Journalists do not have a good reputation for predicting recessions. Indeed, they are reputed to have predicted 10 of the last three recessions. A month ago, I wrote that the US had a 33% chance of going into recession next year. Events of the last month have, in my view, increased the chances to over 50%, meaning that a recession is not merely possible but probable. This assessment does not place me among the greatest pessimists: Merrill Lynch rates the chances of a recession at 65%.
We need to address two issues. First, why have the chances of a US recession increased? Second, what impact will that have on the Indian economy?
As for the first issue, financial crises do not automatically lead to recessions. So, last month’s turmoil in financial markets has affected stock market surprisingly little. Indeed, the sensex is not far from its all-time high, the Dow is resilient, and Chinese bourses are roaring ahead. The stock markets believe that central banks will soon soothe fears and end panic.
Such optimism ignores bad news in the real economy. Because of rising population, the US needs to create on average 120,000 additional jobs per month to keep the employment rate stable. But in August the US actually lost 4,000 jobs. This looks more a trend than a blip: the new-jobs data for June have been revised down from 126,000 to 69,000, and for July from 92,000 to 68,000.
In August, jobs in construction fell by 22,000, and in manufacturing by 46,000. This suggests that the slowdown has spread from housing to other sectors.
Services continue to be the mainspring of the US economy. But financial jobs are going to be slashed after the recent troubles. For instance, Countrywide, the biggest mortgage financier, is slashing 12,000 jobs and Lehman Brothers 2,000 jobs.
Not all the news is bad. Wages for non-supervisory workers are up 3.9% over the last year. Productivity continues to rise. GDP in the April-June quarter grew by a very healthy 4%. Hence optimists think that the US economy will have a soft landing, and keep growing, albeit at a slower rate. Much hinges on whether the housing bust will cause a sustained fall in consumer demand. That is what will lead to recession.
In the financial sector itself, contagion is spreading from subprime mortgages to other areas. Central banks have opened the credit spigot for banks to borrow more. Yet risk-aversion has driven the asset-backed commercial paper market into deep freeze. Corporates who used to float commercial paper for 60 days are now told by banks to borrow for just seven days, affecting $250 billion of commercial paper. Further, bridge loans of $300 billion can no longer be offloaded in the financial markets, so banks will have to take these onto their books, dampening credit growth and creating issues of capital adequacy.
Banks facing difficulties in getting bridge loans off their books are suddenly hoarding cash, and this explains the problem in inter-bank lending in the UK, where LIBOR has shot up to 100 basis points over the corresponding gilt rates in the US. Special Investment Vehicles — off-balance sheet instruments operated by banks — have also turned illiquid and may have to be taken onto balance sheets, causing fresh capital adequacy problems.
In response to liquidity fears, European central banks have stopped raising interest rates, and the US Federal Reserve seems certain to cut its rate. So the financial turmoil will probably cool down.
The main risk ahead is the serial bursting of housing bubbles across the world. Even in India, real estate prices have fallen recently.
The subprime problem in the US started with a sudden inability to service mortgages. The official explanation is that many mortgages were re-set at higher levels, which borrowers could not service. But such re-setting of mortgages has gone on for six years, and was not a problem earlier. Pessimists claim this is evidence that a recession has already begun, and the consequent decline in incomes is causing the mortgage defaults.
According to this theory, the problem has spread from the real economy to the financial sector, and not the other way round. If so, new and revised data over the next six months may reveal that a recession started in the second half of 2007.
Okay, now to the second issue. If there is a US recession, what will be the impact on India? Substantial, surely. Some theorists think that countries like China and India have decoupled from the US economy, and can keep forging ahead through a US downswing.
Now, the US has certainly ceased to be the sole locomotive of world growth, and many other economies have become minor locomotives too. Yet the US still accounts for a quarter of world GDP. Moreover, Chinese GDP growth depends in substantial measure on exports to the US, which will surely be affected by a US recession.
In India, the share of trade in GDP (including services trade) is now 45% of GDP, a far cry from the heyday of self sufficiency. The country is now integrated into the global economy as never before. Exports have been critical in pushing manufacturing growth into double digits.
So a US recession will have a substantial impact on India. India’s GDP could dip by two percentage points. That is, it could fall from its recent average of 9% to 7%.
Now even 7% will remain a very impressive rate of growth. However, the deceleration in the corporate sector will be much sharper, especially in export-oriented sectors. Corporate profits have been growing at the rate of 20-25% per year. That will fall to single-digit growth overall, with several corporates going into the red. In such circumstances the stock markets will surely take a dive.
Optimists say that won’t happen since the US economy will a have a soft landing. They think that scenario, combined with a continuing glut of global savings, could keep stock markets buoyant next year. But I would not bet on it.