The Recession Aftermaths

Being part of the sector without any national boundaries, the global recession has mauled the financial sector worldwide. The bubble that had been created in the US created further bubbles, leaving the global economy in mayhem. What was the root cause for this? Going by the popular opinion, regardless of their income, financial institutions provided excess implicit and explicit housing subsidies to Americans. One law forced banks to lend to sub prime poor borrowers. Legislators created Fannie Mae and Freddie Mac, government-sponsored entities that bought or underwrote 80% of all US mortgages, and enjoyed exemption from normal regulations. Politicians ignored the warning that such a dominant role for two under-regulated giants posed a huge financial risk. This can be termed as a root cause behind the meltdown. Thus, leftists claim that the global financial crisis was caused by reckless deregulation and greed while rightists blame half-baked financial regulations and perverse incentives.

If we look at the positive aspect as to why the recession cannot affect us, we can be relieved that India’s annual GDP growth accelerated to 9.3% in the three years, to 2007-08 owing mainly to greater impact and acknowledgement of favorable structural factors and exceptionally easy global liquidity conditions and heightened appetite for risk taking that caused a surge in capital inflows into emerging economies, including India.

The structural factors driving India’s economic rise remain well entrenched and thus safeguard the attractive medium-term outlook. Since Indian banks had not been exposed much to the “toxic assets” of the foreign banks, India has largely avoided being impacted; it has not escaped the remaining two channels: It faces a temporary liquidity crunch as also a decline in the export demand induced by the global slowdown. To combat the liquidity crunch, the RBI must continue working towards restoring confidence in lending and injecting liquidity. It must dispel the fear of lending that currently engulfs the banks.

But the reality is that the impact of the recession in the United States and Europe, which has also slowed down China, is likely to remain with India. India will take a cut of two percentage points in the growth rate this year and the next, bringing the growth rate to 7%. This is not a catastrophe, but it does setback our efforts to eliminate poverty. Though it is difficult to quantify the exact implications at this stage, some factors should be kept in mind. Most Indian IT firms are vulnerable to the emerging global recession, 70% of India’s $40 billion software exports are to the US and 40% of it for financial services which are shrinking rapidly. Our manufacturing and construction trade face prospects of further slackening investment; funding constraints could result in some uncertainty for the real estate sector; and while direct exposure for Indian financial institutions is negligible, there are a few firms which could be impacted at the margin. After asserting that the global financial meltdown will not affect us, it is now being acknowledged that India is impacted and the effects will intensify.

India may be one of the least open economies in Asia, but its external trade already constitutes over 40% of its GDP. Net investments by FIIs in Indian stock exchanges by January 2008 were $65 billion. In the last four years, India has received $50 billion as FDI. On October 23, by which time FIIs had pulled out over $10 billion, the rupee plunged to 49.79 against the dollar, in comparison to under Rs 39 a year ago. April-August 2008 saw 4.9% growth compared to 8.5% in April-August 2007 and 10% during entire 2007-08. Expansion in manufacturing, the emerging star of Indian economy, fell from 10.6% to 5.2%. Electricity generation nose-dived from 8.3% to 2.3%.

Agriculture declined in Q1 2008-09 from 4.4% to 3% and services from 10.6% to 10.2%. Foreign trade during H1 2008-09 registered a deficit of $60 billion as against $30 billion in H1 2007-08. Hitherto, export growth was being bolstered by rising commodity prices and the yet strong demand from emerging markets and oil producers. All these contributory factors no longer exist. By mid-October, the economy had clearly deviated from its long run growth path. The positive cycle had turned negative and the actual growth had lagged behind the potential output growth. The manufacturing inflation gap has become positive, with the actual inflation being higher than warranted for many months. Financial services are up against tight liquidity and falling markets. Plummeting travel and tourism are slowing down transportation and hospitality sectors. More focused action, including fiscal, is needed to stem the worsening of the real economy.

Though the speculations may appear scary, India can be relieved that she is among the least affected. One of the biggest positives is that this experience provides lessons for us. Something that we must learn from this experience is that while India must eventually liberalize its financial sector, we must not err on the side of caution. Modern-day ‘wizards’ in the financial sector have the talent to ‘innovate’ products that even the most sophisticated analysts are unable to evaluate. These innovations, unless rooted in the basics of safe financial practices, are bound to be disastrous.

Regil Krishnan

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