Just when 2012?s first quarter?s news looked to give us some assurance that the worst of the global turmoil was behind us, up pops renewed volatility together with a slew of worsening economic data from all major geographies.
To validate our fears or to reassure us, twice a year, the IMF (probably the largest official repository of actionable knowledge of global financial markets and conditions) releases an update on global risk perceptions, together with economic and now fiscal updates. This April?s version might have been particularly relevant with the eurozone vulnerables resuming their descent into the abyss, after having been seemingly been rescued from the brink. Although IMF research has previously been shown to be quite fallible, its wide ranging coverage serves as a good overview of the economic and financial issues which impact countries, particularly their external sectors.
So what, according to the IMF, are the concerns about the current environment? Rarely have economic and financial conditions been as unsettled as they are now. And very seldom has India been as exposed to global volatility. What are the channels through which India?s economy is likely to be affected? These two questions are the focus of this article.
Directly related to the biggest concern regarding potential defaults in sovereign debt is the issue of deleveraging, i.e. drawing down the enormous debt that had, owing to a constellation of circumstances, generated a long period of high growth and relative price and financial stability. The IMF GFSR is a valuable resource in understanding the process of deleveraging.
The sharp increase in risks associated with government debt is partially due to the large increase in accumulation of assets by central banks. These holdings of government and other securities will need to be liquidated or passed on to the private sector as ?demand for base money? returns to more normal levels. This process of reducing central bank balance sheets will therefore need to be accompanied by a parallel medium term fiscal consolidation.
The IMF?s Fiscal Monitor elaborates on this, emphasising in particular, that the negative effects of fiscal adjustment is likely to be large, given research on ?the size of fiscal multipliers during periods of weak economic activity?. The immediate policy implication is that a ?gradual but steady pace of adjustment? might be preferable to ?heavy front loading?.
Even as the government and central banks deleverage, there has to be a parallel reduction in the debt buildup of corporates and households. Expanding its previous research, the report is an extensive cross-country tabulation of debt by borrower category?government, corporates and households. In addition, the point is made that aggregate data convey only a partial sense of the vulnerabilities. High public debt is only a part of the story. Private debt in Ireland and Spain weigh down the sovereign. Strong household balance sheets balance high public debt in Italy and Japan. The troubles of Greece, Portugal and even Ireland and Spain are exacerbated by weak external positions.
A strong message that comes across is the wide divergence of economic responses to similar patterns of debt across countries: what levels of debt are sustainable? Australia and Norway, which have high levels of household debt, have escaped crises. So is there a mix of debt and growth which can sustain high debt while being insulated from business cycles? (Both the countries are sparsely populated nations with access to vast natural resources).
Why should all this matter to India? Because stress indicators, both domestic and external, are becoming stronger. India?s stake in the global environment probably has not been higher, with its current account deficit rising to levels even higher than in 1991 and prospects of capital flows required to cover the gap becoming ever more uncertain. The rupee has borne the brunt of this uncertainty in the last few months of 2011; after stabilising as a result of concerted RBI actions in the early months of the year, it has again started weakening.
India?s vulnerability to euro-area banks deleveraging, while nominally high, might not be as big a concern as some other factors which have lately induced volatility in capital flows. As of September 2011, European (including UK) banks held about $154bn of Indian assets. We had estimated, using European Banking Authority?s December stress tests, that $11-13bn of capital could be repatriated out of India based on June 2012 recapitalisation requirements of euro 115bn. Balance of payments data later showed that $6.4bn of banking capital (after adjusting for NRI deposits, this is India?s liability to foreign banks) had flowed out in the October-December quarter.
Although it is unlikely that there would be a major exodus (and Indian banks have expressed their willingness to fund the perfectly good assets which might be sold by the European banks), India remains vulnerable to short term volatility following large funds outflows.
Even more pernicious is India?s increasing external vulnerability. India?s bulwark against external pressures?its forex reserves?is precariously low, compared to the scale of vulnerability. In 2007-08, when India?s economy was $1.2tn, India?s forex reserves were $310bn. Now, when the GDP is almost $2tn, forex reserves have slipped below $300bn. Given the broad relationship of the current account to the fiscal deficit, our external gap is likely to remain high.
The emphatic bottom line of the IMF reports is that ?highly indebted agents face a continuous risk of reaching hard budget constraints that leave no choice but to reduce debt?. The world is likely to remain volatile for some time. India?s process of de-risking itself from forced deleveraging has already started with an attempt at fiscal consolidation this year. The need to put automatic stabilisers in place to reduce our external vulnerabilities warrant that this consolidation is deepened in the coming years.
The author is senior vice-president, business and economic research, Axis Bank. These are his personal views