India Risk Assessment -Base Case

India Forecast Sriranjini Latha
Stable with some downside

Under the base case scenario, the UPA government is likely to settle internal disagreements over the Indo US Nuclear deal, with its Leftist coalition partners by the end of the year. The period of instability however, leads to (1) debates over India’s allegiance to the US and its future Foreign Policy (2) uncertainty in domestic financial markets. The Indo-US nuclear deal plays a big part in the stability of the current UPA government, which is attempting to solve internal disagreements through a government established committee of experts and representatives from the coalition. The economic environment continues to attract foreign inflows of cash; the economy is conducive to new investments, and growth in the core service sectors continue. The two possible downsides in economic trends is the appreciation of the rupee diluting India’s competitive advantage, and the increased short-term speculative capital inflows. The effect of the appreciating rupee without a pre-fixed band (like China), and the uncertainty that it brings to markets and exporters remain uncertain.

Stories ▪ Indo US Nuclear Deal ▪ Terrorism in Kashmir & stability of Pakistani government
▪ Export Policies & Foreign exchange risk ▪ Financial Stability (Short term capital inflows)

Political trends: (High probability, high impact) The United Progressive Alliance (UPA) led by the Congress Party, is dealing with the disagreements with the Left Communist coalition partners, over the Indo-US Nuclear deal. The left parties insist that the deal compromises the sovereignty and non-alignment policy of India because of its restrictions on nuclear testing and re-enrichment of nuclear fuel. The Left parties are threatening to withdraw support from the coalition government. If they do, that will then dissolve the UPA government, and mid term elections will be held. It is unlikely that there will be mid term elections before the scheduled date in May 2009, for the following reasons.
(1) The lack of a strong opposition party contributes greatly to the view that mid term elections will bring back the Congress to power. The Bharatiya Janata Party, BJP is the only opposition party, which now has no clear leader, and has been mired in internal conflict and corruption issues since the fall of their government in 2004. The BJP is seen as a more religiously charged party and is unable to find an agenda rooted in religious sentiment as the middle class in India is growing increasingly intolerant to such divisiveness.
(2) The Nuclear deal is seen as an elite topic to contest and people in rural areas find it difficult to comprehend, and when they do, find it hard to justify why this might be a bad deal. During the heated debate between the 2 parties, the Communist Part (CPM) decided to “take the issue to the people” by running awareness campaigns, the results of which didn’t seem to tilt in their favor, and instead turned out to be supportive of the deal or indifferent to it as it does not affect daily lives.

The above 2 reasons are big deterrents for the left parties to withdraw support. In the event that they do, polls show that it’s likely that the Congress will be re-elected to power in a coalition government along with regional parties, who are in favor of the Indo US Nuclear deal. The party that looks especially keen to join the Congress is the Bahujan Samajwadi Party in Uttar Pradesh, lead by Mayawati, in India’s most populous state with 1/7th of the seats in Parliament. Therefore, even in the event of mid term elections the deal is unlikely to fail. The top two reasons for the deal to go through, even in the event of re-elections:
(1) International implications for India. The failure of the deal means having to forgo being the US diplomatic and economic ally in the coming years.
(2) The strength and bargaining power of the leading party of the UPA the Indian National Congress will make sure the deal does not fail, through their re-election bid.

The issue is being dealt with internally through the setting up of the UPA-Left committee on Indo-US Nuclear deal, which will discuss and allay the fears of the Left parties. The risk posed by the stability of the government is reflected in uncertainty in financial markets as well as debates over India’s future foreign policy especially toward Russia and China. Russia, almost an old friend to India, is India’s largest military supplier. India sourcing military material from the US does not go down very well with Russia. China is increasingly hostile towards India’s proximity to the US agenda, as it believes the US is looking to India to establish a foothold in the SE Asian region. This might imply a “strategic base” in India in the long term, which is certainly is not acceptable to the Chinese government. India is likely to fend off US attempts at a “strategic or military base” as the Indian government is not likely to jeopardize their economic relations with China. The upside risk however, when the deal comes through is the increased economic ties between the US and India that is hugely beneficial to both American corporations and to Indian companies and consumers.

