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Concern over impact of U.S. crisis

The convulsive developments in the U.S. financial sector have affected grievously not only the American economy but also those of the European Union, the U. K and Asia. The Indian economy too has felt the impact of the U.S. meltdown though not to the same extent. A rescue package of $ 700 billion has been approved by the U.S Congress after some modifications. The British Government too has announced a massive package while many central banks have decided to cut interest ra tes along with the U.S. Federal Reserve. The signing of the enabling legislation by the U.S. President has not however helped reduce panic on Wall Street and other bourses.

In India, there is serious concern about the likely impact on the economy of the heavy foreign exchange outflows in the wake of sustained selling by FIIs on the bourses and withdrawal of funds by others. Panicky selling since the beginning of April this year has led to a fall of over 33 per cent in the BSE index. This came on top of a 25 per cent decline up to April from the peak level touched in January. Thus the gains made over a long period have been nearly wiped out in less than ten months.

Equity values are now at very low levels and many established companies are unable to complete their rights issues even after fixing offer prices below related market quotations at the time of announcement. Subsequently market rates went down below issue prices and shareholders are considering purchases from the cheaper open market or deferring fresh investments. This situation naturally has upset the plans of corporates to raise resources in various forms for their ambitious projects involving heavy outlays.

No one can forecast at this stage about the duration of impact of the U.S. crisis on the Indian economy. There is even the prospect of a balance of payments deficit emerging in the not distant future. Such a contingency can, of course, be managed by drawing down the huge foreign exchange reserves built in recent years. The current account deficit was higher at $10.72 billion in April-June against $6.3 billion a year ago. After wiping out this deficit the surplus on capital account was only $2.24 billion. As a result, reserves were even marginally lower at $298.66 billion in the week ended July 4 against $299.23 billion at the end of March. The increase in current account deficit was mainly on account of a larger trade gap of $31.57 billion against $20.70 billion according to RBI while net invisibles improved to $20.85 billion from $14.40 billion. (The trade gap according to BCCI was $ 30.38 billion in the same quarter against $ 21.50 billion comparably.)

In 2007-08 additions to foreign reserves were as much as $ 108.03 billion in spite of a rise in current account deficit to $17.40 billion from $9.76 billion. The increase in the previous year was $45.77 billion. Since the reserves declined by $ 6.84 billion from the end of June to $291.82 billion during the week ended September 26 and the trade deficit is likely to rise to $ 58 billion in April-September, the current account deficit in the second quarter may exceed the $10.72 billion recorded in April-June. It is a moot point whether there will be a net increase in capital inflows helping to avert a balance of payments deficit for this quarter. The forex reserves declined further by $7.87 billion to $ 283.94 billion during the week ended October 3.

The heavy FII selling and withdrawal by others have been responsible for the sharp deterioration in the external value of the rupee to 48.50 to a dollar after touching a low of 49.30 on October 10 against 40.02 in April and 39.33 on October 30, 2007. The rupee has thus declined by as much as 19 per cent in less than a year. But the drop has been pronounced only since April as the decline in October-March was just 1.73 per cent. It is also significant that the deterioration in terms of the dollar has been more pronounced than against the British pound and the euro. The Japanese yen, on the other hand, has appreciated sharply against the U.S. dollar as well as the rupee.

Sale of dollars by the RBI to arrest sharp depreciation of the Indian currency could have been more aggressive from the beginning. Its purchases of the greenback were as much as $78.2 billion in 2007-08 and $26.8 billion in 2006-07. The purchases of dollars continued in April-May to the extent of $4.5 billion but in June there were net sales of $5.2 billion. Thus in April-June net sales were only $756 million.

The only comforting feature is the downtrend in crude oil prices to around $78 from the peak of $147 a barrel. It has been stated that the average price for 2007-08 was around $79. It remains to be seen whether the average cost of oil imports will be less this year. It is felt that the demand for crude and petro products may come down in the immediate future and the downtrend in crude prices may continue. Members of the Organisation of Petroleum Exporting Countries are, of course, thinking of cutting production to avoid further sharp decline in prices.

However, in rupee terms, oil as well as other imports will be costlier and it may not be possible to derive full advantage out of the drop in prices of crude, metals and other products. It is now clear that hectic speculation in the world commodity markets was mainly responsible for the “boom” in gold last year along with base metals and other commodities. Profit margins of Indian corporates, especially those with foreign commitments, may be affected as interest rates also have remained high.

The inflation rate has been receding slowly and is likely to continue in the coming months though a cheaper rupee may stand in the way of a faster decline. There may of course be the benefit of abatement of external inflationary pressures with a continuing fall in prices for many products.

While there may not be any disposition to lower interest rates when the external value of the rupee is falling, there should not be any hesitation to reduce the CRR as and when needed. The Finance Minister has therefore indicated a substantial injection of funds into the banking system, probably exceeding Rs. 25,000 crore, with Parliament agreeing to approve supplementary demands promptly.

A liberal approach to freeing immobilised resources in various ways is required as credit expansion has been taking place in a big way and banks cannot meet the rising demand if the RBI and the Finance Ministry do not provide the required funds. The special committee appointed for this purpose should make early and helpful recommendations. The decisions of the RBI Governor and the committee are anxiously awaited.

P. A. SESHAN

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