We have come a long way

Indian Express, 26 March 2011

Warren Buffet said that India is no longer an emerging market. In some ways, India does seem to have outgrown the symptoms of emerging markets. The patterns of a typical emerging market crisis are well known, and now it appears that such a crisis is increasingly unlikely to hit India. But in other respects, there is still much work in store for India to get away from the difficulties of emerging markets.

Let us outline the features of the classic emerging market crisis. Foreign investors in the country are usually an important element of the story. But the country has a tiny weight in their overall portfolio, so they do not have an incentive to spend time and money to learn a lot about the country. They tend to merely buy index funds, as a way to participate in the good asset returns that are expected. This way they gain from international diversification. For the rest, they have a low engagement with the country.

In such a situation when a domestic crisis occurs, a few foreign investors get nervous and start selling. Many other foreign investors, who are ignorant, see that other foreign investors are selling and start selling themselves. In the typical emerging market, equity and currency markets are illiquid, and even small amounts sold by foreigners result in large scale price movements. The herd behaviour of foreign investors, combined with market illiquidity, generates pressure on the equity and currency markets, and prices fall.

In the classic emerging market crisis, the government tries to prop up the currency and/or equity markets. This has the effect of giving a public sector subsidy to foreign investors on their way out. Further, when the central bank sells dollars, this leads to high interest rates at home. This is exactly the wrong recipe for monetary policy in a time of stress. The sharp rise in interest rates hurts large companies who have high debt. Worse, the country can then run out of reserves, at which point the exchange rate can devalue dramatically. Large currency devaluation can induce bankruptcy for the large companies who have borrowed abroad but not hedged their currency risk. Poorly supervised banks can also start going bust. This corporate balance sheet crisis then feeds into and exacerbates the crises of the equity and currency markets and the banking system.

It is important to obtain a deep understanding of this typical crisis, so as to guide an array of policy responses. India is at a point where numerous elements of this crisis would not arise.

Foreign investors in India are not merely buying index funds and putting a tiny weight on India. They are invested in India on a substantial scale, given that India is one of the large emerging markets. The combination of the FII framework and the Mauritius route has many problems, but it has led to a very large number of foreign investors who take interest in India, who study India, and know about stocks. Many of these investors have built up teams which systematically work on learning and trading Indian companies.

When a crisis occurs, such as on 17 May 2004, this pool of foreign investors does not engage in herding. They act just like any other pool of speculators. Some are optimistic and buy, others are pessimistic and sell. The net sale on 17 May 2004 was a tiny fraction of the overall trading activity of foreigners.

The Indian equity and currency markets are now quite deep and liquid. Each of these markets now has global turnover of roughly $50 billion a day. So if there is an external shock of a few billion dollars in a single day, this is not big enough to generate extreme price movements.

By now, MoF and RBI have learned to abstain from trading in either the currency or the equity markets. So when some foreigners sell, the government does not rush in, trying to prevent stock market or rupee depreciation. This policy stance of price flexibility generates a deeper stabilising response: after some foreigners sell, the prices go down, which makes the stock market and the rupee more attractive to foreign investors.

RBI's policy framework of a floating exchange rate has blocked the ability of currency market issues from constraining monetary policy. In difficult times, RBI would be able to cut interest rates, thus helping the economy.

High currency volatility has become the norm in India. As a consequence, the large companies know that when they borrow abroad, they have to hedge their currency exposure. Hence, if a large rupee depreciation should take place, as in the last two years, there is no crisis.

The FII framework, the deepening of the equity market and the policy of allowing price flexibility, alongside the fact that India is a large country with a $1.5 trillion GDP, now implies that the classic emerging market crisis is not a likely scenario in India. In this sense, India has emerged.

While the danger of this classic emerging market crisis no longer haunts India, we are far from finished with our institution building. Fiscal, financial and monetary institution building are the three pillars of what makes an emerging market emerge. India remains a much more volatile economy, with weak policy-making capabilities, when faced with shocks. A lot remains to be done on improving fiscal, financial and monetary institutions. As a first step, Budget 2011 proposed to push a number of financial sector reform bills through parliament this year. It remains to be seen whether the government will be able to do that successfully or not.

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