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Macroview | Will mkt turmoil hit economic growth?

The Sensex dropped more than the Dow Jones because the FIIs had to sell Indian stock to mobilise liquidity for hedge funds. DH Pai Panandikar tells us more...

india Updated: Aug 25, 2007 04:14 IST
DH Pai Panandikar
DH Pai Panandikar
Hindustan Times

Although mortgage crisis is hardly our problem it is visibly reflected in the precipitous fall in BSE stock prices. Possibly we shall also have to pay a small penalty on growth for financial indiscretion elsewhere.

The Sensex dropped more than the Dow Jones not because our banks were holding sub-prime mortgages or derivative instruments but because the FIIs had to sell Indian stock to mobilise liquidity for hedge funds. The fall in Sensex meant a loss of Rs 6,00,000 crore to shareholders. Much of this loss may be notional and will be recovered but presently, it affects investor sentiments and can therefore cause real damage.

The damage is caused because, with the loss in share value, investors are reluctant to look at new issues and companies are unable to raise capital, which is necessary to fund investment. Economic growth is currently driven by investment and difficulties in acquiring equity capital can delay projects and slow down development.

The other source of funding that is likely to be affected by the crisis is external commercial borrowings (ECB). The RBI had already put restrictions on their use. Now, with the mortgage crisis, credit spreads have widened and the rate of interest not only for mortgages but also for commercial credits has increased. There is therefore bound to be a decline in ECBs for funding domestic investment

In short, the market crisis will make it difficult to raise both equity and loans and therefore delay investment. But there is a silver lining to this cloud. The reduction in the flow of FII portfolio investment would drive down the rupee, which had unreasonably climbed up. Since mid-August, it has depreciated from 40 to the dollar where it was finally stopped to 41.

That would undoubtedly be a welcome development for exporters. In the first quarter of the current year export growth was down from 23 to 18 per cent when the rupee hardened from 45 to 40 to the dollar. Since nearly 12 per cent of the industrial production is exported, with the improvement in exports, it will be possible for growth in industrial production to pick up. With the source of excess liquidity likely to shrink, inflation would taper down and may prompt the RBI to reduce the rate of interest.

The stock market experiences ups and downs all the time and the present crisis will also be blown over. But what is different about this crisis is that it will cause huge losses and many bankruptcies in the US and EU. Besides, it is not mere sub-prime loan defaults that make up the crisis but also the ‘carry trade’. The latter is yet to reveal its impact. It is therefore possible that the present crisis may survive longer. If it ends before September it will not make any difference to our growth; if it survives beyond October investment will be delayed and slow down growth, which can only be partly made up by improvement in exports.

The writer is president, RPG Foundation

First Published: Aug 25, 2007 04:03 IST