India\’s high savings rate and forex reserves will weather global economic troubles

Given the global financial turmoil, India faces three possible outcomes – slow global growth, a borderline recession, and a financial crunch resulting in serious recession. I put the chances of slow growth at 65%, of borderline recession at 25%, and of serious recession at 5%. So, despite evident risks, stock market investors should treat the current turmoil as a buying opportunity rather than a signal to flee.

That makes me an optimist. The Economist feels there is a 50% chance of a recession. Ruchir Sharma of Morgan Stanley, who is a regular Economic Times columnist, feels the world will slide in and out of recession – the borderline scenario.

How will the three scenarios impact India? Consider first the worst scenario, a serious double-dip recession. Such recessions are rare, and usually brought on by strong-arm government action, wittingly or unwittingly. For instance the 1980-82 double-dip recession was deliberately engineered by US Fed chief Paul Volcker to crush inflation out of expectation no matter what the cost in lost jobs and output.

Political Worries

Ben Bernanke, head of the US Fed, has proved that he will throw the full weight of monetary policy behind preventing a double-dip recession. So, that battle is half won already. The Republicans want to squeeze government spending, but any such squeeze will be mild. Only if all OECD countries go for austerity simultaneously is global demand likely to dip sharply enough to engineer a serious recession. The only other driver of recession could be a truly ugly European financial crisis, leading to major bank failures. This is not impossible, but is very unlikely. Banks are better capitalised and much less leveraged than in 2008.

Political bungling is more likely to create a borderline recession. Continued political squabbling in the US over the government debt ceiling could spook investors and inhibit investment. So could European political squabbling over the future of the euro and the 17 countries using this common currency.

European politicians are understandably reluctant to let the eurozone shatter by allowing Greece and weaker countries to go bust. Yet the eurozone can be saved only if Germany, Holland and other fiscally strong countries agree to permanently help out regions in trouble, such as Greece and Portugal. This economic price is necessary to maintain the political vision of a unified Europe. This alone will cut to sustainable levels the interest rate on government bonds of Greece and other weak members.

Voters in northern Europe don\’t want to keep bailing out countries whom they regard as lazy and incompetent. One possible solution is to allow the issue of eurobonds guaranteed by all eurozone members, up to 60% of the GDP of each member. Such eurobonds will carry low interest rates because they are effectively guaranteed by Germany and other strong members.

Beyond 60% of GDP, government bonds will be unguaranteed, and so carry higher interest rates. This solution will mean a significantly higher interest rate for eurobonds issued by Germany, and this interest premium will be a non-transparent subsidy which transfers cash to weak members like Greece. This non-transparency may fool voters into thinking that guaranteed eurobonds are different from constant rescues.

Political uncertainties in the US and Europe will certainly discourage entrepreneurs and fuel fears of consumers, thus creating a simultaneous decline in private investment and consumption even as governments seek to stimulate these. This could be a recipe for a borderline recession.

Yet the most probable outcome is a slowdown, not recession. When all governments know the danger of a double-dip and want desperately to avoid it, the chances of it happening are not very high.

The travails of Greece and Portugal were initially ascribed to excessive spending and populism, yet their attempts at austerity have not solved their fiscal problem – the fall in government revenue caused by austerity can overwhelm spending cuts. The UK has shown that austerity need not mean a double-dip recession, but it does mean slow, unconvincing growth.

Besides, some economic indicators suggest that gloom and doom are being over done. The latest employment data in the US are better than expected, and so are retail sales. Growth in the first half of 2011 has been well below expectation, yet that low base makes it easier to grow in the second half.

India Response

What should India do in the light of the three scenarios? Nothing much needs to be done if there is slow global growth or even a borderline recession. There will be some impact on exports and FDI, and portfolio inflows into stock markets may dry up. The RBI has been tightening monetary policy to tame inflation, sacrificing growth for India\’s own internal reasons. An additional downward nudge from the global economy may actually help.

However, the government must speed up decision-making, prune wasteful subsidies, and speed up land acquisition and environmental clearances that have stalled many projects. The Doing Business series of the IFC/World bank show that India comes only 165th of 183 countries in ease of starting a business, 177th in ease of getting a construction permit and 182nd in enforcement of contract. Action is desperately needed on all three fronts.

If there is a serious recession, the government will have to consider a fiscal stimulus as in 2008-09. A deep recession will push down global prices and solve the inflation problem, so monetary policy can become looser too. India\’s high savings, high forex reserves and modest current account deficit mean it is well placed to survive a double-dip recession.

But it will certainly mean slower growth and distress for outward-oriented companies. Exports will suffer, foreign investors will pull out of stock markets, and Indian companies will find it difficult to borrow abroad. India should be able to cope with these problems, as it did in 2008-09.

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