Economic Melt-down and its Impact on Indian Econom

(Revised Version for Printing)

NATIONAL SEMINAR

ECONOMIC MELT DOWN AND ITS IMPACT

INDIAN ECONOMY

Keynote Address

G.Thimmaiah

Former Member, Planning Commission

March 24-25, 2010

Department of Economics

S.V.University, Tirupati.

ECONOMIC MELT DOWN AND ITS IMPACT ON

INDIAN ECONOMY

Keynote Address

G.Thimmaiah

President of the Inaugural session, Chief Guest of the Occasion, Head of the Department of Economics and seminar Coordinator Professor P. Devasena Naidu, distinguished invitees, ladies and gentlemen.

I am happy to be invited to deliver the keynote address to this seminar which is organized to deliberate on an important contemporary economic issue which is still plaguing major part of the world.

Global financial crisis is an important economic event which engulfed the entire world towards the end of 2008. It resulted in the economic meltdown of USA and Europe It proved the Marxian prediction of the inevitable collapse of capitalism. It also revived the interest in the long forgotten Keynesian solution of government intervention in economic activity to save the western capitalist economies. How is India affected by this global financial crisis? How has the government managed the impact of the global financial crisis on the Indian economy?

1. Genesis of Global Financial Crisis.

An American economist Professor Paul Krugman observed in his column published in the New York Times that: “Everyone has a theory about the financial crisis. These theories range from the absurd to the plausible – from claims that liberal Democrats somehow forced banks to lend to the undeserving poor(even though Republicans controlled Congress) to the belief that exotic financial instruments fostered confusion and fraud”.

It is generally believed that the US housing bubble was the main cause for the US financial crisis of 2007.That financial crisis spread to other parts of the world through the interconnected globalized financial markets. How did the US housing bubble emerge? Easy availability of mortgage loans for house buyers in general resulted in profligate lending by mortgage banks to people who were previously refused housing loans on the basis of their low credit rating, ( ‘sub-prime’ borrowers, as they were not having regular income). But when there was easy availability of refinance at low rates of interest from commercial banks and investment banks, mortgage banks overstretched their lending to prime borrowers and later to even ‘sub-prime’ borrowers. In order to replenish their funds, the house mortgage banks started securitizing their house mortgage loans and selling the securitized mortgage loans at a discount to investment banks, hedge funds and insurance firms. These securitized mortgage loans were rated for their credit quality by US credit rating companies like Standard and Poor, Moody and Fitch. Such credit rating encouraged the commercial and investment banks to take risk mainly guided by sheer greed making profit. They in turn packaged those securitized house mortgage loans which they had purchased from the mortgage banks and sold them to insurance firms and foreign banks through globalised capital markets. The total housing mortgage loans so packaged and sold amounted to a woofing $10.5 trillion by mid-2007.The
US Wall Street
played a major role in transacting these securitized financial instruments which were issued on the basis of house mortgage loans. When the foreign financial institutions started purchasing packaged mortgage loans, mortgage banks started lending more to housing companies who in turn used that money for construction of more and more houses and selling them to financially unviable buyers. However, the house mortgage banks, the original sinners, started facing delinquency in loan repayment from the ‘sub-prime’ borrowers and were forced to declare foreclosures,(public auction of houses), as they could not absorb the massive defaults of loans. When the mortgage banks and other financial institutions failed to sell these securitized houses to other buyers, they became toxic assets on their balance sheets. Such bad loans entered into the balance sheets of almost all financial institutions which had participated in the sophisticated process of mortgage financing.

There was another factor which led to this kind of reckless lending resulting in housing loan defaults by the ‘sub-prime’ borrowers. After the great depression of 1930’s several banking regulations were introduced in USA. But those were ignored during and after the Second World War. But after the savings and loans banks failure in the USA in the 1980’s, more regulations were imposed on the operation of all types of financial institutions like banks, mutual funds, hedge funds, mortgage banks, insurance firms and stock markets. They stabilized the America financial system and USA experienced one of the longest growth trend during 1990’s. However, when there was world wide revival of the ideology of free market capitalism, Reagan administration scrapped most of the regulations of the USA financial system. This encouraged American financial intermediaries like commercial banks, investment banks, mortgage banks, mutual funds, hedge funds, stock markets, broking firms to innovate new instruments of trading in financial assets like shares, debentures, and commodities like oil, food grains, metals and other raw materials. They devised new forms of derivatives, financial futures, credit default swaps and used them in sophisticated futures trading. When the USA economy was booming in the early 2000’s, these financial institutions encouraged the commercial banks, investment banks, insurance firms and hedge funds to trade the securitized housing loans through these newly created financial instruments. What is more, such repackaged mortgage loans were sold to commercial banks, mutual funds and insurance companies outside USA. Many European, British, Canadian, Australian, Japanese and South Korean banks purchased them hoping to make profit through capital appreciation.

