India is more exposed to the global financial markets than other South Asian countries, but its strong fundamentals and pro-active monetary policy management will help it tide over the crisis, a World Bank study has said.
The study 'Global financial crisis : Are storms gathering over South Asia?' said there will be a significant slowdown in South Asia's growth prospects for 2009-10, and particularly notable for Pakistan and India, which is "relatively more exposed. . . through capital flows. . . and exposure of domestic financial institutions to troubled international ones. . ."
In the last five years, price increases of global commodities, especially those of oil, metal and food, budget deficits widened and trade balances worsened. With this, the growth softened and inflation reached double digits.
"Yet these risks are countered by a fundamentally strong macro economy including prudent foreign debt management, high savings rate, solid financial sector health, and a pro-active monetary policy management that will likely allow India to ride the crisis without destabilising the financial sector," it added.
The study mentions the swift action of the Reserve Bank in injecting extra liquidity into the financial sector, and raising the limit on private foreign borrowing, adding that the global financial crisis is still evolving and there is a significant risk of further slowing down of net capital flows.
"The global financial crisis will likely worsen. . . particularly on the growth and balance of payments front. Slowdown in global economy will adversely affect South Asian exports and could hurt income from remittances. Lower foreign capital flows and harder terms will reduce domestic investment. Both will lower growth prospects," it said.
"The possible downside effects of the financial sector crisis are much more direct and substantial from the real economy implications. These will work through trade, remittances and investments... South Asian economies have become much better integrated with the global economy than in the early 1990s, the study has said.
Exports are now over 20 per cent of GDP and are a major source of growth stimulus, it said.
"The recession in Organisation for Economic Co-operation and Development countries will almost certainly lower the export prospects for all South Asian countries, but especially India that has done remarkably well in the services sector and now faces a sharp slowdown in demand," it added.
South Asia is also a major exporter of textiles and garments that are vulnerable to the recession in the OECD economies. Depending on the magnitude and the period of this recession, the adverse effects on exports can be large, the report said.
"One redeeming feature emerging from the import side is the observed downward trend in commodity prices, especially food and fuel. The import bills on these accounts, especially fuel, are already coming. The recession in OECD countries will likely cause a further reduction in commodity prices with positive effects for South Asia," the report added.
The study said foreign remittances have grown rapidly in South Asia over the past few years providing an offsetting cushion on the balance of payments and they have been a huge source of income and safety net for a large number of poor households, especially in Afghanistan, Bangladesh and Nepal.
"Much of these remittances come from low-skilled workers engaged in the oil-rich countries of the Middle East. These earnings do not face an immediate risk as these economies have huge earnings and reserves from the oil price boom and oil prices are still substantially higher than in 2002 in real terms.
However, remittances from OECD countries can be adversely affected. India and Pakistan are particularly exposed to this slowdown. On balance the downside risk of substantial lower earnings from remittances appear low," the study said.
"Growing fiscal deficits due to food and fuel subsidies and rising inflation suggest that South Asian countries have basically run out of fiscal space and do not have the option of riding out further shocks with expansionary fiscal and monetary policies.
"So, in the near term growth will need to fall to absorb the shock from the financial crisis. Indeed, as noted, all South Asian countries have responded with some degree of monetary tightening and cutbacks in development spending, and have also adjusted domestic fuel and fertiliser prices in varying degrees to stem the widening of the fiscal deficit," it said.
The policy option of full pass through of fuel and fertiliser prices to consumers is not a politically viable option, although further reduction of the gap between domestic and international prices and better targeting of open-ended subsidies are possible, especially in Pakistan which faces the largest macroeconomic imbalances, the study said.