Chicago, IL – August 31, 2009 – Zacks.com announces the list of stocks featured in the Analyst Blog. Every day the Zacks Equity Research analysts discuss the latest news and events impacting stocks and the financial markets. Stocks recently featured in the blog include: Franklin Resources (BEN), United (UAUA), The Gap (GPS), J.C. Penney (JCP) and Family Dollar (FDO).

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Here are highlights from Friday’s Analyst Blog:

Savings Rate Dips in July

We have already seen a dramatic improvement in the trade deficit over the last year -- more than cutting it in half. However, most of that improvement is due to the fall in the price of oil, and we are past the anniversary of the oil price peak, so that effect is going to fade. We have seen some pick-up in the economies of other major countries recently, but they are far from booming (with the exceptions of China and India, but even there things are going slower than they used to). That does not auger well for a dramatic increase in exports.

Thus, by process of elimination, it means that we will have to dramatically reduce our non-oil imports (or cut the volume of oil imports if we are not getting the help on the price side). The only other option is an increase in Government as a share of GDP.

This is a trend that has all sorts of implications. If we are going to be saving more, it should help investment management companies like Franklin Resources (BEN). On the other hand, if we are consuming less, it means that the consumer discretionary sector will face a particularly stiff headwind. People will take fewer vacations which will hurt airlines like United (UAUA).

Retailers, particularly in the mid-range like The Gap (GPS) and J.C. Penney (JCP) will find growth very hard to come by. Spending will not come to a stop, but it will slow, and people will be more concerned with cost as opposed to cash. This makes discounters like Family Dollar (FDO) relatively much better positioned.

Keep in mind here that I am talking about a trend that will play out over a decade, and it will not be a straight line, so from time to time some of the less-well-positioned firms might be good trades, but I suspect that they will be lousy long-term investments.

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The annualized drop in these imports was 36.5% in 2008Q4 (log terms). In addition, with non-oil imports dropping about 5% (non-annualized, in logs) in the first two months of 2009, 2009Q1 imports seem set continue the drop. In Figure 1, I've assumed that the drop witnessed in January and February continues into March.

These declines are so large that they are difficult to reconcile with standard models. To formalize this assertion, consider the predictions of a standard imperfect goods model used in traditional (i.e., old fashioned) macroeconometric models (see [1]. The model is given by:

Imp = α ₀ + α ₁ y + α ₂ r

Where Imp is real imports, y is real income, and r is the real value of the dollar.

I estimate an error correction version of this model, wherein there is a long run relation between the levels of imports, income and the real dollar.

Δ imp _t = β ₀ + φ imp _t-1 + β ₁ y _t-1 + β ₂ r _t-1 + γ ₁ Δ imp _t-1 + γ Δ ₂ y _t-1 + γ ₃ Δ r _t-1 + u _t

In this specification, the long run elasticities are given by the ratio β _i/ φ . When this model is estimated over the 1974q1-2008q4 period, one obtains sensible estimates (in that higher income or a stronger dollar induces greater imports in the long run).

One way of evaluating whether the 2008q4 observation is anomalous, in a statistically significant sense, is to examine the recursive residuals. A recursive residual is the time t prediction error based upon the regression estimated up to time period t-1, but using time t values of the X variables. Figure 2 depicts the 95% standard error band; an observation outside that band suggestive structural instability in the regression equation.

I thought that modeling imports with durable consumption as a trend variable would make this "instability" disappear. While it did mitigate the prediction error, a statistically significant overprediction remains.

Another possible covariate is (log real) household net worth; adding this into the model, both with long and short run effects allowed does improve the fit (3 lags of the first difference of net worth).

Δ imp _t = β ₀ + φ imp _t-1 + β ₁ y _t-1 + β ₂ r _t-1 + β ₃ hh _t-1 + γ ₁ Δ imp _t-1 + γ Δ ₂ y _t-1 + γ ₃ Δ r _t-1 + γ ₄ Δ hh _t-1 + γ ₅ Δ hh _t-2 + γ ₆ Δ hh _t-3 + u _t

Where hh is log real household net worth, obtained from the Federal Reserve Board's Flow of Funds statistics. The adjusted-R ² is 0.4 versus the 0.3 in the standard formulation. Figure 3 depicts the recursive residuals for the augmented model.

This model does not exhibit the instability apparent in the standard model. This suggests that household net worth is important to imports, which certainly makes sense if one thinks that the reason that non-oil goods imports are declining (recalling that non all imports are used for consumption). Of course, there are other explanations that are consistent with this effect. For instance, there could be a common shock affecting both household net worth, and trade financing. This latter interpretation could work on both LDC exports, and also LDC imports [2] -- given that some US imports are used to produce US exports (i.e., vertical specialization, as described in this post).

What do these models predict for 2009q1? Figure 4 depicts the results.

The standard model badly mispredicts 2008q4, while the augmented model does slightly better (6% error vs. 9% error). Both models predict the downturn in 2009q1; which model proves more accurate depends upon what the March numbers will be. (That being said, these are all fitted models, and not dynamic forecasts).

The global financial crisis is drying up the financing that firms depend on for trade. That's making the global recession nastier and deeper than it otherwise would be.

As with all kinds of credit these days, financial institutions are making less trade finance available and charging more for it. But the squeeze in trade stands out because it pinches otherwise healthy companies that should be driving a recovery in global commerce. Already, the World Bank predicts trade will contract next year for the first time since 1982.

The Deteriorating Trade Outlook

Here's the IMF's recent forecasts for exports -- from October and then November -- for world trade, disaggregated into advanced and developing country groupings.

These developments in trade financing suggest that the recent drop-off in US exports and imports might be due only in part to macroeconomic factors. In particular, I suspect that some of the precipitous decline in US non-oil imports is driven by difficulty in obtaining financing. Similarly, for US exports.

The article continues:

Despite better growth prospects in developing countries, many lenders are pulling back drastically from these regions. The institutions are cutting exposure to economies traditionally perceived as more risky in order to patch up holes in their balance sheets. Other big players in trade finance, such as Wachovia, have disappeared.

"For emerging markets, the deleveraging process is extensive, and dollar sources have dried up," says Hung Tran, an economist at the Institute of International Finance, a Washington association of international financial firms.

Dating back to ancient commercial hubs such as ninth-century Baghdad, trade finance is the collection of hard-currency credit lines, insurance policies and guarantees that allows firms in different countries to do business with each other. It's the oil that lubricates $14 trillion of global trade.

"The trade-finance business globally is under significant stress," says John Ahearn, the global head of trade finance at Citigroup, one of the world's biggest trade-finance sources. Some repricing is expected as the globe readjusts from a period where credit flowed too freely. "We are coming out of an incredibly benign credit environment when trust levels were too high," says Stuart Nivison, head of trade and supply chain at HSBC Holdings.

Even big lenders such as Citigroup and HSBC that have expanded international credit lines to some markets recently are hitting obstacles. A big part of these banks' business is setting up trade lines that are offloaded to smaller banks in a secondary market. These days, however, the smaller banks aren't buying.

Consider what's happening in Brazil, an emerging export power that sells the world everything from soy and beef to iron ore and jets. Brazilian companies need dollar-denominated credit to finance the sales. The cost of these credit lines -- the bread and butter of trade finance -- has soared, doubling in many cases. The phenomenon hits smaller firms the hardest: Some no longer qualify for the lines and others are squeezed out of shrinking market by credit-hungry giants like state oil company Petroleo Brasileiro.

...

At times, credit is available, but the higher cost of it exceeds the profit margins, so the deals collapse. That's especially the case in commodities transactions.

By the way, the spike up in the value of the dollar (represented in the downward movement in the USD exchange rate), while often mentioned in journalistic accounts, is unlikely to have had a big impact in the September and October figures, given the lags usually estimated in trade flow equations (for a discussion of lag lengths, see this paper [pdf]).

The observed co-movement is ascribable to the common factor of flight to safety and reduction in trade credits in the wake of the financial crisis (see some stunning pictures in Brad Setser's recent post).

China

Other coverage is in Globe and Mail, Journal of Commerce, Reuters, Bloomberg. Many of the articles focus on China, and we now have some feeling for the combined macro/finance impact: "According to Chinese customs figures, Chinese exports declined 2.2% and imports fell 17.9% in November, compared with a year earlier." (Volz in FEER.) This suggests to me that the more rapidly the supply of export credit can be restored (at least partially), the less significant the downturn in Chinese exports, and hence in the Chinese economy.