Once the commercial banks, investment banks and insurance firms which had purchased securitized repackaged mortgage loans found these as good as useless, they started facing huge losses on their balance sheets. Once this negative financial impact started, many big financial firms like Bear Streans, investment banks like Lehman Brothers and Insurance companies like AIG and even federally owned refinancing institutions like Fannie Mae and Freddie Mac faced huge losses and started laying off their employees. This led to fall in consumer demand through multiplier effect. All this led to the collapse of both investment and consumer confidence in the American economy

by mid-2007. What was worse, such bank losses were transmitted to other countries through the globalized financial markets and led to chain reaction all over Europe and England where Royal Bank of Scotland and Barclays bank faced severe losses which forced them to cut their labour force. This process spread to Middle East, Asia and even to Australia.

Thus, excessive lending by house mortgage banks to ‘sub-prime’ borrowers hoping to make more profit from house sales created housing bubble. Failure of house buyers to repay their loans to mortgage banks because of absence of regular income forced the banks to resort to public auction of houses. Failure to realize the invested amount from the securitized mortgage loans led to enormous losses to the financial institutions which had invested in securitized loans. In order to minimize their losses, they laid off thousands of workers. This created sudden fall in domestic demand for not only domestic products but also for the products imported from many European, Asian and Middle East countries. Many Asian countries like Singapore, Malaysia, and Taiwan who were dependent on their exports to USA suddenly faced sharp decline in their export earnings. This is evident from the following Table 1:

Table 1:Growth Rates of World Exports and Imports During

Recession Years

(Goods and Services) % Change

_____________________________________________________________

2008 2009 2010 (Projected)

_____________________________________________________________

I. Exports From :

1. Advanced Economies 1.8 -12.1 5.9

2. Emerging Economies 4.4 -11.7 5.4

II. Imports Into:

1. Advanced Economies 0.5 -12.2 5.5

2. Emerging Economies 8.9 -13. 5 6.5

Source: Economic Survey, 2009-10, GOI

Such decline in the demand for exports did not spare even emerging economies like China and India. This resulted in reduction of work force employed in export units. That in turn reduced domestic demand in their economies which resulted in fall in the growth rates of their GDP.

Even the financial sector was not free from such globalised impact. As soon as the stock markets collapsed in USA and Europe, there was panic in the Indian stock markets. The foreign institutional investors who had invested in Mumbai stock market suddenly withdrew their investment. This naturally dipped the BSE sensex. The value of sensex which reached 17578 on February 2008 declined to 16371 on March 28, 2008. It further declined to 14043 on July 6, 2009 because of the net selling by the foreign institutional investors (FIIs). Such decline was noticed in many other Asian stock markets also. The following Table 2 shows the change in the equity index value of share indices of major Asian countries in major Asian Stock Markets after the US financial crisis. It may be observed that the downward pressure on the share values was severe in 2008. However, in 2009 share values recovered in some Indian and Chinese stock markets because of economic stimulus measures announced by their governments.

Table 2:Cumulative Change of Equity Index Over 2003 Level

in Asian Stock Markets (Points)

________________________________________________

Equity Index 2007 2008 2009

BSE Sensex (India) 247.4 65.2 199.1

Hang Seng Index (Hong Kong) 121.2 1.1 74.2

Nikkie 225 (Japan) 43.4 -22.9 -5.3

TSEC Weighted Index (Taiwan) 44.4 -25.2 32.3

SSE Composite Index (China) 251.5 43.7 116.9

Source: Economic Survey, 2009-10, GOI.

It may be observed from Table 3 below that the Foreign Institutional Investors sold more than they purchased in their portfolio investment in India in 2008 resulting in net disinvestment in Indian equity and debt in 2008 when the financial crisis was deep. This obviously resulted in loss of share value for the Indian companies whose shares were purchased by the FIIs. This was the only impact of the US financial crisis on the Indian financial system. There were no bank failures in India as it happened in USA and Europe. It has been estimated that the value of shares of international companies melted down by $14.5 trillion in 2008 which was more than the GDP of USA, which was $13.8 trillion.

