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?

The Dollar Crisis

I've been reading a book called 'The Dollar Crisis', which talks about how a rising US trade deficit is unsustainable and is sooner or later likely to be reduced through currency devaluation and general reduction in consumption and import. This will lead to severe repercussions for all export-oriented economies given that they basically survive on exports to the US (the Asian economies are the leaders in this respect, but India will also be affected) as well as other nations, since the world's reserve currency is the US dollar.

A slowdown in US imports will lead to a global slump and perhaps even a recession, creating worldwide stock and property market crashes, among other things. The good news is that prices of goods and services will most likely reduce, but if you're an investor that might not be much to cheer about! Further, if you are one of the many immigrants working in the US, I need not explain how a falling dollar will affect you. The book talks about currency devaluations of the order of 50% or more!!!

Reading all this has got me thinking about the general direction of the Indian economy, as the book provides multiple examples of 'bubble' economies, all of which showed similar trends in the years leading up to the inevitable crashes. We are all most familiar with the dot-com bust and perhaps the Asian crisis, but similar situations have been happening on a fairly regular basis e.g. Japan's bust in the early '90s, from which it is only now recovering...

The 'Crisis' In a Nutshell

Till early in the 20th century, the world followed what was called the 'gold standard', in which their money was backed by gold and, hence, redeemable as such. In such a system no country could afford to have a sustained net trade deficit as that would cause their gold reserves to deplete till it reached a stage when they no longer had enough gold to sustain their economy. Once this stage was reached, their economy would go into a recession and prices and wages would fall till they were low enough for their exports to become cheap so the rest of the world would start importing from them again, allowing their gold reserves to build up once more.

Today's system has no such checks and balances. The international standard is a set of currencies that float in value against each other, with the US dollar as the de facto reserve currency of the world. In such a situation, and with a strong dollar, there is nothing stopping the US from sustaining a large trade deficit (i.e. importing more than it exports). And since it is to the advantage of exporting nations like India, China and the Asian countries to keep their currency values low, they cannot take the US dollars they get from exports and convert them into their own currencies, as that would increase the value of their on currencies and hurt exports.

Therefore, these countries invest them back in the US and state them in the form of national reserves. Thus, the US gets goods and services and pays for them in dollars, which it then gets back in the form of investments. These investments are pumped into the US banking system, which it then lends out, thereby allowing businesses and consumers to buy more things, most of which are imported! This cycle allows the US to continue with a rising trade deficit. Thus, in effect, the US has been buying goods on credit!

This huge US trade deficit has been financing most of the economic growth in the Asian nations and other export-oriented economies, allowing for increased lending and creating jobs and wealth that are leading to economic booms and rising asset values (stocks, property etc). Therefore, a slowdown in US consumption will hurt these economies badly, leading to a very severe recession.

Since the US deficit is underpinned by the willingness of the rest of the world to continue to hold their reserves in dollar instruments, it is only a matter of time before it has to be curtailed as countries begin to get uneasy about the credit-worthiness of the US (after all, it cannot repay infinitely large sums of money) and either withdraw their funds or at least reduce their annual investments. The other possibility is that the US consumer, already neck-deep in debt thanks to all the low-cost credit they have had access to, is no longer able to service increasing debt repayments and chooses to cut back consumption, thereby reducing the extent of US imports.

Both of these scenarios spell doom for the rest of the world, as the net result will be for the US to have to sharply depreciate the dollar against countries with trade surpluses (China, India and the Asian economies) in order to reduce, and eventually reverse, the trade deficit.

The next post will focus on India