Terrorism trends
India’s foremost military dispute is with Pakistan over Kashmir. The Kashmir dispute will remain on the radar of political debate but is not likely to escalate into a big issue, as long as President Musharaff remains in power. The conclusion of the recent Presidential elections in Pakistan, last Saturday October 6th, shows President Musharaff in a clear majority and he is to continue in office for another 5 years. This is an upside because of the stability associated with the Musharaff government and its positive association with the US government, though a potentially damaging factor for Pakistan’s democratic proponents. With the increased anti Musharaff sentiment within Pakistan, the big risk to political stability is the threat that General Musharaff could be assassinated. This could mean the return of exiled Bhutto or Nawaz Shariff or alternatively pose a dangerous threat of a new radical taking over the reigns of power. Given that the status quo continues in Pakistan, especially with India and the US government, both pushing to keep the Musharaff government, it would mean stable Indo-Pak relations. India and US’s increased influence over Pakistan, as well as strengthening of Indo-US ties, in the long run could stand in conflict with the jihadi’s and could lead to increased problems across the Kashmir border. (Low probability, high impact)


Foreign Exchange Risk, Investment Climate and Export policies
The rise of the rupee by more than 12 percent against the dollar this year is increasingly seen as a risk that is eating into the profit margins of foreign firms as well as Indian exporters to the US. Technology services exports that outsource work for American firms account for 22% of India’s exports and was the forerunner in India’s outsourcing boom. These firms face a problem because their costs are in Indian rupees while 60-80% of their revenue is in dollars. This makes them highly dependent on US customers for revenue growth. With the depreciating dollar and preset contracts in an already low margin service sector, these companies have to bear the foreign exchange risk without passing them on to clients. These suppliers attempt to stay profitable by increasing volume contracts, renegotiating existing contracts, boosting productivity in the long term, and hedging and forward contracts for the short term. The firms could alternatively, pass on the costs to their customers i.e. US firms. This scenario is plausible, in part because of the technical skills and English-speaking population that is increasingly proving to be a “comparative advantage” and not just an “absolute advantage”. This is backed by the fact that volumes of US contracts and inflow of capital has not been decreasing. Since both, absorbing foreign exchange risk or passing them on, are company level strategies it is hard to predict their collective behavior and their effects on profit margins and continued contracts with the US.

The downside indicators are proof of exports being hit: (1) In the short term the political actors within the Ministry of Commerce are implementing industry specific steps to mitigate the impact of the rise in the rupee against the U.S. dollar, examples of which were seen as waivers of export tax for jute. (2) Exports in the fiscal year ending March 31 2008 are expected to reach only $140 billion, compared to $160 billion target the government had set. With both upside and downside indicators, and specific company level strategies to deal with the situation, the potential effects of the rupee appreciation cannot be fully assessed yet. (High probability, variable impact)

Financial Stability
The current account deficit increased in the quarter ended June 30th, because of the widening trade deficit (declining export revenue and increasing import cost). On the other hand, the capital account is in surplus, mostly because of huge capital inflows into domestic financial markets. This has caused the appreciation of the rupee, and the rupee will remain up as long as the capital inflows remain strong. This exposes the currency’s vulnerability to inflows especially short-term capital. In the first 8 months in 2007 foreign institutional investors (FII) have invested $8.3 billion in Indian stocks, of which 25-30% is estimated to be from hedge funds. This number is high in comparison with China, where hedge funds are at 4% of total FII inflows. The method of investing through derivatives (Participatory notes), gives these funds easy entry and exit into the market. This also leaves the regulatory body the Securities and Exchange Board of India (SEBI) unable to track the exact inflows, as the derivatives bypass the SEBI registered route. This vulnerability is currently outweighed by the stable growth in the economy. But this situation could escalate if there is a slow down in the economy, or if speculative short-term capital is withdrawn very fast upon some perceived risk. (Low probability, high impact)

My conclusions on the base case for India is temporary political instability till the end of 2007 along with continued strong growth in the economy which will level off to about 8% GDP growth in 2008.