Growth story in volatile times

Indian Express, 9 March 2007

The recent turmoil in international financial markets could be a harbinger of bad news for India. The coming year may see even greater volatility in global markets and in these uncertain times, the Indian growth story may get less support from global trade and finance. Economic reform will need to be strengthened and tendences to revert to inward-looking policies, resisited.

In recent weeks, global financial markets have moved sharply. Some feel that a 9% drop in stock prices in China on one day triggered off these global reverberations. China has only 5% of the world's GDP, and the institutional structures of Chinese firms and the Chinese stock market are deeply flawed. A more likely explanation centres on the US.

The roots of recent events go back to the 9/11 attacks, which plunged the US and the world economy into a recession. The immediate response to the 9/11 recession were countercyclical policies both on the monetary and the fiscal front. The recession was vigorously counteracted by the US Federal Reserve, which cut the short-term interest rate sharply. At the same time, the recession was counteracted by the US Treasury through the public expenditures incurred for waging two wars and through a cut in tax rates. These three factors - interest rates, tax cuts and wars - pulled the US economy, and with it the world economy, out of a recession. From 2002 onwards, the world economy has been faring unprecedentedly well. This supportive external environment constitutes one important explanation of the good times seen in India in this period.

Consumer demand in the US was propped up in this period by a great expansion in home construction and house prices. US consumers became good at going to banks, taking loans with their homes as collateral and at very low interest rates, and using this money to enjoy a vacation or buy consumer durables. The large scale of expenditures on construction and renovation, coupled with consumption based on loans-against-homes, propped up the US and the world economy. Households spent more than they earned. In 2006, savings as a proportion of personal disposable income was negative at -1 percent. This could not last.

When early signs of inflation surfaced, the US Federal Reserve got back to raising rates. Even though it does not have an explicit inflation target, the US Federal Reserve is known for nipping inflation in the bud, well before it becomes a problem. Higher interest rates started crimping home prices and inducing slower growth. In 2006, US house prices dropped slightly. Many commentators applauded the achievement of US monetary policy in achieving a `soft landing', where the frenzy in house prices had been checked without pushing the economy in a recession. This sense that the US economy was back into a safe zone, even if at a lower growth rate, was the foundation of the powerful performance of equities worldwide in 2006.

In recent weeks, many cracks have appeared in this happy story. A sharp revision in US GDP growth data for the 2006 fourth quarter shows anaemic growth of just 2.2 percent. The revision of last week consisted of a downward revision from 3.5 percent. With this, three key regions of the world - Japan, continental Europe and the US - appear to be headed for GDP growth of just 2% or so. This suggests a sombre outlook for the global economy. Some top economists now expect that in 2007, the US will fall into a recession.

One part of US housing is called the "subprime market": it involves poor people overloading on debt in order to buy houses. This market seems to be in particularly bad shape, and a few financial firms like HSBC have suffered very large losses in it. Continued downward pressure on US house prices suggests that the `soft landing' remains elusive - more bad news could well be in store.

When US monetary policy was widely believed to have found the `soft landing' in 2006, stock prices worldwide went up sharply. With a renewed sense that the `soft landing' has not yet come about, stock prices worldwide have dropped. There are market based indicators which show that expectations of equity volatility have risen sharply. In Asia, the four countries with the best developed stock markets are Japan, Taiwan, South Korea and India. From Feb 20 to March 5, these four markets have experienced a drop in share prices. While some of the poor performance of the share market in India can be attributed to the weaknesses of Budget 2007, a significant part of the explanation lies in these difficulties of the global economy.

What does this mean for India? Broadly speaking, it suggests that the benign global environment, where the Indian economy was supported by unprecedented global growth in GDP and trade from 2002-2006, will not persist in the next few years. The Indian stock market is roughly 17% below the recent peak; a comparable decline in real estate prices may also be expected. At the same time, with a modest overall stock market P/E ratio of roughly 17, Indian equity valuations do not have a lot of negative potential.

Indian exports will find greater competition in slowly growing markets. Price pressure from cheap imports will exert greater competition in domestic markets. Financial markets and entrepreneuers worldwide will be somewhat more circumspect in embarking on investment, which will (in turn) affect GDP growth.

India has achieved remarkable GDP growth in recent years. To some extent, this remarkable growth has reflected supportive global conditions. Looking forward, with a much slower world economy, this channel of growth will not be available. Achieving high Indian GDP growth will once again depend on India's ability to identify fundamental structural bottlenecks to growth and engage in far-reaching policy reforms. High Indian GDP growth will, above all, depend on India's ability to persuade domestic and foreign entrepreneurs that the Indian State is serious about economic reforms.

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