For the global economy, August 2011 was a particularly
bad month. A string of economic indicators released
early that month suggested that close to four years
after the onset of the global recession in December
2007 a sluggish world economy was set to sink again.
Sentiment too was at an exceptional low. Though completely
out of line and even irresponsible, the first-in-history
downgrade of US Treasury bonds by Standard and Poor's
did reflect the mood in the market. Though the assessment
was based on wrong numbers, the fact that the debt
of world's most powerful country that was home to
its reserve currency was even considered to be of
suspect quality was telling.
Besides the never-ending crisis in Europe, one factor
explaining this despondency was the fear of a second
recession within half a decade. The news from almost
all sources was disconcerting. Recovery from the recession
was still sluggish in the U.S., Japan, that had been
experiencing long-term stagnation, had been devastated
by a wholly unexpected exogenous shock. And, France
had announced that it had experienced virtually no
growth in that quarter. But the real dampener was
the release of evidence that the strongest economy
in the rich nation's club-Germany-was losing all momentum,
registering a growth rate of just 0.1 per cent in
the second quarter. The real economy crisis had penetrated
Europe's core, pointing to the possibility of a return
to recession in the Eurozone as a whole (which registered
0.2 per cent growth).
For an India that is now more integrated with the
world economy this has to be bad news. But if the
Government of India is to be believed, the Indian
economy is not likely to be very adversely affected
by the current round of global volatility. Finance
Ministry sources argue that the Indian economic growth
story is so robust that the current uncertainty will
cause no more than a minor blip in its confident trajectory.
Consider, for example, the Indian government's response
to the market collapse that followed the US debt standoff
and subsequent Standard and Poor's downgrade. While
acknowledging that India would be impacted, the effort
was to play down the likely intensity of that impact.
''Our institutions are strong and [we] are prepared
to address any concern that may arise on account of
the present situation,'' Finance Minister Pranab Mukherjee
reportedly stated. He also promised that the government
''will fast track the implementation of the pending
reforms and keep a close eye on international developments.''
That response misses the point. The problem is not
that India is not adequately reformed, but that past
reforms have resulted in its greater integration through
flows of goods, services and finance with the global
economy.
Chart
1 >> Click
to Enlarge
One
obvious and important consequence of the global downturn
is bound to be a fall in exports revenues. As Chart
1 shows, the European Union accounts for 20.2 per
cent of India's merchandise exports and the US for
another 10.9 per cent. Thus, markets accounting for
close to a third of India's exports are already stagnating
or in recession. Only two regions can, hypothetically,
counter this tendency: Developing Asia (excluding
China) and the OPEC countries. The former accounts
for a sizable 23.4 per cent of India's exports and
the latter for another 21.1 per cent. However, most
of developing Asia would be adversely affected by
the OECD downturn to a greater extent than India.
And unless geopolitical developments intervene, a
global recession would moderate oil prices and dampen
import demand from the OPEC bloc. Finally, the hope
that China would be a balancing force is of less relevance
to India since it accounts for just 6.5 per cent of
the latter's exports. Overall, India is likely to
take a hit in terms of its exports of goods, which
has been a source of buoyancy recently.
The other significant source of demand and revenue
that is likely to be adversely impacted is services.
As per Balance of Payments data, gross revenues from
the exports of software services amounted in 2010-11
to as much as 24 per cent of the gross revenues from
merchandise exports. In 2009-10, the US alone accounted
for 61 per cent of India's total software exports.
European countries (including the UK) followed with
as much as 26.5 per cent. If these two regions are
the first to be hit by the recession, it is unlikely
that software export revenues would remain unscathed.
Over the period 2004-05 to 2009-10, services accounted
for 66 per cent of the increment in India's GDP. And
revenues from software services amounted to 9.4 per
cent of the GDP from services (excluding public administration
and defence). The deceleration or decline in software
export revenues is bound to affect GDP growth adversely.
Besides export volumes and revenues, the other reason
why India is likely to be adversely affected by global
uncertainty is exposure to global finance. Direct
exposure to international financial assets, including
the now less valuable debt issued by OECD governments,
is only a small part of the problem. As the distribution
of India's gross international asset position (Chart
2) indicates, the two important forms those assets
take is direct investment and accumulated reserve
assets. Portfolio and other forms of investment are
small or negligible. Since private players largely
hold direct investment assets, the squeeze in global
demand would affect the overseas revenues of these
firms, but possibly not do too much damage to the
Indian economy.
