GLOBAL RECESSION: IMPACT ON INDIA

Jyoti Bahl 1
Ravinder Singh2

Abstract:

There is a raging fire so enormous that no economy seems to be safe from

it. It has engulfed America and Europe and spread in Asia and Africa and
has left behind carnage of mass unemployment, slowing of industrial
growth: fall in the stock market and overall negative sentiment of the
economy. This raging fire is none else than Global Recession, which is
now posing serious questions requiring urgent solutions. With the global
GDP growth rate expected to be merely 0.5 percent this year our
concerns immediately shift to what implications it will have on India and
what can be done about it. India has however not been much affected by
the current recessionary trends, as India is a domestic consumption and
investment driven market where contribution of exports to the growth is
not as big goes in its favour to tackle this crisis in a much better way than
few of the other emerging economies. Further, the inflationary pressures
have eased out to a comfortable level and the government can refocus on
its growth strategies. In addition, Indian banks have very limited exposure
to the US mortgage market, directly or through derivatives, and to the
failed and stressed financial institutions.

1
Jyoti Bahl is Lecturer in Commerce, University of Jammu.
2
Ravinder Singh is Lecturer in Commerce, University of Jammu, Udhampur Campus
The global economy today is going through its worst since the great
depression of the 1930s. The thriving global economy of yesterday
marked by widespread growth, development and prosperity is now
virtually on the verge of collapse. Stock markets everywhere are
witnessing steep falls; profit margins of companies are fast eroding;
unemployment and job losses are on the rise, consumer confidence
appears to be at an all time low and increasingly more and more people
have lesser and lesser money to spend. Fears of recession and even
depression are looming large and there is significant lack of demand that
is so very crucial to revitalise the markets. The situation appears to be
going from bad to worse.

Impact on India

In the age of globalisation, no country can remain isolated from the

fluctuations of world economy. Heavy losses suffered by major
International Banks is going to affect all countries of the world as these
financial institutions have their investment interest in almost all countries.
India is facing challenges mostly on the following three fronts. These
fronts are deeply interlinked.

 The continuous fall in the stock markets. For the last two years, our
stock market was touching new heights such as crossing the impossible
to imagine 20000 mark by the Sensex, thanks to heavy investments by
Foreign Institutional Investors (FIIs). However, when the parent
companies of these investors (based mainly in US and Europe) found
themselves in a severe credit because of sub-prime mess, the only option
left with these investors was to withdraw their money from Indian Stock
Markets to meet liabilities at home. FIIs were the main buyers of Indian
Stocks and their exit from the market is certain to wreck havoc in the
market. FIIs that were on a buying spree last year are now in the mood
of selling their stocks in India. As a result, our Share Markets are
touching new lows everyday.
  Rupee is weakening against dollar. Since, the money, which FIIs get
after selling their stocks, needs to be converted into dollars before they
can sent it home, the demands for dollars has suddenly increased. As
more and more FIIs are buying dollars, the rupee is loosing its strength
against dollar. As long as demands for dollars remain high, the rupee
will keep loosing its strength against dollar.

 Our banks are facing severe crash crunch resulting in shortage of

liquidity in the market.

The current financial crisis has also started directly affecting Indian
Industries. For the past few years, the two most preferred method of
raising money by the companies were Stock Markets and external
borrowings on low interest rates. Stock Markets are bleeding everyday
and it is not possible to raise money there. Regarding external borrowing
from world markets, this option has also become difficult. International
lenders have become extremely risk averse and this is affecting the Indian
financial markets and real economy. In the present scenario, the earlier
targets of nine per cent growth rate seem to be out of reach. A modest
seven per cent is a more realistic target in the existing circumstances.
The contagion of the crisis has spread to India through all the channels –
the financial channel, the real channel, and importantly, as happens in all
financial crises, the confidence channel.

India's financial markets – equity markets, money markets, forex markets

and credit markets - had all come under pressure from a number of
directions. First, because of the global liquidity squeeze, Indian banks and
corporations found their overseas financing drying up, forcing
corporations to shift their credit demand to the domestic banking sector.
In addition, in their frantic search for substitute financing, corporations
withdrew their investments from domestic money market mutual funds
putting redemption pressure on the mutual funds and down the line on
non-banking financial companies (NBFCs) where the MFs had invested a
significant portion of their funds. This substitution of overseas financing
by domestic financing brought both money markets and credit markets
under pressure. Simultaneously, corporations were converting the funds
raised locally into foreign currency to meet their external obligations.
Both these factors put downward pressure on the rupee. Third, the
Reserve Bank's intervention in the forex market to manage the volatility in
the rupee further added to liquidity tightening.

The transmission of the global cues to the domestic economy has been
quite straight forward – through the slump in demand for exports. The
United States, European Union and the Middle East, which account for
three quarters of India's goods and services trade, are in a synchronized
down turn. Service export growth is also likely to slow in the near term as
the recession deepens and financial services firms – traditionally large
users of outsourcing services – are restructured. Remittances from migrant
workers too are likely to slow as the Middle East adjusts to lower crude
prices and advanced economies go into a recession.

