Hot spots: India.(economic scenario)

In the early months of this year, as during all of 2005, India was the beneficiary of heavy inflows of foreign capital into the local equity bazaar. The stock market was one of the world's best-performing and the Bombay Stock Exchange's Sensitive Index (BSE, or Sensex) surged by 34 percent from the start of 2006 to May 11, following a 42 percent gain in all of 2005. But then the tide turned and the Sensex started to plummet, after foreign institutional investors began trimming their exposure.

They were doing so in other emerging equity markets as well, as they became more risk-averse and took note of rising interest rates in North America and Europe. The unwinding of positions was a wakeup call for many investors in India, however, reminding them that this country has been attracting relatively little reliable, long-term, direct investment capital and is, instead, heavily dependent on volatile inflows of short-term funds (hot money) to finance its current-account balance-of-payments deficit.

The economy grew at an annual clip of 9.3 percent in the quarter ended March 31 this year, which was the last of the 2005/06 financial year, driven by strong gains in the farm and service sectors. The expansion was up from 7.5 percent in the preceding three months, and it raised the real GDP gain for the entire fiscal year to 8.4 percent from the 8.1 percent that had been initially estimated. While the rapid growth was welcomed by investors, some have been expressing concern that it may fan inflation and prompt the Central Bank to hike its key interest rate.

The annual inflation rate is currently about 4.3 percent, but the Central Bank, rightly, does not expect it to rise beyond 5.5 percent for the fiscal year that began on April 1. More of a problem is the country's current-account BoP deficit, which is expected to reach 3.6 percent of GDP in the 2006/07 fiscal year, or USD 30.4 billion. The monthly merchandise trade deficit weighed in at a seven-month high of USD 4.2 billion in April. Due to stiff oil prices and soaring demand for imports of all kinds, it blew out by 52.7 percent in 2005/06, to USD 39.6 billion.

It takes quite a bit of capital to bridge a gap this size and announcements such as the one made recently by IBM that it plans to invest USD 6 billion in India over the next three years are not heard every day. This makes short-term capital flows critical. There are several reasons why economic growth may slow during the course of this year. The government has just raised fuel prices and will have to do so again to reduce the losses of state oil companies such as Indian Oil Corp. and Bharat Petroleum Corp. In June, the government boosted short-term interest rates by 25 basis points. Another hike may follow at the Central Bank's next policy meeting on July 25. Agricultural production, as always, hinges on the Monsoon rains, which in a number of regions were reported to be weak in the early weeks. None of this suggests that there will be a major contraction of the current-account BoP deficit, however, and there will continue to be concerns about how it is going to be financed.

This is not to suggest that India is headed for an all-out crisis. The country has a comfortable foreign exchange reserve cushion in the neighborhood of USD 155 billion. ...