Indian Economy | Global Unresolved Issues Download PDF

Unaddressed Issues

There are still a number of global unresolved issues, first being the absence of consensus at the WTO or in the inability to push through conclusion of the Doha round of negotiations which will be discussed in the next section. There are still other issues, potentially destabilizing in nature, which would need an early addressing and early resolutions such as:
(1) The issue of the continuation of ‘USD as an international reserve currency’. In the wake of crisis, many critics have favoured a neutral currency like the SDR as an international reserve currency.
If that happens, it may completely destabilize the US Economy and may lead to grave economic fall outs.
Any reserve currency will require it to be a currency in circulation for settling transactions, completely convertible, backed by a strong and large economy, globally acceptable and market-determined. All of which presently is satisfied only by the USD.
The issue of switching to some other currency should not arise as the problem is not with the currency but with US economy, as USD continues to be a strong currency and widely acceptable.
An unbiased collective view, putting to rest all speculations, would have to be taken in the ‘global’ interest for global stability.
(2) The future of Euro as a unified currency of the Euro zone has begun to show signs of cracking up especially with the recent crisis in Greece, Spain, Portugal, Ireland or the PIGS Economy which are not only destabilizing Euro zone but also smaller economies having the capabilities to destabilize the global economy.
The Euro has raised a number of fundamental questions of compatibility of smaller and larger economies, differential growth, differences in sectoral contribution of output, labour immobility, high levels of unsustainable deficits and different strategies for growth.
Whether Euro will survive or disintegrate is a big question mark? This will decide whether unified currency a good option or a limitation in the Euro zone.
(3) The ‘quantitative easing’ (QE) by the US of lowering reserves ratio to near zero first and then purchase of US securities from them market referred to as QEround2,is leading to surge
in inflows into emerging economies of the world, resulting in appreciating currencies, leading to ‘currency war’ situation with each economy trying to protect their respective currencies.
This would threaten the relevance of market-determined exchange rates.
This is also a dangerous proposition, as it fuels ‘carry trades’, which is money being utilized for earning higher returns in the emerging economies.
This could be destabilizing both for the US and emerging economies.
(4) With China becoming the second largest economy of the world and increased contribution to world trade, their reluctance to discontinue with their ‘pegged exchange rates’, would only distort world trade in future.
(5) There is a larger crisis in the making again epicentred in the US, which is credit card or plastic money becoming the preferred mode of transactions. The credit card market in the US is many more USD trillions.
It leverages spending beyond one’s means and a default similar to the sub-prime borrowers, can again potentially paralyze the financial system.
If the sub-prime borrowers were a USD 1.3 trillion market the credit card is more than double the market of around USD 3 trillion.
Can one fathom the fall outs of defaults in credit cards?
(6) The ageing workforce in countries such as US, Europe, Japan and others have grave fiscal implications of increased social security pension liabilities, representing unfunded public liabilities, have seeds of fiscal crisis as that seen in Greece and Ireland.
(7) Already the debt level of the US is over 100 per cent of its GDP, similarly for UK and the other European economies. Can such high levels of debt be sustainable in the long run? Probably, the emerging economies including India are fortunate that their debt levels though high but have not reached the levels seen in the US and other economies.
Clearly as said earlier, the global economy today is at crossroads, uncertain, highly fluid, with lots of question marks.
However, two things can be said with certainty, one that the emerging economies would increasingly play a very important role in reshaping the global economy and two that in multilateral trading lies the future.

Yet a recent disturbing trend is signs of recovery in the US and Europe is adversely affecting emerging economies with India included. While QE in the US was largely responsible for currencies in these economies appreciating, the reverse is happening. Withdrawal of QE or abandoning loose monetary stance has contributed to reversal of inflows in emerging economies resulting in their currency depreciating.
First the worry was global recovery and now the fall out of recovery in bigger economies has become a cause of concern. The concerns of economies like India are genuine and thus withdrawal of QE has to be gradual, not coming in the way of recovery and also not destabilizing emerging economies like India.

