Economy in eclipse

For most Indians, the global financial crisis has been more of a spectacle so far. They have seen and heard in amazement how several till recently high and mighty financial institutions of the western world have evaporated. They have seen how the US and Europe, the financial citadels of the global economy, have been grappling to keep their financial systems up and running. But the crisis hasn’t hit home in any significant way—notwithstanding scares and rumours about a bank or two. There have also not been any widespread job losses or income cuts specifically due to the financial crisis. That’s for two reasons: The Indian economy was already in a slowdown, the impact of which was being felt by consumers and producers alike.

First level impact Uncertainty, leading to risk aversion and shortage of funds Sharp decline in stock prices Further fall in business sentiments Erosion in investor wealth and company valuations Second level impact Loan-led demand to remain low as interest rates remain high Companies with highly leveraged balance sheets face shortage of investible funds Infrastructure companies may see projects' costs go up Private infrastructure projects could face a review Third level impact Income growth and job creation to slow GDP growth to get snipped

India is also one of the least globalised economies among the emerging markets, notwithstanding the all you hear of India’s rip roaring exports and successes in outsourcing.

Before the financial implosion began on Wall Street, the problem was more of managing the slowdown—cooling down the raging growth in credit to dampen the inflationary trend. Beginning September, the fall in commodity prices, most notably of crude, was expected to tame the double-digit inflation, just in time for the impact of a good monsoon to kick in. That would have meant an end to the cycle of interest rate hikes—good news for consumers and producers.

The eruption of the global financial crisis has suddenly stalled this possibility—at least for now. “It is, perhaps, the most intense upheaval in the global financial sector ever. And the linkages to India are quite complex and still unanticipated. Things will get much worse before they get better,” says Abheek Barua, Chief Economist, HDFC Bank.

The question now is how much will the financial crisis hurt the real economy and for how long? Will it prolong the slowdown and make it more painful?

The story in numbers
Let us check the latest available numbers from the real economy. In the first quarter of 2008-09, the economy expanded by 7.9 per cent, against 9.2 per cent in the corresponding period of 2007-08. The cumulative value of exports for the period April-August, 2008 was $81.23 billion (Rs 3,89,904 crore), up 35 per cent over the figure for the previous year. During the same time, imports clocked around 38 per cent growth to around $130 billion (Rs 6,24,000 crore) over the same period last year.

Despite the negative trend in portfolio investments, foreign direct investment during the April to August period was a healthy $14.8 billion (Rs 71,040 crore), higher than the figure for the corresponding period of last year.

The annual rate of inflation year-on-year remains in double digits though it seems to be easing somewhat over the past few weeks. “The underlying inflationary pressures on the economy are not there anymore,” says Ajit Ranade, Group Chief Economist, Aditya Birla Group. The latest growth figures for the Index of Industrial Production signal a setback. IIP grew just 1.3 per cent in August 2008, stoking fears of an industrial recession. But remember, IIP has been erratic for a while. However, personal income tax collections—a rough proxy for urban income growth—was up by 23.4 per cent between April and September 2008 over the same period of 2007.

No surprise then that India’s Finance Minister P. Chidambaram in one of his initial comments on crisis said: “There is a storm blowing across the world. India will be affected to some extent, although indirectly, but Indian business and industry have placed India in a situation where we can weather the storm.”

So, what is the scare for? To be sure, investor sentiment had been sagging for quite some time due to high inflation and interest rates. The Dun & Bradstreet Composite Business Optimism Index for October-December recorded a decrease of 28.1 per cent over last year.

The global crisis, of course, injected a huge dose of uncertainty and scarcity of funds. Even the most cashrich have turned risk-averse. “Credit spreads for blue chip companies (AAA and AA+ rated) have widened from 30-350 basis points a few months ago to over 600 basis points over government securities. This is unprecedented,” says the treasury head of an Indian bank.

The paralysing impact on the short-term financial management strategy is evident. In the coming months, the impact will percolate down to the real economy. Economist Bibek Debroy estimates that the crisis “will shave off 0.5 per cent of the GDP growth in India”.

The first impact is on portfolio investors, who pulled out nearly $10 billion (Rs 48,000 crore) last fortnight. This trend is expected to intensify. Former investment bank-now-turned commercial bank, Morgan Stanley forecasts that slowing global growth will reduce capital flows to emerging markets to between $400 billion (Rs 1,92,0000 crore) and $450 billion (Rs 2,16,0000 crore) from $750 billion (Rs 3,60,0000 crore) in 2007-08.

Heightened risk perceptions and greater uncertainty will hit investments sharply. “The next 5-6 months are going to be difficult,” says HDFC Bank’s Barua. “Beyond the obvious and visible strains such as on IT revenues, there will be serious funding problems for investment expenditures across sectors,” he says.

