And we all fall down?

Several markets, including India’s, have plunged amid fears about the US economy. ILA PATNAIK tracks the current crisis and its implications for India

• Markets have always cheered rate cuts by the US Federal Reserve. So why are they reacting differently this time?

In the last few months, when trouble in the US economy started, it seemed that a Fed rate cut would save the economy. So when the US Fed first cut rates, investors were overjoyed thinking the Fed had come to the rescue and there would be no recession. Now, it seems it has started dawning on the stock market that the Fed cut rates because it is deeply concerned about what was happening in the economy — which is not good news. US unemployment data suggests there is a good chance that a recession may commence, and there is extensive discussion in the US of what macro policy should do in response.

• What does this mean for India?

First, the strength of the rupee-dollar rate should be seen in the context of dollar weakness. If we try to hang on to Rs 39 a dollar when the dollar is dropping, this constitutes a forced devaluation of the rupee. Second, it is not surprising that India is getting a lot of capital — the macroeconomic outlook in India is better than that seen in many parts of the world. This has increased the pressure on the rupee to appreciate. Third, if the US goes into recession, it will affect more Indian firms than we tend to think today. That is what explains the reaction of the Indian stock market to US markets last week.

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• Did no one see the imbalances emerging in the US economy?

For many years now, the US stock market has been faring well. Once the nervousness after the 9/11 attacks subsided, the S&P 500 index bounced back and doubled in five years. But macroeconomists diverged from the financial markets in warning that all is not well. They warned about the massive Chinese exchange rate manipulation (accompanied by other Asian countries on a lesser scale). They warned about the massive US current account deficit. They warned about the extent to which the perceptions of low-risk and low-interest rates were generating incentives in the financial sector to seek out high-risk portfolios.

• How did the imbalances affect the US dollar?

A slow decline of the US dollar commenced in January 2002. The US Fed computes a ‘major currencies index’, which shows the value of the US dollar against all the major floating exchange rates of the world. The governments of these countries, and the US, do not trade in their own currency markets; hence these prices can be trusted. This index shows end-January 2002 as the high. From that point onwards, the dollar started a long-term decline. This decline appeared to be working in terms of addressing the global imbalances. As the dollar got cheaper, slowly, US exports started rising and the US current account deficit started dropping. Some people started announcing victory for US macro policy, saying that a ‘soft landing’ had been achieved in resolving the global imbalances.

• What impact did the sub-prime crisis have on this situation?

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In mid-2007, difficulties broke out in the US housing market. Many households started defaulting on their home loans and several financial firms started reporting large losses in their home loan portfolios. Credit rating agencies came under cloud for having used faulty methods for coming up with ratings, and the business model of rating agencies (taking money from the company getting rated) came under severe attack. Matters worsened because the market stopped trusting credit ratings and froze.

Merrill Lynch and Citibank have reported portfolio losses of roughly $20 billion and the total losses reported now exceed $110 billion. For a sense of scale, US GDP is roughly $14 trillion, so the reported losses are now nudging one per cent of the US GDP. In India, it would be like a group of financial firms reporting portfolio losses of Rs 40,000 crore, which is 1 per cent of the country’s GDP. This would be big news. It is rumoured that in late 2007, Citibank was under extreme stress.

In summary, the US has a serious problem on the housing market and possibly with some financial firms. A downturn in the US is bad news for the world economy, including India. We do not yet know whether this undermines the framework of a gradual adjustment process that has been correcting global imbalances.

The writer is senior fellow, National Institute of Public Finance and Policy ilapatnaik@gmail.com