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Researchers in the Macro Unit at ICRIER have been developing the model of leading economic indicators to try and forecast India's GDP growth. The latest results from this exercise were published in an early December issue of Business Standard. This paper attempts to further extend our GDP forecast until the end of 2009-10 and also provides an analysis of recent trends in the Indian macroeconomic situation. The structure of the paper is as follows: The next section initially describes the changes in India's external environment. It also examines the nature and intensity of the on-going global economic downturn by looking at recent trends in world economic growth, global trade and financial flows and the collateral damage that has been caused in major emerging economies. Section 3 then provides an analysis of past crises that India had undergone and also the recent trends of the Indian economy before and after the onset of the global downturn. Section 4 examines the policy response to the downturn and points out its strengths and weaknesses. Sections 3 and 4 thus provide the context for the growth forecast included in this paper. The penultimate section outlines the methodology of the leading economic indicators analysis and provides the forecasts for 2008-09 and 2009-10. Finally, section 6 contains policy suggestions for India to recover from the current slowdown and resume sustained high and inclusive growth in the medium term.
2. Global Economic Downturn
The extraordinary financial crisis in the US has spread to Europe and Japan and is likely to see most developed economies suffering a prolonged period of recession that could extend beyond 2009 and according to some even beyond 2010. The financial crisis in the US started in the latter half of 2007, with the so-called sub-prime housing mortgage crisis. As is by now well established, 1 the crisis had its real roots in hugely excessive leveraging by investment and commercial banks, under-pricing of risk and lack of necessary regulatory oversight. The busting of some of the big financial institutions has created an atmosphere of lack of confidence. This in turn has near completely clogged the flow of credit in the system. The banker's adage that 'it's not the speed that kills, it's the sudden stop' fits the present precarious situation quite well. The impasse seen in the credit flow has had a direct impact on investment and consumption and has taken a massive toll of the real economy. The morphing of the 'Wall Street crisis' in to a historical 'Main Street crisis' has led to the majority of OECD economies sliding into deep recession. And it is not yet clear as to when the bottom of this recessionary slide will be reached. This causes a further loss of confidence.
The enormity of the situation can be sensed by looking at some numbers. The IMF has re-estimated that the losses for financial institutions on account of US-based mortgage loans (the so called sub-prime loans) and securities may rise up to US$ 2.2 trillion (last estimate in October 2008 was US $ 1.4 trillion) [IMF, 2008a and 2009a]. The total funds made available by the US government and the Federal Reserve so far under the various rescue programs have already amounted to a whopping US$ 7.5 trillion or more (James Barth, 2008). In addition, the loss of market capitalization can be gauged from the sharp fall in stock market prices both in mature and emerging economies. The loss of wealth this represents is bound to adversely impact global demand for a prolonged period. This year in the Forbes list of billionaires the total wealth registered was 2.4 trillion U.S. dollars, down from 4.4 trillion last year, reducing more than 45 per cent and marking the worst reading since Forbes began compiling the list.
This acute financial crisis resulted in a sharp slowdown of global GDP growth rate (Fig. 1). The acuteness, unpredictability and speed of the economic downturn can be gauged by the frequent downgrading of forecasts by the IMF. An IMF assessment in early November 2008 has projected that the world output would grow by 2.2 per cent in 2009 as compared to 3.4 per cent in 2008 and 5.2 per cent in 2007 (IMF, 2008b and 2009b). This has been revised in January 2009 to as low as 0.5 per cent and there is talk of the global GDP actually contracting in 2009 if major emerging economies are unable to compensate for the massive loss of external demand . Projections by the IMF in November 2008 for advanced economies had estimated a contraction of around 0.3 per cent in 2009. This has been revised downwards in January 2009 to around 2.0 per cent. This is the first annual contraction for developed economies taken together since World War II. The World Bank had projected in early December 2008 that world trade will contract by 2.1 per cent in 2009, the first time since 1982 (World Bank, 2009). The IMF in January 2009 has revised it downwards to 2.8 percent. The decline in exports in some major economies in the third and fourth quarters of 2008 has been simply stunning. In January 2009, exports fell sharply in Japan by 46.3 per cent, in Germany by 20.7 per cent, China by 17.5 per cent, in India by 15.9 per cent and in UK by 6.7 per cent.
