Global Financial Crisis

The global financial crisis surfaced around August 2007. Its origin lay in structured
investment instruments (Collateralized Debt Obligations, synthetic CDOs) created
out of sub-prime mortgage lending in the United States. The securitization process
however was not backed by due diligence and led to large-scale default. The
complexity of the instruments and the role of credit rating agencies played a
contributory role. The high ratings assigned to certain CDO trenches, which were
then quickly reversed with the onset of the crisis, created a panic situation among
investors and precipitated the crisis. While the initial effect of the crisis was
profound on the US financial institutions and to a lesser extent on European
institutions, the effect on emerging economies was less serious. In the initial stages,
the capital flows to the emerging economies actually increased, giving rise to what is
termed as “positive shock” and the “decoupling’ debate. In the case of India, for
example, the net FII inflows during the five-month period from September 2007 to
January 2008 was US$ 22.5 billion as against an inflow of US$ 11.8 billion during
April-July 2007, which were the four months immediately preceding the onset of
crisis.

The effect of the global financial crisis on emerging economies (including India)
thereafter was mainly through reversal of portfolio capital flows due to unwinding of
stock positions by FIIs to replenish cash balances abroad. Withdrawal of FII
investment led to stock market crash in many emerging economies and depreciation
or decline in the value of local currencies vis-a-vis US dollar as a result of supply-
demand imbalances in domestic markets. In the case of India, the extent of reversal
of capital flows was US$ 15.8 billion during five months (February-June, 2008)
following the end of “positive shock” period in January 2008. Following the collapse
of Lehman Brothers in mid-September 2008, there was a full-blown meltdown of
the global financial markets. It created a crisis of confidence that led to the seizure of
inter-bank market and had trickle-down effect on trade financing in the emerging
economies. Together with slackening global demand and declining commodity
prices, it led to fall in exports, thereby transmitting financial sector crisis to the real
economy. Countries with export-led model of growth, as in many South-East Asian
countries, and that depended upon commodity exports, were more severely affected.

The impact on Indian economy was less severe because of lower dependence of the
economy on export markets and the fact that a sizeable contribution to GDP is from
domestic sources. India’s trade reforms since 1991 have moved progressively
towards neutral regime for exports and imports, eschewing tax and other incentives
for exports. The direct impact of the crisis on financial sector was primarily through
exposure to the toxic financial assets and the linkages with the money and foreign
exchange markets. Indian banks however had very limited exposure to the US
mortgage market, directly or through derivatives, and to the failed and stressed
international financial institutions. The depending of the global crisis and
subsequent deleveraging and risk aversion however affected the Indian economy
leading to slowing of growth momentum. The overall balance of payment situation
however remained resilient despite signs of strain in the capital account that
manifested in the net reversal of FII flows of US$ 15.0 billion during fiscal year
2008-09 and on current account through decline in exports. In 2008-09, the
merchandise exports recorded a growth of 13.6 per cent reaching US$ 189 billion.

While export growth was robust till August 2008, it became low in September and
became negative from October 2008 to July 2009. The rupee depreciated by 21.2 per
cent against the US dollar during the fiscal year 2008-09. The US dollar however
appreciated by 17 per cent against the broad index (FRB, New York) between March
2008 and March 2009, suggesting that only 5 percentage points of the rupee
depreciation was due to India-specific factors. Money and credit markets had been
affected indirectly through the dynamic linkages. The drying up of liquidity, a fallout
of repatriation of portfolio investments by FIIs, affected credit markets in second
half of2008-09. This was compounded by the “risk aversion” of banks to extend
credit in the face of general downturn.

The extent of the external financial and monetary shock on the Indian monetary
financial system is best captured by the precipitous contraction in reserve money by
more than 15 per cent between August 2008 and November 2008 (compared to 0.5
percent increase in the corresponding period of the previous year). Reserve money
growth (y-o-y) collapsed from 26.9 per cent in August 2008 to 10.3 per cent in
November 2008 and further to 6.4 per cent in March 2009. The various monetary
policy measures taken by RBI kept narrow money M1 and broad money M3 from
falling as precipitously. Despite these, however, Ml growth decelerated from 19.4 per
cent in August 2008 to 10.3 per cent in November 2008 and further to 8.2 per cent
in March 2009, while M3 growth decelerated from 21 per cent in August 2008 to
18.7 per cent in March 2009. A series of unconventional measures actually helped to
push up the rate of growth of bank credit from 25.4 per cent in August 2008 to 26.9
per cent in November 2008.

However, this only partly offset the effects on short-and long-term credit to Indian
companies in the United States and EU markets, because of the freezing of financial
markets. Subsequently, credit growth decelerated sharply to 17.1 per cent in March
2009, partly because of transmission of OECD recession effects to Indian exporters
and organized manufacturing. Despite these developments, the macroeconomic
impact of the global financial turmoil, particularly on the GDP growth, has been
relatively muted due to the overall strength of domestic demand in India and the
predominantly domestic nature of investment financing.

Impact of Global Financial Crisis on India’s Growth:

In the last two decades (1990-2009) fluctuations in India’s economic growth were
not closely linked to the cycles in developed countries or high-income OECD
countries. The upward jump in Indian growth between 2003-04 and 2008-09
however seems to coincide with a similar jump in global and OECD growth. The
sharp decline in growth to 5.8 per cent in the second half of 2008-09 from 7.8 per
cent in the first half of 2008-09, following the US and global financial meltdown in
August 2008, seemed to support this perspective. Following the global recession,
there was a view among global market analysts, that growth in emerging markets
and developing countries was driven by the global excess liquidity/monetization, the
associated capital flows from developed countries and the demand for commodities.

Consequently, with the bursting of the bubble the initial impact would be a growth
collapse, followed by a return in the medium term to growth rates that prevailed
before 2004-05, because of the painful process of de-leveraging and collapse of
capital flows. It was therefore concluded by some of these analysts belonging to
World Bank and IMF that India’s growth would collapse to around 4 per cent during
the subsequent four to six quarters and thereafter it may- revert to around 5 to 5.5
per cent over the medium term. An analysis of the growth history of India during
2008-09 suggests that this superficial generalization of a plausible global analysis to
India was erroneous.

The first half (H1) of 2008-09 saw the Indian economy recording a growth of 7.8 per
cent in GDP, despite the build-up of uncertainty in the international commodity and
financial markets. Among the domestic growth drivers, gross fixed capital formation
(GFCF) retained some of its momentum from the preceding years with a growth of
nearly 11 per cent. Consumption – both private and government however declined
significantly. The growth in private final consumption expenditure (PFCE) in of the
first half 2008-09 was 3.3 per cent, which was less than half of the corresponding
period in 2007-08. Similarly, government final consumption expenditure (GFCE) in
the first half of 2008-09 grew at less than 1 per cent, or just one-third of the growth
in first half of 2007-08.

In the second half (H2) of2008-09, GDP growth declined to 5.8 per cent, with a
further decline in private consumption growth to 2.5 per cent and a significant
moderation in growth rate of GFCF to about 6 per cent over the corresponding
period of 2007-08. However, with the roll-out of the fiscal stimulus, primarily in the
shape of implementation of the Sixth Pay Commission recommendations in Q3, as
well as the second round of fiscal expansion announced in Q4, the growth in
government final consumption expenditure shot up by nearly 36 per cent, partly
making up for the shortfall in other components of the domestic aggregate demand.
The overall GDP growth for the fiscal 2008-09 at 6.7 per cent surpassed all estimates
and forecasts, mostly ranging from 5.5 per cent to 6.5 per cent, made by
international agencies and analysts.

As expected, outcome of the recession in countries to which India exports its goods
has been the sharp fall in growth of Indian organised manufacturing. The trend in
India’s manufacturing sector started in the second quarter of calendar year 2007
with the slowing of the US economy and its imports of several products from India.
The trend was merely accelerated after the US meltdown and the onset of the global
recession. Services sector growth of India was not expected to slow sharply because
of its well-known insensitivity to demand cycles and relatively small contribution of
service exports to GDP. In fact, there was a sharp increase in the growth of
community, social and personal services which includes GDP from government
administration. It is also important to note that in 2009-10 the Indian economy
recovered faster and GDP growth rate in 2009-10 was 8.6 per cent and in 2010-11 it
was 9.3 per cent. This shows the resilience of the Indian economy against external
shocks.
Stock-Market Crash:
Following the eruption of financial crisis when the Wall Street of the US and stock
markets of the European countries crashed, its effect spilled over to India and our
stock market (Dalai Street) was also badly hit.

