The global crisis and its impact on India

September 21, 2008

Globalisation has ensured that the Indian economy and financial markets cannot stay
insulated from the present financial crisis in the developed economies.

The debate, therefore, can only be on the extent of impact and how resilient India is to
withstand the storm with minimal damage! In the light of the fact that the Indian
economy is linked to global markets through a full float in current account (trade and
services) and partial float in capital account (debt and equity), we need to analyse the
impact based on three critical factors: Availability of global liquidity; demand for India
investment and cost thereof and decreased consumer demand affecting Indian exports.

The concerted intervention by central banks of developed countries in injecting liquidity

is expected to reduce the unwinding of India investments held by foreign entities, but
fresh investment flows into India are in doubt.

The impact of this will be three-fold: The element of GDP growth driven by off-shore
flows (along with skills and technology) will be diluted; correction in the asset prices
which were hitherto pushed by foreign investors and demand for domestic liquidity
putting pressure on interest rates.

While the global financial system takes time to “nurse its wounds” leading to low
demand for investments in emerging markets, the impact will be on the cost and related
risk premium. The impact will be felt both in the trade and capital account.

Indian companies which had access to cheap foreign currency funds for financing their
import and export will be the worst hit. Also, foreign funds (through debt and equity) will
be available at huge premium and would be limited to blue-chip companies.

The impact of which, again, will be three-fold: Reduced capacity expansion leading to
supply side pressure; increased interest expenses to affect corporate profitability and
increased demand for domestic liquidity putting pressure on the interest rates.

Consumer demand in developed economies is certain to be hurt by the present crisis,

leading to lower demand for Indian goods and services, thus affecting the Indian exports.

The impact of which, once again, will be three-fold: Export-oriented units will be the
worst hit impacting employment; reduced exports will further widen the trade gap to put
pressure on rupee exchange rate and intervention leading to sucking out liquidity and
pressure on interest rates.

The impact on the financial markets will be the following: Equity market will continue to
remain in bearish mood with reduced off-shore flows, limited domestic appetite due to
liquidity pressure and pressure on corporate earnings; while the inflation would stay
under control, increased demand for domestic liquidity will push interest rates higher and
we are likely to witness gradual rupee depreciation and depleted currency reserves.
Overall, while RBI would inject liquidity through CRR/SLR cuts, maintaining growth
beyond 7% will be a struggle.

The banking sector will have the least impact as high interest rates, increased demand for
rupee loans and reduced statutory reserves will lead to improved NIM while, on the other
hand, other income from cross-border business flows and distribution of investment
products will take a hit.

Banks with capabilities to generate low cost CASA and zero cost float funds will gain the
most as revenues from financial intermediation will drive the banks’ profitability.

Given the dependence on foreign funds and off-shore consumer demand for the India
growth story, India cannot wish away from the negative impact of the present global
financial crisis but should quickly focus on alternative remedial measures to limit damage
and look in-wards to sustain growth!

India and the global financial crisis

C. P. Chandrasekhar
Jayati Ghosh

While India is not likely to face a financial meltdown of the kind that was nearly experienced in the US, the
global financial crisis will certainly have an impact. In this edition of Macroscan, C. P. Chandrasekhar and
Jayati Ghosh consider the possible negative effects of the crisis on India and whether the Government’s
response so far has been appropriate.

When the financial crisis erupted in a comprehensive manner on Wall Street, there was some premature
triumphalism among Indian policymakers and media persons. It was argued that India would be relatively
immune to this crisis, because of the “strong fundamentals” of the economy and the supposedly well-
regulated banking system.

This argument was emphasised by the Finance Minister and others even when other developing countries in
Asia clearly experienced significant negative impact, through transmission of stock market turbulence and
domestic credit stringency.

These effects have been most marked among those developing countries where the foreign ownership of
banks is already well advanced, and when US-style financial sectors with the merging of banking and
investment functions have been created.

If India is not in the same position, it is not to the credit of our policymakers, who had in fact wanted to go
along the same route. Indeed, for some time now there have been complaints that these “necessary”
reforms which would “modernise” the financial sector have been held up because of opposition from the Left
parties.

But even though we are slightly better protected from financial meltdown, largely because of the still large
role of the nationalised banks and other controls on domestic finance, there is certainly little room for
complacency.
The recent crash in the Sensex is not simply an indicator of the impact of international contagion. There
have been warning signals and signs of fragility in Indian finance for some time now, and these are likely to
be compounded by trends in the real economy.

Economic downturn

After a long spell of growth, the Indian economy is experiencing a downturn. Industrial growth is faltering,
inflation remains at double-digit levels, the current account deficit is widening, foreign exchange reserves are
depleting and the rupee is depreciating.

