• SEPTEMBER 14, 2007

Will India catch a cold if the US sneezes?

After five years of above-average growth, the global economy has lately been facing significant downside risks. The extent of the fallout from deepening troubles in the credit markets remains unknown, despite the coordinated effort of central banks to bring an end to the turmoil and normalise credit conditions. Consequently, economists now expect higher uncertainty and tighter financial conditions to slow the pace of global growth in the remainder of this fiscal. The all-time- high crude oil prices (near US$ 80 per barrel) may further accelerate the process. Infact, a more pronounced correction in the US economy is likely to have a repercussion on the rest of the world. Albeit the fact that the global economy has come to stand on stronger structural pillars, the growth trajectory is still highly dependent on the US economy.

How is India poised?
India's exposure to the global trade cycle is one of the lowest in the Asian region and therefore the impact of slower foreign trade is likely to be one of the lowest. The export to GDP ratio was relatively low at 21.8% in 2006 compared to the average of 60.1% for the rest of Asia excluding Japan. While the US slowdown will add to the pressure of the overall growth slowdown underway in India, given that elections are due in the coming fiscal, India's policymakers will keep a close watch on the inflation risks. While the Reserve Bank of India's (RBI) restrictive monetary policy will offer limited support in the initial phase of the slowdown, if the government continues to comply with the fiscal deficit targets (specified in the Fiscal Responsibility and Budget Management Act), there will be limited scope to pursue an expansionary fiscal policy. In terms of trade linkages in the Asian region, the impact of a slowdown in the US will be more severe for economies like Singapore and Malaysia, for which, the US still remains the key export destination accounting for about 10% to 20% of the export share.

The soft spots...
Delinquency levels of banks: Monetary tightening in the last 12 months has lifted banks' lending rates significantly. Despite the recent 0.5% cut in the mortgage-lending rates, they continue to rein nearly 4% above the bottom (close to 2001 levels). Similarly, the steep interest rates on personal loans and credit cards have begun to erode the asset quality of banks. The NPA levels of Indian banks have risen by 0.5% to 1% in the past 6 months. Any unexpected aftershock of the global credit turmoil can only worsen the situation.

Outsourced businesses: Even as goods export growth may suffer, the export of services does not seem likely to be materially impacted. Despite the economic slowdown, outsourcing to cheaper destinations is likely to continue. Moreover, the share of outsourcing in overall revenues of the IT industry stands at merely 1%. However, in the medium term, the low IT spending budgets of the global heavyweights, especially the ones in the mortgage lending and BFS (banking and financial services) businesses, may have a detrimental impact.

Capital inflows: Over the last 3 to 4 years, India's growth acceleration has benefited more from the globalisation of capital markets than from the globalisation of trade. The higher risk-appetite of global investors, thanks to the prevalence of relatively higher interest rates in the emerging markets and strong credit-driven industrial growth, has led to the heavy liquidity generated from global capital inflows. In this context, we believe that another key concern for India's growth outlook will be a potential turbulence in US financial markets and its impact on capital inflows into India in the medium term.

Without disregarding the fact that even a softer landing of the US economy implies a high probability of the economic slowdown spilling over into Asian and Indian financial markets, we do not envisage the same to potentially derail the domestic growth momentum. While the high base effect of the last two years, be it in terms of GDP growth, credit growth or consumption growth is destined to pass through the cyclical trough, a smoother and quick recovery is certain. The long-term story therefore remains intact!

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