Sunday, August 14, 2011

How did India escape the global recession of 2008?


Everyone these days is talking about economy. Ever since the world markets crashed and the US rating went down from AAA to AA, it has been a matter of growing concern. Two countries which continue to prevent the whole world falling into recession include India and China.

Even now Brazil, Chile and many countries are learning from India how to manage capital flows (international money flowing into markets). India truly went beyond the regulated norms of IMF (international monetary fund) to use a variety of techniques in tandem to prevent a collapse. This is a fact that India was chosen as one of the top contenders for G-20 - a forum where developed countries wanted the inputs from developing countries like India and China to help in their revival. Let us feel proud as Indians on this Independence Day despite all the complaints we have from our corrupt politicians. We continue to grow!!!

How did India escape the recession in 2008 when the mighty US and Europe fell like a deck of cards? 

The answer is not simple and I have tried to answer in a simple manner in this article.

Prior to 2007, the global liquidity was very high. Cash was surplus and money was flowing into emerging markets quite rapidly because the return of investment was quicker especially in India and China. India was growing since 2000 when the Vajpayee led NDA government brought in huge reforms leading to 6% growth unseen in the earlier years.  The country was expanding and was giving higher returns on investment from foreign countries. Then came the Congress led UPA Government. When UPA govt introduced National Rural Employment Scheme (NREGS), it brought cash into the hands of the unemployed; sufficient enough to buy pulses, simple clothes and many more. Although there is corruption in the implementation of NREGS it truly added life to the rural economy.

Remember: India saves 33% of its earnings compared to 40% w.r.t Chinese and 1/5th of what India produces is only exported. The rest is used for domestic consumption. This is a unique economy unlike China which heavily survives on exports. However, even when export demand crashed, China continued to grow (still growing) as it is spent huge amounts in infrastructure in its own land. 

The Indian economy was such that it was heavily dependent on domestic banks for its fiscal needs. This was the case till 2005-06. From the late 2006 large parts of govt funding began to come from these foreign investments which directly come as cash or investment like FDI (Foreign Direct Investment). This was the reason that Govt's foreign exchange reserves came to more than 30 billion$  to around 300 billion during that time. But in any emerging market this capital has to be controlled because if this depletes suddenly, the govt will have nothing to fund its own programmes. 

The Indian debt market (the market in which the investor gets Govt Bonds in return for investment - the largely dominant debt market component) has been till now restricted enabling both the Govt and the central bank (Reserve Bank of India - RBI) to manipulate as per the needs instead of a free flow. This is perhaps the biggest macroeconomic feature India has. If the debt market is allowed unhindered the capital accumulation can be very high and the RBI would not be able to control this. 

In other words to summarize things explained in the previous paragraph it means there is a limit on the extent and the amount to which bonds can be issued by RBI on behalf of the govt. Just because a foreigner wants to invest in return for a bond doesn't simply get to do this. Also, the corporates across various sectors cannot borrow how much ever money from international market. 

No one knows if India has the capability to completely go to a system where such limits do not exist. But by restricting so, RBI can control both exchange rate (the rupee-dollar rate fluctuation) and price stability (where the inflation and deflation - neither of them happens over a certain time and prices remain stable).

Given this scenario in early 2007, due to rising capital in the market the RBI resorted to further cap the inflow, restricted overseas borrowing for corporates beyond a certain amount. The central government disposed off huge amounts as loans in a regulated manner to people (education loans, home loans, auto loans etc) which spurred the domestic growth further. That is why from 2005-07 the growth rate was close to 9% in addition to rising incomes. 

After disbursing a huge amount of its reserves as loans, RBI stopped further easy lending of loans by hiking interest rates. At the same time the govt sterilized huge sums of money through 

a) Market Stabilization Bonds (this is a mechanism by which excess dollars will be absorbed by the RBI. RBI  in return will inject the equivalent Indian rupees in the market. If these rupees continue to flood, RBI would sell Govt bonds and the money raised would be given to government to fund its fiscal needs and the govt would have to pay interest on it to RBI). Market Stabilization Bonds is truly a new thing implemented in India.
b) increased the cash reserve requirements for banks (banks need to maintain cash as reserve and not spend it as loans).

Despite this the surge continued even further. In mid 2007, the RBI raised interest rates after seeing an overheated economy. Adding to rising interest rates there was a huge inflation already because of govt's mismanagement of food distribution ( a problem that plagues India till date).

RBI''s options were so less to contain this money flood. Economics is not physics as explained by RBI Governor (Subbarao in a speech. Click here). Unlike physics where human influence doesn't change underlying facts, human behaviour can definitely impact an economy and again it is humans who have to act to control it. 

By mid 2007 the trade and financial integration of Indian economy with the world had gone deeper. 

RBI could have easily allowed the rupee to appreciate but it could not do so as exports could be hurt. It could not lower interest rates as it would have overheated the economy. The only thing it then began to do was some out of box thinking like imposing further caps over overseas borrowing (loans above the limit had to be left overseas itself), prohibited foreign currency conversions into rupees and many more as explained in this detail paper. IMF provides a lot of guidelines to help countries in this regard, but India's case was very unique. So, RBI had to resort to some extra ordinary actions.

All these steps prevented a collapse of the Indian economy during the great global recession in late 2008. It only shows how RBI acted like a great watchdog. However, the fact that should not be underestimated is that our growth rates slipped to 6% during that time and our exports which grew by 25% during 2005-08 dropped to 12% eroding lots of money from the middle and poor people involved in these.  

In addition to these the corporates who were getting easy international loans had to resort to domestic banks for survival and expansion. This was all in addition to stock market crashes even in India where thousands of crores were withdrawn from the market. 

Post 2008, Indian economy began to grow mainly because of domestic consumption again and govt's stimulus which cushioned the exporters against heavy losses. Due to increasing spending on national highways, new projects to increase electricity generation, higher incentive on manufacturing, increasing number of IT presence of MNC's, growing auto sales and many more Indian economy showed a robust growth of 6% better than growth rates of the West.

How is the economy now in 2011? What lies ahead?

The answer to this question also is not too very positive(Click here). The inflation continues to grow alarmingly. The govt totally is not initiating any reforms to improve the supply side of food. The UPA-2 seems to be caught in enough scams and misgovernance that it has stopped functioning. Already there is slowdown in industrial growth and infrastructural growth and this is slowing down the economy to below 6%. We are still doing better than Europe and the US, but we can do much better to compete with Chinese economic growth.

Hope the sense of judgement prevails and the govt would initiate the much needed Land Acquisition Act which is badly needed for a desperately growing India.

Jai Hind!!