The last two features can also be directly related to the current international crisis. The most immediate
effect of that crisis on India has been an outflow of foreign institutional investment from the equity market.
Foreign institutional investors, who need to retrench assets in order to cover losses in their home countries
and are seeking havens of safety in an uncertain environment, have become major sellers in Indian markets.

In 2007-08, net FII inflows into India amounted to $20.3 billion. As compared with this, they pulled out $11.1
billion during the first nine-and-a-half months of calendar year 2008, of which $8.3 billion occurred over the
first six-and-a-half months of financial year 2008-09 (April 1 to October 16). This has had two effects: in the
stock market and in the currency market.

Given the importance of FII investment in driving Indian stock markets and the fact that cumulative
investments by FIIs stood at $66.5 billion at the beginning of this calendar year, the pullout triggered a
collapse in stock prices. As a result, the Sensex fell from its closing peak of 20,873 on January 8, 2008, to
less than 10,000 by October 17, 2008 (Chart 1).

Falling rupee
In addition, this withdrawal by the FIIs led to a sharp depreciation of the rupee. Between January 1 and
October 16, 2008, the RBI reference rate for the rupee fell by nearly 25 per cent, even relative to a weak
currency like the dollar, from Rs 39.20 to the dollar to Rs 48.86 (Chart 2). This was despite the sale of
dollars by the RBI, which was reflected in a decline of $25.8 billion in its foreign currency assets between the
end of March 2008 and October 3, 2008.

It could be argued that the $275 billion the RBI still has in its kitty is adequate to stall and reverse any further
depreciation if needed. But given the sudden exit by the FIIs, the RBI is clearly not keen to deplete its
reserves too fast and risk a foreign exchange crisis.

The result has been the observed sharp depreciation of the rupee. While this depreciation may be good for
India’s exports that are adversely affected by the slowdown in global markets, it is not so good for those who
have accumulated foreign exchange payment commitments. Nor does it assist the Government’s effort to
rein in inflation.

A second route through which the global financial crisis could affect India is through the exposure of Indian
banks or banks operating in India to the impaired assets resulting from the sub-prime crisis. Unfortunately,
there are no clear estimates of the extent of that exposure, giving room for rumour in determining market
trends. Thus, ICICI Bank was the victim of a run for a short period because of rumours that sub-prime
exposure had badly damaged its balance sheet, although these rumours have been strongly denied by the
bank.

Exposure of banks

So far the RBI has claimed that the exposure of Indian banks to assets impaired by the financial crisis is
small. According to reports, the RBI had estimated that as a result of exposure to collateralised debt
obligations and credit default swaps, the combined mark-to-market losses of Indian banks at the end of July
was around $450 million.
Given the aggressive strategies adopted by the private sector banks, the MTM losses incurred by public
sector banks were estimated at $90 million, while that for private banks was around $360 million. As yet
these losses are on paper, but the RBI believes that even if they are to be provided for, these banks are well
capitalised and can easily take the hit.

Such assurances have neither reduced fears of those exposed to these banks or to investors holding shares
in these banks.

These fears are compounded by those of the minority in metropolitan areas dealing with foreign banks that
have expanded their presence in India, whose global exposure to toxic assets must be substantial. What is
disconcerting is the limited information available on the risks to which depositors and investors are subject.
Only time will tell how significant this factor will be in making India vulnerable to the global crisis.

A third indirect fallout of the global crisis and its ripples in India is in the form of the losses sustained by non-
bank financial institutions (especially mutual funds) and corporates, as a result of their exposure to domestic
stock and currency markets.

Such losses are expected to be large, as signalled by the decision of the RBI to allow banks to provide loans
to mutual funds against certificates of deposit (CDs) or buyback their own CDs before maturity. These
losses are bound to render some institutions fragile, with implications that would become clear only in the
coming months.

Credit cutback

A fourth effect is that, in this uncertain environment, banks and financial institutions concerned about their
balance sheets, have been cutting back on credit, especially the huge volume of housing, automobile and
retail credit provided to individuals. According to RBI figures, the rate of growth of auto loans fell from close
to 30 per cent over the year ending June 30, 2008, to as low as 1.2 per cent.

Loans to finance consumer durables purchases fell from around Rs 6,000 crore in the year to June 2007, to
a little over Rs 4,000 crore up to June this year. Direct housing loans, which had increased by 25 per cent
during 2006-07, decelerated to 11 per cent growth in 2007-08 and 12 per cent over the year ending June
2008.

It is only in an area like credit-card receivables, where banks are unable to control the growth of credit, that
expansion was, at 43 per cent, quite high over the year ending June 2008, even though it was lower than the
50 per cent recorded over the previous year.

