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The Fate of India Unincorporated

While evaluating the Indian policy responses to the global crisis, this article focuses on the likely extent of the spread of the crisis to India and how it will affect the domestic economy. In India, exports have declined, foreign institutional investment has fallen, and share and real estate prices have crashed. The social cost of the slowdown has been unemployment. India's policy response has so far addressed the issue of reviving the real economy but has done little to build firewalls around the financial sector and provide safety nets for the vulnerable sections. Some measures which could go a long way towards attainment of the last two objectives are outlined.


The Fate of India Unincorporated

Dilip M Nachane

While evaluating the Indian policy responses to the global crisis, this article focuses on the likely extent of the spread of the crisis to India and how it will affect the domestic economy. In India, exports have declined, foreign institutional investment has fallen, and share and real estate prices have crashed. The social cost of the slowdown has been unemployment. India’s policy response has so far addressed the issue of reviving the real economy but has done little to build firewalls around the financial sector and provide safety nets for the vulnerable sections. Some measures which could go a long way towards attainment of the last two objectives are outlined.

The views expressed here are personal and do not reflect those of the institution that the author works for.

Dilip M Nachane ( is Director, Indira Gandhi I nstitute of Development Research, Mumbai.

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he genesis of the current global financial crisis, its unfolding in the United States (US) and the European Union (EU), and the official responses (the revised Paulson Plan, the Bush and Obama bailout packages and similar huge fiscal stimuli in the other developed economies) are by now too familiar to bear repetition here.1 In this article, therefore, I confine myself to the likely extent of the spread of the crisis to India, how it will affect the Indian economy (especially its vulnerable sections) and then evaluate the policy responses attempted so far.

While descriptions (of the milestones in the crisis) abound, analytical explanations are fewer and more controversial. Some explanations try to locate a common thread between the current crisis and notable past crises such as the Kondratieff of 1873, the Great Depression of 1929 and the more recent Japanese (early 1990s) and Asian crises (1997-98). Others tend to view this crisis as fundamentally different (the mother of all crises) and see the financialisation of global capital as the single most important f actor responsible both for its precipitation and its unprecedented severity. The latter group interestingly includes both those who view the current crisis as a systematic crisis of capitalism (a la Marx) and those who contend that it is a Minsky moment (M insky 1982) when liquidity dries up as unsustainable financial exuberance runs its course, in the wake of deteriorating credit standards.2 In contrast, the first group of explanations shares the common view of crises as typifying Schumpeter’s process of creative destruction (from which will emerge a r ejuvenated capitalism). While some of these issues are viewed as of mere academic interest by policymakers, there is no denying that such theoretical writings often contain valuable insights for practical policy d esign, and hence it may not be wise to neglect them altogether in evaluating alternative policy options.

Decoupling Theory

As soon as the first signs of the crisis became visible in the US, the top economic leadership in several emerging market economies (EMEs), including India, hastened to reassure their citizens as well as foreign investors that their financial systems were safely insulated from that of the western economies and that the recent impressive growth that many of them had experienced was most unlikely to lose its sheen. The basis of this robust optimism was located in the fashionable decoupling theory, which was then d oing the rounds of the Ivy League academic circuit in the west and the International Monetary Fund (IMF) – see Akin and Kose (2007) – and was strongly endorsed by The Economist as late as 6 May 2008. Since policymakers in EMEs tend to view these sources as infallible, the theory had quickly acquired in their eyes an almost hallowed status. The decoupling theory simply asserted that growth in Asia was driven mainly by domestic factors, that these factors were decoupled from trends in the west, and that the growth engines in Asia (ASEAN-5, China and India) would not only continue to chug along but also serve as shock absorbers for the western economies and might even help to pull them out of the recession. The strength of the Asian economies was seen to stem from their recent (that is, the last two decades) shift to m arket-oriented policies in a big way, their regional consolidation via trade and investment relationships, and the benefits they derived from global inflows of capital.3 However, recent data stemming from sources such as the IMF and other international organisations, as well as national sources, is seriously at variance with the decoupling thesis. The IMF’s World Economic Outlook (WEO) (January 2009) concedes that “Financial market conditions have remained extremely difficult for a longer period than envisaged in the November 2008 WEO Update, despite wideranging policy measures to provide additional capital and reduce credit risks”. Growth estimates for 2008 and projections for 2009 and 2010 have been scaled down considerably vis-à-vis the N ovember 2008 update. The advanced economies are estimated to have grown at 1.0% in 2008 and projected to grow at -2.0% in 2009 and at 1.1% in 2010.4 As far as the Asian EMEs are concerned, the growth of ASEAN-5 at 2.7% in 2009 and 4.1% in 2010 (in contrast to 6.3% and 5.4% in 2007 and 2008, respectively), of China at 6.7% in 2009 and 8% in 2010 (13.0% and 9% in 2007 and 2008, respectively) and of India at 5.1% in 2009 and 6.5% in 2010 (9.3% and 7.3% in the previous two years),5 are far from the comforting l evels that the decoupling theory would lead us to expect, and instead speak of a substantial deceleration in 2009 followed by a tepid recovery in 2010.

What seems to have happened is that the channels of contagion have been substantially underestimated. As is well known from the literature (see, e g, Van Rickenghem and Weder 2001, Forbes and Rigobon 2000, etc), there are at least four major p otential channels of contagion, namely, (i) trade channel (comprising both merchandise and invisibles), (ii) foreign capital flows, (iii) contamination of financial assets, and (iv) interdependence of asset markets, especially equity, bonds and housing markets. We examine each of these briefly in the Indian c ontext below.

