Leading Question: Can India Be the First ‘Fallen Angel’ to Fly Again?

Over the past few months, one crisis after the other has gripped India. The problems of coalition politics have paralyzed the reforms process. A campaign against rampant corruption in the government and bureaucracy has brought decision-making in New Delhi to a standstill. Ministers are worried that anything they do — even a minor policy change produces winners and losers — will be given the color of corruption later.

The fiscal numbers signal trouble. The GDP growth rate in the January-March quarter has slipped to 5.3%; the earlier expectation was around 8%. The growth in the index of industrial production (IIP) in April was just 0.1%. Interest rates remain too high, choking investment and growth. Rating agencies are taking notice: Standard & Poor’s warns that India could become the first “fallen angel” among the BRICS countries (Brazil, Russia, India, China and South Africa) and Fitch has cut India’s rating outlook to negative. All indicators of business confidence reflect the growing gloom. Dilip Gadkar, editor of Macro Viewpoints and CEO of G-Square Capital Management, a hedge fund advisory firm in New York, argues in this opinion piece that these problems are the result of populist politics combined with unsound economics – but India could bounce back faster than the pessimists fear.

India’s perplexingly sudden fall from its growth pedestal is the topic du jour among analysts and reporters. The unkindest cut came from the ratings agency Standard & Poor’s (S&P) which warned that India could be the first BRIC country to be downgraded to “junk.” The S&P report was direct in placing the blame: “The division of roles between a politically-powerful Congress party president [Sonia Gandhi], who can take credit for the party’s two recent national election victories, and an appointed prime minister [Manmohan Singh] has weakened the framework for making economic policy, in our view.”

We say “perplexingly” because analysts and reporters seem surprised by the fall. Frankly, in our opinion, it was guaranteed. The reality is that the story of today’s fall of the Indian economy was written in 2009 and it so happened.

The May 2009 Election

The 2009 election was a huge victory for Sonia Gandhi, president of India’s Congress Party. For the first time since 1972, the incumbent party and prime minister were re-elected. This election delivered absolute power to Sonia Gandhi. She reappointed Prime Minister Manmohan Singh but restructured the rest of the cabinet. Most analysts missed the message that the policies of India would now be Sonia Gandhi’s policies and not those of Manmohan Singh. And Sonia Gandhi’s policies were a modern version of Indira Gandhi’s economic policy after her huge election victory in 1971.

Yet, analysts and observers kept waiting for Prime Minister Singh to introduce economic reforms that would free up the private sector. They are still waiting. They should have remembered the 1971 campaign slogan of Indira Gandhi — “Garibi Hatao” (Remove Poverty). That is exactly what Sonia Gandhi set out to do.

Noble Aims and the Credit Boom of 2009-2010

Recently, Alan Greenspan, the former chairman of the U.S. Federal Reserve, described the euro as a “noble but failed experiment.” These words could just as easily be used for Sonia Gandhi’s policies. Supported by her shadow cabinet of social activists, she launched programs that guaranteed monthly cash payments to hundreds of millions of India’s poor. These programs did not create jobs or much-needed infrastructure. They simply delivered cash.

This was easy to do in 2009 and 2010. The global rally in risk assets and the lure of secular high growth drove a flood of foreign capital into India. The distribution of free money worked well in the short term. Indians love to spend and rural spending drove up India’s growth rate. The uniqueness of the rural growth story drove more capital into India.

The intermediate-term consequences were becoming visible by 2011. Thanks to the distribution of free money, workers from poor states like Bihar refused to travel to prosperous Punjab to help in agriculture or to industrial states like Maharashtra for construction or manufacturing jobs. This undermined labor migration, an underlying strength of India’s economy.

Handing out monthly cash payments to millions of people is the time honored recipe for inflation, structurally high inflation. Not content with giving out cash, Sonia Gandhi’s advisers planned a food security program to guarantee a minimum level of food (or its price in cash) to about 61% of Indians. The mere announcement of this program launched food inflation into a higher orbit.

The years 2009-2010 represented good times with foreign capital flowing in and everyone in the Congress looked forward to an even greater election victory in the 2012 state elections and then in the 2014 national elections.

