RBI rate cut may be further delayed: Citi

A perplexing thing about the euro crisis is its perceived impact on the Indian economy. In virtually all explanations given for the country’s low economic performance, there is a reference to the euro crisis and the overall global economic situation. But, at other times when we are questioned on the future prospects of the country, we tend to say that we are basically a domestic economy and that there is only a peripheral impact of such developments. It seems like the euro crisis is a convenience explanation depending on what you want to convey.

Logically, the afflictions of the eurozone should strike us in four ways. The first is through the trade route. Assuming the worst case scenario of negative growth in this region, will it affect our exports which have done well in the last two years to cross $ 300 billion?

A fortunate development here is that our exports have become fairly diversified over the years across geographies. In the 10-year period ending 2010-11 (FY11), the share of America and Europe in total exports came down from 53 percent in FY01 to 36 percent in FY11, with that to Europe from 28 percent to 21 percent.

This means that by exploring more markets in Africa and Asia, our exports are in a way less dependent on the growth stories in the developed world.  Therefore, negative growth in this region will not be a terrible blow for our exports, though admittedly there will be some deceleration. A lot will depend on the kind of goods that are exported to this region and the relative elasticity of exports to changing incomes. The current state of rupee depreciation should help at the margin to boost our competitiveness and negate some of this decline in exports on this score.

Second, the flow of funds from this region to India could be impacted by the crisis. Here there are two kinds of flows that can be considered. The first is foreign direct investment (FDI), where India got around $ 36 billion last year, which was quite decisive for the balance of payments considering that the current account deficit was under pressure and foreign institutional investor (FII) flows were relatively tardy.

In FY12, Germany and France featured in the top 10 investing countries and accounted for around 6 percent of the total while, on a cumulative basis, the euro region contributed to around 10 percent of total FDI. Clearly there could be some impact, which, however, will be in the region of around $ 5 billion or so at the upper limit.

In the case of FII investment, the overall flow of funds to emerging markets as such is expected to decline, according to the World Bank, in 2012. This being the case, the euro impact may not be significant enough to act as a bottleneck. Therefore, while there would be a negative impact, the quantum would tend to be less distinct due to a breakdown in this region.

Third, the euro crisis would certainly have an impact through the exchange rate route.  The dollar-euro relationship affects the strength of the rupee even under ceteris paribusconditions. Hence, if the euro crisis escalates, there will be a tendency for the dollar to strengthen which, in turn, weakens the rupee and vice-versa. This is important for us since our own fundamentals appear to be wobbly on the forex front and hence any disturbance on the exchange rate through extraneous forces will tend to affect us perversely. This is definitely a major concern for us simply because even theoretically we cannot ask for any policy action to redress this repercussion.

Last, there is the sentiment factor, which cannot be ignored. A crisis in any region, even if remotely connected to global economic prospects, has the potential to spook the markets and create turmoil. This goes across all the markets. The stock markets behave the way they do because they must. The forex market sentiment worsens at these signs and an element of volatility creeps in rather fast.

The government bond markets also get shaken on news of corrective action, or rather possible corrective action, from the European Central Bank of the European Financial Stability Fund (EFSF), which in turn could cause interest yields to move in a certain direction. This is important as there is a cost involved when the market turns volatile and this cannot be ignored.

Therefore, in net terms, the euro crisis cannot really be ignored by us. It may not have been that important if the same situation was replicated in, say, FY11 when the economy was doing well and sentiment was upbeat. But today, when literally every dollar matters, any slowdown in export growth or flow of investment has the potential to affect our foreign exchange position discernibly. This is so because there is no easy and quick substitutability for either exports or investment flows at a time when the global economy is also to be at a lower level.

The direct impact on domestic growth will be muted, but to the extent that FDI goes into investment and is not substituted by other countries, a drop will have multiple effects in such fragile times. Foreign investment is, in fact, the most valuable source of funds and investment because such investors are not bogged down by domestic conditions. They look for the future bigger picture. But this would be a secondary impact, and may not come on clearly in the emerging picture.

Hence, while growth may still crawl onwards from here, the balance of payments would tend to come under pressure, adding some gloom at a time when the rupee is not doing too well. In fact, even these marginal withdrawals of dollars will only ensure that the rupee continues to struggle, creating problems for the Reserve Bank.

In short, it will be choppy times ahead in case conditions deteriorate further, though the European crisis has abated somewhat apparently due the decision to move towards a common banking authority in the eurozone. But then, there are no easy solutions in this globalised world. The eurozone crisis is by no means over.

(curtsey : first post)

Rupesh Yatesh Dalal
Head Research Department

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