Table 3: FII Investment in Equity and Debt Instruments of Indian

Companies.

(Rs.Crores)

FII Investment 2007 2008 2009

____________________________________________________________

Gross Buying(B) 846295 769625 736010

Gross Selling (S) 765380 810841 648023

Net Investment (B-S) 80915 -41216 87987

_____________________________________________________________Source: Economic Survey,2009-10, GOI

The financial crisis created by US house mortgage banks was transmitted to the real economy through the mechanism of financial losses forcing large scale lay off of their workers which in turn reduced consumer demand both for domestic and foreign products. This ultimately shrank the GDP of the countries which were connected through financial globalization as well as international trade. The real economy of USA started melting down which was in turn transmitted to European and Asian economies in the form of falling exports, falling domestic and foreign demand and ultimately fall in the growth rates of their GDP. The globalized interdependent economies started facing fall in their growth rates of GDP. This was the economic melt down which originated from the US housing financial crisis. It was estimated that the world output would grow by 3 per cent in 2008 but likely to decline to a mere 0.8 growth rate in 2009. It was also estimated the advanced economies will grow only by 0.5 per cent as compared to negative growth in 2007 and their growth may improve only in 2009.

2. Impact of Global Financial Crisis on Indian Economy.

Though the financial crisis started in USA in August 2007, its impact on the real economy started manifesting only by September 2008 all over the world. When the process of financial crisis was evolving in USA and Europe, Indian policy makers argued that since Indian financial system was well regulated and not closely integrated with the global financial system,(in the absence of full capital account convertibility of Indian rupee), its impact would be very minimal. However, Indian financial system could not escape completely from the impact of the US financial crisis. Some Indian banks were exposed to the toxic assets of the mortgage banks of USA. One big private bank namely, ICICI bank, was exposed to the American toxic assets substantially. It is true that the Reserve Bank of India had supervised the Indian banking system effectively and ensured adequate capital base for the banks. Their loan policies were also carefully watched which prevented any substantive impact on the Indian financial system. As a result, Indian financial system did not adversely impact the real economy of India. The macroeconomic fundamentals were reasonably in balance and hence the real economy was saved from any possible adverse impact from the well insulated financial system.

Notwithstanding such prudent management of the Indian financial system, the Indian economy could not escape from the adverse impact of the melt down of the real economy in the west. After the introduction of structural reforms, Indian economy got integrated into the global economy. Globalization process integrated the Indian economy with the economies of the west, which enabled India to move on to a higher growth path and reduce poverty. But that global economic integration itself exposed the Indian economy to adverse impact of the economic melt down of the western countries. In other words, though the financial crisis of USA did not spread to Indian financial system, the melt down of the real economy of USA and Europe impacted the real economy of India. This is evident from the following Table 4:

Table 4:Sectoral Growth Rates of GDP in India in Pre-Melt

Down and Melt Down Years.

( At 2004-05 Prices) Per Cent

Pre-Melt Down Years Melt Down Years

____________________ ___________________________

Sector 2006-07 2007-08 2008-09 2009-10

_____________________________________________________________

1.Agriculture,

Forestry

&Fishing 3.7 4.7 1.6 -0.2

2. Mining &

Querying 8.7 3.9 1.6 8.7

3. Manufacturing 14.9 10.3 3.2 8.9

4. Electricity, Gas

& Water Supply 8.5 10.0 3.9 8.2

5. Trade, Hotels

& Restaurants 11.2 9.5 5.3 8.3

6. Construction 10.6 10.0 5.9 6.5

7. Transport, Storage

&Communication 12.6 13.0 11.6 Note

8. Finance,Insurance,

Real Estate

& Business Services 14.5 13.2 10.1 9.9

9. Community,Personal

& Social Services 2.6 6.7 13. 9 8.2

_____________________________________________________________

Total GDP of India

from all sectors. 9.7 9.2 6.7 7.2

_____________________________________________________________ Note: Included under item 8.

Source: CSO /Economic Survey,2009-10, GOI.

It may be observed from the data presented in the above Table 2, that of all sectors of the Indian real economy, only mining and manufacturing sectors and to some extent trade were affected from 2007-08 by the economic melt down of the western economies. This was obvious because of the fall in the demand for India’s iron ore and also due to the decline in exports particularly garment exports. Even then the Indian economy sustained an impressive growth rate of 9.2 per cent in 2007-08.This was the second highest growth rate next only to China in the whole world. And this is in contrast to the shrinking of the real economies of many western economies.

