Indian Recession of 2007-09

Abstract

The paper discusses about the Global Economic Recession of 2007-09. It states the causes of it and its consequences and impact on the Indian economy. It mainly focuses on the financial and economic impact of the crisis. It further analyzes the monetary and fiscal response undertaken by the monetary authority and government respectively in the context of IS-LM model.

Keywords: Recession, financial sector, GDP.

The era of LPG (liberalization, privatization and globalization) began in India after 1991 Indian economic crisis. Since then, India’s contribution in world GDP had increased to 2% in 2004 from almost negligible pre-1991. Indian economy was performing very well till 1999 when dotcom bubble crisis led to an economic shock and GDP rate fell to 3.8% in 2000. This crisis was caused by increase in stock prices in the Internet and technology sectors due to increased internet surfing, evolution of IT industry and digital transformation. Though it led to recession in India from 2000-2002, but economy soon recovered from the shocks and performed more effectively due to IT boom. In fact, from 2003-07 India’s GDP was progressing at the 7-8%.

 

             

Source: World Bank

Unfortunately, severe ‘Great Recession of 2008-2009’ started initially in August 2007 from USA. The easy availability of credit at comfortable interest rates led to increase in demand in real estate sector in the country. As a consequence of increased demand, the price of real estate sector began to rise since 1990. With the subsequent increase in price every consecutive year, the price in the sector finally reached its climax during 2007 leading to the collapse of the sector. The financial crisis ultimately reached its peak in September 2008 after the collapse of fourth largest American financial firm, Lehman Brothers. It had a strong ripple effect spreading rapidly to developed and advanced nations leading to the collapse of financial institutions, falling stock prices, plummeting real estate which impelled their government to release rescue packages. However, all the economies were not equally affected. Advanced economies due to strong globalization, were more affected than developing and emerging economies. Emerging economies like China and India were moderately affected due to following reasons-

·   Global recession was specifically related to housing and finance sector rather than to generalized sectors like oil mining, agriculture sector, IT sector.

·   Growth in emerging markets was dominated by domestic rather than international demand.

·   Emerging markets were net savers rather than investors.

·   High GDP and efficient economic performance in last decade.

 

  

Consequences -

Out of three channels of globalization, trade channel, finance channel and confidence channel, financial channel was affected the most. In finance channel, financial market, trade flows and exchange rate were remarkably affected. Though the channels remained liberally affected in 1^st round of crisis form 2007-08, they were significantly affected in second round 2008-09.

In trade channel, as India’s trade accounted for less than 15% of its GDP, the trade in short-run was affected, but soon it recovered. As the crisis led to unemployment and recession in developed countries, the policy of protectionism avoided them to import from other countries. Therefore, India’s export declined more than its import. India’s export declined to US $12428.919 million in November 2007 from US $14128.4 million in October in the same year. In second round, showing an increasing trend it again rose to US $ 17009.5 million in July 2008 but fell to $14929.3 million in September due to Lehman crisis. India’s export which was mainly in garment industries, hospitality and tourism sector reduced by a significant amount leading to informal employment resulting in fall in consumption spending, which accounts for 70% of GDP component. India being an emerging economy which was not integrated fully with industrialized and advanced economies, its exports started gradually increasing and reached US $24193.9 in September 2012.

India’s import was on the increasing phase from October-07 till August-08. India’s import increased to US $29003.5 million in August-08 from US $20962.3 million in October-07. However, the second round of crisis imports showed a negative trend and imports declined to all time low of US $13095.7 million in February 2009. As notified earlier, the imports increased to its pre-recession levels after from October 2009 and increased to US $41931.5 in September 2012. Thus, imports were on increasing phase post-recession. This shows India was affected by international trade for only one year but the country regained momentum after the crisis. Trade channel pulled down GDP by less than 2 %.

       

 

In the financial sector, the scenario was rather different which had terribly affected the economy. Financial sector includes access to overseas finance, domestic liquidity, stock prices, banking sector, capital flow, remittances and exchange rate. As India’s access to global borrowing and fund raising was limited, there was moderate effect on banking sector. Moreover, banking sector was moderately affected due to extended lending by commercial banks (on the order of RBI) to finance housing sector. Secondly, there was less provision of sub-prime lending to public. Since interest rate in India at that time was positive in comparison to other countries where it declined to zero and turned negative, banking sector had recovered the direct shock of this crisis in less than one year.  Due to welfare economic policies, interest rate at that time were generally stable. Thirdly, close scanning by RBI on lending guidelines to commercial banks balanced the quality of banking assets. This is one of the few global examples of a countercyclical capital provisioning requirement by any central bank. This accounted for healthy balance sheet of the banks. However, indirect banking effect of the crisis was a challenging one.

