1 Introduction

T

Blaming an “out-group” villain2 or purely external events for one’s woes is universal among human beings, but not generally well-founded. The present instance is no exception. Though international economic conditions have no doubt been affecting the Indian economy adversely, there were palpable signs of the economy losing steam long before the outbreak of the global crisis. Nor has the role of policy omissions and commissions during the course of the crisis been minor in aggravating domestic economic difficulties. For an adequate appreciation of the country’s ongoing economic slide, it is thus useful to consider the domestic as well as the external factors at work both before and during the crisis.

2 Pre-Crisis Developments

India’s gross domestic product (GDP) growth, it needs to be emphasised, had started decelerating in the first quarter of 2007-08 (Table 1A, p 95), nearly six months before the outbreak of the US financial turbulence and considerably ahead of the surge of recessionary tendencies in all developed countries from August-September 2008. That the beginning of the deceleration of the

march 28, 2009 vol xliv no 13

Indian economy predates the global meltdown is also attested to by the sharply downward trend since March 2007 of the year-onyear (y-o-y) rise in the index of industrial production (IIP), the bellwether of the country’s economic performance (Table 2, p 98). Indeed, the slowdown in industries during 2007-08 was much more pronounced than that in GDP growth; while the latter registered a 0.5 percentage fall (to 9.2% ) from the earlier year, the decline in industrial GDP amounted to as much as 3.1 percentage points.

EPW

(i) AE: Advanced Estimate; QE: Quick Estimate. (ii) ELEM: Export (of goods and services) less export-related imports; ILEM: Import (of goods and services) less export-related imports.

(iii) REER: Real effective exchange rate; NEER: Nominal effective exchange rate. For both the indices weights are based on 36-country trade and the base year is 1993-94. @ Excluding construction, which is included in the service sector. * Quarterly figures for gross investment (not adjusted for errors and omissions) comprises gross fixed capital formation and changes in stocks while annual figures for gross investment (adjusted for errors and omissions) additionally includes valuables. ** Rise in either of REER and NEER indicates appreciation of rupee. $ Based on CSO figures of real exports of goods and services, estimated by using export price indices as the deflator. # Growth based on real exports and imports of goods and services and remittances estimated by using GDP deflator. Source: Central Statistical Organisation, GOI, National Accounts Statistics, 2008 and various press releases; RBI's web site.

demand-side factors operating in the markets for non-agricultural For analysing variations in demand it is customary in macroproducts. One of the factors governing the demand for these prod-economic analysis to focus on the relatively autonomous compoucts is agricultural income; but since its impact was positive during nents of demand which do not depend significantly on current 2007-08, the effects of other demand-side factors must have been levels of production or income.4 Following this principle, as a sufficiently adverse to outweigh the salubrious impact of a bumper first approximation investment, government expenditure and harvest. Let us examine the most important of these factors. exports are treated as autonomous, while imports and household

Economic & Political Weekly

EPW

march 28, 2009 vol xliv no 13

consumption are considered endog-Table 2: Macroeconomic Indicators of the Indian Economy (Figures are Y-o-Y growth rates except for exchange rates and capital inflows)

Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar

Real GDP at market prices 9.3

quires modification in two respects. IIP 8.2

8.1 10.8 12.2 4.7 7.6 7.2 9.8 6.0 5.7 8.5 8.8 8.9

of which capital goods 15.8

14.6 13.4 13.5 14.9 12.9 22.8 24.3 11.5 12.9 27.0 10.7 11.9

Net import of capital goods 64.1

CPI (IW) 4.2erations, often differ quite consider- 5.0 3.7 3.3 4.1 3.4 3.6 4.2 5.3 5.6 4.7 4.9 4.9

ably; and (b) unlike in developed WPI 4.4

5.9 5.5 4.3 4.3 3.7 4.1 4.7 4.2 4.4 4.1 4.0 3.9

Exchange rate* 43.7 43.5 43.6 43.5 43.6 43.9 44.8 45.8 45.8 44.4 44.3 44.5

NEER** 89.0 90.0 91.2 92.1 91.0 90.4 89.4 88.3 88.1 89.4 89.9 89.5

REER** 100.6 102.1 103.7 105.0 104.0 103.9 102.5 101.4 100.6 101.5 101.7 101.3 still remains fairly significant. Second, In million $

in the Indian economy, remittances Export of goods 36.1 33.8 30.1 28.8 43.3 22.2 32.3 2.9 25.5 11.9 12.5 13.8

from non-resident Indians (NRIs) are Import of goods 62.2 63.9 35.4 46.2 56.9 36.9 32.2 21.0 18.5 17.1 11.4 15.7 Trade balance -172.0 -149.1 -47.6 -95.7 -94.9 -77.5 -32.0 -77.5 -1.7 -32.4 -7.3 -24.3

