Rupee to the rescue

Written by Dominique Dwor-Frecaut | Updated: Apr 26 2008, 04:44am hrs
The global backdrop to the RBI decision next week seems one of increasing risks for emerging markets and for India. Last month, global markets went close to dislocation when US investment bank Bear Stearns went bankrupt. The ongoing US recession suggests Indias strong export performance is unlikely to last. And the seemingly endless dollar depreciation keeps alive the risk of major currency instability.

And yet, Indias FY08 export growth is likely to be above 20%; over the past nine months of record high global market volatility, Indias forex reserves have increased by $83 billion; and economic growth at 8.7% remains well above Indias historical average.

This suggests the global economic environment may not be as negative for India as feared. In fact, recent data and economic news suggests the global economy is creating more downside risk to Indias domestic demand than to external demand.

Indias remarkable export performance is supported by a major realignment of global economic forces. Emerging markets are becoming the main drivers of global economic growth and trade. According to IMF data, starting in 2003 emerging markets have accounted on average for about three quarters of global growth, largely supported by the commodities price boom. And this time around, according to a recent IMF study, emerging markets have become better able to leverage higher commodities prices to support higher investment and growth. According to the IMF, this is largely due to an improvement in the quality of economic management and business environments.

Emerging markets are also becoming the main driver of world trade: according to the WTO, in 2007 emerging markets accounted for half of the increase in global trade of 5.5%. China has now displaced the US as the second largest exporter in the world, after Germany. And emerging markets increasingly trade among themselves, which suggest these trends are sustainable. With emerging markets importing largely capital and intermediate goods, exporters in these markets are likely to do better than, for instance, exporters of consumer goods to the US.

While emerging markets are coming into their own, Europe is also decoupling from the US. Before the introduction of the euro, US and EU growth tended to be closely correlated. But EU growth continued after 2004 even though US growth started to slow: EU growth only started to slow last year. With Europes real estate market and financial sector stronger than those of the US, EU growth is set to remain above US growth for the next year or so.

India is well positioned to benefit from these structural shifts. The share of Indias exports going to the EU, US and Japan now represent about one-third of total exports from about one half only five years ago. At the same time, the share of Indian exports going to the EU remains above 20%. In addition, Indias exports are becoming more sophisticated, and capital goods exports are increasing: the share of pharmaceuticals, chemicals, cars and trucks or electronics is increasing while the share of consumer goods such as textile or jewelry is falling. In the three months to February 2008, average export growth in India was 24% against 19% in China which may well reflect Chinas greater exposure to the US and to consumer goods markets.

But an emerging market-driven global growth also has consequences for global food and energy prices. According to the IMF, emerging markets account for more than 90% of the increase in consumption of oil products and metals and 80% of the increase in consumption of grains since 2002. Global growth driven by emerging markets could see more upside to raw material and energy prices, even from current levels.

And while India exports many raw materials for instance, iron ore, rice, or jute, on balance it is still a net importer of commodities and raw materials. In FY07, for instance, net imports of commodities represented more than 7 percentage points of GDP. This means global commodities prices have a significant impact on Indian domestic demand. When food and energy prices rise, Indian households have less income to spend on discretionary items.

Indias domestic demand is also likely to be affected by a higher cost of credit. Credit growth slowed down in India during FY08, and after the January 2008 policy review, a number of commercial banks cut their lending rates. But for the past nine months, global markets have been through a re-pricing of risk. For borrowers across the world, the cost of credit on international markets has gone up. Against this backdrop, Indian banks could find it difficult to expand credit while maintaining low lending rates.

The global economy, therefore, could be creating greater downside risk to Indias domestic than external demand. This makes a case for allowing currency appreciation to contain the increase in domestic prices of food and energy, support household income and help keep India on the fast growth trajectory initiated in FY05.

Dominique Dwor-Frecaut is an economist with ABN Amro. She has worked with IMF and World Bank. These are her personal views