Tell Me Where It Hurts

Thirty-Eight days after India went defiantly nuclear, at exactly 2 am IST on June 19, the United States slapped formal sanctions against India. Squeezing a total of $2 billion in foreign capital inflows, a much whittled-down figure from the $21 billion impact threatened earlier. Business and foreign investors, especially in the US, breathed easy. Even New Delhi, behind its belligerent posturing, seemed inwardly relieved. An aggressive Yashwant Sinha, finance minister, scoffing at the suggestion that foreign funding to India might dry up, described the sanctions as a "minor roadblock".

And the Congress, happy that "good sense prevailed in the US government", quipped that the sanctions were, after all, "not an economic disaster".Not a disaster perhaps, when compared to Pakistan, which faces a suspension of the IMF restructuring loan—there're no new World Bank loans coming up for approval in the next six months anyway. But global outlook changed ever so subtly. Moody's Investors Services, which had already frowned at the budget and hinted at a downgrading, scaled down India's sovereign debt rating from Baa3 (highest investment grade) to Ba2, considered by many as junk rating. At one stroke, it pushed long-term debt to Ba2, short-term debt to 'not prime' from 'prime three' and foreign currency deposit ceiling from Ba1 to Ba3. While Sinha characteristically chose to underplay the downgrading by hinting at India's strong fundamentals, Moody's cited precisely that "weakening macro-economic balance" worsened by a "fractious political environment" as the cause.

India runs a big risk of getting caught on the wrong foot if it chooses to undermine the impact of sanctions. As Sinha did by ignoring the sanctions in the budget and by hinting last Friday that they would affect only $2.5 billion of external flows and India would explore alternate sources of funding to meet the gap.

That's the total external assistance budgeted for in the current fiscal—it was $2 billion last year. However, he also said that the government was assessing the impact to get a clearer picture.

That picture apparently didn't exist in the government till Thursday night, even after the G-8 reached an agreement over economic isolation for India. Says Deena Khatkhate, World Bank consultant: "The actual stance taken by these funding agencies would primarily depend upon the indirect political pressure applied by the US, the biggest contributor of funds." And India, for now, isn't contesting the deferment. Said India's top gun at the World Bank, Surendra Singh: "A postponement was in everyone's interest, even India's, which would have preferred an approval. Our hope is that the delay will be as brief as possible." But, defending the finance ministry stand, a senior ministry official said: "What do we have that's new? It's just a suspension, a postponement of consideration of new loans. The budget has to be predicated on hard numbers, and as far as sanctions are considered, there's no effect on this year's balance of payments."

That's because budget allocations are made on the basis of disbursements, money that's already come in. And as far as multilateral loans are concerned, there's a huge amount—$11 billion odd—waiting to be disbursed, $8.5 billion of World Bank aid and $2.5 billion of ADB aid. At the current rate of use, they could last for years. World Bank projects, for instance, have the longest gestation in India, five to seven years typically, thanks to infrastruc-tural and administrative bottlenecks.In fact, it would seem that we really don't need the aid, the bulk of which comes from the World Bank, ADB, Japan and Germany, in that order.

But we do, especially the states, the social sector, and infrastructure. The states, which are pursuing reform in urban services and power, are up in arms. Andhra Pradesh chief minister Chandrababu Naidu told Outlook: "It's no secret that my state would be the worst hit by sanctions." Among the $1.9 billion Bank loans that weren't approved this year (Bank fiscal year ends in June) was the much-publicised $550-million AP economic restructure loan. Plus $1.2 billion for power and water supply under negotiation. In Tamil Nadu, Bank loans of $600 million for panchayats, urban development and transport, housing and the Third Chennai water supply project won't come through. In Kerala, Japanese aid of around $100 million for tribal development and a plan to connect the mainland with three islands in Kochi are suspended.