To meet the liquidity requirements or liabilities of their parent companies, Foreign

Institutional Investors (FIIs) started selling the shares of the Indian companies held
by them.

The selling pressure by FIIs brought about a crash in Dalai Street (i.e., Bombay Stock
Exchange). In the last few years FIIs had invested on a massive scale in the equity
shares of several Indian companies operating in various industries from consumer
goods to infrastructure industries.

As a result of the buying spree of shares of Indian companies by FIIs, share prices
rose to new heights. The Sensex which was around 6000 in 2004 rose to 8000 in
Aug.-Sept. 2005 and went on rising further crossing 10,000 mark in 2006, 13000
mark in 2007 and reached the peak of around 21,000 mark in January 2008.

At around this time, share prices in the US and European markets started falling
sharply and the problems of liquidity and credit crunch assumed grave proportions.
This led FII to sell shares held by them in the Indian stock market to pull out capital
from India.

This was done to fulfill the needs of redemption pressures on their parent companies
who were facing liquidity problem. As a result of this selling pressure, Sensex of
Bombay Stock Market (which is called Dalai Street) started tumbling; it fell from
around 21000 in Jan. 2008 to 11000 in Sept. 2008 and in its downward march it fell
below 10,000 in Oct. 2008 and 9000 mark in Nov. 2008, that is, 60 per cent fall
since Jan. 2008.

This caused huge losses to the Indian companies and investors whose huge wealth
was wiped out in a couple of months in 2008. Foreign institutional investors sold
more than $ 13 billion worth of shares of Indian companies up to Nov. 2008 and
repatriated them to their home countries. This also led to the decline in foreign
exchange reserves held by RBI to $ 250 billion by the end of 2008.
Depreciation of Indian Rupee:
But the effect of capital outflow by FIIs was not confined to drastic fall in share
prices but was more deeper and divesting. When foreign institutional investors
(FIIs) sold their shares in India they got rupees. They had to convert their rupees
into dollars to send them abroad. This led to the increase in demand for dollars.
Rupee-dollar exchange rate being determined by demand for and supply of
currencies, the increase in demand for dollars caused appreciation of US dollar in
terms of rupees, that is, rupee depreciated against US dollar.

The Indian importers also demanded dollars to pay for the imports of goods. The
Indian banks doing foreign exchange operations also bought US dollars at home to
keep their foreign exchange operations afloat since due to credit crunch no one in
foreign countries was willing to lend dollars to any Indian bank.

This further raised the demand for dollars causing fast depreciation of rupee in the
months of September, October and November 2008. The Indian rupee whose value
had appreciated to Rs. 39.4 for a dollar in Dec. 2007 depreciated to Rs. 49.3 for a
dollar in end-Oct. 2008 and further to all time low of Rs. 50.6 for a dollar in mid-
Nov. 2008.

This depreciation of Indiana rupee though made our exports cheaper, made our
imports costlier. In Oct. and Nov. 2008, crude oil price declined from all time high of
$ 147 per barrel to around 50 US dollar in Nov. 2008 and to $ 40 per barrel in Feb.
2009.

Liquidity Crunch in the Banking Sector:

But the story of impact of capital outflow by FIIs did not end here. As a result of
large outflow of dollars fast depreciation of rupee against dollar began. To prevent
fast depreciation of rupee and maintain relative exchange rate stability, RBI
intervened and supplied dollars from its foreign exchange reserves.

With this too much depreciation of rupee was prevented but in this process of
supplying more dollars in the foreign exchange market, it got rupees in return. As a
result the quantity of rupees with the banking system declined causing liquidity
problem in the Indian banking system which affected credit flow to the industry for
financing of working capital and fixed investment projects.
This problem became so severe that inter-bank credit market was mostly frozen; no
bank was willing to lend to other banks as every bank needed liquidity to tide over
contingencies and this restricted credit flow to the industries. Risk aversion by banks
in India also played an important role in restricting credit flow to consumers for
buying cars, houses etc. and companies for making investment.

Thus the cause of liquidity and credit crunch that arose in India was the sale of
billions of dollars from its reserves by the RBI which withdrew rupees from the
banking system in the process. It is estimated that each sale of a billion US dollars by
RBI sucks around Rs. 5000 crores from the domestic market. The call rates, that is,
rates at which banks lend to each other for a short period rose to all time high of 23
per cent.

Impact on Indian Economic Growth:

When all powerful US economy witnessed slowdown in economic growth and
ultimately experienced recessionary conditions as a result of financial crisis, its effect
spilled over to Europe, Japan and other Asian countries. Britain, Germany, Italy and
15 nations sharing Euro slumped into recession for the first time after several years.

In September 2008 IMF gave the bleak assessment of the global economy whose
growth rate was expected to hit 3 per cent in 2008 and near zero in 2009. In
September 2008. IMF also predicted lower growth of 7.7 per cent for India for the
year 2008-09 which was later further lowered to 7 per cent as against over 9 per cent
growth in the previous 4 years (2004-08).

Our Finance Minister repeatedly assured that despite stock market crash, the
fundamentals of the Indian economy are quite strong and Indian growth story is
quite intact. Prime Minister Dr. Manmohan Singh also expressed the similar views
and said that global meltdown would have minimal effect on India’s economic
growth. However, India’s growth of GDP fell to 6.8 per cent in 2008-09 as against
over 9 per cent per annum in the preceding three years. In 2009-10 and 2011-11, the
Indian economy recovered and its growth of GDP was 8 per cent and 8.6 per cent
respectively.

However, as against the 11th plan target of 9 per cent annual growth, fall in India’s
growth to 6.7 per cent in 2008-09 and 8.0 per cent in 2009-10 will badly affect the
targets of employment generation and poverty reduction. It is true that unlike that of
China, India’s economic growth depends more on domestic demand rather than
external demand and is driven mostly by domestic saving and investment.

However, at present after 18 years of globalisation, our exports constitute 14 per cent
and imports 20 per cent of GDP (2006-07). Therefore, India could not escape from
the adverse consequences of global meltdown. This is evident from industrial growth
during the second half of the fiscal year 2008-09; India’s industrial production (IIP)
registered 4.8 per cent growth in September 2008 and a negative growth of 0.41 per
cent in October 2008 for the first time in 15 years. For the whole year 2008-09 the
growth in industrial production dipped to 3.7 per cent as compared to 10.3 per cent
in 2007-08 and 14.9% in 2006-07.

There was a fall in output of automobile, aviation and shipping industries. Besides,
export-oriented industries such as textiles, leather, gems and jewellery have been
badly hit by the global meltdown and registered a fall in production and employment
opportunities. Agriculture registered 1.6 per cent growth rate in 2008-09 as
compared to 4.7 per cent in 2007-08. There was a very slow growth of 0.4% in
agriculture in 2009-10.

The most adverse consequence of global turmoil was that the growth rate of
manufacturing in India fell to 3.2% in 2008-09 from 10.3 per cent in 2007-08. Not
only did domestic demand come down even export orders fell substantially due to
recession in the developed countries.

The other important causes of slowdown in manufacturing are that banks were not
willing to give credit and lack of adequate power supply and high input costs. It is
worth mentioning that though growth rate of Indian economy slowed down under
the impact of global financial crisis, its estimated growth rate of 6.8 per cent in
2008-09 and 8 per cent in 2009-10 was still quite high in view of the fact that other
countries such as US, UK, Japan, Euro countries, Germany were experiencing severe
recession (that is, contraction in GDP).

In fact, growth rate of Indian economy is second highest in the world next only to
China. However, a matter of serious concern is that employment situation worsened
in the fiscal year 2008-09. There were large scale losses in jobs in the sectors like
textiles, metals, leather and jewellery. With slowdown in economic growth in India
unemployment in India also went up.
Another matter of concern is that due to large increase in government expenditure to
pull the economy out of recession and slow growth of agriculture, inflation rate as
measured by CPI rose to more than 11 per cent in 2008-09. Besides there has been
severe food inflation which in Feb. 2010 went up to around 20%. In 2009-10 and
2010-11 food inflation spilled over to manufactured products as well. Rate of
inflation based on CPI (for industrial workers) went up to 9.1% 2008-09, 12.4 in
2009-10 and 11% in 2010-11.

