Understanding Recessions Background After 5 years of synchronized high economic growth since 2004, the global economy is now

grappling with synchronized recessionary conditions. The financial turmoil that started in the United States, initially led by sharp declines in house prices, has transformed into a severe credit crunch with substantial losses in equity markets. Moreover, it has now spread to a number of advanced and emerging countries, and become the most severe global financial crisis since the Great Depression. This has led to an intensive debate about how much the crisis will impact the real economy.

In India too, the slowdown has become evident initially in the tradeable segments, such as industry and exports. The linkage effects would then lead to a slowdown even in the non-tradeable segments of the economy. Industrial output which had been growing in double digits (since Jul 07), led by a strong upsurge in capital goods, has been slowing down and declined by 0.4% in Oct 08. Similarly exports which grew by 27% in FY08 started slowing down since August 2008, declining by 12 % in October 2008.

Hypothesis In this note we attempt to explore the following questions; What could be the severity and probable duration of this recession in the developed countries and whether India is likely to get into a recession? For the purpose we have used the recent research findings of the IMF Working Paper “What happens during Recessions, Crunches and Busts”.

The IMF Report Recessions, or a decline in GDP over 2 quarters can result from a number of causes. When recessions are caused due to a crisis in financial markets, the impact on the economy is different from recessions emanating from other causes such as the oil price hike. The current spell of recession has begun with a crisis in the housing and credit markets. In view of this a recent IMF research report becomes relevant in making some assessment of the current recession. The report covers 21 OECD countries over the

period 1960-2007. There is analysis of the implications of 122 recessions, 112 (28) credit contraction (crunch) episodes, 114 (28) episodes of house price declines (busts), 234 (58) episodes of equity price declines (busts) and their various overlaps in these countries. Through empirical research, the study has explored the linkages between the financial and key macro economic variables, with a view to determining the severity and duration of recessions.

Highlights of the IMF Study • The study indicates that interactions between macroeconomic and financial variables can play major roles in determining the severity and duration of a recession. • In particular, recessions associated with credit crunches and house price busts are deeper and last longer than other recessions. They typically result in output losses two to three times greater than recessions without such financial stresses. o The more adverse effects of a recession with a (severe) house price bust arise in part due to compressed credit markets, in turn leading to a considerable reduction in consumption and (residential) investment. o A regression analysis shows that the changes in house prices tend to be the financial variable most robustly associated with the depth of recessions. • The typical recession lasts almost 4 quarters and is associated with an output drop of roughly 2 %. Most macroeconomic and financial variables exhibit pro-cyclical behavior during recessions. • There is also a pattern of recessions becoming shorter and milder over time, especially after the mid-1980s. In particular, the amplitude of a typical recession fell from 2.6% in 1973-1985 to 1.4% in 1986-2007. (Amplitude is the percent change in output from a peak to the next trough of a recession). • Recessions remain highly synchronized across countries. Moreover, recessions often coincide with the episodes of contractions in domestic credit and declines in asset prices. • Episodes of credit crunches, house price and equity price busts last much longer than recessions do. • A credit crunch episode typically lasts two-and-a-half years and is associated with nearly a 20% decline in credit.

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• A housing bust tends to persist even longer—four-and-a-half years with a 30% fall in real house prices. • And an equity price bust lasts some 10 quarters and when it is over, the real value of equities drops by half. • There can be considerable lags between financial market disturbances and real activity. • The lessons from the earlier episodes of recessions, crunches and busts examined by IMF are sobering, suggesting that recessions following the current crisis will likely be more costly than other recessions, because they take place alongside simultaneous credit crunches and asset price busts. • Furthermore, although the effects of the current crisis have already been felt gradually around the world, the past evidence suggests that its global dimensions are likely to intensify in the coming months.

View on US Recession In the light of the summary findings stated above, some assessment of the US recession can be conjectured. Since the crisis emanated in the credit and housing markets, the duration of the recession can be expected to range between 8 – 18 quarters depending on the severity of the problem.

In Q3, 08, US GDP shrank 0.3% (QoQ), its sharpest contraction in 7 years with consumption expenditure declining 3.1% and residential investment declining 19.1%. (Consumption expenditure forms 72% of GDP).

