India most exposed to global funding risks

Towering fiscal deficits and negative real policy rates to blame, says Morgan Stanley.

These pushed inflation rates to dangerous highs for almost two straight years, it said in a new research report. Further depreciation of the Indian rupee against the dollar is expected until mid-2012.

Here's more from Morgan Stanley:

Following the credit crisis, the Indian government has persistently been relying on high fiscal deficits (9-10% of GDP) and negative real policy rates to support growth. There was a short period of recovery in productive private investments during the first half of 2010, but since then it has again been weak.

This approach of boosting domestic demand (consumption) while external demand has been relatively weak has pushed the current account deficit to 2.5-3% of GDP since the credit crisis from 1-1.5% before. Inflation has already remained in the 9-10% range for an unprecedented 23 months now.

India has been dependent on less stable non-FDI capital inflows to fund its current account deficit. Slowdown in these non-FDI inflows is resulting in FX outflows and currency depreciation pressures. RBI's ability to intervene in the FX markets is constrained by the potential adverse impact of further tightening on the domestic banking system.

Our currency research team expects INR/USD to move to 54.8 by Q2 2012 and stabilize in the second half of 2012. We remain concerned about potentially sharper than expected depreciation in INR in the event of deterioration in global funding markets.

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