FDI inflows 268 654 264 324 399 282 412 746 342 482 127 1,240

FII inflows -338 -318 1,209 1,784 1,062 1,022 -1,054 420 1,831 603 1,660 1,450

of which, Equity -150 -261 1,226 1,824 1,161 1,066 -841 903 2,047 805 1,693 1,509

Debt -188 -56 -16 -40 -99 -43 -213 -483 -216 -202 -34 -58

In Rs crore Exports, imports and trade balance are in real term@

mous component of aggregate de-Export of goods 30.2 23.5 19.7 17.0 29.6 11.9 24.4 0.2 25.2 9.1 9.7 11.4

mand is not the remittance itself, but Import of goods 55.2 51.4 24.6 32.8 41.9 25.3 24.3 17.8 18.2 14.2 8.6 13.2 Trade balance -160.3 -130.0 -35.8 -77.8 -41.0 -62.5 -24.2 -72.8 -1.5 -29.1 -4.7 -21.6

FDI inflows 1,172 2,845 1,151 1,411 1,740 1,238 1,846 3,414 1,567 2,141 563 5,518

FII inflows -1,476 -1,386 5,258 7,760 4,621 4,458 -4,627 1,874 8,361 2,756 7,436 6,430

of which, Equity -654 -1,140 5,329 7,934 5,051 4,647 -3,694 4,039 9,335 3,678 7,588 6,689

Debt -821 -246 -70 -174 -430 -188 -934 -2,165 -974 -922 -152 -258

in driving variations in domestic out-2006-07 put is to consider their growth rates Real GDP at market prices 9.7

IIP 11.6

9.9 11.7 9.7 13.2 10.3 12.0 4.5 15.8 13.4 11.6 11.0 14.8

of which capital goods 18.2the larger the weight of some com- 19.6 21.4 21.6 18.3 16.6 9.5 6.5 29.4 26.2 16.3 18.0 18.1

ponent, the greater will be its impact Net import of capital goods 19.2

on the proportional increase in GDP. CPI (IW) 6.8

5.1 6.3 7.6 6.7 6.3 6.8 7.3 6.3 6.9 6.7 7.6 6.7

WPI 5.4

3.9 4.8 5.1 4.8 5.1 5.4 5.5 5.5 5.7 6.4 6.4 6.6

Exchange rate* 44.9 45.4 46.1 46.5 46.5 46.1 45.5 44.9 44.6 44.3 44.2 44.0 crisis period.7 NEER** 87.7 85.4 85.1 84.2 83.6 84.7 86.2 86.5 85.9 87.1 87.2 87.1

One of the major sources of decel-REER** 98.2 96.4 96.6 95.8 95.6 98.0 100.0 100.4 99.1 100.7 100.6 100.5 In million $

Export of goods 11.8 25.9 31.8 40.6 24.5 26.9 13.7 34.3 14.9 19.0 16.3 11.3

Import of goods 10.6 8.1 19.0 26.4 15.6 30.5 40.7 35.5 20.9 6.7 22.6 19.7

Trade balance -7.9 18.8 6.9 0.2 2.5 -37.4 -112.2 -37.5 -38.4 23.5 -46.0 -55.2

FDI inflows 661 538 523 1,127 619 916 1,698 1,151 5,130 1,921 698 603 private sector. After its prolonged FII inflows 174 -1,473 193 285 1,173 1,318 1,879 2,213 -599 -370 1,834 82

slump from the mid-1990s to 2001-02, of which, Equity 118 -1,630 106 252 1,000 1,166 1,736 2,037 -797 113 1,620 -244

investment recovered in 2002-03 and Debt 56 157 88 33 173 152 142 176 198 -482 214 325

clocked an average growth of nearly In Rs crore Exports, imports and trade balance are in real term@ Export of goods 8.9 24.5 32.0 42.1 25.8 26.2 9.3 24.8 6.5 12.5 9.7 4.3

Import of goods 7.6 6.9 19.1 27.7 16.8 29.8 35.3 25.9 12.0 0.9 15.7 12.2

Trade balance -5.0 19.7 6.8 -0.9 -23.2 -36.7 -103.9 -27.7 -28.2 27.6 -37.8 -45.6

FDI inflows 2,979 2,444 2,410 5,239 2,880 4,231 7,723 5,164 22,902 8,520 3,083 2,652

FII inflows 770 -6,647 875 1,297 5,448 6,133 8,670 10,187 -2,766 -1,682 8,195 361

of which, Equity 522 -7,354 480 1,145 4,643 5,425 8,013 9,380 -3,667 492 7,240 -1,082 growth recorded by public invest-Debt 249 707 396 152 805 709 657 806 901 -2,174 956 1,443

ment) and constituted the principal (Contd)

of which, Capital goods 18.0points (to 12.5%) from that in the pre

10.9 22.4 23.1 12.3 30.8 20.9 20.9 24.2 17.6 2.6 10.7 20.3

6.7 6.6 5.7 6.5 7.3 6.4 5.5 5.5 5.5 5.5 5.5 7.9

Debt -422 -40 -248 897 312 794 -461 1045 155 199 tant demand-reducing factor operat- In Rs crore Exports, imports and trade balance are in real term@ ing in the pre-crisis period was the

Export of goods 29.0 22.9 35.5 34.1 24.4 16.2 0.9 4.4 13.7 -2.7 -0.2

Import of goods 23.7 33.6 29.6 55.3 49.0 50.9 26.9 22.9 25.1 -5.4 -5.4

Trade balance -15.1 -51.9 -20.2 -100.2 -92.6 -145.8 -85.0 -54.2 -50.4 10.5 19.1

FDI inflows 137,701 16,595 10,258 9,626 10,011 11,688 7,304 5,304

FII inflows -627 -5174 -11,095 1,782 46 -5,074 -17,205 1,617 2,377 -3,443

of which, Equity 1075 -5012 -10,096 -1,837 -1,212 -8,278 -15,347 -2,598 1,750 -4,245

Debt -1702 -163 -999 3,619 1,258 3,204 -1,858 4,215 627 802

Figures of export, import and trade balance for February 2009 are taken from Business Standard, 5 March 2009.

* Per US $. ** Base: 1993-94=100. Weights are based on 36-country trade. Rise in either of REER and NEER indicates appreciation of Rupee.

# Advanced Estimate. @ Growth based on real exports and imports of goods and trade balance estimated by using GDP deflator. Source: Central Statistical Organisation’s web site; Reserve Bank of India’s web site; SEBI’s web site. omy. The CSO estimates of export

Economic & Political Weekly

EPW

march 28, 2009 vol xliv no 13

growth are obtained by deflating nominal export earnings by the export price index. This yields the percentage change in the volume of export. However, for estimation of the demand generation impact of exports (a la the foreign trade multiplier analysis) what is relevant is the command of export earnings over domestic consumption and investment. Hence, the need for using theGDP deflator rather than the export price index.12 Again, to the extent some exports directly involve use of imported items (for example uncut diamonds or gold in the export of gems and jewellery), it is export earnings less the value of the items that denote the autonomous component of domestic demand arising from trade.13 In the context of these observations it is easy to see how important export slowdown was in causing the decline in GDP growth in general and industrial growth in particular during 2007-08. Exports (of goods and services) less export-related imports (ELEM) were a little over 20% of GDP in 2006-07, but their share in total autonomous expenditure was nearly 30%. This together with the fact that between 2006-07 and 2007-08 there was a

15.8 percentage fall in ELEM attests to the enormous significance of exports in engineering the GDP deceleration.

The decelerating trends of industrial and GDP growth started, let us remember, from April 2007 and the first quarter of 2007-08, respectively. Though quarterly data for ELEM are not available, our estimates of export growth (gross of export-related imports) indicate how closely this turning point corresponds to the behaviour of export earnings. Export growth started decelerating from the third quarter of 2006-07, plummeted from 13.2% to 0.6% in the first quarter of 2007-08, and declined further to minus 3.1% per cent in the second quarter of 2007-08.14 It is thus clear that the two most important factors behind the deceleration of GDP in general and industrial production in particular15 were in operation well before the onset of the global crisis.

The slowdown in GDP growth in the pre-crisis period, it needs to be noted, was significantly less than what the precipitous fall in the growth of private investment and exports would suggest. The reason lay partly in a step-up in public expenditure. Between 2006-07 and 2007-08, the growth of public investment and government consumption went up by 15.6 and 0.8 percentage points, respectively. Given their shares in autonomous expenditure at 11.4% and 15.1% respectively, the accelerated increase in public expenditure helped greatly in preventing a sharper slide in GDP growth.16 The more important mitigating factor was perhaps the 1.3 percentage point rise in the growth of agricultural GDP. Apart from its direct contribution to overall GDP growth, the increase in farmers’ income also helped in raising the demand for industrial goods and services and triggering off a multiplier process in the non-agricultural sector.

The foregoing analysis brings to the fore a significant difference between the growth-debilitating and growth-enhancing factors operating before the crisis. While the former are related to structural features of the economy or behaviourial characteristics of private agents (domestic or foreign), the latter are either primarily policy instruments or (as in the case of agricultural performance) largely random, at least in the short and medium run. It is for this reason that in the absence of vigorous and sustained expansionary policy measures, the downward drift of the Indian economy, we believe, would have continued, albeit at a slower pace, even without the global meltdown. The pre-crisis trend in household consumption also lends support to our surmise.

In recent years there appears to have occurred a significant change in the propensity to consume, which has an important bearing on GDP growth. Since the first quarter of 2005-06, there has been a marked deceleration in household consumption that cannot be accounted for by the behaviour of GDP. Between 2005-06 and 2006-07, growth of private consumption declined by as much as 1.6 percentage points even though there was a 0.5 percentage point rise in GDP growth. Nor is it easy to explain why the slowdown in consumption growth was larger than that in GDP in 2007-08. The point to appreciate in this context is that since private consumption accounts for around 60% of domestic income, the downward trend in the consumption ratio is of major macroeconomic significance when GDP growth is demand-driven. The ratio had shown a relentlessly downward trend since 2001-02, registering a huge 9.4 percentage fall over the period 2002-07.17 One reason behind the slowdown of consumption in relation to aggregate income was the decline in personal disposable income as a ratio of GDP. But note that as per estimates from CSO data (GOI 2008), between 2002-03 and 2006-07 the ratio of private disposable income to GDP came down from 84.3% to 77.6%, and that of private consumption to disposable income from 75.0% to 71.9%. This points to the operation of other factors in curbing household expenditure. The most important of these was perhaps the worsening distribution of income between those engaged in the sunrise sectors and the vast and growing majority of the populace working in unorganised enterprises. The other factor, relatively transient, was the rise in prices of articles entering the consumption basket of rural and urban workers. Since April 2006 there was a significant rise in consumer price index (CPI-IW and CPI-RL) inflation18 due mostly to an increase in food and other commodity prices, and this tended to have a restraining impact on consumption demand for non-agricultural goods and services. However, the role of commodity price inflation in the performance of the Indian macroeconomy acquired much greater significance after the onset of the global crisis.19

3 Global Crisis: Domestic Consequences

Though the decelerating phase of the Indian economy started way ahead of the US mortgage market meltdown, there can be little doubt that the global crisis has seriously aggravated the problem and made the task of reversing the domestic downturn much more difficult. Before examining how international economic developments might have affected the domestic economy since the outbreak of the crisis, it is useful to take stock of some of the striking features of the Indian macroeconomy during this period, especially of the sources and components of aggregate demand. First, the slowdown in GDP and industrial growth, which as already noted had started from the first quarter of 2007-08, became much more pronounced from the fourth quarter of 2007-08 and the first quarter of 2008-09, respectively, that is, more than three to six months after the eruption of the sub-prime crisis (Table 1A). The proximate source of this was the sharper slowdown in both private consumption and aggregate investment20

