Can India survive the triple emerging markets unwinding?

India can come through unscathed if it unleashes big-bang measures to fight the triple unwinding

If economists and equity strategists are to be believed, emerging markets (EM) are in for a lot of pain. These economies have gotten used to the rush of liquidity that was released after the Lehman crisis in 2008. But with the Federal Reserve announcing its intention of unwinding its bond buying programme earlier in June, emerging markets are expected to witness pain, even if it is in varying degrees. For instance, India has funded 33 per cent of its current account deficit through portfolio flows last year. Economies that are vulnerable to external risks need to brace themselves for a quantitative easing (QE) tapering.

What makes things worse for emerging markets like India is also its slowing growth. As current accounts come under stress with reversal flows, the currencies of these EMs will start weakening, which in turn will push up interest rates and slow growth further. This vicious cycle is already playing out in India. Morgan Stanley's team of emerging market experts say: "Regardless of whether US QE has accounted for the bulk of portfolio inflows into EM or not, recent and future shocks to US real rates and the dollar raise the risk of a sudden stop of capital flows into EM."

Other than the US pulling back its bond buying programme, there are two other kinds of unwinding expected to impact emerging markets. The first is China's de-leveraging, which will bring down growth and consequently demand for commodities. This will impact the commodity exporting countries like Brazil, South Africa and Indonesia a lot more than others. The other unwind that strategists are expecting is the credit unwinding by countries such as India and Thailand, which had seen rapid growth in credit over the last few years. Credit growth in India has been ahead of deposit growth over the past several years but with rates inching up and savings coming down steadily, de-leveraging will happen a lot more aggressively in India as rates rise. JP Morgan is underweight on emerging markets, as PMIs have come in below estimates and the weak tracking of 3Q activity data suggests further downside risks on EM growth projections.

However, countries such as India are relatively better placed as they will not be hit by China's unwinding. In fact, India would stand to benefit from falling commodity prices. Morgan Stanley believes that of the entire lot of EMs, India, Turkey and Indonesia need to play to their strengths (reforms in India, policy flexibility in Turkey and domestic fundamentals in Indonesia) to come through relatively unscathed. Scotia Bank's Sacha Tihanyi believes India needs big-bang steps on the rupee as incremental measures have proved useless.