 

Indian Economy | Global Consensus – Going Forward Download PDF

Post Crisis

Any crisis having global implications should and rightfully be driven by consensus across major economies not only in terms of the kinds of intervention but also in terms of consensus on the way going forward. First thing in going forward, is to review the damage control interventions, in terms of their effectiveness of having ‘arrested’ free falls of output contraction and unemployment.
It is equally imperative to understand that things have to be seen from a global perspective rather than the country perspective. The next would be to keep in mind that recovery of economies is going to be slow, long-term and more importantly ‘uneven.
It also needs to be understood that stimulus and bailout packages should be seen as short-term and withdrawable, but replaced with sustained long-term reforms. Accordingly, withdrawing of the interventions should be well thought out, staggered and again done collectively or could facilitate fears of double-dip recession.
More than the recovery, the nature of recovery would not be like the alphabet W but U-shaped with the bottom more elongated, which is the reflection of a longer time period and no sudden spurts of growth. Despite the slow process, the way going forward is not to restrict trade or return to neo-protectionism but on the contrary increased trade across countries as a way for economies to expand.
The crisis should not be seen as the collapse of the free market economy and larger role for the respective states in both acting as a producer or a regulator both. It is not to bring back the public sector or regulations but to continue with the market mechanism. It should not be seen as a market failure or question the merits of the market mechanism, but to bring in awareness in the markets about the following: –
(1) Of their larger role and responsibility which is freedom to do business, but not compromising on the moral ethics of businesses.
(2) The desire for expansion and growth can be passions of businesses, but not greed.
(3) They also have societal and responsibilities to their nation.
(4) The interest of the people can and should never be compromised.
At the government level too, there will have to be a greater inter-government monetary cooperation and also at the apex central bank level. At a still broader level, there would be a need to have ‘better global supervision and not regulations over the global financial system’. Finally, the need for the good collective leadership is to provide good governance and also to lead both at the same time.The way going forward has a larger role for the governments of the US, EU, Japan,India and China for resurrection of the global economies as fundamental and primary ^ objective. That is, economics dominating politics and setting aside political differences.However, the most important in going forward lies in understanding, the importance of trade, not return of neo-protectionism, in these troubled times. Multilateral trade could have never ever been in economic history, as relevant, as it is today for revival of the economies.

 

Indian Economy | Overview of Recent Crises Since 2008 Download PDF

US Crisis 2008 And 2011

The largest economy of the world went through two major crises in the recent time and the worst since the Great depression 1929-1933. The crisis of 2008 was a ‘financial sector crisis’, the genesis which was sowed in the inverted financial system, highly over leveraged, as an inverted pyramid. The mechanism of the over leveraging was through complex financial derivative products (products deriving value from an underlying financial assets) which had excessive risk. Globalization of the financial system had happened even earlier to the economic globalization, resulting in a broad global financial architecture covering banks, investment banks, pension and insurance funds, housing finance companies, hedge funds all finely inter meshed with each other difficult to differentiate the financial products and the holders of such products. These products were traded ‘over the counter’, outside the stock exchanges resulting in their being unregulated or any kind of supervision on their trading.
It was also driven by consumption-led growth especially through housing loans making it relatively easy for people to get mortgage hacked loans which were then sliced and diced as multiple risky derivative products. This crisis has been covered in an earlier section as the Global meltdown or sub-prime crisis.
The US crisis of 2011 was a ‘fiscal crisis’, arising out of reckless fiscal spending over the past decade with deficit to GDP climbing to double digit in less than a decade. This was due to compulsions of the US of mounting expenditure of social security and the crisis of 2008 only making matters worse, in terms of recession and also rising unemployment of one of the highest in the history of US, requiring increased spending besides monetary easing. At the same time, taxes were never reviewed with tax rates virtually unchanged and on the contrary, as a response to the crisis during 2008, tax rates were lowered for boosting consumption in an attempt to revive growth.
The fiscal crisis occurred when the US hit the ceiling of the overall level of debt of USD 16.4 trillion, which meant that deficit could not be sustained through increased borrowing as done in the past. Further with fears of breaching the cap, there also arose the likelihood of a default as bonds due for payment could not be done through more borrowing, unless the cap was raised.