Trade Channel: As demand contracts in the affected economies, exports from other countries are adversely impacted. The contraction in demand would stem not only from reduced incomes in the US, EU and Japan but also from the wealth effect arising out of substantial asset deflation currently under way in the US. A substantial proportion of our exports of key merchandise items is to the western economies (and Japan) which are in the grip of a recession-cum-depression situation. If we term these vulnerable exports, then as a proportion of our total exports they constituted nearly 22% in 2007-08. The prognosis for Indian exports in 2009 is rather gloomy because of the expected unabated fall in incomes in the economies of the US, EU and Japan. The IMF WEO estimates imports in advanced economies to decline by 3.1% in 2009, translating into a decline of 0.8% in the total exports of emerging and developing economies. While separate forecasts for India within this framework are not available, the latest data emanating is far from reassuring. Exports in January 2009 at $12,381 million were lower by 15.9% when compared to the corresponding figure last year. The commerce ministry now expects total exports in 2008-09 to be between $170 billion and $175 billion, that is, a growth rate of between 5% and 8%. Among the sectors worst affected are gems and jewellery, textiles (and within textiles the handloom sector), leather and leather products, cotton and manmade yarn, tea, oil meals, marine products, carpets and handicrafts. As all these industries are highly labour intensive, the impact on employment is bound to be substantial. About 1.5 million jobs have already been lost or are in jeopardy in these sectors.

The trade impacts are, however, not confined to merchandise trade alone but have spilt over into the exports of invisibles. As jobs shrink and incomes contract in the US and EU, private transfers and remittances from non-resident Indians or NRIs (which are shown on the current rather than capital account of the balance of payments in India) are likely to decline. Currently these stand at Rs 1,63,709 crore for the year 2007-08 (RBI Bulletin, D ecember 2008) or about 3.48% of the gross domestic product (GDP) and represent a substantially significant item of the balance of payments. Another important category in the invisibles section of the current account is “Miscellaneous Services” (with software services as the major component followed by communication, financial and business services) accounting for about 3.32% of the GDP. This category is facing the prospect of a huge decline in exports as the major demand for these services (about 60%) is from the US (and especially its financial sector), which is in the vortex of the storm.

Foreign Capital Flows: Ever since the crisis started showing signs of surfacing in Asia, foreign institutional investors (FIIs) have been withdrawing from the region on a noticeable scale. As against a total inflow of FII funds of $16,040.20 million in 2007-08, there has been a net outflow of $8,268.70 million b etween April 2008 and December 2008 (SEBI Bulletin, January 2009). Further fears of capital flight have been raised in the wake of global rating agencies downgrading India’s sovereign rating, in response to the burgeoning fiscal deficit and lower than e xpected growth in the third quarter of 2008-09.6 A plausible risk of capital flight and steep rupee depreciation certainly exists at the moment.

Financial System Contamination: It is indeed a matter of solace that in this critical time the Indian financial system, by and large, continues to be robust. Thus there is a fundamental difference between the crises in the US and EU and India. In the US, the crisis originated endogenously within the financial system and then spread from Wall Street to Main Street (to use President Barack Obama’s famous expression). In the EU and other western countries, the financial system was first affected largely by contamination from the US financial system and the crisis then spread to the real economy. In India (and some other Asian countries), the

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primary source of contagion has been the trade channel. So the real sector has been affected to a great extent but the financial system has remained intact. It is true that sporadic evidence of the exposure of domestic private sector banks, as well as some nationalised banks and foreign subsidiaries, to so-called toxic a ssets and collateralised debt obligations (CDOs) in the US and EU has come to light, but the extent of total exposure is likely to be limited to something like $1.5 billion (on a mark-to-market basis). A substantial share of the credit for the robustness of the Indian financial system must go to former Reserve Bank of India (RBI) Governor Y V Reddy, who carefully monitored the securitisation process in India and forestalled the emergence of asset bubbles feeding on indiscriminate credit expansion. The New York Times (20 December 2008) came closest to the mark when it described him as “the right man in the right job at the right time”.

Asset Markets: Indian equity and currency markets have experienced considerable volatility in the wake of the crisis. The Bombay Stock Exchange (BSE) Sensex stood at 8,325.82 on 6 March 2009 (compared to its average value of 15,644.44 over the year 2007-08), largely due to sizeable FII outflows. September 2008 saw several mutual funds experiencing losses and liquidity problems on redemption pressure, and there was a sharp decline in the volume of the assets under their management, from Rs 5,44,534 crore in August 2008 to Rs 4,83,270 crore in September 2008. What could have been a potential crisis was staved off by the RBI’s prompt response. First, the cash reserve ratio (CRR) was reduced in two steps (6 and 10 October) and then banks and other financial institutions were permitted to lend to the funds on the basis of the certificates of deposit (CDs) held by them. There has been at work a wealth effect related to the declining values of equity and other assets. This decline has largely affected the demand for goods (such as consumer durables and fastmoving consumer goods) by those who typically own such assets, namely, the middle and upper classes.

The real estate market in India (and perhaps in south Asia as a whole) has certain special features marking it off as distinct from the markets in the west. As a country still experiencing very strong demographic as well as urbanisation pressures, shortage of urban housing is chronic in India.7 Hence it is a safe bet that real estate prices have a strong upward secular trend, and realty investment is thus an attractive option for parking long-term funds. What really set the market on fire, however, was the government’s decision in March 2005 to permit 100% foreign direct investment (FDI) in the construction business.8 Foreign capital on the lookout for medium-term capital gains soon discovered the attractiveness of the Indian housing investment option. As a r esult total FDI into housing and real estate which stood at $0.39 billion in 2004-05, shot up to $0.87 billion in 2005-06 and to $2.12 billion in 2006-07 – an unprecedented fivefold increase in three years. Further, funds were also channelled into the sector via the establishment of real estate mutual funds (REMFs) and real estate investment trusts (REITs). Even conceding that the government acted from the best of motives, it cannot disclaim responsibility for initiating one of the worst property bubbles in recent history in India, by what stands out in hindsight, as a hasty