Karnataka government officials estimate sanctions to impact an inflow of about $1 billion, $200 million of which is the threatened OECF aid for the fourth phase of the Cauvery drinking water scheme. The Orissa projects facing rough weather are $350 million power reforms, $350 million water resources consolidation, the ADB-funded Rs 400 crore Paradip coal handling facilities and the four-laned National Highway No 5. The Gopalpur port, essential for the Tisco steel plant, is now unlikely to leave the drawing board. However, the OECF-funded projects in West Bengal, including the prestigious Bakreshwar thermal power plant, will come through, though the ADB-funded Haldia-Siliguri six-lane express highway connecting south and north Bengal is now in peril. But all new aid negotiations, whether in World Bank or for Japanese OECF or in Danida (which is closing down), have come to an indefinite stop. As has the India Development Forum meeting, which Japan has opposed.

Also hanging fire in the Bank are $76.5 million for Orissa state health systems and $250 million for reproductive and child health. And talks for a $310-million hazardous waste sites clean-up project and conservation of an Indian heritage project. The Germans have put on hold a DM 290 million grant for poverty eradication and environment—no new commitments have been made for calendar 1998. In fact, the social sector, along with infrastructure, survives on interest-free IDA loans. Even if India manages to pay a little more to replace the 6.7 per cent Bank loans, substituting the IDA component, which is 43 per cent of this year's total external aid, will be tough. As a result, fears Kannan Srinivasan, a Bombay-based policy analyst, the government may be forced to cut down its spending on the social sector even further. The upside is a little grey area on what defines humanitarian aid, whether it includes education, health, low-cost housing, sewage etc. The US says it does because all these come under non-basic human needs. Environment doesn't, for the US has suspended the $6 million Greenhouse Gas Program.

Says Kinichi Komano, economic counsellor in the Japanese embassy: "Grant, aid or loans won't be provided except in emergency aid (e.g. cyclone relief), humanitarian aid (including the social sector) and grassroots grant assistance (aid to NGOs)." Japan, which gave a little over $1 billion last year, maintains that Yendong or concessional loans will continue in the case of long-gestation infrastructure projects involving large amounts of money. "However," adds Komano, "the government will exercise some selectivity in these projects."

The third patron of infrastructure is ADB, which grants about $1.3-1.4 billion every year for energy, transport and urban services, and which has still not tied up any project this year. The first flush of projects are coming up before the Bank board in September, said an ADB spokesperson. Under review are projects for the Railways, Rajasthan urban infrastructure, Gujarat power, MP public resource management, and power grid development.

A much bigger threat, however, lies in private capital flows which are dependent on investor sentiment. For now, it does seem that foreign investors, including NRIs, are looking away from India. Says Jairam Ramesh, economic secretary, AICC: "The sanctions, though soft thanks to Pakistan, now seem to be permanent. Mainly, bilateral government deals are affected. SBI overdraft facilities in the US has come to an end. This will affect nationalised banks. Inflow of private capital into India also may be affected." A large damage will come from the loss of over $1 billion in US and Japanese Exim Bank credits for aircraft and power projects—Dabhol Power II of Enron, National Power of the Hindujas, BPL Power and Hughes Ispat.

Says Y.B. Desai, MD, Exim Bank of India: "These companies may have to restructure their costs and look elsewhere." Daewoo Power, which is promoting the $1.3 billion Korba power project in MP, will approach the Italian Exim bank, SACE. S.C. Muthiah, SPIC president, conceded that the guarantee problem would affect their 550-MW Tuticorin project with Raytheon, which was now scouting for contractors in other countries. Admits Raju Patel, CEO of Hughes Ispat, which has a tie-up with US Exim for $275 million: "Any financing that requires us to get political risk coverage will be adversely affected. But for that, we have alternatives like the American Insurance Group."

