When I wrote my previous column, the upheaval in global equity markets was just a couple of days old and the weight of opinion was that it was going to be just a blip in an otherwise stable global economic environment.
Two weeks later, as more revelations about the extent of exposures to assets based on sub-prime housing loans across the world come to light there is a distinct shift in opinion about the potential seriousness and macroeconomic impact of these exposures.
In that piece, I had argued that while all of the Asian emerging economies had developed significant defensive capabilities against a global market meltdown, mainly by virtue of their massive foreign exchange reserves, the unknown nature of global portfolio linkages prevalent today made it impossible to assess how significant the risks really were and how a relatively small shock might transmit through the system.
The developments of the last couple of weeks, during which a major French bank was rocked by its large exposures to the US sub-prime market, reinforce the sense of things being worse than they appear at first.
Although it is still far from clear how the phenomenon will play out, a "better safe than sorry" attitude already seems to have permeated global investors. Any asset that looks the least bit suspect when viewed through this new lens is likely to be dumped.
Relatively high on this list are emerging market equities, which, while remaining attractive in the medium term, are still some way below the comfort thresholds of newly conservative investors.
Importantly, this view may well persist even if markets in the affluent countries themselves stabilise fairly quickly. Obviously, the impact is unlikely to be uniform across markets, but regulators and policymakers in all of them should be prepared to deal with it, whatever it might be.
What is the likely scenario for India? And, what, if anything, should policymakers do to mitigate or respond to the potential threats?
The immediate impact on India has already been felt in the form of persistently high volatility in the stock markets over the past couple of weeks. That this is part of the global instability is attested to by the movements in the rupee, which, after some months of steady appreciation, actually moved, however slightly, in the opposite direction during this period.
But, the fact of the matter is that, in relative terms, these movements, at least so far, hardly constitute major shocks to the system.
Looking back at India's passage through the Asian crisis of 1997, it now appears that our restrictions on the end-use of funds coming in from abroad were a primary reason for us escaping the more serious consequences that hit some countries - huge declines in domestic asset prices and a sharp depreciation of the currency.
Although our global exposures are much larger now and, more importantly, a more liberal regime prevails for end uses for funds from abroad, there is really no sense that the overall vulnerability to a meltdown has increased significantly.
One important reason for this is the deployment of funds from abroad in activities that are oriented towards the domestic market. In sectors in which foreign resources are heavily invested, notably IT and ITES, the competitive edge of Indian firms is not really under any immediate threat from any other country.
The net result of this is that, as long as economic growth continues to be driven by domestic factors and the rest of the world continues to need IT and ITES, the risks of a dramatic decline in the growth rate are small; smaller, certainly than for a country that exports a large proportion of its GDP and, that too, in an intensely competitive environment.
The "wealth effect" - the impact of changes in wealth through asset price movements on consumption spending - may have some effect. However, the economy is at an early stage in the spread of ownership of risky financial assets, so it is likely to be quite limited.
Heightened volatility in the stock markets may deter investors and also induce companies to postpone their fund-raising plans, but, here again, the medium term compulsions of capacity expansion in order to survive will probably outweigh the higher cost of capital.
In short, a realistic scenario for the Indian economy appears rather benign. The benefits of a large and buoyant domestic market really become visible in a global environment such as this. However, this does not mean that the possibility of a massive exit of foreign portfolio investment does not exist. This will bring in its wake both a hugely depressed stock market and a sharp reversal in the rupee's trend.
Many would argue that the latter is not such a bad thing after all. But, that depends on the circumstances of the depreciation. An unstable financial environment generates many forces that offset the benefits of a more competitive exchange rate.
Under the circumstances, Indian policymakers need to focus simultaneously on two objectives. One is to ensure that domestic drivers of growth, which will be an important differentiating factor as global investors re-work their emerging market strategies, are not hampered.
In this respect, the timing is relatively favourable; declining inflation has created the space for a reduction in interest rates, should the need arise in the next few weeks or months. On the fiscal side, ensuring that money allocated to investment and safety net programmes is spent can contribute to this.
The second is to ensure that the balance of payments and exchange rate situation remains stable. In doing this, there is going to be a conflict between the long-term objective of full convertibility and its corollary of an effectively floating exchange rate and the immediate necessity of establishing a credible level of reserves, enough to meet any conceivable level of capital flight.
There are already mixed signals in the air about this. Recent announcements of a cap on external commercial borrowings and the raising of the limit on bank deposits by individuals outside the country go against the objective of rapidly ramping up reserves.
On the other hand, the raising of the limits on securities issuable under the Market Stabilisation Scheme and the removal of the cap on reverse repo transactions, more importantly, with a variable rate to be determined by market conditions, point to an intention to accumulate reserves. These instruments help to sterilise reserve accumulation by absorbing the additional liquidity that they generate.
A difficult re-conciliation, undoubtedly, but the thing to remember is that, in managing a crisis, what is urgent usually triumphs over what is important.
The author is chief economist, Crisil. The views here are personal .