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and ill-planned move. The presumption that FDI would help solve the chronic mass urban housing shortage problem has turned out to be a pipe dream. The fact is that exactly the reverse of this process is at work. Foreign investment in real estate development has actually aggravated the shortage as the funds have gone into financing real estate development that involves constructing condominiums catering for the tastes (and budgets) of the small u pper crust of Indian society (comprising a motley group of multinational corporation executives, corrupt politicians, businessmen and criminals) and, of course, NRIs and persons of Indian origin (PIOs). Such estate development has actually blocked off the s upply of effective housing space for the poor and the middle class. This phenomenon is rampant in most least developed countries (LDCs) and EMEs, and India constitutes a prime example. Thus, the stratospheric property prices that were witnessed over 2005-08, far from reflecting genuine demand trends, actually r eflected collusion between builders, criminals and politicians. Lower and middle class home seekers (whose salaries would be indexed, if at all, to a price index which does not incorporate housing prices) were subject to tremendous strain as they found themselves rapidly priced out of the housing market. Hence, the recession in the housing sector is characterised by an excess s upply of high-end residential and commercial accommodation, coexisting with a huge backlog of unsatisfied demand in the basic economy residential category.9

It is interesting to note that even though real estate developers and real estate companies are facing acute liquidity shortages, they are steadfastly refusing to bring down prices to affordable levels. This is often justified by them on the grounds of high land acquisition and construction costs (though, in fact, the latter have come down sharply in recent months owing to falling steel and c ement prices) but the truth seems to be that their speculative greed makes them reluctant to let go of the high profit margins that they have got addicted to during the boom. Ironically the low interest regime that has come into operation as a response to the crisis, and other measures (such as rescheduling of loans to developers, and reduction of risk weights on commercial real estate lending by banks) are helping builders postpone the inevitable price adjustment that is necessary to get this industry out of recession.

Employment Dimension

The major social costs of a recession are those associated with the enforcement of job cuts, lay-offs and significant upheavals in ( organised as well as unorganised) labour markets. The International Labour Organisation’s (ILO) Global Employment Report for January presents a rather dire picture. Considering three alternative scenarios,10 it projects an increase in world unemployment ranging from 18 million (optimistic scenario) to 51 million (worstcase scenario) over the years end-2007 to end-2009. The corresponding figures for south Asia range from 4 million to 17 million. Even though separate figures are not presented for India, on the basis of the relative distribution of the workforce in south Asia, one could estimate job losses in India to be between 1.3 million and 6 million over this period. The Indian government’s official survey of the unemployment impact of the global crisis was conducted by the Labour Bureau, with a focus on eight sectors (mining, metals and metal products, textiles and g arments, automobiles, gems and jewellery, construction, transport, and infor mation technology/business process outsourcing). The survey estimated a total job loss of 50,000 over the quarter September- Decemeber 2008. Extrapolating this trend in conjunction with the official growth projections in the EAC (2009), the e stimated job losses (on a rough calculation) would be about 1.5 million over the entire recessionary phase (September 2008 to December 2009).

Both the ILO regional estimates and the EAC’s estimates for I ndia are likely to prove substantial underestimates because they neglect several important factors, of which the most important is the rise of global protectionism.

Rise of Global Protectionism: Ever since the eruption of the c risis in the west, there has been a sharp hardening of the fortress mentality across the globe, especially in the US and Europe. Since October 2007, about 66 new trade restriction measures have been introduced, including alterations of tariffs and stiffening of non-tariff barriers (NTBs) to trade (involving licensing r equirements, product standards and intellectual property rights). There has, in addition, been a huge increase in antidumping claims and actions (up by 20% in 2008 over the previous year), and new cross-border taxes (such as carbon border taxes11). Several bailout packages targeted at export-oriented units are tantamount to export subsidies12 and hence trade distorting. US bailout packages are often linked to Buy American clauses and employment restrictions on foreigners.13 Restrictive clauses on foreign lending by banks getting government support are becoming quite common (for example, Switzerland) and this, in turn, is aggravating the drying up of international trade credit already under way in the wake of the crisis.

Let us briefly turn to some other potential causes for the downward bias in the unemployment estimates. Many of the export sectors facing adverse demand (and in some cases supply) shocks have strong backward linkages to the rest of the economy (for example, automobiles, engineering goods, chemicals and allied products, construction, and tourism). It is not clear whether e ither the ILO Report or the Labour Bureau estimates factor these into account. The latter in particular being based on a single snapshot survey is most unlikely to reflect the indirect impact on employment in sectors vertically integrated with the sectors surveyed.

There are at least two other factors which seem to have been ignored. The banks’ safety-first syndrome in an impending crisis situation involves a flight to safety with a disproportionate axing of credit to small and medium enterprises (SMEs) where employment is most concentrated. Reinforcing this credit crunch is the well-known pro-cyclicality of capital requirements, which arises owing to general downgrading of enterprises by credit-rating agencies in a recession and where once again the largely bankdependent SMEs are the ones most prone to facing stiffer terms on their access to credit.

A major contribution, however, of the ILO Report is that it recognises the need to look beyond unemployment rates per se to get a more accurate assessment of the social distress dimension of the crisis. With this end in view, it introduces two supplementary concepts, (i) working poverty, and (ii) vulnerable employment. These two classes are not mutually exclusive and may be found in both the organised and unorganised sectors.14

Working Poverty: This is defined with respect to people who are employed but still fall below a threshold income level. The ILO Report uses two threshold levels – $1.25 per day and $2 per day.

