What the BRIC concept did for India

I first visited India in 1986 and despite its rather haphazard infrastructure and obvious inefficiencies and bureaucracy, it was easy to be impressed by the country’s potential for economic growth, and this generally optimistic long run expectation looks to be in place.

However, despite this optimism, we have always been rather uncomfortable with the country’s once vaunted position as one of the BRICs, not least because as witnessed most notably in north and south Asia during 1992-6, the investment bank and portfolio management industries have the impressive ability to mobilise ultimately excessive levels of funds into what were once great concepts but which soon become compromised by the arrival of too much investor exuberance and money.

Thus, between June 2009 and March 2013, India received just over $100bn of foreign portfolio capital inflows and during this period, these inflows proceeded at rates that were roughly double the rate that they had achieved during the period before the global financial crisis, and they were fully ten times the size of the inflows that had occurred in the early 2000s before the onset of the global capital flows boom and the beginning of the ‘BRIC concept’.

Interestingly since the global financial crisis, India has experienced a further $120bn in direct investment flows – a rate of inflow that was perhaps five times as fast as that which India experienced in the four to years prior to the crisis. While in theory the latter are long term flows conducted by non-financial companies, we know from our own experience that many of the sponsors will have been in the receipt of the BRIC ‘Kool Aid’ presentation from their own corporate finance advisors and they will presumably also have been enticed by the promises that the BRIC concept offered. There can be little doubt that the BRIC concept, coming as it did during a generalised global capital flows boom (both before and after the GFC), represents one of the most successful fund marketing themes of all time, at least in the investment world.

These essentially huge inflows of capital were of course far larger than India’s expanding current account deficit and, as a result, the country both amassed large basic balance surpluses within its balance of payments and it acquired large quantities of foreign exchange reserves. These external surpluses were then re-cycled by the domestic banking system into a particularly intense credit boom that appeared to transform the ‘demand side’ of India’s economy. Indeed, within the domestic economy, years of domestic credit growth in excess of 15–20% allowed for a boom in housing and other forms of domestic expenditure, which in turn ensured that India’s nominal economy expanded rapidly. We use the term ‘nominal’ economy here since over the longer term the real level of output and GDP will be determined by the size of the population, its productivity and the economy’s other factor endowments, and just because India’s nominal economy was growing at a faster pace did not automatically imply that its real ‘supply side’ was keeping pace. Indeed, confirmation that the supply side could not keep pace with the booming level of demand was provided by the high rates of inflation and of course by the rising current account deficit.

What’s more league tables of countries’ levels of GDP tend to state the numbers in US dollar terms and India’s rapidly expanding rupee-denominated nominal economy appeared even larger on a global scale as the rupee appreciated against the dollar under the weight of the capital inflows. More importantly, the combination of rapidly rising nominal GDP, appreciating currency and access to a seemingly abundant supply of domestic credit implied that India’s population’s notional spending power abroad boomed during this period, thereby seeming to validate its inclusion in the whole BRICs concept.

Given such a heady mixture of ‘expansionary’ and confidence-building influences, it is not surprising that India’s business community and indeed its government began to feel more upbeat and perhaps a little ‘masters of the universe’ like. Consequently, domestic spending levels increased yet further, both in the private and public sectors, and they increasingly began to include white elephants, grandiose projects and other signs of a reduction in financial discipline. We had, of course, witnessed such events many times before in the run up to the Asian Crisis, and in 1995 it was apparent that so much money had flowed into Southeast Asia in the early 1990s that the economies became increasingly wasteful of the money and operationally inefficient (particularly in a cash flow sense) as a result of the seeming permanence and abundance of these capital inflows. These growing inefficiencies and the excesses that the fund inflows allowed led the countries to spend more and more relative to their economies’ underlying supply potentials and, as their output gaps expanded, their underlying inflation rates increased (although in many cases headline inflation rates were held down by their strong currencies) and their current account deficits expanded sharply, both as they over spent (thereby sucking in more imports) and even began to neglect their export sectors in favour of another shopping mall or ‘world’s tallest building’.

However, as current account deficits expanded, countries began to need ever larger and constant injections of new foreign capital just to keep these deficits and the whole cycle financed and it looks as if India became dependent on large scale capital inflows around two to three years ago. As is usually the case in these types of cycles, eventually foreign investors begin to notice the excesses, the inefficiencies and most of all the country’s dependence on new flows, and this is usually the cue for markets to begin to attempt to extract a higher price for further injections of the now ‘necessary’ funds. At this point, having become hooked on the cheap funds, the borrowing country must decide whether to pay a higher price (via offering higher yields to investors, and much of Asia attempted this strategy in mid 1997 but the countries quickly found that the required price was simply too high for them to bear), or it must wean itself off its foreign capital dependency by reducing domestic expenditure back in line or below its own supply potential. If this is achieved, the current account deficit will ultimately shrink or even reverse and so solve the ‘addiction’. However, the ‘bad news’ is that this implies that the domestic nominal economy, particularly in third party currency terms, will likely have to be deflated via falling incomes and wealth, a falling currency, rising import prices, and higher domestic inflation in the short term.

It is into this ‘deflation’ of the once excessive and unrealistic nominal economy that India has finally fallen over recent weeks, although the signs that this has been about to happen have probably been all too clear on and off for 18 months or more. Hence, we should not be surprised to find the rupee weak, the balance of payments under pressure, bond prices falling, interest rates rising, inflation rising and nominal incomes in general under pressure.

Quite simply, the economy is being obliged to experience ‘cold turkey’ as the capital flows and credit induced hallucination of the last few years fades, and the Indian government having failed to control the initial addiction or adopt more reform and fiscal austerity during the period of heavy capital inflows, is now more a passenger in the process than a driver. More positively, although ‘cold turkey’ will not be pleasant, at least it is better than remaining addicted to capital flows and having more inefficiencies and distortions baked in to the economy, and at least a falling rupee and presumably rising wages and general inflation that will follow, will restore affordability to the housing markets while the period of credit stringency ahead will no doubt address some of the mis-allocation of capital and other forms of excessive or exuberant behaviour that have dogged the economy in both the public and private sectors.

Ultimately, the bulk of Asian economies emerged from the ashes of 1998 economically and politically stronger than before, and India’s current travails should not prove fatal. Indeed, on a long term view, the current chapter may support the economy in achieving its potential. So as the hangover ends, the economy can re-emerge stronger than before, and investors may look to build exposure to India. For now, the risk really is that the Indian government’s policy response exacerbates rather than addresses the problems. We will need to monitor with special care what the government says and does.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla