The lowering of the US' sovereign rating to AA+ from AAA on August 5, was a jolt to the standing of the economic superpower. The ratings downgrade evoked extreme reactions from some sections of the media on the possible consequences for India.
Some feel the downgrade will lead to a post-Lehman like situation. Such a comparison may not be appropriate. The bankruptcy of Lehman brothers in September 2008 was a tangible event, whereas the downgrade is an opinion on the US economy's capability to reduce its debt. The political squabble amidst the slowing pace of recovery in US has made debt consolidation difficult and triggered the downgrade. Besides, it should be kept in mind that rating agencies were assigning the best of ratings to companies till the time they went bust.
Unlike the deterioration in the case of US, the debt situation in India has improved in the last few years and stands at 65 per cent of GDP in 2010-11. India has also been among the few nations which suffered little output loss after the global financial crisis of 2008.
MARKET RESPONSE
Except for the equity and forex markets, the condition in the money market has remained stable, and some softening was observed in the g-sec yields. The benchmark Sensex fell by almost 450 points and the rupee depreciated by 48 paise in two trading sessions following the downgrade.
The movements in the Sensex and the forex market have been guided by FII flows. The net FII selling was close to $280 million on August 7. The yields on benchmark 10-year g-sec have softened from 8.31 per cent on August 5 to 8.23 per cent on August 8. The slide in the Sensex has not only been guided by the developments in US, but also the uncertainty about the quantum of bail-out needed for the weaker Euro area members and the ability of ECB to fund these bailouts.
The RBI's move to calm the markets by assuring adequate rupee and forex liquidity helped smoothen out the situation. As has been pointed out in the editorial in this paper, markets may respond to sentiment in the immediate term but it is fundamentals that eventually govern investor confidence and flow of resources in the medium term.
TRADE AND GROWTH
The Indian economy is affected by global events through three channels — trade, finance and the confidence channel. As things stand, growth in US and Europe will be below the trend growth rate in the rest of 2011. Indian exports in the first six months have been quite resilient. This has been possible on account of the change in the composition and the direction of India's trade. The US and EU which used to account for 46 per cent of India's exports in 1995, accounted for 32 per cent of exports in 2009.
Notwithstanding the lower dependence on the US and the EU, exports will be affected to some extent because of a deceleration in global trade growth. As per WTO estimates, the global trade volume is set to grow by 6.5 per cent in 2011, compared with 14.5 per cent in 2010.
As far as the finance channel is considered, India has seen robust FDI flows in the first half of 2011, though FII flows have been rather weak. As growth prospects in India remain much better than in the developed world, one can expect capital to flow to India in search of better returns.
The confidence channel plays through the uncertainties created after an event. It is a matter of time before the risk-return trade-off will prompt a flow of resources to economies having higher growth potential. During the previous global recession, the Indian economy posted a respectable growth of 6.9 per cent in 2008-09. This was possible because growth is fuelled by strong domestic demand. The forces driving domestic demand remain intact in 2011-12. In fact, the central bank has been trying hard to contain domestic demand for quite some time by raising interest rates 11 times in the past 18 months.
COMMODITY PRICES
Muted growth in the developed world is likely to have two major implications. First, export growth might weaken and, second, pressure on commodity prices might ease.
Brent Crude had fallen to $99.68 on August 8, down from a peak of above $127 in April 2011. On the one hand, if commodity prices soften further or are maintained around the present levels because of growth deceleration in advanced economies, a potential source of inflation in the Indian context might ease.
This would ease the pressure on RBI to raise rates further to control the demand side of inflation. On the other, weak export growth will have a dampening effect on overall GDP growth. Thus, we could have a combination of lower growth and moderate inflation by the end of 2011-12.
(The author is Chief Economist, Bank of India. The views are personal.)