From Reuters:

Stunningly bad trade figures from China underlined the problem. China had been expected to show double digit growth in trade last month as compared to November 2007, but the data showed exports falling 2.2 percent from a year ago and imports down 17.9 percent.

"Global demand for Chinese products is vanishing," said Gene Ma, an economist at China Economic Monitor, a Beijing consultancy. "Secondly, the credit freeze in importing countries has made it hard for Chinese exporters to sell abroad. I heard some Chinese exporters had to cancel shipments as they were worried about getting paid by their buyers."

Chinese banks have been very nervous about accepting letters of credit from abroad, making it tougher for imports to China to get the needed financing. China and the U.S. pledged $20 billion to fund trade with developing countries last week, but that is a tiny balm for a huge market.

Some Disparate Observations

In some previous posts, I observed that globalization was a function of trade -- and other transaction -- costs [1], [2], [3]. That observation was focused on transportation costs, but it's clear (in retrospect) that one of the drivers of globalization was decreasing financing costs. With financing costlier for the foreseeable future, secular growth in trade flows may be even more muted than one would expect from the slowdown in global GDP.

There is a good news/bad news aspect to this conclusion. The bad news is that decreased international trade means a reduction (relative to counterfactual) in the gains from exploiting comparative advantage. This will show up in further reduced GDP.

The good news, such as it is, is that reduced import penetration in the developed economies will mitigate protectionist tendencies. In addition, higher transactions costs (due to higher financing costs) will likely act to reduce the marginal propensity to import, thereby boosting the Keynesian multiplier (as described by me, and Dani Rodrik) in a way that will not induce retaliation. Of course, the net effect is still likely to be toward greater protectionism.

Technorati Tags: imports, exports, trade credit, credit crunch, and protectionism.

First, after reflecting upon the collapse of exports noted by Setser, think "disaggregate".

Figure 1 depicts exports of capital goods; they declined 10%, exceeding the 8% reported for all goods exports (all calcuations in log terms). That's 10% for September alone. Since the standard deviation of monthly log changes is 3.1% (2004M02-08M9), well, that's pretty significant... Why focus on capital goods exports (more so than say ag exports), given their volatility? Because they represent foreign demand for goods that can be used to produce things; as demand for capital goods goes down, so too should one's inferences about future growth prospects abroad. And that growth abroad (and the associated US exports) has been what's been keeping the US economy out of recession. Well, as I noted earlier, exports alone have not kept the US economy out of recession in past episodes [1], and this time doesn't seem like an exception.

Figure 1 also depicts imports of consumer goods. That series declined 8.1% (compared 2.7% for all non-oil imports). What this seems to suggest is that the consumer has "hit a wall" (as if we needed any additional confirmation of that).

In figure 2 I present a more long run view of these two series, using the NIPA series, from the October 30th release (so predating the release of the September trade release -- but this won't affect the picture save for the 2008Q3 observation for consumer goods imports, which will be revised downward). The key point here is the the import series has flattened out in the period before the consumption downturn.

That consumption downturn is illustrated in Figure 3.

My interpretation of this figure is that the consumption slowdown [2] [3] signals the end of the role of the US as consumer of last resort.

Lastly, perhaps an obvious point, but it bears restating: as US consumption declines, this will induce a reduction in imports, which will decrease foreign exports and hence foreign income -- which then reduces US exports, etc. What's the implication of this? Let's use some concrete numbers in a simple two-country Keynesian model (math here). If the marginal propensity to consume out of total income is 0.7, and the marginal propensity to import is 0.3, then the multiplier for an autonomous drop in consumption is 1.67, when there are no repercussion effects. But if the drop in US imports decreases foreign income, then (assuming symmetry for the sake of simplicity), the multiplier is 2.22. The multiplier worked on the way up; it will work on the way down.

Now add that idea to the estimate I presented in this post on the consumption prospects -- the implied 2% decline of 164 bn Ch.2000$ (if treated as largely due to wealth effects) will imply a larger decrease in output than implied by .

So, to sum up:

• The sharp and significant decline in exports is worrisome, since exports have been maintaining US GDP growth thus far.
• The sharp and significant decline in capital goods exports is worrisome, because it presages a decline in future output, insofar as expenditures on capital goods are a forward looking indicator of investment prospects.
• The sharp and significant decline in consumer goods imports further substantiates the view that consumption is sharply dropping. Even if the drop is reversed next month, the sustained flattening out of consumption imports (already it looks longer than in the previous two recessions) represents a big departure from the past.
• If the US has truly stopped being the consumer of last resort, then to the extent the impending consumption decline in the US is autonomous (largely unrelated to income), we should expect the repercussions to be widely felt amongst our trading partners.

Technorati Tags: imports, exports, consumption, capital goods, and consumer goods.

And rather than ending with a whimper, Bretton Woods 2 may end with a bang.

In some sense Bretton Woods 2 has been on life support for a while now. China’s recent export growth has depended far more on Europe than on the US. US demand for non-oil imports peaked in 2006. One irony of the past year is that the US was borrowing far more from China that it was buying from China. Campaign rhetoric that the US was paying for Saudi oil with funds borrowed from China isn’t far off – though it leaves out the fact that the US also borrows from
Saudi Arabia to pay for Venezuelan, Mexican and Nigerian oil.

You can read more on that story (with more cool charts) at the International Monetary Fund.

You probably know that I love history. Mike Panzer over at "Financial Armageddon" (catchy name) looks at The Pain on Main. He refers to a story by Nick Turse which talks about how, during the Great Depression, writers associated with the Federal Writers' Project interviewed 10,000 Americans to get oral histories of their times. I thought this next part was very interesting ...

Panzer then draws some interesting parallels to today. It's all worth a read.

Infrastructure: Nation's physical plant another crisis for next president
As if the next president won't have enough on his plate — with the collapse of the financial markets, two foreign wars, persistent security threats and a host of other concerns — America's infrastructure is collapsing.
The civil engineers association gave the country a "D" on its 2005 infrastructure Report Card. It called for a $1.6 trillion five-year improvement program.

Investors remained wary of emerging-market debt as evidence mounted that most of the major major economies - the U.S., the UK, Japan and the Eurozone - are sliding into recession. This realisation has triggered a major exit from commodities, which are a significant source of export revenue for a large number of developing nations. In particular bonds extended losses on the perception that the $700 billion U.S. bank bailout would not work miracles and thus many developed economies will be struggling to digest the impact of the credit blow-out for some time to come.


Until credibility is restored, we will not see people investing in the numbers that emerging economies like India and Brazil badly need to see. But at the same time, we might ask ourselves, at theis moment in time if they don't invest in India and Brazil, then where are they going to invest? The problem is that in the present global environment people are not simply not willing to take assume what is perceived as "risky" without being paid a large - and from the emerging economy point of view - damaging premium. Of course, the situation is also confused since people are no longer clear what constitutes "risky" and what doesn't - the German government, for example, yesterday found itself forced to offer a blanket guarantee of all domestic bank deposits to head off any risk of flight from German bank accounts.

One result of all this nervousness is that the cost of protecting developing nations' bonds against default has been steadily rising. Five-year credit-default swaps based on Argentina's debt climbed 44 basis points to 12.55 percentage points last week, the highest since at least June 2005. That means it costs $1.255 million to protect $10 million of the country's debt from default. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.


Emerging Market Stocks

Emerging-market stocks also fell substantially last week, experiencing their the biggest weekly decline in seven years, led by the banks and energy companies. The MSCI Emerging Markets Index dropped 2.3 percent on Friday to 741.73, following a 3.4 percent decline on Thursday. The index lost 10 percent on theweek, the most since the September 2001 terrorist attacks.


Turkey's benchmark index fell the most in three weeks, losing 4.2 percent to 34,553 in the first trading day since Sept. 29. Russia's Micex Index slumped 5.3 percent, extending its annual loss to 51 percent. India's Sensex index slid 4.1 percent to 12,526.32. Reliance Industries Ltd., India's biggest company by market value, slumped 7.6 percent, to its lowest in a year.

