Economic Disaster at the Doorstep!!

Money and money making are two different and independent aspects of modern economy. The former is a medium to transact having no intrinsic value and the later is created out of thin air. How much money is created in an economy depends on multiple factors,of which demand is one. Hence, governments and banks across the world pump money in the system to create purchasing power and galvanize the economy.

Global Bailout packages were the savior during the last recession which helped the economy to recover and come out of the recession, albeit temporarily. This mirage is about to be broken because we are on the verge of witnessing another dip in international markets and its cascading affects will be felt across nations, including emerging markets specifically India.

The last recession (2008-09) came on the back of very strong economic growth. This meant that our economic health and ancillary support was at its best which made bailout packages conveniently possible for countries. It is going to be different this time. We have not yet fully recovered from the after effects of the last recession while the next one is staring at us. It is much more complex this time and I guess handful of people understand what are the potential effects of downgrading of US credit ratings. Let us give it a try!!!

US treasury investments are considered as “safe heavens”, i.e. the place where one has least risk. Downgrading of this “safe heaven” means that now there is some element of risk in it. What made the credit rating companies think so??? One answer would be US has got a 100% Debt to GDP ratio, i.e. their national debt is equal to their gross domestic output. Under such circumstances one should hesitate to call US debt market/treasury as “safe heaven”, it may not be one.

What has India to do with this??? Any investment is judged based on the return it generates against the potential risk that it carries. If the world’s “safe heaven” has become riskier now, then in relative terms everything else is also more riskier. Higher risk necessarily needs to be backed by higher returns which means the companies listed in the stock markets need to come out with flying colors if they want their investors to stay put and attract fresh money.

But India has also suffered a credit rating downgrade, that too the lowest possible of BBB-. With input costs soaring due to sustained high inflation profit growth may be tough. Indian markets have tanked in the last week and would continue to go down, till one thing happens. The economy has witnessed enough slowdown that it pulls down the demand for oil and subsequently its price . A fall in oil prices should ease things out considerably and provide us with some breathing time. But that wont happen until we have reached a downside threshold in demand.

Once the demand has shrunk and oil prices have come down by half, would be the time to galvanize the economy. But will we be able to create money out of think air this time too??? In the last recession US bail out package was largely funded by China who had bough US treasury bonds worth $878 bn. I have my doubts if that would happen this time. There is a fair possibility that India will witness a slowdown in its trade due to a declining rupee.

Domestically we face a steep challenge to manage increasing fuel costs and ballooning subsidies. With India having a 80% oil import economy, it is unlikely that this problem is going to be solved anytime in the near future. Hence, our fiscal deficits would keep getting bigger and this recession will make it worse. Money making will not be easy this time and currency valuations will come under severe stress.