3. Indian Economy: Past Crises and Recent Developments
3.1 Past Crises
Using an averaging process of past crises as done in the seminal study of Reinhart and Rogoff (2008) we try to see the impact of the present global crisis on the nature, severity and duration of the economic downturn in India. The past crises that have been considered are the three major crises - 1991-92 balance of payment (BOP) crisis; 1997-98 fallout from the Asian financial crisis; and 2000-02 crisis caused by the worldwide bursting of the dotcom bubble and 9/11 incident.
Quite expectedly, the sequencing of the crisis and the transmission mechanism are different in developed and developing economies. In the developed world the crisis originated in the financial sector and then impacted the real economy. The Swedish and Norwegian crises of the nineties and the present crisis in the US followed this sequence. For developing economies in the current crisis the causality and sequencing generally runs the other way, with the real sector being hit first and the financial sector thereafter. The pattern was of course different in the Asian financial crisis of the later nineties when the crisis also originated in the financial sectors of Asian economies. In line with this trend, in each of the cases of external shock, the real sector of the Indian economy has been initially impacted by the crisis as its banks are considered safe and robust . Exports and foreign trade overall have been the first to be impacted and act as the channel for the external crisis to be transmitted to the Indian economy.
The chart below shows the average of annual exports growth rates during the three major crises that India has suffered since the end of eighties. The period that has been selected is three years before and after the worst hit year of the crisis. In the past times of crisis, we find that the export growth declined by 12 percentage points during the crises period. But quite fortunately for the export sector, it recovered within a year of the slump in all the three major crises. Now, the sudden recovery of the exports sector can be attributed to the fact that huge depreciations were charged during the crisis period.
On the other hand if we look at the imports we find that the slump is for a longer duration. As we can see from Fig. 4b, import growth starts falling two years prior to the crises. The fall in import growth, unlike the export growth, during all the three major crisis seasons is greater than the fall seen in export growth. The import growth declined at an average of 14 percentage and recovered in times longer than that for exports. The reason can be attributed to the fact that sharp depreciation during the crisis period makes the imports more expensive, hence, leading to their prolonged slump. The recovery in the case of imports is longer i.e. for around a period of two years as compared to exports wherein the time taken is just one year. As they say "Time doesn't spare anybody", during the present crisis i.e. 2008-09, the growth in exports and imports has started receding in September and October 2008 respectively.
In the earlier crises the manufacturing sector also was negatively impacted. For example during the BOP crisis of 1991-92, the index of industrial production (IIP) grew at just 0.6 per cent. Industrial production has also weakened during the present downturn. IIP growth for the period, October to December 2008, averaged 0.4 per cent. In the month of January 2009, IIP registered a negative growth of around -0.5 per cent. As can be seen from the average of past crises, IIP growth in the peak year of the crises has fallen by an average of 3 percentage points, year on year (Fig. 5a). In the present global downturn, manufacturing has virtually collapsed. In India's case it is not yet clear if the trough of the industrial cycle has been reached and hence it is difficult to forecast the trend for the recovery.
Finally, in the case GDP growth we find it falling by about 3 percentage points during the peak crises year (Fig. 5b).