Inflation Falls

But while India's financial system has been taking a beating, Indian inflation, almost un-noticed -slipped back to a 13-week low in late September, giving the central bank some breathing space to keep interest rates unchanged and lossen the liquidity strings when it next meets at the end of this month. Wholesale prices rose 11.99 percent in the week to Sept. 20 from a year earlier after gaining 12.14 percent in the previous week, the commerce ministry said in a statement in New Delhi on Thursday.



Reserve Bank of India Governor Duvvuri Subbarao is under pressure to boost money supply as a local stock sell-off triggered by the global credit crunch has drained funds from the banking system, increasing borrowing costs. Subbarao will undoubtedly seek to steer a middle course, since, given that inflation is still double the central bank's target he will not want to seem to be "soft", while on the other hand he will want to be prudent and will try to head off an excessively rapid credit tightening on the back of the global crunch. In addition, the peak of global inflation has now undoubtedly past, and we are now likely to see growing deflationary (rather than inflationary) headwinds as capacity levels exceed demand across the whole global economy and commodity prices tumble, as Claus Vistesen explains in this excellent and timely post.

The Indian central bank had been busy tightening, and had raised the cash reserve ratio, or the proportion of deposits that lenders maintain with it as reserves, by 400 basis points to 9 percent during the period between December 2006 and July 2008 in an ongoing battle to contain inflation. The bank will make the outcome of its next meeting in Mumbai known on Oct. 24, but we can be pretty sure that the "bias" will now have shifted towards loosening liquidity conditions rather than tightening them, as the priorities have changed, and the big priority now is to avoid any systemic bank problems, to keep the cost of borrowing for Indian companies down, and to prevent consumer credit slowing too dramatically.

The Indian banking system has been under increasing strain in recent days, and one symptom of this is that the rate at which Indian banks lend to each other reached an 18-month high of 17.5 percent on Oct. 1. Indian banks borrowed an average 413 billion rupees a day from the central bank in September, almost twice the amount in August, further indicating a shortage of funds in the banking system.


Commodities Down

Commodities, as measured by the Reuters/Jefferies CRB Index of 19 raw materials, tumbled 9.9 percent last week, the most since at least 1956.

Crude oil has lost 12 percent during the week, the most since 2004. The contract for November delivery traded at $94.47 a barrel, up 0.5 percent, as of 12:11 p.m. London time. Copper fell as much as 3.1 percent to $5,670 a ton on the London Metal Exchange, the lowest since February 2007 and was down 12% on the week.

Such downward movement in commodity prices has a double-edged impact on emerging economies. On the one hand inflation, which has in large part been driven up by rising commodity prices, will reduce significantly, but on the other hand many emerging economies are dependent on revenue from commodity sales to finance growth and development. Really this is a situation which will sort the "men" from the "boys", since those emerging economies which are really going to emerge will be in a position to switch the driving force of growth from commodity and agricultural dependence to industrialisation and domestic investment and consumer demand. It is my firm belief that India is now decidedly inside the group which is in the process of making this transition.


Stocks Down

Indian stocks fell during the week, with the benchmark Sensex stock index declining to its lowest in 18 months. The Bombay Stock Exchange's Sensitive Index, dropped 529.35, or 4.1 percent, to 12,526.32, its lowest since April 2, 2007. The index posted its second weekly decline, falling 4.4 percent. The S&P CNX Nifty Index on the National Stock Exchange fell 3.4 percent to 3,818.30. The BSE 200 Index declined 3.8 percent to 1,515.29. Nifty futures for October delivery fell 2.9 percent to 3,853.


Overseas investors bought a net 845 billion rupees ($18 million) of Indian stocks on Sept. 30, trimming their net outflow this year from equities to $9.1 billion, the nation's stock market regulator said.


Forex Reserves

India's foreign exchange reserves fell marginally by USD 153 million to USD 291.819billion for the week ended September 26 from USD 291.972 billion in the previous week. Reserves had jumped by USD 2.511 billion in the previous week. Foreign currency assets (FCA), during the week, dropped to USD 282.652 billion from USD 282.811 billion a week ago, according to data issued by the RBI on Friday.

Rupee

India's rupee slumped to the lowest since 2003, adding to speculation investors will take continue taking money out of the currency. The currency completed its eighth weekly loss, the longest drop since December 2005. The rupee was down 1 percent on the day to 47.085 per dollar, the lowest since June 2003, as of the 5 p.m. close in Mumbai on Friday. The currency lost 1.15 percent this week.

September Global Manufacturing PMI Shows Sharp Contraction

September seems to have been the ultimate "mensis horribilis" for industrial output internationally - and thus it is only natural to assume that Indian industry was also adversly affected - with global manufacturing activity contracting for the fourth consecutive month, and output falling to its weakest level in over seven years according to the JP Morgan Global Manufacturing PMI, which at 44.2 hit its strongest rate of contraction since November 2001, down from 48.6 in August (Please see the end of this post for some information about countries included and the JP Morgan methodology).


According to the JP Morgan report the retrenchment of the manufacturing sector mainly reflected marked deteriorations in the trends for production, new orders and employment. The declines in output and new work received were the second most severe in the survey history, while staffing levels fell at the fastest pace for over six-and-a-half years. The Global Manufacturing Output Index registered 42.7 in September, well below the 48.5 posted for August.

The sharpest decline in production was recorded for Spain, followed by the US, Japan and then the UK. Although the Eurozone Output Index sank to its second-lowest reading in the survey history, it was above the global average for the first time in four months. Within the euro area, France and Spain saw output fall at survey record rates, while in Italy and Ireland the contractions were the second and third most marked in their respective series. Germany, which until recently was the main growth engine of the Eurozone, saw production fall for the second month running and to the greatest extent for six years. Manufacturing activity in Japan fell to the lowest in over 6- years with the Nomura/JMMA Japan Purchasing Managers Index declining to a seasonally adjusted 44.3 in September from 46.9 in August.

At 40.8 in September, the Global Manufacturing New Orders Index posted a reading well below the neutral 50.0 mark. JP Morgan noted that the trends in new work received were especially weak in Spain, the UK, France and the US, with the all bar the latter seeing new orders fall at a series record pace (for the US it was the strongest drop since January 2001). The downturn of the sector led to further job losses in September, with the rate of reduction in employment the fastest since February 2002. Conditions in the Spanish, the UK and the US manufacturing labour markets were especially weak.

Russian manufacturing shrank for a second month in September, and in so doing registered its first back-to-back contraction since November 1998, as companies cut jobs and growth in new orders slowed, according to the latest VTB Bank Europe Purchasing Managers Report. The PMI came in at a seasonally adjusted 49.8, compared with 49.4 in August. The August reading was the lowest figure in three and a half years, according to the bank statement. On such indexes a figure above 50 indicates growth while one below 50 indicates a contraction.

Manufacturing in China contracted for a second month in August, underscoring the risk of a slump in the world's fourth-biggest economy. The Purchasing Managers' Index was a seasonally adjusted 48.4, unchanged from July, the China Federation of Logistics and Purchasing said today in an e-mailed statement.




Brazil's industrial output fell a seasonally-adjusted 1.3 percent in August, the largest monthly drop this year, bolstering expectations the central bank will ease monetary tightening in response to slowing economic growth. On an annual basis, output rose 2 percent, the slowest pace since March, according to data from the national statistics agency in Rio de Janeiro.

And the situation seems to have deteriorated further in August, since the headline seasonally adjusted Banco Real Purchasing Managers’ Index (PMI) registered a 25-month low of 50.4, down from 51.1 in August.

So basically this is where we get to learn what a global credit crunch means in terms of output and economic growth.

India's Industrial Output Weakens Too

India's industrial output growth bounced back again in July (the last month for which we have official data), reaching a five-month year on year expansion rate high of 7.1%. This follows a noted slowdown where output only rose by 5.4 percent gain in June, and 4.1% in May, according to data from the Central Statistical Organisation.


But if we come to look at the manufacturing PMI we will see that India's manufacturing output has also slowed somewhat, and expanded at its slowest pace in 14 months in September according to the ABN AMRO Bank purchasing managers' index. The PMI reading - which is based on a survey of 500 companies operating in India - fell to a seasonally adjusted 57.3 in September from 57.9 in August. This reading was the lowest since July 2007. Still 57.3 still suggests Indian industry continues to grow quite vigoursly, although the report did highlight the fact that the drop in the index was mainly the result of a decline in growth of new orders, and implied a deterioration in demand conditions, both locally as well as in export markets.