march 28, 2009 vol xliv no 13

from early January 2008. Second, over March-August 2008, export as well as import growth was significantly higher than in the precrisis period – something which cannot but be viewed as counterintuitive in the context of the global economic woes. It was only from September 2008 that the crisis seems to have finally taken its toll of the country’s trade flows. This combination of the sharper slowdown of demand driven primarily by domestic factors along with an acceleration of exports and imports21 constitutes a veritable conundrum of the Indian economy during this period. Third and no less paradoxical, from June-August 2007-08, non-resident Indian (NRI) remittances zoomed, averaging a y-o-y growth of more than 38% between the second quarters of 2007-08 and 2008-09, and thereby belying the predictions of most pundits regarding the adverse impact of the world crisis on the inflow of such funds. Finally, with a much sharper deceleration of investment and private consumption and a steep downturn of export growth from the third quarter of 2008-09, the economy seems to have entered a new phase and been sucked into the maelstrom of the global crisis.

Financial Contagion

For a year or so after its outbreak, the crisis raged mostly in the financial sectors of developed countries, causing mounting losses, a string of bankruptcies,22 and a severe log-jam in the flow of credit, especially in the inter-bank money market. Given their relatively small exposure to US asset-backed securities (ABSs) and structured derivative products like collateralised debt obligations (CDOs), Indian banks have not been seriously rocked by the global financial turmoil. However, apart from the heightened uncertainty and darkening prospects making domestic banks extremely wary of extending loans, there have been other routes through which the crisis has cast its long shadow on Indian financial markets and hence on the real sector of the economy.

With increasing relaxation of capital account transactions and the close integration of the domestic economy with international financial markets, the first significant impact of the global crisis was on the country’s capital inflows, especially external commercial borrowings (ECBs) and foreign institutional investment (FII).23 Almost immediately after the crisis surfaced (net) ECBs and FII registered a steep fall between October and November 2007, from $3.6 billion and $5.7 billion to $2.2 billion and minus $1.6 billion, respectively. Since then the downward trend of the two components of capital inflows has remained unabated. The most important reason behind drying up of ECBs was the huge financial meltdown and the associated credit crunch, with a widening spread between the yield on private bonds and that on government securities. The sharp fall in FII flows to EMEs, including India, even though their economic prospects seemed better than that of the US, was due in large part to the need for repairing the balance sheets of developed-country financial firms in the context of the mind-boggling operational and mark-to-market losses being suffered by them. As is to be expected, the reversal of capital flows has led to a steady fall in the value of the rupee despite substantial running down of foreign currency assets by the Reserve Bank of India (RBI); between October 2007 and November 2008, both the nominal effective exchange rate (NEER) and

Economic & Political Weekly

EPW

the real effective exchange rate (REER) went down significantly,24 the former by 11.6% and the latter by 12.8%. As we shall elaborate later, this fallout of the global financial meltdown was positive for the Indian economy inasmuch as it led to an improvement in the trade balance.

Other consequences of the financial upheaval were not so salubrious. To the extent domestic producers relied upon ECBs for funding their projects partly or wholly, drying up of this source of long-term credit may have played a role in the significant dip in investment growth since the outbreak of the crisis. However, the importance of this factor for domestic demand can easily be exaggerated. When external borrowings are used entirely for buying machinery and equipment from abroad, the associated investment does not raise domestic income or employment. In general most investment projects use both domestic and external (real) resources so that the investment reducing impact of a fall in ECBs, even when the borrowings were meant to be used fully for raising productive capacity, would generally be a fraction of their decline.

FII outflows might also have had a negative impact on domestic investment. Given the relative thinness of the Indian share market, the sharp fall in FIIs followed by their withdrawal contributed, albeit with some lag, to the bursting of the India’s stock market bubble. Curiously enough, though IIP growth had started declining since March 2007, the share market boom continued until early 2008; between March and December 2007, the Bombay Stock Exchange (BSE) index, fuelled in part by substantial FII inflows, went up from 12,858 to 19,827. The bullish sentiments prevailed for a short while even after the downward drift in FII began in November 2007.25 However, a whopping $3.2 billion FII (equity) outflow in January 2008 triggered a relentless bear run, making the BSE plunge by 52% (to 9,350) between December 2007 and January 2009. For the Indian economy, it is true, there appears to be no direct, casual link between capital formation and either FII or share prices. But remembering that many companies have cancelled their proposed equity issues in the face of plunging share prices, the bearish trend is likely to have had a dampening effect on the private propensity to invest. This is not to deny that in the context of the (pre-crisis) bull run despite the industrial slowdown, domestic factors might in all probability have been more important in the bursting of the bubble and development of pronounced bearish tendencies.

