US Tariffs: A Wake-Up Call for India?

On August 27, the United States Department of Homeland Security released a notification imposing additional 25% tariffs on Indian imports, which will raise the total levy to 50%. This move is viewed by many in India as a form of tariff weaponization to penalize India for continuing to import oil from Russia. 

This sharp escalation in tariffs, which made India one of the worst-affected countries in Donald Trump’s tariff war, has rattled Indian exporters, particularly exporters from small and medium sectors such as textile exporters, auto parts manufacturers, gems and jewellery exporters, seafood exporters, etc., who now expect a steep decline in shipments, rushed to the government for immediate support to overcome the threat to their businesses. 

The stock market, too, reflected this anxiety. On the day of the announcement, the BSE Sensex plummeted 849.37 points to close at 80,786.54, while the NSE Nifty 50 dropped by 255.70 points to end at 24,712.05—the biggest loss in the last three months. 

Economists opine that if the 50% tariff persists, India’s gross domestic product (GDP) growth during the current fiscal could slip to or even below 6%. This elevated tariff is feared to hurt India’s relative competitiveness, dampen export momentum, erode investor sentiment, and potentially slow foreign direct investments. Cumulatively, these factors could impact the current account deficit, and eventually, build pressure for a sharper depreciation of the rupee. The rupee has already dropped to an all-time low of 88.31 to the US dollar. 

That aside, companies from several key export sectors that have become victims of high tariffs vis-à-vis exporters from countries like Vietnam, South Korea, Taiwan, etc., fear falling capacity utilization and job losses. Indeed, Crisil has already projected a 50% drop in the revenue growth of readymade garment makers, suggesting significant job losses in the sector.  

Yet, not all is bleak. Some analysts, including government agencies, believe that rising domestic demand, aided by the recent GST rationalization, low inflation, and falling interest rates, could soften the impact. Moreover, as India’s overall export dependence on the US is relatively limited—$86.5 bn during FY 2025—the broader economy might still avoid a deep shock. Rick Rossow of Center for Strategic and International Studies, Washington, also opined that as the tariffs targeted goods and manufacturing remained a relatively small share of India’s economy—around 14%—the impact on the “real economy will be limited”. 

Interestingly, in a recent public address, Prime Minister Narendra Modi said, “I appeal to the citizens of our country to prioritize purchasing goods that are made in India. Whether it is decorative items or gifts, let us choose products manufactured within our own nation.” Such a spirit, if it prevails among all citizens, could not only enable us to absorb the threat of tariffs but also keep India’s growth ambitions intact. 

Nonetheless, these high tariffs, which the government observed as “unfair, unjustified and unreasonable”, are not in the interest of the nation. Deteriorating access to the largest export market of the world at this critical juncture, when we are actively prioritizing manufacturing under “Make in India” policies, and also working towards placing ourselves as the alternative manufacturing hub for what is currently being made in China, may stifle our economy.  

That being the reality, India, as it has handled the issue of tariffs and the rhetoric surrounding it so far with maturity and pragmatism, may have to keep pushing the negotiations for a favorable accommodation with the US. Intriguingly, there is also an argument that Russian oil is not that cheap today compared to the prevailing global prices, and the benefits so accrued are not that encouraging even vis-à-vis the costs that it has to absorb by losing the US exports. So, keeping these facts in view, India has to play its cards deftly and navigate through the impasse with diplomatic finesse for a win-win outcome. 

Simultaneously, affected exporters must be helped to explore alternative markets by providing liquidity support in the meantime to sustain their operations. Indeed, it is a wake-up call for India not to rely on a single market to keep export business intact. 

Over and above all this, there is an urgent need to launch reforms to radically improve the ease of doing business in India. A fully functional single-window clearance system must be created to speedily clear investment proposals. Also, lower levies to make exports globally competitive. The immense potential offered by tourism must be exploited by launching necessary reforms that encourage tourist flows.  

Now is the time for Indians to act rationally, and as R C Bhargava, Chairman, MSIL, observed, to do their best and stand by the government in overcoming the hurdles and keep growing.

 

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Is the Rupee Overly Depreciated?

 

The rupee has been in a kind of free fall: it hit 85 to the US dollar on December 19, 2024, slipped to 86.62 on January 13, 2025, despite large-scale interventions by the Reserve Bank of India (RBI), and then touched a historic low of 87.1850 on February 3, a drop of 0.67 against the dollar.  

The Indian currency remained volatile throughout January 2025 as foreign portfolio investors sold stocks worth $6.7 bn and repatriated the proceeds during January alone. The two key market indices, Nifty 50 and BSE Sensex, which peaked on September 27, 2024, were down 11% by January 13, 2025, partly due to the relentless selling by foreign institutional investors during this period.

The depreciation of the rupee is not a new phenomenon; it has been depreciating by around 3.4% annually since 2005. However, the recent fall in the currency is largely attributed to the fear surrounding the tariff plans of US President Donald Trump, and the uncertainty that accompanied them. This was evident on February 3, when the Trump administration imposed tariffs on Mexico, China, and Canada, sparking a wave of risk aversion in emerging markets. As a result, the rupee touched a low of 87.28 at one point on that day.

 In response to tariff increases, the US dollar index—the value of the dollar relative to a basket of six currencies—rose from 107.8 on January 31 to 109.8 on February 3. The imposition of 25% tariffs on Mexico and Canada and 10% on China by the Trump administration indeed hammered markets globally. Tracking the global stock sell-off, the benchmark Sensex closed down 0.4% at 77,187, while the broader Nifty 50 index declined 0.5% to 232,61. Indeed, it was the intermittent intervention of the RBI in the dollar/rupee spot market that helped contain some losses.

