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Enduring the Subprime Tsunami

Wall Street opened higher as central banks propped up markets on September 18, 2008. (Spencer Platt/Getty Images)

Wall Street opened higher as central banks propped up markets on September 18, 2008. (Spencer Platt/Getty Images)

by Pramit Pal Chaudhuri

Originally published in Far Eastern Economic Review, September 23, 2008

India's economic leadership transited from concern to confidence within a few days of the second wave of the United States' subprime crisis buffeting the country. The initial concern was that the collapse of Wall Street heavies like Lehman Brothers and Merrill Lynch would have a tsunami effect on the rupee, the Mumbai stock market and, therefore, the Indian economy's overall growth prospects.

It only took a few days for this to be replaced with guarded confidence. By the time they reached India the West's financial difficulties assumed the dimensions of a surface ripple rather than atidal wave. If anything, argued some Indian commentators, subprime could actually help India solve its more pressing economic problem of domestic inflation.

Subprime 2.0 did land some blows to the Indian economy. Two key sectors, software services and real estate, were seen as vulnerable. The impact on software was obvious: roughly 40% of the industry's service exports arefor overseas financial sector clients. A shrinking Wall Street burnt a medium-sized hole in the pockets of some large Indian software firms like Satyam and TCS. Som Mittal, head of the National Association of Software and Service Companies, recently told Business Line,  "The impact will be short term and company specific. " Lehman and Merrill had also invested heavily in commercial real estate in India and a number of realty firms, like Unitech and Piramyd, had to scramble for replacement financing.

The economy saw the Bombay Sensitive Index fall 3.5% the day Lehman filed for bankruptcy. Foreign institutional investors, which have been exiting from Indian equities the past nine months, accelerated their departure. However, as has been the case so far this year, domestic institution albuyers more than made up for the FIIs. Between Sept. 1-18, FIIs sold 67.38 billion rupees worth of shares but domestic institutional investors bought 70.38 billion rupees. Another reason for the initial source of worry was the rupee, which fell 8% against the dollar between mid-August and mid-September. The rupee stabilized after sustained but not extensive intervention by the central bank, the Reserve Bank of India. While the fall was steep it was not market-shaking and partly reflected the fact that despite the net outflow of FII money, the country has experienced record capital inflows this year.

The relative speed with which Indian firms were able to fill in the funding gaps that Wall Street's woes opened, and the ease with which India's economic institutions were able to ride out the storm, has led New Delhi to take a relatively relaxed attitude to the crisis.

At the heart of this is a belief that India's real economic headache continues to be double-digit inflation and that this inflation is caused by excess liquidity in the market. The liquidity comes from over $100 billion in foreign capital coming into the country in the first half of 2008 as well as excessive, election-driven, government spending. Against an RBI target of M3 growth of 17%, broad money supply has risen 20.5% as of July.

Therefore, a drop in such capital flows as well as a dampening of global commodity prices eases inflationary pressure in the Indian economy and allow the RBI to ease interest rates. Hence the argument that subprime might have a silver lining for India.

But as is true for most Asian countries, this will be the case only if subprime comes this far and no further. A further meltdown of the U.S.economy would be wholly negative for India. The U.S. is one of India's biggest trading partners and investors. A full-fledged slowdown would impact almost every Indian industrial and service sector. (Already there has been a substantial increase in borrowing costs for private companies, the main driver of India's economic growth.

In addition, domestic capital pools are not infinite. If the dollar decamped from India en masse, it is questionable if domestic buyers would be prepared to empty their coffer to fill the gap. New Delhi's past few years of fiscal imprudence means the government would run astrong risk of inflating prices and deflating currency if a major financial blowup on its shores forced it to pump in a lot of liquidity. Given New Delhi's poor record in recent years of managing the tradeoff between prices and growth, India would have to sacrifice much of the projected 7.5% growth that it is already struggling to attain.

India's leaders like to say they survived the 1997 Asian financial crisis because of the relative isolation of their economy. The result is that the policy discourse uses global economic volatility as an excuse to stall various financial reforms like currency convertibility. One of the more damaging legacies of the present situation may be that much-needed financial sector reform, whether it is more leeway forse curitization or a larger role for foreign banks and insurance firms, may be shelved until the memory of the Day Lehman Died has faded.

Pramit Pal Chaudhuri is senior editor of the Hindustan Times in New Delhi and a member of the Asia Society International Council.