This resulted in the first ever down grade of the US rating by Standard & Poor during 2010. The Senate realizing the gravity of the problem passed a resolution of suspending the cap but with strict austerity measures in government spending and roll back of tax concessions given effective December 2012, resulting in a ‘fiscal cliff’, of the relative inability of the government to reduce spending and also raise taxes, in the wake of the growing un employment rates and marginal growth of the US economy. The US government has to cut expenditure by USD 1.2 trillion over a 9-year period beginning December 2012. In view of the fiscal cliff, US congress has further extended suspension of the debt ceiling first till 19 May 2013 and now for a further six months. The fiscal crisis of the US has not been resolved but only postponed and the fiscal cliff would resurface soon.
However, a silver lining has been a beginning of the revival of the US economy. This is evident in the Federal Reserve now considering withdrawing its quantitative easing (QE), that of not injecting liquidity, a sign of a revival of the US economy. It is difficult to say at this stage whether it will be end of the down turn of the US economy or whether there will be a double dip recession.

Euro Zone Crisis

Earlier, European Union represented one economic market as an economic union with free trade with each other. The Euro zone came into existence with the signing of Maastricht treaty signed during 1992, of a monetary union, one central bank and single currency, replacing country specific currencies in the European Union. As a result, the Euro as common currency came into existence during 2002, but of the twenty-seven member countries only, seventeen members of the EU accepted Euro as the common currency and became part of Euro Zone.
Some of the members not opting for Euro (10) especially Sweden, UK and Switzerland which while accepted Euro, also had their own respective currency and not part of the Euro zone even though part of European Union. There are six other countries which have Euro as their currency but are not part of the Euro zone resulting in twenty-three countries in the world having Euro as their currency with seventeen as part of Euro Zone.
The Euro zone had structural problems ever since it came into existence. They are as follows:
(1) Of a union of dissimilar economies, difference in sizes, economic activities, resources, technology and levels of development and incomes. On the one hand, the stronger economies of Germany, France and Italy and the other ‘peripheral economies’ such as Greece, Portugal, Spain, etc.
(2) Some of the Euro zone member had strong currency before Euro came into existence such as Deutsche Marks (Germany), French Francs and the Italian Lira, while other had a weak currency such as Greece (Drachma), Portugal (Escudo) and Spain (Peseta). Thus, monetary union was not across similar monetary strengths of economies.
(3) The larger economies especially Germany had a current account surplus while others had a current account deficit largely with Germany.
There was a ‘growth with stability pact’ amongst Euro zone members which was more of an understanding rather than a ‘fiscal union’ of debt to GDP not exceeding 60 per j cent and deficit to GDP of not exceeding 3 per cent, which was never adhered to by ‘ the member countries resulting in ‘fiscal excesses’, high levels of deficits resulting in large borrowings especially by what is referred as PIGS economies, which comprises of Portugal, Ireland, Greece and Spain.The Euro zone crisis is a ‘sovereign debt crisis’ as it is government debt outside the country.

Cyprus Crisis

The crisis Cyprus is a ‘banking sector crisis’, with volume of business many multiple of its GDP, unregulated, high exposure to Greek bonds almost resulting in collapse of the second largest bank necessitating a bail out by European central bank.

 

Indian Economy | Global Crisis- Government Interventions Download PDF

Collective Intervention

A positive aspect post-global crisis has been the prompt and collective government level interventions unidirectional, which otherwise, was fraught with graver consequences, as mentioned previously, had the potential to surpass the agony of the great depression.