Beyond the financial and real channels, the crisis also spread through the
confidence channel. In sharp contrast to global financial markets, which
went into a seizure on account of a crisis of confidence, Indian financial
markets continued to function in an orderly manner. Nevertheless, the
tightened global liquidity situation in the period immediately following
the Lehman failure in mid-September 2008, coming as it did on top of a
turn in the credit cycle, increased the risk aversion of the financial system
and made banks cautious about lending.

Why India escaped?

India is going to be directly hit by the depression. India has continued to

maintain the sound banking practices and indiscrete lending has been
discouraged. The regulation of RBI through credit policy has been
maintained. The banks have maintained SLR and CRR as per the
instructions of the Central Bank. RBI has pointed out that Indian banks
have very limited exposure to the US mortgage market (directly or
through derivatives) or to the failed/stressed financial institutions; hence
the impact on their balance sheet will be marginal. Things could have
been worse had banks invested irresponsibly in US securities. The fact
that banks pulled out $ 14 billion over the last 15 months from overseas
markets also saved the day.

Secondly, the derivatives market remained under strict monitoring of

SEBI. Derivatives are financial instruments, which can spread the default
risk attaching to loans. RBI and GOI should prohibit indiscriminate use of
such derivatives if they intend to introduce such products in India.

Thirdly, Indian companies made prudent investment outside.

Fourthly, India continued its policies to attract foreign direct investment.

Fifthly, RBI has also informed that India’s real economy would be
affected to a lesser degree than USA or Europe since our growth is largely
domestically driven and our export markets not concentrated. Moreover,
the current boom in the oil economies will be supportive of exports and
inward remittances.

Sixthly, as regards the stock markets, it must be noted that the loss or gain
arising from market movement is notional. In this context, it may also be
mentioned that only a very small portion of our total population, less than
two per cent, has any sort of exposure to the stock market.

Seventhly, despite turmoil, according to World Bank, India, China and

Mexico are likely to maintain their position as the top three recipients of
remittances among developing countries.

Finally, amidst global financial crisis, India’s foreign direct investment

saw an impressive jump of 124 per cent in the first five months of the
current fiscal, while the FDI flows in August went up by huge 180 per
cent.

RBI Response to the Crisis

The financial crisis in advanced economies on the back of sub-prime

turmoil has been accompanied by near drying up of trust amongst major
financial market and sector players, in view of mounting losses and
elevated uncertainty about further possible losses and erosion of capital.
The lack of trust amongst the major players has led to near freezing of the
uncollateralised inter-bank money market, reflected in large spreads over
policy rates. In response to these developments, central banks in major
advanced economies have taken a number of coordinated steps to increase
short-term liquidity. Central banks in some cases have substantially
loosened the collateral requirements to provide the necessary short-term
liquidity.

In contrast to the extreme volatility leading to freezing of money markets

in major advanced economies, money markets in India have been, by and
large, functioning in an orderly fashion, albeit with some pressures. Large
swings in capital flows – as has been experienced between 2007-08 and
2008-09 so far – in response to the global financial market turmoil have
made the conduct of monetary policy and liquidity management more
complicated in the recent months. However, the Reserve Bank has been
effectively able to manage domestic liquidity and monetary conditions
consistent with its monetary policy stance.

This has been enabled by the appropriate use of a range of instruments

available for liquidity management with the Reserve Bank such as the
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
stipulations and open market operations (OMO) including the Market
Stabilisation Scheme (MSS) and the Liquidity Adjustment Facility (LAF).
Furthermore, money market liquidity is also impacted by our operations in
the foreign exchange market, which, in turn, reflect the evolving capital
flows. While in 2007 and the previous years, large capital flows and their
absorption by the Reserve Bank led to excessive liquidity, which was
absorbed through sterilisation operations involving LAF, MSS and CRR.
During 2008, in view of some reversal in capital flows, market sale of
foreign exchange by the Reserve Bank has led to withdrawal of liquidity
from the banking system. The daily LAF repo operations have emerged as
the primary tool for meeting the liquidity gap in the market. In view of the
reversal of capital flows, fresh MSS issuances have been scaled down and
there has also been some unwinding of the outstanding MSS balances.
The MSS operates symmetrically and has the flexibility to smoothen
liquidity in the banking system both during episodes of capital inflows
and outflows. The existing set of monetary instruments has, thus, provided
adequate flexibility to manage the evolving situation. In view of this
flexibility, unlike central banks in major advanced economies, the Reserve
Bank did not have to invent new instruments or to dilute the collateral
requirements to inject liquidity. LAF repo operations are, however,
limited by the excess SLR securities held by banks.

