India’s emerging challenge

This is my Perspective column from this week’s Fund Strategy magazine.

An important side effect of the debate about “tapering” by America’s Federal Reserve is heighted concern about emerging economies. It is widely argued that as the developed economies start to recover their emerging counterparts could falter.

As it happens a western recovery is still far from certain as discussed in my cover story of 21 August. However, there are signs of high volatility in emerging economies since the Fed’s tapering talk started in May. The emerging market sell-off in June focused attention on their vulnerabilities.

Several key emerging economies – including Brazil, Indonesia and South Africa – have suffered possible signs of distress. Bond yields have risen and, except for South Africa, so have official interest rates.

Trouble in the financial markets has coincided with concern about economic growth. Although the emerging world still easily exceeds the West’s aneamic performance the GDP growth rate seems to be slowing. Even China, for long the powerhouse of the world economy, has fallen to a relatively poor rate of 7.5%. Indeed China’s growth has dropped steadily since peaking at an annualised 11.9% in the first quarter of 2010.

Leaving aside China the emerging economy attracting the most anxiety is India. It is all too easy to find negative indicators for the country. Not only are interest rates and bond yields up but the rupee seems to hit a new low against the dollar every day. Inflation, at almost 6%, is one of the highest in Asia.

Some even warn that there could be a repeat of the 1991 balance of payments crisis. Shweta Singh, an economist at Lombard Street Research, recently estimated that the twin deficit – the current account deficit plus the fiscal deficit – amounted to 12% of GDP. That compares with a high of 14% in 1991.

India’s weaknesses were already becoming apparent well before the Fed’s taper talk. Back in February I wrote a blog post for Fundweb on the problem of India’s economic slowdown. It quoted P Chidambaram, the finance minister, saying signs of an upturn were already apparent. However, if anything the situation seems to have deteriorated since then.

If India is indeed facing economic stagnation, it would be bad news both for Indians and for the global economy. India is still classified as a lower middle-income country by the World Bank, with an average annual income of only about $1,500 per head. It may have a relatively large GDP in total but it has to be shared between over 1.2 billion people.

Growth in the emerging world is also vital to the developed economies. The developing economies have outperformed the advanced economies for many years. No doubt the crisis in the West since 2008 would have been much more painful if the developing world had not kept global growth alive.

The challenge is to discern whether India’s recent troubles are simply cyclical or whether the country’s growth dynamic is weakening. A falling rupee or high inflation may be painful for individuals or investors but they are typically symptoms of economic weaknesses rather than their fundamental cause.

Gauging the strength of the underlying economy is enormously tricky given the conceptual and data problems. However, a useful starting point, although far from perfect, is to look at the level of investment relative to GDP. This is because investment in the economy should, other things being equal, be a key determinant of future growth.

According to the latest available figures from the International Monetary Fund, the country performs relatively well on this score. Investment in India is running at about 35% of GDP compared with 26% for Russia and only 18% for Brazil. Most western countries fare much worse, with Germany and America both at about 17% and Britain languishing at 15%.

Of course the difference between absolute and relative levels is key. The western economies may have lower investment rates than India but they are starting from a much higher base. Advanced economies are investing to become richer while India still has to escape from dire poverty.

The figures also need to be treated with care. China’s investment rate, at 48%, is no doubt partly an indicator of economic dynamism. But it is widely argued that a significant portion of investment is wasteful. Investment in high profile vanity projects, for example, or in facilities that are not used, does not contribute to future growth.

In any case, the challenge facing India is to maintain and indeed strengthen investment for the future. India needs sustained investment in infrastructure and productive capacity if it is to make the leap to becoming a developed economy.

The challenge is as much cultural as economic. Influential voices are calling for it to play down the importance of economic growth and focus on alleviating the worst poverty instead. This is an understandable temptation but the historical experience shows economic growth is a precondition for eliminating poverty.

Short-term fluctuations in the rupee or inflation rate should be secondary concerns. They key challenge for India, and indeed other emerging economies, is to maintain high economic growth and investment over the long term.