While the current economic environment in the US may share some features with the onsets of typical U.S. and OECD recession (IMF Report), it is worse in some dimensions. The difference can be seen particularly in terms of speed of credit contraction, drop in residential investment and decline in house prices. The IMF study has shown that such credit contraction (crunch) and house price decline (bust) episodes on average lasted 6 (10) and 8 (18) quarters, respectively. If these statistics, based on a large number of episodes, provide any guidance, they suggest that the adjustments of credit and housing markets in the United States are only in the early stages relative to historical norms and

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might still take a long time. The earlier episodes suggest that the process of adjustment in the United States might persist in the coming months with further difficulties in credit markets and drops in house prices. This could bode further decline in output which falls more in recessions associated with credit crunches and house price busts than in recessions without such events. Lead Indicators of Recession The IMF has identified some lead Macroeconomic variables such as output, consumption, investment, residential investment, non-residential investment, industrial production, exports, imports, net exports, current account balance, and the unemployment and inflation rate. Each of these indicators had reached their peak before the GDP peaked. Subsequently they showed deceleration before the onset of recession and a decline in some cases. The decline in GDP was seen with a lag to this movement.

1) Residential Investment The IMF findings reveal a negative growth in the residential investment in the 1st quarter of the recession itself and that generally stays upto 6 quarters. Further, in case of severe recessions, it may take upto 3 years to recover.

2) Industrial Production Industrial Production has been found to fall before the recession starts.

3) Inflation Inflation is seen to be generally high in a pre recession economy and starts falling gradually during recession.

4) Unemployment It is one of the best leading indicators of a recession and is seen to generally rise one quarter ahead of recession.

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5) Imports Imports often fall before the start of the recession and may fall upto 7% in its 1st year itself.

6) Credit Growth The study has found a slowdown upto 2-3% in the credit growth before the start of the recession and a further fall of 2% during the recession. Also, credit growth doesn’t return to its pre recession level even after 3 years from the end of recession.

7) House & Equity Prices It was seen that the house prices fall by 3% (YoY) while equity prices fall by 16%, before output starts declining.

Application of Lead Indicators to India Since the beginning of Q3 FY 09, India has been witnessing a slowdown in some sectors. Some of the lead indicators given in the IMF study were applied to India to make an assessment of any possible build-up of recessionary conditions. As can be seen from the tables below, many of the lead indicators of India are still robust and are not declining. In the case of some, such as Industrial output, imports, Fixed investment, house prices, employment which are showing some deceleration/decline, tracking of the

monthly/quarterly trend in the future would be required for further analysis.

GDP Q1, 07 GDP growth rate (%) 9.6 10.1 9.3 9.7 9.2 9.3 8.8 8.8 7.9 7.6 Q2, 07 Q3, 07 Q4, 07 Q1, 08 Q2, 08 Q3, 08 Q4, 08 Q1, 09 Q2, 09

There has been no decline in GDP growth. However, the quarterly growth in GDP shows a deceleration from Q3 FY08 onwards and which is likely to accelerate further in the year.

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Industrial Production Q1, 07 IIP growth rate (%) 10.4 11.8 11.2 12.5 11.2 8.6 8.4 5.6 3.1 4.4 Q2, 07 Q3, 07 Q4, 07 Q1, 08 Q2, 08 Q3, 08 Q4, 08 Q1, 09 Q2, 09

The IMF results indicate a decline in production before the recession sets in. In case of India, it is evident that there has been a slowdown in the industrial production from Q2, 08. On a monthly basis, IIP fell by 0.4% in Oct 08 for the first time in 5years. We will need to watch the subsequent months to identify a trend if any.

Gross Fixed Capital Formation (GFCF) Q1, 07 GFCF growth rate (%) 17.1 13.5 15.7 14.3 13.3 16.7 14.3 11.2 9.0 13.8 Q2, 07 Q3, 07 Q4, 07 Q1, 08 Q2, 08 Q3, 08 Q4, 08 Q1, 09 Q2, 09

The IMF study states that before recession, investment starts declining. GFCF is an indicator of investment and future production and expansion plans. It has been volatile over the quarters and declined for three consecutive quarters from Q2, 08 onwards. Although it picked up in the last quarter (Q2, 09), we may witness some slowdown in the coming months in view of the tight liquidity conditions, more so for the private sector and expectations of lower corporate earnings.

