Source: Economic Times
Financing India growth would not be that much of an issue:
Deepening financial distress in the United States has affected even the most basic financial intermediation, with US authorities currently making great efforts to restore fully functioning markets.
These conditions would probably have a limited direct effect on India, but the implications for global demand could result in a moderation in exports. Moreover, heightened risk aversion could also impact pricing of assets.
Being largely a domestic economy with exports including software at 17% of GDP, India is relatively insulated in comparison with most other economies.
Though it is difficult to quantify the exact implications at this stage, a couple of points worth keeping are: (1) Indian IT companies have around a 30% exposure to financial services; (2) funding constraints could result in some uncertainty for the real estate sector; and (3) while direct exposure for Indian financial institutions is negligible there are a few firms which could be impacted at the margin.
However, a point to note is that given the deterioration in the global and domestic macro environment seen over the year, India Inc has been adapting and innovating with a clear focus on profitability. But the adverse macro environment is having an impact on growth and expansion plans with growth estimates now in the 7%-7.5% range.
Our FY09 and FY10 GDP estimates of 7.5% and 7.4% factor in single-digit investment growth from a CAGR of 17% seen during FY03 to FY08. This is basically due to the fact that investments have faced a double whammy with rising input costs on the one hand; and higher, more stringent borrowing constraints (both domestic and global) on the other.
Growth would have been lower were it not for the buoyant savings, productivity gains, healthier balance sheets and the possibility of monetary easing next year. In addition, a sustained fall in commodity prices bodes well for inflation, rates and the fisc.
While the impact on growth and exports can be quantified, the impact on currency and capital flows is not as clear. The reason is that despite India being a domestic-driven economy with strong macro fundamentals, in times of an increase in risk aversion, countries with twin deficits, inflation and political challenges tend to be viewed with caution.
Moreover, a lot would also depend on monetary policy responses (both of the Fed and the RBI) as asset reallocation could result in inducing capital flows to those countries where interest rates are higher.
The panic over the health of the US financial system has caused severe de-leveraging of balance sheets with firms and investors rushing to convert assets into cash to reduce risk and to preserve operating capital. The process is likely to continue and will impact economies/corporates who access international capital.
De-leveraging and the increase in risk aversion could result in higher spreads thus increasing recourse to domestic sources of funding. However, we believe that financing the India growth story would not be that much of an issue given the buoyancy in deposits, high savings and levers available with the RBI to inject liquidity.
Recent steps taken such as increasing the attractiveness of NRI deposits, and providing additional liquidity support via the LAF window to alleviate the liquidity shortage are encouraging. We believe that we could see the RBI becoming more active in the coming months.
Possible measures include (1) further relaxation of norms on the capital account, both NRI and ECB guidelines, (2) a likely cut in the SLR given the continued buoyancy in both credit and deposits and consequent demand for government securities to meet statutory requirements, and (3) a possibility of keeping rates on hold given lower commodity prices and stabilising inflationary expectations.
India should push ahead with hiking prices of domestic fuels:
India’s annual GDP growth accelerated to 9.3% in the three years to 2007-08 owing mainly to three key drivers: (1) greater impact and acknowledgement of favourable structural factors; (2) strong global cyclical growth uplift; and (3) exceptionally easy global liquidity conditions and heightened risk appetite that caused a surge in capital inflows into emerging economies, including India.
The structural factors driving India’s economic rise remain well entrenched and thus safeguard the attractive medium-term outlook. However, the other two factors have reversed course, and will undoubtedly extract a price for the excesses of recent years.
Growth will slow down this year and next, led by deceleration in investment spending, and some rolling over in consumption. GDP growth will moderate to a touch over 7% next year, not a bad outcome considering the global backdrop and the domestic constraints, but lower than the sustained 9% or so several businesses and investors had unrealistically assumed.
The impact of the global mayhem will be transmitted via softening external demand and lower capital inflows, especially portfolio investment. The reversal in foreign capital inflows, which is already playing out, will affect local money market liquidity and the rupee.
Policymakers here are well positioned to cushion the adverse impact, owing mainly to the sensible approach by the former Reserve Bank governor Y V Reddy, which also sets the stage for greater liberalisation now. The policy response in the coming months will be a reverse of what happened over the last 2-3 years when the RBI was faced with surging capital inflows, and had to hike the cash reserve ratio (CRR) and check rupee’s appreciation.