Nevertheless, indirect effect on banking sector was quite shocking. After Lehman Brothers crisis and collapse of real estate sector in US, dependence on ECB (external commercial borrowings) declined leading to high pressure on financing through domestic banks, which in turn increased liquidity preference and credit crunch in the economy. Credit expansion declined by 68% in October-March 2009 in comparison to same period in last year. Due to high demand for channel of domestic financing, short term lending rate increased drastically. The inter-bank call money rate spiked to 20% in October 2008 and remained high for the next month. The magnitude of the impact of the crisis can be understood from the fact that non-food credit expansion during last five months of FY2008–2009 has declined by more than 68% as compared with the same period in previous financial year. Yet, Indian housing sector was not as severely affected by the crisis as European and American nations as housing loans accounted for only 10% of bank credits in India. 

Globalization promotes the accumulation of foreign currencies in foreign exchange reserves (FER). However, since the 2008 crisis, advanced economies’ low production and financial activity affected the inflow of foreign exchange due to outflow of FII and FDI from Indian equity market. Due to fall in stock prices of foreign companies in their home countries, FII fell from $15.5 billion in April-September 2007 to $6.6 billion in same period in 2008-09 which resulted in falling stock prices in India. This diverted Indian firms to opt for bank finance. At a time of low share prices, firms are reluctant to tap the capital market. Unless bank finance can substitute adequately for the capital markets, firms' investment plans are bound to be hit. The most significant change was observed in the case of FIIs, which saw a strong reversal of flows. In contrast to the net inflow of US$20.3 billion in FY2007–2008, there was a net outflow of US$15 billion from Indian markets during FY2008–2009. This massive outflow of FII created panic in the stock markets. Since most of the Indian immigrants move to the gulf economies for their employment, declining global oil prices significantly affected their income which in turn affected remittances arriving into the country. Remittances fell by 29% in the fourth quarter of FY2007-08 as compared to same period in the previous financial year.

 FII while selling their stake in India, began to convert the internally raised funds to their respective currencies to absorb the shock in their home countries which resulted in depreciation of the Indian Rupee. The depreciation of currency led to rise in CPI and costly imports led to fall in aggregate demand. Thus, consumers were bowed to cut down spending which reduced velocity of money leading to decline of liquidity in economy at an alarming rate. This was accompanied by the Indian investors who were not willing to invest in loss ridden share market. In this way, confidence channel was affected.

Another major macroeconomic variable which was drastically affected is the exchange rate. With the outflow of portfolio investments and higher foreign exchange demand by Indian entrepreneurs who are seeking to replace external commercial borrowing by domestic financing, the Indian rupee has come under pressure. FER reduced from Rs. 40.46 in April 2008 to Rs. 50.94 in March 2009 or it had tumbled by 25.8% vis-à-vis the US dollar (RBI). At the same time, foreign exchange reserves had also fallen to USD 247686 million in November 2008 from USD 314155 million in October 2008 (RBI). Depreciation of Indian rupees by approximately 25% caused no additional benefit (for increasing exports) due to increase in ECB rates and lending rates by IMF. The IMF lending rate to India reduced to 4.75% in 2009 against 6.5% in 2008 but again it rose to 6.25 % in 2010 (IMF). However, with foreign exchange reserves remaining at 110% of total external debt at the end of December 2008, investment sentiments should not be unduly affected in the near term.

Proceeding with the sector wise-growth, financial, tourism, hospitality, logistics and technology, manufacturing and construction sector were seriously affected leading to fall of GDP to 3.08 in FY 2007-08.  However, due to expansionary fiscal policies to revive economy through agriculture and infrastructure sector and by reduction in tax rates, the sectors re-emerged to perform at pre-levels resulting in GDP growth rate of 7.86% in 2009.

 

Policies-

Fiscal-

The revenue deficit increased from 1.4% of the GDP in FY2007–2008 to 4.3% in FY2008–2009(RBI). At the same time the fiscal deficit of the central government increased from 2.7% in FY2007–2008 to 6.1% in FY2008–2009. The expansionary public outlays comprised of steps for benefiting the rural and agriculture sector. These outlays involved waiving off farmer loans, funds allocation to the National Rural Employment Guarantee Program (NREGP), Bharat Nirman (targeted for improving rural infrastructure), Pradhan Mantri Gram Sadak Yojana, increased subsidies for fertilizers and power supply to the farmers.

