India Raises Interest Rates and Eyebrows

India Raises Interest Rates and Eyebrows

In a move that has surprised investors worldwide, Royal Bank of India has raised a key interest rate from 7.75% to 8%. Though this move is to ostensibly combat the rapid inflation currently at 10%, there are other motivations at work.

Systemic issues

India, suffering in the stock selloff that began last week, has been languishing as dietary staples have soared in cost and investors seem poised to flee the country. Economists have blamed the deadlocked political system and the lack of effective economic reform, but uncontrollable events such as the four-month drought in 2013 have also exacerbated matters.

The country's finances seemed doubly doomed with the strengthening of the U.S. economy and interest rates. Historically, emerging markets have always suffered with a strong dollar as supplies of cheap money swiftly dry up and foreign investors seek a higher return on investment.

A slowing China has not eased fears. Although a slowdown in China could contribute to a balancing of the trade engagement between India and China, a subsequent lack of Chinese shadow banking opportunities could also slow Indian productivity.

'If they follow the path...'

Yet economic leadership is optimistic about the future. India's finance minister, Palaniappan Chidambaram, expects India to grow by 6% in 2014, but only if politics does not "muck up this whole thing." Claiming that growth is conditional on continuing current political leadership, Chidambaram has been preaching fiscal consolidation as the solution to a large current deficit.

To accomplish these goals, he elevated former University of Chicago professor Raghuram Rajan. Respected for his prediction of the 2007 crisis, Rajan has already pushed through reforms that allowed for a September recovery of the rupee as well as simplifying the licensing process of Indian banks.

A new model

Despite negative predictions by the World Economic Outlook, Rajan believes that the Indian economy will be stronger than suggested. He goes on to note that the current account deficit, expected to be higher than at present, should be significantly smaller.

Numbers aside, Rajan makes the argument that emerging markets are forced into a new model of economic growth as developed markets slow in output. This model, based on investment as opposed to consumption, necessitates an economic slowdown as the processes of a new model are implemented.

Though Rajan and Chidambaram's predictions are aggressive to say the least, their detractors are far more tentative. Claiming India's reported growth figures as inflated, many expect that India will be lucky to achieve 7% growth by 2018. Investors are similarly skeptical and have not yet committed in a fashion agreeable to either of the Indian economists.

Current Prime Minister Manmohan Singh has been unequivocally on board with these policies, having called for developed countries to cease all "unconventional monetary policies" to allow the developing world (i.e., India) to explore growth policies that require a testing period absent outside interference. As it is, Rajan believes that being lumped into the same negative position as many of the other developing markets has given India a large amount of undeserved bad press.

They may be onto something...

Initial prospects look good for India. Although the country has had a checkered growth rate since 2000, GDP growth has been trending positively. With the exception of a positive outlier in 2010 (10.4% reported growth), there seems little stopping India from maintaining and marginally increasing what is fairly consistent growth.

Considering the nation's ability to pay off all short-term debt immediately, the market seems prime for an Indian resurgence in the coming year. Whether or not this is the case depends entirely on the ruling administration, but it is not often when the rupee makes gains against the pound. Coupled with gains against the dollar, Rajan and Chidambaram have a strong position from which to make their case.

An Indian official noted "the risk is there, but well managed emerging markets will be able to cope with it." If nothing else. it will be interesting to see how compatible the new Indian approach is with the developed market.

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