Whatever happened to 'India Decoupled'? - Views on News from Equitymaster

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Whatever happened to 'India Decoupled'?

Apr 2, 2009

For investors who firmly believed the 'Decoupled India' story, the extent to which the global crisis has affected us has come as a huge surprise. At the time there seemed to be umpteen reasons to believe that Indiaís growth story, led by domestic consumption, would be enough to tide over any downturn in the developed countries. After all, external demand as measured by merchandise exports accounts for less than 15% of our GDP. So then, if our reliance on external demand is so limited, the question that arises is why should India get so affected? Whatís more, even our domestic banking system remains as sound as ever, nowhere even close to the contagion destroying the US and European banks. Quite an intriguing mystery to say the least.

In a recent speech delivered by the governor of the RBI, Mr. Duvvuri Subbarao, he had some interesting observations to make about this conundrum. Here we shall discuss some of the important takeaways from his speech.

The first point is about India's remarkably rapid trade integration with the world economy over the last decade. In terms of globalisation as measured by two-way trade, India's merchandise exports plus imports as a proportion of GDP increased from 21.2% in FY98 to 34.7% in FY08.

Secondly, India's financial integration with the rest of the world has been equally deep. The ratio of total external transactions (gross current account flows plus gross capital flows) to GDP had more than doubled from 46.8% in FY98 to 117.4% in FY08.

The last five years have seen a substantial increase in the Indian corporate sector's usage of external funding (from outside the country). During FY03 to FY08, the share of corporate investment in India's GDP rose by 900 basis points. While corporate savings financed a little over half of this, a significant portion of the balance financing came from external sources. This is because even though funds were available within the country, foreign funding was perceived to be less expensive than domestic financing. It became even more easier for Indian companies to raise funds due to the fact that the global market had abundant liquidity and investors were more than willing to lend due to the promise of India's growth potential.

Thus, the exponential increase in the importance of external financing to Indian corporates also contributed to the depth of India's financial integration. So despite the presence of some mitigating factors, one of the biggest reasons India was hit by the crisis is India's rapid and growing integration into the global economy.

Further, Mr. Subbarao went on to expound on how the crisis has spread to India via three channels: the financial channel, the real channel and the confidence channel.

The Financial Channel: This includes India's equity market, money market, forex market and credit market all of whom came under pressure due to various factors. Corporates began turning to the domestic banking sector for their borrowing needs because external sources suddenly dried up due to the global liquidity squeeze. They also resorted to withdrawing their investments from local money market mutual funds, which caused abnormal redemption pressure over there. Thus were hit the credit and money markets. Further global deleveraging induced reversal of the capital flows, along with conversion of locally raised funds to meet overseas obligations by corporates caused the depreciation of the rupee. RBIís intervention to buy rupees in the forex market to stem the depreciation of the rupee further caused an inadvertent tightening of liquidity.

The Real Channel: The biggest factor here is the collapse of the exports due to a sudden slump in demand from places like the US, Europe and the Middle East (these together contribute towards 75% of Indiaís goods and services trade). Along with manufactured goods, exports of services like IT and ITES too have taken a hit due to its major user industries being in the doldrums. Thus, the damage to India's export oriented industries has caused some disruption in the real economy.

The Confidence Channel: The failure of Lehman Brothers around September 2008, followed by a string of other large banks threatening to go down under, caused a major crisis of confidence around the world, including India. The subsequent risk aversion intensified the effects of the already tight liquidity situation due to the cautious lending attitude it caused amongst Indian banks.

The above is how India, despite not being part of the core problem of derivatives and subprime related issues in developed countries, has been affected by the crisis to the extent that it has.


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