Global Meltdown and India

Jean-Claude Trichet, President of the European Central Bank, delivering the Tenth L. K. Jha Memorial Lecture at Reserve Bank of India, Mumbai, on November 26th 2007 on ‘The growing importance of emerging economies in the globalized world and its implications for the international financial architecture’ said –“It is never time for complacency. The next crisis is always different from the previous one. Both industrialised and emerging countries have to continue to work to keep up with new developments and challenges. Efforts to ensure global stability and prevent crises have to be made constantly, by all of us, and should be guided by the principles of transparency, good practices and dialogue between relevant players.”
The financial meltdown has resulted in effective nationalisation of major financial institutions in the US, UK and Europe. So far global banks, mortgage lenders and insurance firms have announced write downs of over US$ 800 billion. There has been a massive increase in central bank lending to the banking system and rescue packages totalling almost US$3 trillion have been announced by governments around the world. Monetary policy has been eased aggressively but given the lagged impact attention has shifted to fiscal policy.

The global financial situation continues to be uncertain and unsettled. What started off as a sub-prime crisis in the US housing mortgage sector has turned successively into a global banking crisis, global financial crisis and now a global economic crisis. The contagion has traversed from the financial to the real sector; and it now looks like the recession will be deeper and the recovery longer and painful.

The IMF has revised its forecast for global growth from 3.9 to 3.7 per cent for 2008, and from 3.0 to 2.2 per cent for 2009. Notably, advanced economies, as a group, are projected to contract by 0.3 per cent in 2009. If all this were indeed to come true, 2009 will mark the first year on record when emerging economies will be the sole contributors to global growth.

The Indian Scenario
India’s share in world exports of goods and services tripled between the early 1990s and 2006, to close to 1.5%, with a notable acceleration in the last three years, due to dynamic exports of services, including IT and IT-enabled services. Going by the common measure of globalisation, India’s two way trade (merchandise exports plus imports), as a proportion of GDP, grew from 21.2 per cent in 1997/98, the year of the Asian crisis, to 34.7 per cent in 2007/08. If we take an expanded measure of globalisation, that is the ratio of gross current account and gross capital flows to GDP, this ratio has increased from 46.8 per cent in 1997/98 to 117.0 per cent in 2007/08. These numbers are clear evidence of India’s increasing integration into the world economy over the last 10 years. The decoupling theory has almost completely lost credibility.

The endeavour of our monetary policymakers has been to balance growth, inflation and financial stability concerns. By managing liquidity – both domestic and forex – it tries to ensure that credit continues to flow for productive activities. When inflation surged earlier this year, the RBI moved quickly to suck out excess liquidity. Then again, as oil prices softened and decline in inflation was expected, RBI has its monetary adjusted by reducing Cash Reserve Ratio (the portion of deposit banks have to keep with RBI) and repo rate(the rate at which RBI lends to other banks). Since mid September 2008, the RBI has reduced repo rate by 350 basis points from 9 to 5.5 per cent, reduced the reverse repo rate (the rate at which RBI borrows from banks) by 200 bps from 6 to 4 per cent and by 400 bps from 9 to 5 per cent. The cumulative amount of liquidity made available to finance system through these measures is over Rs 3, 00,000 crore.

Why the crisis in India?

Despite Indian banking system not being directly exposed to the sub-prime mortgage assets, or to the US mortgage market, or to the failed institutions or stressed assets, how come we landed into trouble? Also Indian banks, both in the public sector and in the private sector, are financially sound, well capitalised and well regulated.

Even so, India is experiencing the effects of the global crisis, through the monetary, financial and real channels. Our financial markets – equity markets, money markets, forex markets and credit markets – have all come under pressure mainly because of what is being called ‘the substitution effect’. As credit lines and credit channels overseas went dry, some of the credit demand earlier met by overseas financing shifted to the domestic credit sector, putting pressure on domestic resources. The reversal of capital flows taking place as part of the global de-leveraging process has put pressure on our forex market. Together, the global credit crunch and deleveraging were reflected at home in the sharp fluctuation in the money market rates in October 2008 and the depreciation of the rupee.

The Road Ahead

The outlook for India is mixed. The real GDP growth has moderated in the first half of 2008-09. Industrial activity, particularly in the manufacturing and infrastructure sectors, is decelerating. The services sector too, which has been our prime growth engine for the last five years, is slowing, mainly in the construction, transport and communication, trade, hotels and restaurants sub-sectors. Recent data indicate that the demand for bank credit is slackening despite comfortable liquidity in the system. Higher input costs and dampened demand have dented corporate margins while the uncertainty surrounding the crisis has affected business confidence. It will be tough for investors and businessmen to commit money to buy shares or fund new projects till there is more clarity on the extent of the slowdown and how long it will last.
On a positive note the fundamentals of our economy are stronger than is often recognised. India’s growth has been based on a sustained rise in the capital formation and gross savings rate as a percentage of GDP. FIIs have already started coming back. There has been a net inflow of FII funds in December 2008. This is seen in the Sensex rising from 8K to around 10k presently.
The focus of our attention must shift to the real economy. India needs growth in its core sectors, especially manufacturing, construction and agriculture. The western countries are not likely to be growth propellant for us. We have to depend on domestic demand, which will sustain our growth. There are few lessons to be learnt: uncontrollable greed, over leveraging and debt is not good for the economy; putting profit as a motivator over and above people is not a good idea; and living on credit is simply bad lifestyle.

The projections for long-term growth, based on demographic trends and models of capital accumulation and productivity, tell us that emerging markets like India are likely to become even weightier in the world economy tomorrow than they are today. Will 2009 be the beginning of India’s journey to become an economic superpower?

Tilak Jha
MACJ (P)