Vulnerable Employment: The ILO does not go into a formal definition of vulnerable employment but for all practical purposes, the following definition given by the UK government suffices. We may define a vulnerable worker as “someone working in an environment where the risk of being denied employment rights is high and who does not have the capacity or means to protect themselves from that abuse” irrespective of whether “an employer exploits that vulnerability” (Department of Trade and I ndustry, UK). The UK Commission on Vulnerable Employment cites the following as examples of vulnerable employment, agency workers, casual workers, freelancers, young workers (less than 22 years), industrial homeworkers, unpaid family workers, and recent migrants.

What typically happens in a crisis is that workers laid off from their regular jobs may not find other regular jobs even if they are prepared to accept wage cuts. Unemployment in countries which have no unemployment insurance schemes is not a viable alternative as there are no accumulated past savings for the workers to fall back upon. They have thus no choice but to join the army of vulnerably employed at lower wages. These lower wages, if b elow the threshold poverty level, could put the worker in both the vulnerably unemployed and working poverty categories. Hence, the above two classes are not mutually exclusive and can be found in both the organised and unorganised sectors.

In the Indian context, considerable information about the i nformal sector is now available thanks to the efforts of the N ational Commission for Employment in the Unorganised Sector (NCEUS). Its definition of the informal/unorganised sector as “all unincorporated private enterprises owned by individuals or households engaged in the sale and production of goods and services with less than 10 total workers” would mean that employment in this sector could be considered as a close correlate of the ILO concept of vulnerable employment. The informal sector (as per the NCEUS definition) accounts for about 50% of the GDP, and employs 393 million out of a total workforce of 457 million (about 86%). According to the NCEUS, about 45% of the l abour in the organised sector would be denied access to basic workers’ rights and would thus come under the ILO classification of vulnerable employment (in the unorganised sector this proportion would be nearly 99%). As the crisis unfolds, this section is the first to be hit (for example, in the construction sector). In a memorandum to the government of India, the NCEUS has given s everal pointers as to how the crisis could affect this segment of workers (NCEUS 2008). Small producers and traders dependent upon export markets have already been badly affected in industries such as handlooms, textiles, apparel, leather products, gems and jewellery, metal products, carpets, oil meals, marine

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products, and handicrafts. The NCEUS estimates that prior to the onset of the crisis, enterprises with investment in plant and machinery below Rs 25 lakh used to get a mere 5% of formal sector credit, whereas those with investment below Rs 5 lakh got less than 2% of the formal credit. Even this minuscule proportion is estimated to have shrunk to 1.2% after the crisis hit. The NCEUS memorandum also indicates the domino dependence of the u norganised sector on the organised sector. Slowdown in the

o rganised sector (which accounts for about one-third of the unorganised sector’s output) thus has a twofold impact on vulnerable employment – a direct impact in the organised sector itself and an indirect effect via the backward linkages with the unorganised sector. Finally, the fall in international prices of several commodities (both agricultural and non-agricultural) has impinged on small producers’ incomes via import competition as well as low prices in sectors such as cotton and oilseeds production.

Indian Policy Response: An Assessment

As mentioned above, the recessions in the US, EU and India represent three distinct patterns. Given that the recessionary characteristics in India are of a fundamentally different hue from those obtaining in the US and EU, the nature of our policy response should not necessarily track theirs, but be specially designed to account for the specificities of our situation. In particular, three concerns should be paramount in the Indian context.

Triad of Objectives
  • (1) Revival sans stagflation: First, there is the need to revive the real economy without, in the process, unleashing forces that could trigger a future asset and/or commodity price inflation.
  • (2) Firewalls around the financial sector: As mentioned above, since the Indian crisis is largely an imported one (primarily via the trade and investment routes) and further, since the financial sector has been more or less secure so far, policy should emphasise the insulation of the Indian financial sector from adverse shocks originating either in the Indian real sector or in the financial systems of the US and EU.
  • (3) Safety nets for the vulnerable sections: As successive ILO Reports point out, in a classic moral twist to the global crisis tale, those who had the least to do with the perpetration of the crisis (the vulnerable sections of society across the globe) are being forced to bear the brunt of the consequences. India is no exception and hence a necessary third pillar of any anti-recessionary strategy should be to build extensive safety nets for those at maximum risk of exposure to collateral damage.
  • Indian policy in the aftermath of the crisis has been addressed almost exclusively to the first objective, with attention to the second confined mainly towards bank capitalisation The last objective has largely languished in the domain of rhetoric. The remaining part of this paper is thus devoted to (i) an evaluation of the policy measures so far adopted from the perspective of meeting the avowed goal of “revival without stagflation”, and (ii) outlining some measures which (in my opinion) could go a considerable way towards attainment of the remaining two objectives.

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    Evaluation of Policy Measures

    The policy measures so far adopted in India may be summed up in a single phrase – easy money and fiscal stimuli. On the monetary policy front there has been a flurry of activity – the repo rate was reduced in a succession of steps from 9% in September 2008 to 5% in March 2009 (with a corresponding reduction in the reverse repo rate from 6% to 3.5%), the CRR was also reduced from 9% to 5% over the same period, whereas the statutory liquidity ratio (SLR) was brought down by 1% to 24%. Altogether, it has been estimated that these measures have released more than Rs 4,00,000 crore ($80 billion approximately) of liquidity into the system.

    There have also been three successive fiscal stimuli packages amounting to a total cost of Rs 80,100 crore ($16.3 billion) to the exchequer.15

    The indications so far seem to be that the package of policy measures is not really having the intended impact of reviving the real sector. In spite of the more than Rs 4,00,000 crore of liquidity released into the financial markets, the credit offtake has been remarkably poor. An RBI press release of 4 March 2009 ( announcing a 50 bps reduction in both the repo and reverse repo rates) is revealing in this regard. expansion during the period between December 19, 2008 and 13 February 2009 at Rs 8,091 crore was sharply lower than that of Rs 86,978 crore in the corresponding period of the last year ... The t otal flow of resources to the commercial sector from banks and nonbanks during 2008-09 so far (up to February 13, 2009) at Rs 4,98,136 crore was lower than Rs 6,08,351 crore during the corresponding p eriod of the last year.

