Global Financial Crisis And Its Impact On The Indian Economy

GLOBAL FINANCIAL CRISIS AND ITS IMPACT ON THE

INDIAN ECONOMY

“In a time of crisis we all have the potential to morph up to a new level and do things we never thought possible” – Stuart Wilde

Shradha Diwan, IBS Kolkata, Class of 2010

Global Financial Crisis and its impact on the Indian Economy

Author:

20TH MAY, 2009

Shradha Diwan 08 BS 000 3170 IBS Kolkata Class of 2010

Organization: INSTITUTE OF INTERNATIONAL TRADE, KOLKATA

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Shradha Diwan, IBS Kolkata, Class of 2010

Authorization

―This report is submitted as a partial fulfillment of the requirement of MBA Program at IBS, Kolkata.‖

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Shradha Diwan, IBS Kolkata, Class of 2010

Acknowledgements I would like to express my heartfelt gratitude to Dr. D.R. Agarwal, Director, Institute of International Trade, for giving me the opportunity to work with the organization, and for being my guide and mentor during the tenure of my internship at the Institute.

I would also like to take the opportunity to thank Mr. Anurag Agarwal, Director, Board of Studies, Institute of International Trade, for the valuable advice, inputs, and support he has given me during the composition of this report.

I am grateful to Dr. Rachana Chattopadhyay, my faculty guide at ICFAI Business School (IBS), Kolkata, for her constant guidance and encouragement during the entire tenure of the Summer Internship Program.

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Table of Contents 1.

EXECUTIVE SUMMARY .......................................................................................................................... 7

2.

INTRODUCTION ..................................................................................................................................... 9

3.

UNDERSTANDING BUSINESS CYCLES .................................................................................................. 12

4.

BACKGROUND OF THE CRISIS ............................................................................................................. 13

5.

CAUSE OF THE CRISIS: The Financial Crisis: How it happened ............................................................ 14

6.

IMPACT OF THE CRISIS ........................................................................................................................ 16

7.

INDIA AND THE FINANCIAL CRISIS ...................................................................................................... 19 7.1.

Global Liquidity Crunch and the Indian Economy ....................................................................... 20

7.2.

Decreased Consumer demand affecting exports........................................................................ 23

7.3.

The Financial Crisis and the Indian IT Industry ........................................................................... 25

7.4.

The Financial Crisis and India’s Financial Markets: ..................................................................... 28

8.

BAIL-OUT PACKAGES AND RBI INITIATIVES ......................................................................................... 32 8.1.

9.

India’s response to the Crisis .................................................................................................. 33

OUTLOOK FOR THE INDIAN ECONOMY............................................................................................... 35

10.

LIMITATIONS OF THE STUDY ........................................................................................................... 37

11.

ENTREPRENEURSHIP IN TIMES OF FINANCIAL CRISIS ..................................................................... 38

11.1. 12.

Early-Stage Entrepreneurial Activity Rates and Per Capita GDP ............................................. 41

REFERENCES .................................................................................................................................... 42

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List of Illustrations Figure 1: Business Cycles; Source: Seguin Financial Group ........................................................................ 12 Figure 2: Ratio of Gross Domestic Savings to GDP ..................................................................................... 21 Figure 3: Ratio of Gross National Savings to GDP ....................................................................................... 21 Figure 4: Source- Ministry of Communications and Information Technology, Govt. of India .................... 25 Figure 5: Source- Ministry of Communications and Information Technology, Govt. of India .................... 25 Figure 6: Foreign Exchange Reserves held by the RBI. Source: The Hindu BusinessLine .......................... 29 Figure 7: Rupees per US Dollar; Source: The Hindu BusinessLine .............................................................. 29 Figure 8: Sensex Daily Movements; Source: The Hindu BusinessLine ........................................................ 29 Figure 9: Foreign Investment; Source: The Hindu BusinessLine ................................................................. 30 Figure 10: Cumulative FII Investments in Equity; Source: The Hindu BusinessLine ................................... 30 Figure 11: FIIs and the Stock Market; Source: The Hindu BusinessLine ..................................................... 31 Figure 12: Foreign Investment and Change in Reserves; Source: The Hindu BusinessLine ....................... 31

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1. EXECUTIVE SUMMARY The world economy is engaged in a spiraled mortgage crisis, starting in the United States, which is carving the route to the largest financial shock since the Great Depression.

A loss of confidence by investors in the value of securitized mortgages in the United States was the beginning of a financial crisis that swept the global economy off its feet. The major financial crisis of the 21st century involves esoteric instruments, unaware regulators, and nervous investors.

Starting in the summer of 2007, the United States experienced a startling contraction in wealth, triggered by the subprime crisis, thereby leading to increase in spreads, and decrease in credit market functioning. During boom years, mortgage brokers, enticed by the lure of big commissions, talked buyers with poor credit into accepting housing mortgages with little or no down payment and without credit checks. Higher default levels, particularly among less creditworthy borrowers, magnified the impact of the crisis in the financial sector.

The ability to raise cash, i.e. liquidity, is an essential component for the markets and for the economy as a whole. The freezing liquidity has closed shops of a large number of credit markets. Interest rates had been rising across the world, even rates at which banks lend to each other. The freezing up of the financial markets eventually lead to a severe reduction in the rate of lending, followed by slow and drastically reduced business investments, paving the way for a nasty recession in the overall economic state of the globe.

A collapse of trust between market players has decreased the willingness of lending institutions to risk money. The bursting of the housing bubble has caused a lot of AAA labeled investments to turn out to be junk. Nervous investors have been sending markets plunging down. Markets all over the world including those of Britain, Germany, and Asia, had to confront all-time low figures since the past couple of years or more.

Britain also witnessed the so-called ―bursting of the Brown Bubble‖, in the form of the highest personal debt per capita in the G7, combined with an unsustainable rise in housing prices. The longest period of expansion, which Britain claimed to be undergoing, eventually revealed itself 7

Shradha Diwan, IBS Kolkata, Class of 2010

as an illusion. The illusion of rising to prosperity had been maintained by borrowing to spend, often in the form of equity withdrawal from increasingly expensive houses. The bubble ultimately burst, exposing Britain to the most serious financial crisis since the 1920s. This brings a lot of misery to the home owners who are set to see the cost of mortgages soar following the deepening of the banking crisis and the Libor – the rate at which banks lend to each other.

The impact of the crisis is more vividly observable in the emerging markets which are suffering from one of their biggest selloffs. Economies with disproportionate offshore borrowings (like that of Australia) are adversely affected by the western financial crunch. Globalization has ensured that none of the economies of the world stay insulated from the financial crisis in the developed economies.

Contrary to the ‗decoupling theory‘, emerging economies too have been hit by the crisis. According to the decoupling theory, even if advanced economies went into a downturn, emerging economies would remain unscathed because of their substantial foreign exchange reserves, improved policy framework, robust corporate balance sheets, and a relatively healthy banking sector. In a rapidly globalizing world, the ‗decoupling theory‘ was never totally persuasive.

The ‗decoupling theory‘ stands totally invalidated today in the face of capital flow reversals, sharp widening of spreads on sovereign and corporate debt and abrupt currency depreciations.

The Project: In the subsequent parts of the project, several issues will be discussed which will provide a detailed account of the origin of the crisis and the ripple effect of economic downturn of the world‘s largest economy which engulfed even the fast growing emerging economies into the crisis. The impact of the crisis on the Indian economy will also be dealt with. The main aim of the study is to find relevant answers to questions like why and how India has been hit by the crisis and how the Indian economy and the Reserve Bank of India have responded to the crisis. The recommendations include the outlook for the Indian economy in the wake of the economic turmoil. The project concludes with an analysis of Entrepreneurship in times of the financial crisis and a swift overview of the various aspects of entrepreneurship which can help in the revival of a plummeting economy.

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2. INTRODUCTION The Indian economy is experiencing a downturn after a long spell of growth. Industrial growth is faltering, the current account deficit is widening, foreign exchange reserves are depleting, and the rupee is depreciating.

