If the U.S. slips into recession

October 7, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

In his testimony to the Joint Economic Committee of Congress, Federal Reserve Chairman Ben Bernanke described the U.S. economy as “close to faltering”. That is disconcerting enough. But with the EU also on the edge of a financial crisis, the threat to the world economy can be enormous.

The U.S. is on the brink of recession with GDP growth already down to less than 0.5 percent.

Greece will not be able to escape default in its sovereign debt repayment unless the hesitant European Central Bank finds an instant solution. In 2008, in spite of the U.S. being the only country dipping into recession, the impact on the rest of the world was extensive. In India, GDP growth had dropped from 9 to 6 percent. The silver lining was that it also brought down inflation from 8 to 3 percent.

It will probably be the last quarter of 2011 when the U.S. economy will sink into recession. If simultaneously Europe gets into a financial straightjacket, the combined impact on the rest of the world may be stronger than in 2008. For, the U.S. and EU together make up about half of the world economy.

What the sinister effect of U.S. and EU recession will be on any country will depend upon how closely it is tied up to the U.S. and the EU. Indian banks do not hold much of foreign debt.

Hence, our banking system will remain almost insulated from the secondary effect of the possible bank failures in Europe. However, India has fairly strong trade ties with the U.S. and EU which take up 30 percent of India’s exports. In 2008-09, our exports had actually declined 3 percent following U.S. recession. Since then there has been diversion of exports to Asia and Africa. As such, the fall in exports this time will be somewhat cushioned.

It is the FIIs that can upset the apple cart. They will sell their stocks and rush out of the market with dollars in their pockets.

Being shallow, the market will collapse and the rupee will depreciate. In 2008, the Sensex was down 40 percent. That shut out new issues and reduced investment and consumer demand. The government and the RBI, following global strategy, had responded quickly. The RBI brought down the repo rate in giant steps from 9 to 4.75 percent.

Presently, the RBI and the government do not appear to be much concerned about likely U.S. recession or the EU financial crisis, going by their silence. But the FIIs have already been acting to protect their investment. In September, they sold $1 billion worth of stocks, pushing the Sensex below 16,000 and depreciating the rupee to 49 to the dollar.

Pre-emptive action on the part of the RBI is necessary to prevent U.S. and EU recessions from creeping into the Indian economy. The immediate need is for the RBI to bring the interest rate down as was done in 2008 in quick steps and reduce CRR to make up for the likely liquidity drought.

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