Impact of Crisis on the Indian Economy

3.1 Global Integration of Indian Economy

In response to its balance of payments (BOP) crisis in the early 1990s, India implemented a series of trade, industry, and investment reforms. These reforms effectively liberalized the economy, ending a long period of relative isolation from global markets and financial and technology flows. Since then the Indian economy has become increasingly integrated with the world economy.⁶ Consequently, current account flows (receipts and payments of merchandise and invisibles) as a proportion of GDP increased from 20% in FY1990–1991 to 53% in FY2007–2008 (Figure 2 [ PDF 36.8KB | 1 page ]). However, the most significant change can be witnessed in the capital account. Due to the rationalization of procedures and conditions for foreign investment, India has emerged as an attractive investment destination. This is reflected as an increase in foreign portfolio investment inflows from US$2 billion in FY2001–2002 to US$29 billion in FY2007–2008. Foreign direct investment (FDI) inflows have also gone up significantly in recent years, having risen to US$34.3 billion in FY2007–2008 from US$6.1 billion in FY2001–2002. At the same time, Indian corporations have also entered the global market for mergers and acquisitions, resulting in some capital account outflow from India. As a result, two-way flows of portfolio and direct foreign capital have gone up from a mere 12% of GDP in FY1990–1991, to 64% of the GDP in FY2007–2008, registering a fivefold increase. Interestingly, these ratios are significantly higher than those in the US, for which trade in goods and services constituted only 41% of GDP in 2007 and capital flows another 25% in the same year.

3.2 Transmission of the Crisis to the Indian Economy

With India's increased linkage with the world economy, India could not be expected to remain immune to the global crisis or be decoupled from the global economy. While it is true that the Indian banking sector remained largely unaffected because of its very limited operations outside India or exposure to sub-prime lending by foreign investment banks, the global crisis has affected India through three distinct channels. These channels are financial markets, trade flows, and exchange rates.

The financial sector includes the banking sector, equity markets (which are directly affected by foreign institutional investment [FII] flows), external commercial borrowings (ECBs) that drive corporate investments, FDI, and remittances. The global crisis had a differentiated impact on these various sub-sectors of the financial sector.

Given prudent regulations and a proactive regulator,⁷ the Indian banking sector has remained more or less unaffected, at least directly, by the global crisis. The imposition by the RBI of a higher provisioning requirement on commercial bank lending to the real estate sector helped to curb the growth of a real estate price bubble. This is one of the few global examples of a countercyclical capital provisioning requirement by any central bank. In general, Indian banks were not overly exposed to sub-prime lending. Only one of the larger private sector banks, ICICI Bank, was partly exposed but it managed to thwart a crisis because of its strong balance sheet and timely action by the government, which virtually guaranteed its deposits. The banking sector as a whole has maintained a healthy balance sheet. In fact, during the third quarter of FY2008, which was a nightmare for many big financial institutions around the world, banks in India announced encouraging results. Against an absolute decline in the profitability of non-financial corporate enterprises, the banking sector witnessed a jump of 43% in its profitability (Figure 3 [ PDF 109.1KB | 1 page ]). A ban on complex structures like synthetic securitization coupled with a close monitoring of appropriate lending norms by RBI also ensured a better quality of banking assets. The non-performing assets as a ratio to gross advances have remained well within prudential norms (Figure 4 [ PDF 109.1KB | 1 page ]). Further, with an average capital risk weighted assets ratio (CRAR) of 13%, Indian banks are well capitalized and better placed to weather the economic downturn.

However, the indirect impacts of the crisis have affected Indian banks quite badly. The liquidity squeeze in global markets following the collapse of Lehman Brothers compelled Indian banks and corporations to shift their credit demand from external sources to the domestic banking sector. This move exerted a lot of pressure on liquidity in the domestic market and consequently short-term lending rates shot up abnormally. The inter-bank call money rate spiked to 20% in October 2008 and remained high for the next month (Figure 5 [ PDF 35.5KB | 1 page ]). This credit crunch, coupled with the loss of confidence that followed the Lehman Brothers episode, increased the risk aversion of Indian banks and eventually hurt credit expansion in the domestic market. Contrary to the trend, non-food credit expansion started declining in November 2008 and became negative in January 2009 (Figure 6 [ PDF 37.7KB | 1 page ]). The magnitude of the impact of the crisis can be understood from the fact that non-food credit expansion during last five months of FY2008–2009 has declined by more than 68% as compared with the same period in previous financial year.

