India: no policy space to ease the slowdown in capital inflows-Moody's Global Macro Outlook for 2014-15

Overall, global growth is likely to rise this year

Advanced economies and emerging markets are assuming unexpected roles, with the former group leading the global recovery while the latter will weigh on world growth, at least temporarily. In advanced economies, reforms and accommodative monetary policy in the aftermath of the global financial crisis and the euro area crisis are slowly bearing fruit. After a soft patch at the start of the year, US economic activity is set to pick up during 2014 on the back of strong private sector balance sheets, favourable financing conditions, a smaller fiscal drag and strong price competitiveness. Moreover, after two years of recession, the euro area will contribute positively to global growth in 2014 as exporters benefit from competitiveness-improving reforms and as constraints on households' budgets ease.

By contrast, for some emerging markets, a range of factors point to slower growth than in recent years. In China, measures to slow credit growth and wean the economy off its dependence on investment are likely to ensure medium-term sustainability. However, in the short term, these goals will probably imply lower GDP growth than in the recent past, slightly below the official 7.5% target. In other emerging markets, some of the risks highlighted in Moody's February Global Macro Outlook have crystallised and growth will be dampened by tighter financing conditions this year. Capital inflows will likely be slower than in recent years as a result of investors adjusting their investment allocations to changes in US monetary policy while domestic monetary policy has already been tightened in response to inflationary pressures. Apart from credibility-enhancing actions by a number of central banks in response to inflation risks, plans for reforms to strengthen emerging markets' economies and reduce their vulnerability to a slowdown in capital inflows are limited to campaign rhetoric so far. As a result, growth in G20 emerging markets is likely to remain slower for some time.

Growth prospects for India are similarly hampered by a lack of reforms in recent years. The country is also vulnerable to capital outflows given a history of sizeable current account deficits. Although the current account deficit was reduced to only 0.3% of GDP at the end of 2013, some of that narrowing is unlikely to be sustained once restrictions on gold imports are lifted. Moreover, high inflation, at more than 8% in March 2014, implies that the central bank has no room to ease monetary policy in the short term and may even need to tighten further.

Like in Brazil, India's government has only limited opportunities to provide some fiscal stimulus to offset a possible slowdown in capital flows given that we expect the debt-to-GDP ratio to rise to more than 65% this year. On a positive note, according to the Institute of International Finance, portfolio flows in India increased sharply in March 2014, and, although they decreased somewhat in April, robust flows so far this year suggest that international investors continue to perceive attractive investment opportunities in India. Some of these capital inflows may be based on expectations of reforms after the parliamentary elections. These expectations could be disappointed if a coalition government lacks the political flexibility to pass reforms. Even if the new government pursues a strong reform agenda, the depth of the issues to be addressed means that India's economy is unlikely to return to previous growth rates of around 7%-8% in the near future.

Overall, positive developments in advanced economies will raise global growth this year to around 3%. For emerging markets, growth in 2014 is likely to be lower than in 2013. In 2015, as stronger trade spills over to improved domestic activity in most countries, global growth is expected to rise further, to reach close to 3.5% for the G20 economies, in line with historical averages.

According to Moody's, overall, global growth is likely to rise this year. We forecast that real GDP growth in the G-20 countries (weighted by 2013 GDP at market exchange rates) will rise to around 3% in 2014, up from 2.7% last year. Initially, improvements in the global economic environment will be solely accounted for by advanced economies. For emerging markets, growth in 2014 is likely to be lower than in 2013. However, policy responses by emerging markets to the implications of the US Federal Reserve's tapering of quantitative easing (QE) and the eventual increase in interest rates should enhance their economies' ability to benefit from accelerating global trade. In 2015, global growth is expected to rise further, to reach close to 3.5% for the G20 economies, as stronger trade spills over to improved domestic activity in most countries; this is the highest growth rate since 2011 and in line with the annual average growth rate observed in the 10 years to 2007.

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