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US flu, hot crude & more... - Views on News from Equitymaster
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  • Mar 14, 2008

    US flu, hot crude & more...

    • At the first signs of the credit problems in the US and Europe six to eight months ago, it appeared that the trend might not affect India's financial markets and real economy significantly. However, things have changed rapidly wherein a slowdown in FII inflows, private equity inflows and real estate investments, coupled with slowdown in earnings growth, have begun to weigh heavily on India's growth outlook.

      The reason why India seems to be dangerously exposed to catching the contagious US flu is because our economy runs a large current account deficit, and its large balance of payments surplus has so far been driven by capital inflows. On the contrary, most other countries in Asia have large current account surpluses. Second, India has had a strong credit cycle over the last four years, driven by surplus liquidity, thus pushing up domestic demand. India's credit growth has averaged 29% over the last three years. While the monetary policies seem to have done their duties, the loose fiscal policies (camouflaging off-budget liabilities) have been blatantly ignored.

      The revelation of exposure to subprime risks by some Indian banks has raised doubts with regard to regulation and supervision over banks as well. Hence, currently there appear to be simultaneous challenges from several angles to the conduct of monetary policy, emanating from recent financial turbulence. These also relate to abrupt and large shifts in monetary policy measures of the major economies (particularly the US), major realignments in exchange rates (again, particularly the US dollar vis-a-vis Indian rupee) within a short period and unprecedented inflationary pressures due to food and energy prices. These warrant some interaction between the government and the financial sector, which may be influenced not only by the growing importance of financial discipline but also the cross-border linkages in the financial flows.

    • The spike in crude oil prices over the last couple of months has been largely attributed to speculation attracted by the weak US dollar. This argument is also supported by the fact that the rise in crude prices is not due to the market's underlying fundamentals, as the supplies are generally rising while demand is falling. Further, conflict between the major oil producing nations have not helped matters either. The potential conflict involving Venezuela, an OPEC (Organisation of the Petroleum Exporting Countries) member and major oil supplier to the US, pushed oil prices higher last week. Nonetheless, the end consumers in India remain largely oblivious to the steep energy burden as the artificially low prices of petroleum products (that are subsidised) fail to provide the price signals that can reduce demand. This again calls for some fiscal prudence on the part of the government.

    • China's trade surplus plunged in February 2008 as sales of goods to the US and Europe weakened. The situation was further aggravated by the snowstorms that disrupted the economy. The 63% YoY drop in trade surplus has been partly due to a global slowdown as also due to lower industrial production. China's industrial production grew at the slowest pace in more than a year as exports cooled and the worst snowstorms in half a century closed factories and disrupted power supplies. China's imports in February surged 35% YoY while the exports grew by 6.5% YoY - a much slower rate than January's 26%. That also spurred worries that slowing US demand will hurt Chinese exporters and could wipe out thousands of jobs.

      However, the Chinese government has a different story to narrate. Chinese leaders say they are not actively pursuing a large trade surplus. The communist government is prodding China's consumers to spend more in hopes of reducing reliance on exports and industrial investment to drive growth.

      The People's Bank of China (China's central bank) has already lifted borrowing costs six times in 2007 and has pushed banks' reserve (CRR) requirements to 15%, the highest ever. China has also let the Yuan appreciate more quickly to reduce import costs. The currency has climbed 2.9% in 2008 (year to date) versus the dollar after a 7% gain in 2007.



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