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The Sub Prime Crisis and What it Means for India
Tuesday, May 06, 2008

The sub prime mortgage crisis and its potential impact on US economic growth has raised concerns whether growth in India - which averaged over 9% in the last three years - will be adversely affected. The Indian economy showed signs of overheating in mid-2007, with inflation rising above 6%. Although the central bank has pursued a tight monetary policy, inflation has recently risen above 7%. Buoyant capital flows posed challenges for liquidity and macroeconomic management, and the Reserve Bank of India responded effectively by adopting a mix of policy measures including imposing capital controls, allowing the rupee to appreciate, and liberalizing outflows of capital.

India is running a current account deficit (CAD) which is likely to increase to 2.6% of GDP in 2009 from the 1.5% in 2008, driven largely by the sharp increase in international prices of oil and food commodities. So far India's CAD has been comfortably financed through capital inflows and FDI. In this scenario, the question whether a global credit crunch and significant slowdown in the US economy could undermine India's growth prospects, becomes pertinent.

The main channels through which a global credit crunch and a recession in the US can affect India are: (i) a decline in capital inflows and lower corporate access to credit in international markets; (ii) slowdown in exports of goods and services from India to the US; and (iii) remittances. The impact on Indian growth through the first two of these channels is likely to be negative though the structure of India's trade could mitigate the impact through trade (explained later).

The bulk of India's remittances come from the Gulf and are therefore unlikely to be impacted, significantly. Compensating effects from increasing government expenditure, budget boosts for consumption, infrastructure and investment spending may still keep the aggregate demand side of the story intact, though there are signs even here of credit growth and investment spending slowing down.

Capital inflows/Access to credit: India has never raised a sovereign bond in global capital markets, so any effect of a credit shortfall will be on the ability of Indian corporates to access overseas capital and through capital inflows. India received $99 billion (approximately 10% of GDP) in net foreign exchange flows in 2007-08 including net FDI ($11 billion), portfolio flows ($41 billion), ECBs and overseas borrowings by Indian corporates ($33 billion), banking capital ($7.5 billion).

As the sub prime crisis unfolds, counterparty risk aversion has become acute and has led to financial institutions building up significant liquid assets as precautionary measures, sometimes equivalent to 20-25% of their balance sheets. This has resulted in banks cutting lending and shifting out of exposures to corporates, a reversal of portfolio flows away from emerging markets (including India), and widening spreads on emerging market paper (including Indian paper). These developments will slow down capital inflows into India, with estimates for 2008-09 ranging between $40 and $50 billion. The recent drop in the Indian equity markets, also a reflection of the global rise in risk aversion and reduction in liquidity, will have a negative impact on investment and consumption.

According to market estimates reported by the BIS, outstanding asset-backed commercial paper reached $1.5 trillion in March 2007, of which $300 billion was based on mortgage-backed assets. So far, the total of all write-downs and credit loss for major banks and brokerages is approximately $200 billion but far more is expected as other asset classes (such as Liquidity Puts, Credit Default Swaps and Leveraged Loans) get impaired.

The total global write-downs are expected to be around $1 trillion (IMF estimates) of which the banks have so far written down around $200 billion. The prospect of further losses and the need for greater reserve provisioning suggests that the supply of new credit is likely to become increasingly restricted - with tighter credit standards, and higher spreads. Tight market liquidity has been further exacerbated by fears of a US recession.

Issuance by Indian companies had increased rapidly in recent years (albeit from a small base) driven by robust domestic economic growth and the need to fund rapid overseas expansions by corporate India. Indian companies were active in the foreign debt markets (both primary and syndications) for financing overseas expenditures denominated in foreign currency, mergers and acquisitions, and the overseas needs of their clients (banks/financial institutions). However, given the tight liquidity in the foreign debt market and loss of risk appetite on the part of banks, it is becoming increasingly difficult for Indian corporates and banks to raise foreign loans. Pricing for foreign borrowing by even top-tier Indian borrowers (e.g., Tata Motors, Reliance, ICICI, Exim) has increased significantly since the beginning of January 2008.

Very little foreign borrowing by Indian companies has been done in the last few months because of ECB restrictions (the interest rate cap in some cases is lower than the applicable market spread), other than offshore M&A transactions. A prolonged period of inability to access international bond markets for private Indian companies, coupled with increasing spreads in the domestic market is likely to lower investment and growth.

The big question that arises is how a major correction in the international capital markets, the "flight to quality," and lower risk appetite of financial institutions and international institutional investors will impact India's ability to finance its large infrastructure needs. Given that credit growth has not been responsive to liquidity injecting measures by central banks (the Fed has cut rates by 225 bps since January 22 2008), it would be reasonable to assume that the supply of long-term financing for infrastructure projects world-wide will reduce over the next 12-24 months, while spreads will increase. The need, therefore, for developing the local long-term debt market has assumed even higher urgency.

Trade: On the trade front, the impact of a slowdown in US economic growth is likely to be less significant because of the structure of India's trade and the declining importance of the US as a trading partner. A possible favorable consequence of lower US demand for commodities such as oil and food grains could be a lowering of their prices, which have been surging lately (India is a net importer of these commodities). The downside will come from a decline in demand for Indian exports, mainly IT (the US accounts for nearly 65% of the revenues of IT vendors) and BPO services. However, the bigger picture shows that India's overall exposure to the US market is limited and declining. However, the impact of the US slowdown could be felt through Europe, which is also likely to slowdown.

In sum, the expected impact of a global credit crunch and slowdown in the US economy on India appears to be relatively small through the trade channel, as exports are diversified; the financial channel effects are likely to be more significant through a reduction in capital inflows - in the event that lower global interest rates do not lead to more credit becoming available and banks continue to pull back lending (to counter illiquidity) and shift out of exposures to corporates - globally and in India - to safer assets.



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