Chart
2 >>
Click
to Enlarge
What is more of an issue is the fate of the $274 billion
of foreign currency assets (out of a total of $305
billion of reserve assets) held by India. While $127
billion of these are held as deposits with central
banks, the Bank of International Settlements (BIS)
and the IMF, as much as $142.1 billion is invested
in securities, consisting largely of government securities
(Chart 3). With the uncertainty surrounding the value
and soundness of public debt, the danger of the erosion
of the value of those assets is now significant. For
example, India holds $41 billion of US Treasury securities
that have been downgraded recently by S&P. The
balance is likely to be in the even more suspect public
debt of European governments.
Chart
3 >>
Click
to Enlarge
In addition to this, banks in India reporting to the
BIS have disclosed holdings amounting to $31.3 billion
in financial assets abroad. Of these, $14.9 billion
are the external positions of banks in foreign currencies
vis-à-vis the non-bank sector abroad. These
exposures too are vulnerable given the volatility
in financial markets in the OECD countries.
While the sums involved may be small (relative to
the $1.2 trillion held by China in US Treasury bonds,
for example) they are of significance because of the
nature of India's reserves. Unlike in the case of
China, the reserves that insure India against adverse
global responses are not earned through current account
surpluses, but are drawn from what foreign investors
have delivered in the past. They represent liabilities
that are being held as assets that on average yielded
returns as low as 2.09 per cent over the year ended
June 201 (down from 4.16 during 2008-09). If the value
of those assets is eroded, other things constant,
India's ability to cover its liabilities is eroded
as well.
Besides this there is the fact that because of the
presence of legacy capital in the country (consisting,
as of March 2011, of $204 billion of direct investment,
$174 billion of portfolio investment and $265 billion
of debt and other investments) India is vulnerable
to global investor sentiment. International finance
may assess its so-called fundamentals very differently
from the way they are assessed by the government.
Consider the issue that now captures financial market
attention: public debt. The experience in Greece,
Spain, Portugal and elsewhere suggests that finance
capital is increasingly ''intolerant'' of what is perceived
as excessive public debt. Though India's gross public
debt to GDP ratio declined from 75.8 per cent to 66.2
per cent between 2007 and 2011, it still is among
the highest in the region. India's 66.2 per cent level
compares with Malaysia's 55.1, Pakistan's 54.1, Philippines'
47, Thailand's 43.7, Indonesia's 25.4 and China's
16.5 (Eswar Prasad calculations quoted in ''Comparing
the burden of public debt'', interactive graphic on
the Financial Times website).
It is no doubt true that a number of factors make
Indian public debt less of a problem than in many
other contexts. To start with, much of public debt
in India is denominated in Indian rupees and is owed
to resident agents and therefore is unlikely to be
adversely affected by uncertainty in international
debt and currency markets. Secondly, within the country
public debt is largely held by the banking system
dominated by public sector banks. They are subject
to government influence and are unlikely to respond
to developments in ways that make bond prices and
yields extremely volatile. Given these circumstances,
public debt is not a potential trigger for a crisis
and in any case should not worry private financial
interests.
But if a wrong downgrade can make a difference to
US markets and interest rates, so can it for India's.
It is in that background that we should view reports
of S&P's statement that fiscal capacities in Asian
emerging markets, including India, have shrunk relative
to 2008. This, it has argued, would mean that in the
event of a second global slowdown: ''The implications
for sovereign creditworthiness in Asia-Pacific would
likely be more negative than previously experienced,
and a larger number of negative ratings actions would
follow.''
If, for its own reasons, S&P needs a target to
declare that some governments in the Asia-Pacific
are excessively indebted, then India is in the firing
line. India has been a favoured target of foreign
finance. And if it does not satisfy the latter's requirements,
it can fall out of favour. Clearly, a fiscal surplus
and a low public debt to GDP ratio are part of those
requirements even if for the wrong reasons. India
has neither.
*
This article was originally published in Business
Line on August 23, 2011.