Finally, despite the resilience of Indian banks, the global financial meltdown has had some adverse consequences for creditfinanced economic activities. Widespread banking troubles created a serious credit crunch for traders. Instances of banks delaying or not honouring guarantees extended to traders became more frequent. Domestic exporters were also finding it increasingly difficult to secure credit. Since it is the advanced country banks that have been in the eye of the financial storm from the very beginning of the crisis, the credit crunch tended to have a greater impact on Indian exports than imports. The difficulty of importing components or raw materials directly required for producing exportables also has had a negative impact on domestic demand. Again, with the globalisation of the supply chain in the production process, a disruption anywhere in the cross-border flow of intermediate inputs tends to create a disproportionately large effect on output and employment in both the domestic and the international economy.

The problem of accessing credit was not confined to traders alone. Though Indian banks remained relatively unscathed, they became increasingly choosy in extending loans, especially to buyers of real estates and consumers durables – the two categories of economic agents who had so far played an important role in sustaining domestic demand. One reason for the banks turning more cautious was no doubt the heightened volatility of global financial markets in general and the plight of the once mighty transnational banks in particular. But the caution was also warranted by the rise in non-performing assets (NPAs), the resulting erosion of banking capital and the far-from-rosy prospects of the domestic economy. Irrespective of the reasons behind the reversal of bank behaviour, its significance for domestic demand, via operation of the (negative) financial accelerator,26 could be profound.

Global Inflation

For a little over a year after the outbreak of the financial crisis, the world economy experienced, between September 2007 and October 2008, a pronounced stagflationary phase, with growth slowdown on the one hand and rising inflation on the other (Rakshit 2009b). For Organisation for Economic Cooperation and Development (OECD) countries the y-o-y consumer price index (CPI) inflation, starting from a lowly 1.9% in August 2007 exhibited an uninterrupted increase to peak at 4.9% in July 2008 and remained at an elevated level over the next two months (at 4.7% and 4.5%, respectively). The trend of producer price index-manufactured goods (PPI-M) inflation during this phase was similar but more pronounced, rising as it did from 1.9% in August 2007 to 9.9% in July 2008 and then moderating somewhat to 9.4% and 8.9%, respectively in the next couple of months (Table 3). The global inflation was driven mostly by commodity prices,27 especially prices of energy and agricultural goods.28 So far as the Indian economy is concerned, since prices of practically all

memo item:

World

Oil price

OECD

PPI-Manufactured

memo item:

march 28, 2009 vol xliv no 13

petroleum products are administered and trade in agricultural goods is far from free, transmission of global inflation to domestic prices occurred with a time lag, from November rather than September 2007. However, with the wholesale price index (WPI) inflation rising from 3.1% in October 2007 to 12.8% in August 2008, and staying in double-digit figures during the succeeding two months, the price pressure in India was significantly greater than that in advanced countries. This is particularly so for CPI inflation which turned double digit in August 2008 and did not show any sign of deceleration even by January 2009.29

Though the worldwide commodity price-led inflation did not owe its origin to the global financial crisis,30 it reinforced the decelerating tendencies in the Indian economy31 in a number of ways. First, since the demand for food and fuel are income as well as price inelastic, the sharp rise in their prices relatively to those of other goods led to a fall in demand for industrial products and services and strengthened the recessionary forces already at work in the domestic economy.

