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India's economy in junk mode

The Indian stock market continues to slide following revelation of the scandal surrounding the outsourcing company Satyam Computer Services, of which the founding brothers have been interrogated and jailed and the chief financial officer arrested following the revelation of fraud that could exceed US$1.5 billion. Chairman Ramalinga Raju resigned in the middle of last week with a letter confessing the falsification of profit and revenue.

The crisis has affected the stock market, which in turn influences government economic and fiscal policy in the run-up to elections for the Lok Sabha, Lower House of parliament, due by May this year), with knock-on effects on the further evolution of the economy through the end of the calendar year and beyond.

The BSE Sensex 30 index, which opened on Wednesday, January 7, over 10,400, closed a week later on Tuesday, January 13, under 9,100, a decline of 13%, losing over half that amount on the day the Satyam scandal was made public. The shares of the company lost over 80% of their value in one day and the market followed in its wake.

There is a distinct chance that the Sensex will test the near-term support at 8,500 before going further to test the long-term support at 8,000. The broader-based Nifty index was down about the same proportion as the Sensex and with the same pattern, to under 2,750. These indexes had stabilized recently after an especially horrible year, even for Asian and emerging markets, down 56% from their January 2008 highs. Almost every major sector - energy, real estate, housing, automotive industry, banking, finance, technology - has taken a hit, all for different but interrelated reasons.

The fall in stock prices has brought the general price-to-earnings ratio down to less than nine, yet this is still higher than for other Asian markets, even if it looks attractive by European and North American norms. Meanwhile, the Indian market will continue to be affected by global conditions, including the general slowdown and liquidity crunch putting pressure on earnings and dividends, all while domestic demand slows down with the overall rate of national economic growth.

The consensus view, therefore, is that corporate earnings will not support even current valuations. For these reasons, compounded by an unfavorable macro-economic prognosis, continuing sell-offs by foreign institutional investors (FIIs) are to be expected, contributing to further price weakness.

Indeed, FIIs continued their sale of Indian equities in 2008, shedding over $13 billion worth in 2008 after selling $17 billion in 2007. Indian stock market regulators report that their access to overseas capital permitted them also to use offshore derivatives called P-notes for short selling. All these developments have progressively depleted Indian's foreign exchange reserves and weakened the rupee.

As a result, the government has taken measures to stimulate economic activity in the past month, but it is not clear that these will have a significant countervailing effect. In particular, it has announced fiscal measures in favor of consumer goods exporters (textile, leather, jewelry) and other policies to protect jobs while halving the value-added tax, making low-interest loans available to small- and medium-sized enterprises.

However, capital expenditure is putting on the brakes as investment projects are postponed or canceled with the disappearance of the global liquidity boom and asset bubbles. The decline in world trade and decreased availability of credit for investment and consumption contribute to the industrial slowdown in India, which will soon spread to the service sector.

Domestic Indian banks have lost liquidity for these reasons and FIIs, seeking to avoid risk, have sold off not only in the stock market but also in real estate, with negative knock-on effects on bank lending for both consumer spending and capital investment.

The Reserve Bank of India intends to continue a policy of rate cuts and injecting liquidity. Spending in the run-up to the Lok Sabha elections, together with subsidies for consumer goods, is projected to increase the fiscal deficit to 9% or more of gross domestic product. Countermeasures to stabilize monetary and fiscal policy could lead to sovereign credit ratings to be cut to "junk", according to Standard & Poor's, and Moody's Investors Service reports similar downgrade dangers.

If the recent above-average growth rates were driven mainly by capital inflows, as many analysts believe, then the stimulus will not succeed in boosting exports, production or domestic demand. The Satyam scandal is just what neither India's economy nor its politicians wanted at this moment.

The government has removed the company's board and replaced its members with appointed directors, but survival of Satyam, one of India's largest outsourcing companies, is in doubt. Aside from the international implications (its clients include one-third of the Fortune 500 companies which must now scramble in an uncertain legal and organizational environment), perhaps the most worrisome aspect is the fear that has been sown that Satyam could be only the beginning of a snowball of scandals and collapses, as occurred in the US last year. This would be the worst possible time for such a series of collapses, and even if they do not occur, confidence has been shaken.

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URL:  http://www.robertcutler.org/blog/2009/01/indias_economy_in_junk_mode.html
First published in Asia Times Online, 15 January 2009.

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