Current Account and Trade Deficit

The Rupee has also been dropping in reaction to India's deteriorating current account situation. The current account deficit rocketed to $10.7 billion in the three months from April to June, up from a $1.04 billion gap in the previous quarter,according to data from the Reserve Bank of India last week.

India's trade deficit almost doubled to a record in August as a surge in crude oil prices increased the import bill and overseas sales of goods slowed. The trade deficit widened to $13.9 billion from $7.2 billion a year earlier, according to data from the Ministry of Commerce and Industry. Imports grew 51 percent, the fastest gain in seven months, to $29.9 billion, while exports expanded 27 percent to $16 billion.

A near doubling of oil prices has boosted import costs, since India relies on overseas purchases for three-quarters of its energy needs. India paid an average $8 billion a month this year for oil imports, up from $5.5 billion in 2007, as crude oil costs surged to a record $147 a barrel on July 11. In India's case the 35 percent drop in oil prices we have seen since July has been partially offset by the decline in the rupee to a five-year low.

India's oil imports in August rose 77 percent to $10.9 billion as refiners paid more for crude oil purchased overseas. Non-oil imports gained 40 percent to $18.9 billion. Imports in the five months ended August 31 rose 38 percent to $130.3 billion from $94.6 billion a year ago. That took the trade deficit to $49.2 billion, compared with $34.5 billion in the same period a year earlier. Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.

India and Brazil Critical Weathervanes

What I have been arguing in this post is not that everything about India's economy is perfect - far from it, but neither is it the "perfect storm" disaster which current knee jerk reactions among international investors would seem to suggest. The problems which are hitting the Indian economy at the moment, from the rapid rise in inflation to the sudden withdrawal of sentiment have a common origin: the dynamics of the global economy, and it is to these we must now look if we are to be able to sort the wood from the trees about what happens next. Basically, when the dust settles, I think it will be apparent that there are few economies left sufficiently well standing (not Russia certainly, and probably not China, given the export dependence on the developed economies) and with sufficient energy to bounce back. Many may be sceptical that Brazil and India are going to lead the coming charge (this recession cannot, after all, last forever), but I ask you, if it isn't Brazil and India, who is it going to be?

JP Morgan Global Manufacturing PMI Methodology


The Global Report on Manufacturing is compiled by Markit Economics based on the results of surveys covering over 7,500 purchasing executives in 26 countries. Together these countries account for an estimated 83% of global manufacturing output. Questions are asked about real events and are not opinion based. Data are presented in the form of diffusion indices, where an index reading above 50.0 indicates an increase in the variable since the previous month and below 50.0 a decrease.

The countries included are listed below by size of global GDP share, and the figures in brackets are the % og global GDP in each case (World Bank Data).

United States (30.5), Eurozone (18.7), Japan (13.9), Germany (5.6), China (4.9),United Kingdom (4.5), France (4.0), Italy (3.2), Spain(1.9), Brazil (1.9),India (1.7), Australia (1.3), Netherlands (1.1), Russia (0.9), Switzerland (0.7), Turkey (0.7), Austria (0.6), Poland (0.5), Denmark (0.5), South Africa (0.4), Greece (0.4), Israel (0.3), Ireland (0.3), Singapore (0.3), Czech Republic (0.2), New Zealand (0.2), Hungary 0.2.

Investors distanced themselves from emerging-market debt as the evidence mounted that major economies - the U.S., the UK, Japan and the Eurozone - are sliding into recession and this triggered a major exit from commodities, which is a significant source of export revenue for a large number of developing nations. In particular bonds extended losses on the perception that the $700 billion U.S. bank bailout would not work miracles and thus many developed economies will be struggling to digest the impact of the credit blow-out for some time to come.


Until credibility is restored, we will not see people investing in the numbers that emerging economies like India and Brazil badly need to see. In the present environment people are not simply not willing to take assume what is perceived as "risky" without being paid a large - and from the emerging economy point of view - damaging premium. As a result the cost of protecting developing nations' bonds against default has been steadily rising. Five-year credit-default swaps based on Argentina's debt climbed 44 basis points to 12.55 percentage points last week, the highest since at least June 2005. That means it costs $1.255 million to protect $10 million of the country's debt from default. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.


Emerging Market Stocks

Emerging-market stocks had the biggest weekly decline in seven years last weeks, led by banks and energy companies. The MSCI Emerging Markets Index dropped 2.3 percent on Friday to 741.73, following a 3.4 percent decline on Thursday. The index lost 10 percent on theweek, the most since the September 2001 terrorist attacks.


Turkey's benchmark index fell the most in three weeks, losing 4.2 percent to 34,553 in the first trading day since Sept. 29. Russia's Micex Index slumped 5.3 percent, extending its annual loss to 51 percent. India's Sensex index slid 4.1 percent to 12,526.32. Reliance Industries Ltd., India's biggest company by market value, slumped 7.6 percent, to its lowest in a year.

Inflation Falls

But while India's financial system has been taking a beating, Indian inflation, almost un-noticed -slipped back to a 13-week low in late September, giving the central bank some breathing space to keep interest rates unchanged and lossen the liquidity strings when it next meets at the end of this month. Wholesale prices rose 11.99 percent in the week to Sept. 20 from a year earlier after gaining 12.14 percent in the previous week, the commerce ministry said in a statement in New Delhi on Thursday.



Reserve Bank of India Governor Duvvuri Subbarao is under pressure to boost money supply as a local stock sell-off triggered by the global credit crunch has drained funds from the banking system, increasing borrowing costs. Subbarao will undoubtedly seek to steer a middle course, since given that inflation is still double the central bank's target he will not want to seem to be "soft", while on the other hand he will want to be prudent and will try to head off an excessively rapid credit tightening on the backs of the global crunch. In addition, the peak of global inflation has now undoubtedly past, and we are now likely to see growing deflationary headwinds as capacity levels exceed demand across the whole global economy, as Claus Vistesen explains in this excellent and timely post.

The central bank has raised the cash reserve ratio, or the proportion of deposits that lenders maintain with it as reserves, by 400 basis points to 9 percent since December 2006 to contain inflation. The bank will make the outcome of its next meeting in Mumbai known on Oct. 24.

The rate at which Indian banks lend to each other climbed to an 18-month high of 17.5 percent on Oct. 1 as investors hoarded cash. Indian banks borrowed an average 413 billion rupees a day from the central bank in September, almost twice the amount in August, further indicating a shortage of funds in the banking system.

Essentially the wholesale price index fell because of a decline in the prices of farm products such as cereals, fruits and vegetables. The index of primary articles, that includes food items, dropped 0.2 percent, while the indices of manufactured and fuel were unchanged in the week to Sept. 20, today's report said.

Commodities Down

Commodities, as measured by the Reuters/Jefferies CRB Index of 19 raw materials, tumbled 9.9 percent last week, the most since at least 1956.

Crude oil has lost 12 percent during the week, the most since 2004. The contract for November delivery traded at $94.47 a barrel, up 0.5 percent, as of 12:11 p.m. London time. Copper fell as much as 3.1 percent to $5,670 a ton on the London Metal Exchange, the lowest since February 2007 and was down 12% on the week.

Such downward movement in commodity prices have a double edged impact on emerging economies. On the one hand inflation, which has in large part been driven up by rising commodity prices, will reduce significantly, but on the other hand many emerging economies are dependent on revenue from commodity sales to finance growth and development.


Stocks Down

Indian stocks fell during the week, with the benchmark Sensex stock index declining to its lowest in 18 months. The Bombay Stock Exchange's Sensitive Index, dropped 529.35, or 4.1 percent, to 12,526.32, its lowest since April 2, 2007. The index posted its second weekly decline, falling 4.4 percent. The S&P CNX Nifty Index on the National Stock Exchange fell 3.4 percent to 3,818.30. The BSE 200 Index declined 3.8 percent to 1,515.29. Nifty futures for October delivery fell 2.9 percent to 3,853.


Overseas investors bought a net 845 billion rupees ($18 million) of Indian stocks on Sept. 30, trimming their net outflow this year from equities to $9.1 billion, the nation's stock market regulator said.


Forex Reserves

India's foreign exchange reserves fell marginally by USD 153 million to USD 291.819billion for the week ended September 26 from USD 291.972 billion in the previous week. Reserves had jumped by USD 2.511 billion in the previous week. Foreign currency assets (FCA), during the week, dropped to USD 282.652 billion from USD 282.811 billion a week ago, according to data issued by the RBI on Friday.

Rupee

India's rupee slumped to the lowest since 2003, adding to speculation investors will take continue taking money out of the currency. The currency completed its eighth weekly loss, the longest drop since December 2005. The rupee was down 1 percent on the day to 47.085 per dollar, the lowest since June 2003, as of the 5 p.m. close in Mumbai on Friday. The currency lost 1.15 percent this week.

September Global Manufacturing PMI Shows Sharp Contraction

September seems to have been the ultimate "mensis horribilis" for industrial output internationally, with global manufacturing activity contracting for the fourth consecutive month, and output falling to its weakest level in over seven years according to the JP Morgan Global Manufacturing PMI, which at 44.2 hit its strongest rate of contraction since November 2001, down from 48.6 in August (Please see the end of this post for some information about countries included and the JP Morgan methodology).


According to the JP Morgan report the retrenchment of the manufacturing sector mainly reflected marked deteriorations in the trends for production, new orders and employment. The declines in output and new work received were the second most severe in the survey history, while staffing levels fell at the fastest pace for over six-and-a-half years. The Global Manufacturing Output Index registered 42.7 in September, well below the 48.5 posted for August.

The sharpest decline in production was recorded for Spain, followed by the US, Japan and then the UK. Although the Eurozone Output Index sank to its second-lowest reading in the survey history, it was above the global average for the first time in four months. Within the euro area, France and Spain saw output fall at survey record rates, while in Italy and Ireland the contractions were the second and third most marked in their respective series. Germany, which until recently was the main growth engine of the Eurozone, saw production fall for the second month running and to the greatest extent for six years. Manufacturing activity in Japan fell to the lowest in over 6- years with the Nomura/JMMA Japan Purchasing Managers Index declining to a seasonally adjusted 44.3 in September from 46.9 in August.

At 40.8 in September, the Global Manufacturing New Orders Index posted a reading well below the neutral 50.0 mark. JP Morgan noted that the trends in new work received were especially weak in Spain, the UK, France and the US, with the all bar the latter seeing new orders fall at a series record pace (for the US it was the strongest drop since January 2001). The downturn of the sector led to further job losses in September, with the rate of reduction in employment the fastest since February 2002. Conditions in the Spanish, the UK and the US manufacturing labour markets were especially weak.

Russian manufacturing shrank for a second month in September, and in so doing registered its first back-to-back contraction since November 1998, as companies cut jobs and growth in new orders slowed, according to the latest VTB Bank Europe Purchasing Managers Report. The PMI came in at a seasonally adjusted 49.8, compared with 49.4 in August. The August reading was the lowest figure in three and a half years, according to the bank statement. On such indexes a figure above 50 indicates growth while one below 50 indicates a contraction.

Manufacturing in China contracted for a second month in August, underscoring the risk of a slump in the world's fourth-biggest economy. The Purchasing Managers' Index was a seasonally adjusted 48.4, unchanged from July, the China Federation of Logistics and Purchasing said today in an e-mailed statement.




Brazil's industrial output fell a seasonally-adjusted 1.3 percent in August, the largest monthly drop this year, bolstering expectations the central bank will ease monetary tightening in response to slowing economic growth. On an annual basis, output rose 2 percent, the slowest pace since March, according to data from the national statistics agency in Rio de Janeiro.




So basically this is where we get to learn what a global credit crunch means in terms of output and economic growth.




Current Account and Trade Deficit

The Rupee has also been dropping in reaction to India's deteriorating current account situation. The current account deficit increased to $10.7 billion in the second quarter of 2008 from a $1.04 billion gap in the previous quarter,according to data from the Reserve Bank of India last week.

India's trade deficit almost doubled to a record in August as a surge in crude oil prices increased the import bill and overseas sales of goods slowed. The trade deficit widened to $13.9 billion from $7.2 billion a year earlier, according to data from the Ministry of Commerce and Industry. Imports grew 51 percent, the fastest gain in seven months, to $29.9 billion, while exports expanded 27 percent to $16 billion.

A near doubling of oil prices has boosted import costs, since India relies on overseas purchases for three-quarters of its energy needs. India paid an average $8 billion a month this year for oil imports, up from $5.5 billion in 2007, as crude oil costs surged to a record $147 a barrel on July 11. In India, the 35 percent drop in oil prices since July has been partially offset by the decline in the rupee to a five-year low. India's oil imports in August rose 77 percent to $10.9 billion as refiners paid more for crude oil purchased overseas. Non-oil imports gained 40 percent to $18.9 billion. Imports in the five months ended August 31 rose 38 percent to $130.3 billion from $94.6 billion a year ago. That took the trade deficit to $49.2 billion, compared with $34.5 billion in the same period a year earlier.

Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.


Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.

India's current account deficit widened to a record in the three months to June as a surge in crude oil prices increased the nation's import bill. The shortfall, the amount by which imports exceed exports, remittances and other income from abroad, increased to $10.72 billion from a $1.04 billion gap in the previous quarter, the Reserve Bank of India said in a statement in Mumbai. Analysts expected a deficit of $11.52 billion.

Executive Summary


India’s latest run of strong economic growth and continuing macroeconomic stability is a tribute the important progress made in recent years in macroeconomic management techniques as well as to an earlier generation of structural reforms. India’s economy has now expanded at an average rate of about 8½ percent for four years running, on the back of rising productivity and sustained investment. Inflation after ebbing in the second half of 2007 has now returned in full force and become one of the most pressing macro problems facing the Indian economy. In fact the record capital inflows which have followed the bout of global financial turbulance and a slowing U.S. economy, while in the long run beneficial, have only served to complicate the application of sound monetary policy. The current account deficit, which had remained modest, is now – on the back of high oil prices, heavy external energy dependence and a growing fiscal deficit – in danger of becoming a matter of concern.

India Needs:

- to bring inflation back under control and to within the central bank “comfort zone”.
- to reduce the growing fiscal deficit
- to extend and substantially upgrade infrastructure

India's Strong Points:

- solid and sustained economy growth, no likelihood a a major slowdown
- significant foreign exchange reserves
- proven human capital resources
- demographic tailwinds blowing strongly in her favour, and for several decades to come


Economic Background

India’s recent macroeconomic performance has been truly impressive, the result of sound macroeconomic policies, steady reforms which have been ongoing since the start of the since 1990s, and increasingly favourable demographic tailwinds. Growth averaged about 8½ percent in the four years through 2007/08, and while it is set to drop to the 7- 8 percent range this year, India will remain one of the world’s fastest-growing economies in 2008. The poverty rate fell from 36 percent in 1993/94 to under 28 percent in 2004/05.

India’s productivity growth has also been rapid when compared with that of other countries. The IMFs September 2006 World Economic Outlook found that India’s total factor productivity growth has averaged about 3⅓ percent in recent years, which within Asia is only exceed by China. Other recent growth accounting exercises have found TFP growth for India in the range of 3.2–3.5 percent for the recent period.

It’s the demography

At the present time some some 31 % of India’s populations are under 15 years of age. Between now and 2015 that proportion isn’t expected to change too much, but after 2015, with fertility nationwide now falling rapidly, the proportion is set to decline continually, with India moving steadily nearer the proportion which is to be found in more developed economies – Ireland, for example currently has some 21% of its population under 15, while in the United Kingdom the equivalent figure is 17%.

What this means is that India post 2015 will see a steep and sustained decline in its child dependency ratio and a steady increase in the proportion of its population who are of working age. In those Asian economies (the so called “Tigers”) who have previously passed through this demographic transition such steep declines in dependency ratios have been found to boost GDP growth incrementally, and substantially. This boost is known as the “demographic dividend”. The process is not a mechanical one, of course, and to get the increment, jobs have to be created for the new entrants into the labour force, and in India’s case these jobs will be needed at something like a rate of 15 million a year. What is really different about India is that the demographers are forecasting a continuing decline in the dependency ratio for a period of 30 years or so, as India's fertility rate - that is, the average number of children a woman expects to have in her life time – (which was standing at 3.8 in 1990) falls from the present national average of 2.9 to levels which in all probability will be well below replacement level.

