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Economy: 'Managing' currency risks - Views on News from Equitymaster
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  • Oct 11, 2007

    Economy: 'Managing' currency risks

    "Emerging markets are now driving world growth, a turnaround in recent decades. World growth remains strong despite weakness in the US economy - especially because of healthy domestic demand conditions in the emerging markets and export strength to non-US markets."

    "The fact that the US slowdown is concentrated in housing, which has relatively lower import content helps." These words of Mr. David Wyss, Chief Economist at Standard and Poor's point towards a buoyant future for the Indian economy. However, some key observations that were made by the global ratings major in the mid-year review of the global economy highlight some important aspects that need to be looked into. Following are some of the key excerpts from the S&P meet.

    Global economic outlook
    S&P estimates the growth of the US economy to slow down to 2% in FY08 and FY09 from the 3% growth witnessed earlier and expects the world economy to grow at 4.9% in 2007 (5.4% in 2006). The agency estimates the magnitude of subprime losses to be around US$ 100 to 150 bn and attributes the same to an inefficient risk pricing that led to the credit spread between the US Treasury and US Junk Bond move to a historical low of 2.6% in May 2007. The same corrected to a more normalised 4.5% in October 2007. The subprime crisis also erupted with the re-pricing of the floating rate loans that made the mortgage more expensive than the value of the property and instigated a sharp sell-off of houses taken on mortgage. S&P expects the risk of subprime lending to linger for the next two years going forward.

    Importance of emerging markets
    Although economies are even more tightly linked by trade and financial flows than in the past, the US is no longer the only driver for growth in these economies. Last year, China accounted for 30% of the increase in world GDP on a purchasing power parity (PPP) basis compared with only 12% for the US. This year, the slower US growth will reduce its share to only 9%, while China's share will rise to 33% and India's to 12% (from 11% last year).

    S&P also highlighted that foreign capital to the tune of US$ 600 bn is expected to flow in from the OPEC to the emerging markets. This will ensure consistency in the FII inflows. However, the cause of worry here is that majority of these funds hitherto have been portfolio funds as against FDI inflows.

    To put things in perspective, as per the Securities and Exchange Board of India (SEBI), during the 12 months ended September 2007, portfolio equity inflows (cash market plus derivatives) rose to US$ 22 bn. During the quarter ended September 2007, portfolio equity inflows alone were US$ 11.3 bn. In other words, FDI accounted for only about 12% to 14% of the total capital inflows during this period.

    How is the rupee appreciation different this time?
    S&P favoured a managed pace of appreciation of the Indian rupee to provide enough time for the economy and the exporters to adjust with the evolving environment. There was a sharp appreciation (about 10%) in the Indian rupee against the dollar in three months and there was very little opportunity for adjustments. China has used a route of managed pace in the appreciation of the Yuan. India could consider the strategy on these lines to deal with the rupee appreciation.

    There are three key issues weighing on the RBI's relatively cautious approach to monetary policy. First, while both core and headline inflation are within the Reserve Bank of India's (RBI) comfort zone of 5%, the recent rise in the oil prices and the foodstuff index has raised concerns. Food price pressure has lifted the consumer price index to 7.3% in August from a trough of 5.7% in June. Secondly, the risk of a reversal in capital inflows due to risk aversion to recent problems in the credit markets in the US and Europe. And finally, the Central Bank's hesitation in allowing faster rupee appreciation. Allowing faster appreciation of the exchange rate would help maintain the effectiveness of monetary policy. However, with the RBI having already allowed the rupee to strengthen sharply over the past 12 months (the currency has appreciated by 13% against the US dollar during this period), a regulated policy move in this regard seems pertinent.



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