3.2 Indian Economy: Recent Developments
India had been growing robustly at an annual average rate of 8.8 per cent for the past five years (2003-04 to 2007-08). This was higher than the potential growth rate of output as estimated both by the IMF and OECD (See IMF, 2007 and OECD, 2007). The strong Indian growth story, based on its structural strengths of a young population, skilled manpower, rising savings and investment rates, large unfulfilled domestic demand and globally competitive firms attracted significant investor attention in recent years. Analysts have predicted that by the year 2025, India would be the third largest economy in the world after China and the US. Recent high rates of economic growth have been the result of high levels of investment, rise in productivity supported by technological up-gradation and greater integration with global flows of trade, finance and technology. The challenge is to sustain these high growth rates while also preventing an unacceptable rise in income and spatial inequities and also eliminating absolute poverty in a given time frame. The answer to this challenge is in raising India's potential rate of output growth by removing the binding constraints. We have also estimated the potential growth rate for India during the last decade based on HP filter technique (Hodrick and Prescott, 1997) and found that in the last three years, India had been growing above its potential growth rate (Fig. 6)
Fears of over-heating of the economy prompted the Reserve Bank of India (RBI) to begin monetary tightening as early as September 2004 when the cash-reserve ratio (CRR) for commercial banks was raised. The sharp increase in global fuel and food prices in the first quarter of 2008 aggravated inflationary concerns and resulted in further monetary tightening that saw interest rates being hiked until August 2008. This was clearly a case of policy running behind the curve and consequently over-compensating in its attempt to weaken inflationary expectations. Expectedly, this amount of monetary contraction resulted in a slowing down of the economy with the GDP growth coming down to 7.8 per cent during April-September 2008 from 9.3 per cent in the same period of 2007.
The global financial sector meltdown precipitated by the collapse of Lehman Brothers in September 2008 and the subsequent virtual nationalization of AIG, the world largest insurance company, impacted India at a time when the economy was already in the midst of a cyclical slowdown. The immediate transmission of the financial crisis to India was through a cessation of credit flows which was reflected in the spiking of overnight call money rates that rose to nearly 20 per cent in October and early November 2008 (See Fig. 7). Spooked by market rumors and some circumstantial evidence, depositors sought safety by shifting their deposits away from private banks to large public sector banks as reflected in the State Bank of India (SBI) seeing an increase in deposits of more than Rs. 1000 crore per day during that period. Foreign institutional investors (FIIs) withdrew from the Indian markets to provide the much-needed liquidity to their parents in the US or Europe. This resulted in a net repatriation of about $ 13 billion by the FIIs in 2008 on account of equity disinvestment though small has resulted in a sharp decline in equity prices and market capitalization. Besides, there had been large-scale redemption of holdings with mutual funds which put further pressure on liquidity. Thus, while the Indian banking sector remained largely unscathed by the global financial crisis, it could not escape a liquidity crisis and a credit crunch. This in turn has had its impact on investment and consumption and the real economy.
Thus, the present global crisis has already begun affecting the Indian economy. With the sharp fall in oil and other commodity prices, inflation fears have receded. The year- on-year inflation rate has already come down to 2.4 per cent in the week ended 28 February 2009 from the peak of 12.9 per cent for the week ended 2 August, 2008. This does not fully reflect the actual softening of prices in the last few months, which is better seen by looking at month-on-month price changes (See in the next section). The significant decline in prices is worth noting as it presents policy options that could be missed otherwise.
4. Causes of the global meltdown in 2008-09
4.1 Impact of Monetary Tightening
Price stability, strongly anchoring inflationary expectations, promoting growth and maintaining financial stability are the avowed objectives of Indian monetary policy. The tolerance limit for the purposes of monetary policy for inflation in India is considered to be at about 5 per cent. Inflation in India has been at moderate levels as compared to other emerging economies but during 2003-04 the wholesale price index
(WPI) inflation crossed the 6 per cent mark (Fig. 9).
In response to the rise in inflation, the RBI, with its hawkish stance on inflation, and faced with an overheating economy, started monetary policy tightening as early as September 2004 when the CRR was raised from 4.5 to 5 per cent in two steps. As the inflationary situation worsened in the subsequent period the tightening got harder as
shown in Fig. 9. With headline inflation crossing double digits first time in the second week of June 2008 and reaching 11 per cent primarily due to the abnormal hike in global fuel, food and commodity prices, the RBI continued with further monetary tightening. The last set of measures to cool the economy was announced at the end of August 2008. The RBI, ostensibly in response to global oil prices crossing $147 per barrel and domestic year-on-year inflation reaching 12.9 per cent raised the CRR by 25 basis points to 9 per cent. As several critics pointed out, the tight monetary policy stance was provoked principally to compensate for the fiscal expansion that originated with the 2008-09 budget. But the RBI perhaps overlooked that price trends, as reflected in the month-on-month changes had begun to head southwards since end of September 2008. The economy had already slowed down before the onset of the global crisis on account of the measures taken since the latter half of 2004.
The effects of monetary policy are subject to long lags and the full impact of the progressive tightening that continued until August 2008 is still to fully work itself out. However, the contractionary impulses generated by the tightening undertaken until August 2008 are now being countered by the expansionary impact of monetary policy relaxation that started in the latter half of October 2008.
4.2 Industrial Sector Weakness
Fig. 11 plots the 12-monthly moving average of growth rates in the index of industrial production (IIP) from September 1982. This shows that industrial growth is characterized by prolonged periods of downturns. We had two previous downturns since the early 1980s: the first one in the early 1990s lasting 33 months and the second one since the mid-nineties lasting a longer 71 months. The first downtrend that happened in the early 1990s was on the back of the external payment crisis whereas the second downtrend coincided with the East Asian crisis. The recent downturn started since May 2007 and by December 2008 has already run for 20 months was preceded by the longest upward industrial cycle during which the IIP growth rate improved almost continuously for 64 months. Underlying the beginning of theslowdown is the hardening of interest rates since March 2007 in the wake of the tightening monetary policy. The second quarter year-on-year IIP growth in the current year (Q2 2008-09) has dropped to 4.7 per cent from 5.3 per cent in the first quarter. In Q3 2008-09, the growth rate had turned to just 0.4 per cent. In January 2009 the growth rate turned negative at -0.5 per cent. The downturn is turning severe and would be prolonged due to the global crisis.
4.3 Investment Weakness
The major drivers of India's high growth rate in the last five years have been investment and private consumption. As we can see from Fig. 13, the rate of growth in gross fixed investment more than doubled from about 7 per cent during 2001-03 to about 16 per cent during 2003-07. Growth in private final consumption also rose from about 5 per cent during 2001-05 to about 8 per cent during 2005-07. Private consumption growth has slowed down since Q3 2007-08, and the growth in fixed investment has continuously fallen since Q2 2007-08 with some pick-up just in Q2 2008-09. Government final consumption expenditure which normally is subject to wide swings has shown some reasonable growth in recent quarters and substantially so in Q3 2008-09.
The financial crisis in the US and the consequent recession in major developed countries have altered investment sentiments in India. The investment weakness which had already begun in India in the second half of 2007-08 has further worsened
4.4 Fiscal Measures
Fig. 14 provides a synoptic view of fiscal trends from 1990-91, the year in which India confronted its gravest economic crisis. There has been a steady improvement in central and state finances since 2001-02 when the fiscal and revenue deficits of the combined central and state governments reached a peak of 9.9 per cent and 7.0 per cent of GDP respectively.
Fig: 13 Fiscal indicators of the combined centre and the state
There was some deterioration in the central government finances in 2005-06 but these improved in 2006-07. The fiscal consolidation by the states has also been quite significant in recent years.
The central government budget for the current year 2008-09 targeted a further improvement in the fiscal situation. However, several leading experts and economists have conclusively pointed out the gross underestimation of fiscal deficit in that budget. The Interim Budget, released in February 2009, has now disclosed a huge rise in financial deficit of the central government to 6 per cent of GDP in 2008-09 from 2.7 per cent in 2007-08.
The table given below summarizes the trends of the budget as presented in the Interim Budget 2009-10. The fiscal deficit in 2008-09 got worsened from the budget estimates which was due to an increase in the expenditure of Rs. 150,069 crore (2.8 per cent of GDP) and a decline in the revenue of Rs. 40,762 crore (0.75 per cent of GDP). The financial burden which arose from financial stimulus packages (including both revenue fall and expenditure increase) amounted to Rs. 40,700 crore constituting just 0.75 per cent of GDP. Thus, besides the fiscal deficit of 3.5 per cent of GDP from the budget estimates, the bulk of it, i.e., 2.8 per cent of GDP has not been due to fiscal stimulus packages.
Table 2: Central Govt Budget 2009-10 (Rs iin Crores)
The estimates given above do not take into account the non-budgetary items of oil and fertilizer bonds which are estimated to be around Rs. 95,942 crore, which is equivalent to 1.8 per cent of GDP. For the fiscal year 2007-08 which was a year before the crisis struck, this amounted to Rs. Nineteen thousand four hundred and fifty three crore or around 0.4 per cent of GDP. Thus including these non-budgetary items, the fiscal deficit at the centre, in 2008-09, would be 7.8 per cent of GDP as compared to around 3.1 per cent of GDP in the fiscal year 2007-08. More than doubling of the deficit and largely, arguably, on account of political electoral considerations as it was generated prior to the eruption of the global crisis in September 2008. The fiscal deficit of the states taken on the whole is expected to be over 3 per cent of GDP in 2008-09 against the budget estimates of 2.1 percent. Considering the additional borrowing of Rs. 30,000 crore for the financial stimulus package and the likely shortage in tax revenues, the combined overall fiscal deficit would be around 11 per cent of GDP in 2008-09 as against 5.4 per cent in 2007-08.
5. Policy introduced in response to the Economic Slowdown
5.1 Monetary Policy Measures
Before the spread of the global crisis, rising inflation was one major downside risk for the Indian economy. But the fall of prices of oil and other commodities and overall fall in demand as a result of recession in major developed countries has pushed down the rate of inflation in India. Inflation measured by the wholesale price index (WPI) had peaked at 12.9 per cent in early August 2008 and has been coming down since then. WPI inflation dropped to 4.4 per cent by 31 January 2009 and just 2.4 per cents on 28 February 2009. Monetary policy shifted gear and became expansionary from October after the scale of the US financial sector meltdown and its likely adverse effects on the Indian economy became evident. The policy focus has shifted from containing inflation to promoting growth. The RBI thus acted with considerable alacrity in infusing considerable liquidity in to the system.
Falling inflation, a positive byproduct of global crisis, enabled the central bank to loosen monetary policy more aggressively. As indicated earlier, the RBI lowered the cash reserve ratio (CRR) requirements of banks from 9 per cent to 5 per cent, statutory reserve ratio (SLR) requirements from 25 per cent to 24 per cent and the repo rate (the rate at which it lends to banks overnight), from 9 per cent to 5 per cent and reverse repo rate (the rate at which RBI borrows from banks) from 6 per cent to 3.5 per cent. It also opened a special window for banks for short-term funds for on-lending to mutual funds, NBFC's and housing finance companies. It has also started the buy-back of the market stabilization scheme (MSS) securities from mid-November. RBI has opened a refinance facility to Small Industrial Development Bank of India (SIDBI), National Housing Bank (NHB) and EXIM Bank and a liquidity facility to NBFCs through a SPV. It also has opened a dollar swap arrangement for banks for their overseas operations. The actual or potential liquidity injection under all these measures has been estimated at Rs. 3,88,045 crore equivalent to over 7 per cent of GDP (Table 5).
This is indeed an impressive slew of monetary policy measures and shows that the RBI is both watchful and active. The present problem is that this additional liquidity seems to have either found its way into a build-up of bank deposits or been preempted by government borrowing. There is hardly any evidence that it has been used for boosting either investment or consumption demand.
The liquidity crisis and credit crunch felt in the economy from mid-September to October 2008 has turned into a situation of deep demand contraction for bank finance as the effects of global recession has spread to India. In fact the expansion of bank finance in January 2009 has been negative at Rs.11, 218 crore as against an expansion of Rs. 70,396 crore in the same month of 2008 (Fig. 18). In the last four months from November 2008 to February 2009, expansion of bank finance to the commercial sector has been just Rs. 60,862 crore as compared to Rs. 2,36,227 crore in the same period last year. This reflects a very soft investment sentiment in the economy which may persist in the coming months.
5.2 Fiscal Stimulus
Due to the acuteness of the financial crisis and the ineffectiveness of monetary policy, governments across the world have announced various fiscal stimulus packages to counter the crisis. In terms of GDP, South African government has announced the biggest stimulus package that constitutes around 24 per cent of GDP (Fig. 19). The second biggest stimulus package has been announced by the Chinese government which constitutes 16.3 per cent of GDP with a total amount of around US$ 586 billion. In absolute terms, the US fiscal stimulus is the largest with an amount of US$ 787 billion. However, these fiscal numbers do not provide the real estimate of total stimulus as guarantees are not included in these calculations nor automatic stabilizers provided in certain countries. The Indian government's fiscal package is small in magnitude constituting around 1.3 per cent of GDP for 2008-09. This seems to be quite small as compared to most of the countries. But as has been reiterated earlier there is less fiscal headroom in India which is already running a high public debt.
6. Conclusion and Policy Suggestions
The Indian economy was on a cyclical slowdown after a five-year record boom and there was every hope that the economy will go for another strong growth phase after this brief slowdown. The global crisis has changed this very outlook and will instead deepen and prolong Indian economy's slowdown. The policy response has been prompt, by far, and to the point in the form of easing monetary policies, laws and regulations and fiscal expansion but the impact may not be much in the near term. A major worry is the severe weakening of India's fiscal position and balance of payments during this crisis period. The basic question that still lingers is how much time it will ta ke to re vive the invest ent and consumer de mand which are falling apart like anything.
Fiscal and monetary steps to expand at a time of extreme uncertainty like was there during the worldwide meltdown will have limited impact. On the other hand, the sharp reversal of the steady fiscal improvement over the past five years or so would weaken public finances considerably and store up problems for the economy sooner than later. The objective of economic policy must be to maximize on gains from global integration while causing a reduction in poverty and inequities. Therefore, a better way to respond to the present crisis is the often repeated and now become cliché of triggering the "second round of reforms" which is long overdue. India has to considerably relax its "permit and approval" system by any manner they could carrying. One way could be to chalk out procedural reforms which will soar up the investment climate for both domestic and foreign investment. It should introduce reforms in its education system at both the school and university levels, it should carry out reforms in agriculture at its various stages i.e. from input to output through marketing. The government should be a bit more rigid and proactive in changing policies and procedures to reach anywhere near the champions that are already blooming all around the world and building world class infrastructure of power, roads, ports, airports, urban infrastructure, water and sanitation. Reforms in areas like India, where situations are tough, would be much more effective.
The real challenge for Indian policy makers and India Inc. is however to try and raise the share of India's exports in major markets and product segments. It is really ironical that India's share in world trade is lower than the level as in 1950!! This is not tenable any longer if we have to achieve rapid growth with equity. Exports have the desirable characteristic of being relatively labor intensive. This is especially true of services exports that include a wide range of exports such as software, tourist earnings, films, accountancy, legal services etc. On the other hand, there is hardly reason for our textile and garment exports to loose grounds, as they have been doing, to Bangladesh, Vietnam and other such smaller economies when we still have such a large pool of unemployed human resources. For pushing both services and labour intensive manufactured exports, the policy makers must pay much greater attention to labour market reforms on the one hand and to development of vocational skills on the other.