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Negative wealth effect

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Negative wealth effect

By TN Ninan, editor and publisher of Business Standard

Published: June 20 2006 06:20 | Last updated: June 20 2006 06:20

The key question to be asked is what effect the gyrations on the stock market will have on the real economy. Will the sharp drop in share prices mean that the real economy too will slow down? That is easy, and the answer is “Yes”. The tricky part is figuring out by how much.

To take the macro picture first, a net outflow of portfolio investment means that the dollar inflow, which helped pay for the large deficit on trade in goods and services (more than $20bn a year), is no longer there. This puts pressure on the rupee, as the deficit has to be paid for. As rupees get sucked out of the system to buy the dollars, money supply tightens, and its price (interest rates) goes up.

That is usually a signal for a general economic slowdown, as people borrow less for spending and investment. This is elementary. So it is no surprise that the Reserve Bank has already raised interest rates, even as the rupee has dipped. A lower rupee means costlier imports (of items like oil), and benefit for exporting firms like Infosys. Expect therefore a shift in favour of exporting sectors.

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http://www.ft.com/cms/s/830c64aa-000c-11db...00779e2340.html

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