Persistent outflows from the capital market and the demand for dollars from oil companies are putting continuous pressure on the rupee. As the impact of the US tariffs deepens, the rupee is likely to face even more pressure.  That aside, economic theory suggests that the tariffs imposed by Trump are expected to strengthen the dollar. If he proceeds with re-imposing the paused tariffs on Canada and Mexico, the dollar could further strengthen significantly.  The rupee is already one of the worst-performing Asian currencies. Furthermore, if the RBI, as anticipated by India Inc., cuts interest rates by 25 basis points, analysts fear that the rupee could soon hit the 88-per-dollar mark. 

Amidst this evolving scenario, analysts who once advocated for the RBI to let the rupee depreciate are now calling for it to defend the rupee. They fear that further depreciation of the rupee will increase the cost of commodity imports, which could, in turn, fuel persistent inflation. Exchange rate volatility also raises risk premia, which typically exceeds the actual depreciation in emerging markets. Indeed, such volatility harms the real sector as well. Over it, if depreciation continues at a faster pace, it may even affect the foreign investor sentiment. Given all this, some analysts are urging the RBI to intervene in the market to maintain a flexible nominal exchange rate that minimizes volatility. 

Raghuram Rajan, the former RBI Governor, stated that the central bank need not intervene in the market to protect the rupee, citing several reasons. He pointed out that the rupee is not the only currency depreciating against the dollar and that there is still room for the rupee to depreciate further. He believes that the rupee remains overvalued in real terms when compared to its peers. In fact, an estimate by the Bank of Baroda suggests that under ceteris paribus conditions—where only external factors are considered—there is still room for the rupee to depreciate.

In the last few months, foreign exchange reserves with the RBI have fallen from $705 bn to $635 bn as it sold dollars to protect the rupee from sharply depreciating. As a result, the appetite for further intervention has naturally diminished. Secondly, during the recent fall in the rupee against the dollar, the rupee has appreciated relative to the currencies of other trading partners. Therefore, exports to countries whose currencies have depreciated not only against the dollar but also against the rupee, and which are denominated in those currencies, are becoming less competitive. This may be another reason for the RBI’s recent muted intervention in the forex market.

That aside, managing both the exchange rate and inflation simultaneously is a challenging task for the RBI. Nevertheless, in the context of growing global uncertainty and weaponization of tariffs, RBI should use its reserves to reduce excess volatility in the exchange market, for reserves can be rebuilt over time.   

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Indian Economy: An Approach to the Trump Era ...

 

Intriguingly, European Central Bank Chief Christine Lagarde, in her first interview since Donald Trump won his second term to enter the Oval Office as the 47th President of the US, advised Europe’s political leaders “not to retaliate, but to negotiate” with the President-elect who asserted that he would impose tariffs between 10% to 20% on all non-Chinese imports into his country. 

She also warned that a “trade war at large” is “in nobody’s interest” for it would lead to “a global reduction of GDP”. Indeed deviating from her earlier stance, Lagarde advised European leaders to navigate through Trump’s second term by adopting a “cheque-book strategy”, they may “buy certain things from the US” such as liquefied natural gas, defense equipment, etc. For, it would signal a willingness to cooperate with the US, which in turn could aid both sides to de-escalate the conflict further. 

This advice given by Lagarde to EU nations perhaps merits consideration by India, for the country’s economy too is unlikely to remain unaffected by Trump’s vow to hike tariffs. Although many opine that for now India has been spared, one cannot afford to ignore what Trump said during his first term: “India has high tariffs”, citing its 100% tariff on Harley-Davidson motorcycles and 150% on American whisky, even labeled India the “tariff king”. 

So, it wouldn’t be surprising if Trump this time round pressurizes India for reduction in tariffs on American goods, particularly on agricultural produce, dairy, and animal products, despite the fact they are well within the WTO norms. Indeed, he aired similar comments in his recent press meet in Florida. Besides, US being the top trading partner with more than $190 bn in trade, and 80% of IT sector exports relying on US, India cannot afford to ignore these probabilities. 

That aside, as the BCG India Chairman Janmejaya Sinha observed, it is no guarantee that the pain, if any, inflicted by the proposed tariffs by Trump on China will automatically leads to a gain for India. For, to compete with China in production what a country needs to offer to the global corporates’ investment is not merely the reduction in cost but stability—stability in policy framework, the persistence of which China continues to offer till date, in many ways. 

Another big challenge is scale. Even though large industrial houses have of late started investing heavily in sectors such as electronics and semiconductors duly supported by the government scheme to offer tens of billions of dollars in the form of production-linked incentives, it is no match for what China did. There is a fear that unlike in China, there is a great problem relating to not only scale but also procurement of raw materials in India. 

Over and above all this, to realize the ambition of India becoming the electronics manufacturing hub, the country has to penetrate deeper into the supply chain by increasing the domestic value addition from the current 18%-20% to 40% in the immediate future. In view of all these hurdles, one wonders if the proposed hike in tariffs on Chinese goods by the Trump regime may not necessarily divert massive investments away from China. In fact, there are already reports indicating that US companies have put a pause on making further investments in India. Analysts even say that today from an investing perspective, America has zero interest in international markets. 

Speaking at the Global Economic Policy Forum 2024, World Bank Chief Economist Indermit Gill made two very important observations which demand India’s attention: one, global economic growth has been decelerating, with the potential growth rate in advanced economies halving over the past two decades; and two, even emerging markets and developing economies are seeing a decline in potential growth rates due to ongoing geopolitical tensions, trade fragmentation, policy uncertainty, and persistent inflation. Further, observing that the “changes needed are not happening quickly enough” in India, he urged policymakers to leverage the economy’s strength by accelerating structural reforms. 

Amidst all these hurdles coupled with consistently high inflation for the past two years, if India has to pursue its Viksit Bharat objective, it must continue to grow at least above 7-8% annually. Here, it is pertinent to remember that India ranks 153 against South Korea’s 44 and Taiwan’s 35 in the per capita export data generated by the World Bank and UNCTAD for about 200 countries. Even in service exports, India ranks 89 out of 114 countries trailing behind Malaysia, Turkey, Thailand, etc. Secondly, according to best-selling authors Gary W Keller and Jay Papasan, the one thing that could drive economic success is climbing the global value chain and thereby accomplishing sustained double-digit export performance. And, if this has to happen, we may have to follow the advice given by Lagarde: Adopt a cheque-book strategy while navigating through the Trump era and strengthen the ties with the US by leveraging on the friendly chord already struck as a participant of QUAD dialogue. 

