Nobody really talks of Asia being “decoupled” any more, except perhaps in India. The Chinese government, seriously noting the collapse in imports, has embarked on a comprehensive range of extensive fiscal and monetary measures designed to counteract the effects of the global downturn.

In East and Southeast Asia, other heavily globally integrated economies are being buffeted by the adverse trade and investment winds, to the point where indicators in several of these economies are now worse than in the developed North, and so governments of these countries are also well aware of the seriousness of the problems.

Indian policymakers, by contrast, still seem to be caught in some complacent time-warp, whereby they proudly point to the GDP growth rate (now spluttering, but still high by international standards) and to the supposed “resilience” of the domestic financial sector.

Of course, neither of these is as positive as the Government would like to make it out. The current slowdown in GDP is sharper than the Government would like to admit, and more significantly it has been accompanied by a much steeper than expected reduction in employment, especially in export sectors.

Domestic banking is still generally secure, especially because nationalised banking remains the core of the system, largely thanks to resistance from the Left parties to government attempts to privatise it.

Even so, there are clear signs of fragility and inadequacy within the banking sector: the recent rapid growth of often dodgy retail credit, associated attempts to securitise such debt, the emergence of a credit crunch in the face of macroeconomic uncertainty, and the inability or unwillingness of the banking system to provide loans to medium and small borrowers other than in the form of personal credit.

Beyond these implications, the effects of the global crisis have directly impacted some important macroeconomic variables. Three such indicators stand out in terms of their quite sudden deterioration since the middle of last year: the decline in the foreign exchange reserves held by the Reserve Bank of India; the fall in the external value of the rupee, especially vis-À-vis the US dollar; and the decline in stock market indices.

Chart 1 shows how foreign exchange reserves, which had been increasingly steadily over the past few years, started declining after June 2008. Not that the earlier build-up of reserves reflected any great macroeconomic strength, since unlike China it was not based on current account surpluses. Instead, the Indian economy experienced an inflow of hot money, especially in the form of portfolio capital of FII investment.

Domestic macro policies combined with the need to prevent exchange rate appreciation to prevent increased domestic absorption of such resources, as a result of which these were largely added to reserves. Since they were based on hot money inflows, it was only to be expected that they would reverse with any bad news, and that is essentially what has happened over the past eight months, with the bad news coming from the US and other developed markets rather than from the Indian economy.

But that movement of foreign institutional investors was in turn related to the sudden collapse of the rupee, shown in Chart 2. Early in March 2009 the rupee even breached the line of Rs 51 per dollar, and it may continue to fall. There are those who argue that this depreciation is positive since it will help exports, but conditions prevailing in the world trade market, with falling export volumes and values, does not give rise to much optimism in that context.

India currently has a current account deficit, including a large trade deficit and also quite significant factor payments abroad. The falling rupee will imply rising factor payments (such as debt repayment and profit repatriation) in rupee terms, which is not good news for many companies or for the balance of payments.

Associated with all this is the evidence of falling business confidence expressed in the stock market indicators. The Sensex, shown in Chart 3, had reached historically high levels in the early part of 2008, capping an almost hysterical rise over the previous three years in which it more than tripled in value. But it has plummeted since then, with high volatility around an overall declining trend, such that its levels in early March were below the levels attained in December 2005.

How much of all this is due to the behaviour of foreign investors, rather than domestic investors? Chart 4 tracks the changes in total foreign investment, split up into direct investment and portfolio investment, over the period since April 2007. It is evident that both have shown a trend of increase followed by decline. FDI has been more stable with relatively moderate fluctuations (even though it does include some portfolio-type investments that get categorised as foreign direct investment). It peaked in February 2008 and thereafter has been coming down but is still positive.

Portfolio investment (which includes both FII investment in the domestic share market and GDRs/ADRs) has been extremely volatile and largely negative (indicating net outflows) since the beginning of 2008, and this has dominated the overall foreign investment trend.

As a result, as Chart 5 shows, the cumulative value of the stock of Indian equity held by FIIs fell quite sharply, by 24 per cent between May 2008 and February 2009. This is not likely to be due to any dramatically changed investor perceptions of the Indian economy, since if anything GDP growth prospects in India remain somewhat higher than in most other developed or emerging markets. Rather, it is because portfolio investors have been repatriating capital back to the US and other Northern markets.

This reflects not so much a flight to safety (for clearly US securities are not that safe anymore either) as the need to cover losses that have been incurred in sub-prime mortgages and other asset markets in the North, and to ensure liquidity for transactions as the credit crunch began to bite.

Whatever the causes, the impact on the domestic stock market has been sharp and direct. Since the Indian stock market is still relatively shallow, and FII activities play a disproportionately strong role in determining the movement of the indices, it is not surprising that this outward flow has been associated with the overall decline in stock market valuations.

As Chart 6 shows, the Sensex has moved generally in the same direction as net FII inflows. In fact, movements in the latter have been much sharper and more volatile, suggesting that domestic investors have played a more stabilising role over this period.

Overall foreign investment flows (including not just FII but direct investment) have also, predictably, played a role in determining the level of external reserves. Chart 7 shows the pattern of aggregate net foreign investment and change in reserves since April 2007.

Once again the two move together. In this case, however, foreign investment has been less volatile than the change in reserves, suggesting that other components of the balance of payments have been important as well. The changes in external commercial borrowing are likely to have been significant.

In addition, the possibilities of domestic investors moving their funds out should not be underestimated. As the Table shows, the recently liberalised rules for capital outflow by domestic residents have led to outflows that are not insignificant, even if still relatively small.

Liberalised rules for capital account transactions by Indian residents seem to be increasing the vulnerability that derives from India’s dependence on foreign investment flows. This an aspect of India’s external payments that policy must address, especially since there are constraints set by WTO membership on using tariffs and quantitative restrictions on reducing foreign exchange outflows that occur on account of imports.

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