Companies are expected to scale back plans to spend on growth and expansion. Subir Gokarn, Chief Economist, Standard & Poor’s Asia-Pacific, says: “New projects, which have not attained financial closure, will get the short shrift.”

“Funding will be very difficult to come by in the next year to year-and-a-half,” says Arvind Parakh, CFO, Jindal Stainless. The company has already put on hold a $300-500 million (Rs 1,440-2,400 crore) expansion at its plant in Orissa.

Infrastructure spending, the big bulwark for the economy, is expected to be hit in projects with larger share of private and foreign funds. Typically, the public sector undertakes 80 per cent of the infrastructure spends. Vinayak Chatterjee, Chairman of Feedback Ventures, believes that the gross capital formation of infrastructure in the terminal year of the 11th Five Year Plan (2007-2012) will drop from the expected 9 per cent of GDP to 7-7.5 per cent of GDP.

The decline in fund flows through external commercial borrowings (ECBs) or the rising cost of raising such funds will also hurt a lot. “High interest rates will make private infrastructure projects less profitable, and we are likely to see less aggressive bidding in PPPs. For infrastructure assets depending on traffic and demand, such as airports, ports and highways, revenues may be less than expected. Demand destruction will also happen for such traffic,” says Shailesh Pathak, Senior Director, Investments, with private equity firm ICICI Venture.

Real estate, another sector that was banking on foreign flows through the private equity route, will face a tighter funds crunch as many companies had built aggressive land banks at high prices.

Don’t forget the good news Click here to Enlarge Amidst the current gloom, it’s easy not to count Indian economy’s blessings. And they are more than one. Another season of good monsoon has just ended. Imagine reeling under the impact of a drought when global crisis broke out? Adequate rainfalls ensure enough food, stable food prices and a robust rural demand. Price of crude oil, and a whole host of other commodities, are on a definitive decline. A big relief to the RBI who could release liquidity without worrying as much about inflationary flare-up as it would have if crude price was still flaring. Then, there is the seemingly unstoppable inflow of foreign direct investment (FDI) into the country, unmindful of the FII outflow that has been on through most of 2008. There are traditional economic strengths to be counted—one of the highest household savings rates (higher than even China’s) and a relatively more domestic demanddriven economy. All these good tidings are not just to be rejoiced, but to be leveraged in a way so that India comes out of the crises as a stronger and better reformed economy.

Companies with large leverage on the balance sheet will face a bigger crunch. Several Indian companies, though, do have large cash reserves. But how much of this cushion was spent in the last couple of quarters under margin pressure will show up in the second quarter results.

In battle mode A few suggestions by the industry and policy watchers for policy reforms. Cut in interest rates—in repo and re verse repo rates—in addition to liquidity infusing measures such as a cut in cash reserve requirements Unwinding of market stabilisation bonds as liquidity becomes an issue Infrastructure should be included in priority sector lending with targeted subsidies or maybe even a separate interest rate regime Select infrastructure projects should be backed by sovereign guarantees Rationalisation of the combined tax level in India, which is between 28 per cent and 35 per cent

The prospects for consumer demand—the driving force for the economy—don’t look too bright, especially if job creation and income growth begin to slacken. That could lead to gloomy forecasts for job and income growth, though a more definitive picture on this count will emerge only after one more quarter.

It’s not that there are no silver linings in the dark clouds. Despite the uncertain investor sentiment, Mumbai Metro raised Rs 1,194 crore as debt from six domestic banks and IIFCL in early October. For some companies, this crisis also presents opportunities.

Tata Consultancy Services bought Citibank’s outsourcing company in India for $505 million (Rs 2,424 crore) in cash. In the process, it also managed to snag a nine-year servicing contract from the US bank. Inflation, the economy’s enemy for a few months, is almost certain to fall now that commodity prices have plummeted and demand, too, has slowed down.

No matter what the scale of damage from the global financial crisis, India is expected to weather it much better than the developed world. As Economic Advisor to the Finance Minister Shubhashis Gangopadhyay says: “It is a huge opportunity for us if we play it right.” Playing it right, according to him means having “investor-friendly policies” in place. “Our own fundamentals are strong. We are not as dependent on the world as other emerging countries.”

While that is a convenient situation to be in right now, much will depend on the policy stance adopted over the coming months. While the government frittered away the opportunity to undertake unpopular reforms during good times, maybe this crisis will drive some reforms in the coming months. Don’t forget, India’s economic destiny changed from a crisis in 1991. Not being a part of the crisis should not prevent us from using it as an opportunity.