Rise of Inflation and the Credit Bust of 2011-2012

The combination of the credit bubble, unprecedented distribution of cash to millions of people, and the lack of critical infrastructure for food distribution led to skyrocketing food inflation in India. So the Reserve Bank of India (RBI) went into action in late 2010 with an aggressive campaign to raise interest rates. Not surprisingly, November 2010 marked the peak of the Indian stock market.

Unfortunately, that was like performing heart surgery to cure a kidney malfunction. The interest rate hikes slowed down India’s industrial production and led to urban unemployment. But the RBI and the Indian Cabinet were powerless to reduce Sonia Gandhi’s delivery of cash into the hands of millions. As a result, food inflation kept rising and industrial production began slowing as the RBI kept raising interest rates. The result is today’s stagflationary bust in India.

As the luster of India’s growth story dimmed and the stock market stopped delivering gains, foreign capital began leaving India. This created a very serious problem for the Indian government which relies on capital inflows to make up the balance of payment deficits. When Europe’s debt problems shocked the world in late 2011, the outflow of foreign capital from India became a flood and the rupee collapsed by 20% in one single month — November 2011.

Unfortunately, India’s brains trust considered this rupee collapse as merely an accident. So did non-residents Indians and most foreign investors. To them, the fundamentals of India’s growth story were sound and secular. They sent in more than US$5 billion in capital into India in January 2012. Global investors went back into risky assets in the first quarter of 2012, the Indian stock market rose by 18% in the first seven weeks of the year, and the Indian rupee rose by 10% to recover half of its November 2011 loss. So India, ever complacent and self-rejoicing, decided the worst was over.

March 2012 Elections and the May Debacle

In pursuing these populist policies, Sonia Gandhi’s goal was to ensure the accession of her son Rahul Gandhi to the prime minister’s seat. The critical first step was to win the pivotal state elections in March 2012, especially in Uttar Pradesh, India’s largest state. The expectation was that the electorate, especially the poor, rural electorate, would remember the monthly cash payments delivered to them and elect the Congress Party led by Rahul Gandhi. Unfortunately, he lost and lost big. Following the defeat, Congress Party members have begun to question the power of the Gandhi lineage. The result has been infighting within the Congress and the Indian cabinet.

The anger and fury had to be directed against somebody and the government needed revenue right away. The obvious targets were foreign institutional investors. The Government targeted Vodafone despite a Supreme Court ruling in its favor. The Government raised the specter of retroactive taxation on capital gains realized by foreign investors in prior years.

Just as India’s finance ministry began its ill-conceived attack on foreign investors, global markets began their downturn in May 2012. This time, everyone realized the long-term problems India faces. Foreign capital again resumed its flight out of India. The rupee did not collapse this time, but it went on an unrelenting selloff, which was worse. The despair in India was palpable. The Indian growth story was officially over. To use S&P’s metaphor, the angel’s wings were clipped.

Growing New Wings

What could go right for India? Could the country, the first emerging market to fall, become the first to rise again?

I believe this could happen – for several reasons. Frankly, the steep fall in the rupee has been a blessing for India. The country is as much of a fiscal mess as any among Europe’s PIIGS (Portugal, Italy, Ireland, Greece and Spain). But it has the flexibility of a free currency. There is no question that India is much more attractive at Rs. 55 to the U.S. Dollar than at Rs. 44.

A global slowdown might actually make India more attractive than other emerging markets that rely on exports, chiefly commodity exports. In contrast, India benefits from falling commodity prices. A fall in oil and agricultural commodities could cool down Indian inflation and allow the RBI to cut interest rates. These cyclical factors could add to the real structural strength of the Indian economy and boost consumer demand.

Contrast this with China where, according to a Financial Times article, “demand is fading fast.” The article states, “With demand weak… to many parts of the economy…[this] feels like deflation, as corporates appear to be losing pricing power….At this moment… the economy needs a new structural breakthrough.” Other emerging markets, dependent on commodity exports, could suffer from China’s waning demand. This makes India’s real, secular, structural consumer demand story both unique and attractive.

So India, the first BRIC and major emerging market to fall, could end up being the first to recover with a cyclically positive story of low inflation, falling interest rates and the structurally positive story of secular demand. America, the first country to suffer a credit bust in 2008, is widely recognized today as the first economy to emerge from the bust. India could end up being the first economy to come out of a global emerging market bust.

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