Can India withstand global threats?

However, the comparison should end there. A lot has happened in between the two events, because of which the causes and consequences of the decline in stock prices during the last week are quite different from the crash of May 2004.

For a start, the size of the domestic economy has increased by slightly over 16 per cent during this period, while inflation has remained in the moderate range. No major macroeconomic indicator has begun to point in the negative direction during this period and virtually all forecasts of the economy's performance during the current year indicate more of the same.

So, what caused the fall in prices and is it the first sign of a sustained downward movement? While there was a widespread belief last week that an adverse interpretation of the tax status of foreign investors contributed to the fall in the market, the finance minister's subsequent clarification should take care of that provocation in the coming days.

However, his reference to 'global factors' in explaining the fall is significant. If, indeed, there are hostile global forces at work to slow down growth in India, or in emerging economies as a group, we need to understand how they are likely to play out, as well as what we can do domestically to buffer ourselves to the extent possible.

After three years of persistent increases in crude prices, during which they hardly seemed to have impacted on economic growth around the globe, there are increasing signs that they are finally beginning to bite.

Inflation in the US is beginning to rise, while countries in which the pass-through of higher prices to the consumer was restrained by a combination of lowering taxes and price controls are running out of room to continue with these measures.

So far, stronger inflationary tendencies across the globe have been quite effectively offset by the expanding scale of international trade. Increasing imports of goods and services from lower-cost locations has allowed the US, for example, to absorb the oil shock to a far greater degree than in the past. It is no surprise that the high growth-low inflation scenario in the US over the last three years has been accompanied by a ballooning current account deficit.

The problem, of course, is that anti-inflationary forces based on off-shoring cannot go on indefinitely even in the US, let alone countries that are far less open to imports. Since the process is quite unprecedented, there aren't any readymade tools that enable any prediction.

However, from a stock market perspective, the first signs of accelerating inflation should provide a warning that the ride could be about to end and more conventional anti-inflationary policy measures -- higher interest rates -- are just around the corner.

It is perhaps still too early for a clear reading of the signs manifesting themselves around the globe, but in today's environment, both central banks and global investors are more likely to interpret these signs negatively rather than positively.

So, we should anticipate a period of monetary tightening by central banks, declining asset values in markets across the globe and, more so in emerging markets, as investors from the affluent countries retreat to safer havens.

This process is unlikely to precipitate balance of payments crises in the emerging economies, because most, if not all, have buffered themselves heavily with foreign exchange reserves. But, it will, inevitably, induce a slowdown in growth, as demand in the US and EU contracts in response to rising interest rates.

The 'wealth effect' -- consumers' willingness to spend as the value of their asset portfolio increases -- viewed as an important contributor to demand growth in the US over the past decade and a half, will obviously work in reverse to exacerbate the impact of monetary tightening. Exports from Asia to the rest of the world, such an important force in the region's growth, will suffer.

However, an important feature of this potential global slowdown will be its asymmetric impact. Some countries will be hit harder than others. The dividing line will essentially be the degree of exposure to international markets, measured roughly by the export/GDP ratio.

Economies with large domestic markets -- the distinguishing feature of BRICS, or Brazil, Russia, India and China -- are going to be somewhat less vulnerable, provided that their domestic growth drivers are relatively insulated from the generally negative global environment.

From this perspective, India is in a relatively comfortable situation. Its exposure on exports, particularly to the US, is nowhere near China's even if we are to factor in IT and ITES exports.

Its trade and remittance inflow from oil-exporting countries will go up as these economies spend their windfall gains. But, most importantly, its growth momentum over the last couple of years has been generated by the cumulative effect of domestic policy changes and an inexorably expanding internal market.

These forces have helped the economy to stave off the impact of high oil prices so far and they will provide a very significant buffer against an anticipated global slowdown.

Most importantly, the strength and credibility of domestic buffers will determine the extent of net investment outflows, as global investors reallocate funds across emerging markets in search of relative stability and insulation from global forces.

But, as always, there is a catch. The effectiveness of the domestic buffers depends on the persistence of the process that generated them in the first place.

Economic reforms laid the foundation for these buffers; maintaining forward movement on reforms is critical to strengthening the buffers and more effectively insulating the country's economic performance from the global turbulence that very likely lies ahead.

While the finance minister may be correct in attributing last week's market movements to global factors, his government's record does not seem to inspire much confidence with what it has done (or not done) to sustain and reinforce the domestic drivers of the economy.

Ironically, the other big story on the second anniversary -- reservation -- is symbolic of this. The country's most abundant resource having to struggle so hard to get educated and find employment is such a waste of a good domestic buffer.

Subir Gokarn is chief economist, Crisil. The views here are personal