Residential Investment Housing loans disbursal (SCBs) has been taken as a proxy for residential investment. The IMF study predicts a negative growth in residential investment during the first quarter of the recession itself. In case of India, residential investment do not show any decline,

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although there is a deceleration as can be seen in the table below.

23 Jun 06 Growth in Housing Loan Disbursal (%) 54.3

27 Oct 06

24 Nov 06

16 Feb 07

25 May 07

31 Aug 07

23 Nov 07

15 Feb 08

23 May 08

29 Aug 08

32.3

33.4

8.9

21.6

17

15.1

12

13.8

13.9

Imports Q1, 07 Import Growth (%) 12.5 24.2 32.4 16.3 38.3 20.3 27.7 49 34.5 47.5 Q2, 07 Q3, 07 Q4, 07 Q1, 08 Q2, 08 Q3, 08 Q4, 08 Q1, 09 Q2, 09

As per the IMF report, imports start falling before a recession. The table above shows a continuous increase on a quarterly basis. However, on a monthly basis, in October 2008 while exports declined by 12.1% (35.65%), imports decelerated to 10.6% (24.27%). Subsequent month’s data would need to be watched for an assessment.

Inflation Q1, 07 WPI growth rate (%) 4.6 5.1 5.6 6.4 5.4 4.1 3.4 5.8 9.6 12.5 Q2, 07 Q3, 07 Q4, 07 Q1, 08 Q2, 08 Q3, 08 Q4, 08 Q1, 09 Q2, 09

The report states that inflation accelerates before recession. Inflation had been on an uptrend since the beginning of FY 09. Since the last 3 weeks however, inflation has started decelerating in view of the monetary easing as well as the fall in global commodity prices.

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Credit Growth Q1, 07 SCBs Credit Growth (%) 31.2 31.1 28.9 29.2 25.9 23.6 22.7 23 24.9 25.5 Q2, 07 Q3, 07 Q4, 07 Q1, 08 Q2, 08 Q3, 08 Q4, 08 Q1, 09 Q2, 09

The IMF study talks of a 2-3% decline in credit as a precursor to recession. Credit growth in India has not shown any sign of a slowdown. As of Dec 5, 08, growth in credit was still strong at 26% (22%) on a YoY basis.

House Price House prices fall before recession. A report by the Goldman Sachs (Nov 08) pointed out that there is gross oversupply of both residential and commercial property. Supply in Mumbai is four times that of demand and in New Delhi, supply is two times that of demand. Bangalore appears to have the least unsold inventory, but is likely to follow. Overall, supply outstrips demand by at least 40%. In India, house prices should decline more on account of supply outstripping demand.

According to India Reality News (Dec 11, 08), “the last time when there was a crash in property prices (in 1996), it took four years for real estate prices to bottom out. This time, while property prices have fallen 25% rather sharply, the bottoming out is expected to take at least another year. So, evidently, the real estate sector could experience either a sharp downturn or a slow prolonged one”.

Equity Price The stock markets in India have been volatile and have witnessed large outflows by FIIs since October 2008. On Jan 10 this year, the Sensex was ruling at an all-time intra-day high of 21,206.77 points. But as the year is drawing to a close, it is languishing at around the 9,000-point mark - a fall of over 50% in the year. Last year, the index had gained nearly 50%.

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Unemployment This is the most robust indicator of an approaching recession. Organisations tend to downsize in anticipation of falling demand, which in turn further depresses demand leading to more output cuts. In the absence of data on unemployment we have provided some anecdotal evidence. A large number of units in the unorganized sector have closed down. Sectors such as Gem & Jewellery, Textiles, Leather, and Auto ancillaries have announced large job cuts as also production shut downs.

As per Assocham’s new report ‘Jobs scenario, post-Diwali’, India Inc. is likely to announce lay offs of nearly 25% - 30% of its workforce within the next 10 days across seven key industrial segments (steel, cement, ITeS/BPO, financial and brokerage services, construction, real estate and aviation). Apart from layoffs, companies are also planning to cut down on perks/bonuses etc.

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