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Why Some Countries are Rich while Others are Poor?

Traditionally, economic models emphasize that economic growth rests on the accumulation of factors of production, namely, labor, capital, and technology that enhance productivity and efficiency. In other words, the greater the capital stock per worker and the more productive and efficient its use, the richer a country would be. The obvious question that it raises is: Why did some countries accumulate more of these factors of production and grow richer than others?

This year’s winners of the Sveriges Riksbank Prize in Economic Sciences, awarded in memory of Alfred Nobel, “for studies of how institutions are formed and affect prosperity”—Daron Acemoglu, Professor at MIT, Cambridge, US; Simon Johnson, Professor at MIT, Cambridge, US, and James A Robinson Professor at University of Chicago, US—argue that accumulation of factors of production in a country depends on the quality of its institutions/government.  

In 2001, these three Laureates published a paper, “The Colonial Origins of Comparative Development: An Empirical Investigation”, that became one of the most cited papers in economics. This paper examined the long-lasting effects of colonialism on the economic development of countries. Employing a range of empirical methods, including regression analysis, and analysing the colonial experiences of various countries and their current economic performance using historical data, the authors have shown a clear correlation between the type of institutional patterns established during colonialism and present-day economic outcomes. 

According to them, colonizers had established two kinds of institutions in the colonies: One, extractive institutions, and the other inclusive institutions. Extractive institutions are designed to exploit the resources and labor of a colony such as Congo, etc., for the benefit of the small elite, i.e., the colonizers. Such institutions helped colonizers retain control and thereby enjoy short-term gains. On the other hand, inclusive institutions promoted broad participation including locals in the economic process and provided secure property rights, which ultimately fostered investment and innovation. This kind of institutional pattern had a lasting impact on the economic prosperity of the colonies such as North America, Canada, Australia, and New Zealand, leading to flourishing economic growth. 

This phenomenon of establishing different institutions in different colonies gave the Laureates a “natural experiment” to analyze and unearth the underlying criteria for the creation of different institutions in different colonies. The authors hypothesized that the said colonization strategy was in part determined by the feasibility of European settlement in the colonies. In support of this argument, they, cleverly using the historical data about the mortality rates of settlers in different colonies, inferred that those countries with low mortality rates had become attractive for colonizers to stay for long, and as a result, they built inclusive institutions allowing the colonized to share in the wealth produced through private property and free markets. 

Contrarily, in colonies such as in Africa and South America, where mortality rates of Europeans were high, colonizers tended to develop extractive institutions, for they had less incentive to settle there for long and build lasting governance structures. They finally concluded that these institutions by virtue of their persistence to the present continue to impact their economic performance. Their results also indicate that “reducing expropriation risk would result in significant gains in income per capita but do not point out what concrete steps would lead to an improvement in these institutions”. 

Some economists, however, argue that the data for the key variable, namely, “settler mortality” on which their very argument rests is flawed and selectively chosen to flatter their hypothesis and hence their empirical findings are not robust. They also commented that their style of inferring causation is debatable, for it cannot distinguish between the places that the colonizers went to and the human capital they brought along with them.  

Nevertheless, this paper was found to have greatly influenced several disciplines such as economic development, political science, economic history, institutional studies, etc. It also highlights the importance of historical specificity in understanding economic growth, and in that sense, it moved development economics away from traditional growth models.

Interestingly, way back in 1997, Jared Diamond argued in his trans-disciplinary non-fiction book Guns, Germes, and Steel: The Fates of Human Societies that it was the geography of European countries that led to early economic growth. Moving a bit beyond Diamond’s assertion, current year’s Nobel Laureates in economics, argued that it was the kind of institutions built by the colonizers in colonies—defined by mortality rates linked to the region’s geography—that ultimately influenced economic growth.

Indeed, two of the Laurates, Acemoglu and Robinson, taking the chain of causation one step further, argued in their best-selling book, Why Nations Fail, that political institutions as determinants of economic institutions led to long-run development. This argument, however, fails to explain how China with that kind of political institutions could grow economically so well, while India despite its democratic setup could not grow that well.

Nonetheless, the Nobel Laureates’ exploration to find an answer to the question as to why some countries are rich and others poor, has certainly laid a foundation for later generations of economists to build fresh knowledge over it. That aside, their paper also suggests strengthening property rights, encouraging political inclusivity, and promoting good governance for fostering economic development in post-colonial countries. Simply put, the Nobel Laurates argue for a genuine commitment of governments of the erstwhile colonies to build institutions that promote inclusive economic growth.   

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India-EFTA Trade Deal: Will It Serve India’s Interests?

It is after 21 rounds of negotiations spreading over 16 long years that India and the European Free Trade Association (EFTA) comprising Switzerland, Norway, Iceland, and Liechtenstein could at last sign the Trade and Economic Partnership Agreement (TEPA) on March 10. EFTA terms it a significant milestone in the relationship between EFTA and India and also claims that it reflects a deeper economic partnership. This agreement however comes into effect only after the member countries ratify the accord. 

The EFTA block is India’s fifth largest trading partner after the EU, China, US, and UK. Its member countries are not part of the EU. It is an intergovernmental organization meant to promote and intensify trade. It is neither a politically integrated bloc nor a customs union. They have one of the largest networks of free trade agreements (FTAs) spanning over 60 countries and territories. That reveals the growing importance of trade agreements for growth in international trade in a globalized world. 

The present agreement between these four small countries of EFTA and India is likely to open the doors of economic cooperation, knowledge sharing and job creation both in India and EFTA countries provided they work collaboratively and resolve every obstacle that pops up in the way strategically and move forward with faith in each other to implement the accord effectively. 

