India is Asia’s third largest economy. India has had an amazing growth in the past few years, however in 2019, it has experienced slowdown in its manufacturing and construction sectors. On November 7, 2019, Moody’s downgraded India’s outlook from “stable” to “negative”, citing the ongoing economic slowdown, financial stress among rural households, weak job creation, and the liquidity crunch in non-banking financial companies. According to the Center of Monitoring Indian Economy (CMIE), the unemployment rate of India in October 2019 was 8.45%, which is considered to be the highest in 45 year. The Reserve Bank of India (RBI) lowered India’s interest rate in October to 5.15%. India’s GDP growth rate expanded by only 1% in the second quarter of 2019. As an emerging economy, India is clearly facing a slowdown. The citizens of India are blaming the government for not taking necessary actions amid this slowdown. In this week’s blog post, I will talk about the Indian (emerging market) economy, and why there is no easy fix to this slowdown.
As a developing market economy, India has to attract foreign investments in order to expedite its growth. The way to attract foreign investments is by having a high interest rate. For example, if RBI’s interest rate was at 10%, then foreign investors are incentivized to invest in India rather than Vietnam, which has a 6% interest rate. So, if RBI drops interest rates, then the foreign investors would simply take their money out of India and invest it in some other economy that pays a higher interest rate.
Now you might be thinking, if that is the case, why doesn’t India just increase its interest rates? Well, increasing interest rates dries up the money supply domestically because individuals are less likely to borrow money at a high interest rates. Furthermore, rapid increase in interest rates could push the country into deflation.
You might think that India should just forget about foreign investors, and drop the interest rates in order to incentivize domestic businesses to borrow and spend money. Yes, this should work, however it will also bring inflation. By lowering interest rates, the borrowing increases, which increases the money supply, which then causes prices to rise i.e. inflation.
You might look at Japan, which is a neighboring economy. Japan has a negative interest rate. So, why do negative interest rates work for Japan and not for India? It is because Japan is a net exporter, however India is a net importer. Japan wants its exports to be “cheap” so that more people across the world would buy them and help Japan’s economy grow. India on the other hand would experience tremendous amount of inflation and Indian citizens would not be able to afford any of the imports such as petroleum.
Now you might ask why doesn’t the Indian government just increase its spending similar to how United States government spends? Unfortunately, currencies aren’t pegged against the Indian Rupee. World currencies are pegged against the United States Dollar. By lending to US, export based economies can devalue their own currency; this keeps the manufacturing cheap and grows their respective export based economies (China, Japan, etc). Furthermore, United States is a stable and developed economy, and other counties are willing to lend money to the United States. India on the other hand does not have this luxury. India also has to achieve IMF and World Bank targets to check inflation and price stability. If RBI creates money from thin air (Quantitative Easing) to finance Indian government spending, it would lead to rise in prices/inflation. Currently, India’s debt is 300% of its revenue which is much higher than of other BBB rated economies. So, if India takes on more debt, it might negatively affect the credit rating of the country. With a lower credit rating, others countries are less likely to lend money. Indian government would need to play around with its existing budget to find ways to allocate more spending towards welfare, infrastructure, etc.
In conclusion, India cannot drop interest rates to near zero without expecting higher inflation domestically. As liquidity is already drying up domestically, India cannot increase interest rates, even though it attracts foreign investors. In order to maintain price stability, India cannot simply start printing money out of thin air in order to fund the government spending. To fund the increased government spending, India could potentially borrow from other countries, which would increase its debt burden, but would likely counter the slowdown it is experiencing.
Hope you learned a little and found this blog post helpful. We talked India’s economy, and the various options that India has to counter its slowdown. As we saw, each option had an unwanted consequence. Only time will show how India withstands this slowdown. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
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