By Sanjana Basu

Now more exposed to the global market, India looks to weather the effects of the U.S. debt downgrade. Source: Mark Nye's flickr photostream, used under a creative commons license.

World markets continue to be in turmoil since Standard & Poor’s downgrade of the U.S. AAA credit rating on August 5. This time around, India is not as cushioned from a global financial crisis arising out of the U.S. debt debacle, due to its increased exposure to global markets. Moreover, domestic political paralysis, inflationary pressures, market volatility, and falling overseas demand may exacerbate the negative impact of this debt crisis on India. That said there are also several reasons to stay positive: India’s rupee has held up well against the major global currencies, India’s foreign exchange reserves are strong and growing, exports are surging and economic growth is still robust.

Exploring the situation in greater detail, there are three ways the fallout from the S&P decision may hinder India’s economy:

First, Indian equity markets have been shaken up by global uncertainty. Volatility in global markets has affected India’s equity markets, with the main Bombay Stock Exchange Sensex closing at a near 19 month low on August 26.

Second, continuing slow growth figures in the U.S. will impact trade flows to India. Among other sectors, the services sector that constitutes a majority of India’s exports to the U.S. will be most impacted. One of the main drivers of the Indian economy, it is likely to experience a dent in demand.

Third, there is already an adverse impact on capital flows to India. A foreign institutional investor (FII) pull out two weeks ago pulled down the Indian rupee to a six-month low and brought the Sensex to the level it was four years ago. In such a climate, foreign direct investment (FDI) into India could also slow down, especially investment in infrastructure where FDI is needed most and where it creates substantive employment opportunities. The U.S. debt downgrade has also hit the fund raising plans of Indian corporates, who are looking to borrow overseas to finance acquisitions and growth opportunities.

Further, the domestic inflationary environment and political paralysis could exacerbate the situation.  India’s usual 8% rate of growth was dampened this year by extreme inflation and just came in at 7.7% for the second quarter. To combat inflation, the government has taken deflationary steps like interest rate hikes. However, high interest rates combined with slow global growth could impede economic growth in India. Consequently, a dip in global demand along with a slump in domestic demand could intensify India’s problems and add to social tensions.

In addition, if the current anti-corruption movement continues to paralyze the government, one can expect little progress on bills or reforms to be passed in this parliamentary session. This will delay the implementation of pending economic reforms (including those currently in parliament) that could cushion India from the crisis and allow it to take advantage of slower global growth across the West.

Yet not all the news indicates a rainy day. Keeping the above in mind, India could also withstand and benefit from a U.S. debt crisis when considering these factors:

• Indian Banks and companies are better capitalized than in 2008, and there is greater liquidity.
• Closer integration with Asian economies (which accounts for the majority share of consumer demand in services) could offset the fall in demand arising from slower growth in the West.
• Moreover, a global crunch leading to a fall in commodity and oil prices could reduce imported inflationary pressures into India.

Finally, if the government is able to withstand current political upheavals and accelerate its reforms process, it can maintain its estimates of 9% growth for the next five years and position India for further growth and stability. This could help maintain domestic demand to offset the crisis and allow India to take advantage of opportunities in the West.

Sanjana Basu is an intern scholar in the Wadhwani Chair in India-U.S. Policy Studies at CSIS.