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Economy: When Reddy sees red

Aug 1, 2007

Much to the angst of bankers, retail borrowers and leveraged corporates, the Reserve Bank of India (RBI) in its first quarter review of the FY08 monetary policy yesterday, chose to use its oft-sought tool, the CRR (cash reserve ratio) to solve multiple macro economic problems that have surfaced in the last couple of months.No longer shielded from global implications
The Indian economy is no longer impervious to global macroeconomic adjustments. According to the projections released by the International Monetary Fund (IMF) in July 2007, growth in the world economy is likely to moderate to 5.2% in 2007 as also in 2008 from 5.5% in 2006. While global economic activity has remained resilient during 2007 so far, protectionist pressures, further rise in oil prices, persisting global imbalances, adjustment in the US on account of housing slowdown and potential shifts in financial market sentiment pose downward risks to global growth prospects. The higher interest rates are expected to tame the inflationary pressures on economic growth, albeit, notwithstanding some negative repercussions as well.

(%) GDP growth (YoY)Exports growth (YoY)
1HCY061HCY071HCY061HCY07
US3.7 1.9 14.2 10.8
UK2.4 3.0 3.4 6.4
Japan3.0 2.6 5.3 5.4
India9.6 9.1 13.0 12.6
China10.3 11.1 26.6 27.8
Brazil3.9 4.3 10.6 14.6
Source: RBI Macroeconomic review

Liquidity overhang

Foreign investment into India by way of FDI and ADR/GDR in addition to the external commercial borrowings (ECB) has been the prime reason for the liquidity overhang. Net ECB inflows rose from US$ 8.2 bn in FY06 to US$ 16.1 bn during FY07, reflecting sustained domestic investment and import demand besides hardening of domestic interest rates. Having said that, reserve money expanded by 29% YoY in 1QFY08 as compared with 17% in 1QFY07. Also, growth in broad money and domestic deposits of 22% and 23% YoY respectively were higher than that of 1QFY07 (19% and 20% respectively) and their projected rates.

Net capital inflows
(US$ bn)FY06FY07Change
FDI4.8 8.5 77.1%
FII9.9 3.2 -67.7%
ADR / GDR2.6 3.8 46.2%
ECBs*8.2 16.0 95.1%
NRI deposits2.8 3.9 39.3%
Short term credits1.7 3.3 94.1%
Source: RBI Macroeconomic review *Excluding IMD redemption

According to the RBI, a comparison of major reserve holding countries over the period 2000 to 2006 shows that current account surpluses accounted for 179% and 138% of accretion to reserves in Japan and Russia respectively, and 56% each in case of China and Korea. In contrast, in India, over the same period, accretion to foreign exchange reserves was almost entirely due to capital inflows.

Contagious delinquencies
Risk of the US subprime mortgage delinquencies surfacing above what seem apparent, looms large on financial markets worldwide. For the uninitiated, subprime mortgages are issued to people with poor credit histories and thus carry higher risk. It is estimated that US$ 50 bn to US$ 100 bn have been invested in the US subprime market. Suck out of excess liquidity is expected to further worsen the situation, as funds invested in the risky assets will get more expensive. Resultantly, a tighter liquidity situation is expected to force speculators unwind their positions in the risk-heavy assets and thus bring more sanity in the markets.

What is in it for investors?
The RBI's policy review clearly states that growth rates in tourist arrivals, revenue earning railway freight, new cell phone connections, export cargo handled by civil aviation, passengers handled by civil aviation, cement and steel demand have moderated. Given this, while the Finance Minister's claims of notching double digit GDP growth in FY08 seems unrealistic, the RBI's target of 8.5% sounds more feasible. In the central bank's own words, holding inflation within 5% in FY08 assumes priority in the policy hierarchy and thus you, as an investor, should keep yourself prepared and your investments resilient to such temporary (short-term) macro economic shocks.


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