Theoretically speaking, a free trade agreement is a pact between two or more nations to reduce barriers to imports and exports among them. Under an FTA, goods and services can be bought and sold across international borders with little or no governmental tariffs, quotas, or subsidies. Free trade has indeed allowed many countries to attain rapid economic growth. It enables countries to capitalize on the principle of Ricardo’s ‘comparative advantage’ —focusing on producing such goods that a country can produce with cheap labour, and sell in the global market at a lower price and thereby garner the market. 

For the first time ever in the history of FTAs, the EFTA member nations have committed to invest $100 bn excluding foreign portfolio investment and help create a million jobs in India over the coming 15 years. The investment flow is however predicated on India’s GDP growing at a nominal rate of 9.5% over 15 years. There is, of course, an option in the agreement that enables India to revoke its trade concessions if there is any shortfall in the proposed investment but only in proportion to the extent of the shortfall in the said investment. This again could be undertaken only after a review which could take about three years, which means such revocation is possible only after 18-20 years of the agreement coming into force. It has also offered 92.2% of its tariff which covers 99.6% of India’s exports. The EFTA’s market access offer covers 100% of non-agri products and tariff concession on processed agricultural products. 

Now the question is: Whether India stand to gain market access, particularly to Switzerland? According to the Global Trade Research Initiative, 98% of India’s exports to Switzerland are industrial products and the duties on these products are now brought down to zero from the existing 1.3%. Thus, there appears to be no real gain. But the government hopes that the TEPA would stimulate our service exports in sectors where we are considered strong globally such as IT services, business services, personal, cultural, sporting and recreational services, audio-visual services, etc. Our IT companies such as TCS, Infosys and HCL already have their offices in EFTA countries but the free movement of IT professionals across these nations could only result in gains for India. Norway has, of course, said that there would be ‘no capping’ on the entry of Indian IT professionals, but there are no such explicit concessions in the agreement. In light of these realities, one has to wait and watch how the EFTA countries handle the entry of Indian professionals. 

In return, India offered to lift or partially remove very high customs duties on 95.3% of industrial imports, of course, excluding gold, in a phased manner over varying periods. Sectors such as dairy, soya, coal and sensitive agricultural products are excluded from the said list. Nevertheless, the reduction in tariffs is likely to expand the trade deficit that stood at $18.6 with EFTA countries. That aside, there are already more than 300 Swiss companies such as Nestlé, Holcim, Novartis, Sulzer and banks such as UBS operating in India. Switzerland, which already has a trade surplus of over $12 bn with India could now increase its export of electrical machinery, engineering products, wine, watches, medical devices and pharmaceuticals to India. 

Over it, Switzerland, the largest partner in the EFTA, has a thriving FTA with China. Recently, they have even upgraded their trade relationship. This posits a challenge: Will Chinese goods find an easy way into India via Switzerland? Of course, there are rules of origin in the agreement but one is not sure if they cannot be circumvented as it happened under the ASEAN FTA route. Incidentally, Switzerland is currently working towards resetting its ties with the EU. In case it enters the EU by adopting the ‘Carbon Border Adjustment Mechanism’ and other related conditions imposed by the EU, it may pose a new challenge to India. A vigil over these challenges is likely to keep gains in good stead.

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India in the Global Bond Index: What Next?

 

At last, India has made its entry into JP Morgan’s global bond market index. This will of course happen over a period of 10 months, starting from June 28, 2024, with a weight that is expected to reach 10% at an incremental of 1% per month by March 2025 in the GBI-Em Global Diversified Index. That aside, India is also likely to be included in other indices under the GBI-EM suite, with total assets of $236 bn under its management. 

With Russia out of the index after being ostracized post-Ukraine invasion, there emerged a free slot for another country to fill it and India with a fully accessible route for investment in the Government Securities (G-Secs) market that offers 23 government bonds with a notional value of Rs. 27 lakh cr equivalent to $330 bn, fit the bill quite well. 

Obviously, when G-Secs are included in a global index, the Indian bond market is certain to get a fillip, for foreign funds are likely to invest in G-Secs in larger quantities than what they are currently doing. The very inclusion in the global index affords a kind of gold standard to our bonds due to which foreign funds will be encouraged to invest. Even through passive investments of fund houses in a bond index, we are likely to get about $20-30 bn by way of our share of 10% in the index. In addition to that we may also get additional inflows by way of direct investment in our bonds as they offer higher interest vis-à-vis global rates. All this cumulatively leads to an increase in foreign portfolio investment (FPIs) in the debt market. 

One may now pose a question: Isn’t this happening today? True, FPIs do invest in G-Secs, but the limits prescribed for FPIs are not being fully utilized. The debt utilization statistics reveal that FPI holdings in G-Secs stood at 23.51% for general foreign investors and for long-term foreign investors it was about 5.59%. 

In such a scenario, the inclusion of our bonds in the index will be a game-changer: it is certain to widen our investor base, besides bringing down the cost of capital. Secondly, at a later stage, lured by the favorable yield on these indices, investors may even show security-specific interest, which means a still wider investor base.  Thirdly, it may even lead to the inclusion of corporate bonds at an opportune time. Finally, all this results in large capital inflows, which means not only a stronger rupee but also a strong surplus balance of payments position despite a widening current account deficit. 

Over and above all this, funding of the government deficit by FPIs, eases pressure on domestic banks for funds. This in turn will pave the way for banks to allocate more resources for lending to the private sector, resulting in economic expansion. 

However, there is a flip-side to this hunky-dory scenario. The inclusion of Indian bonds in the global indices exposes our bond markets to the repercussions due to exogenous forces. For instance, a phenomenon like the 2008 Global Financial Crisis would lead to a sell-off across markets and once our bonds are a part of the indices, it would result in capital flight. Such capital flight can destabilize not only the bond market but also exchange rates. In such situations, the intervention of Reserve Bank of India (RBI) assumes paramount importance in stabilizing both the forex and bond markets.  