However, the Indian economy could not withstand the impact of the global meltdown beyond 2007-08. In 2008-09 there was an all round decline in the growth rates of GDP from almost all sectors except from community, personal and social services. Consequently, the GDP of the country could grow only at 6.7 per cent in 2008-09, a decline of 2.5 per cent over the previous year. What became alarming was the sudden decline of the growth of exports from 29 per cent in 2007-08 to 13.6 per cent in 2008-09, a negative growth of 20.3 per cent in 2009-10. All these declining economic activities resulted in lay off of workers. It was estimated by Bibek Debroy,(2009),that Indian export sector had created about 6 million direct jobs and another 9 million indirect jobs. Of these, two million jobs were lost owing to the decline in exports. In the manufacturing sector about 25 per cent of the workers were laid off. In the construction sector of Gulf countries about 20000 workers, mostly from Kerala, lost their jobs. About 40000 workers in engineering industry,(cycle and hand tools), lost jobs though from all over India but mainly from Punjab and Tamil Nadu. In Gujarat about one lakh gems and jewellery workers were laid off. The garment industry laid off about five lakh workers mainly in Punjab,(Ludhiana), and Tamil Nadu,(Tirupur). Job losses spread even to sun rise sectors like IT and BPO services. It is necessary to remember that whereas in western countries laid off workers get social security benefit for almost six months until they get new jobs, in India out of 50 crore workers only about four crores are in organized sector where social security benefit is provided. The rest the workers who are mainly in the unorganized sector have to fend for themselves. The only social security for them is MNREGS which has come into effect only for the last five years. Mr.Pr nab Mukherji has made a beginning to provide them pension and insurance benefits in his budget for 2010-11.

The efforts of the successive governments after the introduction of economic reforms to reduce poverty by achieving higher growth rates of GDP were made ineffective by the decline in the growth rate of GDP and large scale job losses on account of the melt down of the real economy of India.

3. Policy Response to Economic Meltdown And Its Impact

The above narrated economic melt down alarmed the UPA government in 2008 itself though the Union Finance Minister asserted that it will not have much impact on Indian economy as it was well insulated from. global economic events However, the country was expected to face Parliamentary elections in middle of 2009 which added political weight to the plight of the unemployed. Alarmed by these ground realities, the policy makers swung into action. So on December 6, 2008 the Prime Minister Dr.Manmohan Singh, who was temporarily holding the finance portfolio,( after the exit of Shivraj Patil as Home Minister which resulted in shifting of P.Chidambaram as Home Minister), announced a very bold 14-point stimulus package to revive the Indian economy. These 14- points were fourteen stimulus measures. They were:

1. Additional plan expenditure was increased by Rs. 20000 crores for infrastructure development during next four months from December 2008 to March 2009.

2. Authorised Infrastructure Investment Finance corporation to raise an additional amount of Rs.10000 crores by issuing tax-free bonds for spending on infrastructure development.

3. Excise duty reduced across the board by 4 per cent.

4. Public sector banks were asked to lend housing loans up to Rs.20 lakhs at 7 to 8 per cent interest.

5. Rs.350 crores were allocated for providing export incentives to revive exports.

6. Backup guarantee was announced for Export Credit and Guarantee Corporation,(ECGC),for up to Rs.350 crores.

7.Two per cent interest subvention was announced for labour intensive exports.

8.Rs.1100 crores were announced to ensure full refund of excise duty.

9. Additional Rs 1400 crores of assistance was announced for textile sector under TUF ( Technology Upgradation Fund), scheme.

10. The guarantee cover for loans to SMEs was doubled to one crore rupee.

11. The lock-in period for such collateral-free loans was reduced.

12. Government departments were allowed to take up replacement of vehicles.

13. Export duty on iron fines was eliminated.

14. Import duty on naptha for use in power sector was eliminated.

In addition to these fiscal stimulus measures, the Reserve bank of India also announced monetary measures to increase the liquidity available in the economy particularly for export sector, housing sector, auto sector and construction sector. The RBI reduced the Repo rate from 7.5 to 6.5 and Reverse Repo rate from 6 to 5 per cent. The RBI also enhanced the refinance capacity of SIDBI to Rs.7000 crores and of NHB to Rs. 4000 crores.

