Ever since Alan Greenspan set the cat among the pigeons a few weeks ago, by saying that there is a 30% chance that the US economy will slip into recession in 2007, economists and investors have wondered whether India’s growth story will be at risk as a result.
The answer: It depends on the nature of the slowdown. The current fears in the US are that the bursting of the housing bubble will create problems in the rest of its economy. Already, lenders who have lent to risky customers (the so-called subprime market) have been hit by defaults. The situation could get worse as the defaults pile up.
Should Indians worry about the American subprime crisis? A short excursion into history should help assuage fears. Take a look at two recent recessions—in 1991 and 2001. The former was sparked off by a domestic problem in the US that has striking parallels with the current scenario. The collapse of savings and loans companies in the late 1980s tipped the world’s largest economy into recession. In contrast, the 2001 recession was the result of global factors, especially the bursting of the technology bubble and the ensuing drop in equity prices and corporate investment around the world.
Interestingly, the 2001 US recession led to declines in growth around the world while the 1991 recession was more benign in its effects— growth in Europe fell a bit while it actually increased in Asia.
The issue then is whether the subprime mess sends ripples into the rest of the US economy, affecting capital flows and investment. This is one of the points highlighted by the International Monetary Fund (IMF) in its new World Economic Outlook, a few chapters of which were released on the IMF website on Thursday. “If the housing market downturn spreads to consumption and business investment, then cross-border spillovers could be significantly larger,” say the IMF economists who wrote the report.
And even if the housing contagion spreads to other parts of the US economy, India has less to worry than many other countries (such as China) which are heavily dependent on exports to the US to fuel their economic growth. This does not mean that we will not be affected—a recession in the world’s largest economy is bound to have some repercussions here. But they are likely to be limited.
India’s economy is powered by domestic demand, partly because we have a less open economy than many others in our part of the world. But other countries in Asia have also been trying hard to push up domestic demand, and make their economies less susceptible to the vagaries of the global economy.
The bigger danger will come from the financial system, suggests IMF. It is clear now that asset prices across countries move in tandem, as money switches tracks at the press of a button. Research shows that correlations between asset prices tend to be higher during downturns than they do during bull markets. In other words, according to IMF, global contractions tend to be more highly synchronized across countries than global expansions.
Thus, the smaller danger is that the US housing slowdown pulls down consumption and investment there. The larger danger emanates from the financial markets, where a sudden bout of volatility in global equity and bond markets could hit India very hard.
So it is tremors in the financial markets—be it equity, bonds or foreign exchange— that should be the main sources of worry. Right now, it is still unclear whether the downturn in US housing will be limited. If it isn’t, India needs to focus less on the impact this will have on its real economy and more on what will happen in the financial markets.
Should India worry about a US recession? Write to us at firstname.lastname@example.org