Downside risk to profitability rises

The emerging market economies (EMEs), which showed considerable resilience in weathering the crisis up to September 2008 on the strength of domestic demand supported by sustained export growth, came under strain in the last quarter of 2008 through contagion from trade and financial channels. The slowdown of world trade was deeper than anticipated causing reduction in aggregate demand in the EMEs. In a sign of flight to safety, capital flows from developed countries to the EMEs declined sharply in 2008.

Reflecting lower flows through both current and capital accounts, currencies of the EMEs depreciated against the US dollar. EME equity markets suffered large losses in the wake of reversal of portfolio flows. Bank lending to the EMEs declined and credit spreads increased sharply due to the prevailing credit crunch in advanced economies. EME exports declined because of tighter trade credit coming on top of slumping export demand. Going forward, exports to advanced economies are expected to decline further posing a major risk to growth in the EMEs.

In evaluating the current and potential problems arising from the crisis, it is important to note some broad differences between the advanced economies of Europe and North America and the EMEs. The crisis originated in the financial sector in the US, which led to the near collapse of their largest financial institutions and banks. Because of linkages across the financial system, the crisis spread almost immediately to Europe with European banks reporting very large losses. Both the US and European governments responded through large scale infusion of funds into the banking systems. Furthermore, with the erosion of banks' balance sheets, mistrust among banks intensified, as a result of which money markets dried up, and inter-bank markets choked. This engendered a credit squeeze which transmitted to the real economy. The first line of defence in fighting the crisis was aggressive monetary policy action, including rate cuts followed by quantitative monetary and credit easing. These measures were also accompanied by a significant expansion of central banks' direct participation in money markets in several ways.

The situation in the EMEs has been quite different. By and large, their financial institutions have not exhibited fragility, inter-bank confidence has been relatively normal and inter-bank money markets have continued to function. Nevertheless, the crisis has affected the EMEs in mainly three ways. The first was the exit of foreign equity which resulted in decline in stock markets, capital flow reversals and pressures on the exchange rate. The second source of impact was the drying up of overseas lines of credit for banks and corporates which shifted demand to the domestic credit market. The third source of impact is the significant deceleration in global trade growth reducing the demand for EME exports. Monetary policy actions by the EMEs have, therefore, been more in response to emerging real economy problems rather than financial sector problems. It is important to keep this distinction in view in designing and evaluating responses to the crisis.

Topics

1. Domestic outlook
2. Agriculture and industry
3. Corporate performance
4. Business confidence
5. Lead indicators
6. Inflation
7. Fiscal scenario

Domestic outlook

Like other EMEs, India too has been affected by the global financial crisis. Real GDP growth moderated to 7.8% in the first half of 2008-09 as against 9.3% in the first half of 2007-08. The third quarter of 2008-09 witnessed signs of further moderation in growth, especially in the industrial sector and some segments of the services sector.

Agriculture and industry

Good sowing and favourable weather conditions suggest that agricultural production during 2008-09 may be close to or better than last year's record production. During April-November 2008, the index of industrial production (IIP) growth decelerated to 3.9% from 9.2% a year ago. Episodes of large inventory build-up, production cuts and temporary closure in some sectors such as automobiles at the beginning of the second half of 2008-09 indicate a period of stress on account of lack of demand.

Corporate performance

During the first two quarters of 2008-09, despite high top-line growth, operating margins of the private corporate sector were eroded by higher input costs and significant drop in 'other' income. In light of the subsequent slowdown, industrial investment plans are slowing down, although ongoing investment projects appear to be continuing. The erosion in pricing power of corporates was reflected in rising inventories as a proportion to sales. While the downside risk to corporate profitability has increased, this may at least be partly offset by falling input prices and a gradual reduction in borrowing costs.

Business confidence

The Reserve Bank's latest round of quarterly Industrial Outlook Survey shows weak and deteriorating business sentiment among private manufacturing companies for the last quarter of 2008-09. The survey indicates weak demand conditions and decline in sentiment for production, order books, capacity utilisation and exports. Corporates also reported a significant decline in employment expectations for January-March 2009. This picture is consistent with business confidence surveys conducted by other agencies.

Lead indicators

In terms of lead indicators, service sector activity appears to be moderating in several sub-sectors, barring communications and freight movement. On the positive side, sustained performance of the agricultural sector, fiscal stimulus, falling global crude oil prices and softening of domestic input prices such as energy, cement and steel would have a positive impact on industrial production in the coming months.

Inflation

Headline inflation, as measured by year-on-year variations in the wholesale price index (WPI), fell by more than half from its intra-year peak of 12.91% on August 2, 2008 to 5.60% by January 10, 2009. While prices of primary articles and manufactured products increased, fuel prices declined. In terms of relative contribution to decelerating headline inflation between August 2, 2008 and January 10, 2009, petroleum and basic metals (combined weight of 13.2% in WPI) together accounted for 79.4%, followed by 'oilseeds, edible oils and oil cakes' (16.4%). Clearly, the fall in commodity prices reflecting global trends has been the key driver of the sharp fall in WPI inflation although effective management of domestic demand too has contributed to this moderation.

On the other hand, inflation based on various consumer price indices is still in double digits due to the firm trend in prices of food articles and the higher weight of food articles in measures of consumer price inflation (CPI). As the decline in input prices percolates over time to the prices of manufactured and other products, consumer price inflation too is expected to soften in the months ahead. For its overall assessment of inflation outlook for policy purposes, the Reserve Bank continues to monitor the full array of price indicators.

Fiscal scenario

As a proportion of the budget estimates (BE), both tax and non-tax revenue receipts of the Central Government for the period April-November 2008 were lower than those in the corresponding period of the previous year. On the other hand, both revenue expenditure and total expenditure, as a proportion to the BE, were higher than a year ago. Consequently, the revenue deficit and the gross fiscal deficit (GFD) were significantly higher during April-November 2008 as compared with the corresponding period of the previous year.

For 2008-09, the Central Government had budgeted gross market borrowing of Rs.1,78,575 crore and net market borrowing of Rs.99,000 crore. Subsequently, the Government presented two supplementary demands, as a result of which the market borrowing programme of the Central Government was raised to Rs.2,52,154 crore (gross) and Rs.1,75,374 crore (net). Against this enhanced borrowing programme, market borrowing of the Central Government was Rs.2,22,154 crore (gross) and Rs.1,51,697 crore (net) during 2008-09 so far (up to January 23, 2009). The weighted average yield and weighted average maturity of central government dated securities issued during 2008-09 (up to January 23, 2009) were at 8.03% and 14.59 years respectively as compared with 8.10% and 14.38 years in 2007-08. The State Governments have borrowed a net amount of Rs.46,327 crore up to January 23, 2009.

The evolving scenario raises some concerns on the extent of stress on the fisc in the current year emanating from several factors. First, the Centre is expected to suffer revenue losses from lower direct tax collection on account of the economic slowdown. Second, the Centre is likely to lose further revenues worth about 0.6% of GDP due to cuts in excise and customs duties. Third, there has been a disproportionate growth in expenditure of the Central Government during April-November 2008, particularly in respect of revenue expenditure arising out of increase in subsidies, disbursements as well as implementation of the recommendations of the Sixth Pay Commission and the farm debt waiver scheme.