Again, the surge in prices of crude oil in the international market affected the country’s trade balance and hence the scale of domestic economic activity both directly and through the multiplier mechanism. However, since the global financial meltdown and recessionary tendencies have also affected domestic output and employment through exports and imports, it is useful to consider simultaneously the transmission of the main external impulses via the trade balance.32

External Impulse and Foreign Trade

The significance of the impact on external trade for the domestic economy arises on three counts. First, with the spectacular increase in both merchandise and services exports lasting for more than a decade,33 massive investment has been undertaken in export-oriented sectors, including special economic zones (SEZs). A sharp drop in export growth thus not only effects an economic slowdown through the textbook-type multiplier process, but is also likely to cause debt default, bankruptcies, and severe cutbacks in investments in the pipeline with all their adverse implications encompassing both the financial and the real sectors. Second, given the share of exports at around 22% of GDP, the quantitative impact of a slowdown in exports on domestic demand is far from negligible. Third, crude oil, perhaps the most crucial intermediate input required for sustaining the production process, is the single-most important item of India’s merchandise import, accounting for around one-third of the total. Changes in international oil prices, it is thus no wonder, have major consequences for the Indian economy, remembering that demand for petroleum products34 is relatively price inelastic in the short run.

In a demand-constrained economy, a rough and ready measure of the growth-debilitating effect of external factors operating through the trade route is the current account deficit,35 reflecting the net leakage of domestic demand to the rest of the world. Judged by this index, the adverse impact of global developments transmitted through trade is fairly clear; since the fourth quarter of 2006-07 the current account deficit has continued to widen and was as high as 4.3% of GDP in the second quarter of 2008-09.36 However, the deficit is the outcome of all factors, both domestic and external.

Economic & Political Weekly

EPW

Hence arises the need to examine the various ways in which global developments since the onset of the US sub-prime turmoil have affected India’s exports and imports of goods and services.

First, the slowdown in global GDP growth has constituted by far the most important factor constraining the country’s exports. Indeed, the extent of deceleration of world income does not fully reflect the seriousness of the problem faced by exporters. The OECD countries account for around 42% of India’s merchandise exports and practically the entire export of services, especially the high-growth ones. With services accounting for 37% of export earnings (including earnings from invisibles) in recent years, the precipitous fall in GDP growth and emergence of strong recessionary tendencies in advanced countries have constituted a major contractionary factor for the Indian economy.37 This is not to deny the importance of exports to developing countries whose share in merchandise exports jumped from 30.9% in 2001-02 to 42.3% in 2007-08. The important point to note in this connection is that, since the world income elasticity of demand for India’s exports appears to be quite high, the negative impact of a global economic meltdown on the country’s export earnings would tend to be correspondingly large.

Second, the surge in international oil price inflation led to an increase in India’s crude import bill from $5.6 billion in July 2007 to $10.96 billion in August 2008, with the share of oil in total imports rising from 30.5% to 36.6% over this period. The quantitative significance of this doubling of oil imports may be appreciated from the fact that at its height the incremental (monthly) drain from domestic demand on account of oil imports was about 6% of the country’s income and hence constituted a significant source of GDP deceleration during this period. (By the same logic the declining trend in the oil import bill should ceteris paribus be growth enhancing.)

Third, the global financial crisis, as already noted, affected exports and imports through a drying up of the supply of trade credit. Its net impact on India’s trade balance was perhaps favourable (though the overall effect of the crisis on aggregate demand, operating through the domestic banking system, was undoubtedly negative).

We have noted earlier a much more important route through which the financial turmoil had a positive fallout for the country’s export earnings. Mounting difficulties faced by the US and other advanced country financial firms have led to large-scale withdrawal of foreign funds, especially FIIs, from the Indian (and other EME) capital market(s). The resulting depreciation of the rupee has helped in limiting the GDP slowdown in two ways. First, in the initial phase of the crisis, when the global meltdown was mostly in the financial and not so much in the real sector, currency depreciation provided a significant boost to the country’s foreign exchange earnings. Thus between October 2007 and August 2008 the NEER and the REER indices declined from 93.3 and 106.1 to 88.6 and 99.6, respectively. During the same period, India’s earnings from merchandise exports in terms of dollars registered a whopping 33.3% (y-o-y) growth (Table 2). It is only since then that the recessionary forces have become dominant everywhere and export growth plummeted and turned negative from October 2008 onwards.