And European banks. Adds Desai: "Some Swiss banks have already approached Indian banks to open dollar denominated lines of account. Most of India's trade even with non-American countries is in US dollar terms, and the settlement of such transactions is done in the US which will now be upset. Swiss banks which have big reserves of Euro dollars, can offer the same services from Europe." Chairman of UK-based Prudential Corporation Sir Martin Jacomb said that the Bank of England has decided to extend LCs to Indian banks. "Prudential is bullish on India and would like to increase its exposure in the stock market in future."

But the big battleground is over dual-use exports, which are technically all items not classed as munitions, raising exporters' concerns about more than $1 billion a year. US manufacturers are worried, for example, that annual sales of $634 million in chemicals and related products could be hurt, and some are reportedly arguing that fertilisers should be exempted on humanitarian grounds. The US Commerce Department has already moved to block exports and withheld all pending licence applications.

In the readymade garments sector, most US importers and retailers are still waiting and watching before deciding to shift the sourcing of $4 billion worth of goods. Says Julie Hughes of the US Association of Importers of Textiles and Apparel:"If the MFN status is revoked, it could push tariffs on Indian goods up to 90 percent,making imports prohibitive. "

Technically, sanctions shouldn't affect private business. More so, because sanctions have proved counter-productive in the US. The National Association of Manufacturers, in a 1997 study, concluded that sanctions cost billions of dollars in lost sales, opened up opportunities to competitors and damaged the reputation of US companies, while seldom working anyway.But sentiments do get hurt, whether in India or in the sanctioning country. In Mumbai, the Sensex fell again last Friday to end the week at 3143 points, reflecting a major scare among FIIs. Says Moody's: "Loss of investor confidence has led to net withdrawals of institutional capital in recent months, for the first time since 1991."

And that hits investor plans. California-based Unocal Corp, for example, said it was assessing the possible impact on its plans to be lead developer for some $4 billion worth of power and other projects in India. With political risk premium going up, a dollar loan may now cost 16-18 per cent. Rates of Indian commercial paper have risen by 200-250 basis points already. The Power Finance Corporation has deferred issue of $100 million seven-year bonds, as has Ispat Industries to raise $75 million through external commercial borrowing. The finance ministry has also put on hold several corporate applications seeking to prepay their past foreign borrowings. This is expected to act as a cushion against any possible speculative attack on the rupee. All giant infrastructure projects face a steep rise in costs, now that the four financial institutions and eight nationalised banks including the SBI face a lower rating from Moody's.

Says R. Ravimohan, managing director, CRISIL: "In the short-term, the impact may be negative. Interest rates could rise as money market in the short term is likely to be driven more by sentiment rather than fundamentals. The government may need to borrow more to support infrastructure development and demand for rupee funds from corporates might also increase. There's a perception of a fall in the dollar inflows through official sources."

 And perception counts. Especially when the budget has done little to change that. With economic performance not showing any sign of looking up—fiscal deficit last year was at 6.6 per cent, business confidence is still low and the CII has predicted a decline in industrial production—the sanctions might just end up indirectly triggering a balance of payments crisis.

Just how is lucidly summed up by Rafiq Dossani, Professor at the Asia Pacific Research Center at Stanford University: "There'll clearly be a slowdown in direct foreign investment into India. Foreign portfolio investors are also wary. India's forex reserves exceed $25 billion and seem secure for the moment. However, if exports continue to be sluggish, the trade gap could reach $10 billion. If portfolio investment is substantially withdrawn, say more than $2.5 billion, the reserves will tumble by half. This is without reckoning the effect of any repayments of foreign loans."

And that's just what international agencies have warned against. International management consultants Ernst & Young, for instance, expect exports to grow by only 7 per cent this year. And that's what Moody's too feels. Trade and credit sanctions, it says, are likely to hamper efforts to overcome severe infrastructure constraints and whet concerns about whether growth and exports can be suffi-ciently stimulated to reverse the recent weak performance of the external sector and government finances. Sadly, that's a doubt few in the government, including the finance minister, can dispel.