August 08, 2008
While India is not as dependent on external markets as several other developing countries, notably China, this cannot but have a dampening effect on export growth as the US accounts for 15 per cent of India’s merchandise exports (compared to 20 per cent in the case of both Brazil and China), while western Europe accounts for another 23 per cent. The dependence on OECD, and particularly on the US market, and on services exports, through which India mostly plugs its yawning merchandise trade deficit, is even greater. Of India’s trade deficit of $90 billion in 2007-08, 40 per cent was covered by IT-related invisible exports to the US and Europe. While the falling rupee could make non-import intensive Indian merchandise exports more competitive, since banking, financial services and insurance (BFSI) are at the centre of the credit storm in western markets, there is likely to be shrinkage in both job opportunities and export revenues in what is the largest outsourcing vertical of India’s IT sector.
The combination of current account and inflationary pressures has put the Indian rupee under pressure since capital flows other than FDI are drying up as a consequence of the credit freeze and repricing of risk in western capital markets. There was a net outflow of $3.7 billion of FII from India during April-August 2008. The reduction in capital flows may have made monetary management easier, but the reduction is so sharp that the rupee is coming under heavy pressure, having dipped below Rs 46 to the dollar, even as RBI’s foreign exchange reserves have fallen by $20 billion between March 31 and September 5, 2008. The reversal in FII flows has sharply reduced market capitalization on account of the stock market’s dependence on FII flows. Although the current account deficit is eminently fundable in view of the large stock of foreign currency reserves, rupee depreciation at this point will only feed inflationary pressures. Fiscal pressures have moreover led international credit agencies to consider downgrading India’s credit rating from investment to speculative grade. Should this occur, the rupee would come under even greater pressure through re-balancing of currency portfolios.
Savings and investment, widely credited for the rise in trend growth over the last few years, are both likely to be adversely affected. The Economic Advisory Council to the PM estimated in July 2008 that the commodity terms of trade shock could administer an additional fiscal shock of up to 4.5 per cent, thereby sharply lowering savings. Although oil prices have fallen sharply since this estimate was made, this would undo only some of the damage especially in view of the depreciating rupee.
While the domestic savings investment gap over the last few years was modest, ranging from 1 to 1.5 per cent of the GDP, Indian companies and public sector enterprises had become increasingly dependent on cheap overseas finance for investment, possibly as a result of monetary tightening at home and rupee appreciation. External commercial borrowings as a percentage of gross capital formation of the corporate and public sectors rose sharply from 3.2 per cent in 2005-06 to 12 per cent in 2006-07 and is likely to be even higher in 2007-08. The dependence on foreign investment, net of portfolio flows, likewise rose from 2.8 per cent to 6.4 per cent. While foreign direct investment is unlikely to be immediately impacted by the credit crisis, the expected sharp increase in the cost and access to external credit could drive both investment and growth below trend.
(Source: Business Standard)