Experts say the Rs will continue to rise against the dollar.
Even before the world could come to grips with the economic impact of the earthquake in Japan, US rating agency Standard & Poor’s (S&P) on Monday downgraded its outlook on US sovereign debt from “stable to negative,” citing worries over budget deficits and debt.
“We believe there is a material risk that US policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013. If an agreement is not reached and meaningful implementation does not begin by then, this will in our view render the US fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns,” the agency said. It reaffirmed the sovereign rating at AAA.
S&P had not downgraded the sovereign debt of the world’s largest economy even at the peak of the financial crisis in 2008. Monday’s move will have a long-lasting impact on the global economic order.
US stocks fell sharply in early trade after the announcement. The Dow Jones Industrial Average plunged 226 points, or 1.8 per cent, to 12,113 in mid-morning trade.
European stocks also fell, as overseas investors feared more trouble on Greek debt and China raised banks’ reserve requirement.
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Experts said a sovereign debt crisis in the US would not only impact equity and money markets across the world but also alter the fundamental structure of the world economic order. Within minutes of the news, gold shot up to $1,497/ounce before easing to $1,493 at the time of going to the press.
For India, which has a high current account deficit and is an import economy, this is a mixed bag. If India’s current account deficit is at a manageable level of 2.4 per cent of the gross domestic product, a lot of it has to do with capital flows and currency appreciation. Economists said the first victim would be the dollar, which would fall further because a poor sovereign rating would increase the interest rates on US government securities.
For a net-import economy like India, this is good news as the rupee will continue to appreciate against the dollar, as it has all through 2011. The Dollar Index has fallen 4.45 per cent since the beginning of this year. If the rupee becomes stronger, India will save foreign exchange while paying for imports. This resilience of the rupee attracted inflows from abroad in March, triggering a rally in Indian shares.
A key development for India will also be how capital flows move. Siddhartha Roy, chief economist of the Tata group, said, “After the last crisis in the US, the US Federal Reserve printed money and gave it to banks. The money found its way into attractive asset classes. The banks used the returns to repay their debts.” Following Monday’s downgrade, there are chances the perceptions about emerging economies may change and inflows into Indian equities will continue.
Abheek Barua, chief economist, HDFC Bank, said: “In the short term, the impact on India depends on how the risk aversion pans out, but in the long run, there is a possibility that the focus will shift towards emerging markets because of their strong fundamentals.”
With a high current account deficit, an increase in foreign institutional investor inflows may not be that big a concern for the central bank.
The main concern will be if this money fuels commodity prices. This is because inflation in the main worry right now.
However, some say the downgrade will increase the cost of capital as the coupon rate on US treasury bonds will rise. As the cost of capital rises, the risk appetite will be re-assessed, which may result in flight of capital form risky assets like India.
Saurabh Mukherjea, head of equities at Ambit Capital, said: “The era of cheap capital is gradually coming to an end. As the cost of capital rises in the western economies, there will be an eventual revaluation of risk and consequently a pullback in capital as the market realises how serious the sovereign crisis is.”
However, India does not have much to worry as the rupee will stay within 44-46 against the dollar. As Monday’s development weighs on global equity markets, market experts believe a correction will happen. Ambit Capital expects Sensex to touch 16,000 and then rebound from there.