Emerging markets: Why India is at risk of an extended down-cycle

Pendal’s emerging markets team explores the latest developments in India and explains why the team remains underweight in the region

• High risk of India shifting into a down-cycle
• Pendal remains heavily underweight India in emerging markets portfolio
• Find out more about Pendal Global Emerging Markets Opportunities Fund

MOST emerging markets — particularly those with weaker export bases and greater dependence on external capital flows — go through multi-year positive and negative cycles.

In the up-cycle, incoming capital flows strengthen the currency and depress bond yields, facilitating lower policy interest rates. This drives growth, attracting more capital inflows.

In the down-cycle, outgoing capital flows weaken the currency and raise bond yields, driving policy interest rates higher. This weakens growth and encourages greater capital outflows.

There are many factors to consider in these cycles. But a core component is that in the upcycle, central banks do not need to defend the exchange rate.

India cuts rates, but currency remains weak

In February, the Reserve Bank of India cut its benchmark “repo rate” by 0.25 percentage points to 6.25%, marking the first policy interest rate cut in nearly five years.

(Repo stands for “repurchase agreement” and refers to the cost of borrowing. When banks need money they can sell government securities to the RBI with an agreement to repurchase them at a future date. The repo rate is the interest rate the banks pay on this transaction.)

The RBI’s move signalled a shift towards supporting economic growth amid declining inflation, which stood at 4.3% in January.

However, the decision came against a backdrop of geopolitical tensions, global monetary policy divergence, and volatile financial markets.

India’s appointment of a growth-focused governor, Sanjay Malhotra, was seen as a sign of prioritising expansion over inflation control.

But concerns remained regarding the exchange rate.

The Indian Rupee experienced significant volatility, reaching an all-time low of 87.95 against the US dollar before rallying in mid-February due to aggressive intervention by the RBI.

The RBI reportedly sold around $US6 billion of foreign exchange reserves to stabilise the currency, which gave the Rupee a one-day lift.

But foreign investors have continued withdrawing from domestic markets, with net sales amounting to nearly $10 billion so far this year.

Policy-easing by the RBI has encouraged speculative pressure on the Rupee, making it one of the EM universe’s weakest-performing currencies this year.

This contrasts with currencies such as the Brazilian Real, Colombian and Chilean Pesos and South African Rand, which have all strengthened against the US dollar this year.

Decline in foreign exchange reserves raises concerns

The RBI’s intervention raised another major concern: the decline in India’s foreign exchange reserves.

Reserves fell from a peak of $700 billion in September to about $631 billion by the end of January.

This depletion raises concerns about India’s ability to manage external shocks in the face of capital outflows, rising import costs, and weakening investor sentiment.

The broader economic outlook suggests slowing growth.

India’s GDP growth fell to 5.4% in the September quarter – a seven-quarter low and well below initial RBI estimates.

Weak consumer demand, sluggish private investment, and reduced government spending have contributed to the downturn.

Inflation peaked at 6.2% in October 2024 (driven by rising food prices), but lower interest rates may not be sufficient to revive growth without stronger demand.

Risk of a down-cycle

India is not yet definitively in a down-cycle.

The bond yield curve has barely moved, for example, and currency weakness is not yet driving higher forward inflation expectations.

However, the local-currency equity index peaked at about the same time as foreign exchange reserves, and a poor fourth quarter for equities has been followed by further weakness.

We believe most Indian assets are too expensive to provide a backstop to weakness and the risk of an extended down-cycle is high.

We remain heavily underweight India in our portfolio and defensively positioned where we do have exposure.

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund’s top-down allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

James, Paul and Ada are senior fund managers at UK-based J O Hambro, which is part of Perpetual Group.
 
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