The Credit Crunch Creeps Up on India

Credit problems in the U.S. and Europe have finally crept up on India, writes Chetan Ayha in Morgan Stanley's latest Global Economic Forum. The impact could drive down its GDP growth, and cause particular difficulties for sectors such as financials and industrials. Initially, it was thought that the troubles would be contained in the U.S. and Europe, but things have been changing. As Ahya reports:

The Asian credit market has also been feeling the heat. This is reflected in a sharp rise in Asian dollar bond yields. We believe that this, coupled with a slowdown in portfolio equity inflows, private equity inflows and real estate investments, will weigh adversely on India’s growth outlook. For the last 3-4 years, India’s growth acceleration trend has benefited more from the globalization of capital markets than from the globalization of trade. This trend now appears to be reversing.

According to Ahya, the credit default swap [CDS] rate, which measures perceived risk, has risen sharply: The average CDS rate in AXJ, as measured by Bloomberg’s iTraxx Asia ex-Japan Index, which comprises 70 equally weighted entities, has increased from 48bp as of early July 2007 to 285bp currently. Similar rises across the board, should they continue, would make foreign capital-raising for India all that more difficult. And there's the rub, for India has relied heavily on large capital inflows to support its extraordinary growth rate (average GDP growth of 9.3% in F2006, F2007 and F2008).

The credit crunch has toughened the conditions for global financial institutions to raise funds, and Indian companies, inter alia, are withdrawing their foreign currency bond issuances. According to Morgan Stanley, capital inflows into India could slow to "US$30-40 billion over the next 12 months compared with US$106 billion in the last 12 months, unless there is a dramatic turnaround in the global credit market environment."

The impact on India is more pronounced than on other countries in the region, Ahya writes, as, unlike the others, India runs a current account deficit, and its large balance of payments surplus has been driven by capital inflows. Also in contrast to other Asian economies, India has pursued a loose, pro-cyclical fiscal policy. The overall impact therefore of the credit crunch, Ahya believes, will be to push India's growth down, with some sectors being more at risk than others:

We believe that capital access for capex and household spending will become more constrained over the next few months, affecting aggregate domestic demand and GDP growth. We estimate that GDP growth will slow to 7% during the quarter ending December 2008 from 8.9% during the quarter ended September 2007. In our view, the downside risk to our below-consensus estimates has increased. Morgan Stanley strategist Ridham Desai believes that the key sectors affected by this trend are (i) banks with large international operations, (ii) property and (iii) capital goods and construction. In general, he expects that companies with floating-rate foreign exchange liabilities, asset side exposure to equities and sub-par fixed income securities will likely surprise negatively. Hence, financials and industrials are the main underweight positions in his model portfolio.