At times, FPIs can induce volatility in domestic markets through their responses to exogenous reasons. For instance, when the US Federal Reserve raises interest rates dollar gets strengthened automatically, and this would simply trigger capital flight. This creates volatility in the forex market calling for RBI intervention. Such outflows create a cost for the central bank. Similarly, country rating plays an important role in the trading patterns of fund managers. Any change in rating outlook can also affect the investment patterns of funds, which can cause volatility. 

Today, RBI is in a position to successfully regulate excess volatility in the bond market by affecting liquidity. Thus, it has all the while managed to keep yields from G-Secs range-bound. This has helped the government in keeping its cost of borrowing moderate and stable. But once the FPIs start playing actively in the G-Secs market, the scene will change. Similarly, high foreign holding of debt exposes our markets not only to external macroeconomic shocks but also to geo-political risks. That aside, it subjects our fiscal situation to greater scrutiny. To sum up, on the positive, there will be an influx of foreign funds but the market and the RBI must be ready to manage external shocks and volatility with alacrity.

Is Inflation Getting Entrenched?

“Inflation is taking too long to get back to target,” told Gita Gopinath, first deputy managing director of IMF to the ECB’s annual forum in Sintra, Portugal, which, according to her, warrants that “central banks, including the ECB, must remain committed to fighting inflation even if that means risking weaker growth or much more cooling in the labor market”. 

She even feared that structural factors such as redesigning global supply chains, geopolitical tensions, and climate change may further prolong inflation. Obviously, all this points to the risk of “inflation getting entrenched” and thus the scope for returning to the ultra-low interest rates that prevailed during the pre-pandemic is less likely.  

Recalling the experiences of the high inflation period of the 1970s, she, while addressing the annual conference of the Central Bank of Brazil, also cautioned that “Central banks must remain resolute in keeping policies tight and recognize that insufficient monetary tightening now may necessitate even more painful actions down the road”. 

It is needless to say here that fiscal restraint will go a long way in aiding central banks’ fight against inflation. For, in an environment where the growth outlook is uncertain and the rates of interest are likely to stay higher for longer, there is every need to observe fiscal restraint. Else, there is a danger of financial market instability.  

As against these happenings in the developed world, emerging market economies, aided by well-orchestrated monetary policies and reforms, are reported to have maintained growth in recent years. Nevertheless, owing to the tightening of monetary policies by the developed countries, emerging economies may still face “considerable downside risks” that may worsen the conditions. 

Against this global scenario, Indian consumers are continuing to struggle to cope with a sharp rise in the prices of kitchen essentials such as vegetables, rice, pulses, etc. This overall rise in prices across a wider food basket is perceived by a few analysts as a reflection of the unsettling build-up of underlying inflationary pressure in the economy.  

The retail inflation data released by the government for May reveals that prices of pulses have reached a 31-month high of 6.56%. And the stock limits imposed by the government on traders of lentils appear to have had little or no impact on their price behavior. Similarly, there is also an increase of 19% in the price of rice. Of course, there is always the element of seasonality of crop arrivals to market playing a role of its own in determining the prices of agricultural produce.   

It is in this context that the announcement of the India Meteorological Department (IMD) revealing a 23% deficit in the all-India rainfall in the month of June is causing concern. For, it has impacted the Kharif sowings:  the acreage under paddy is reported to have come down by 5.6% vis-à-vis last year’s level, while in maize and cotton, the shortfall stood at 2% and 4.6%, respectively. 

Added to it, as El Nino is in play this year, it is feared that owing to the fact of the accompanying negative Indian Ocean Dipole (IOD)—also known as the Indian Niño—conditions remaining neutral so far, there is a likelihood of a sub-par monsoon this year. If the conditions turn negative, it could cause severe drought across the country. And history is replete with instances where IMD’s long-range forecasts issued in the months of April and May turned out to be overestimates. Should this happen again, it is certain to pose upside inflation risks. 

Furthermore, given the critical impact of monsoon rains on the Indian economy, delayed arrival of the monsoon and the forecasted deficiency in rainfall is certain to pose a threat not only to prices of food products but also to the growth estimates as spatial patterns and distribution of rainfall assume utmost significance. Therefore, policymakers must keep a constant vigil on the evolving IOD conditions as commented by IMD from time to time, and be ready with appropriate policy measures to counter the drought-driven spike in food prices. 

In a nutshell, all this calls for a close monitoring of liquidity in the system and its agile and flexible management. Of course, the Reserve Bank and its monetary authorities are well seized of the matter as is revealed by their proclamation that the monetary policy shall firmly stay focussed on maintaining price stability. Equally important is the management of fiscal deficit, for that is what ultimately matters in managing the inflation-growth dynamic.

It is however worth remembering here that experiences of the past suggest that even a small amount of sticky underlying inflation makes the task of taming it more difficult!   

Transition from LIBOR to … …

The London Interbank Offered Rate (LIBOR) was originally considered as a very systematic and well-managed international benchmark interest rate for a large volume and variety of financial products and contracts including derivative products, syndicated corporate loans, sovereign bonds, etc.

LIBOR was earlier calculated by adopting a polling method. At a specified time quotations were gathered by the Intercontinental Exchange (ICE) from about 16 to 18 major banks that have a significant role in the London market for their charge rates if they were to lend money in five major currencies—US dollar, Euro, British pound, Japanese yen, and Swiss franc—for seven different maturities: overnight/spot next, one week, and one, two, three, six and 12 months. The extreme rates were removed and the remaining rates were averaged to determine a median borrowing rate. This was announced each morning as LIBOR, at around 11.55 am by the ICE Benchmark Administration.

This procedure went on well for quite some time. But with the eruption of the LIBOR scandal of 2012 that sent shockwaves across the global financial markets, the flaw in arriving at the LIBOR rate came to light. It was revealed that major bank players—Citi Bank, HSBC, Barclays Bank, Deutsch Bank, and JP Morgan— colluded amongst themselves for garnering benefit by quoting mutually decided rates to the market officials. Once this manipulation came to light, market-participants lost their confidence in this widely used benchmark rate.

