The Sub Prime Crisis and What it Means for India

The sub prime mortgage crisis and its potential impact on US economic
growth has raised concerns whether growth in India – which averaged
over 9% in the last three years – will be adversely affected. The Indian
economy showed signs of overheating in mid-2007, with inflation rising
above 6%. Although the central bank has pursued a tight monetary policy,
inflation has recently risen above 7%. Buoyant capital flows posed challenges
for liquidity and macroeconomic management, and the Reserve Bank of
India responded effectively by adopting a mix of policy measures including
imposing capital controls, allowing the rupee to appreciate, and liberalizing
outflows of capital.

India is running a current account deficit (CAD) which is likely to
increase to 2.6% of GDP in 2009 from the 1.5% in 2008, driven largely
by the sharp increase in international prices of oil and food commodities.
So far India’s CAD has been comfortably financed through capital inflows
and FDI. In this scenario, the question whether a global credit crunch
and significant slowdown in the US economy could undermine India’s growth
prospects, becomes pertinent.

The main channels through which a global credit crunch and a recession
in the US can affect India are: (i) a decline in capital inflows and
lower corporate access to credit in international markets; (ii) slowdown
in exports of goods and services from India to the US; and (iii) remittances.
The impact on Indian growth through the first two of these channels
is likely to be negative though the structure of India’s trade could
mitigate the impact through trade (explained later).

The bulk of India’s remittances come from the Gulf and are therefore
unlikely to be impacted, significantly. Compensating effects from increasing
government expenditure, budget boosts for consumption, infrastructure
and investment spending may still keep the aggregate demand side of
the story intact, though there are signs even here of credit growth
and investment spending slowing down.

Capital inflows/Access to credit: India has never raised a sovereign
bond in global capital markets, so any effect of a credit shortfall
will be on the ability of Indian corporates to access overseas capital
and through capital inflows. India received $99 billion (approximately
10% of GDP) in net foreign exchange flows in 2007-08 including net FDI
($11 billion), portfolio flows ($41 billion), ECBs and overseas borrowings
by Indian corporates ($33 billion), banking capital ($7.5 billion).

As the sub prime crisis unfolds, counterparty risk aversion has become
acute and has led to financial institutions building up significant
liquid assets as precautionary measures, sometimes equivalent to 20-25%
of their balance sheets. This has resulted in banks cutting lending
and shifting out of exposures to corporates, a reversal of portfolio
flows away from emerging markets (including India), and widening spreads
on emerging market paper (including Indian paper). These developments
will slow down capital inflows into India, with estimates for 2008-09
ranging between $40 and $50 billion. The recent drop in the Indian equity
markets, also a reflection of the global rise in risk aversion and reduction
in liquidity, will have a negative impact on investment and consumption.

According to market estimates reported by the BIS, outstanding asset-backed
commercial paper reached $1.5 trillion in March 2007, of which $300
billion was based on mortgage-backed assets. So far, the total of all
write-downs and credit loss for major banks and brokerages is approximately
$200 billion but far more is expected as other asset classes (such as
Liquidity Puts, Credit Default Swaps and Leveraged Loans) get impaired.

The total global write-downs are expected to be around $1 trillion
(IMF estimates) of which the banks have so far written down around $200
billion. The prospect of further losses and the need for greater reserve
provisioning suggests that the supply of new credit is likely to become
increasingly restricted – with tighter credit standards, and higher
spreads. Tight market liquidity has been further exacerbated by fears
of a US recession.

Issuance by Indian companies had increased rapidly in recent years
(albeit from a small base) driven by robust domestic economic growth
and the need to fund rapid overseas expansions by corporate India. Indian
companies were active in the foreign debt markets (both primary and
syndications) for financing overseas expenditures denominated in foreign
currency, mergers and acquisitions, and the overseas needs of their
clients (banks/financial institutions). However, given the tight liquidity
in the foreign debt market and loss of risk appetite on the part of
banks, it is becoming increasingly difficult for Indian corporates and
banks to raise foreign loans. Pricing for foreign borrowing by even
top-tier Indian borrowers (e.g., Tata Motors, Reliance, ICICI, Exim)
has increased significantly since the beginning of January 2008.

Very little foreign borrowing by Indian companies has been done in
the last few months because of ECB restrictions (the interest rate cap
in some cases is lower than the applicable market spread), other than
offshore M&A transactions. A prolonged period of inability to access
international bond markets for private Indian companies, coupled with
increasing spreads in the domestic market is likely to lower investment
and growth.

The big question that arises is how a major correction in the international
capital markets, the "flight to quality," and lower risk appetite
of financial institutions and international institutional investors
will impact India’s ability to finance its large infrastructure needs.
Given that credit growth has not been responsive to liquidity injecting
measures by central banks (the Fed has cut rates by 225 bps since January
22 2008), it would be reasonable to assume that the supply of long-term
financing for infrastructure projects world-wide will reduce over the
next 12-24 months, while spreads will increase. The need, therefore,
for developing the local long-term debt market has assumed even higher
urgency.

Trade: On the trade front, the impact of a slowdown in US economic
growth is likely to be less significant because of the structure of
India’s trade and the declining importance of the US as a trading partner.
A possible favorable consequence of lower US demand for commodities
such as oil and food grains could be a lowering of their prices, which
have been surging lately (India is a net importer of these commodities).
The downside will come from a decline in demand for Indian exports,
mainly IT (the US accounts for nearly 65% of the revenues of IT vendors)
and BPO services. However, the bigger picture shows that India’s overall
exposure to the US market is limited and declining. However, the impact
of the US slowdown could be felt through Europe, which is also likely
to slowdown.

In sum, the expected impact of a global credit crunch and slowdown
in the US economy on India appears to be relatively small through the
trade channel, as exports are diversified; the financial channel effects
are likely to be more significant through a reduction in capital inflows
– in the event that lower global interest rates do not lead to more
credit becoming available and banks continue to pull back lending (to
counter illiquidity) and shift out of exposures to corporates – globally
and in India – to safer assets.