Several other indicators, e.g. industrial production and trade, have also pointed toward a slowdown in the economy. Traditional wisdom has it that the GFC should have had minimal impact on India because i) Indian banking had no direct exposure to the sub-prime mortgage crisis, and ii) India’s growth is largely based on domestic consumption and domestic investment. External demand as measured by merchandise exports account for less than 15 per cent of India’s GDP.

However, 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. During the same 10 year period the ratio of total external transactions more than doubled from 46.8 percent to 117.4 percent. Corporate borrowing from external sources has also increased significantly. In 2007–08 India received capital inflows to the extent of 9 per cent of GDP as against a current account deficit of 1.5 per cent of GDP.

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. India instituted three stimulus packages (amounting to a liquidity injection of about 7 per cent of GDP) in response to the slowdown in demand:

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. Thus, the Indian auto industry, which was heading towards decline recorded positive growth of 0.71 per cent in total vehicle sales in fiscal 2008–09, services and manufacturing sectors are expected to record reasonable growth and investment rates are still high. The sharp fall in inflation has provided room for more aggressive interest rate cuts by the RBI, although the burden of servicing the larger debt because of the stimulus packages will not be insignificant. Although equity markets have registered steep declines the wealth impact on domestic residents is limited since only a small number of Indians participate in equity markets.

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. However, since the stimulus packages have already imposed a significant fiscal burden, the new central government would need to eschew undue populism, failing which high fiscal deficits could again restrict India’s growth between potential as was the case in the mid to late 1990s. The chances of this happening are lower now. The Indian economy has certainly grown in terms of sophistication and depth since the 1990s. On balance, there is reason to be guardedly optimistic about the Indian economy in the short run.