Now, the worsening balance of payments will adversely affect local money market liquidity, and also put pressure on the rupee to weaken. Interest rates for non-resident Indians have already been increased, and will likely to be increased further. Also, policymakers will ease the restrictions on capital inflows to ease dollar supply, though it will now be far more expensive for firms to borrow internationally.
Intervention in the foreign exchange market to check rupee’s weakness will tighten local liquidity, which in turn will set the stage for unwinding of securities issued under the market stabilisation scheme, and for cuts in CRR. Real interest rates are pretty high (ignore those who were screaming for rate cuts some time back but now argue that real rates are too low!) Expectations of lower inflation will also prompt significant reversal in interest rates.
Given the local constraints and the global backdrop, last week’s quasi and temporary cut in the statutory liquidity ratio (SLR) was perhaps the only workable option, especially since the central bank cannot cut CRR just yet.
Still, it also shows the ad-hocism in policymaking due to, among other things, exceptional and adverse global factors, the need to check rupee depreciation and the fiscal bleeding that is forcing banks to lend to the state oil companies. Indian policymakers cannot control global factors, but they should push ahead with increasing local prices of some fuels, so as to check the fiscal mess.
The greatest challenge for policymakers will be to deflect bad advice, and there has been plenty going around in recent years. It is ironic that those who were rooting for a free-floating rupee when it was under pressure to appreciate appear to have done a convenient about-face and are now making the case for greater intervention by the RBI to prevent rupee weakness! It is worth remembering that currency flexibility is part of the solution, not part of the problem.
Indian growth rates should continue to attract:
The short answer is no, since domestic drivers of growth are robust and varied. But the element of panic and herd reactions make crises uncertain creatures.
Whatever the earlier errors, policy reactions to the crisis itself have been largely correct, injecting liquidity, at a price, to prevent freezing of markets, helping institutions, such as Fanny Mae, Freddie Mac and AIG, whose collapse would have large externalities, but letting the shareholders and management suffer.
Concerted action by a number of central banks to pump in liquidity is another good sign of global stakes in the financial system and a readiness to prevent its collapse. Liquidity injections need not be inflationary, they substitute for a drying up of systemic liquidity and can be withdrawn as the latter revives.
Plans to help banks clean out illiquid assets and restrictions on short selling to restrict attacks on vulnerable stocks may end the uncertainty about who is next. Tackling the root cause may prevent periodic eruptions from the festering sores of the subprime crisis.
Policy has to be interventionist in such a crisis to minimise contagion and collapse. Tightening regulatory loopholes that helped create excessive financial leverage must follow, but later. Since taxpayer money is going to investment banks, they must accept tighter regulation.
They can only survive as regular banks. Incentives must be redesigned, current huge bonuses in good times and limited liability in bad encourage risk-taking. A premium could be paid in good times to finance the risk of future bailouts.
Since Indian banks are healthy, with little exposure to the derivatives and institutions at risk, they will be all right. Fall in global commodity prices will help reduce imported inflation and allow policy to revive growth. There will be a drying of international liquidity and outflow from troubled FPIs.
But Indian growth rates are one of the few bright spots in a dismal situation, and should continue to attract robust long-term investments. Excessive FPI inflows were a problem for policy in the past year. The reversal is still minor compared to past accumulations. So there should not be any hesitation to allow some reduction in forex reserves. The cost of carrying reserves and of sterilisation will be reduced.
Selling the dollar when the rupee is low makes good profit for the Reserve Bank. As long as inflation is still high excessive rupee depreciation should be prevented.
The liquidity withdrawn by dollar sale can be countered by unwinding MSS balances and reducing CRR. The latter will reduce bank costs, and allow domestic credit to compensate to some extent for the drying of international credit. Domestic savings are high enough to finance investment, with whatever external help remains.
Sectors most at risk are those that have dealings with troubled financial companies. Some Indian professionals will loose jobs. But quick restructuring makes these losses short-lived. Talent becomes available to go into areas where it is scarce.
A deeper global recession may not adversely affect the outsourcing business, despite the loss of some big clients, because of the search for cheaper alternatives. Air travel loses some of its frequent flyers but gains from lower fuel prices. There are always pluses and minuses, it is up to us to build on the pluses and provide an alternative growth pole for the world.
The problem is the increasing indebtedness of the United States government. But at least in the short-term, surpluses of other countries should continue to shore it up, because of the latter’s stake in the global system. Gradual adjustment away from the dollar towards a less unipolar and therefore more robust global system will, however, continue.