There is another reason why this demographic change is important and that is that we human beings exhibit variable spending and saving activity at different moments in our life cycle. Basically we tend to save most either when we have just started working and are waiting to establish a family home, or during the latter years of our working lives. Whatsmore having children makes it harder to save wherever we are in the life cycle, and thus reducing the proportion of children in a society will tend – other things being equal – to increase the level of saving.

And, not unexpectedly, India's savings rate as a percentage of GDP has been rising steadily since 2003. It now stands in the region of 33% of GDP – a figure which is comparable to the Asian super-performers, all of whom save at above 30%, with China saving at an astonishing rate of nearly 40%.

This recent savings growth has been driven in India by improvements in the government's fiscal health and a sharp rise in corporate savings, but even if these positive factors should gradually disappear, the decline in the dependency ratio should enable India to hold its savings and investment rate above the 30% mark for the next 25 years at least.

Recent Economic Indicators

The Indian economy continued to expand strongly in the first quarter of 2008, even though growth has now dropped back somewhat from the 10.1% peak reached in Q3 2006. GDP, however, still grew at a pretty solid y-o-y rate of 8.8% in Q1, and indeed output growth was unchanged from the last quarter of 2007. So while the Indian economy is slowing, it is doing so very gradually indeed.

Private consumption continued to grow rapidly in Q1 2008 (13.5%) but gross fixed capital formation dropped back (from an average of 20% y-o-y in the previous 3 quarters to 15% in Q1). Since construction activity was still running at a strong pace (12.6%, the fastest rate since Q2 2006) it would not be unrealistic to assume that spending on machinery and equipment slowed somewhat. This would also follow from the fact that manufacturing growth (5.8%) showed the slowest expansion in many quarters (well down from the 10% average over the previous 3 quarters). Infrastructure development also lagged behind in terms of electricity, gas and water supply growth, which was only up by 5.6%. Indeed utilities output has only grown by an average of around 6% over the last 8 quarters. On the other hand government spending shot up, growing at an annual rate of 22.4%. Hence here we have two of the key themes which continue to preoccupy observers of India’s economy: the slow growth of manufacturing and infrastructure, and the rapidly increasing fiscal deficit.


Both India’s exports and imports were up quite strongly in Q1 (12.7%), and this revival in exports offers some evidence that Indian exporters have now started to benefit from the weaker rupee, which has declined by some 7 percent so far this year. India's export growth accelerated again in June and overseas shipments, which account for about 15 percent of the Indian economy, were up 23.5 percent year on year (reaching a total of $14.66 billion), following a 13 percent gain in May. Imports, however, have been increasing even more quickly, and were up 26 percent (to $24.45 billion) in June, thus widening the trade deficit (as compared to June 2007) to $9.78 billion. The deficit was however down on May's whopping $10.77 billion. India's oil imports in June rose 53.4 percent to $9.03 billion as refiners paid more for crude oil purchased overseas. India relies on imports of oil for three-quarters of its energy needs. Non-oil imports gained 14 percent to $15.4 billion.India has paid an average $8 billion a month for oil imports in the year through June, compared with $5.4 billion in 2007.

India's inflation accelerated again in late July, and hit it highest level since 1995, providing additional evidence to support last week's central bank decision to raise borrowing costs for the third time in two months. Wholesale prices were up 12.01 percent in the week to July 26, after rising 11.98 percent in the previous week.



The Reserve Bank of India raised its repurchase rate by a half-percentage point to 9 percent on 29 July, giving priority to the inflation fight over India's short term growth rate. Indeed many economists consider that the bank may well increase the benchmark rate again in the next three months. The cash reserve ratio was also raised 8.75 to 9 percent and in the statement which followed the decision the bank said it still had "headroom'' to further tighten monetary policy. The bank also increased this year's inflation forecast to 7 percent from the previous range of 5 percent to 5.5 percent.



However while the inflation process in India still has some momentum, as the global economy slows – thus reducing pressure on commodity prices - and monetary tightening reins in domestic demand, India’s inflation peak can not now be far away. Despite constant ups and downs oil prices have been generally falling since hitting the record high of US$147.27 a barrel on July 11, and by August 1st they had dropped around 15 per cent in a mere three weeks. If this trend continues then India should eventually obtain some notable relief and this is why it is so important to maintain strict monetary policy and avoid second round inflation effects at this juncture.


India's industrial production provides the most evident sign of the economic slowdown, with output growing at the slowest pace in more than six years in May as continuing price rises and tightening credit lead consumers to cut back on purchases of items like cars, fridges and other manufactured goods. Industrial output was up 3.8 percent from a year earlier after gaining 6.2 percent in April. Manufacturing, which accounts for about 80 percent of India's industrial production, was up 3.9 percent. Electricity rose 2 percent, and mining grew 5.5 percent. Consumer-goods production increased 7.2 percent.




The Ratings Agencies

One notable recent development has been the decision by ratings agency Fitch to lower India's local currency credit rating. The decision by Fitch to revise India's local currency outlook to negative from stable was based on a perception by the ratings agency of a worsening fiscal position and rising inflation. The assignment of a negative outlook suggests an increase in the sovereign default rate may follow if the problem is not corrected, and this would affect the flow of funds - and hence investment - into India. The new revised local currency rating will be 'BBB-' with negative outlook as against the earlier 'BBB-' with stable outlook.

James McCormack - Head of Asia Sovereign Ratings for Fitch - is quoted as saying the "the revision to the local currency outlook is based on a considerable deterioration in the central government's fiscal position in 2008-09, combined with a notable increase in government debt issuance to finance subsidies not captured in the budget." The rating agency has revised its economic growth forecast for 2008-09 from just under 9% to 7.7%, and this seems to be not unreasonable.

Fitch did, however, continue to affirm India's long term foreign currency Issuer Default Rating (IDR) at 'BBB-' with stable outlook, its short-term foreign currency IDR at F3 and the country ceiling at 'BBB-'. The assignment of a local currency negative outlook thus means that agency has effectively put India on watch with the implication that is the underlying causes (inflation and the underlying dynamics of the fiscal deficit) are not addressed over the next 12 to 18 months, the rating could be subject to downgrade. Obviously this is a warning shot as much as anything else, and an attempt to put pressure on the Indian government.

As regards its external balance India is rather different from many other large emerging economies since while the central bank (which has a high level of independence from government) does intervene in the spot market to try to keep a lid on the rupee’s rise and to built up a “war chest” of international reserves the bank has allowed the currency to rise substantially against the US dollar (while the rupee has fallen in 2008, it appreciated by some 12% against the dollar in 2007).



Foreign Exchange Reserves

India's foreign exchange reserves fell another $504 million - to reach $306.6 billion - in the week ended July 25. Despite the fact that India’s foreign exchange reserves, have increased by $81.3 billion in the last twelve months they have in fact now been falling since May. It could be however that the increase in interest rates and the falling price of oil could now see a reversal in this trend.




The big unknown here is the future movement in the oil price. Despite the recent price easing, India still faces an import bill for crude that may reach $120 billion this fiscal year, compared with $69 billion the year before. This extra burden is about 4% of GDP.

Add the impact of the fiscal deficit to the oil bill, and it is not hard to see that the external deficit could reach 4% of GDP this fiscal year. The IMF In April were forecasting a 3.1% for 2008. Reducing this gap is now becoming a priority, especially given the comparative strictness of the ratings agencies vis-a-vis India. Any future downgrades in credit will only make funding the gap more expensive, and as we have seen attracting the foreign capital necessary to bridge the gap has been becoming harder in recent weeks.




Money Supply and Credit

Short term cash rates have been pushing the 8.5 to 9% range in India of late as liquidity has been tighter due to the significant increase in the cash reserve ratio required by the Reserve Bank of India. Banks credit remains strong and rose by 25.8% in the 12 months through July 18. Total bank deposits rose by 21%, over the same period. At the same time, money supply in India grew 20% in the two weeks ended July 18 from a year earlier, compared with 20.5% in the prior two weeks.

While much of the recent increase in lending is likely to be associated with increased credit needs on the part of the oil companies, it also seems that bank credit to other sectors has been picking up. The Reserve Bank of India is unsurpringly rather concerned about the level of credit growth, especially considering that deposit growth slowed to 21% over the same period.