The government level interventions were first, avoiding any kind of panic but use collective wisdom. Secondly, at the government level itself, of that being ‘collective’ and ‘consensus’ driven unidirectional intervention. The third, being of its distinction made between direct and immediate, the other as indirect, in the medium-term and in the long-term, addressing structural issues of the global financial system, to prevent their recurrences in future. Fourthly, interventions would be short-term, as a medicine but need addressing the issues of the global financial system collectively, as part of the larger reform package.
Depending on the impact level, different governments could choose on the immediate intervention either as ‘bailout package’, which is providing government finances, capital infusion or as a ‘stimulus package’ driven around fiscal loosening. The US government resorted to bailout packages through capital infusion, also took over some of the institutions, relaxed its monetary stance by going for ‘quantitative easing’ and bringing down interest rates to near zero to revive growth and output of the US economy.
The Indian Government on the other hand resorted to a preventive-cum-stimulus measures like:
(1) RBI allowing banks to restructure their loan accounts and reschedule loan installments, as a preventive measure to prevent build-up of bad loans.
(2) It also went for quantitative easing by lowering CRR, to improve liquidity.
(3) It advised banks to shed their risk awareness, as it was a problem not a solution, to the slowdown in the economy.
(4) Fiscal measures as part of the stimulus package were, through rolling down excise duties and corporate tax rate to provide industrial sector necessary boost.
(5) It also ran up a high fiscal deficit by increasing spending in the economy, even at the risk of inflationary pressures and compromising on the compulsions under the FRBMA. In fact, India ran the highest fiscal deficit in the last 16 years.
(6) As a fillip to exports concessions were extended and new strategies of incentives were given to diversify to Afro—Asian countries impacted lesser by the crisis
Overall, it was a combination of all which limited the impact, without the need for any bailout as no financial institution in India had collapsed. Can we say that impact on India was fairly limited because of the public sector character of Indian financial system, less exposed to global markets?
Many critics feel so that public sector dominated financial sector was the reason for the limited impact. However, as mentioned previously, it was the timely intervention by the RBI and the government, without which, it could have resulted in collapse of some of the smaller banks even in the public sector. Banking globally has elements of risk. Any lending will have risks. But the answer to that is not to become risk averse.
The answer lies in growth and expansion by better risk assessment capabilities, risk diversification, have risk mitigants, understanding risk appetite and sufficient capital for the risk. The public sector character inherently has risk awarness and cautious approach, both of which are helpful in warding off crisis situations, but are also an impediment to expansion and growth of size of-banks, so important in developing risk appetite.
That is why despite India’s status as the fourth largest in the world, does not have any bank in the top fifty banks of the world, under any parameter, except may be the number people employed. So the larger question is not the ability to have withstood the global crisis and of having passed the test of time but what lies in future?
As India goes for deeper levels of integration, it would require mergers of banks to attain a critical mass and at some point will have to discard the public sector character, if it wants a few Indian large banks, actually becoming global banks and play a larger role in global financial system.

 

Indian Economy | Global Financial Meltdown Download PDF

De Coupling Theory

On a number of occasions previously, we have made a passing reference to ‘The Global Crisis’ as a crisis first ever, in economic history, ever outshadowing the ‘Great Depression of 1929—1933’, in terms of the potential wide ranging impact and ability to destabilize the global economy. The great depression also resulted in contraction of US output and resultant global output, leading to the widespread global unemployment. However, it was confined to the US and Europe. The impact was little on Asian economies given their small size and most of them under the domain of the colonial rule, with little international stature, for any perceptible impact of the depression. Similarly, all the other crises were relatively confined to geographies and had brought forth the ‘decoupling theory’. That it was possible for economies to insulate themselves from adverse fall-outs in different parts of the world or ability of economies to remain ‘de-coupled’.The decoupling theory had worked during all the earlier crises but the theory was first tested during the ‘oil shock of the seventies’, which had affected most economies of the world.The global crisis has broken this myth, that in the present era of integration and globalization, it is not possible for economies to remain decoupled or insulated from adverse global developments. The degree of impact may vary but insulation is not possible.
Thus, it got its name as a global crisis, also known as the ‘global meltdown’ or the ‘sub-prime crisis’. It is first, a financial sector crisis, gradually seeping through to other sectors of various economies. Financial sector globally is seen as the backbone of an economy on which other sectors are heavily dependent for their financial needs. In its strength lies the ability of economies to grow. Any crisis in the financial sector cannot be insulated from the rest of the economy. In the earlier section on Global Integration, we had seen how financial integration had taken place and it was natural for the financial sector crisis to move across borders across different economies. The global financial institutions besides their spread across economies, over a period of time, had become complex, with new diversified risky products, operating on wafer thin margins, overleveraging and stretching the financial sector.

