It’s almost like global markets woke up towards the end of last year, and decided that the despondency and gloom of the last few years was but a bad dream, disconnected from a more buoyant future. Since then, global equities have been surging, repeatedly setting new highs, and capital has been rushing back to emerging market assets. Indeed, India received $9 billion of foreign portfolio inflows in March alone — the highest monthly portfolio inflow on record.
What explains this swing from depressive to manic behaviour? To be sure, the global reflation story was alive and kicking in the first quarter of 2017, with nominal GDP growing by 6 per cent (annualised) for a second successive quarter — a significant jump over the last two years. More importantly, global manufacturing growth is finally on the surge, amidst tantalising signs that global business equipment spending is gaining steam. Advanced economies — reliant thus far on just consumption growth — have suddenly found a second engine of growth: Business spending.
But this is only half the story. Despite the growth lift, markets remain relatively sanguine about global inflation as oil prices are expected to be capped by the impressive supply response from shale. Consequently, even as activity lifts, markets believe that the Fed will remain relatively dovish, reflected in the fact that benchmark US treasury yields retreated to a five-month low in recent days.
From an emerging markets’ perspective, this is as good as it gets. They get the benefit of stronger global growth through higher exports, but are shielded from tighter global monetary conditions. Indeed, Asian exports have surged in recent months, and India’s own manufacturing exports galloped in February and March. What’s not to love? A Goldilocks story, right?
Only if you believe in fairy tales. Yes, the global economy is experiencing a cyclical lift. But we could be bouncing towards a malaise. The inconvenient truth is that the underlying fundamentals have not changed. In the US, for example, revealed potential growth — the sum of labour force participation and productivity growth — has fallen to an abysmal 1.1 per cent in the last three years. So, for an economy that is near full employment, growth much stronger than this will simply elicit higher inflation and a faster hiking cycle from the US Federal Reserve.
Europe is healing but is peppered with political risk in the coming year, starting as soon as this weekend. China has stabilised but at the cost of much-needed re-balancing: The can has simply been kicked down the road. Finally, many emerging markets —India included — need to undergo a painful deleveraging and asset resolution process. So, the underlying structural malaise around the world is simply being papered over by a temporary cyclical lift emanating in advanced economies.
If anything, global risks have risen under the radar as economic nationalism becomes more pervasive around the world. Much was made about the tightening of H1-B visas and its impact on India. But that could be just the tip of the iceberg. What if the US were to impose a border-adjustment tax (BAT) to help pay for the promised tax cut later this year, especially since the expected fiscal savings from healthcare reform did not materialise?
Either markets will have to brace for a much smaller tax package or accept a disruptive BAT to pay for a bigger tax cut. Both outcomes are likely to be badly received. The BAT is essentially a large tariff on imports into the US and would dramatically accentuate recent de-globalisation trends. It would also result in (potentially significant) pressure on the US dollar to appreciate, thereby creating innumerable complications for policymakers in emerging markets, who will be faced with sharp depreciation pressures of their currencies.
Finally, think of US trade protectionism as being akin to a negative supply shock to the economy. The resulting price pressures would likely force the Fed to normalise at a faster pace. In turn, the growth-impinging fallout of more rapid normalisation could simply fuel more economic protectionism and nationalism. We could get stuck in a self-reinforcing bad equilibrium. Why is this so important for Indian growth prospects? Because we are far more open — and therefore vulnerable — than we believe. India’s exports to GDP have almost doubled over the last 15 years, from 12 per cent of GDP in 2000 to 20 per cent of GDP currently, having peaked at 25 per cent in 2013. To put this in perspective, India’s exports/GDP are at the same level as Indonesia and twice the level of a Brazil.
This has crucial implications for India’s potential growth. India was able to attain 8.8 per cent average growth between 2003-2008 because exports were surging at nearly 18 per cent a year in that period. In contrast, domestic consumption grew at just 6.5 per cent and, more generally, has averaged 7 per cent over the last 15 years.
In the last five years, however, exports have grown at just 2.6 per cent a year. With exports making up 20 per cent of GDP, even if they were to grow at 5 per cent (twice the level of the last five years), instead of the 18 per cent growth in 2003-2008, we would need to deduct a full two percentage points from the 9 per cent growth during that period. In other words, unless global prospects improve on a sustainable basis or we can find offsetting domestic growth drivers, 7 per cent will become the new 9 per cent, as regards India’s growth prospects.
Furthermore, what we export today makes us slightly more vulnerable. Gone are the days of primarily exporting textiles, leather, gems and jewellery. Today, engineering goods and pharmaceuticals constitute 60 per cent of the non-oil manufacturing basket. We find that these higher value-added manufacturing exports along with services are also much more sensitive to global growth impulses. So, volumes surge in the good times but collapse in down-cycles. Being more cyclical, they are also more volatile and risky. In particular, the bulk of India’s exports to the US are engineering goods, pharmaceuticals and IT services. Given the high sensitivity of these sectors to the business cycle, any reduction in imports from the US — either through lower growth or increased protectionism — could disproportionally impact India’s exports.
It is easy to get carried away in the current environment. Markets are surging, the global data-flow has become more constructive and the past looks like a bad dream. It isn’t. We cannot let a transient, cyclical lift be mistaken for underlying structural improvements. The structural drags remain in place, monetary accommodation has maxed out, and economic nationalism is creeping up. We are bouncing, but towards a malaise (confirmatory signs are in the most recent US retail sales data). Markets may ignore these realities but policymakers cannot, because when markets diverge from fundamentals, it’s markets — not the fundamentals — that end up having to say mea culpa.