Standard & Poor (S&P) downgraded the US sovereign debt rating to AA+ from AAA rating. A rating downgrade of sovereign debt would mean that credibility of sovereign debt is reduced. Therefore if the US govt wants to raise funds by issuing bonds, it would have to offer higher interests to investors to make these bonds more attractive. The higher interest payments would add to the govt expenditure and consequently fiscal deficit. One way of tackling fiscal deficit that has been agreed in the recent US debt-ceiling agreement is that govt spending would be reduced. Two consequences:
1. US Govt is a big contractor in the US economy- if it reduces expenditure, this means that US companies get fewer and smaller contracts. Consequently the tasks that it sub-contracts to offshore companies like India will also reduce.
2. US govt also spends towards medical insurance, social security, pensions of its permanent residents/citizens- these payments form a sizeable part of people’s incomes. If the govt reduces its contribution in these areas then people will have lesser money to spend. Thus spending on non-essentials is reduced and concentrated on essentials only.
Impacts on Indian Economy
It should be noted that this has occurred at a time when there is a prevailing Eurozone debt crisis and has compounded the global economic problems.
- Increased the risk aversion of investors. Investors are withdrawing from equities and investing in bonds, bank deposits etc (more reliable and now interest rates on these are increasing).
- Stock markets crashed in India. Foreign Institutional Investors (FIIs) sold Indian shares.
o logic herein is that a continued downfall in the share price is expected, so FIIs sold shares now with an aim of buying again when share-prices fall further.
o FIIs may invest the money withdrawn from the Indian equities, in bonds (which have an assured return that equity doesn’t promise in the near term), gold (which is appreciating and is considered a safe bet) or in markets that are not so interconnected with the US market, and thus will face lower volatility.
o Analysts say that when massive sell-off of securities happens, then share prices fall to a level where they become cheap and highly attractive- at this point investment will come back.
- Currency movement of Dollar vis-a-vis Rupee. The immediate effect of the downgrade was that the Rupee depreciated against the dollar. However if the dollar were to depreciate against the rupee, then:
o Indian exports will become more costly and thus uncompetitive. Export-driven industries like garments, leather, jewelery could come under pressure.
o Also downgrade will impact consumption in US, lowering demand there and export volumes to US will be reduced because of this.
o Indian imports would become cheaper- important because oil bill will become cheaper.
- Attempts to raise foreign capital by Indian firms from foreign publics will be affected, as the global investors attraction to foreign currency-denominated bonds would have lowered.
o ‘Foreign-currency denominated bonds’ are bonds wherein the foreign investors are promised an assured return in foreign currency. Such bonds had become very useful to Indian companies mainly because of the lower-interest rates prevailing in these foreign markets. Therefore they could raise capital at low interest rates (as opposed to India where high interest rates are prevailing). In the first half of 2011 itself, Indian companies raised $7.6billion in this manner.
o To attract capital through this route, Indian companies may have to pay higher interest rates.
- IT industry
o Being an export-oriented sector (derives 60% revenue from US) IT is likely to be hit. Shrinking of IT budgets of companies is expected.
o A large part of IT servicing can be categorized as non-essential, thus US companies will not spend money on those areas now. This will reduce contracts for Indian companies.
o However, NASSCOM feels that IT industry will not be affected in the near-future because the economic slump will cause US companies to innovate (through IT) to reduce costs and improve profitability.
o Regarding long-term impact, industry watchers feel the lag will show up two quarters later.
- BPO Industry- is directly linked to volume of spending on non-essentials.
- Oil prices are going down because of slower growth and hence lower demand
o This is beneficial to India because it will help battle inflation (cost price of goods will reduce) and keep fiscal deficit in check (lower oil price means that govt subsidy bill on oil will be lower, thus fiscal deficit will be reduced).
o It is estimated that every $10/barrel fall in oil prices, will reduce current account deficit by $8billion. This will also help the govt in a situation where risk aversion is leading to a drying up of capital flows.
- RBI declared that it would ensure that adequate rupee and forex liquidity in the domestic market is maintained. This is to prevent volatility in interest rates and exchange rates.
o Rupee liquidity in domestic market will be affected because of high volume of transactions in the stock market, to finance which people may take loans from banks.
o Rupee liquidity has to be maintained because if not, then the available money will command higher interest rates. Interest rates are already at a high (due to RBI rate revision). High interest rates result in decreased profit margins for companies and consequently decreased returns for share-holders (which is why when RBI revised interest rates up recently, stock-markets fell). Following from this, industry borrows less and there is lower investment and fewer jobs are created.
o To address this need for liquidity RBI has made provisions to provide liquidity to banks, in the following ways:
§ Borrow by pledging govt bonds
§ Avail of ‘marginal standing facility’ which is an emergency borrowing facility.
o Forex liquidity will be affected because FIIs are selling shares. When FIIs invest in Indian market, they bring their foreign currency (say dollars) and convert it into equity. Thus when they sell shares and exit the Indian economy, they have to be paid back in dollars. Thus demand for forex goes up. This is what the RBI seeks to address.
o Forex liquidity has to be maintained so that the dollar exchange rate is maintained. [has implications for imports, exports]
- Gold price shot up being the usual investment alternative to the dollar.
- S&P has forecast that Indian govt’s fiscal capacity has shrunk, and the impact of another downturn on India and other economies will be ‘more prolonged’. S&P feels that another slowdown will require govts to use their fiscal capacities to support their economies and financial sectors again.
o Since GOI and others (Japan, Malaysia, Taiwan…) already supported their respective economies in the 2008 crisis, S&P feels their fiscal capacity has reduced and is not sufficient to support their economies again, in such a short time.
o However other analysts contend that the decreased oil prices will provide govt with enough resources to support industry, if needed.
Sources:
Business Standard - 8th and 9th August 2011
The Hindu- 8th and 9th August 2011
"The immediate effect of the downgrade was that the Rupee depreciated against the dollar." .. if this is true that why have u given the effects of opposite i.e "However if the dollar were to depreciate against the rupee, then:" ... is it because Dollar is expected to depreciate against rupee in future due to this downgrade ??
ReplyDeleteThe immediate depreciation of the rupee was because of the withdrawal of capital by the FIIs.
ReplyDeleteTo understand why some analysts have contemplated a depreciation of the dollar, am giving a little background:
- The US has a huge trade deficit. To finance this deficit, it issued govt bonds. These govt bonds are bought by countries (China, India) and other agencies. Thus now the US has run-up a huge debt too.
- Normally when a country faces huge trade deficit its currency depreciates automatically. This is because the trade deficit requires a conversion of domestic currency into foreign currency to pay the foreign companies/countries. For instance US has a trade deficit vis-a-vis China, so US has to convert its dollars into yuan and pay China. The demand for yuan is greater than dollar, and so will its value be greater. Since the demand for dollar is lesser, its value depreciates. This depreciation continues till the US exports become competitive again and increase, and correspondingly its imports become costly and decrease. In this way the trade balance is restored.
- Perhaps the analysts in light of the huge debt that US has run-up, feel that US currency will have to depreciate for the country to attempt a regaining of fiscal and trade balance.
However the case of the US dollar is compounded due to its status as the international currency. Countries around the world hold US govt bonds. If the dollar depreciates, the value of these bonds also decreases. Thus other countries too have an interest in maintaining the dollar
value. For this reason it is difficult for the US dollar to depreciate much.
Another possible impact: If India continues to have a strong economy, it will attract foreign capital- this may result in an upgradation in India's credit rating from the present 'BBB stable' status.
ReplyDelete- Kaushik Basu (Chief Economic Advisor)