    Whether the low credit off-take reflects a reluctance of banks to supply credit or a deficiency of credit demand becomes a moot question. Considering, however, that the liquidity adjustment f acility (LAF) window of the RBI has been in continuous absorption mode over the past few weeks (with banks parking about Rs 40,000 crore at this window on a daily basis), and that both bank lending and deposit rates have softened appreciably in the past few months, there is reason to believe that the liquidity situation is fairly comfortable. Low demand then seems to be primarily responsible for the poor credit offtake.16 This is not to deny that at least part of the explanation for the poor credit offtake would lie in credit rationing by banks rendered extra cautious in an uncertain environment. Hence, further monetary easing at this stage would be somewhat akin to pushing on a loose string, and the continuous clamour to this effect by a determined group of economists in the business press seems to be quite misplaced.

    If the possibilities of monetary policy are near exhaustion, what prospects does fiscal policy have to offer? The three fiscal stimuli announced so far comprise three distinct elements:

    (i) general tax cuts, (ii) fillip to infrastructure spending, and

    (iii) strengthening bank capital. In addition, outlays such as farm loan waivers, Sixth Pay Commission pay-outs and the forthcoming election campaign expenditure are all in the nature of fiscal stimuli. There are two groups of issues related to the effectiveness of fiscal stimuli (i) macroeconomic issues, and (ii) issues related to the relative effectiveness of alternative modes of a pplying the stimulus.

    As far as the macroeconomic issues are concerned, the first and foremost bears on the size of the budget deficit. India’s consolidated fiscal deficit (of the central and state governments t ogether with off-budget liabilities) is now estimated to be b etween 11% and 12% of the GDP for the current year (see Rao 2009) – way beyond the Fiscal Responsibility and Budget M anagement (FRBM) rules stipulation. Fiscal slippage on such a scale has prompted Standard & Poor’s to revise its sovereign

    o utlook on India to negative. This has already triggered turbulence in the foreign exchange market for the rupee, leading to steep decline and enhanced volatility of the currency. The financial markets also seem to be viewing the fi scal developments with concern, judged by the stock markets going into a nosedive in the immediate aftermath of the announcement of Fiscal Stimulus III.

    The second macroeconomic issue pertains to the raising of long-term interest rates. The augmentation of the government’s borrowing target for the current fiscal to Rs 2,38,000 crore has meant a noticeable “fatigue for government securities in the market” (in the words of a senior finance executive, Business Line, 9 March 2009). As a reflection of the hysteresis of longterm interest rates, the cut-off yields on securities of 10 years’ maturity still remain at 6.5% (as of 8 March 2009).17 There is thus some evidence of monetary and fiscal policy working at cross-purposes here.

    But apart from the general macroeconomic issues, as mentioned earlier, the specific form of the fiscal stimulus is also c rucial in determining its success. Elmendorf and Furman (2008) propose three canons for a successful fiscal stimulus, namely, it should be well targeted, timely and temporary, to which one may add a fourth, that it put incomes in the hands of people who are likely to spend, and spend quickly. From the point of view of these canons, general tax cuts are an inferior option. The tax cuts in Fiscal Stimulus III, for example, are largely expected to benefit higher income households, who may not spend the entire additional income put in their hands by the tax cuts.18 Similarly, the infrastructure thrust in Fiscal Stimulus II may not be very effective as a stabilisation (shortterm) measure.19 The long gestation period of infrastructure investments and the rigid sequencing of capital expenditure (and hence limited possibility for front-end loading of this expenditure) often means that the bulk of the expenditure may fall due after the economy has already transited to the r ecovery phase. Thus infrastructure spending could well turn out to be pro-cyclical rather than contra-cyclical. Further, i nfrastructure spending is no longer the labour-intensive type of activity that it was in the days of Roosevelt’s celebrated New Deal. Much of the infrastructure activity today (such as integrated townships, highways and ports) is highly capital-intensive, with negligible multiplier spending or e mployment effects.

    In evaluating the Indian policy response to the crisis so far, it is also necessary to examine whether the expansionary policies do not contain within themselves the seeds of a future high inflation phase. While many analysts seem to firmly believe that the inflation genie has been securely bottled for at least the medium term,

    this complacency may not be entirely warranted. The RBI itself strikes a fairly cautious note. However, consumer price inflation, as reflected in various consumer price indices, is in the range of 9.85-11.62% as of December 2008-January 2009, and has yet to show moderation. Consumer price inflation has remained at elevated levels due to increase in primary articles’ prices. With WPI [wholesale price index] inflation having moderated significantly, consumer price inflation may also be expected to d ecline, though with a lag (RBI Press Release, 4 March 2009).

    The threat to inflation in the Indian context comes from three sources.

  • (i) Oligopolistic collusions among large firms in several important sectors, which create a ratchet effect on prices, preventing them from declining to the levels necessary for stimulating d emand in a recessionary situation.
  • (ii) The overall liquidity overhang in a low-interest regime, with low credit off-take, could mean that this liquidity could gradually seep through to asset markets via non-bank financial institutions and feed asset price booms, especially in the equity and realty segments (going by the experience of past low-interest regimes in the US in 2001-04 and India in 2004-07), which later inevitably translate into general inflation.
  • (iii) A further threat in the same direction as (ii) stems from the huge liquidity which has come into the global system in the wake of the US and EU stimulus packages. To the extent that this liquidity is not absorbed domestically (in these countries) it is g oing to find its way into the global equity, debt and housing m arkets and the Asian region (especially India) would serve as a magnet for this footloose financial capital. The longer the real recovery in the US and EU is delayed, the greater the danger of such inflows.

