MacroScan (Printable Version) - The Global Recession and India*

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.

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.

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.

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.



Themes > Features	29.08.2011


The Global Recession and India*

C.P. Chandrasekhar and Jayati Ghosh

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. 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. 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. 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.



© MACROSCAN 2011