Is the Indian Economy a Bubble?

Characteristics of a Bubble

A bubble is caused by extraordinary amounts of foreign capital coming into a country through the banking system, leading to excessive credit creation (lending) to consumers and businesses. This allows people to consume more and businesses to expand their manufacturing capacity to meet vastly increased demand. Thus, when the flow of foreign capital slows down, stops or reverses direction, businesses are left with over-capacity, forcing them to cut prices in order to survive, wages go down as jobs are cut and consumption reduces as a result, putting further pressure on prices. This is a downward spiral and governments usually try to rescue the economy by spending like crazy and reducing interest rates, trying to stimulate demand and revive businesses. The country has to take on a lot of debt in order to do this over a period of years and is left weak and financially exhausted.

Foreign capital can come into the economy either through trade surpluses (i.e. the country exports more than it imports), through foreign investments in the stock market or through foreign direct investment (FDI) and making its way into the banking system in the form of deposits, which are lent out to individuals and businesses. And as deposits continue to grow faster and faster, interest rates fall as banks try to lend what they have. This leads to over-investment (and hence over-capacity) and over-consumption.

Key symptoms to watch for are a massive buildup in forex reserves, very high credit growth, large-scale property development, unprecedented and sharp rises in asset prices (property, stocks, art...). However, once capacity reaches a stage when supply far outstrips demand, prices begin to fall and the downward spiral begins.

The Indian Economy Today

Based on the above discussion, let's examine the Indian economy today:

Forex reserves: $140 bn, as of 2005. Note that the article says the Reserve Bank has been trying to keep exchange rates in check. This is up from $3.96 bn, in 1990, with nearly 50% having been built up in the previous two years!

Credit Growth: A per a November article in the Financial Times, credit has grown by 30% overall last year, a rate that has the Reserve Bank of India rather concerned. Of this, retail loans have growth by an average of 47% as opposed to 27% and 37% for agriculture and business, respectively. Within retail loans, housing loans have grown by 54% and commercial real estate loans by a staggering 104%. It may be noted that Thailand's domestic credit growth in the years immediately preceding the crash were in the range of 15-35%. However, India's credit to GDP ratio stands at a fairly low 45%, as opposed to the almost 300% that Japan had before its crash in 1990

Growth in Property Prices and Development: The same article states that "analysts estimate India’s property industry will be worth $50bn in sales by 2010, from $12bn last year. Property companies are reported to have plans in the pipeline worth up to three times the value of all the projects they completed in the past five years". I think these statements pretty much sum up everything. Housing prices have risen by up to 60-100% in some parts of the country in the last year alone!

Growth in Stock Market: The Sensex has risen at a long term compounded rate of around 13% from 1,000 in 1990 to around 7,000 in 2005, but it has almost doubled since then to about 13,000 in a span of just about a year and a half!

Growth in Other Assets: I've already written about the phenomenal levels of appreciation in Indian art. Gold, too, has been on the rise, though this is of course a global trend

These statistics are disconcerting, to say the least, and there are two questions that need to be answered:

1. Is India a 'bubble economy' waiting to burst? This could be determined by comparing the amount of foreign inflows as a % of GDP vs what it was for the bubble economies before they burst
Foreign investment inflows have jumped sharply from $6 bn in 2003 to $ 20 bn in 2006, as per Reserve Bank statistics, and these are about 2.5% of India's $800 bn GDP. India is essentially a net importer, so that is a non-issue.

2. Is India so heavily dependent on exports to US that the economy would collapse on a reduction in trade deficit and / or a devaluation of the US dollar? Prima facie, it seems not because India runs only about a $10 bn trade surplus with the US, which is a small fraction of its $800 bn GDP, as per Reserve Bank statistics

Conclusion

We're not a bubble quite yet, and neither are we very heavily dependent on a strong US dollar, so you can probably stay invested still. However, the trends need to be analyzed further to get a better assessment of where we are heading...

The story is, however, not over for you dollar-earners, as the dollar exchange rate is probably an axe that is waiting to fall.... maybe you should start repatriating some funds to India?