Cheer up, the outlook is not so bad

Cheer up, the outlook is not so bad
27 Dec, 2007, 0548 hrs IST,T T Ram Mohan, TNN

The year ends on a sombre note for the world economy. The impact of the subprime crisis in the US is stretching out. Whatever the prospects of an economic depression, the barrage of morose comment is certain to generate pervasive mental depression.


Cheer up, the outlook is not so bad. The US economy will slow down appreciably but still looks unlikely to go into recession, that is, two successive quarters of negative growth. The global economy too will slow down but growth will still be good by past standards. The Indian economy will continue to grow strongly and the stock market should provide attractive returns over the coming year.


The fundamental basis for optimism about the world economy is this: major economic crises have their roots in big supply shocks (e.g., a sharp rise in oil prices) or a currency crisis (caused by foreign investors’ lack of confidence in an economy) or a banking crisis. None of this appears likely today.


The world economy has shown an uncanny ability to live with high oil prices. But prices above $100 still have the potential to cause damage. During the year, prices inched towards the $100 mark but they have since shown signs of softening. A big factor is the US intelligence agencies’ assessment that Iran suspended its nuclear weapons programme in 2003 and is still quite far from acquiring the bomb. This renders a neocon-inspired strike on Iran rather difficult in the coming year. That is good news for oil prices.


The US is hugely indebted and foreigners hold a huge amount of US government securities. The US is theoretically vulnerable to a currency crisis. But currency crises are more common when debt is foreign currency-dominated. This is not true of the US.


The US enjoys an even bigger advantage. As the world’s sole superpower and the biggest economy, the US will remain the choice of central banks and other investors for some time to come. While investors may lower their US holdings in their portfolios, a big sell-off that could trigger a currency crisis is just not on the cards.


What about a banking crisis? Banks’ losses are expected to rise in the months to come as the crisis unfolds. Many of the off-balance sheet vehicles floated by banks are now coming on to their balance sheets. As banks are expected to carry a minimum of regulatory capital against balance sheet assets, it is argued that their ability to extend credit will be impaired and we could see a credit crunch.

This is true, of course, but a credit crunch does not imply a banking crisis. A banking crisis involves the failure of several banks, that is, the net worth of several banks gets wiped out. There is nothing so far to suggest that such a crisis threatens American banking. Large banks operate with a capital adequacy ratio of over 12% against the regulatory minimum of 8% or so. They are well placed to absorb the impact of the subprime crisis and also to boost their capital.
That is because, as Citibank and UBS have shown, there are overseas investors willing to provide capital.

US banks have non-core assets that could be sold off at a pinch. Secondly, as the Financial Times points out, the global US banks are sitting on a gold-mine in the form of their investments in Chinese banks — the nine biggest stakes are worth $81 billion compared to the write-offs announced of $50 billion. So, yes, banks’ ability to lend will be constrained but this falls well short of a banking crisis.

The prospects, therefore, are of a slowdown in the US economy but not a recession. A US slowdown will drag down global economic growth, of course, but strong domestic demand in emerging markets can be expected to mitigate this impact. Despite what is believed to be a crippling credit crisis, world economy growth in 2008 in PPP terms will not be much lower than the rate of 4.4% seen in 1999-2008.


India’s own growth prospects remain bright. In 2008-09, we can expect growth of the order of 8%-8.5%. Exports are bound to be impacted by external conditions and the appreciation of the rupee. But investment will remain strong.
The big change in the Indian economy in recent years is that it is becoming investment-driven: investment has outstripped consumption in its contribution to growth every year since 2002-03. Businessmen are looking far beyond the present global conditions and they like what they see in India, so they will invest and invest.

India’s stock market should continue to deliver good returns. The earnings outlook remains good. Moreover, the Indian stock market is showing signs of attracting new classes of investors (US pension funds, oil wealth, Japanese retail investors, etc). The combination of strong fundamentals and FII flows augurs well for the market.

There is an economic crisis in our midst alright. But it is not formidable in relation to crises we have seen in the past. On balance, it is still amenable to concerted policy action. Not a bad note on which to usher in the New Year.