    Some Policy Suggestions

    A policy package, in consonance with the three objectives set out above, would be one that would include the following specific measures.

  • (1) Any further monetary policy easing or fiscal stimulus runs the grave danger of laying the foundation for a future high inflation phase. Given the long lags in monetary and fiscal policy20 (between two to three quarters), the effects of the policy measures taken so far are likely to take effect towards end-2009, just about the time when the excess capacity in the economy is estimated to be working itself out.
  • (2) There is no denying that the failure of credit delivery to micro small and medium enterprises (MSMEs) is having systemically important effects in spreading the recessionary virus and in aggravating social distress due to job losses. It is now time to strike out boldly by attempting measures like government guarantees of loans to MSMEs on the lines of the Mandelson Plan in the UK (Peter Mandelson, Business Secretary, UK Governemnt has announced plans to guarantee bank loans to SMEs with sales of up to £500 mn). Actually there is provision for credit guarantees under the Deposit Insurance and Credit Guarantee Corporation (DICGC) Act 1961. However this has now become defunct.21 The DICGC needs to be strengthened with an infusion of funds and entrusted with the responsibility of administering such a scheme.
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  • (3) There already exist provisions for special treatment of risk weights on loans to MSMEs under Basel II. The provisions envisage exemption of loans to MSMEs from capital requirements (or at least assigning these loans a lower risk weight than warranted by their ratings). These provisions need to be operationalised with immediate effect.
  • (4) As a purely temporary measure, for the duration of the crisis, loans above a certain limit to industries in sensitive sectors can be tied to some employment protection guarantees.
  • (5) Encouraging the adoption of innovative schemes like SME-CARE and SMEHELP (initiated by the State Bank of India) by other banks on an extensive scale.22
  • (6) Financial crises affect vulnerable sections of society (including labour) far more than non-vulnerable sections. Hence in the interests of such sections, ensuring against financial contagion should receive top priority. The general monetary and fiscal measures undertaken so far contribute very little to this objective, with the possible exception of the bank capitalisation provisions under Fiscal Stimulus II. But bank capitalisation is not an insurance against a crisis – it is at best a damage-limitation measure in the event of a crisis actually occurring. Hence there is the need for several prudential and “fire fighting” measures such as
  • (i) A switch-over to a system of risk-based deposit insurance relying on a system of Fair Value Accounting.23
  • (ii) A raising of the deposit insurance coverage from the current Rs 1 lakh to Rs 5 lakh. This will provide a much needed safety net for the savings of the middle classes.24
  • (iii) The role of rating agencies in the perpetration of the current crisis has come under heavy scrutiny from economists like Buiter (2008), Portes (2008) and Giovanni and Spaventa (2008). Such criticism has prompted the Financial Stability Forum, through the International Organisation of Securities Commissions (IO-SCO) to offer a code of conduct for credit-rating agencies. The RBI should see that this code of conduct is accepted and adhered to, by major credit-rating agencies in their Indian operations.

  • (iv) A strict monitoring of off-balance sheet items and structured product vehicles (SPVs) of banks and financial institutions.
  • (7) There is the need to recognise that substantive capital flows (in either direction) have potentially strong destabilising consequences. In such circumstances, it is necessary to reserve for ourselves the right to impose key capital controls on a pre-announced basis for specified periods of time. The extent and duration of these controls could be related to the setting off of certain macroeconomic triggers. This trip-wire, speed-bump approach is elaborated at length in my earlier paper (Nachane 2007).25
  • (8) One of the most effective safety nets for the poor has been suggested by the NCEUS. This involves the setting up of a National Fund for the Unorganised Sector (NAFUS). The fund is proposed to have an authorised capital of Rs 1,000 crore and would be designed to provide
  • (i) refinance to banks and other financial institutions to supplement their efforts to provide credit to unorganised sector enterprises with investment in plant and machinery below Rs 25 lakh, but with a special focus on enterprises with investment less than Rs 5 lakh;
  • (ii) microfinance support through non-governmental organisations/self-help groups/microfinance institutions; and
  • (iii) venture capital for innovative enterprises in the unorganised sector.

    This suggestion of the NCEUS requires serious consideration by the government.


    At the Exim Bank Commencement Day Lecture on 13 March 2009 in Mumbai, World Bank Chief Economist Justin Lin gave clear indications that the World Bank was switching over from a policy of global neoliberalism to one of global Keynesianism.26 Evidence of this may be found in World Bank President Robert Zoellick proposing the establishment of a Vulnerability Fund and the “1% Solution”.27 The stimulus packages in several other countries (most notably the US, UK, Germany and Singapore) also incorporate a host of special measures to help their vulnerable sections.

    In contrast, in India, very little seems to have been done towards relieving the distress caused by the crisis to the vulnerable sections of society. Making extremely clever use of the media, India Inc has succeeded in projecting itself as the sole casualty of the financial crisis. Since official policy finds it extremely difficult to ignore media feedback in a democracy, it is not surprising that the major policy thrust so far has been on rescue packages aimed at salvaging this sector. But just as rescue operations in a shipwreck cannot be confined to first-class passengers alone,28 the vulnerable sections of Indian society (on whom the media seems to have virtually turned its back) need help too. The package of measures suggested above (and the list is by no means exhaustive) may be viewed as broad pointers in this direction, whose full details need to be worked out. The fate of such measures d epends, of course, on the election outcome. Though a cinematic slumdog has suddenly been catapulted to popularity, how long his real life counterpart will be remembered once the elections are over, even by those who are singing Jai Ho paeans to his glory at the moment, is anybody’s guess.