The Rupee

The rupee appreciated significantly during 2007, raising concerns about the competitiveness of Indian industry. In nominal bilateral terms vis-a-vis the dollar, the appreciation has been particularly notable, reaching successive nine-year highs as it rose about 12 percent over the year. Although the increase has been lower in nominal and real effective terms—only about 7–7½ percent—the appreciation of the effective rupee has taken it out of the historical range in which it fluctuated during most of the last decade




Growth Prospects

On the growth front a large gap has now opened up between the increasingly gloomy views about India’s prospects as seen from abroad, and the relative optimism displayed by a number of internal forecasters. The Centre for Monitoring the Indian Economy (CMIE), in Mumbai, still thinks India will grow by 9.5% this fiscal year, while JPMorgan only anticipates growth somewhere in the region of 7%.



While the CMIE estimate is undoubtedly unduly high for this (calendar) year, with growth more than likely coming in in the 7.5% to 8% range, their optimism is not totally unjustified looking forward to 2009 and 2010. Trend growth in India is surely higher than many conventional analyses tend to hold, and if inflation can be gotten under control India then India may well start to hit double digit growth come 2010, and once it breaks the 10% ceiling, it may well stay above it for some considerable time. This is simply because India has a very large untapped capacity for growth, and it is not unrealistic to anticipate that this capacity can be unleased, especially if institutional reform continues, and the fiscal deficit concerns are addressed.

But things are likely to go down before they bounce back up again, since he tightening in monetary policy will surely achieve the desired effect of slowing aggregate demand and GDP growth further. Also negative global factors are likely to continue to weigh adversely on India’s growth outlook in the short term. Consumption growth has already slowed significantly. Investments growth has also begun to moderate and it is quite probable that the slowdown in the investment cycle will accentuate over the next six months.


Everything really now depends on the outlook for inflation and capital inflows. I believe that Inflation should peak in late summer at levels which are not too far above those we are currently seeing. The rate should then start moderating and we could well be back down at 7% - 8% by the end of the financial year. In part this depends on oil prices, and year on year base effects, and oil and food prices, of course, also partly depend on growth in India and the other key emerging economies. Thus we have a kind of "inbuilt stabiliser", since as the major emerging economies slow, commodity prices ease back, and as this happens the central banks can begin once more to loosen monetary policy, providing a kind of win-win feedback effect, until, of course, commodity prices bounce back again, and they need to start tightening once more.

The key point to grasp in all this is that it is consumers in the heavy energy consumption OECD economies who are going to do the heavy lifting of bearing the pain here, as resources are effectively transferred from their wallets to those of the oil producers, and it is this process, rather than what happens in the emerging economies which is likely to keep a cap on global growth in the coming years.



Outlook on Key indicators

• Following the most recent rate hike market expectations have now solidified towards further interest rate increases in the pipeline. The driving orce here will, as ever, be inflation running above the central bank's comfort zone. Here at Emerginvest we see the Reserve Bank of India being rather more prudent at coming meetings, and we feel the current rate hike cycle may possibly peak at 9.5%. Key factors here will be the behaviour of oil prices, and wages and fiscal policy in India itself with election year approaching.

• The Rupee is likely to continue to be supported by central bank tightening and declining demand for dollars from oil producers as oil prices ease. Also should the Rupee continue to head upwards and inflation start to fall, a win-win process will again be set in motion as investors see the prospect of currency related increasing returns once more opening up. In the great global search for yield there is no better winning strategy than to back a winner. At some point however macroeconomic fundamentals will undoubtedly take over, and as the economy slows and inflation moves down towards the comfort zone (around 5%) the central bank will also move into easing mode pushing the Rupee down in the process. A violent correction however is not expected.

• Obviously, with the domestic credit induced consumer boom now fading, exports are going to become more important than ever for India's headline GDP growth. India's Trade Minister Kamal Nath recently set the target of more than tripling India's share of world trade to 5 percent by the year 2020 from the current 1.5 percent. This is a worthy target, and perfectly realiseable, but it will require India to conduct a substantial infrastructural overhaul and to intruce widespread regulatory reform. In the shorter term India is targeting exports of $200 billion in the current fiscal year, up 28 percent from the $155.5 billion achieved in the previous year. This is attainable – exports were up 23.5% y-o-y in June - but with a deteriorating external environment it will be quite hard work.
  
• GDP growth is expected to moderate in 2008 compared to the levels seen in the last three years but at this point growth projections remain solid (probably 7.5 to 8% in calendar 2008). We certainly see India’s mid term sustainable growth rate as being above the consensus 7%-8% rate once inflation is firmly under control, and expect double digit annual growth rates to be hit in either late 2009 or 2010 depending on the extent to which the global slowdown in 2009 negatively affects India’s GDP growth.

• We expect India's credit ratings to remain broadly stable even as the nation weathers higher oil prices and slowing economic growth – a view which was endorsed in a statement at the start of August by Moody's Investors Service. Moody's has a Ba2 rating on India's long-term, local currency debt, leaving it two levels below investment grade, although it rates India's foreign-currency debt Baa3, the lowest investment level. The downside risk here obviously comes from fiscal laxity, but the authorities in New Delhi are undoubtedly very aware of this.
  

The Reserve Bank of India raised its repurchase rate by a half-percentage point to 9 percent on 29 July, giving priority to the inflation fight over India's short term growth rate. Indeed many economists consider that the bank may well increase the benchmark rate again in the next three months. The cash reserve ratio was also raised 8.75 to 9 percent and in the statement which followed the decision the bank said it still had "headroom'' to further tighten monetary policy.



Inflation accelerated during the week largely because of an increase in the price of pulses, fruits, spices and sugar. Manufactured price inflation was up 10.82 percent in the week ended July 19, compared with a 10.72 percent gain in the previous week.

However while the inflation process in India still has some momentum, as the global economy slows - reducing pressure on commodity prices - and monetary tightening reins in domestic demand, the peak can not now be far away. Light, sweet crude for September delivery rose 90 cents, or 0.7 percent, to $124.98 a barrel yesterday (at the 2:30 pm close of floor trading on the New York Mercantile) but prices have been falling generally since hitting the record high of US$147.27 a barrel on July 11. International oil prices have now dropped around 15 per cent over the last three weeks, and if this trend continues then India should obtain some relief.

This is why it is so important to maintain strict monetary policy and avoid second round effects.



Foreign Exchange Reserves


India's foreign exchange reserves fell another $504 million - to reach $306.6 billion - in the week ended July 25 according to data from the Reserve Bank of India weekly statistical supplement.

Gold reserves were unchanged at $9.21 billion while reserves with the International Monetary Fund fell $2 million to $515 million. The nation’s special drawing rights with the International Monetary Fund held at $11 million. Despite the fact that India’s foreign exchange reserves, have increased by $81.3 billion in the last twelve months they have in fact now been falling since May. It could be however that the increase in interest rates and the falling price of oil could now see a reversal in this trend.





Exports Up In June

Indian exporters have started to benefit from the weaker rupee, which has now declined by 7.3 percent so far this year. India's export growth accelerated in June and overseas shipments, which account for about 15 percent of the Indian economy, were up 23.5 percent year on year to reach $14.66 billion, following a 13 percent gain in May. Imports increased 26 percent to $24.45 billion, widening the trade deficit (as compared to June 2007) to $9.78 billion. The deficit was however down on May's whopping $10.77 billion. India's oil imports in June rose 53.4 percent to $9.03 billion as refiners paid more for crude oil purchased overseas. India relies on imports of oil for three-quarters of its energy needs. Non-oil imports gained 14 percent to $15.4 billion.

India has paid an average $8 billion a month for oil imports in the year through June, compared with $5.4 billion in 2007.

Even though oil prices have now moderated from their peak at around US$145, they still remain quite high by historical standards, hence the further widening in the trade deficit. Each US$10 increase in crude oil prices results in an increase of approximately US$7 billion (or 0.6% of GDP) in oil imports and the trade deficit. High non-oil import growth may also cause further widening of the current account deficit at a time when global capital inflows are slowing. Non-oil imports grew at an average of 24.9% during April-May 2008.

