Indian Economic Crisis

Impact of Global Financial Crisis on Indian Economy

By

S. Lalitha Mani
Lecturer in Commerce

A.Siva Kumar
Head of Department in Commerce

Dr. S.N.S. Rajalakshmi College of Arts and Science
Saravanampatti, Coimbatore-641006

INTRODUCTION:-
The financial crisis has been erupted in a comprehensive manner on Wall Street; there was some premature triumphalism among Indian policymakers and media persons. It has been argued that India would be relatively immune to this crisis, because of the "strong fundamentals" of the economy and the supposedly well-regulated banking system.
These effects have been most marked among those developing countries where the foreign ownership of banks has been already well advanced, and when US-style financial sectors with the merging of banking and investment functions have been created.
The recent crash in the Sensex was not simply an indicator of the impact of international contagion. There have been warning signals and signs of fragility in Indian finance for some time now, and these are likely to be compounded by trends in the real economy. So far the global financial crisis has had three major impacts on the Indian economy: (i) Economic Downturn (ii) Exposure of banks (iii) Domestic policy. The paper also explains (i) India: confronting the global financial crisis (ii) India: turning crisis into opportunity.
ECONOMIC DOWNTURN:-
After a long spell of growth, the Indian economy were experiencing a downturn. Industrial growth has been faltering, inflation remains at double-digit levels, the current account deficit is widening, foreign exchange reserves are depleting and the rupee is depreciating. The last two features can also be directly related to the current international crisis. The most immediate effect of that crisis on India has been an outflow of foreign institutional investment from the equity market. Foreign institutional investors, who need to retrench assets in order to cover losses in their home countries and were seeking havens of safety in an uncertain environment, have become major sellers in Indian markets.
In 2007-08, net FII inflows into India amounted to $20.3 billion. As compared with this, they pulled out $11.1 billion during the first nine-and-a-half months of calendar year 2008, of which $8.3 billion occurred over the first six-and-a-half months of financial year 2008-09 (April 1 to October 16). This has had two effects: in the stock market and in the currency market. |

Given the importance of FII investment in driving Indian stock markets and the fact that cumulative investments by FIIs stood at $66.5 billion at the beginning of this calendar year, the pullout triggered a collapse in stock prices. As a result, the Sensex fell from its closing peak of 20,873 on January 8, 2008, to less than 10,000 by October 17, 2008 (Chart 1).
Falling rupee |