While LAF and MSS have been able to bear a large part of the burden,
some modulations in CRR and SLR have also been resorted, purely as
temporary measures, to meet the liquidity mismatches. For instance, on
September 16, 2008, in regard to SLR, the Reserve Bank permitted banks
to use upto an additional 1 percent of their NDTL, for a temporary period,
for drawing liquidity support under LAF from RBI. This has imparted a
sense of confidence in the market in terms of availability of short-term
liquidity. The CRR which had been gradually increased from 4.5 per cent
in 2004 to 9 per cent by August 2008 was cut by 50 basis points on
October 6 (to be effective October 11, 2008) – the first cut after a gap of
over five years - on a review of the liquidity situation in the context of
global and domestic developments. Thus, as the very recent experience
shows, temporary changes in the prudential ratios such as CRR and SLR
combined with flexible use of the MSS, could be considered as a vast pool
of backup liquidity that is available for liquidity management as the
situation may warrant for relieving market pressure at any given time. The
recent innovation with respect to SLR for combating temporary systemic
illiquidity is particularly noteworthy. The relative stability in domestic
financial markets, despite extreme turmoil in the global financial markets,
is reflective of prudent practices, strengthened reserves and the strong
growth performance in recent years in an environment of flexibility in the
conduct of policies.

Active liquidity management is a key element of the current monetary

policy stance. Liquidity modulation through a flexible use of a
combination of instruments has, to a significant extent, cushioned the
impact of the international financial turbulence on domestic financial
markets by absorbing excessive market pressures and ensuring orderly
conditions. In view of the evolving environment of heightened
uncertainty, volatility in global markets and the dangers of potential
spillovers to domestic equity and currency markets, liquidity management
will continue to receive priority in the hierarchy of policy objectives over
the period ahead. The Reserve Bank will continue with its policy of active
demand management of liquidity through appropriate use of the CRR
stipulations and open market operations (OMO) including the MSS and
the LAF, using all the policy instruments at its disposal flexibly, as and
when the situation warrants.

Approach towards the future:

It is of utmost importance that India takes appropriate lessons from

current financial mess because those who do not learn from history are
doomed to repeat it. Some important learnings that emerge would enable
India to have a pragmatic approach towards the future and will help it to
ward off similar problems in a more efficient manner.

1. India will be increasingly moving towards a more integrated financial

network with the world over the next 10-15 years. There is a need to
rethink our policy framework for such integration. India is fortunate that
 her economy is relatively decoupled and pretty much free from such
external shocks.
2. India never realised the ill effects of 1970’s oil crisis nor East Asian
crisis of the 90’s. This time if caution is not taken, it will make India
stand vulnerable in the coming future.

3. The policy makers should rather be interested in protecting the interests

of our markets such as agriculture (though it only contributes ¼ of the
GDP but employs 60 per cent of our work force.)

4. There is a great demand for deregulation in the economy especially

from the middle class and the media. India should however not be
fooled into thinking that economic freedom will automatically lead to
economic growth. There is a need to focus on developing a regulatory
framework for the economy at a much faster rate.

5. Market failure is a distinct possibility. The Indian policy makers should

make use of various simulation models and construct ‘what if’ scenarios
for banks and NBFCs. This would ensure the government’s readiness to
tackle various contingencies.

6. Many experts are now appreciating the prudent practices and the
socialist fiscal policies followed by countries such as India. India should
take heart from its well thought of economic model for removing
glaring social inequalities and its aversion for blindly jumping into a
dark alley in pursuit of instant profits.

7. India should resort to old Buddhist teachings of the following the

middle path and develop a unique modified economic model. A model
that would be neither socialistic nor a free economy model and which
would be regulated by independent regulators. Thus, the model should
be influenced by neither the left nor the right and neither should be self-
serving in nature.
8. India has an important lesson in the fact that we should not let our own
judgment to be replaced by that of self serving international institutions
propagating absurd financial doctrines having no semblance what so
ever of either the past or of the future.

9. India could also benefit from international effort for co-ordination

between the various agencies entrusted with the task of maintaining
financial stability. The IMF suggests that the respective roles of central
banks, regulators, supervisors, and fiscal authorities regarding financial
stability needs to be revisited.

10. India should cooperate and coordinate with the developed countries in
the management. It should also ensure its participation as a
representative of the developing world so that the implications of this
management on the developing world are factored in. this move would
also open a dialogue for the future, so that continuous cooperation can
take place between north and south.

Conclusion

It is very well understood that the current situation has precipitated

due to the greed of few, their inability to foresee the consequences of
their actions and has led to the woes of millions worldwide. It is thus
imperative for us to rethink our economic strategies and not to
swayed by the blind claims of self professed financial messiahs
claiming clairvoyance when it is quite clearly evident that they have
trouble seeing disaster sitting right under their noses. An effective
regulatory framework needs to be developed that would keep abreast
with financial innovations and new emerging business models and a
quick reaction time in case of market failures.

References
  Civil Service Times (2008) What Happened? And Why?, XIV
Year, Issue No. 12
 Civil Service Times (2009) The Global Slowdown: Lessons for
India, XV Year, Issue No. 03
 Civil Service Times (2009) India’s Take on Recession: 3 Stimulus
Packages Back to Back, XV Year, Issue No. 04
 Mohan, Rakesh (2008) Global Financial Crisis and Key Risks:
Impact on India and Asia
 Subbarao (2009) Impact of the Global Financial Crisis on
India Collateral Damage and Response.