This string of LIBOR-related scandals made market players feel like going for a new alternative benchmark rate. But replacing LIBOR turned out to be not that easy, for almost all of the then-existing loans were benchmarked against LIBOR. However, in 2017, the US Federal Reserve introduced the Secured Overnight Financing Rate (SOFR) as an alternative to LIBOR. In the same year, the LIBOR regulator announced that LIBOR would be discontinued by December 2021. As a sequel to this, the Reserve Bank of India issued instructions to banks and other RBI-regulated entities to stop entering into new contracts that use LIBOR as a reference rate (as soon as possible) and latest by December 31, 2021.

This had, of course, created a lot of commotion in the market. For, this entailed two challenges: one, it called for banks to ensure that existing contracts in which LIBOR was the reference rate and the contracts fall due after the date on which LIBOR ceases to be effective contain Fall-back Clauses; and two, in the event of its absence banks to ensure that a new benchmark rate is identified, financial risks thereof are mapped along with identification of legal risks involved post the adoption of the new benchmark. Coming to the new contracts, banks have by and large adopted SOFR—a benchmark interest rate for dollar-denominated derivatives and loans arrived at based on observable repo rates—as a replacement for LIBOR.

Simultaneously, the use of LIBOR-based Mumbai Interbank Forward Offer Rate (MIFOR) was restricted to certain specific purposes such as transactions executed to support risk-management activities such as hedging, market-making in support of client activities, etc. They were also to assess the risk emanating out of LIBOR-linked contracts and place a framework in force to handle risks arising from such exposures. Banks are also required to create the necessary infrastructure to offer financial products linked to ARR. All this is a real challenge, which the banks are navigating through with the advisories offered by RBI.

Against this backdrop, and expecting that banks have developed the necessary wherewithal to manage the complete transition away from LIBOR, RBI issued a circular on May 12 asking banks and other financial institutions “to ensure that no new transaction undertaken by them or their customers rely on or are priced using the US $ LIBOR or the Mumbai Interbank Forward Outright Rate (MIFOR)” from July 1, 2023. They were also advised “to take all necessary steps to ensure insertion of fallbacks in all remaining legacy financial contracts that reference US$ LIBOR (including transactions that reference MIFOR)”.  

This complete move to alternative benchmark rates from LIBOR will take a while for banks to settle on the alternatives. Although SOFR is less likely to be manipulated since the treasury repo market is one of the most liquid markets, it is “backward-looking”. Secondly, there is an argument against Term SOFR that it lags in a rising rate environment. Of course, it is also true that the reverse happens in a decreasing rate environment and thus some argue that over a period of a few years, this difference might average out. Nevertheless, navigating through these nuances is a big challenge for Indian banks.

 

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‘Friend-shoring’: What Does It Mean for India

Over the past couple of years, owing to the US-China trade war, the Covid-19 pandemic and the resulting lockdowns, and Russia’s invasion of Ukraine and the resulting sanctions and export controls, the world has experienced a series of escalating trade disruptions. This has called into question the very idea of globalization. 

Meanwhile, the immediate effect of these disruptions is feared to result in a recession in the global economy. In response to these adverse developments, countries hitherto relied on outsourcing for reaping cost benefits are now exploring ways and means to build risk-free supply chains. One such concept pushed forward by the US officials is: ‘friend-shoring’, which is nothing but shifting manufacturing away from authoritarian countries such as China, Russia, etc., to allies. 

Friend-shoring, though not good for globalization, is a shade better than the extreme version of ‘reshoring’ i.e., bringing key manufacturing activities back to one’s own country. Right from Mr Donald Trump’s time, the American administration encouraged their companies to shift at least some of the hardware supply chains out of China, and the current President, Mr Joe Biden, has been pushing it even further. 

As a result, many companies have either started to set up new production facilities in other countries of Asia, such as Vietnam, Indonesia, and South Korea, or European countries, Mexico or Brazil that are considered sufficiently trustworthy by the US, or expanding their existing production facilities in countries that are trust-worthy for them. Such a move is believed to afford more resilient supply chains from external shocks such as war, famine, political change, or future pandemic consequences. 

In a recent meeting with India’s top technology leaders, Ms Janet Yellen, US Treasury Secretary, said: “As we look towards the future, I am eager to deepen our ties [with India] in the technology sector. The United States is advancing an approach called ‘friendshoring’ to bolster the resilience of our supply chains. We are seeing progress; as an example technology companies like Apple and Google have expanded their phone production in India”. She further said that the US is investing in digital technologies that will drive resilient growth in India. She also said that the US is aiming to mobilize $200 bn through 2027 for the Partnership for Global Infrastructure and Investment (PGII) to continue its investment in India’s future. 

Today, India is at a historic pivot: transforming itself into a fast-growing economy of the world. It could attract eight years of record FDI that spread across all sectors and regions. The world is looking toward India as the growth engine. To sustain this movement, India should leverage all of its strengths to become the destination of choice for not only the US but also for anyone seeking dependable supply-chain resilience. 

The logistics policy introduced by Indian government on September 18, 2022, is expected to give a gentle push to the manufacturing sector besides strengthening national supply chains through the establishment of eco-friendly waterways, air cargo terminals, multimodal logistics facilities, etc., to facilitate exports.. The recent budgetary push given for infrastructure development is sure to give a further fillip to its manufacturing activity. 

Strategically, it is worth bearing in mind here that attracting global supply chains in industries in which India has already made a mark in the global arena, such as the pharmaceutical sector, telecommunications, textiles, chemicals, automotive industry, software solutions, etc., would be more beneficial for it rather than spreading its efforts all around. For, it is said that leveraging on known strengths is a safer bet for success rather than attempting to pick up new strengths. In a similar vein, India should gear up to seize the opportunity to attract those who are hurrying to relocate rather than attempting to invite companies to establish supply chains afresh. 

