Global Financial Crisis and the Indian Economy

Here we detail about the effects of global financial crisis on the Indian economy.

Stock-Market Crash:

Following the eruption of financial crisis when the Wall Street of the US and stock markets of the European countries crashed, its effect spilled over to India and our stock market (Dalai Street) was also badly hit.

To meet the liquidity requirements or liabilities of their parent companies, Foreign Institutional Investors (FIIs) started selling the shares of the Indian companies held by them.

The selling pressure by FIIs brought about a crash in Dalai Street (i.e., Bombay Stock Exchange). In the last few years FIIs had invested on a massive scale in the equity shares of several Indian companies operating in various industries from consumer goods to infrastructure industries.

As a result of the buying spree of shares of Indian companies by FIIs, share prices rose to new heights. The Sensex which was around 6000 in 2004 rose to 8000 in Aug.-Sept. 2005 and went on rising further crossing 10,000 mark in 2006, 13000 mark in 2007 and reached the peak of around 21,000 mark in January 2008.

At around this time, share prices in the US and European markets started falling sharply and the problems of liquidity and credit crunch assumed grave proportions. This led FII to sell shares held by them in the Indian stock market to pull out capital from India.

This was done to fulfill the needs of redemption pressures on their parent companies who were facing liquidity problem. As a result of this selling pressure, Sensex of Bombay Stock Market (which is called Dalai Street) started tumbling; it fell from around 21000 in Jan. 2008 to 11000 in Sept. 2008 and in its downward march it fell below 10,000 in Oct. 2008 and 9000 mark in Nov. 2008, that is, 60 per cent fall since Jan. 2008.

This caused huge losses to the Indian companies and investors whose huge wealth was wiped out in a couple of months in 2008. Foreign institutional investors sold more than $ 13 billion worth of shares of Indian companies up to Nov. 2008 and repatriated them to their home countries. This also led to the decline in foreign exchange reserves held by RBI to $ 250 billion by the end of 2008.

Depreciation of Indian Rupee:

But the effect of capital outflow by FIIs was not confined to drastic fall in share prices but was more deeper and divesting. When foreign institutional investors (FIIs) sold their shares in India they got rupees. They had to convert their rupees into dollars to send them abroad. This led to the increase in demand for dollars. Rupee-dollar exchange rate being determined by demand for and supply of currencies, the increase in demand for dollars caused appreciation of US dollar in terms of rupees, that is, rupee depreciated against US dollar.

The Indian importers also demanded dollars to pay for the imports of goods. The Indian banks doing foreign exchange operations also bought US dollars at home to keep their foreign exchange operations afloat since due to credit crunch no one in foreign countries was willing to lend dollars to any Indian bank.

This further raised the demand for dollars causing fast depreciation of rupee in the months of September, October and November 2008. The Indian rupee whose value had appreciated to Rs. 39.4 for a dollar in Dec. 2007 depreciated to Rs. 49.3 for a dollar in end-Oct. 2008 and further to all time low of Rs. 50.6 for a dollar in mid-Nov. 2008.

This depreciation of Indiana rupee though made our exports cheaper, made our imports costlier. In Oct. and Nov. 2008, crude oil price declined from all time high of $ 147 per barrel to around 50 US dollar in Nov. 2008 and to $ 40 per barrel in Feb. 2009.

Liquidity Crunch in the Banking Sector:

But the story of impact of capital outflow by FIIs did not end here. As a result of large outflow of dollars fast depreciation of rupee against dollar began. To prevent fast depreciation of rupee and maintain relative exchange rate stability, RBI intervened and supplied dollars from its foreign exchange reserves.

With this too much depreciation of rupee was prevented but in this process of supplying more dollars in the foreign exchange market, it got rupees in return. As a result the quantity of rupees with the banking system declined causing liquidity problem in the Indian banking system which affected credit flow to the industry for financing of working capital and fixed investment projects.

This problem became so severe that inter-bank credit market was mostly frozen; no bank was willing to lend to other banks as every bank needed liquidity to tide over contingencies and this restricted credit flow to the industries. Risk aversion by banks in India also played an important role in restricting credit flow to consumers for buying cars, houses etc. and companies for making investment.

Thus the cause of liquidity and credit crunch that arose in India was the sale of billions of dollars from its reserves by the RBI which withdrew rupees from the banking system in the process. It is estimated that each sale of a billion US dollars by RBI sucks around Rs. 5000 crores from the domestic market. The call rates, that is, rates at which banks lend to each other for a short period rose to all time high of 23 per cent.

Impact on Indian Economic Growth:

When all powerful US economy witnessed slowdown in economic growth and ultimately experienced recessionary conditions as a result of financial crisis, its effect spilled over to Europe, Japan and other Asian countries. Britain, Germany, Italy and 15 nations sharing Euro slumped into recession for the first time after several years.