Depreciation, it is worth noting, also helped in raising the purchasing power of export earnings over domestic consumption and investment. This is so even allowing for the pass through of higher prices of foreign goods (due to depreciation) to domestic prices.38 The quantitative significance of this factor in moderating the slowdown may be appreciated from the fact that during the third quarter of 2008-09 the decline in export growth in terms of dollars was 7.7%, but both under the CSO measure and in terms of command over domestic output there was an increase in export growth of about 6.3%.39 For the five-month period, October 2008-February 2009, when export proceeds valued in dollars showed an uninterrupted negative growth averaging 10.5%, the (direct) contribution of merchandise export growth to domestic demand growth was, in fact, positive and amounted to 3.2%. Hence arises the importance of focusing on the value of exports (or imports) in terms of domestic products for purposes of assessing the effects of exchange rate movements on domestic demand.

Nor can one overemphasise in this context the need to distinguish among the sources of depreciation. When the depreciation is due primarily to the capital outflow, as happened during the earlier phase of the crisis, it would tend to produce a favourable impact on export and domestic demand. However, if it is the rising trade deficit due to declining world income that lies at the root of depreciation, it only moderates, but cannot reverse the contractionary forces transmitted through trade to the domestic sector. With the decline in export earnings due to the global economic downturn playing an increasingly greater role in driving down the value of the rupee, it is no wonder that since September 2008 there has been a significant fall in foreign exchange earnings from merchandise exports. Over January-February 2009, real exports40 registered an absolute decline, amounting to nearly 3%, even though there was a near 20% (y-o-y) depreciation of the rupee against the dollar during these two months. Indeed, since the demand for services exports are more (OECD-) income elastic, in recent months the (domestic) growth debilitating impact of the crisis operating through trade is much greater than that suggested by the decline in merchandise exports.41

Let us see how the foregoing analysis helps in explaining the post-crisis features of the Indian macroeconomy noted at the beginning of the present section. There is little doubt that from the last quarter of 2008 both the financial stress and contractionary forces have become significantly stronger in the developed as well as the developing countries. This coming on top of the sharply eroding confidence of domestic economic agents has accelerated the downturn in all components of private demand – household consumption, exports and private investment. No wonder then that, from this quarter onwards there has occurred a qualitative change in the country’s macroeconomic performance.

We have already explained at length the economic forces at work behind the improvement in export earnings till September 2008 even while there was a slide in world GDP growth. The reason, we have noted, lay in the depreciation of the rupee due to outflow of foreign funds and the sharp fall in capital inflow by way of ECBs. A significant jump in inward remittances in this period also contributed towards the rupee’s weakening and hence larger exports (Table 1A).

But how to account for the rise in remittances in the midst of the global gloom? The answer seems to be that the gloom as yet was not truly global. Thanks to booming petroleum prices, oil exporting countries were doing very well. Given the importance of the Middle East nations as sources of NRI incomes and as markets for Indian goods and services, the oil bonanza seems to have been an important factor behind the rise in remittances as also in exports.

Finally for the more pronounced decline in the domestic components of aggregate demand in the earlier phase. The drying up of external sources of borrowing, the sharply rising costs of production of investment goods (due to the jump in prices of minerals and metals), the bursting of the stock market bubble, and the domestic credit crunch, especially in respect of loans for housing and consumer durables – all these acted as major impediments to domestic demand. However, no less important was the role of government policies or their absence.

4 Policy Omissions and Commissions

One may identify two types of policy failures that contributed towards the per-crisis slowdown and magnified the negative impact of the global downturn. The first is structural, the second relates to macro-management.

The deceleration of GDP and industrial output significantly ahead of the global financial storm was, as we have seen, driven by the slowdown in private investment and exports; for both the government’s structural policies were largely to blame. This is not to suggest that all these policies were counter-productive. Indeed, despite tardy execution in some instances, programmes like the Golden Quadrilateral and other highway projects, ruralcum-urban reconstruction, and the employment guarantee scheme have provided both a demand- and supply-side boost to the economy. The initiative for roping in the private sector, through what is called the public-private partnership (PPP), for closing the country’s huge infrastructural gap is also well intentioned. However, the sharp downturn in private sector capital formation since 2004-05 attests to a serious deficiency in this policy of stimulating private investment, especially in sectors with large positive externalities.