OUR GOVERNMENT is very confident about the country’s growth story. Several people are of the view that a contagion of US crisis will not spread to India, although US treasury secretary Paulson maintains that the world will certainly be affected by what is happening in a “big” country (read USA). The recent slump in the Asian stock markets (including the Indian stock market) somehow seems to justify Paulson’s view. It also indicates that sooner or later US will slip into recession. It is worth noting here that in January’08, the indices of China lost 21.4 per cent, Russia, 16.12 per cent, India, 12.44 per cent and the emerging market as a whole, 12.44 per cent. It proves that coming out of the contagion effect is difficult at least for the emerging market economies.
In the circumstances, it is all the more important to ascertain if the US will slip into recession. Since recession witnesses a fall in demand, we need to ascertain too if demand in US is actually falling. Recent data shows this is the case. It is now widely accepted that the sub prime crisis is the root cause of the slump the US economy has been witnessing.
It is not very difficult to understand how the sub prime crisis has affected demand in the US economy. During the boom, which was witnessed for the past 3-4 years, mortgage prices spiralled upward in US. People invested in bloated mortgages. Properties purchased at, say, USD 20 million crashed to USD 14-15 million levels (roughly, a 25 per cent crash in property prices has been observed). Thus, investors who sell can realise only 75 per cent of what they paid to purchase the property. Those who purchased by availing of loans from banks and financial institutions have been worst hit.
Now to repay the loan, the investor should save by curtailing spending. Many are already doing this. This has led to a chain reaction in the economy – there has been an overall fall in demand. Continuous fall in demand may lead to recession. The Fed is trying to increase demand by cutting the overall lending rates and making credit cheaper. So the problem engendered by the sub prime crisis has transformed itself into a problem that affects the whole of the US market. The resultant contagion effect is being felt in the emerging markets.
India will be affected by the US market turmoil. The difference in interest rates between US and India will give rise to arbitrage opportunities and may lead to sustained inflow of massive forex into India. This will lead to strengthening of the Indian Rupee (INR), which in turn will have deleterious effects on Indian exports