The big unknown here is the future movement in the oil price. Despite the recent price easing, India still faces an import bill for crude that may reach $120 billion this fiscal year, compared with $69 billion the year before. This extra burden is about 4% of GDP.

Add the impact of the fiscal deficit to the oil bill, and it is not hard to see that the external deficit could reach 4% of GDP this fiscal year. Reducing this gap is now becoming a priority, especially given the comparative strictness of the ratings agencies vis-a-vis India. Any future downgrades in credit will only make funding the gap more expensive, and as we have seen attracting the foreign capital necessary to bridge the gap has been becoming harder in recent weeks.

Obviously, with the domestic credit induced consumer boom now fading, exports are going to become more important than ever for India's headline GDP growth. India's Trade Minister Kamal Nath recently set the target of more than tripling India's share of world trade to 5 percent by the year 2020 from the current 1.5 percent. This is a worthy target, and perfectly realiseable, but it will require India to conduct a substantial infrastructural overhaul and to intruce widespread regulatory reform. In the shorter term India is targeting exports of $200 billion in the current fiscal year, up 28 percent from the $155.5 billion achieved in the previous year. This is attainable, but with a deteriorating external environment it will be hard work.


The Rupee


India's rupee was up again this week on speculation the demand for foreign currency from oil refiners would reduce following the decline in crude oil prices. The rupee touched its highest in a week on Friday and advanced 0.5 percent to 42.35 a dollar at the 5 p.m. close in Mumbai.


The rupee also strengthened on speculation gains in the benchmark stock index will encourage overseas funds to stay invested in the country. The Mumbai Stock Exchange Sensitive Index, or Sensex, climbed for a fourth week, and was up by 1.86% on Friday at the 3:00 pm close, capping its best run in three months.

Overseas investors have sold $6.9 billion more Indian equities than they bought this year through July 30, compared with $17.2 billion in net purchases in 2007. Overseas investors bought a net 5.97 billion rupees ($148 million) of Indian equities on July 31, reducing their net outflow this year from stocks to $6.62 billion, according to the India's stock market regulator.



India's stock markets were given a boost when a senior oil ministry official said the ministry had requested the finance ministry to ask the central bank to restart its foreign exchange operations with oil refiners. The central bank had said earlier in the week that it would stop a two-month old scheme which provided foreign exchange directly to oil refiners in exchange for their oil bonds. Refiners are the biggest buyers of dollars in the currency markets.


Money Supply And Liquidity Conditions

Short term cash rates held below 7 per cent in India on Friday due to lower demand for funds on the end of fortnight reporting day, since the banks had already made arrangements to fund their reserve requirements in advance. At 12:30 pm call rates were at 6.50/6.60 per cent, higher than the its previous close of 6.00/6.25 per cent, but much lower than Thursday's weighted average rate of 8.34 per cent.

Banks have to report their cash balances to the Reserve Bank of India every second Friday, this has the consequence that demand for fund tends to be lower in the second week of the fortnight as banks generally try to fund most of their requirement in the first week itself. The general impression is that call rates will now climb back towards 9 per cent at the start of a new fortnight next week.

Banks loans fell by Rs 720 crore in the two weeks ended July 18, taking outstanding advances to Rs 24,07,860 crore. Credit rose by 25.8%, or by Rs 4, 93,805 crore, in the 12 months through July 18. Total bank deposits rose by 21%, or Rs 5, 72,859 crore. At the same time, money supply in India grew 20% in the two weeks ended July 18 from a year earlier, compared with 20.5% in the prior two weeks.

So non-food credit growth stood at 25.8%Y during the fortnight ended July 18, up from the end of 2007 low of 21.9%. While much of the increase is probably due to increased credit needs on the part of the oil companies, it also seems that bank credit to other sectors has been picking up lately. The RBI is particularly concerned about the level of credit growth, considering that deposit growth had already slowed to 21% over the same period.

The RBI recently expressed its concern about this situation and stated that "It is noteworthy that the growth in credit during 2008-09 so far has taken the incremental non-food credit-deposit ratio to 82.4%, which appears high, given the prescribed CRR/SLR and banks’ preference for holding excess reserves on a day-to-day basis…In F2009 so far, however, some banks have expanded credit rapidly in relation to the system level growth, with attendant worsening of their credit-deposit ratios. These developments warrant heightened policy concerns in the interest of overall systemic stability and the quality of financial intermediation”.

And the bank warns: “If necessary, the Reserve Bank would consider undertaking supervisory review of those select banks which are over-extended in terms of their credit portfolios relative to their sources of funds”.

Fiscal Policy

The government has continued its loose fiscal policy in recent months. Apart from a higher oil subsidy, there is the off-budget burden of fertilizer and food subsidies to think about, as well as the farm loan waiver costs. The recent decision to raise wages for government employees will also add to the deficit burden. It is not unrealistic to anticipate the combined central plus state government fiscal deficit (including all off-budget spending) in the region of 7.7% in 2008 rising to 11.5% of GDP in F2009.

On the growth front a large gap has now opened up between the increasingly gloomy views of India’s prospects as seen from abroad, and the relative optimism of internal forecasters. The Centre for Monitoring the Indian Economy (CMIE), in Mumbai, still thinks India will grow by 9.5% this fiscal year, while JPMorgan, a foreign bank, anticipates growth in the region of 7%.

While the estimate is undoubtedly unduly high for this (calendar) year, with growth more than likely coming in in the 7.5% to 8% range, the optimism is not unjustified looking forward to 2009 and 2010. If inflation can be gotten under control India may start to hit double digit growth come 2010, and once it breaks the 10% ceiling, it may well stay above it for some considerable time. This is simply because India has a very large untapped capacity for growth, and it is not unrealistic to anticipate that this capacity can be unleased, especially if institutional reform continues, and the fiscal deficit concerns are addressed.

But things are likely to go down before they bounce back up again, since he tightening in monetary policy will achieve the desired effect of slowing aggregate demand and GDP growth further. Also negative global factors are likely to continue to weigh adversely on India’s growth outlook in the short term. Consumption growth has already slowed significantly. Investments growth has also begun to moderate and it is quite probable that the slowdown in the investment cycle will accentuate over the next six months.


Everything really now depends on the outlook for inflation and capital inflows. I believe that Inflation should peak in late summer at levels which are not too far above those we are currently seeing. They should then start moderating and we could well be back down at 7% - 8% by the end of the financial year. In part this depends on oil prices, and year on year base effects, and oil and food prices, of course, also partly depend on growth in India and the other key emerging economies. Thus we have a kind of "inbuilt stabiliser", since as the major emerging economies slow, commodity prices ease back, and as this happens the central banks can begin once more to loosen monetary policy, providing a kind of win-win feedback effect.

This wioll then operate until commodity prices rebound once more and the emerging central banks tighten again, etc, etc. The key point to grasp here is that it is consumers in the heavy energy consumption OECD economies who are going to do the heavy lifting of bearing the pain here, as resources are effectively transferred from their wallets to those of the oil producers, and it is this process, rather than what happens in the emerging economies which is likely to keep a cap on global growth in the coming years.

Thus the RBI is now unlikely to hike policy rates further unless oil and other commodity prices lift up again from the current levels, and if global growth slows further this is hard to see happening. The second risk to the ‘no further rate hike’ outlook is, of course, any large global financial market shock that triggers major capital outflows from emerging markets generally and from India. In such a case, the RBI would need to hike the policy rate to prevent any major depreciation in the exchange rate and consequent adverse impact on the inflation outlook. I feel however that this scenario is being rather overplayed at the present time. There will almost certainly be some kind of "emerging market correction" (in central and eastern Europe, perhaps, or possibly in China) but if this is the case it is hard to see India being in the direct line of fire, since if the money leaves India, one might well ask where it will be bound? Certainly not to Japan, where yields are still more or less on the floor, and the economy almost certainly in recession. It is also hard to see financial turmoil troubled economies in the US and Europe serving as safe havens this time round, so on balance I would put the risk of major outflows from India at a rather low level, which is not, of course, the same thing as being complacent.


More fickle, however, are the foreigners who bet large sums on Indian shares when the stockmarket was in full bloom. They are deserting the country, withdrawing $6.7 billion so far in 2008. The only consolation is that as share prices fall, so does the amount they can repatriate, relieving some of the pressure on the currency.