“A blessing in disguise”

Sub-Prime markets offer loan/credit facilities to individuals that have weak credit history and have higher probability of defaulting on the loan (principal or interest or both). Sub-Prime markets are present in most credit categories housing, credit cards, automobile loan etc. Concerns over a crisis in the US sub prime lending market - where loans are offered to borrowers who do not qualify for market interest rates because of poor credit history - had sent global markets into a tailspin since the mid-week of July.

Impact on Indian Economy and Financial Markets

As India has large number of Foreign Institutional Investors that invest in the equity markets and if there is an effect on foreign economies, the FIIs may withdraw funds from Indian equity markets. A simple analysis shows that covariance between US equity market (Dow-Jones) and India's equity market (BSE-Sensex) has increased in 2007 and in August 2007 the covariance is even higher. This indicates that markets have not only been tracking US markets, the change is higher than what it was in US markets previous day. This is a concern for Indian equity markets as US and other Markets are expected to correct post sub-prime meltdown. However, in the long run, with Indian economy still going strong (IMF has revised India's GDP growth rate for 2007-08 upwards from 8.5% to 9%), the Indian equity markets should track India's growth pattern.

FIIs sold Rs 7770.5 crore worth of stocks in August 2007 as problems in the subprime loan segment resurfaced in the US, sparking a sell off in the equity market everywhere. The last time foreign funds had sold as aggressively was in May 2006, when they pulled out Rs 7354.2 crore in a single month.

The US subprime meltdown has to a certain extent proved as a blessing in disguise for Indian market. Surplus liquidity in the market which resulted in rupee appreciation and fears of inflationary pressures regaining grounds subsided as result to a certain extent. The domestic market was flooded with capital from foreign investors which created surplus liquidity in the market along with absence of any sterilization methods adopted by RBI to rein in liquidity.

The impact of withdrawing of money by FIIs has put a downward pressure on the rupee and INR has depreciated with respect to USD. The rupee has appreciated to as much as 40.24 a dollar since the beginning of the FY 2007-08 tracking the surge in FII inflows. Till 31 July 2007 FII inflow was about USD 10.9 billion. However, because of the meltdown in equity markets in August 2007, the FII outflow in August has been around USD 1.9 billion so far. This has led to depreciation of the rupee. The rupee depreciated by 1.29% to 40.96 a dollar on 31 August 2007 over 40.44 a dollar on 31 July 2007. Hence, the future level of rupee with respect to USD would also depend on overall effect of the sub-prime meltdown.

This along with measures taken by RBI like hike in CRR, removal of Rs 3000 crore cap on reverse repo auctions and modification in the external commercial borrowing (ECB) policy to modulate capital inflows, resulted in relatively tight liquidity situation in the market. ECB of more than $20 million per borrowing company would be permitted only for foreign currency expenditure for permissible end-uses. Accordingly, borrowers raising ECB more than $20 million would have to park the proceeds overseas.

However, Indian economy would continue to grow resulting in sustained capital inflows. As a result upward pressure on rupee would continue, thus remaining a concern for the policymakers.