In September 2008 IMF gave the bleak assessment of the global economy whose growth rate was expected to hit 3 per cent in 2008 and near zero in 2009. In September 2008. IMF also predicted lower growth of 7.7 per cent for India for the year 2008-09 which was later further lowered to 7 per cent as against over 9 per cent growth in the previous 4 years (2004-08).

Our Finance Minister repeatedly assured that despite stock market crash, the fundamentals of the Indian economy are quite strong and Indian growth story is quite intact. Prime Minister Dr. Manmohan Singh also expressed the similar views and said that global meltdown would have minimal effect on India’s economic growth. However, India’s growth of GDP fell to 6.8 per cent in 2008-09 as against over 9 per cent per annum in the preceding three years. In 2009-10 and 2011-11, the Indian economy recovered and its growth of GDP was 8 per cent and 8.6 per cent respectively.

However, as against the 11th plan target of 9 per cent annual growth, fall in India’s growth to 6.7 per cent in 2008-09 and 8.0 per cent in 2009-10 will badly affect the targets of employment generation and poverty reduction. It is true that unlike that of China, India’s economic growth depends more on domestic demand rather than external demand and is driven mostly by domestic saving and investment.

However, at present after 18 years of globalisation, our exports constitute 14 per cent and imports 20 per cent of GDP (2006-07). Therefore, India could not escape from the adverse consequences of global meltdown. This is evident from industrial growth during the second half of the fiscal year 2008-09; India’s industrial production (IIP) registered 4.8 per cent growth in September 2008 and a negative growth of 0.41 per cent in October 2008 for the first time in 15 years. For the whole year 2008-09 the growth in industrial production dipped to 3.7 per cent as compared to 10.3 per cent in 2007-08 and 14.9% in 2006-07.

There was a fall in output of automobile, aviation and shipping industries. Besides, export-oriented industries such as textiles, leather, gems and jewellery have been badly hit by the global meltdown and registered a fall in production and employment opportunities. Agriculture registered 1.6 per cent growth rate in 2008-09 as compared to 4.7 per cent in 2007-08. There was a very slow growth of 0.4% in agriculture in 2009-10.

The most adverse consequence of global turmoil was that the growth rate of manufacturing in India fell to 3.2% in 2008-09 from 10.3 per cent in 2007-08. Not only did domestic demand come down even export orders fell substantially due to recession in the developed countries.

The other important causes of slowdown in manufacturing are that banks were not willing to give credit and lack of adequate power supply and high input costs. It is worth mentioning that though growth rate of Indian economy slowed down under the impact of global financial crisis, its estimated growth rate of 6.8 per cent in 2008-09 and 8 per cent in 2009-10 was still quite high in view of the fact that other countries such as US, UK, Japan, Euro countries, Germany were experiencing severe recession (that is, contraction in GDP).

In fact, growth rate of Indian economy is second highest in the world next only to China. However, a matter of serious concern is that employment situation worsened in the fiscal year 2008-09. There were large scale losses in jobs in the sectors like textiles, metals, leather and jewellery. With slowdown in economic growth in India unemployment in India also went up.

Another matter of concern is that due to large increase in government expenditure to pull the economy out of recession and slow growth of agriculture, inflation rate as measured by CPI rose to more than 11 per cent in 2008-09. Besides there has been severe food inflation which in Feb. 2010 went up to around 20%. In 2009-10 and 2010-11 food inflation spilled over to manufactured products as well. Rate of inflation based on CPI (for industrial workers) went up to 9.1% 2008-09, 12.4 in 2009-10 and 11% in 2010-11.

Exports and Balance of Payments:

As a result of globalisation and the adoption of export-oriented strategy of growth in place of import substitution, the Indian economy now depends to a greater extent on external market to sell our goods and services. In 1990-91 we exported goods to the tune of 5.8 per cent of GDP whereas in 2006-07 our exports of goods rose to 14 per cent and our imports to 20 per cent of our GDP.

Our foreign trade balance worsened during 2008-09. India’s foreign trade balance registered a deficit of $ 60 billion in the first half of 2008-09 as against $ 30 billion in the first half of 2007-08. Actually, our exports in Oct. 2008 were not just down but declined 12.8% as compared to the same month of the previous year 2007.

This negative trend continued in the remaining years of 2008-09. As a result, our target of exports of 200 billion US dollar for 2008-09 was revised downward to $ 175 billion. Actually, growth of Indian exports in 2008-09 was around $ 170 billion, much short of the original target. Due to global financial crisis the growth of our exports were bound to decline as a result of recessionary conditions in the US and the European countries.

Besides, due to sharp depreciation of rupee during 2008-09, our imports also costed more despite the fall in international commodity prices and crude oil. Hitherto our export growth was bolstered by rising commodity prices and yet strong demand from emerging markets and oil producing countries.

All such contributory factors are no longer there. In 2008-09 and 2009-10 deficit in our balance of payments on current account went up to 2.4% and 2.9% of GDP_mp respectively. However, beginning from Nov. 2009, there has been positive growth in our exports indicating recovery in the world economy, especially in the US. However, due to high growth in imports our current account deficit has gone up.