the last six weeks. Countries with large current account deficits, such as India, have been particularly affected.”

The policy tightening in India follows similar moves in Brazil and Indonesia where the prospects of a withdrawal of quantitative easing from the US Federal Reserve is sparking fears of a liquidity crunch and an unwelcome fall in their currencies.

Weaker economic growth at a time of a severe widening in the current account deficit in India presents a problem for the global economy in general and Australian exporters in particular. Depending on which measure is used, India is either the third or fourth largest economy in the world, currently rivaling Japan for the status of the third largest economy. In any event, India will definitely overtake Japan in 2014 to move into a clear third place which means that what happens in India does matter.

India is Australia’s fourth largest export market which makes the recent news of economic weakness and market risks problematic for businesses and policy makers alike. The main items that Australia exports to India are coal (over $5 billion last year), gold ($3 billion), copper and education services (both around $1.3 billion in 2012). Reflecting a combination of the strong Australian dollar and the growth slowdown in India, the value of exports to India fell a sharp 20 per cent over the past year.

India will continue to have a greater influence on the world economy as it grows. While the latest economic news and policy ructions did not have a significant impact in global markets, this will soon change. The bigger India becomes in the years ahead, the more markets will pay attention to its economic conditions in much the same way that the world is currently agonising over the signs of weaker growth in the second largest economy in the world, China.