Thus the stimulus measures targeted power sector, exports, housing, automobile, SME and infrastructure sectors to revive the economy from recession. These stimulus measures coupled with anti-cyclical fiscal deficit measure announced in in the Union budget for 2008-9 created positive impact on the economy. Growth rate of exports which suffered sharp fall in 2008-09 started recovering from the third quarter of 2009-10 as may be seen in Table 5 below:

When the Union Finance Minister Mr. Pranab Mukherji presented only the interim budget for 2009-10 in February, because of the ensuing Parliamentary elections, he did not want to announce major policy decisions on the ground that the government did not have the mandate to do so as the Parliamentary elections were due in the middle of 2009.After the return of the UPA government to power following the Parliamentary elections, Mr.Pranab Mukherjee presented the full budget in July 2009 in which he increased the plan expenditure by14.9 per cent, non-plan expenditure by as much as 17 per cent and overall government expenditure by 13.3 per cent. The non-plan expenditure included the sixth pay commission recommendations on the pay scales of government employees. He also extended the exemption of export earnings of IT companies under STPI by one more year. He increased the exemption limits of income tax. All these measures increased the fiscal deficit of the government beyond the limit prescribed under Fiscal Reform and Budgetary Management Act . Such increased fiscal deficit was justified as a counter-cyclical fiscal measure which was needed to stimulate the recession stricken economy. exports.

Thus the stimulus measures targeted power sector, exports, housing, automobile, SME and infrastructure sectors to revive the economy from recession. These stimulus measures coupled with anti-cyclical fiscal deficit measure announced in December, 2008 created positive impact on the economy. Growth rate of exports which suffered sharp fall in 2008-09 started recovering from the third quarter of 2009-10 as may be seen in Table 5 below:

Table 5: Quarterly Growth Rates of Exports and Imports . (Per Cent)

2008-09 2009-10

_____________________ __________________

Q1 Q2 Q3 Q4 Q1 Q2 Q3

Exports 57.0 39.5 -4.0 -20.3 -38.6 -21.0 6.0

Imports 38.7 73.8 7.4 -24.0 -35.0 -33.6 1.2

Source: Economic Survey, 2009-10, GOI

It becomes clear from the foregoing data that growth rates of both exports and imports went on declining until the middle of 2009-10. By that time most of the export specific stimulus measures started stimulating the exports and as a result the growth rate of exports turned positive at 6 per cent in the third quarter. It may be mentioned here that the Union Finance Minister Mr. Pranab Mukherjee has continued most of the stimulus measures specifically provided to export sector. This continuation will further push up the growth rate of exports in the next quarter and thereafter.

As far as the recovery of other sectors is concerned, data presented in Table 4 indicate that they have started recovering from 2009-10. In view of this recovery of sectoral growth rates of GDP, the Union Finance Minister Mr.Pranab Mukherjee has rolled back partially some of the fiscal stimulus measures to reduce the fiscal deficit from 6.9 per cent to 5.5 per cent in his recent budget for 2010-11. This is intended to moderate the inflationary pressure in the economy which has started showing up in food grains prices. He has increased the excise duty on non-petroleum products by two per cent. He has also restored the basic custom duty on petroleum products. But he has increased plan expenditure on infrastructure and rural development to ensure adequate domestic demand for the economy..

Thus the Indian economy started recovering from the slowdown towards the end of the fiscal year 2009-10. This is evident from the 7.2 per cent growth rate of GDP. Except agriculture which suffered a negative growth rate of 0.2 per cent and transport, real estate, finance and community and social services, all other sectors have shown recovery. Notably, mining, manufacturing, construction and electricity generation have shown remarkable recovery. Thus the Indian economy which was negatively impacted by the meltdown of the western economies for one year has started recovering. The Union Finance Minister has projected a growth rate of GDP of 8.5 per cent for the coming fiscal year 2010-11. This would mean that the Indian economy will return back to 9 per cent growth path by 2011-12. However, Mr.Ruchir Sharma of Morgan Stanley has argued that no country including India and China will be able to return to the high growth path of 2003-2007 in the next decade because of many structural changes that have occurred in the world economy as a result of the financial crisis. Let us hope that the Indian economy will achieve at least 9 per cent growth rate which is necessary to reduce persisting poverty.

Ladies and gentlemen, before closing this address, I would like to take this opportunity to thank Professor P.Devasena Naidu and V.Jayasimhalu Naidu for inviting me to come and participate in this seminar.

Thank you all

Reference:

1. Debroy, Bibek, “Global Downturn and Its Impact”, in

Global Financial Crisis: It’s Impact On India’s Poor, (2009),

UNDP, India