After an impressive performance for nearly five years, foreign capital inflows lost their momentum in the second half of 2008. The most significant change was observed in the case of FIIs, which saw a strong reversal of flows. Against a net inflow of US$20.3 billion in FY2007–2008, there was a net outflow of US$15 billion from Indian markets during FY2008–2009 as foreign portfolio investors sought safety and mobilized resources to strengthen the balance sheet of their parent companies. This massive outflow of FII created panic in the stock markets. Consequently, equity markets lost more than 60% of their index value and about US$1.3 trillion of market capitalization from an index peak of about 21,000 in January 2008 to 8,867 by 20 March 2009. This bad run at Dalal Street⁸ wiped out the primary market completely, which had been flourishing before the onset of the crisis. Between FY2007–2008 and FY2008–2009, fund collection through the primary market declined by 63%. In 2007, 106 initial public offerings (IPO) were issued and raised a total amount of about US$11 billion. In contrast, only 38 IPOs were issued in 2008 and resulted in accumulations of only US$3.8 billion.

Given the presence of unutilized liquidity in the global market, and India being one of the few countries with positive growth, FIIs have once again started flowing back to India (Figure 7 [ PDF 69.8KB | 1 page ]). During the first two months of the current financial year (April and May 2009), Indian equity markets received net FII inflows of more than US$5 billion. Consequently, equity markets have partially gained their lost value. However, owing to prevailing uncertainties, the primary market has still not shown any sign of recovery. Most of the companies have put their IPOs on hold and only one IPO has been issued so far in 2009.

Figure 8: Bombay Stock Exchange Sensitive Index (Sensex) [ PDF 69.8KB | 1 page ]

Figure 9: Market Capitalization Percent to GDP [ PDF 36.3KB | 1 page ]

The economic boom in India from FY2004–2005 to FY2007–2008 has also been accompanied by a substantial increase in the inflows of FDI and external commercial borrowings. The inflows of FDI increased from US$6 billion in FY2004–2005 to US$34.3 billion in FY2007–2008 (Figure 10 [ PDF 65.9KB | 1 page ]). The surge in FDI not only improved the domestic rate of capital formation but also helped many industries improve in a technological capacity due to the technology inflows that accompanied these FDI inflows. Like FDI, the inflows of ECBs also went up from US$9 billion in FY2004–2005 to US$30.3 billion in FY2007–2008, registering a threefold increase over four years. The spurt in ECBs benefited Indian entrepreneurs in two different ways. First, it supported them in their overseas mergers and acquisitions, making it easier for them to gain a market presence in target countries. Secondly, the influx of ECBs allowed Indian firms to finance their domestic capacity expansion at relatively lower capital costs.

Both FDI inflows and ECB volumes have been adversely affected by the turmoil in the financial markets in advanced economies. Given the credit crunch in the global markets since September 2008, Indian corporates managed to raise only US$18 billion in FY2008–2009 as commercial credit from the overseas market, which is 41% less than the amount raised in the previous year. The fall was rather phenomenal during the second half of FY2008–2009 (Figure 11 [ PDF 65.9KB | 1 page ]), when ECB approvals⁹ declined from US$3 billion in September 2008 to less than US$0.5 billion in February 2009. Likewise, though not to the same extent, FDI inflows have also taken a hit. For the first time in last six years, FDI inflows witnessed a negative growth of 2% in FY2008–2009.

Remittances are another source of inward foreign capital flows that in the past have helped to balance India's large trade account deficit and keep the current account deficit at a reasonable level. The remittances from overseas Indians started feeling the impact of the global crisis during the third quarter of FY2008–2009 when, on a year-on-year basis, they declined by 0.5%. The impact becomes more evident in the fourth quarter of FY2008–2009 when the inflow of remittances declined by more then 29% as compared to the same period in previous year (Figure 12 [ PDF 64KB | 1 page ]). With the poor economic outlook for oil producing economies in the Gulf and West Asia, coupled with rising pressure against immigration in advanced countries, it is expected that remittances will further decline in the coming quarters.

The sluggishness of the inflows of FDI, ECBs, and remittances combined with the massive outflow of FII has resulted in the significant deterioration of India's capital account in FY2008–2009. From its peak in September 2007, the capital account surplus as percent of GDP started to decline and disappeared completely by December 2008 (Figure 13 [ PDF 64KB | 1 page ]). This is the first time after a long period that the capital account component of India's BOP has been negative.

