India’s structural opportunity in a new age of financial repression

March 17th, 2022

The country could receive capital flows from rich countries that attempt to inflate their debts away

Russell Napier is an investment strategist, historian, author and an advisory board member at Bay Capital Partners

We are living through a time of structural change in the way the global monetary system works. During such times, low-risk investments are turned high-risk, and vice versa. In this new system, capital is likely to be repelled by a growing risk of decline in the purchasing power of savings in both the developed world and China. Capital so repelled will have to go somewhere. India is likely to be a key destination of such capital, and, in the embarrassment of riches that follows, the risks of investing in India could drop.

To handle huge levels of debt, the developed world and China may need to inflate away their debts. It is in devising a new monetary system to meet that goal that the world is turned upside down.

Where does India fit into this new global monetary system? Well, India needn’t inflate away its debts nor change its monetary system. Advanced economies have a total non-financial debt-to-GDP (gross domestic product) ratio of 300%. For India, it’s just 176%. China’s stands at 285%, near-similar to the US. There is a level of debt-to-GDP where countries can reduce their financial fragility through low inflation and low nominal GDP growth. The Great Financial Crisis and the ensuing European Sovereign Debt Crisis pushed Germany’s total non-financial debt-to-GDP ratio from 193% in 2007 to 211% by June 2012. Moderate economic growth with low inflation from 2012 onwards reduced Germany’s debt-to-GDP ratio to 185% as covid dawned. If Germany could reduce its debt-to-GDP levels, India can too can without adopting a monetary policy aimed at inflating away its debts. There is early evidence that Indian policymakers are moving in that direction.

Across the developed world, during covid, banks were encouraged to lend despite lockdown-led recessions. By February 2021, OECD total broad money growth, at almost 20%, exceeded even its peak levels of 1981. It continues to grow by over 10% year-on-year and is almost double its pre-covid level.

This is in contrast to India. After a long decline, the rate of broad money growth fell below 10% year-on-year in 2016 after demonetization, and then stabilized at near 10%. Beginning 2022, India’s broad money growth returned to its pre-covid level, while in the developed world, it remains above its pre-covid levels.

If India’s low debt-to-GDP ratio suggests it has greater policy flexibility, the trends in broad money growth over the past two years suggest that local policymakers are taking advantage of this
flexibility. If the developed world has discovered its ‘new normal’ in inflating away debts and India continues with its existing monetary system, surely something has to give?

Investors are realizing that the key to inflating away debt is not to produce higher inflation, but to keep interest rates low while inflation is high. Such legerdemain is not temporary, but at the core of a new monetary system.

Historically, the only easy way to preserve the purchasing power of savings during such repression was for capital to leave the repressive system. We should thus expect an acceleration of capital outflows from the developed world. This new developed world monetary system would create new problems for India, not just in the form of higher global inflation, but also, should India continue with its current monetary policy, too much capital inflow, including the import of inflation. That Indian policymakers are not prepared to let their exchange rate be strained from capital flows is evidenced by the rapid rise in India’s foreign exchange reserves since 2014. Intervention has kept the exchange rate weak at a time when it might naturally have appreciated. If India now faces even larger capital inflows, the scale of intervention could rise. Attracting too much capital is a wonderful problem to have, but the flip side is the creation of local currency commercial bank reserves— the key liability created by the central bank on its intervention.

Managing the scale of capital inflows through administrative restrictions might be essential. Not doing so might risk market-determined interest rates being pushed too low relative to inflation, and also boost broad money growth and inflation. Can Indian policymakers take the steps needed to partially inoculate the economy from the pro-inflation policies entrenched in the developed world’s repressionary monetary system? Should they succeed, they will be in the enviable position of attracting and allocating capital more efficiently. For investors, there is significant upside to be in a system which, though far from perfect, sees its resources allocated largely according to price signals rather than political fiat.

The breakdown in relations between the West and China, and the latter’s own record high debt-to-GDP level, suggests that China won’t be the destination for capital flight. India, however, shows no sign that it will depart from monetary orthodoxy. If India receives capital flight from the West, then key risks in India could decline, especially exchange-rate risk. History shows that investors should place savings in a system where capital is efficiently allocated. Here, India has its problems, like others do, but it is the relative direction of travel that counts.

Long-term investors should consider allocating more capital to India in the expectation that India will not turn from the path it set out upon in 1991.

Posted by Siddharth Mehta, Founder & CIO