In the context of tightening global financial conditions, a stagnating world economy, and a stronger US dollar, some of the emerging economies are struggling to catch up, especially those that were already lagging behind in the global post-pandemic recovery story. While headline inflation seems to have peaked in low-income economies, where food and energy comprise a larger share in the consumption basket, it continues to rise in middle-income economies.
Overall, the exceptionally wide differential in headline inflation rates between middle-income and high-income countries underlines how lower-income economies are disproportionately affected by the ongoing cost of living crisis. Tighter financial conditions affect EM economies through three channels – 1) financing costs rise following higher credit risk premia, 2) a stronger US dollar increases the relative burden from USD-denominated debt, and 3) access to funding deteriorates as foreign investors prefer low-risk assets that now yield positive nominal returns.
In this context, EM economies with substantial external vulnerabilities such as high debt, budget and current account deficits, and limited foreign reserves, face the highest risk of acute balance of payments or FX crises. Trade exposures, reliance on specific trading partners such as China or significant reliance on imported fuels add to FX vulnerabilities. Local central banks also play a key role, as too loose monetary policies imply negative real rates that tend to trigger capital outflows.
In the longer term, some EM economies are set to benefit from businesses and investors diversifying away from their exposure to China. The reshuffling of supply chains is likely to benefit economies with sufficient supply of affordable yet skilled labor and economies that foster an enabling business environment with limited political (and sanction) risk.
One of the outliers in the EM economies outperforming the rest is India. India is already the fastest-growing economy in the world, having clocked 5.5% average gross domestic product growth over the past decade. Now, three megatrends – global offshoring, digitalization, and energy transition – are setting the scene for unprecedented economic growth in a country of more than 1 billion people. India is set to surpass Japan and Germany to become the world’s third-largest economy by 2027 and will have the third-largest stock market by the end of this decade.
Consequently, India is gaining power in the world order, and in our opinion these idiosyncratic changes imply a once-in-a-generation shift and an opportunity for investors and companies. All told, India’s GDP could more than double from $3.5 trillion today to surpass $7.5 trillion by 2031.
Its share of global exports could also double over that period, while the Bombay Stock Exchange could deliver 11% annual growth, reaching a market capitalization of $10 trillion in the coming decade led by staggering changes: boosting India’s share of global manufacturing, expanding credit availability, creating new businesses, improving quality of life, and spurring a boom in consumer spending. India is also poised to become the factory to the world, as corporate tax cuts, investment incentives, and infrastructure spending help drive capital investments in manufacturing.
India began laying the foundation for a more digital economy more than a decade ago with the launch of a national identification program called Aadhaar. The system creates biometric IDs to establish proof of residence and has been instrumental in digitizing financial transactions, among other benefits.