The crisis originated in the United States but the Indian government had reasons to worry because there was a potential adverse impact of the crisis on the Indian banks. Lehman Brothers and Merrill Lynch had invested a substantial amount in Indian banks, who in turn had invested the money in derivatives, leading to exposure of even the derivatives market to these investment bankers.

Public Sector Unit (PSU) banks of India like Bank of Baroda had significant exposure towards derivatives. ICICI faced the worst hit. With Lehman Brothers having filed for bankruptcy in the US, ICICI (India‘s largest private bank), survived a rumor during the crisis which argued that the giant bank was slated to lose $80 million (Rs. 375 crores), invested in Lehman‘s bonds through the bank‘s UK subsidiary. Even Axis Bank was affected by the meltdown.

The real estate sector in India was also affected due to Lehman Brother‘s real estate partner having given Rs 7.40 crores to Unitech Ltd., for its mixed use development project in Santa Cruz. Lehman had also signed a MoU with Peninsula Land Ltd, an Ashok Piramal real estate company, to fund the latter‘s project amounting to Rs. 576 crores. DLF Assets, which holds an investment worth $200 million, is another major real estate organization whose valuations are affected by the Lehman Brothers dissolution.

The impact of the crisis on the Indian economy has been studied here forth and the study is chiefly focused on 4 major factors which affect the Indian economy as a whole. These are:

(i) (ii) (iii) (iv)

Availability of global liquidity Decreased consumer demand affecting exports The Financial Crisis and the Indian IT Industry The Financial Crisis and India‘s Financial Markets

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Availability of Global Liquidity for India in times of Financial Crisis: The main source of Indian prosperity had been Foreign Direct Investment (FDI). American and European companies were bringing in truck-loads of dollars and Euros to get a piece of pie of Indian prosperity. Less inflow of foreign investment will lead to a dilution of the element of GDP driven growth. India is in no position to ever return this money because it has used the same in subsidizing the petroleum products and building low quality infrastructure.

Liquidity is the major driving force of the stock market performances observed in emerging markets. Markets such as those of India are especially dependent on global liquidity and international risk appetite. The initial stage of the crisis witnessed rising interest rates across global economies. Rising interest rates tend to have a negative impact on global liquidity, and subsequently equity prices, as funds may move into bonds or other money market instruments.

Even though there are threats for the Indian economy due to the global liquidity crunch, they are all oriented for the long term. Any short term liquidity concern will be taken care of by the high rate of household and corporate savings in the country. The Indian economy can certainly rely on its ‗piggy bank‘ to address its short-term liquidity demands as the government is taking measures to channelize large sums of household savings lying unused in physical assets into the more productive financial sector. Thus, the Indian economy will be relatively unaffected by the global liquidity crunch.

Indian companies which had access to foreign funds for financing their trading activities are the worst hit. Foreign funds will be available at huge premiums but will be limited to the blue-chip companies, thus leading to Reduced capacity of expansion leading to supply pressure Increased interest rates which will affect corporate profitability Increased demand for domestic liquidity which will put interest rates under pressure

Decreased consumer demand affecting exports: Consumer demand has plummeted drastically in developed economies, leading to a reduced demand for Indian goods and services, thus affecting Indian exports. Export oriented units are the worst hit; thus impacting employment

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Trade gap has been widening due to the reduced exports, leading to pressure on the rupee exchange rate The Financial Crisis and Indian I.T. Industry In India, IT companies, with nearly half of their revenues coming from financial and banking service segments, are close monitors of the financial crisis across the world. The IT giants which had Lehman Brothers and Merrill Lynch (ML) as their clients are Tata Consultancy Services (TCS), Wipro, Satyam, and Infosys Technologies. HCL escaped the loss to a great extent because neither Lehman Brothers nor ML was its client.

Impact on Financial Markets: The outflow of foreign institutional investment from the equity market has been the most immediate effect of the crisis on India. Foreign Institutional Investors (FIIs) have been major sellers in Indian markets as they need to retrench assets in order to cover losses in their home countries, thus being forced to seek havens of safety in an uncertain environment. Given the importance of FII investment in driving Indian stock markets and the fact the cumulative investment by FIIs stood at $66.5 billion at the beginning of 2008, the pullout of $11.1 billion during the first nine-and-a-half months of 2008 triggered a collapse in stock prices. The Sensex fell from its closing peak of 20,873 on January 8, 2008, to less than 10,000 by October 17, 2008. The withdrawal by FIIs also led to a sharp depreciation of the rupee. While this depreciation may be good for the Indian exports which have been adversely affected by the slowdown in global markets, it is not so good for those who have accumulated foreign exchange payment commitments.

The financial crisis has reinstated the notion that in the globalized world, no country can exist as an island, insulated from the twists and turns of the global economy; growth prospects of emerging economies have been undermined by the cascading financial crisis, though there certainly exist significant variations across the countries.

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Shradha Diwan, IBS Kolkata, Class of 2010

3. UNDERSTANDING BUSINESS CYCLES Business Cycle or Economic Cycle refers to economy-wide fluctuations in production or economic activity over several months or years. These cycles are characteristic features of market-oriented economies – whether in the form of the alternating expansions and contractions which characterize a classic business cycle, or the alternating speedups and slowdowns that mark cycles in growth.

A recession occurs when a decline – however initiated or instigated – occurs in some measure of aggregate economic activity and causes cascading declines in the other key measures of activity.1 Thus, when a dip in sales causes a drop in production, triggering declines in employment and income, which in turn feeds back into a further fall in sales, a vicious cycle results and a recession ensues. This domino effect of the transmission of the economic weakness, from sales to output to employment to income, feeding back into further weakness in all of these measures in turn, is what characterizes a recessionary downturn.

The phases of the business cycle Figure 1: Business Cycles; Source: Seguin Financial Group are characterized by changing employment, industrial productivity, and interest rates.

In the Keynesian view, business cycles reflect the possibility that the economy may reach shortrun equilibrium at levels below or above full employment. If the economy is operating with less than full employment, i.e., with high unemployment, then in theory monetary policy and fiscal policy can have a positive role to play rather than simply causing inflation or diverting funds to inefficient uses.2

1 2

Economic Cycle Research Institute, New York, Pami Dua En.wikipedia.org/wiki/Business_cycle

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4. BACKGROUND OF THE CRISIS A disorderly contraction in wealth and money supply in the market is the basic cause of a financial crisis, also known as a credit crunch. The participants in an economy lose confidence in having loans repaid by debtors, leading them to limit further loans as well as recall existing loans. Credit creation is the lifeblood of the financial/banking system. Credit is created when debtors spend the money and which in turn is ‗banked‘ and loan to other debtors. Due to this, a small contraction in lending can lead to a dramatic contraction in money supply. The present global meltdown is a culmination of several factors, the most important being irrational and unsustainable consumption in the West particularly in United States disproportionate to its income by consistent borrowings fueled by savings and surpluses of the East particularly China and Japan. The second important factor is the greed of the investment bankers who induced housing loans by uncontrolled leveraging on an optical illusion of increasing prices in the housing sector. The third important factor is the failure of the regulating agencies who ignored the warning signals arising out of the ballooning debts, derivatives and financial innovation on the assumption that the Collateral Debt Obligation (CDO), the Credit Default Swapping (CDS) and Mortgaged Backed Securities (MBS) would continue to remain safe with the mortgage guarantees provided by Government Sponsored Enterprises (GSEs) namely Fannie Mae and Freddie Mac which had enjoyed the political patronage since inception. There are other several factors including shadow banking system, financial leveraging by the investment bankers and lack of adequate disclosures in the financial statements leading to fallacious ratings by the rating agencies. The global financial crisis is the unwinding of the debt bubbles between 2007 and 2009. On December 1 2008, the National Bureau of Economic Research (NBER) officially declared that the U.S. economy had entered recession in December, 2007. The financial crisis has moved into an Industrial crisis now as countries after countries are sharing negative results in their manufacturing and services sectors.

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5. CAUSE OF THE CRISIS: The Financial Crisis: How it happened The current crisis has been linked to the subprime mortgage business, in which US banks give high-risk loans to people with poor credit histories. These and other loans, bonds, or assets are bundles into portfolios or Collateralized Debt Obligations (CDOs) and sold to investors across the globe. Falling housing prices and rising interest rates led to high numbers of people who could not repay their mortgages. Investors suffered losses and hence became reluctant to take on more CDOs. Credit markets froze and banks became reluctant to lend to each other, not knowing how many bad loans and non-performing assets could be on their rivals‘ books. The crisis began with the bursting of the United States housing bubble and high default rates on subprime mortgages and adjustable rate mortgages (ARM). The foreclosures exceeded 1.3 million during 2007 up 79% for 2006 which increased to 2.3 million in 2008, an 81% increase over 2007. Financial product called mortgaged backed securities (MBS) which in turn derive their value from the mortgage installment payments and housing prices had enabled financial institutions and investors around the world to invest in U.S. housing markets. Major banks and financial institutions which had invested in such MBS incurred losses of approximately US $ 435 billion as of July 2008 which has mounted further and is now near to the value of US $ 1 trillion. The value of all outstanding residential mortgage owed by US households was US$ 10.6 trillion as of Mid 2008 of which $ 6.6 trillion were held by mortgaged pools Consisting of Collectivized debt 14

Shradha Diwan, IBS Kolkata, Class of 2010

obligation (CDO) already mortgage backed securities (MBS) (CDO and MBS) and the remaining US$ 3.4 trillion by traditional depository institutions. The owners of stock in US corporation alone has suffered loss of about US$ 8 trillion between 1 January and 11 October 2008 as the value of their holding declined from US $ 20 trillion to US $ 12 trillion. The first catastrophe took place when Bear Stearns was sold to JP Morgan at a throw away price in April 2008. The biggest adverse impact was on Fannie Mae (The Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation); the two Government Sponsored Enterprises (GSEs) were granted a very quick bailout package by the US Treasury. A record breaking level of mortgage foreclosures took place for the subprime mortgages. This led to a sharp decline in the value of securities which were based on these mortgages. Most of the investment bankers including Fannie Mae and Freddie Mac reached to the brink of bankruptcy. When homeowners default, the payments received by MBS and CDO investors decline and the perceived credit risk rises. This has had a significant adverse effect on investors and the entire mortgage industry. The effect is magnified by the high debt levels (financial leverage) households and businesses have incurred in recent years. Finally, the risks associated with American mortgage lending have global impacts, because a major consequence of MBS and CDOs is a closer integration of the USA housing and mortgage markets with global financial markets.

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6. IMPACT OF THE CRISIS The global financial crisis is already causing a considerable slowdown in most developed countries. Governments around the world are trying to contain the crisis, but many suggest the worst is not yet over. Stock markets are down more than 40% from their recent highs. Investment banks have collapsed, rescue packages are drawn up involving more than a trillion US dollars, and interest rates have been cut around the world in what looks like a coordinated response. Leading indicators of global economic activity, such as shipping rates, are declining at alarming rates. Rate of unemployment

hikes to 8.9% in the US: 539,000 jobs lost

US GDP shrinks by 8.1% in the first Quarter

US Foreclosures spike 32% in April, 2009

The continuous development of the crisis had prompted fears of a global economic collapse. Retail sales in the US have plunged to historic lows and business and consumer confidence are at their lowest levels. Most of the companies have reported steep decline in sales due to the slackened demand in the market. The rate of unemployment in the United States has skyrocketed to 8.9% with the loss of a total of 539,000 jobs. US GDP shrunk 6.1% in the first quarter; the fall in GDP is recorded despite an increase in consumer spending in the economy which is trying to recuperate from the crisis. The fourth quarter of the previous year had recorded the highest contraction in GDP since the past 25 years – the economy contracted by 6.3%.

US Home Prices fall 14% in first quarter In the classical economics scheme of things, the free market economy is set to correct itself when it verges away from full employment. This was proven to be untrue in the 1930‘s Great Depression when up to a fourth of the workers in the US were out of work.

Quoting US Economist Paul Krugman, as noted in New York Times column, 1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in mortgage-backed securities – assets whose value ultimately comes from mortgage payments. 16

Shradha Diwan, IBS Kolkata, Class of 2010

2. These financial losses have left many financial institutions with too little capital – too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven‘t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling their assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial condition even worse. This vicious cycle is what some call the ‘paradox of deleveraging.’

3

On October 11, 2008, the head of the International Monetary Fund (IMF) warned that the world financial system was teetering on the "brink of systemic meltdown" The sequence of the event can be summarized as below for understanding at a glance.

Bear Stearns was acquired by J.P. Morgan Chase in March 2008 for $1.2 billion. The sale was conditional on the Fed's lending Bear Sterns US$29 billion on a nonrecourse basis.

The Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac were both placed in conservatorship in September 2008. The two GSEs have more than US$ 5 trillion in mortgage backed securities (MBS) and other debt outstanding.

Merrill Lynch was acquired by Bank of America in September 2008 for $50 billion.

Scottish banking group HBOS agreed on 17 September 2008 to an emergency acquisition by its UK rival Lloyds TSB, after a major decline in HBOS's share price stemming from growing fears about its exposure to British and American MBSs. The UK government made this takeover possible by agreeing to waive its competition rules. 3

Global Meltdown: Road Ahead, Dr. D.R. Agarwal, Institute of International Trade

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Shradha Diwan, IBS Kolkata, Class of 2010

Lehman Brothers declared bankruptcy on 15 September 2008, after the Secretary of the Treasury Henry Paulson, citing moral hazard, refused to bail it out.

AIG received an $85 billion emergency loan in September 2008 from the Federal Reserve, which AIG is expected to repay by gradually selling off its assets. In exchange, the Federal government acquired a 79.9% equity stake in AIG.

Washington Mutual (WaMu) was seized in September 2008 by the USA Office of Thrift Supervision (OTS). Most of WaMu's untroubled assets were to be sold to J.P. Morgan Chase.

British bank Bradford & Bingley was nationalized on 29 September 2008 by the UK government. The government assumed control of the bank's £50 billion mortgage and loan portfolio, while its deposit and branch network are to be sold to Spain's Grupo Santander.

In October 2008, the Australian government announced that it would make AU$4 billion available to nonbank lenders unable to issue new loans. After discussion with the industry, this amount was increased to AU$8 billion.

UK: 5000 businesses registered for bankruptcy in Q1

IMF: Economic Crisis to cost $ 4 trillion

Germany sees GDP plunge 3.8%, worst drop in 40 years

GDP of Euro Area falls by 1.6%

In November 2008, the U.S. government announced it was purchasing $27 billion of preferred stock in Citigroup, a USA bank with over $2 trillion in assets, and warrants on 4.5% of its common stock. The preferred stock carries an 8% dividend. This purchase follows an earlier purchase of $25 billion of the same preferred stock using Troubled Asset Relief Program (TARP) funds.

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Shradha Diwan, IBS Kolkata, Class of 2010

7. INDIA AND THE FINANCIAL CRISIS The global financial crisis has not left India unscathed. Over the last seven months, growth has slipped dramatically - to 5.3% in the last quarter of calendar year 2008 - from over 9% in the previous four years. The contagion of the crisis has spread to India through all the channels – the financial channel, the real channel, and importantly, as happens in all financial crises, the confidence channel.

The slowdown is likely to have a large and immediate impact on employment and poverty. Informal surveys suggest significant job losses. Job creation is likely to remain a key concern as new entrants to the labor force - relatively better educated and with higher aspirations - continue to put pressure on the job market.

The country has the option of turning the crisis into an opportunity. The most binding constraints to growth and inclusion will need to be addressed: improving infrastructure, developing the small and medium enterprises sector, building skills, and targeting social spending at the poor. Systemic improvements in the design and governance of public programs are crucial to get results from public spending. Improving the effectiveness of these programs - that account for up to 8-10% of GDP - will therefore be an important part of the challenge.

The impact of the crisis on the Indian economy has been studied here forth and the study is chiefly focused on 4 major factors which affect the Indian economy as a whole. These are:

(i) Availability of global liquidity (ii) Decreased consumer demand affecting exports (iii)The Financial Crisis and the Indian IT Industry (iv) The Financial Crisis and India‘s Financial Markets

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Shradha Diwan, IBS Kolkata, Class of 2010

7.1. Global Liquidity Crunch and the Indian Economy The Indian banking system was gauged as being relatively immune to the factors that had lead to the turmoil in the global banking industry. The problems of the global banks arose mainly due to the sub-prime mortgage lending and investments in complex collateralized debt obligations (CDOs) whose values were sharply eroded. Confidence-related issues had also affected banks across the globe due to the freeze in the inter-bank lending market. Indian banks had limited vulnerability on both counts. The reasons for tight liquidity conditions in the Indian markets during the earlier stages of the crisis were quite different from the factors driving the global liquidity crisis. Large selling by foreign institutional investors (FIIs) and the subsequent interventions by the Reserve Bank of India (RBI) in the foreign currency market, continuing growth in advances, and earlier increases in the Cash Reserve Ratio (CRR) to contain inflation are some of the reasons that accelerated the Indian liquidity crunch.

India’s Household and Corporate Savings will fuel the domestic economy at a time when the global liquidity crunch is aggravating the economic downturn in other parts of the globe.

Thousands of investors, big and small, have been hurt by the downward plunge of the Indian stock market. It will also have broader implications for India‘s financial system and the future savings and investment patterns. Cautious investors had started to diversify away from bank deposits and cash over the past few years, and had moved to equities, mutual funds and insurance products. The current market turmoil is driving them back to the safety of bankdeposits, reducing the amount of capital available to other instruments and possibly retarding the growth of the financial-services industry as a whole.

India's high savings rate has been a crucial driver of its economic boom, providing productive capital and helping to fuel a virtuous cycle of higher growth, higher income and higher savings. Since the 1990s, the gross domestic savings rate has risen steadily from an average of 23% to an estimated high of 35% in the 2006/07 fiscal year (April-March). The latter rate compares very favorably not only with developed economies (the US and the UK have savings rates of around 14%), but also with other emerging economies—with a few exceptions such as Malaysia (38%) and Chile (35%).4 Yet India's household sector (including some small businesses) continues to account for the lion's share—some 70%—of savings. The last five years have seen a surge in corporate savings as 4

From the Economist Intelligence Unit Briefing, Economist.com

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companies became more competitive and increased their profitability. That has been accompanied by a rise in public-sector savings on the back of increased fiscal prudence. However, the current economic situation is putting pressure on both corporate profitability and the public finances, ensuring that savings in these two sectors are unlikely to grow as rapidly as in the past. Household savings will therefore remain crucial to sustaining a strong savings rate. India will be relatively unaffected by the global liquidity crisis because the large fund of India‘s household savings which stood at Rs9.85trn (US$192bn) in 2006/07, will remain available to fuel domestic growth. At an aggregate level, households in India had net savings of Rs 9, 53,212 crore in financial and physical assets in 2007-08 or 19.9% of the GDP, estimated at current market prices. In the preceding year, it was Rs 8, 24,493 crore, or 20.2% of the GDP. Thus, as GDP rose 14.4% at current market prices, net savings of the households grew 15.6%.The Indian government is trying to hasten the shift of India‘s physical savings, still locked up in unproductive physical assets such as houses, durables, and jewellery, into financial assets. The household savings can be channelized into the country‘s debt, equity, and infrastructure finance markets. This would not only deepen and stabilize the financial markets but also reduce the government‘s social-security burden. It is evident from the graph shown alongside that the ratio of gross domestic savings to the GDP of the country has been increasing over the years.

Figure 2: Ratio of Gross Domestic Savings to GDP

Influx of these household savings into the country‘s debt, equity, and infrastructure finance markets will certainly help in the deepening and stabilization of financial markets.

Gross National Savings also include all foreign remittances into India which add to the domestic savings. A positive trend in the ratio further strengthens the fact that India is selfsufficient in the short-term with regard to any immediate liquidity demand.

21 Figure 3: Ratio of Gross National Savings to GDP

Shradha Diwan, IBS Kolkata, Class of 2010

India's savings rate and investment rate for FY08 shows that on both counts the country is well placed not just relative to its own historical record, but also relative to other economies. India's savings rate at present is higher than all other regions of the world, except developing Asia and Middle East. The country's investment rate showed sharp acceleration during the period FY02-07 to surpass the average of all major regions of the world in FY07. However, according to a report5, factors which could weigh down the rate of domestic savings to a moderate 33.0% and further to 32.8% during FY09 and FY10 respectively from around 37.7% in FY08 are: Lower corporate profitability Significant widening of fiscal deficit Erosion in value of financial and physical assets Most Asian economies have been models of prudence. While American and European households were borrowing up to the hilt, Asian ones were tucking away their savings. While rich-country banks were piling into ever-riskier assets, Asian banks kept their holdings of such assets small. And while America and Britain were sucking up the world‘s savings, Asian governments piled up vast stocks of foreign reserves. The long-term trends in the savings of the country are a clear indicator of the fact that even if India’s savings and investment rates undergo a cyclical reduction in FY09, by next fiscal (FY10) these rates should still be around 30%, with 6% growth in the second half of FY10.

5

Dun and Bradstreet’s Indian Economy Outlook 2009-10

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7.2. Decreased Consumer demand affecting exports Some of the sharpest declines in output during the global recession have been suffered by the strongest economies of Asia. It is feared that due to their heavy dependence on exports, some of these economies may not see the face of recovery until demand rebounds in America and Europe. In October 2008, India registered its first every year-over-year decline in exports (of 15%), following growth of 35% in the previous five months. Indian shipments declined 33.3% in March from a year earlier, the biggest fall since the last 14 years. Goods exports dropped 33% from a year earlier to $11.5 billion in April 2009. This was the biggest fall since April 1995. Exports slid 21.7% in February. India‘s exports, which account for 15% of the economy, grew 3.4% to $168.7 billion in the fiscal year ended March 31, missing a $200 billion target set by the government, before the collapse of the Lehman Brothers Holding Inc. accelerated the world financial and economic slump. The government expects exports to total to $170 billion in the year that started April 1. According to estimates from the Federation of Indian Export Organizations, falling overseas sales may cost India about 10 million jobs. A high fiscal deficit and a high current account deficit are a threat to economic stability—which is the main reason why international credit rating agencies have brought the country‘s debt close to junk status. Asia‘s export driven economies had benefited more than any other region from America‘s consumer boom, so its manufacturers were bound to be hit hard by the sudden downward lurch.

“Asia is suffering from two recessions: a domestic one as well as an external one.”

Asia is suffering from two recessions: a domestic one as well as an external one. Domestic demand had been expected to cushion the blow of weaker exports, but instead it was hit by two forces. First, the surge in food and energy prices in the first half of 2008 squeezed companies‘ profits and consumers‘ purchasing power. Food and energy account for a larger portion of household budgets in Asia than in most other regions. Second, in several countries, including China, South Korea and Taiwan, tighter monetary policy intended to curb inflation choked domestic spending further. With hindsight, it appears that China‘s credit restrictions to cool its property sector worked rather too well.6

6

Report by Frederic Neumann and Robert Prior-Wandesforde, HSBC economists

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Shradha Diwan, IBS Kolkata, Class of 2010

In the first quarter of 2009, trade between India and the United States declined by 23.47% in value to $8.2 billion, as compared to $10.69 billion in the comparable period last year.

12% of India’s total exports of $168.7 billion in FY2008-09 went

Shipments of Indian natural pearls, precious and semi-precious stones, and pharmaceutical products, all recorded a decline causing Indian exports to the US to drop by 22.63% to $5.22 billion in Q1 of 2009. According to data from the US International Trade Commission, Indian exports to the US were $6.75 billion during Q1 of 2008. US exports to India also declined by 24.9% in Q1 of 2009; it amounted to $2.69 billion as compared to $3.94 billion in Q1 of 2008.

to the US.

India‘s exports to the US were recorded to be $25.86 billion in 2008 and imports from the US were $ 17.33 billion. 12% of India‘s total exports of $168.7 billion in FY2008-09 went to the US. The Indian Gems and Jewellery sector was significantly affected by the reduced demand in the United States and Europe. Overseas sales of India‘s gem and jewellery items expanded at a seven-year low rate of 1.45% and stood at $21 billion in 2008-09, as exports contracted sharply in the last six months of the year. This lead to about 200,000 job losses in the sector, especially of artisans engaged in polishing diamonds. The fall in exports was caused by lowering of demand in overseas markets for luxury items in the backdrop of the ongoing global recession. Exports of cut and polished diamonds dipped 8.24% to $13.02 billion. This pulled down the overall growth trade of the sector as diamonds accounts for 62 per cent of the overseas sales. The drop in expansion of gems and jewellery exports in 2008-09 was cushioned by a 23.6% growth in gold jewellery, which stood at $6.85 billion as against $5.54 billion in the year-ago period.7

Dun & Bradstreet (D&B) expects exports to be around US$ 178 billion in FY09, which is approximately US$ 22 billion lower than the Government's target, owing to economic downturn witnessed in India's key export markets. D&B, however, expects exports to witness some revival during the second half of FY10, when the world economy begins to stabilize. D&B expects exports to grow around 14% to US$ 203 billion during FY10.8 India and the other Asian economies will have to brace themselves up for the sharply reduced consumption in the United States over an extended period, following the global financial crisis, and change the export-dependent structure of its economies and create more regional demand to drive their growth. 7 8

rd

Business Standard, 23 April, 2009 Dun and Bradstreet’s India Economic Outlook, 2009-10

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Shradha Diwan, IBS Kolkata, Class of 2010

7.3. The Financial Crisis and the Indian IT Industry India‘s emergence as a globally competitive supplier of software and services has attracted world-wide attention. The software and service sector not only contributed significantly to export earnings and GDP but also emerges as a major source of employment generation in the country. Besides, the information technology (IT) sector has served as a fertile ground for the growth of new entrepreneurial ideas with innovative corporate practices and has been instrumental in reversing the brain drain, raising India‘s brand equity and attracting foreign direct investment (FDI) leading to other associated benefits. Economists have long noted that services in general are cheaper in developing countries than in developed countries. An abundant supply of labor – the major input in the production of services – in developing countries, leading to low wages is the chief factor that accounts for the low cost of producing services. India, with its large pool of skilled manpower, has emerged as a major exporter of IT software and related services, such as business process Figure 4: 5: Source- Ministry of Communications and Information Technology, Govt. of India outsourcing (BPO). In fact, one of the notable achievements in India during the last decade has been the emergence of an internationally competitive IT software and service sector (see Figure 4). With the recent emergence of business process outsourcing delivered over the Internet, the socalled IT enabled services (ITES-BPOs) as a major source of employment and foreign exchange, The impact of the global financial crisis, rooted in the United States, on the Indian IT sector can be easily gauged from the fact that approximately 61% of the Indian IT sector‘s revenue were from clients in the US. 58% of the revenue contribution of the top five players who account for 46% of the IT industry‘s revenues is from US clients. Approximately 30% of the industry revenues are estimated from financial services (see Figure 5).

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Shradha Diwan, IBS Kolkata, Class of 2010

The US financial services and insurance sector (BFSI – Banking, Financial Services, and Insurance) was one of the earliest adopters of the trend of outsourcing along with India‘s biggest IT-outsourcing firms. Large outsourcing chunks were created by the US BFSI which made the Indian IT players learn from their experience. Price negotiations and increased commitments on the service level raised the share of US financial services revenue as a Figure 5: Source – Ministry of Communication and Information Technology percentage of total revenues for the Top 3 Indian players from 25% to 38% between 1999 and 2008. Indian companies were appreciated by the US clients for their flexibility, good quality delivery and giving a key lever in managing their selling, general, and administrative expenses (SG&A) and time to market by freeing up more critical IT resources. Indian players were essentially partners in taking some of the fixed costs out of their SG&A. Because there was no partnering of Indian firms with the financial services entities at any closer level, like tying up of their invoices with the client‘s business outcomes, the Indian players were saved from a much worse impact of the crisis. The slowing US economy has seen 70% of firms negotiating lower rates with their suppliers and nearly 60% are cutting back on contractors. Due to a squeezed budget, only about 40% of the companies plan to increase their use of offshore vendors. The US financial crisis has put the growth of the Indian It industry in the short-to-medium-term in an uncertain position. Growth numbers of IT companies were revised down by 2-3% after sentiment started building up against the US financial sector at the time of the Q1 results. A worse downward revision is expected this quarter as well, though some larger players like TCS, and Satyam have denied any larger impact of the crisis.

Some factors offsetting the revenue slowdown are: Favorable Rupee-dollar exchange rate Growth de-risking through Europe Growth in non-financial verticals Growth through counter-cyclical new business (countercyclical to US slowdown) New outsourcing opportunities will also be provided by merger activities as newly-merged entities may have to look at additional or new providers to support the integration work with a broader global presence – considering the large size of combined business operations. 26

Shradha Diwan, IBS Kolkata, Class of 2010

In addition to Mergers and Acquisitions, financial institutions will also be on the look-out for ways to reduce their SG&A costs quickly which will opt for outsourced solutions that affect the cause efficiently and effectively. Efficiencies – Indian IT companies continue to be made of the same DNA as during the dotcom days, and measures to shore up efficiencies are already underway since we saw the exchange rate hit 39 to the Dollar. Some of those gains are permanent since the processes have not been rolled back after the Rupee started depreciating. Potential measures are voluntary salary cuts, complete moratorium on salary raises, travel reduction, tightening of promotion spends, just-in-time hiring, and hire-after-contract. While we have looked mainly at IT, the ITES sector is joined at the hip with IT industry, but with its own flavors. The impact in financial services operations will be much larger, but, over the medium to long term, there will be a huge gain for them from the increase in outsourcing and off-shoring in the financial sector. However, short-term pain alongside the US slowdown is inevitable.

Financial Crisis and the Satyam Saga: In the light of the debacle of the Satyam Computer Services, the current financial crisis has brought the issue of audit committee effectiveness to the fore in India. Satyam, India‘s fourth largest computer software exporter, after years of vastly inflated profits, was shattered and exhausted when the shocking reality of Satyam‘s operating margin of 24% being false was brought to the forefront – its operating margins were a meager 3%. Satyam worked with more than a third of the Fortune 500, and claimed good financial health. Satyam has a remarkably small promoter shareholding of 8.6%. They had 61.57% shareholding by institutions of which 46.86% is made up of foreign institutional investors (FIIs). The financial crisis also struck the company at a time when there were growing suspicions related to the Maytas issue. Satyam was not able to maintain its inflated figures in the wake of the crisis and hence, its majestic accounting fraud was brought to the forefront.

Opportunities for India’s IT sector: 1. Make the growth vs. profitability tradeoff early on during the slowdown: profitability levers are still available if growth is sacrificed when required, and managed well 2. Utilize some of the unavoidable fixed costs for implementing investment ideas that have been on the backburner and could not be done away with due to high utilization 3. M&A opportunities exist in the US, both in financial sector and non-financial sector 4. Intellectual Property (IP) and product related investments in the US should be assessed and made 5. Operational efficiencies can be adhered to especially in an attractive labor market and an environment of budget spend/uncertainty 27

Shradha Diwan, IBS Kolkata, Class of 2010

7.4. The Financial Crisis and India’s Financial Markets: Despite the vanishing foreign institutional investors (FIIs), the Indian markets remained resilient and stayed afloat. Investors‘ sentiments have been significantly impacted by the US financial crisis. The tendency of investors to withdraw from risky markets has resulted in significant capital outflows that have led to a liquidity crunch putting pressure on the Indian stock market. The Indian economy continues to show good health because of the strength of its domestic drivers, like infrastructure projects, SME (small and medium enterprises) sector exports and good yielding from the agricultural sector. The cause behind US economy debacle is that the US investment banks are extremely over leveraged and solely dependent on whole sale finances. This led to their demise. But such is not the case with Indian Banks. The common man‘s deposits are more in India and they have the trust on the Banks, because all most all the Banks are nationalized and the depositor‘s interest is highly protected by Government of India.

Decline in RBI’s Forex Reserves Depreciation of the Rupee Decline in Stock Market Indices

In the US, the investment banks are dependent on institutional investor‘s funds. These investments are highly volatile and always search for high returns on their deposits. They look for Demand-based investments and not time-based investments. Therefore, whenever the returns from one market start dipping, they move their investment to re-invest in those markets which would offer a better return, or take a defensive stance until the market regains momentum. Domestic banking in India is generally secure, especially because nationalized banking remains at the core of the system. Even so, there exist signs of fragility and inadequacy within the banking sector. The effects of the global crisis have directly impacted some important macroeconomic variables. Three such indicators stand out in terms of their sudden deterioration since the middle of last year: (i) (ii) (iii)

Decline in the foreign exchange reserves held by the Reserve Bank of India Fall in the external value of the rupee, especially vis-à-vis the US dollar Decline in the stock market indices

Measures taken by the RBI to stop depreciation of the Rupee led to a steep decline in its foreign exchange reserves. Factors which also contributed to the decline were the revaluation in foreign currencies and large scale pullout by foreign institutional investors.

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Figure 6 shows how the foreign exchange reserves, which had been increasing steadily over the past few years, started declining after June 2008. Not that the earlier build-up of reserves reflected any great macroeconomic strength, since unlike China it was not based on current account surpluses. Instead, the Indian economy experienced an inflow of hot money, especially in the form of portfolio capital investment of FII.

Figure 6: Foreign Exchange Reserves held by the RBI. Source: The Hindu BusinessLine

But that movement of FIIs was in turn related to the sudden collapse of the rupee, shown in Figure 7. Early in March 2009 the rupee even breached the line of Rs 51 per dollar. There are those who argue that this depreciation is positive since it will help exports, but conditions prevailing in the world trade market, with falling export volumes and values, does not give rise to much optimism in that context.

Figure 7: Rupees

per US Dollar; Source: The Hindu BusinessLine

India currently has a current account deficit, including a large trade deficit and also quite significant factor payments abroad. The falling rupee implies rising factor payments (such as debt repayment and profit repatriation) in rupee terms, which is not good news for many companies for the balance of payments. Associated with all this is the evidence of falling business confidence expressed in the stock market indicators. The Sensex (Figure 8) had reached historically high levels in the early part of 2008, capping an almost hysterical rise over the previous three years in which it more than tripled in value. But it has been plummeting since 29 Figure 8: Sensex Daily Movements; Source: The Hindu BusinessLine

Shradha Diwan, IBS Kolkata, Class of 2010

then, with high volatility around an overall declining trend such that its levels in early March were below the levels attained in December 2005. Role of Foreign Investors:

Figure 9: Foreign Investment; Source: The Hindu BusinessLine

Figure 9 tracks the changes in total foreign investment, split up into direct investment and portfolio investment, over a period since April 2007. It is evident that both have shown a trend of increase followed by decline. FDI has been more stable with relatively moderate fluctuations (even though it does include some portfolio-type investments that get categorized as FDI). It peaked in February 2008 and thereafter it has been coming

down but is still positive. Portfolio investment has been extremely volatile and largely negative (indicating net outflows) since the beginning of 2008, and this has dominated the overall foreign investment trend. As a result, as is evident from Figure 10, the cumulative value of stock of Indian equity held by FIIs fell quite sharply, by 24% between May 2008 and February 2009. This is not likely to be due to any dramatically changed investor perceptions of the Indian economy, since if anything Figure 60: Cumulative FII Investments in Equity; Source: The Hindu GDP growth prospects in India BusinessLine remain somewhat higher than in most other developed or emerging markets. Rather, it is because portfolio investors have been repatriating capital back to the US and other Northern markets. This reflects not so much as a flight to safety (for clearly US securities are not safe anymore either) as the need to cover losses that have been incurred in sub-prime mortgages and other asset markets in the North, and to ensure liquidity for transactions as the credit crunch began to bite. Whatever the causes, the impact on the domestic stock market has been sharp and direct. Since the Indian stock market is still relatively shallow, and FII activities play a disproportionately 30

Shradha Diwan, IBS Kolkata, Class of 2010

sharp role in determining the movement of the indices, it is not surprising that this flow has been associated with the overall decline in stock market valuations. As Figure 11 shows, the Sensex has moved generally in the same direction as net FII inflows. In fact, movements in the latter have been much sharper and more volatile, suggesting that domestic investors have played a more stabilizing role over this period.

Figure 11: FIIs and the Stock Market; Source: The Hindu BusinessLine

Overall foreign investment flows (including both FII and direct investment) have also played a role in determining the level of external reserves. Figure 12 shows the pattern in aggregate net foreign investment and change in reserves since April 2007. Once again, the two move together. However, in this case, foreign investment has been less volatile than Figure 7: Foreign Investment and Change in Reserves; Source: The the change in reserves, suggesting that Hindu BusinessLine other components of the balance of payments have been important as well. The changes in external commercial borrowing are likely to be significant. In addition, the possibilities of domestic investors moving their funds out should not be underestimated. The recently liberalized rules for capital outflow by domestic residents have led to outflows that are not insignificant, even if still relatively small.9

9

Global Crisis and Indian Finance, C.P.Chandrasekhar and Jayati Ghosh, The Hindu BusinessLIne

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8. BAIL-OUT PACKAGES AND RBI INITIATIVES Financial markets in the United States and around the world are in a state of dire emergency and they require urgent and decisive action. Some key parts of the credit market were on the verge of a deadlock, resulting not just in the collapse of major financial institutions but also in credit disruption that has been severely weakening the long-term prospects of non-financial companies. There was a need for swift action to deal with the ‗toxic‘ mortgage-backed securities that had been causing credit markets to seize up. The Federal government‘s effort to support the global financial system have resulted in significant new financial commitments, with the U.S. government having pledged more than $11.6 trillion on behalf of American taxpayers over the past 20 month, far in excess of the aggregate of the several bailout packages announced or dolled out in the past, as may be evident from the following figures: Past Event

US$ billion

Invasion of Iraq

597

Life Time Budget of NASA

851

S & L Bailouts of 1980s

256

Louisiance Purchase

217

Korean War

454

The U.S. Treasury also added $200 billion to its support commitment for Fannie Mae and Freddie Mac, the country‘s two largest mortgage-finance companies. The Government of China had also announced a financial package of US$ 585 billion to pump prime the economy by making huge public investment and by providing subsidies to protect domestic economy which is otherwise exposed to external market and is likely to be severely affected because of the cuts in imports by all the major importing countries.

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8.1. India’s response to the Crisis As the contagion of the financial system collapse across the world spread towards India, and into it, the government and the Reserve Bank of India (RBI) responded to the challenge in close coordination and consultation. The main plank of the government‘s response was fiscal stimulus while the RBI‘s action comprised monetary accommodation and counter cyclical regulatory forbearance. The RBI‘s policy response was to keep the domestic money and credit markets functioning normally and see that the liquidity stress did not trigger solvency cascades. RBI‘s targets can be classified into 3 prime directions: (Duvvuri Subbarao, Governor)10 (i)

To maintain a comfortable rupee liquidity position

(ii)

To augment foreign exchange liquidity

(iii)

To maintain a policy framework that would keep credit delivery on track so as to arrest the moderation in growth

The previous period has forced RBI to adopt tightened monetary policies in response to heightened inflationary pressures. However, the RBI changed its approach to handle the current scenario and eased monetary constraints in response to easing inflationary pressures and moderation in growth in the current cycle. The following were the conventional measures of the RBI: (i)

Reduced the policy interest rates aggressively and rapidly

(ii)

Reduced the quantum of bank reserves impounded by the central bank

(iii)

Expanded and liberalized the refinance facilities for export credit

To manage Foreign Exchange, the RBI (i)

Made an upward adjustment on interest rate ceiling on the foreign currency deposits by non-resident Indians

(ii)

Substantially relaxed the External Commercial Borrowings (ECB) regime for corporates

(iii)

Allowed access to foreign borrowing to non-banking financial companies and housing finance companies

10

Duvvuri Subbarao, Governor RBI, Speech delivered at the Symposium on "The Global Economic Crisis and Challenges for the Asian Economy in a Changing World" in Tokyo

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RBI also took unconventional measures as a response to the liquidity scenario: (i)

Indian banks were given the rupee-dollar swap facility to give them comfort in managing their short-term funding requirements

(ii)

An exclusive refinance window, as also a special purpose vehicle, was made available for supporting non-banking financial companies

(iii)

The lendable resources available to apex finance institutions for refinancing credit extended to small industries, housing and exports, was expanded

The Central Government‘s Fiscal Responsibility and Budget Management (FRBM) Act, enacted to bring in fiscal discipline by imposing limits on fiscal and revenue deficit, proved to be the road map to fiscal sustainability at the time of the crisis. The emergency provisions of the FRBM Act were invokes by the central government to seek relaxation from the fiscal targets and two fiscal stimulus packages were launched in December 2008 and January 2009. These fiscal stimulus packages, together amounting to about 3% of GDP, included: Additional public spending, particularly capital expenditure, government guaranteed funds for infrastructure spending Cuts in indirect taxes, Expanded guarantee cover for credit to micro and small enterprises, and Additional support to exporters.

These stimulus packages came on top of an already announced expanded safety-net for rural poor, a farm loan waiver package and salary increases for government staff, all of which too should stimulate demand. The cumulative amount of primary liquidity potentially available to the financial system through these measures is over US$ 75 billion or 7% of GDP. Taking the signal from the policy rate cut, many of the big banks have reduced their benchmark prime lending rates. Bank credit has expanded too, faster than it did last year.

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9. OUTLOOK FOR THE INDIAN ECONOMY India is witnessing a mixed result with respect to its growth prospects in the wake of the global economic downturn. Real GDP growth has moderated to 6.6% and is projected to grow at the same rate in 2009-10. The Services sector too, which accounts for 57% of India‘s GDP, and has been the country‘s prime growth engine for the last five years, is slowing, mainly in construction, transport and communication, trade, hotels and restaurants sub-sectors. According to recent data, demand for bank credit has been slackening despite sufficient liquidity in the system. India‘s exports, which account for 15% of the economy, grew 3.4% to $168.7 billion in the fiscal year ended March 31, missing a $200 billion target set by the government. Corporate margins have been dented due to higher input costs and dampened demand; business confidence has been affected by the uncertainty around the economic condition. The Index of Industrial production has been showing a negative growth and the demand for investment is decelerating. India, though, certainly has some advantages in addressing the fallout of the crisis: (i)

Headline inflation, as measured by the wholesale price index, has fallen sharply; inflation has declined faster than expected. Key factors behind the disinflations have been commodity prices and a part of it is contributed by slowing domestic demand.

(ii)

Decline in inflation should prove to be positive for reviving consumer demand and reducing input costs for corporates

(iii)

Fiscal space will open up for infrastructure spending as the decline in global crude prices and naphtha prices will reduce the amount of subsidy given to the oil and fertilizer companies

(iv)

Imports are expected to shrink more than exports; this will keep the current account deficit at modest levels

(v)

India‘s sound banking system has helped to sustain the financial market stability to a large extent -well capitalized and prudently regulated

(vi)

Overseas investors are confident about the Indian economy due to comfortable levels of foreign reserves 35

Shradha Diwan, IBS Kolkata, Class of 2010

(vii)

The negative impact of the wealth loss effect in the capital markets that have plagued the advanced countries will not affect India because majority of Indians stay away fro asset and equity markets

(viii) Institutional credit for agriculture will also remain unaffected because of India‘s mandated priority sector lending (ix)

Agriculture sector of India will be further insulated from the crisis due to the government‘s farm waiver package

(x)

India‘s development of social safety programs over the years (e.g. the rural employment guarantee program), will protect the poor and migrant classes from the ill effects of the global crisis

Therefore, once the global economy begins to recover, India‘s turn around will be sharper and swifter, backed by its strong financial system and regulatory norms. The present global crisis has taken the shape of the Great depression of 1929 at least in US and Japan. The biggest losers will be US, Japan and China. The biggest gainers may be India, Brazil and few other developing countries with their own domestic savings and domestic market. The world will have to undergo the impact in different forms, somewhere it will be economic slowdown, somewhere recession and somewhere depression.

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10. LIMITATIONS OF THE STUDY The current project discusses key issues of the Indian economy that cropped up as the global economy is swaying in its worst economic downturn. Though the major factors have been discussed, yet there exist more issues which have not been detailed due to time constraints. As the economies across the globe try to protect themselves from the hazards of the crisis, they are trying to maintain domestic demand and protect their domestic industry from foreign invasions, lest their own economy might destabilize. This has been giving rise to ‗Protectionism‘ and rising incidences of countries resorting to protectionist measures have been recorded at the World Trade Organization. India has been recorded to initiate the maximum number of anti-dumping investigations against goods exported into the country. America is propagating its ‗Buy American‘ campaign in order to help itself become a more self-sufficient economy. The Chinese economy is reeling from the global drop in exports; China‘s economy is highly industrialized and a significant fraction of its GDP is accounted for by its exports to the United States. Therefore, apart from internal factors that have affected global economies, there are critical external factors and trade behavior that dictate the nations across the globe to resort to measures to help themselves. The discussion of such issues in detail has not been made a part of the report at hand, though a significant amount of information has been analyzed and studied for the same. Apart from these, there may be some technical flaws like: (i)

The accuracy and reliability of the data collected – data across different sources may vary slightly

(ii)

The measurability of the factors relating to the crisis across a global scale may not be thorough – considering all the factors would not be a feasible option.

(iii)

Opinion biasness may also exist.

The study of the global financial crisis is inexhaustible, and it will continue as long as the world economy does not become self-sustainable again. The impacts of the crisis are a test of the financial market stabilities and regulations across the global economy; the corrections that will be made have been long overdue.

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11. ENTREPRENEURSHIP IN TIMES OF FINANCIAL CRISIS Entrepreneurship can be technically defined as a process of starting new organizations or revitalizing mature organizations, particularly new businesses, generally in response to identified opportunities. Jean-Baptiste Say, a French economist who first coined the word entrepreneur in about 1800, said: ―The entrepreneur shifts economic resources out of an area of lower and into an area of higher productivity and greater yield.‖

The dictionary definition of entrepreneur reads as ―a person who organizes and manages any enterprise, esp. a business, usually with considerable initiative and risk‖; and also ―an employer of productive labor; contractor‖. The propensity to take risks and the desire to create wealth are some qualities possessed by entrepreneurs that define their entrepreneurship. Entrepreneurs are ruthlessly opportunistic; they would persevere with a business plan at a time when others are chasing full-time employment opportunities. The act of innovation holds prime importance; the size of the company is a secondary aspect to that.

Entrepreneurs have traditionally faced the shortage of finance, not of ideas. Moreover, the human capital is also a critical aspect of an organization. The growing industry of venture capitalists has greatly fostered entrepreneurship across the globe. Talented people in an organization make the core machinery of ideas and execution. To establish themselves, businesses need to put forward substantial value propositions and a clear path to achieving their set goals and objectives. Above all, intellectual capital is the chief component of entrepreneurship; human capital and monetary capital fall after that. The information age makes it even easier for ordinary people to start business now.

Entrepreneurship is a stimulator of economic growth and social cohesiveness. The globalization of entrepreneurship is raising the bar of competitiveness for all the players. Once-closed economies like India and China have opened up to enterprisers and entrepreneurs from all over the globe. Innovative entrepreneurs carry more weight because of their ability to create more jobs.

The economic downturn has put the global economy in an awkward situation. The motives of established entrepreneurs are being questioned and their disastrous results are being scorned off at. In the wake of scandals over established figures like Enron, and Satyam, things have become more difficult for start-ups. Potential entrepreneurs are lured towards a safe and secure 38

Shradha Diwan, IBS Kolkata, Class of 2010

government job and are becoming increasingly apprehensive of taking the risk of venturing into an unknown territory. Risk, the lifeblood of the entrepreneurial economy, is becoming something to be avoided.

However, the current financial crisis also brings with itself some unprecedented opportunities that can prove to be a resource haven for the upcoming and new entrepreneurs. Those who are planning to start and manage a new business will now encounter a fresh set of values and a need to go back to the basics of managing a business. Though the crisis does not put forth an appealing landscape for entrepreneurs, yet those with rational expectations will face no dearth of opportunities or ideas or innovations. The average life cycle of a start-up from inception to exit will be much longer – over 5 years – chiefly due to reduced mergers and acquisitions and late initial public offerings. Persistence and commitment are the need of the hour and the willingness to wait with patience before reaping the harvests of an endeavor is indispensable. Those who are driven by the desire for a windfall should prepare themselves for disappointment.

Aspiring entrepreneurs should realize that the receding economy offers them the best time to start a company. The market is full of talented people looking for new opportunities. The opportunity cost of letting go of an attractive and high-paying job is very low as there is a general decline in employment opportunities across the globe.

Moreover, the ordinary costs of doing a business are depressed. Space, equipment, and any other resourceful asset were never available at such low investments. Raising finance in times of the credit crunch is a tough task, but what should be kept in mind is that competitive pressures are much lower during downturns and it becomes relatively easier to establish one‘s company as the leader. Advertising and other marketing expenditures are very low and it‘s easy to make a mark when relatively few in the market are trying to do so. Being the holder of a private company, the entrepreneur would not have to worry about quarter-to-quarter performance and the investors would also have a long term perspective.

‗Time‘ is another critical aspect. A business, at its inception, needs to do a lot of market research, research of potential customers, product designing and building, and also look for investors and financing opportunities. What is not expected from a start-up is the potential to start selling as soon as it is conceived. Therefore, the current slump in demand across global economies is a non-entity with respect to a start-up. Moreover, any new business initially sells to the ‗early adopters‘ whose buying patterns are independent of the economic state of the environment. 39

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Therefore, the initial customer base is not susceptible to economic cycle changes and the business can head off for a great start.

Poorly capitalized start-ups can cope with the grinding recession by reallocating their existing financials and keeping non-essential activities out of operations. Focus should be on the more important features and marketing costs should be cut down to a minimum unless it is proven to give a positive return on investment. Money from all payments which can be deferred should be put into more productive areas of the business. Even well capitalized start-ups need to keep themselves buckled up and cut costs wherever possible. However, it should be borne in mind that ruthless slashing of marketing costs does a lot of harm in the future when companies have to spend a lot more than they saved in order to recover. Therefore, a balanced and judiciously thought out approach should be followed.

Entrepreneurship has the potential to drive an economy out of the economic turmoil. It creates new jobs, generates revenue, advances innovation, enhances productivity, and improves business models and processes. Entrepreneurship has never been as vital for an economy as it is today. The risks and rewards go hand-in-hand. A company should keep its strategic thinking flexible enough to manage uncertain times and should have the aptitude to look beyond the crisis.

History has demonstrated time and again that entrepreneurship and new companies is the way to bolster a flagging economy. Giants like Microsoft, Genentech, Gap, and The Limited were all founded during recessions. Companies which started off in the Depression include HewlettPackard, Geophysical Service (now Texas Instruments), United Technologies, Polaroid, and Revlon. A plummeting economy helps initiators to develop a business which has the tenacity to survive though difficult times and which is relatively unaffected by a cycle of bankruptcies.

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Shradha Diwan, IBS Kolkata, Class of 2010

11.1. Early-Stage Entrepreneurial Activity Rates and Per Capita GDP AO: Angola AR: Argentina BA: Bosnia & Herz. BE: Belgium BO: Bolivia BR: Brazil CL: Chile CO: Colombia DE: Germany DK: Denmark DO: Dominican Rep. EC: Ecuador EG: Egypt ES: Spain FI: Finland FR: France GR: Greece HR: Croatia HU: Hungary IE: Ireland IL: Israel IN: India

IR: Iran IS: Iceland IT: Italy JM: Jamaica JP: Japan KR: Rep. of Korea LV: Latvia MK: Macedonia MX: Mexico NL: Netherlands NO: Norway PE: Peru RO: Romania RU: Russia SI: Slovenia TR: Turkey UK: United Kingdom US: United States UY: Uruguay YU: Serbia ZA: South Africa

Source: GEM Adult Population Survey (APS) and IMF: World Economic Outlook Database (October 2008 edition)

From the above statistic, it is clear that countries with similar geographic backgrounds and customs tend to cluster together. At the lower end of the early-stage entrepreneurial activity, a group of EU-15 countries is situated close together. Countries in Eastern Europe and Central Asia are mainly situated at the left-hand side, below the fitted curve – even though over the years they appear to move towards the curve. People in these countries are not as much engaged in entrepreneurial activity as citizens of Latin American countries, the Caribbean, and Angola with similar levels of per capita GDP. Wealthier countries at the upper right-hand side are industrialized countries outside the EU – with Ireland as a notable exception. Japan‘s rate of early-stage entrepreneurial activity has, over the years, been consistently lower than the fitted curve, but has been increasing in recent years and is now very similar to the EUaverage.

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Shradha Diwan, IBS Kolkata, Class of 2010

12. REFERENCES i.

Economic Cycle Research Institute, New York, Pami Dua

ii.

En.wikipedia.org/wiki/Business_cycle

iii.

Global Meltdown: Road Ahead, Dr. D.R. Agarwal, Institute of International Trade

iv.

From the Economist Intelligence Unit Briefing, Economist.com

v.

Dun and Bradstreet‘s Indian Economy Outlook 2009-10

vi.

Report by Frederic Neumann and Robert Prior-Wandesforde, HSBC economists

vii.

Business Standard

viii.

Wall Street Journal

ix.

Financial Express

x.

Dun and Bradstreet‘s India Economic Outlook, 2009-10

xi.

Global Crisis and Indian Finance, C.P.Chandrasekhar and Jayati Ghosh, The Hindu BusinessLine

xii.

Journal: Duvvuri Subbarao, Governor RBI, Speech delivered at the Symposium on "The Global Economic Crisis and Challenges for the Asian Economy in a Changing World" in Tokyo

xiii.

Harvard Business Review, South Asia, www.hbrasia.org

xiv.

Global Crisis News, www.globalcrisisnews.com

xv.

Paul Krugman: Blog

xvi.

Krugman, Paul (2009). The Return of Depression Economics and the Crisis of 2008. W.W. Norton Company Limited

xvii.

The global financial crisis and developing countries; Overseas Development Institute

xviii.

Embassy of India – Washington DC (website)

xix.

Ministry of Communications and Information Technology – Statistics

xx.

The World Bank – Development Economics Database

xxi.

The Reserve Bank of India – Press Releases, Handbook of Statistics; Special Reports

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