While India is more insulated from the global financial crisis than most other economies, a long drawn out realignment of the global financial markets and a sustained global growth slowdown can affect us more adversely than most have factored in now. By Vivek Sharma

With the Paulson bailout plan having been approved in the US, governments in other major economies are also considering similar plans of their own and central banks across the world continue to pump billions of dollars into the market to ease liquidity pressures. There is talk of interest rate cuts and other measures by central banks, while market regulators are easing rules that restrict capital flows.

In India, the RBI has already cut the CRR by 50 basis points (See: RBI cuts CRR by 50 bps to 8.5 per cent to boost liquidity) and SEBI has removed restrictions on FII investments through the P- Note route (See: SEBI opens PN taps for foreign funds as market sheds 700 pts)

Yet, the stock markets continue to fall and credit markets remain frozen. The Dow slipped below 10,000 and the Sensex has taken out 12,000 on the way down. Credit spreads, the difference between market interest rates and benchmark rates, continue to widen. LIBOR rates are near record levels, but it doesn't matter anymore as banks are still too wary to lend to each other. Many more banks, especially in Europe, are said to be on the verge of failure.

It is not about the credit crisis anymore. The real fears are about a global recession, a painful realignment that can last a while.

In India, we have so far considered ourselves to be somewhat insulated from this global crisis because of our low export dependency and lesser financial integration with the rest of the world. Not anymore. The cataclysmic events of the last few weeks in the global financial markets can have a bigger impact on India than most of us have factored in.

The capital freeze
Until recently, when the rest of the world was slowing down, the one factor that was expected to support growth in India and China was a sustained increase in capital investments. Even if global demand weakens, it was thought that domestic consumption supported by huge capital outlays on infrastructure and capacity additions will balance it to a great extent.

From just over $100 billion a few years back, the Indian government has steadily hiked the proposed investment outlay in infrastructure to more than $500 billion over a 5-year period. Stretched as it is financially, the government cannot find enough resources to finance these ambitions and was heavily banking on private capital. That will be hard now and the adverse effect on overall economic growth will be perceptible.

Indian companies, which had a capital investment pipeline of nearly $500 billion according to ICICI Bank's estimates, will also face a huge shortage of capital. During the last financial year, nearly 20 per cent of the total funds raised by Indian companies were through external commercial borrowings. With global financial markets in a deep freeze, that route has more or less dried up completely.

The sharp fall in equity prices makes it almost impossible to raise money from the markets. Investors have lost heavily in almost all IPO's that came out over the last year or so and it will be a while before issuers and their bankers muster some courage and come out with a new IPO. Private equity, another source of capital for companies in recent years, continues to be available. But, valuations have plummeted and only companies which are desperate for capital will do deals at these levels.

It is not just capital availability, but the cost of capital will also be a big concern in the coming days. Domestic commercial interest rates are now hovering around 16 per cent, except for a few prime borrowers who can still get sub-PLR rates. Though most bankers believe the interest rate cycle has peaked, rates may not fall fast enough. It is possible that inflation may remain high because of lower farm output and force the RBI to go slow on rate cuts.

Corporate earnings
The IT and BPO sectors are thought to take the worst hit from the global financial turmoil, but others may be even worse off if the global economy slips further. Nearly 30 per cent of the aggregate Indian IT and BPO revenues are accounted for by the global banking, financial services and insurance sectors. This space may see a substantial decline in activity over the medium term as many companies go through major restructuring and consolidation.

The global economic slowdown may force companies in other sectors to cut their technology spending, which will further affect our IT services providers. The cheaper rupee will provide some solace in the short term, but cannot balance out the demand slowdown. 

The sharp fall in global commodity prices will squeeze some of the largest domestic companies. Until recently, metal producers all over the world were so confident that they willingly agreed to sharp hikes in mineral prices by miners. That has changed dramatically as demand seems to be falling off sharply and prices are trending lower. Lakshmi Mittal has seen his net worth erode by nearly $20 billion over the last few months as stock prices of metal companies have plummeted. If the market worsens, companies like Tata Steel which took large amounts of debt to finance acquisitions may face difficulties. Most new projects will be put on the backburner, including the mega projects announced by companies like Arcelor Mittal, Tata Steel and JSW in the states of Orissa and Chattisgarh.

Lower oil prices and lower demand for refined products in export markets will see a fall in refining margins for companies like Reliance Industries, which may also be affected by lower demand for petrochemicals. PSU oil companies will find the benefits of lower crude oil prices neutralised by lower refining margins and the cheaper rupee.

The uncertain economic outlook and difficulties in raising capital will definitely cause a slowdown in capital spending. This is bad news for capital goods manufacturers which are already facing a decline in order flows. Larger capital goods and construction companies which were banking on the building boom in the Middle East will be disappointed as lower oil revenues will make those countries more cautious about spending.

Stocks of property development companies have been the worst hit in recent months, with some of them having fallen 60 to 80 per cent from their highs. But their worst phase in terms of business growth and profitability may be yet to come. Demand for property has softened appreciably while at the same time supply continues to build up. Developers have so far resisted major price cuts as they had access to private capital, but those sources are drying up fast. Prices are likely to fall further and may remain weak for a few years as the excess supply, especially in the residential space, is quite high.

The fiscal risks
Just as the economy is slowing down and growth in government revenues is declining, government spending has gone through the roof. The finance minister may continue to claim that every major spending programme is budgeted for and he has the money, government finances will come under increasing strain this year and the next when the costs of populist programmes sink in. Chances of the government making any conscious attempt to restrain spending so close to general elections are very low. If anything, even more populist programmes may be on the way and the next budget will be a please-all, full of goodies.

If the fiscal deficit worsens further, the country's investment grade rating will be under threat. Major rating agencies have already placed the country's ratings on watch because of the sharp increase in government spending over the last year. It may not make much of a difference to investment flows, but if the country is downgraded to speculative grade, it will only worsen the sentiment.

All in all, while we should indeed be thankful that we more insulated than most others, the adverse effects of the financial crisis on India can be worse than most believe. Even though the long term India growth story remains largely intact, businesses and consumers will be forced to tighten their belts while the government and the RBI have some deft handling to do in the months to come.