    Notes in countries like India growth estimates are for 7 Even in this period of supposedly slack demand, 1 Excellent accounts may be found in Felton and

    end-March. The Economic Advisory Council (EAC) when the Maharashtra Housing and Area Develhad initially estimated India’s growth estimate at opment Authority threw open bookings for 3,863 R einhart (ed) 2008, Brunnermeier 2009 and so on.

    7.7% for the year 2008-09, which was later revised low-cost flats, the number of applications exceeded2 This was also noted by other economists of an downwards to 7.1%. But even this lower figure 4,00,000.

    earlier vintage, such as Irving Fisher (1933).

    seems too optimistic in view of the disappointing 8 Till then only NRIs and PIOs (persons of Indian 3 For a lucid exposition of the theory, reference may growth of 5.3% in the third quarter of 2007-08 – origin) were allowed to invest in the housing and be made to The Economist (6 May 2008), while the growth of gross domestic pro duct (GDP) in the the real estate sector. Other foreign investors Chandrasekhar and Ghosh (Business Line, 10 Februfourth quarter will have to be 7.6% if the (revised) were allowed to invest only in the development of ary 2009) provide a recent empirical refutation.

    growth projection of the EAC is to be realised. integrated townships/settlements, either through 4 Within this group, the corresponding figures for the

    6 Standard & Poor’s on 24 February 2009 down-a wholly owned subsidiary or through a joint US are 1.1%, -1.6%, and 1.6%, for the Euro area they graded its sovereign outlook for India from stable v enture with an Indian partner.

    are 1.0%, -2.0% and 0.2%, for Japan -0.3%, -2.6% to n egative. Other rating agencies such as Moody’s 9 In recent months there is some evidence that and 0.6% and for the UK 0.7%, -2.8% and 0.2%.

    and Fitch have also expressed concern on the r ealty companies like DLF in Mumbai, Omaxe in 5 IMF growth figures pertain to the end-year, whereas c urrent macroeconomic situation. Faridabad, and Indu Projects in Hyderabad are

    Economic & Political Weekly

    march 28, 2009 vol xliv no 13 121

    going in for one and two bedroom, hall, kitchen (BHK) flats in the price range of Rs 15-30 lakh – a development encouraged by the recent RBI measure to keep loans below Rs 20 lakh at concessional rates of interest (below 9.25%) (see Corporate I ndia, 28 February 2009).

    10 The three scenarios are (i) trend analysis (optimistic), (ii) incorporating the special employment coefficients likely to prevail during crises (medium), and (iii) 2007 unemployment rate plus 0.5 (largest recorded increase in unemployment since 1991) computed for each country separately and then aggregated (worst case scenario).

    11 These are levied with the express purpose of compensating domestic producers subject to carbon emission taxes vis-à-vis foreign competitors not facing such taxes in their own countries.

    12 An example being the French government guarantee of €5 billion loans to Airbus Industries.

    13 Indian holders of H1-B visas face stiff hiring conditions by US companies in receipt of federal bailout funds.

    14 In India the organised sector is defined as comprising manufacturing enterprises covered under section 2m (i) and (ii) and section 85 of the Factories Act 1948. Basically these refer to factories employing 20 or more workers (without power) or 10 or more workers (with power). All other manufacturing units are classified under the unorganised sector.

    15 Fiscal Stimulus I (7 December 2008) mainly comprised an across the board cut of 4% in e xcise duty (estimated cost: Rs 31,000 crore). F iscal Stimulus II (2 January 2009) comprised Rs 20,000 crore towards bank capitalisation over the next two years, as well as providing greater market borrowing access to state governments and the India Infrastructure Financing Co Ltd (IIFCL) (estimated cost: Rs 70,000 crore). The final Stimulus III (24 February 2009) provides a 2% reduction in both the excise duty and the service tax and an extension of the previous excise duty cuts beyond 31 March 2009 (estimated cost: Rs 29,100 crore). The total burden on the exchequer at Rs 81,000 crore amounts to nearly 1.82% of the GDP (at current prices) or 2.57% (at constant prices).

    16 Bhattacharya (2009) makes a similar point.

    17 While this does represent some softening compared to the figure of 8.35% as of 26 September 2008, it only represents a fall of 1.85% in response to a fall of 4% in the repo rate over the corresponding period.

    18 The excise duty cuts are mainly expected to benefit the sectors of consumer durables, commercial vehicles, tyres, IT hardware, cement, steel, t extiles, aluminium, air travel, DTH cables, telecom, and hospitality. Most of these goods are for upper class consumption.

    19 This is, of course, not to deny the role of infrastructure in boosting long-term growth.

    20 No systematic estimates of these lags are available in the Indian case. Some work in progress currently by the author estimates the lags in monetary policy at around eight months and for fiscal policy around 12 months. However, these estimates have yet to be firmed up.

    21 See DICGC Annual Report 2007-08, 1.

    22 Under SMECARE, MSME borrowers (with fund based limits of up to Rs 10 crore) can avail themselves of additional working capital of up to 20% of their existing fund-based limits, wheras under SMEHELP a five-year tenured loan is extendable to MSMEs with a liberal margin of 15% for financing capital expenditure. Both schemes offer loans at a concessional rate of 8% during the first year. These concessional schemes are mainly in the a reas of pharmaceuticals, food processing and light engineering goods.

    23 Such Fair Value Accounting could be on the lines of the Statement of Financial Accounting Standards (SFAS) No 133 issued by the US Financial A ccounting Standards Board in 1998.