These institutions were not only spread wide but deep and so interwoven that it was impossible to track. A highly risky product of ‘derivatives’ or something deriving value on the strength of an underlying asset (bubble) which can either be exchange rates, bonds, equities or commodities.
It is not the credit derivative which is the issue, but for its exposure extending multiple times the balance sheet of institutions, was a sure recipe for disaster, just waiting to happen, and required only a trigger point. It may be interesting to note that just before the crisis the derivative market was over USD 600 trillion or 11 times the global output during 2007.
The top five banks of the US had combined assets of USD 4 trillion on a capital of USD 200 billion, a leveraging of twenty-one times. While the exposure to the derivative market was leveraged by over 90 times! This is what overleveraging like an inverted pyramid, which can never be stable and can collapse with the slightest of disturbance.
The trigger point was default by the sub-prime borrowers of mortgage loans in the US, against which mortgage backed securities (MBS) were sold after being diced and sliced multiple times by the banks, investment bankers and other institutions spread as tentacles, inter-woven across the global financial system. So much so, it was not possible to track them down not even by the banks which had issued these securities.
As a result, this set of a chain reaction leading to overnight collapse of well-known large financial institutions such as The Lehman Brothers, AIG, Bear & Stearns, General Motors and closure of many established banks, crashing the stock markets thus earning the name of global meltdown. It is the complete decimation of international financial giants and collapse of the stock market, referred as the meltdown.
It is important to understand that the US and European Governments got to know of the collapse ‘after’ the collapse and not ‘before’ the collapse and thus could not prevent the collapse ‘before’ the collapse. Since die beginning of the crisis as many as one hundred and fifty-seven banks have shut down in the US. It can be said that the crisis had its epicentre in the US but shivers went throughout the global economy.
Who are the sub-prime borrowers? It is that class of people who do not have the resources to service the loan taken or those borrowing for consumption purposes. But why lend to them? It was the US model of ‘consumption-driven growth. More the consumption, greater demand for goods and services and thus there would be greater production and output.
As a counter to the earlier slowdown of growth of their economy, US banks went for aggressive lending, reaching out to all, as they had the confidence that their financial sector would be able to balance it, by spreading the risk wide and through their complex range of products.
So what could be the reason(s) for the crisis? Can we say it was the global financial integration, or lending to sub-prime borrowers or aggressive lending or a combination of all, which led to the crisis. They may have contributed their share but there were five ‘excesses’. They are as follows:
(1) Excess overleveraging.
(2) Excess liquidity.
(3) Excess complex products.
(4) Excess confidence of the financial system.
(5) Excessive greed of the financial system.
First is the highly overleveraged financial system something like an inverted pyramid, which is structurally unstable. Secondly, free financial markets and absence of regulations on the overleveraging by financial institutions. Thirdly, overconfidence of international financial institutions of nothing can go wrong.
The sub-prime borrowers only precipitated the crisis, acted as a trigger point, but it was, like said earlier, a crisis only waiting to happen.

Global Crisis and India

The global crisis took its toll on the US and Europe leading to a contraction of their output, but did not enter the recessionary phase, which is continuous contraction of output more than two quarters. However, the fears of recession haunted both the US and Europe. More than the contraction of output, a greater concern was the increasing pace of the unemployment.
India had a higher degree of financial integration than trade integration with capital inflows both in current as well as capital account more than 100 per cent of the GDP. Let us also accept a fact that US is too large an economy to be ignored for their adverse fallouts by any economy. Being the biggest economy is the biggest driver of integration and coupling of economies.
The crisis did impact India as well as other Asian economies such as China with a ‘slowdown in their growth but not contraction of output, in all these economies. The impact was there but less intense than that experienced by the US and European economies. As said previously, this was a financial sector crisis and the Indian financial system was less affected, given dominance of the public sector banks, which are less exposed to complex risk products, not overleveraged, fairly risk averse and not much exposure to international markets and products.
What the crisis did to India was to push the domestic financial sector into a ‘cautious and wait and watch mode’, became averse to lending. It did impact some of the private and foreign banks in India but not to the same magnitude; as such exposures were limited and small in relation to their balance sheet size. This forced tightening of the liquidity by banks, self-imposed, in their own wisdom, dried up money with the industrial sector which in any case, had also gone in the cautious mode.
Both these resulted in build-up of inventories, longer production and repayment cycles and slowdown of industrial and overall growth of the Indian economy. It can be said the banking sector was on the verge of witnessing defaults and build-up of bad loan book, both which could have compounded the problem manifold and impact far greater.
The financial sector was fortunate to have a limited impact in the sense that no bank or any financial institution collapsed. However, it did dent exports, as for the first time, in over a decade or so, there was contraction of exports. But this contraction was not sufficient, to contract overall output, given the relative low share of exports to total output of the Indian economy.
So overall, the impact on India was that it put in the minds of people ‘fear and uncertainty’, resulting in a slowdown and definitely impacting exports for a short period of six months. The impact and fallout could have been greater and deeper both for the world economy and India, but for ‘timely’ and ‘collective’ government interventions both in India as well as other major economies of US, EU and Japan.