Apart from rural development, other measures were also taken to counter global recession. Three stimulus packages were notified in December 2008, January and March 2009 which collectively accounted for 2% of India’s GDP or US $ 21 billion. These relief packages mainly comprised of supporting export-oriented economy, increased government spending on infrastructure and reduction in rate of indirect taxes. For encouraging infrastructure development, the central government increased its spending by US $ 4 billion and authorized state government to borrow additional US $6 billion from the market. Moreover, the India Infrastructure Finance Company Limited (IIFCL), a special purpose vehicle (SPV) established in 2007, had been permitted to issue interest free bonds worth US$6 billion for refinancing the long-term loans for various infrastructure projects. Secondly, to boost domestic demand the central excise duty was gradually slashed from 14% in December 2008 to 8% in March 2009 on all products except petroleum products. Likewise, the services tax rate has also been brought down from 12% to 10%. The government had also provided some relief to export-oriented industries through subsidizing interest costs of exporters by up to 2%, subject to a minimum rate of 7% per annum. It had also allocated US$240 million for a full refund of terminal excise duty or central sales tax, wherever applicable, and another US$80 million for various export incentives schemes.

Monetary-

Following global recession, monetary expansion began from October 2008. The rapid decline in Wholesale Price Index (WPI) inflation, which has come down from its peak level of around 11.1% in October 2008 to less than 1.5% in October 2009 enabled RBI to inject a considerable amount of liquidity into the economy through a series of policy rate cuts to boost credit crunch. The CRR of banks has been brought down from 8% in May 2008 to 5% in January 2009 leading to the injection of US$80 billion in economy while the repo rate had been slashed by 425 basis points. Moreover, to encourage liquidity and discourage parking of overnight funds with RBI, the reverse repo rate has been gradually reduced from 5.0% in December 2008 to 3.25% in April 2009 and SLR was reduced by one percentage point. Lending rates on loans by commercial banks also declined from 13.75–14.0% in October 2008 to 12.0–12.5% January 2009 (RBI). Apart from different bank rates, monetary policy was also supported by extending liquidity support to NBFCs which led to increase of money supply in the economy.

Relaxing, the ECBs and FII related norms the FII limit on corporate bonds was increased from US$6 billion to US$15 billion. In addition, to boost the infrastructure and construction sector, developers had been permitted to raise ECBs for integrated townships projects, while NBFCs dealing exclusively with infrastructure financing have also been allowed to access ECBs from multilateral or bilateral financial institutions.

IS – LM and policy analysis

As FII and FDI reduced, in order to boost domestic investment, there was reduction in interest rates in January 2009 to 12-12.5%. As high interest leads to costly borrowings, therefore more investment occurs at lower rate of interest. This increase in investment lead to upward shift of supply side or Potential Expenditure (PE) from PE^I to PE^II. This shift in PE increased output from Y^I to Y^II which shifted IS curve from IS to IS^I. This inverse relationship between interest rate and income derives the IS curve which is shown as follows-

 

The above graph shows the relation between interest rate and income. From the above fiscal measures, it was quite clear that government expenditure increased in many sectors. IS is affected by autonomous investment and induced investment. Government expenditure, which is an autonomous investment will shift IS curve rightwards leading to increase in income to Y₂ and increase in interest rate to r_2. But will reduce private investment leading to crowding out of investment. The steps taken further to revive private investment is explained in the following figure.

                               

From the above monetary measures, it is clearly noticeable money supply by RBI was not directly disturbed, however it indirectly took measures for changes in different types of interest rates for inhibiting investment and balancing money supply. To counter the effect of increased interest rate and crowding-out resulting from fiscal policy, RBI announced the commercial banks to reduce the lending rate and also guaranteed extra credit to NBFCs to increase the money supply in the economy. This increase in money supply shifted LM curve from LM to LM^I. The leftward shift of LM results in fall in interest rate and further increase in Y from Y₂ to Y₃.

 

From the above analysis, it can be concluded that government had taken appropriate measures at correct time to revive the economy as GDP rebounded to high growth rate of 7.86 in 2009 and further to 8.49% in 2010. The government had brought important sectoral reforms through the combination of fiscal and monetary reforms. However, there were some drawbacks in the measures adopted as, unemployment increased to 6.003% in 2009 from 5.35% in 2008 and trade deficit and BOP account also faced imbalance.