US downgrade a huge opportunity for India

The US sovereign downgrade is not entirely unexpected, but more import-antly, it is yet another sign that the effects of the global financial crisis which began three years back will be felt for many years to come.

Gradually, the loss of its AAA rating will have an impact on US’ standing in the world, the dollar’s status, and, of course, the global financial system.

The action by Standard & Poor’s may trigger some knee-jerk reaction in global markets, especially as the move coincides with the contagion in euro zone and a weakening global economy. But unlike the Lehman Brothers collapse, this time the market seems prepared because it has already discounted to a large extent the US downgrade.

The big question, I feel, is what will happen to US sovereign yields?

The US treasury will gradually weaken and will remain so till there is an upward revision in rating.

Incremental allocation to gold and other strategic commodity assets will increase  at the cost of US bonds.

The dollar as a global urgency reserve has lost its charm — it now constitutes 61% of total global foreign currency reserves, down from 73% in 2001.

The negative outlook assigned on the new AA+ rating of the US will most likely ensure a tighter fiscal policy regime.

It will be interesting to watch the dynamics of tighter fiscal policies and a very loose monetary policy. The effect of this interplay on US growth and inflation would determine the likelihood, timing and nature of further quantitative easing.

At this juncture, the probability of a full-fledged monetary expansion looks low in the near term but cannot be entirely ruled out in 2012. Over a longer-term, global economic equations are set to shift significantly with concerted efforts towards working out a new, alternative global reserve currency and likely gradual change in global reserves’ asset allocation mix towards gold and other commodities and high-potential emerging markets.
In my view, gold will continue to shine on the back of central bank buying support and shortage of physical metal.

Already, Chinese policymakers are discussing ways to diversify the country’s foreign exchange holdings away from dollars (one-third of its reserves) and also how to encourage Chinese companies to invest some of the foreign reserves overseas.    

However, the status of US treasuries as a ‘relative’ safe haven is likely to continue over the medium term, given its stature as the deepest and most liquid sovereign bond market.

India will benefit from lower commodity prices in the long term and a strong rupee, which also help tackle inflationary challenges to some extent.

We need to see how the Reserve Bank of India (RBI) deals with two challenges: the first is currency management, especially allowing more forex inflows, which are crucial in the long term; and, secondly, the change in the hawkish monetary stance.
Despite high core inflation the RBI will surely read into challenges in the global environment.

It should not end up tightening too much, which will dampen the Indian economy particularly when country will have some worries on the export of services to the US in the new order of things.

However, in the case of any sharp currency movements, the RBI is likely to step in and intervene to limit rupee appreciation.
In a way, the current situation throws up massive opportunities to build long-term forex reserves with extraordinary policy reforms and macroeconomic stability.

Overall, while the short-term impact of the latest S&P rating action will give the markets a dose of jitterbugs, in the long term, India should be ready to take advantage of such global shocks by concentrating on economic reforms so that its rating improves.
India will remain big beneficiary in terms of fund flows — both in the portfolio and direct investment segments — in the long term.
India’s growth differential with US will widen, but, at same time, the interest rate differential will compress in times to come.

— The writer is deputy chief executive - financial services, Aditya Birla Group