The second transmission of the global downturn to the Indian economy has been through the steep decline in demand for India's exports in its major markets. Gems and jewelry was the first sector to feel pressure at the very beginning of the global meltdown. In November 2008, it witnessed a sharp decline in export orders from the US and Europe, which resulted in a retrenchment of more than 300,000 workers. Since then, the negative impact has expanded to other export-oriented sectors such as garments and textiles, leather, handicrafts, marine products, and auto components. Merchandise exports have registered a negative average growth of 17% from October 2008 to May 2009. The decline in exports has been accelerating, falling by 29.2% in May 2009 as compared to the same month in 2008 (Figure 14 [ PDF 61KB | 1 page ]). In all likelihood, it seems difficult for merchandise exports to recover within this calendar year.

Like merchandise, exports of services are also facing a rather steep downturn. During the third quarter of FY2008–2009, growth in service exports declined to a mere 5.9% as compared to 34.0% in the corresponding period a year back. The earnings from travel, transportation, insurances, and banking services have contracted, while the growth rate of software exports has declined by more than 21 percentage points (Table 4 [ PDF 52.7KB | 1 page ]). The real shock came in the fourth quarter of FY2008–2009 when service exports witnessed a contraction of 6.6% as compared to the same period in the previous year.

Though exports of both goods and services still account for only about 22% of the Indian GDP, their multiplier effect for economic activity is quite large as the import content is not high, unlike Chinese exports. This is reflected in the manufacturing sector output experiencing a sharp slowdown in recent months, during which exports have also shown a decline. The index of manufacturing sector output (Manufacturing IIP), which had grown at 9.6% during FY2007–2008 and by 5.3% in the first half of FY2008–2009, slowed down to 0.5% in the third quarter and further to -0.16% in the fourth quarter of FY2008–2009. Therefore, the export slump is expected to have a significant impact on GDP growth in the coming period.

The third transmission channel is the exchange rate. With the outflow of portfolio investments and higher foreign exchange demand by Indian entrepreneurs who are seeking to replace external commercial borrowing by domestic financing, the Indian rupee has come under pressure. During last 12 months (from April 2008 to March 2009) the Indian rupee has tumbled by 27% vis-à-vis the US dollar. At the same time, foreign exchange reserves have also fallen by US$60 billion¹⁰ (Figure 15 [ PDF 82.2KB | 1 page ]). However, with foreign exchange reserves remaining at 110% of total external debt at the end of December 2008, investment sentiments should not be unduly affected in the near term. The nearly 25% depreciation in the Indian rupee's exchange rate has partially nullified the benefits from the decline in global oil and gas prices and has increased the cost of commercial borrowings. The weaker Indian rupee should, however, encourage exporters and it is possible that with imports declining as sharply as exports that the country's trade deficit may actually improve in the short run. Additionally, the external sector balance may remain stable and not pose any major policy issue.

The timing of the external shock arising from the global economic downturn has been rather unfortunate. The Indian economy was already in the middle of a policy-induced slowdown and the crisis has further aggravated it. The impact of the global crisis on the real economy became evident in the third quarter of FY2008–2009, belying the optimistic official pronouncements and expectations of some economists,¹¹ when the Indian economy registered a modest growth rate of 5.3%,¹² significantly lower than 8.9% achieved in the corresponding period in FY2007–2008, and after having achieved a 7.8% growth in GDP in the first half of FY2008–2009. At the sectoral level, robust growth in community, social, and personal services (22.5%) and financial, real estate, and business services (8.3%) enabled the services sector to maintain healthy growth despite the sharp decline in trade, hotel, transportation, and communication services. The secondary sector in general and the manufacturing sector in particular performed extremely badly. In the wake of a decline in domestic and export demand, the manufacturing sector witnessed a moderate growth of 0.9%, while growth in construction slowed down significantly from 9.7% to 4.2%.

However, estimates for economic growth in the final quarter of FY2008–2009 (from January to March 2009) have pegged the growth at 5.8% and the full year's GDP growth at 6.7%. These is sharply lower than the average GDP growth of 8.9% during the previous four years (from FY2004–2005 to FY2007–2008) and also lower than 7.1%, which was the official estimate announced at the time of the interim budget in February 2009. The key question is whether the 5.8% growth in the fourth quarter of FY2008–2009 already reflects a turnaround in the economy, which may be expected to achieve a higher GDP growth in FY2009–2010 (Table 5 [ PDF 87.1KB | 1 page ]).

In our view, this is far too optimistic. The economy will in all likelihood continue on its downward trend in the first half of FY2009–2010 (from April to September 2009) before it recovers in the second half as the impacts of the global crisis on the Indian economy potentially taper off by October 2009. For FY2009–2010 we expect the GDP growth to be about 6.0%, still lower than 6.7% in FY2008–2009. This estimate is based on a model of “leading economic indicators”¹³ that is used to forecast the GDP growth and whose estimates are given in Figure 16 [ PDF 38KB | 1 page ].

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