Are we prepared for spillover effects?

There has been a spate of macro news in the last

fortnight or so. The Q2 GDP numbers came first, the trade numbers were the next and then the revised trade data. In between, the rupee has constantly been in the news. Unfortunately, all these numbers are now pointers to an increasing consensus that India is in the midst of a slowdown. What is more important is that India, which emerged relatively unscathed after/from the 2008 crisis, may not be lucky this time around. It is in this context that the macroeconomic impact of the spillovers from the euro crisis on India assumes importance.

In economic parlance, there are primarily three channels through which the spillover impact from the euro crisis can impact India. These are the credit channel, trade channel and financial channel. Let us explore these one by one.

Perhaps the depreciation of the Indian rupee by 17% (RBI monetary policy review-Dec 16), since the precipitation of the US crisis following the rating downgrade, brings into sharp focus the spillover of contagion risk through the credit channel. In particular, the emerging markets (EM) in Asia (India included) have widely tapped foreign funding sources over the last decade to take advantage of low interest rates in advanced economies (read European). However, it has now become a source of contagion risk. In fact, the Institute of International Finance lending conditions survey for Q3 2011 reveals that overall funding conditions (see Exposition 1) for banks have tightened significantly across the globe, with banks in Asia particularly experiencing a significant adverse shift in international funding conditions. This is because European banks have been mandated to increase their core capital to 9.0% by June 2012. Subsequently, the European Banking Authority estimated that total bank recapitalisation needs around $150bn. This, we believe, has already resulted in European banks starting to squeeze in credit lines on EMs, etc, to try to meet the mandated 9% ratio. India is no exception to this, as the author estimates that the claims of EU and US banks on India (see Exposition 2) is now nearly 12% of India?s GDP (as on June 2011), a decline from 13.5% just before the Lehman crisis!

A small tit-bit here. The author estimates that claims of European & US banks on Korea and Malaysia are nearly 25% of GDP. However, these currencies have depreciated less than 5% during the same period (for example, the Korean Won depreciated by only 1.9% during the same period). So, is it weak domestic fundamentals for India that has exacerbated the problem? Perhaps more on this another day.

Apart from the credit channel, the importance of the trade channel cannot be ignored. Even after the latest $9bn downward revision in export data, India?s exports still remain the enigma of many. In the first seven months of the current fiscal, exports rose by 46% y-o-y to $180bn. As Exposition 3 shows, India?s GDP growth excluding new exports has declined to less than 4% in Q2 of the current fiscal. Clearly, a slowdown in exports post the EU crisis could pull down India?s GDP growth significantly.

Even as a slowdown in exports is envisaged post the EU crisis, one good thing is that the continuous stress in advanced economies since 2008 did not have a significant impact on India?s export growth in the last two years, as India has managed to explore new markets through export diversification. For example, exports to OECD and Latin American countries have witnessed a progressive jump during this period, while the share of the EU in India?s export basket actually declined from 21.3% to 18.4% for the three-year period ended 2010-11. However, even then, as Table 1 shows, exposure to PIIGS (Portugal, Ireland, Italy, Greece and Spain) was 3.8% during April-July 2011. At this rate, we estimate that the share of these countries will be roughly 4% of the total exports projected ($300bn) for the current fiscal ($12bn, roughly). Clearly, the impact of the trade channel on India cannot be underestimated (recall, Indian exports have registered a measly 11% y-o-y growth in October, down from 82% in July).

Finally, the spillover impact through the financial channel. The impact is primarily through repatriation in bond markets following a withdrawal of investor positions, and a spillover from global market volatility in the domestic equity market (for example, as per the ADB Capital Monitor, during the period 1994-2010, the percentage of variance of the Indian market equity explained by global factors was as much as 12%). Interestingly, portfolio flows in the current fiscal have declined significantly. Additionally, in the first half of the current fiscal, nearly 25% of the FDI flows (Table 2) were from EU economies, and it is only natural that FDI flows will take a hit in the event of a prolonged crisis.

In the end, the EU crisis, coupled with the limited flexibility of the Indian policymakers on the fiscal front, is likely to pose an enormous challenge to the Indian economy in the next fiscal. Increasingly, the political cycle will play a dominant part in the budget-making cycle. The only point of solace is that the Indian banking system still remains a safe bet. As a matter of fact, India?s exposure to systemic risk (the risk of collapse of a behemoth) remains significantly low, at 0.89% of GDP, though the figure has increased since 2009. A comparison with China reveals that this systemic risk component in China is four times

higher compared to India!

The author is director, Economics & Research, FICCI. Views are personal