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The US-Sensitivity test

Sep 3, 2007

That the Earth is spherical can be gauged by the behaviour of the world's stock markets when the going gets rough! The Indian stock markets take their opening cues from the other Asian markets that open even as most Indians snooze. And these early traders follow the lead of the overnight movements (in India) on the Dow! And that the United States of America is the 'Big Brother' in the world of fast-integrating finance and geo-politics is undisputed; despite the current weakness of the US dollar, it still is the currency of choice to hold and trade in international assets. If President Bush agrees to give India civil nuclear technology despite India not signing the Non Proliferation Treaty, then close US allies like Japan and Australia are ready to hold joint defense exercises in the Indian Ocean. Australia is willing to consider uranium exports to India for making the cleanest form of power and Japan is happy to form a 'democracy-nexus' in Asia with India. The US impact on India is as much a function of perceptions as of actual inflows or outflows of US dollars. In fact the latter depends a lot on the former. Capital inflows from the US into Indian stock markets and Indian companies in the form of loans and or equity are the most visible form of dependence that affects sentiment in India today.

The changes in the Fed rate affect the movement of capital within the US and as India too is in the queue, the inflows into India get impacted. The bailing out by Mr. Bernanke by lowering the Fed discount rate by 50 basis points some ten days ago contrary to all economic prudence, will make higher yields abroad more tempting. This can potentially trigger a move of capital out of the US if the downtrend in interest rates continues in the Fed's September meet. Last week Friday, Mr. Bernanke announced that the Fed will undertake any action that 'will be needed to 'ease' the impact of the recent market turmoil on the economy'. Thanks to the word 'ease' used, one can be forgiven for believing that he means further rate cuts happening in the near future. At the same time, as domestic liquidity concerns within the US diminish, the US equity markets will probably also do well.

On the merchandise front, at 15% or US$ 19 bn, the US is the principal destination of India's exports. Also almost 65% to 70% of India's service exports that comprise of software and outsourcing are to the US. That is another US$ 44 bn; together adding up to almost 6% to 7% of India's GDP. The gauge of dollar flows in and out of the country, i.e., the exchange rate, will reflect the changed scenarios in its movement. Just before the sub-prime issue grabbed international headlines, most forecasters were gung ho about the Rupee touching Rs 38-Rs 39 levels for one US dollar. We, at Equitymaster, were among the few who felt a current account deficit of 2% of GDP does not warrant a strong currency. If the financial blunders of the US markets do affect its real economy adversely, these dollar earnings of Indian companies will be trimmed down to some extent. This in turn will further reduce the inflows of US dollars. Taken along with the capital curbs recently put in place by the Reserve Bank of India (RBI), this will probably prove our estimate of Rs 44 per US$ by March 2008 right.

Thus the world's largest democracy is slowly turning from an insular economy to one that is now joining the ranks of those that get affected by the smallest change in the world's richest democracy.

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