Exports and Balance of Payments:

As a result of globalisation and the adoption of export-oriented strategy of growth in
place of import substitution, the Indian economy now depends to a greater extent on
external market to sell our goods and services. In 1990-91 we exported goods to the
tune of 5.8 per cent of GDP whereas in 2006-07 our exports of goods rose to 14 per
cent and our imports to 20 per cent of our GDP.

Our foreign trade balance worsened during 2008-09. India’s foreign trade balance
registered a deficit of $ 60 billion in the first half of 2008-09 as against $ 30 billion
in the first half of 2007-08. Actually, our exports in Oct. 2008 were not just down
but declined 12.8% as compared to the same month of the previous year 2007.

This negative trend continued in the remaining years of 2008-09. As a result, our
target of exports of 200 billion US dollar for 2008-09 was revised downward to $
175 billion. Actually, growth of Indian exports in 2008-09 was around $ 170 billion,
much short of the original target. Due to global financial crisis the growth of our
exports were bound to decline as a result of recessionary conditions in the US and
the European countries.

Besides, due to sharp depreciation of rupee during 2008-09, our imports also costed
more despite the fall in international commodity prices and crude oil. Hitherto our
export growth was bolstered by rising commodity prices and yet strong demand
from emerging markets and oil producing countries.

All such contributory factors are no longer there. In 2008-09 and 2009-10 deficit in
our balance of payments on current account went up to 2.4% and 2.9% of
GDPmp respectively. However, beginning from Nov. 2009, there has been positive
growth in our exports indicating recovery in the world economy, especially in the US.
However, due to high growth in imports our current account deficit has gone up.
CONCLUSION AND SUGGESTIONS:
India has been hit by the global melt down, it is clearly due to India’s rapid and growing
integration into the global economy. The strategy to counter these effects of the global crisis on
the Indian economy and prevent the latter from any further collapse would require an effective
departure from the dominant economic philosophy of the neo liberalism. The first such departure
should be a return to Food-First doctrine, not only to ensure food security of the large population
but also due to the fact that food production will be more profitable given the current signs of a
shrinking market for export oriented commercial crops. The other important initiative that needs
to be adopted is the building of institutions based on the principle of cooperation that will
provide an alternative frame work of livelihood generation in the rural economy as opposed to
the dominant logic of markets under capitalism. Institutions like cooperative markets and credit
cooperatives can go a long way in addressing the lack of economically viable producer prices
and loaning credit availability for economic activities in the primary sector. Such an alternative
policy to tackle the consequences of the financial crisis will require effective Keynesian policies
in the form of increased public expenditure at the rural and urban infrastructure. We see that
government’s engagement generally arrives very later to solve the financial crisis by which time
many financial firms are near insolvency. This generates larger cost for the economy and
exchequer. Our key goal today should be to avoid these costs through rapid action. The need of
today is not just the pumping of liquidity in to the Indian economy but also in addition the
injection of demand. This can occur only through direct fiscal action by government. In India,
larger government expenditure has to be oriented towards agriculture, rural development, health,
human resources and infrastructure to make inclusive and balanced growth. The biggest
challenges before India are to ensure monetary and fiscal stimuli work, returning to fiscal
consolidation, supporting drivers of growth and managing policy in globalizing world. There is
also need to study the viability of fiscal stimulus in India and economic policy makers should
shift their attention from crisis management to providing the basis for a return to fast growth.
Over the next year, sources of growth should shift to manufacturing and possibly a recovering
agriculture. No doubt, India has come back to high growth but this new growth should have to
come not from some new speculative bubble but from enlarged government expenditure that
directly improves the livelihoods of the people and that is geared towards improving the
production of food grains through a changing of peasant agriculture and not through corporate
farming since that would reduce purchasing power in the hands of the peasantry and perpetuate
its distress. In short, the new paradigm must entail infrastructure and food grain-led growth
strategy on the basis of peasant agriculture sustained through larger government spending
towards the agriculture and rural sector, which can simultaneously sustain the growth and
remove the food crisis in India.