Falling dollar: Beginning of end for Indian IT sector and major exporting economies

Since 2002, the U.S. currency has fallen 40 percent against the Canadian dollar, 33 percent against the euro, weakened 24 percent compared with the British pound and 15% compared with the Japanese yen. There are various reasons for this sudden fall in U.S. dollar. U.S.A. has a very large current account deficit, about 5.9% of GDP and very low interest rates, as low as 1.5%. Hence there is little motivation for the other countries to buy U.S. securities at such a low rate. Due to low interest rates, the American citizens have a low savings to income ratio. As spending increases, so do the imports.

However if the dollar continues to weaken at an alarming rate, then it may have a direct impact on U.S. imports. Its imports will fall resulting in reliance on manufacturing industries in the States itself. Until earlier, manufacturing and exports caused work to shift to low-cost destinations such as China, Korea and India. No wonder, China doesn’t want to revalue its currency.

As for India, its IT sector exports are worth about Rs. 70,000 crore. A large workforce depends on this sector. If the U.S. cuts it’s spending on the sector, it could have far reaching unpleasant consequences on the Indian IT sector. This could lead to reduced salary and workforce, which would in turn lead to reduced disposable income from the Indian working class across major exporting sectors such as IT, textile, jewellery and automotive parts.

Also, there are various sectors, which directly drive the revenue of the IT sector. These are banking, retail and insurance. Due to reduced per capita income in the U.S. worsened by the housing sector slump, these sectors may slow down and cause trouble to the Indian IT sector.

Fitch reviews India’s local currency rating

On Tuesday, 15^th July, Fitch (a global ratings agency) lowered India’s domestic currency rating to negative from stable. The reason mentioned was the central government’s worsening fiscal position. However the outlook on India’s foreign currency rating is stable. Earlier, in August 2006, Fitch had raised India’s domestic currency rating by one level to BBB-. James McCormack, head of Asian sovereign ratings at Fitch said that the rating remains the same; only a negative outlook has been put to it. The government proposes to control the deficit within 2.5% of GDP in 2008-09. According to Fitch, the central government’s deficit this year will be larger than that predicted in the budget.

Fitch is looking at a deficit close to 6.5% of GDP for the next fiscal year. This can be attributed to higher subsidies, interest payments and public wages, along with bonds issued to oil and fertilizer companies. FIIs feel that the impact of this review would be felt more severely on the equity markets than in bonds. It could see withdrawal of funds by foreign institutional investors, both from equity and debt markets.

Foreign Institutional Investor (FII) is a term used mainly in India to refer to an investor - mostly of the form of an institution or entity, who invests in the financial markets of a country different from the one where in the institution or entity was originally incorporated, in this case India. FIIs usually follow norms, which don’t allow them to invest in a country that has been allotted a certain grade. In such a scenario, the FIIs would pull out the dollars and push the rupee to 44-levels. Then the rate hike by the Central Bank would be necessary to prevent the Indian currency from deteriorating.

However, India can have some temporary respite. Strength and support to the external side is provided by the fact that India has a foreign exchange reserve of over USD 300 billion. It now remains to be seen whether the above speculations prove to be true and how the central government copes with the situation.