The title of this article may give the impression that the contents are racy. Alas, coupling here refers to the extent to which Indian asset prices and growth prospects can be buffeted by economic performance in the US and the euro zone. This article reviews inter-linkages across economic blocs and implications for India in the next few years.
In broad terms, India remains coupled or has decoupled from the West depending on the asset class or economic indicator and the time frame of analysis. In this context, it is useful for analytical clarity to disaggregate the linkages and direction of causality. For example, in the early 2000s, the dependence of Indian equity markets on US stock markets was so strong that if Nasdaq sneezed, the Sensex/Nifty caught a cold. More recently, in calendar 2010, equity markets were uniformly up in India, the US and Europe. Equity markets around the world have been sliding in tandem since summer 2011 and that includes India, the US and Europe.
In 2008, real estate prices plummeted in the US after the meltdown in the mortgage-backed securities markets. In the last three years foreclosures have continued in the US and the irresponsible boom in the housing sector in the European periphery has resulted in high unemployment and elevated levels of individual and sovereign debt. In India, because of our cautious approach to asset-backed securities, over-the-counter derivatives and higher risk weighting of the housing sector we have been spared the worst excesses. However, urban realty prices are divorced from reality and real incomes owing to deliberately distorted land ownership policies in and around Indian cities. Consequently, domestic property owners and developers have been lulled into a false sense of being decoupled from real estate markets in developed countries.
In recent months, international commodity prices including oil have become more volatile. As demand slows in traditionally strong consumption centres in the West, the price of oil should drop. However, demand in large developing countries is expected to increase. This suggests that despite the newly discovered large offshore reserves in Brazil and elsewhere, which will take time to develop, oil import prices are likely to be sticky on the down-tick and less immediately correlated with other asset prices.
Turning to fixed income markets, Indian bonds have decoupled from their counterparts in the US and the euro zone. G7 countries have pushed nominal interest rates to ever lower levels by reducing benchmark rates and quantitative easing. Consequently, bond holders in developed countries have enjoyed huge capital gains. In comparison, as the Reserve Bank of India (RBI) has raised interest rates, rupee bond holders are facing substantial mark-to-market losses.
On the issue of sovereign credit ratings, which are expected to reflect a country’s overall economic standing, the unprecedented happened in August 2011. S&P cut the country credit rating for the US from AAA to AA+. According to current S&P ratings, the US has decoupled from Germany, France, Canada and the UK which are still rated AAA, while China is only rated AA-. S&P’s ratings for France and China cannot be compared since a political judgement has been made in favour of democracy versus a one-party state, with the former deemed politically more stable and by extension more predictable economically and financially. Hence the farcical circus of ratings issued by the two major rating agencies can be better understood if the “rated” entity is compared with itself over time rather than cross-country.
Moving on to economic indicators and growth prospects, inflation levels have decoupled between developing and developed countries. Unlike the West, which is worried about deflation, RBI is concerned about persistent inflation and on September 16, 2011 the benchmark rupee repo interest rate was raised for the 12th time in the last 18 months to 8.25 per cent. Incidentally, the central bank benchmark rates in Brazil and China are currently 12 per cent and 6.56 per cent respectively. In stark contrast, as of September 26, 2011, three-month Treasury bill interest rates in the US, Germany and Japan, are unbelievably low at 0.01per cent, 0.16 per cent and 0.10 per cent respectively. Of course, depending on whether wholesale price index or consumer price index inflation rates are considered relevant, real shorter term interest rates are negative in India, the US and several other countries. The picture is less clear on movements of exchange rates and the US dollar’s safe haven status seems to be intact for now.
The US Federal Reserve has recently launched what appears to be a futile “Operation Twist” to reduce long-term interest rates by selling $400 billion of shorter dated Treasury securities and buying longer term bonds. On September 26, 2011, the yields on ten-year US, German and Japanese Treasury bonds were already at historic lows of 1.84 per cent, 1.79 per cent and 0.98 per cent respectively. In the last three years, even cash-rich US corporations have not undertaken fresh investments because of projections of low additional demand from households, neck deep in debt. From current indications it appears that the US and the euro zone are teetering at the edge of a recession precipice.
The Indian economy weathered the 2008 financial and economic tsunami in countries belonging to the Organisation for Economic Co-operation and Development (OECD) relatively well. However, going forward, a widespread economic slowdown in the US and the euro zone is likely to have a substantial recoupling impact on India. It appears almost inevitable that the US and Europe will go through perhaps a decade-long process of reducing their debt levels and protectionism may surface in myriad forms. In a sluggish growth scenario in the developed countries, there is little scope for them to reduce interest rates as was done in 2008. It is also unlikely that there will be a significantly sized and co-ordinated fiscal stimulus, given the already high stocks of government debt all around.
India too has little room for manoeuvre on the fiscal side. Therefore, it made sense for RBI to raise interest rates even though higher nominal rates restrain growth and are not particularly effective against inflation in the face of supply side constraints. On balance, a potentially beneficial aspect of RBI’s interest rate hikes is that it can provide the monetary space for lowering interest rates to combat a prolonged downturn in OECD economies. To sum up, the inexorable march of globalisation, despite its many discontents and malcontents, and attendant economic coupling across borders will continue and India should prepare accordingly.
The author is India’s Ambassador to the European Union, Belgium and Luxembourg. Views expressed are strictly personal.
j.bhagwati@gmail.com
