Wednesday, December 12, 2007

US credit squeeze and India

It is obvious that Indian policymakers can do little about containing the magnitude of the liquidity squeeze that has been the by-product of the sub-prime saga in the US. The RBI will have to factor in this reduced availability of external credit in its plans, if any, to tighten the credit delivery system.....a nice article from Business Line:

News from the US, the main engine of the global economy aided by funds from emerging countries such as China and Taiwan, has been engaging the attention of economists and commentators for the last few weeks. The rising current account deficit of the US, its falling currency and the latest sub-prime credit woes have all drawn excited and focussed attention. Can India remain decoupled from what happens in the US economy?

Notwithstanding assertions of Indian policymakers to the contrary, when America sneezes, India catches a cold, although India is mainly sustained by domestic consumption and investment. Exports in general, and software exports in particular, are linked to US market demand.

If demand in US markets contracts, Chinese goods displaced from the US will descend on the rest of the world, including India. Directly or indirectly, the US economy’s contraction, which can result from a credit squeeze, can impact India. The implications are even more deep-seated than appears to a superficial observer.

Contraction of credit
Recently, TV channels flashed the views of the Chief Economist of Goldman Sachs who predicted that the abstraction from US credit markets will run into a global credit reduction of $2 trillion — a large sum of money by any reckoning.

Such a sharp contraction of credit will mean, at a minimum, the reduction of external borrowing by Indian corporates through the credit markets abroad, or, at any rate, a tightening of interest rates for such borrowing. It will also mean reduction of capital flows into emerging markets, including the Indian markets, which have already been alleged to have too high a valuation.

While this last aspect may not be good news for the Indian market punters, it may be music to the ears of the central banker struggling with $250-plus billion reserves and dreading further inflows.

The rupee may perhaps depreciate a tad from the high levels it has seen in recent months. This may be good news for our exporters and capital goods producers fearing the onslaught of cheaper goods from abroad. Overall, the impact would turn on whether the liquidity drop falls on external commercial borrowing or on investment in Indian stocks.

The reduction of global liquidity may spell a sharp reduction of access to resources for the Indian corporate sector.

The RBI will have to factor in this reduced availability of external credit in its plans, if any, to tighten the Indian credit delivery system. Already, the industrial production index has shown a sharp decline, as the latest reports show. It is important that the RBI does not pursue its inflation fighting credo to the exclusion of growth objective. It is, however, possible that the RBI’s inflation targeting hawks may gain an upper hand in view of the factor of crude oil prices touching the $100-mark.

Avoiding a repeat
The RBI has to take a holistic view of the combination of tightness of global credit availability and Indian investment needs in its next monetary policy stance. One hopes that there will not be a repeat of the mid-nineties experience when a burgeoning pace of economic growth had to be curtailed mainly because of the RBI’s tightening of monetary policy. In the light of this experience, at this time, one has to be doubly careful. This is possible since inflation is already down and global resources as a whole are under pressure.

It is quite possible that the US central bankers may themselves respond positively to the liquidity squeeze by pumping in more resources to avert a US recession. It this happens, the situation may not be as grim as Goldman Sachs predicts. But with Bernanke’s stance being primarily focused on inflation targeting, one may doubt whether he would counter the liquidity drain forecast.

At the same time, one has to bear in mind that world liquidity will be under strain, given the heavy drafts on resources by the $100-plus crude oil and its consequences on both developed and developing economies. How OPEC handles its surpluses will be critical to the issue. If it invests again in US securities, the damage will be mitigated. There is no alternative avenue for OPEC investment.

Difficult task ahead
The implications for Indian policymakers as a result of the global credit squeeze resulting from the US sub-prime mess are varied. First, the reduction in industrial growth might impact adversely, although not immediately, corporates’ profits and hence lower a bit of the good news on the corporate tax front. On the other hand, the recessionary impact of the reduction in credit to Indian corporates must not be worsened by financial tightening by the RBI.

While fiscal deficit reduction is a declared goal of the Government of India, its impact on growth of demand has also to be kept in mind. The Finance Minister may feel that he has a difficult task. On the one hand, he has to stimulate the economy fiscally. On the other, he has to keep fiscal deficit within the Fiscal Responsibility and Budgetary Management targets in order to keep inflation under control. Who said the FM’s crown has no thorns?

While the recent emphasis of Indian policymakers has been on containing the impact of capital flows, it has to be modulated now that the global scenario is changing. It is important that we remind ourselves continuously that we are in and part of a globalised economy. There is no point in insulating ourselves, whatever the other risks may be.

But, the RBI and Ministry of Finance have to work together to ensure that the liquidity in the system, continued effect of external capital flows and internal deposit resources remain optimal. While inflation has, of course, to be contained, food grain prices are showing a slight softening trend, aided by prospects of imports.

Balancing act
The prospects of a recessionary trend in the US have to be kept in mind in framing India’s tax proposals, especially its impact on the export sector. The impact of a rising rupee, plus a falling US market, can be a double-whammy for India’s service sector as well as manufacturing, particularly textiles, auto and electronics. It is the task of the budget-makers to keep these conflicting demands in mind to formulate a growth-friendly budget. Growth is vital if jobs are to grow. Jobs have to grow, if poverty is to be contained.

The debate about the US sub-prime mess and its consequences seems to be necessarily an extensive one because of the growing interconnections of the world economy. What happens in the remotest parts of the world seems to have an impact on us. Globalisation and its discontents are, indeed, many. There is little we can do about it.

For instance, it is obvious that our policymakers can do little about containing the magnitude of the liquidity squeeze that has been the by-product of the sub-prime saga in the US. But we have to do what is our remit — to contain its damage on India’s growth — both in the corporate sector and others.

Inflation management is, of course, critical, but the lack of adequate growth can be a disaster. Let it not be said that India’s growth became hostage to the sub-prime mismanagement of the US housing financial markets.

The answer lies in the hands of our undoubtedly competent central bankers, the mandarins of the Finance Ministry and the magnates of the corporate sector.

No comments: