Global Financial Crisis: India Implications

Background of the Global Financial Crisis; What is it all about? It all began with the one and all American dream, that every American should have a home. Regardless of who you are and what you do, if you are an American, you should have something called a home. Real Estate business was in a boom, and financial agents thought that there wasn’t a better time to give away loans. The Household sector was given a boost with increased monetary supply by commercial financial companies, and people were given loans regardless of the credit rating they received. It was never expected that the boom in the Real Estate business would come to such an abrupt end, and the prices would reach all time low. The US economy being a capitalist driven economy didn’t bother to indulge itself in the policies pursued by the then prominent financial giants. Gradually these financial giants in this business started feeling the heat as “sub-prime” clients started defaulting in their repayment of loans. The properties which were mortgaged by the clients weren’t even covering the principal amount of the loan, leave alone the interest commitments. The credit offered to the people in indiscriminate fashion, achieving short term goals and ignoring warnings from leading economists about long term sustainability of the policy, backfired completely and companies like Lehmann Brothers, Merill Lynch, Freddie Mac and Fannie Mae’s “bad assets” reached magnanimous proportions. An acute credit shortage was experienced in the economy, and simultaneous negative effects started occurring. The credit crunch meant that borrowing interest rates shot up in the market, companies slowed down their investment policies, production declined, lay offs increased, consumption decreased and the whole economy followed the downward spiral. The unemployment rate in the US reached an all time high of 6.1% and industrial growth saw its largest decline in the past three years and fell to 1.1%. The US governments realized the gravity of the situation, and started using monetary as well as fiscal policies to check the diminishing economy. Fiscal policy boost in the way that, an amount of around US$ 1 trillion was pumped into the economy to increase the liquidity scenario. The financial companies which filed for bankruptcy were nationalized, or there non-performing assets were accounted for by the government. The Federal Bank of US also lowered the monetary policy rates, like Statutory Liquidity Ratio (SLR), relating to the amount of money required to be deposited by commercial banks to the Federal bank, so as to have some check on the sky high interest rates. These policies which were targeted to cushion the huge credit shortage scenario has taken somewhat affect and the situation has stabilized a bit. But, as leading economists say, it is too early to comment on whether the trough of the graph has reached or not, or it is still the “tip of the iceberg” scenario. This fear is out there still because there is uncertainty over how many more “sub-prime” creditors are still there in the economy, and how many more companies will get affected by the fallacious policy, which was followed by short-sighted profit oriented companies.

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Impact on the Indian Economy The financial crisis in the US, slowly snowballed to an economic crisis, with growth in the economy stagnating. Efforts have been taken by the US authorities to restore the fully functional markets, but there’s an obvious time lag. Till then, the world economy has been affected by this deep economic crisis and India is no different. India being a net import driven economy, with exports (including the service sector) contributing 17% of GDP, is a little less vulnerable than other economies. Moreover we still have a socialistic pattern of economy where there is enough government intervention, which has somewhat checked the situation from becoming graver. At the present scenario it is a bit difficult to exactly quantify the implications of the global financial meltdown, but a few salient features are:• • • • •

Indian IT companies have around 30% exposure to foreign financial services. Funding constraints would result in uncertainty in the real estate sector. While direct exposure for financial institutions is negligible, but there are a few firms which have impact on its margin. Foreign Direct Investment and Foreign Indirect Investment have decreased dramatically with the liquidity crunch, with companies selling their stakes in a hurry. The rupee has significantly depreciated due to the outflow of foreign reserve capital.

The Government of India and Reserve Bank of India accepted these challenges and took measures, discussed subsequently, to control the effects of the implications mentioned above. The holistic point of view is that it was imperative to improve the liquidity situation in the market as lack of liquidity led to the following effects:• • • • • • • • •

Lack of lack of money available to commercial banks for offering credit. Borrowing interest rates went up. Industrial Sector deferred its investment plans. Decrease in Production. Appreciation in price of commodities. Inflationary trends. Consumption of Household Sector decreases. Government revenue in form of indirect taxes decreases. Fiscal deficit increases.

So we have a glimpse of the downward spiral that affects the economy as a whole, i.e. the household, industrial, government and the foreign trade sector, and hence realize the urgency of the government and the apex bank to apply the controlling measures.

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Monetary Policy measures announced by the Reserve Bank of India and its implications With the trickling of the economic depression in India from the US, the government took aggressive stance on the issue and started immediate control on the monetary policy measures. On consultation with the Ministry of Finance, Planning Commission, heads of other commercial banks, the Reserve Bank of India decided to implement these actions to maintain the liquidity scenario in the market and not to let the growth percentage come down:•

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Both repo rate and reverse-repo rate has been reduced to offer additional liquidity to the banking system. The repo rate was reduced to 6.5% and the reverse repo rate to 5%, effective from 08 Dec, 2008. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) were also reduced to 5.5% and 24% respectively.

The cut in repo and reverse repo rates signifies that the amount lent to commercial banks by the apex bank comes at a cheaper rate, which signifies that the commercial banks in turn offer credit at a cheaper rate to the Industrial sector. The cut in CRR and SLR implies that the proportion of money the commercial banks have to deposit to the apex bank for security purposes have been decreased. This implies that there is greater money supply with the commercial banks, which increases the liquidity situation in the banking sector. The Industry sector thus receives easy available credit from commercial banks at affordable rates of borrowing. The investment is thus improved; production of goods and commodities takes place which in turn meets demand requirements and it adds to the GDP of the country.

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Fiscal Policy measures announced by the Government of India and its implications With the inflation somewhat under controllable limits of around 6.84% (the drastic drop in price of crude being one of the major reasons) and growth also maintaining levels of 7.5%, the government decided to supplement its monetary policy with additional fiscal policy measures. The strategy obviously is to have instant effect on the economy, as the monetary policy takes some time to effect the changes, called the inside and outside lags. Monetary policies are governed by regulations, and firstly it’s through that the government tried to control the situation, but when it comes to immediate effect scenario, fiscal policy on the basis of discretion is applied. The upcoming election also being one of the major concerns for the government for immediate results, the announced fiscal measures was imminent and expected. The fiscal boost of three hundred thousand crores in the form of planned and non-planned expenditure was announced by the government on 7 Dec, 2008. The salient features of the policy are given below:• • • • • • • • • • • • •

Parliament nod to be sought for Rs.20000 crore more toward plan expenditure. Across the board cut of 4% in ad-valorem central value added tax. Interest subvention of 2% on export credit for labour intensive sectors. Additional allocations for export incentive schemes. Full refund of service tax paid by exporters to foreign agents. Incentives for loans on housing for upto Rs.500000 and upto 2 million. Limits under the credit guarantee scheme for SME doubled. Lock-in period for loans to small firms under credit guarantee scheme reduced. India Infrastructure Finance Co allowed raising Rs.100 billion through tax free bonds. Norms for government departments to replace vehicles relaxed. Import duty on naphtha for use by the power sector is being reduced to 0. Export duty on iron ore fines eliminated. Export duty on lumps for steel industry reduced to 5%.

The government went to the fiscal expansion mode by reducing tax rates, providing tax holidays and increasing expenditure in the forms of credit given to SMEs and Real Estate sectors. The government ignored the fiscal deficit, which increases due to more government expenditure and lesser accumulation of government revenue in the form of indirect taxes, but, boosts the industry sector to invests and increase the overall production levels. This in turn solidifies the foreign trade sector, as with increased production levels, exports increase.

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The government has complemented its fiscal expansion efforts with a second stimulus package on 15 Dec, 2008. The salient features in this package are:• • •

Increase limit for low-interest housing loans from Rs 20 lakhs to Rs 30 lakhs. Raise tax rebate on home loans from Rs 1.5 lakhs to Rs 2.5 lakhs per annum. Reduce car and two-wheeler loan rates by 2%, from current levels of 10-12%.

Further reduction in tax rates and loan rates confirms the government’s impetus to reduce the inflationary trend as well as put a thrust to the growth scenario of the country. These tax exemptions will lead to greater production from the Industry sector, and as prices will be less due to lesser excise duties, the aggregate demand will start increasing.

Aggregate Demand-Aggregate Supply Curve Scenario

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Here, after economic recession, the equilibrium (pt. O) shifts from y0 to y1. Supply decreases considerably and prices of goods and commodities increases drastically (pt. A). After the government decides to give monetary thrust to the economy through the apex bank, money supply in the household sector increases. This leads to an increase in demand but the supply curve remains the same (pt. B). After sometime, which is after the inside and outside lags of the measures are over, the investment by the Industry sector increases which leads to an increase in supply curve and hence prices reduces to a stable p2 and output also increases to y2 (pt. C). Thus we see the effects of the economic recession on the Short Run Aggregate Supply Curve and the Aggregate Demand Curve.

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Glossary The macro-economic terms used in the report are:a) b) c) d) e) f) g) h) i) j) k) l) m) n)

Cash Reserve Ratio Statutory Liquidity Ratio Repo & Reverse Repo rates Aggregate Demand Aggregate Supply Household Sector Industrial Sector Government Sector Foreign Trade Sector Gross Domestic Product Fiscal Deficit Excise Duty Inflation Foreign Exchange Rates

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Bibliography •

Indian Economy: Wikipedia. (n.d.). Retrieved 12 18, 2008, from Wikipedia website: http://en.wikipedia.org/wiki/Indian_economy

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Speeches:

RBI.

(n.d.).

Retrieved

12

18,

2008,

from

RBI

http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/87784.pdf •

Files: Worldbank. (n.d.). Retrieved 12 18, 2008, from Worldbank website: http://crisistalk.worldbank.org/files/Oct_31_JustinLin_KDI_remarks.pdf

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