The current attempt of multinationals to rebalance global value chains offers India a unique opportunity to transform its manufacturing sector. It however calls for cooperation between the government and the private sector to foster a competitive manufacturing ecosystem in the country. India did enjoy the benefit of the demographic dividend, but it should work to build an employable workforce by skilling/reskilling/up skilling them systematically to ensure quality and sustainability. The government should also focus on reducing trade barriers and the costs of compliance and establishing manufacturing capacities faster. 

A thriving manufacturing sector is a stepping stone for India’s economic growth and prosperity, and hence it is time for businesses and government agencies to work in tandem with each other to develop new strategies and approaches to capitalize on the new opportunities thrown open by the current geopolitical tensions.

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SVB Hit by the Age-Old Problem— ‘Bank Run’

The stunning shutdown of the Silicon Valley Bank, the 16^th largest bank in the US, at the behest of the US regulators on 10^th instant continues to send shivers through financial markets.  

SVB, the Santa Clara, California-based bank that catered to the credit needs of technology companies, particularly start-ups, is the biggest bank to fail since the 2008 financial crisis. But first things first: let us examine why SVB failed. As we all know, banks accept deposits from the public with a promise to pay them back on demand and in the meanwhile lend the so-acquired funds to businesses to earn interest so that they could service their obligations to depositors in terms of interest on deposits accepted, meet their own establishment expenses, earn profit to distribute dividends to its owners, etc.

Banks thus manage their short-term liabilities (deposits) with the earnings from mostly long-term assets (loans). They thus stand exposed to the risk of the mismatch between their liabilities and assets. However, they successfully manage this risk so long as their deposit customers repose faith in them and continue to retain their savings with banks.

But once they lose faith in the ability of the bank to discharge its liabilities (pay back the deposits), depositors may rush to the bank demanding payment of their deposits. And, if all the depositors at once run to the bank asking for payment of their deposits, Bank will be forced to pull down its shutters for, no bank, as said earlier, keeps all its deposits as idle money in its till, but deploys them as loans/investments elsewhere.

In short, that was what exactly happened with SVB: reports reveal that its depositors in an old-fashioned ‘bank run’, of course, befitting to its client base in an online ride, withdrew $42 billion—almost one-fifth of its total deposits—in a single day, leaving the bank with $ 1 billion in negative cash balance.

Before proceeding further, let us look at the balance sheet of the bank to better understand the trigger for the depositors losing their faith in the bank. As of the end of December 2022, 56% of its loans stood in the names of Venture Capitalists and Private Equity companies. From the end of 2019 to March 2022, SVB’s deposits almost tripled to $198 billion, which is a record growth that outstripped the industry’s average of 37 percent. In normal times this could have been cheered up by any bank but for SVB it became a millstone around its neck.  

For, come Covid-19, SVB found it difficult to deploy these funds as the demand for loans from tech companies waned. It was thus forced to deploy these funds as investments in the market. Initially, it deployed them as short-term investments. But owing to poor returns on these Available for Sale (AFS) investments and to mitigate the resulting mark-to-market losses, SVB, like any other bank in the normal course behaved, switched over to held-to- maturity (HTM) investments.

But with Fed rising interest rates, even these investments proved to be of no use. For, the value of these investments fell drastically, because they paid lower interest compared to the bonds would pay if issued in today’s higher interest rate market. Thus, the unrealized losses from these investments were reported to have been something like $ 16 billion by September 2022. So, with an equity base of $ 11 billion, SVB technically turned insolvent.

In the meanwhile, its deposit customers started withdrawing their deposits from the bank to deploy them elsewhere for capitalizing on the higher returns offered by the market. To meet this demand bank was to sell its investments and in the process booked huge losses. To fill this hole, it attempted to raise additional capital from the market but could not find investors.

Its plans to issue fresh capital and the failure thereof made customers to sense that all is not well with the bank. Once this concern emerged, it took no time for the panic to spread among its rich depositors through social media platforms. Many Venture capitalists appeared to have spread alarm through Twitter among the start-ups advising them to pull their money out immediately. This is followed by founders and CEOs sharing tweets about the alarming position at the bank among themselves/others.

The net result is: everybody, of course, did not run to the bank, instead quickly picked up their laptops, pulled up the web page, logged in, and within a few tries moved every cent in their account to a different bank within no time.  As a professor rightly commented, it was not a ‘bank run’ but true to the digital era, it was a ‘bank sprint’.

Thus, by 12 p.m. of the 10^th instant, the regulators have stepped in and placed SVB in receivership under the Federal Deposit Insurance Corporation. Thus came the end of a fancy bank that exclusively operated around the start-up and venture capital space spreading uncertainty across banks. 

With Fed continuing with its inflation control measures and the raising interest rates worsening banks’ mark-to-market losses, the fear of financial contagion is threatening the global banking system. So, what next? We don’t know!

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FTX Debacle: History Repeats Itself!

FTX International, a Bahamas-based company, is a digital currency exchange—a platform from which people can buy and sell digital assets like Bitcoin, Ethereum, etc. On November 11, it filed for bankruptcy protection throwing the $11 tn digital asset market into a crisis. 

Billions of dollars of customer assets are reported to have evaporated along with the altruistic image of its founder, Sam Bankman-Fried, who built up a huge empire within a short period of time by luring innocent investors with promises of high yields vis-à-vis banks to park their funds, that too, without the hassle of setting up a crypto wallet. Even major venture capital companies are no exception to this greed: they are also reported to have invested around $2 bn in the company.   

It is of course, not yet clear exactly what went wrong at FTX—an exchange that was valued in January at $32 bn and being, neither a trading firm nor a lender, theoretically must always have at its command, funds equivalent to its clients’ deposits—that led it to a humiliating bankruptcy. 

It all started with the publication of the balance sheet of Alameda Research, a crypto-investing firm owned by Bankman-Fried which showed a large chunk of digital currency created by FTX called FTT. These FTTs, which are like Bitcoins but minted by FTX to encourage people to use them like stock in the platform. Though FTX uses blockchain technology, their transactions are less transparent than Bitcoins, and hence it is difficult to track how many tokens had been created. Investors can, of course, buy and sell FTTs, but trading is relatively limited. These tokens are also held by other platforms.  