In addition, this withdrawal by the FIIs led to a sharp depreciation of the rupee. Between January 1 and October 16, 2008, the RBI reference rate for the rupee fell by nearly 25 per cent, even relative to a weak currency like the dollar, from Rs 39.20 to the dollar to Rs 48.86 (Chart 2). This was despite the sale of dollars by the RBI, which was reflected in a decline of $25.8 billion in its foreign currency assets between the end of March 2008 and October 3, 2008.
It could be argued that the $275 billion the RBI still has in its kitty is adequate to stall and reverse any further depreciation if needed. But given the sudden exit by the FIIs, the RBI is clearly not keen to deplete its reserves too fast and risk a foreign exchange crisis.
The result has been the observed sharp depreciation of the rupee. While this depreciation may be good for India's exports that are adversely affected by the slowdown in global markets, it is not so good for those who have accumulated foreign exchange payment commitments. Nor does it assist the Government's effort to rein in inflation.
EXPOSURE OF BANKS:
A second route through which the global financial crisis could affect India is through the exposure of Indian banks or banks operating in India to the impaired assets resulting from the sub-prime crisis. Unfortunately, there were no clear estimates of the extent of that exposure, giving room for rumour in determining market trends. Thus, ICICI Bank was found to be the victim of a run for a short period because of rumours that sub-prime exposure had badly damaged its balance sheet, although these rumours have been strongly denied by the bank.
So far the RBI has claimed that the exposure of Indian banks to assets impaired by the financial crisis was small. According to reports, the RBI had estimated that as a result of exposure to collateralised debt obligations and credit default swaps, the combined mark-to-market losses of Indian banks at the end of July was around $450 million.
Given the aggressive strategies adopted by the private sector banks, the MTM losses incurred by public sector banks were estimated at $90 million, while that for private banks was around $360 million. As yet these losses are on paper, but the RBI believes that even if they are to be provided for, these banks are well capitalised and can easily take the hit.
Such assurances have neither reduced fears of those exposed to these banks or to investors holding shares in these banks.
These fears were compounded by those of the minority in metropolitan areas dealing with foreign banks that have expanded their presence in India, whose global exposure to toxic assets must be substantial.
A third indirect fallout of the global crisis and its ripples in India is in the form of the losses sustained by non-bank financial institutions (especially mutual funds) and corporate, as a result of their exposure to domestic stock and currency markets.
Such losses were expected to be large, as signalled by the decision of the RBI to allow banks to provide loans to mutual funds against certificates of deposit (CDs) or buyback their own CDs before maturity. These losses are bound to render some institutions fragile, with implications that would become clear only in the coming months
A fourth effect is that, in this uncertain environment, banks and financial institutions concerned about their balance sheets, have been cutting back on credit, especially the huge volume of housing, automobile and retail credit provided to individuals. According to RBI figures, the rate of growth of auto loans fell from close to 30 per cent over the year ending June 30, 2008, to as low as 1.2 per cent.
Loans to finance consumer durables purchases fell from around Rs 6,000 crore in the year to June 2007, to a little over Rs 4,000 crore up to June this year. Direct housing loans, which had increased by 25 per cent during 2006-07, decelerated to 11 per cent growth in 2007-08 and 12 per cent over the year ending June 2008.
It is only in an area like credit-card receivables, where banks are unable to control the growth of credit, that expansion was, at 43 per cent, quite high over the year ending June 2008, even though it was lower than the 50 per cent recorded over the previous year.
It is known that credit-financed housing investment and credit-financed consumption have been important drivers of growth in recent years, and underpin the 9 per cent growth trajectory India has been experiencing.
The reticence of lenders to increase their exposure in markets to which they are already overexposed and the fears of increasing payment commitments in an uncertain economic environment on the part of potential borrowers are bound to curtail debt-financed consumption and investment. This could slow growth significantly.
Finally, the recession generated by the financial crisis in the advanced economies as a group and the US in particular, will adversely affect India's exports, especially its exports of software and IT-enabled services, more than 60 per cent of which are directed to the US.
International banks and financial institutions in the US and EU are important sources of demand for such services, and the difficulties they face will result in some curtailment of their demand. Further, the nationalisation of many of these banks is likely to increase the pressure to reduce outsourcing in order to keep jobs in the developed countries.
And the slowing of growth outside of the financial sector too will have implications for both merchandise and services exports. The net result would be a smaller export stimulus and a widening trade deficit.
DOMESTIC POLICY:
While these trends are still in process, their effects were already being felt. They were not the only causes for the downturn the economy has been experiencing, but they were found to be important contributory factors. Yet, this does not justify the argument that India's difficulties are all imported. They have been induced by domestic policy as well.
The extent of imported difficulties would have been far less if the Government had not increased the vulnerability of the country to external shocks by drastically opening up the real and financial sectors. It is disconcerting, therefore, that when faced with this crisis the Government is not rethinking its own liberalisation strategy, despite the backlash against neo-liberalism worldwide.
By deciding to relax conditions that apply to FII investments in the vain hope of attracting them back and by focusing on pumping liquidity into the system rather than using public expenditure and investment to stall a recession, it is indicating that it hopes that more of what created the problem would help solve it.
INDIA: CONFRONTING THE GLOBAL FINANCIAL CRISIS:
Recent events in the global financial system have been nothing short of seismic. Hundreds of billions, if not trillions of dollars in capital value have been lost in stock markets. Inter-bank credit has almost frozen up.
Actual costs of borrowing have gone up (even with falling central bank interest rates), unemployment has been rising in the major world economies, and home foreclosures and bankruptcies are on the rise.
This crisis is sought to be addressed by a variety of policy initiatives, the most important aspects of which are the injection of vast amounts of public funds into financial institutions and the provision of sovereign guarantees on bank accounts.
But the ability to do so is limited. The budget deficit for 2008 in the US has trebled as compared to its forecasted value and the ratio of public plus private debt to GDP is well over 300 percent. The huge injection of funds to stabilise the financial system will need to be financed. But the US treasury is already stretched and, with a recession looming, prospects for enhanced tax revenue in 2009 do not appear bright. Similar comments apply to Europe.
So far the global financial crisis has had three major impacts on the Indian economy: (i) the quantum of liquidity available during the first half of FY 2008-09 is about a third lower than during the first half of FY 2007-08; (ii) with slackening external demand, export growth is expected to slow; and (iii) Foreign Institutional Investors have withdrawn from Indian stock markets leading to sharp falls in key indices.
