Fed Trying to Hedge a Recession through Rate Cuts: Is India Well Balanced?

'The pide-piper of the bull market'

Not all is well on the western frontier. The bull has turned its back on the event of a global contagion effect that spread from the valleys of the US to the plains of this part of the world. Countries reaped the harvest and the ‘bull’ season seams to be over. The fear of a US recession looms high on the eastern horizon that depends much on the US consumer markets has cast a ‘Halloween spell’ on the evolving economies on this hemisphere. While the US economy is heading toward a recession, the Fed is trying to hedge the same by simultaneous rate cuts to ease the credit squeeze and boost the economy and corporate sentiments. In this hour, how is India affected by these macro changes? What challenges does India face in the event of a full blown recession in the US? Could India insulate against one such?

At the recently concluded summit in Davos, at the World Economic Forum 2008, Union Commerce and Industry minister Mr. Kamal Nath quoted it is really difficult for India to decouple from the US economy, though we are not likely to face the heat on the same if there is true recession. Backed-up by strong economic growth and a booming domestic market and good fundamentals which is growing by 8-9% on average, India seems to be a little far from the downside risks to its economy. It should however be kept in mind that India is less export-dependent economy than its peers China, Japan and other who are likely to face the blunt if things go wrong. Domestic fundamentals and macro-economic indicators are quite strong to face-off a downturn. India has already positioned itself as one of the largest economy with a GDP of $1 trillion and as the fourth largest consumer market in the world, behind US, Japan and China. Development on every frontier is the cornerstone of this economic sustenance that India is likely to keep up.

How is India in a better position than others?

Interest rate seems to be driving the speed of the economy in every country as investors and corporate are more inclined to take cover under the central banks’ umbrella. Looking at China, whose economy is already overheated and risks burst, Beijing is trying its best to cool its overheated economy by subsequent rate hikes, the opposite trend US and other developed countries are following. The Bank of China (BoC) hiked bank lending rates and CRR seven times last year to cool off, without much affect. It is assumed that if the interest rate hikes are too fast, bubble will burst eventually eying a slowdown. And if the economic heat is not contained, bubble will burst leading to a huge stock market crash. It seems China is facing a double situation and a tough challenge where it needs to balance the growth without dampening it. India seems to be in a much favorable position as lending rates in India are quite high and it is time for RBI to follow the Fed footsteps to cut lending rates to ensure more investments and smoothen out credit channels.

Who is Chasing the Liquidity?

A question comes to our mind; is there too much liquidity chasing China, and somewhat less in India? Not really. According to EPFR, which tracks emerging market fund flow, India is still and likely to be the top destination for global investors, though FII's pulled out nearly $10.8bn from the EMs, money is going flow back once the valuations comes clear. It’s no doubt that India’s economy is overheated too, well destined to do best and but inflation indicators is well contained also. WPI is 5.38%, but with rising crude oil price is a cause of major inflationary pressure on the economy, and India likely to tide about the same. India also have a good savings rate, 32% one of the highest among the emerging markets, compared to negative savings rate in US and much less in China. Some part of this disposable income will eventually flow to the domestic markets either as investments or consumer spending. That makes sense there is no credit problem in India, in-fact, there is increase in credit demand according to RBI statistics.

India also do not have a subprime lending sector like the one in US that spelled trouble due to lax and easy lending procedures creating a housing bubble that burst in 2007 along with the ABS markets, engorging trouble for the global credit markets. Lending procedures are much stringent in India and as such, we are not going to face such a ‘prime’ trouble in our economy. But banks and financial institution, along with the RBI should be more careful about lending reforms and the interest rate, as low interest will boost borrowing in the real estate sector though the cost of borrowing will come down for the corporate sector.

It comes to one’s mind, what have they learned and how they have reacted to the financial downtrends that swept the globe. In the same breath, ironically, the economies and investment theories holed ground instantaneously once the markets crashed. The economic sustenance though, may not depend solely on the market performances, but they are closely linked to the overall health of the economy. And when the policies, ideas and implications go wrong, every economy has to pay a heavy burden on their growth fundamentals.

US Spending too much while saving none! Where is the balance?

Overspending that resulted people in the US end up in debt is neither acceptable, since it brings down inherent risks of being in debt. Today, an average American has more debt outstanding than what he is able to pay back, and most even have 12-13 credit obligations pending. And the US Fed ‘fed’ their appetites with more cheap credits with virtually no underwritings!

Conversely, Indians are more realistic when it comes to savings and spending. They usually save more than what they spend, and thus the Indian savings rate of 32% are among the highest in the emerging nations. China has a much less savings and US the least. In fact, US have negative savings rate that buried down for their being too much consumptive nature. Too much savings cut down spending and bring down consumption level, which may be detrimental for the economy. Low spending decreases expected revenues from sales and lowered sales make business to cut back production which decreases the total income earned by economy.

India is trying to push spending to boost the economy, but they tend to be more careful in maintaining the balance between savings and spending. Interest rate do affect the savings propensity as a very low interest rate as in Japan (0.50%) discourage savings as bank deposits on fixed-income instruments yield very low.

Dollar still falling;

The US assets have lost much of their shine. And with it, the $ followed the trend. The reigning dollar, though down but not out, eagerly waits to see if any (Euro or Yuan) that could replace it, holding more intrinsic value, to be fed by global demand.

Where is the Fiscal Prudence For US?

While the IMF went preaching to developing countries about fiscal prudence, it missed giving the same advice to the US Government. At hindsight, the pressure IMF put on the Indian Economy helped us pull up our socks and kept us conscious about Fiscal Prudence.

Trade Mismatch-Where and When it went wrong?

US is also facing a huge balance of payments crisis and trade deficits with virtually every emerging nations. US has been continuously running a trade deficit with China from 1985 onwards and the same deficit hit a record high of 763.6 billion US$ dollars in 2006, up from 716.7 billion in 2006.This might create a long-term problem for the US economy and this can already be seen with the depreciation in the $ (dollar). Continuing focus on spending without keeping a check on the Fiscal Deficit would create greater problems for the US economy in the future as they are likely to learn.

Happy Lending: Need to Pay-back?

Lending without financial underwritings played off heavily for the lender, mortgage lenders and financial institutions in the US. The Subprime lending category to less creditworthy borrowers led to the mortgage crisis when borrowers started defaulting on their loans when the interest rate adjusted. The loans were given on I/O and ARM basis that asked for very little credential and collaterals to hold against those loans. These ‘happy lending’ turned out to be soar when things went wrong.

Sometimes, Traditional Reforms Helps!

India, being more conservative on lending practices, have strict norms on commercial and personal borrowings, as thus would not face a situation like one in US. Hence, India will not be impacted in a major way. That said, the Central Banks and RBI are in close monitor to ascertain the credit demand, market liquidity, Inflation and interest rates, and the lending reforms that suits India's demand, and not to let go the things right out of the hand that fuelled subprime debacle in the US.

Right Horizons Research Desk