    24 The concept of middle class used here corresponds to that employed in Sengupta, Kannan and Ravendran (2008).

    25 In direct contrast to this view, we have a substantially influential group of Indian economists who see in the crisis an opportunity for introducing capital account convertibility. Thus Lahiri in his P T Memorial Lecture (16 January 2009) says, “The current crisis may provide an opportunity for introducing capital account convertibility. The dominant worry about introducing convertibility has been an upsurge of capital flows with large upward pressure on the exchange rate of the r upee followed by a sudden sucking out of such a capital, precipitating a crisis. Risk aversion on the part of international investors is an all-time high now, and the risk of large inflows is limited.” Not all of us may be persuaded by this somewhat convoluted logic, though it seems to have provided considerable grist to the mill of several professional bloggers.

    26 Lin himself did not use these terms in his lecture. These terms are defined in Kohler (1998).

    27 The Vulnerability Fund envisions each developed country setting aside 0.7% of its stimulus package for the fund, which would be used to address safety net programmes, infrastructure investments and support for SMEs and MFIs in LDCs (and possibly some EMEs). The 1% Solution entails rich n ations allotting 1% of their sovereign wealth funds to support African infrastructure and other investments in lower income countries.

    28 Remember the aristocratic lady in the Titanic movie who asks for a special seat on the rescue boat because she is travelling first-class?


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    Bank for International Settlements (BIS) (2008): 78th Annual Report (2007-08).

    Bhattacharya, S (2009): “The Lending Puzzle”, The Financial Express, 6 March.

    Brunnermeier, M K (2009): “Deciphering the 2007-08 Liquidity and Credit Crunch”, Journal of Economic Perspectives, Vol 23 (1), Winter, 77-100.

    Buiter, W (2008): “Lessons from the North Atlantic Financial Crisis” in A Felton and C Reinhart (ed.), The First Global Financial Crisis of the 21st Century, (

    EAC (Economic Advisory Council to the Prime M inister) (2009): Review of the Economy 2008-09, January.

    Elmendorf, D W and J Furman (2008): If, When, How: A Primer on Fiscal Stimulus, The Hamilton Project (Brookings Institution).

    Felton, A and C Reinhart, ed. (2008): The First Global Financial Crisis of the 21st Century (www. voxeu. org/index.php?=node/1352).

    State Elections 2007-08

    February 7, 2009

    Rajasthan: Dissatisfaction and a Poor Campaign Defeat BJP – Sanjay Lodha Delhi Assembly Elections: 2008 – Sanjay Kumar understanding the Paradoxical Outcome in Jammu and Kashmir – Ellora Puri Madhya Pradesh: Overriding the Contours of Anti-Incumbency – Ram Shankar, Yatindra Singh Sisodia Chhattisgarh 2008: Defeating Anti-Incumbency – Dhananjai Joshi, Praveen Rai Karnataka: The Lotus Blooms....Nearly – Sandeep Shastri, B S Padmavathi Himachal Pradesh Elections 2007: A Post-Poll Analysis – Ramesh K Chauhan, S N Ghosh

    For copies write to: Circulation Manager Economic and Political Weekly 320-321, A to Z Industrial Estate, Ganpatrao Kadam Marg, Lower Parel, Mumbai 400 013 email:

    Fisher, I (1933): “The Debt-Deflation Theory of Great Depressions”, Econometrica, Vol 1 (3), 337-57.

    Forbes, K J and R Rigobon (2000): “Contagion in Latin America: Definitions, Measurement and Policy Implications”, NBER Working Paper No 7885.

    Giovanni, A and L Spaventa (2008): “Filling the Information Gap” in A Felton and C Reinhart (ed.), The First Global Financial Crisis of the 21st Century, (

    ILO (2009): “Global Employment Trends”, January.

    Kohler, G (1998): “What Is Global Keynesianism?”



    Lahiri, A (2009): “Indian Financial Reforms: National Priorities Amidst an International Crisis”, Sir P urushotamadas Thakurdas Memorial Lecture, Mumbai, 16 January.

    Lin, J Y (2009): “Beyond Keynesian Economics: A Stimulus for Development”, Exim Bank Commencement Day Lecture, 13 March.

    Minsky, H P (1982): Can “IT” Happen Again? Essays on Instability and Finance (New York: ME Sharpe Inc).

    Nachane, D M (2007): “Liberalisation of the Capital Account: Perils and Possible Safeguards”, E conomic & Political Weekly, Vol XLII, No 36, 8-14 September, 3633-43.

    National Commission for Enterprises in the Unorganised Sector (NCEUS) (2007): “Financing of Enterprises in the Unorganised Sector and Creation of a National Fund for the Unorganised Sector (NAFUS)”, Government of India, November.

    – (2008): “The Global Economic Crisis and the I nformal Economy in India”, Government of I ndia, November.

    Nocera, J (2008): “How India Avoided a Crisis”, New York Times, 20 December.

    Portes, R (2008): “Ratings Agency Reform” in A Felton and C Reinhart (ed.), The First Global Financial Crisis of the 21st Century ( php?=node/1352).

    Rao, Govinda M (2009): “The 3rd Stimulus Package and Fiscal Conundrum”, Business Standard, 3 March.

    Sengupta, A, K P Kannan and G Ravendran (2008): “India’s Common People: Who Are They, How Many Are They and How Do They Live?” Economic & Political Weekly, 15 March.

    The Economist (2008): “The Decoupling Debate”, 6 March.

    Van Rickenghem, C and B Weder (2001): “Sources of Contagion: Finance or Trade?,” Journal of International Economics, Vol 54, 293-308.

    World Bank (2009): “Swimming against the Tide: How Developing Countries are Coping with the Global Crisis”, Background paper prepared by World Bank staff for the G20 Finance Ministers and Central Bank Governors Meeting at Horsham, UK (13-14 March).

    march 28, 2009 vol xliv no 13

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