Author: Raghbendra Jha

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.

Further, there is the relatively unspoken fear: if failing private institutions are bailed out now, could it lead to a problem of moral hazard with these players not becoming more careful in the future, in anticipation of being bailed out again?

How is the Indian economy is expected to fare in the short-term and how has it responded to the crisis?

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(ii) with slackening external demand, export growth is expected to slow; and (iii) Foreign Institutional Investors have withdrawn from Indian stock markets leading to sharp falls in key indices.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.

Professor Raghbendra Jha spoke at the India Update, held on the 6th and 7th of November at the ANU.