The Indian stock market is down about 20% from its peak and the rupee is hovering close to its all-time low seen in 2013 when India was in a near-crisis situation. Even though macroeconomic fundamentals have improved significantly since then, this has not stopped foreign investors from dumping stocks and leaving Indian shores. Foreign investors have sold shares worth over a billion dollars so far this year because of volatility and risk aversion in the global financial market.
Currently, the world economy is undergoing a major transition and adjustments are happening on multiple fronts. Falling commodity prices are putting serious pressure on the budget, economic activity and external accounts of several developing economies. China, the second largest economy in the world—which supported global growth for a long period, especially in the aftermath of the 2008 financial crisis—is slowing and striving to shift away from a manufacturing export-led model of growth to a more consumption-driven economy. There are fears that this transition will be difficult to manage and that things may slip out of control with global consequences. Further, the US Federal Reserve has started the much anticipated normalization of monetary policy with a quarter of a percentage point rate hike in December, which has led to a policy divergence in industrial economies and strengthening of the US dollar. However, capital flows in the international market started adjusting way before the actual policy action.
These simultaneous economic and financial adjustments have indeed increased risks for the global economy. Therefore, it is not surprising that both the World Bank and the International Monetary Fund (IMF) have revised their global growth projections downwards. The IMF in its update to the World Economic Outlook this week said that emerging markets and developing economies are facing a new reality of lower growth.
But the immediate trigger for the rout in the global stock market is being traced to China. The gross domestic product numbers released this week, which showed that the economy expanded at 6.9% in 2015 against the target of 7%, doesn’t seem to have convinced investors. There are problems in the financial sector, and markets are worried about the possible fallout of sustained capital flight from China.
The current stress in global markets can also be explained to a large extent by the tightening of financial conditions following the shift in policy stance by the Fed. As the cycle turned, capital started moving out of emerging markets, and weak economic conditions, largely due to falling commodity prices in these countries, did very little to stop this reversal. In fact, the reversal from emerging markets and risk assets is not entirely unexpected. Capital flowed from the US to risky assets across the world in the aftermath of the financial crisis as a result of an unconventional monetary policy followed by the Fed. Economist Silvia Miranda-Agrippino and Hélène Rey have shown in their work that US monetary policy is an important driver of the global financial cycle and explains part of the variation in returns of risky assets across the world. But a sharp reversal in capital flow can increase financial stability risks in several emerging markets.
Where does this leave India? These global economic adjustments will take time, probably years, to play out and India will have to deal with some of the spillover effects, even though it is relatively better placed and is now being popularly referred to as a “bright spot”. The IMF expects India to grow at 7.5% in 2016 and 2017. But these numbers should not lead to complacency in policymaking as there are several domestic macroeconomic challenges that can derail a durable recovery. India should also prepare to deal with a possible fallout of slower global growth for an extended period. For instance, foreign trade at this stage needs deeper examination as exports are consistently falling even as global trade continues to grow.
There will be bouts of volatility which will be difficult to avoid in the short run because of the nature of financial markets, but India should build on its macroeconomic stability to take advantage of the changing global economic order in the medium to long run.
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