It is known that credit-financed housing investment and credit-financed consumption have been important
drivers of growth in recent years, and underpin the 9 per cent growth trajectory India has been experiencing.
The reticence of lenders to increase their exposure in markets to which they are already overexposed and
the fears of increasing payment commitments in an uncertain economic environment on the part of potential
borrowers are bound to curtail debt-financed consumption and investment. This could slow growth
significantly.

Finally, the recession generated by the financial crisis in the advanced economies as a group and the US in
particular, will adversely affect India’s exports, especially its exports of software and IT-enabled services,
more than 60 per cent of which are directed to the US.

International banks and financial institutions in the US and EU are important sources of demand for such
services, and the difficulties they face will result in some curtailment of their demand. Further, the
nationalisation of many of these banks is likely to increase the pressure to reduce outsourcing in order to
keep jobs in the developed countries.

And the slowing of growth outside of the financial sector too will have implications for both merchandise and
services exports. The net result would be a smaller export stimulus and a widening trade deficit.

Domestic policy

While these trends are still in process, their effects are already being felt. They are not the only causes for
the downturn the economy is experiencing, but they are important contributory factors. Yet, this does not
justify the argument that India’s difficulties are all imported. They are induced by domestic policy as well.

The extent of imported difficulties would have been far less if the Government had not increased the
vulnerability of the country to external shocks by drastically opening up the real and financial sectors. It is
disconcerting, therefore, that when faced with this crisis the Government is not rethinking its own
liberalisation strategy, despite the backlash against neo-liberalism worldwide.

By deciding to relax conditions that apply to FII investments in the vain hope of attracting them back and by
focusing on pumping liquidity into the system rather than using public expenditure and investment to stall a
recession, it is indicating that it hopes that more of what created the problem would help solve it. This is just
to postpone decisions that may prove critical — till it is too late.

How the global financial crisis affects India

September 19, 2008 11:57 IST

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The key question confronting the economy now is the backwash effect of the American (or global) financial
crisis. Central banks in several countries, including India, have moved quickly to improve liquidity, and the
finance minister has warned that there could be some impact on credit availability. That implies more
expensive credit (even public sector banks are said to be raising money at 11.5 per cent, so that lending
rates have to head for 16 per cent and higher -- which, when one thinks about it, is not unreasonable when
inflation is running at 12 per cent).

For those looking to raise capital, the alternative of funding through fresh equity is not cheap either, since
stock valuations have suffered in the wake of the FII pull-out. In short, capital has suddenly become more
expensive than a few months ago and, in many cases, it may not be available at all.

The big risk is a possible repeat of what happened in 1996: Projects that are halfway to completion, or
companies that are stuck with cash flow issues on businesses that are yet to reach break even, will run out
of cash. If the big casualty then was steel projects (recall Mesco, Usha and all the others), one of the
casualties this time could be real estate, where building projects are half-done all over the country and some
developers who touted their 'land banks' find now that these may not be bankable.

The only way out of the mess is for builders to drop prices, which had reached unrealistic levels and
assumed the characteristics of a property bubble, so as to bring buyers back into the market, but there is not
enough evidence of that happening.

The question meanwhile is: Who else is frozen in the sudden glare of the headlights? The answer could be
consumers, many of whom are already quite leveraged. More expensive money means that floating rate
loans begin to bite even more; even those not caught in such a pincer will decide that purchases of durables
and cars are not desperately urgent.

And it is not just the impact of those caught on the margin who must be considered. The drop in real estate
and stock prices robs a much larger body of consumers of the wealth effect, which could affect spending on
a broader front. In short, the second round effects of the financial crisis will be felt straightaway in the credit-
driven activities and sectors, but will spread beyond that in a perhaps slow wave that could take a year or
more to die down.

One danger meanwhile is of a dip in the employment market. There is already anecdotal evidence of this in
the IT and financial sectors, and reports of quiet downsizing in many other fields as companies cut costs.
More than the downsizing itself, which may not involve large numbers, what this implies is a significant drop
in new hiring -- and that will change the complexion of the job market.

At the heart of the problem lie questions of liquidity and confidence. What the RBI needs to do, as events
unfold, is to neutralise the outflow of FII money by unwinding the market stabilisation securities that it had
used to sterilise the inflows when they happened. This will mean drawing down the dollar reserves, but that
is the logical thing to do at such a time. If done sensibly, it would prevent a sudden tightening of liquidity, and
also not allow the credit market to overshoot by taking interest rates up too high.

Meanwhile, there is an upside to be considered as well. The falling rupee (against the dollar, more than
against other currencies) will mean that exporters who felt squeezed by the earlier rise of the currency can
breathe easy again, though buyers overseas may now become more scarce. Overheated markets in general
(stocks, real estate, employment-among others) will all have an element of sanity restored. And for
importers, the oil price fall (and the general fall in commodity prices) will neutralise the impact of the dollar's
decline against the rupee.