As the news about Alameda owning FTTs leaked, the CEO of Binance, a rival crypto platform, announced in the first week of November that his company would sell off all its FTT tokens. This resulted in a sharp fall in the price of FTT. As the price dropped, many customers rushed to withdraw their assets from the FTX platform. This rush for withdrawals indeed resembled a classic bank run, though by then the extent of the relationship between Alameda Research Company and FTX was not quite known to the investors. On November 8, FTX stopped allowing customers to withdraw money from the platform. Following this stoppage of withdrawals by FTX, the relationship between Alameda and FTX began to become clearer to everyone. Ultimately, Bankman-Fried admitted in an interview that FTX ‘accidentally’ lost $8 bn of customer deposits but reassured investors that the company hopes to tide over the liquidity crisis. 

But as Bankman-Fried's efforts to sell FTX to Binance fell through, it became clear that FTX lent customers’ funds to Alameda Research, a Bankman-Fried-controlled crypto-investing company that was hit hard earlier by the failures of Three Arrows Capital, a crypto hedge fund and Voyager, a crypto broker. Ironically, the crypto technology was supposed to improve the transparency of financial transactions, but FTX, as stated by John Ray III, the veteran insolvency professional brought in to run the business, stated in the bankruptcy filing, used “software to conceal the misuse of customer funds.” 

Thus, the opacity of FTX and Alameda, their complex corporate structure, the use of tokens minted by FTX to boost the balance sheet of its sister concern, Alameda, the intercorporate transfer of customers’ funds, the resulting liquidity crisis, and the typical rush for withdrawal of funds by the depositors well before the company became insolvent did sound all too familiar for anyone who has studied the financial and banking crises of the past. Indeed, it was not the technology but the governance that supervised its operation, which led to the collapse of FTX. And, importantly, it also shows the lack of effective regulatory supervision. 

Obviously, this calls for making the crypto ecosystem safer for investors. But there is a caveat here. The pain of the current FTX crisis just confined to its customers; it did not spread to the broader economy, for crypto is not integrated with the traditional financial system. There is a fear that any legislation that legitimizes crypto might eliminate this barrier. Secondly, such legitimization of crypto might even tempt the normal financial system to park its assets on the block chain, the open-source software that is maintained by unidentified and unaccountable developers, which is tantamount to placing the financial system on a shaky foundation. So, any legislation to regulate the crypto ecosystem must be attempted with due diligence.

National Logistics Policy: What Now Matters is Execution

Amidst the global supply chain disruptions and post-pandemic restarting of economies, businesses are looking for repurposed and reshaped supply chains that are characterized by resilience and responsibility. Many of them are accelerating their digital transformations to have better capabilities like real-time order monitoring, end-to-end inventory visibility, and exemplary reverse logistics experiences.   

Against this backdrop of evolving global supply chains and realignment of export markets, the National Logistics Policy (NLP) that was drawn through a consultative process among various ministries, industry representatives, and economists, was launched by Prime Minister, Narendra Modi on September 17, and was welcomed by all the stakeholders. 

NLP is expected to complement the PM Gati Shakti Plan announced last October which primarily aims at developing a multi-modal connectivity infrastructure at an investment of 100 lakh cr in the coming five years. As it also envisages improving the efficiency of services such as processes, digital services, etc., the launching of NLP is a logical extension of PM Gati Shakti Plan for improving the overall logistics ecosystem of the country. 

The NLP thus aims at reducing the logistics cost in India, which is currently amounting to around 13 to 14% of India’s GDP by 5% of GDP over the next five years, and thereby improving India’s ranking in the Logistics Performance Index, which in 2018 stood at 44, to figure among the top 25 countries by 2030. 

Today, our logistics sector which includes facilities such as transportation services needed by the trade that is heavily dependent on road transport, storage facilities for perishables, etc., is highly fragmented and unorganized. Even the regulatory environment is equally complex as there are multiple regulations governed by various ministries and their agencies. For instance, there are as many as 20 government agencies, 37 export promotion councils, and 500 certifications that oversee the logistics sector. To obviate this multiplicity, the NLP envisages a unified policy environment and an integrated institutional mechanism to enhance the competitiveness of the logistics sector. 

As a part of it, NLP also aims at creating an appropriate digital framework to track and regulate systems. The ‘action agenda’ involves immediate creation of a ‘Unified Logistics Interface Platform’ with UPI-like characteristics, which can act as a secured network to enable shippers, consignees, as well as government agencies to access real-time information. It will also assist micro, small and medium enterprises, which are considered to be the largest source of formal employment in the country. Another noteworthy feature of the policy is the E-logS dashboard for documentation and processes, which is expected to benefit particularly, textiles and gems and jewelry exporters by saving their time in handling the formalities. This whole process of digitalization is likely to result in a data-driven decision support mechanism that ushers in an efficient logistics ecosystem. 

The plan also aims at the creation of warehousing facilities that conform to global standards, benchmark service quality standards, facilitation of the development of logistics parks, etc. Simply put, the whole policy aims at “developing a technologically-enabled, integrated, cost-efficient, resilient, sustainable and trusted logistics ecosystem for accelerated and inclusive growth.” 

It hardly needs to be stressed here that for the policy to be effective, there must be, as even the stakeholders desire, an alignment of policy across all states. Encouragingly, 14 states are reported to have already developed their logistics policies in line with the NLP. So, it is hoped that the remaining states too will fall in line soon. 

Obviously, the policy is also expected to encourage investment across the logistics sector in a big way. Nevertheless, the mobilization of funds for such long-term investments is not going to be that easy. The government may have to therefore encourage a variety of Public-Private Partnership options to ground the policy with no loss of time. As the trade is hoping for, what the NLP needs to drive in now is: its effective implementation with speed.