India's economic growth has been rising and becoming more stable for the past 25 years, fuelled by higher savings and investment (now over 35 percent and 36 percent of GDP respectively), the demographic dividend of a younger, more educated labor force and accelerated total factor productivity growth. For the past three years, the economy has grown at 9 percent giving the Indian economy considerable momentum. Second, during the current FY trade growth has been impressive, with exports rising 35.1 percent in dollar terms and imports rising 37.7 percent during the period from April-August 2008. Investment has been buoyant and FDI during 2008-09 is expected to reach US$35 billion.
Indian banks have strong balance sheets, are well-capitalised and well regulated. The capital adequacy ratio of every Indian bank is well above Basel norms and those stipulated by the RBI. Not one Indian bank has had to be rescued in the aftermath of the crisis. India has a long history of working with public sector banks and in engineering bank rescues.
India's growth rate will slow in 2008-09. Growth during the quarter ending June 2008 was 7.9 percent. The current consensus for the 2008-09 FY is 7.5 percent to 8 percent.
Principal reasons for this modest drop in economic growth include (i) a large and diversified consumption base for the Indian economy; (ii) India's trade to GDP ratio is much smaller than that of, say, China; and (iii) Indian financial markets are still relatively insulated from global financial markets. India has a healthy external balance, with high foreign exchange reserves, low ratio of short term external debt to GDP and less than complete capital account convertibility.
Nevertheless, that will be a significant slowdown compared to recent experience, but it will still be robust growth. The slower growth will be accompanied by reduced employment growth and slower poverty reduction.
Indian policymakers have responded with measures to enhance liquidity – primarily by reducing the cash reserve ratio and the repo rate – and enhancing confidence. Bank guarantees, beyond those that already exist, have been deemed unnecessary.
In 2009-10, if the world economy recovers, India can grow at 9 percent or more. If the world economy remains in recession, forecasts of Indian growth rates are harder to make.
INDIA: TURNING CRISIS INTO OPPORTUNITY:-
India's economic managers, and particularly the Reserve Bank of India (RBI) take considerable pride in having protected India from Asia's financial crisis in 1997-98. Although India did experience a period of slow growth in the years that followed that crisis, the basic financial machinery of the country remained relatively robust, providing a solid foundation for the much more rapid growth that has taken place this decade.
In common with its East Asian neighbours, India is grappling once again with many of the same challenges that the region faced a decade ago, creating difficult choices for economic and financial policy. In a recent statement, India's PM Dr. Manmohan Singh said that the broad goal of India's policy is to try to ensure that any reduction in India's growth is temporary, so that the economy can return quickly to a nine per cent growth rate.
In charting its course, the Government is juggling multiple considerations: the state of the domestic business cycle; ensuring financing for the balance of payments deficit; the sharp shift in the availability of global risk capital for financing Indian investment; and the slowdown in growth in the world's rich economies.
After three years of buoyant, investment-led growth, the Indian economy started to slow late last year (2007). This growth slowdown was initially welcomed by the RBI, which had been gradually tightening monetary policy (since 2004) in a fight against inflation.
Price pressures were further exacerbated by the sharp rise in commodity prices late last year and early this year. The net effect has been partially to reverse the measured (but inadequate) progress toward fiscal consolidation, as well as to increase the current account deficit in the balance of payments.
The political cycle is at an awkward point. Parliamentary elections are due by next summer, and there is considerable uncertainty as to the government that is to follow. India continues to suffer a series of terrorist incidents in its larger cities, and the political and economic instability in Pakistan adds another layer of uncertainty.
Taking economic and political pressures together, it is perhaps not surprising that, for many Indians the present moment is compared less with 1997 than with 1990-91. That was the year when India suffered a major external payments crisis and was obliged to apply to the IMF for assistance. Thanks, however, to inspired political and economic leadership at that time, that payments crisis was turned into an opportunity for major structural reform from which India continues to benefit till this day.
The interesting question is whether a similar opportunity can be created again. Policy until late August operated on a business-as-usual basis. Even though the financial crisis had been underway for almost a year, policy action was based on the assumption that India could remain largely unscathed.
Government attitudes changed sharply in September. Notwithstanding the generally sound domestic financial position of India's commercial banks, bank liquidity came under strain as banks' overseas subsidiaries found their sources of wholesale finance withdrawn.
This effect was compounded by the intensified sell-off by foreign investors in domestic equity markets and the repatriation of funds to meet liquidity calls abroad.
Over the course of October, the RBI has sharply reversed course on the two key instruments at its disposal: the cash-reserve ratio (that is, reserve requirements) that banks are required to hold in their accounts with the RBI; and the overnight secured lending rate at which the RBI lends to banks.
India's policymakers have both the experience and the tools to ride out the present storm. They will be helped by India's lower integration with world trade and finance, and by a variety of institutional features.
Yet by itself this is not enough: the larger challenge will be, as in 1991, to use this crisis also to resume the momentum of reforms that have largely stalled. Of this there is as yet little sign.
CONCLUSION
The Indian economy has globalized rapidly during the past few years. The ratio of exports plus imports to GDP increased by more than 50 per cent between 1997–98 and 2007–08 (from 21.2 per cent to 34.7). The growth of financial integration has been even more rapid. Three different channels of the GFC's impact on India can be identified: i) The financial channel, i.e., the growing integration of India's financial markets with global financial markets; ii) The growing trade links between India and the rest of the world indicate that exports would decline quite sharply, and; iii) A final avenue is the confidence channel. The tightened global liquidity situation following from the failure of Lehman brothers in September 2008 increased the risk-aversion of several banks and other lending institutions. There is a slowdown in India's growth performance — but not a collapse. The short-run outlook for the Indian economy is unclear. Real GDP growth and major sectors have shown strong signs of slipping. But, the stimulus packages announced by the government and the RBI have had their desired effect.
Assuming that the global economy starts picking up in 2009–10, of which there are some signs, and provided developed countries do not resort to widespread protectionism, an assumption that may be proved wrong, the Indian economy should be in a good position to register a strong comeback
REFERENCE:

Newspaper

1. The Business Standard
2. The Economic Times
3. The Times of India

Websites

www.thehindubusinessline.com www.indianmba.com www.investopedia.org www.wikipedia.org