India and the Lessons of the Global Financial Crisis

John Echeverri-GentDepartment of PoliticsUniversity of Virginiajohneg@virginia.edu

March 15, 2011

I. India managed the crisis very well relative to other emerging markets

• Though the crisis caused a bigger decline of growth in 2008 (4.5%) than the average (2.4%), India’s growth rate (5.1%) remained higher than the average (4.7%) (See Table 1)

• While the growth rate of all other countries declined in 2009, India’s GDP rebounded. The average GDP growth for all other countries dropped from 4.7 to 1. India’s increased from 5.1 to 7.7.

• India’s economy is projected to continue to grow. The GOI’s Economic Survey projects that India’s GDP will grow by 8% in 2009-10 and 8.6% in 2010-11.

TABLE 1 ANNUAL GDP GROWTH RATES FOR SELECTED LA AND ASIAN COUNTRIESIn percent

Annual Country 2005 2006 2007 2008 2009 AverageArgentina 9.2 8.5 8.7 6.8 0.9 6.8Brazil 3.2 4 6.1 5.1 -0.2 3.6Chile 5.6 4.6 6.4 3.7 -1.7 3.7China 11.3 12.7 14.2 9.6 9.1 11.4India 9.3 9.4 9.6 5.1 7.7 8.2Indonesia 5.7 5.5 6.3 6 4.5 5.6Korea, Rep. 4 5.2 5.1 2.3 0.2 3.4Malaysia 5.3 5.8 6.5 4.7 -1.7 4.1Mexico 3.2 4.9 3.3 1.5 -6.5 1.1Thailand 4.6 5.1 4.9 2.5 -2.2 3Average 6.1 6.6 7.1 4.7 1 5.1Source: World Development Indicators 2010

II. Two channels through which the global crisis affected India

A. Trade

• India has become a more open economy in recent years with its trade to GDP ratio increasing from 27.4% in 2000 to 46.3% in 2009. This ratio remains much below Asian exporters with smaller economies such as South Korea (103%) and Thailand (127%) but not that far behind China (51.4%). (Kose and Prasad 2010, 134)

• India’s export growth at 19.8% 2000-07 and 29.7% in 2008 is considerably faster than the average for emerging and developing economies (EDE’s) (16.9% and 25.3%) (See Table 2)

• It share of world trade doubled from 2000-2009, a pace of increase that is twice as great as that for EDE’s.

• In the wake of the global crisis, Indian exports (-15.2%) fared better than the EDE average (-24.8%)

• Exports of all Asian countries in Table 2 – with the exception of Malaysia – fared much better than EDE and world averages.

• The impact of the global crisis on Indian exports was limited by the growing share of Asia in total Indian exports. From 2001-02 to 2010-11 (April-Sept) this share increased from 40% to 53.5%. (GOI 2011, 170) (See Figure 1)

• India’s economy was also helped by its $54 billion surplus in its trade in services. (GOI 2011, 173) (See Figure 2)

• However, after years of rapid growth -- the compound annual growth rate was 28.7% from 2000-01 to 2006-07 and 22% in 2007-08 -- service export growth moderated to 17% in 2008-09. In 2009-10 exports declined by 9.6%. India’s surplus in service trade dropped from $53.9 billion to $35.7 billion due to less in demand for business (-7.5%) and financial services (-5.6%) and an increase in imports of these services. (GOI 2011, 172-3)

Table 2: Selected Countries' Export Growth and Share of World Exports, 2000-2010Value Compound Annual Growth Share in World Exports (Percent) ChangeUS $ bn. Rate in Percent Jan-June Jan-June 2009/

2009 2000-07 2008 2009 2010 2000 2008 2009 2010 2000China 1202 25.4 17.3 -15.9 35.1 3.9 8.9 9.7 10 5.8So. Korea 362 11.6 13.6 -14.3 34.3 2.7 2.6 2.9 3.1 0.2Mexico 230 7.3 7.3 -21.3 35.4 2.6 1.8 1.9 2 -0.8India 165 19.8 29.7 -15.2 35.3 0.7 1.2 1.3 1.4 0.7Malaysia 157 8.7 19.1 -24.9 36.9 1.5 1.3 1.3 1.4 -0.1Brazil 153 16.5 23.2 -22.7 27.5 0.9 1.2 1.2 1.3 0.4Thailand 152 12.1 12.9 -12 36.8 1.1 1.1 1.2 1.3 0.2Indonesia 119 8.8 18.3 -18 38.1 1 0.9 1 1 0EDE'S* 4572 16.9 25.3 -24.4 26.7 25.4 37.9 37 37.2 11.6World 12358 11.7 15.9 -22.7 24 100 100 200 100 NA* EDE's indicates emerging and developing countriesSource: Government of India, Ministry of Finance. Economic Survey of India, 2010-11 . New Delhi: GOI, 2011 p. 162.

Sectoral Share of the Indian

Economy, 2008-09

Services 64.2

Industry 18.7

Agriculture 17.1

B. Finance• Was India’s success in managing the financial

crisis due to its capital controls?• According to several indicators of de jure

capital account openness, (Table 3) India is more closed than other emerging markets, though it has been slowly catching up.

• Many contend that the lesson of India’s experience is that countries should open their capital account with great caution, if at all. Others have argued that India’s experience demonstrates the virtues of public sector banks and limitations on foreign banks.

• Prasad (2009) argues that it is important to consider de facto as well as de jure integration.

• Using the ratio the sum of gross external liabilities and gross external assets to GDP as a measure of de facto financial openness, Prasad (2009) finds that though India’s ratio increased from less than 20% of GDP in 1980 to just under 70% in 2006, it remains one of the least financially integrated emerging market countries

Table 3: Measures of De Jure Capital Account Openness

Emerging Markets India Min. Median Max.

Chinn Ito1985 -1.8 -1.13 2.54 -1.131995 -1.8 0.09 2.54 -1.132006 1.13 0.03 2.54 -1.13

Edwards1985 12.5 37.5 75 251995 25 50 100 252000 37.5 62.5 100 75

Miniane1985 0.83 0.86 1 0.831995 0.71 0.86 1 0.832000 0.71 0.86 0.86 0.86

Note: The Chinn-Ito Index goes from -2.54 to 2.54, with higher scores indicating

more open capital accounts. The Edwards index ranges from 0 to 100 with

higer scores indicating more open capital accounts. The Miniane index runs

from 0 to 1 with lower scores indicating more open capital accounts.

Source: Rasad 2009. See also Chinn and Ito (2006), Edwards (2007), and Minane (2004).

Table 2: Measures of De Jure Capital Account OpennessEmerging Markets India

Min. Median Max.Chinn Ito

1985 -1.8 -1.13 2.54 -1.131995 -1.8 -0.09 2.54 -1.132006 1.13 0.03 2.54 -1.13

Edwards1985 12.5 37.5 75 251995 25 50 100 252000 37.5 62.5 100 75

Miniane1985 0.83 0.86 1 0.831995 0.71 0.86 1 0.832000 0.71 0.86 0.86 0.86

Note: The Chinn-Ito index goes from -2.54 to 2.54, with higher scores indicating

more open capital accounts. The Edwards index ranges from 0 to 100 with

higher scores indicating more open capital accounts. The Miniane index runs

from 0 to 1 with lower scores indicating more open capital accounts.

Source: Prasad 2009. See also Chinn and Ito (2006), Edwards (2007), and Minane (2004)

How did the problems of global financial come to India?

• Despite capital controls and relatively limited financial integration, by 2007, India had an estimated 2104 multinational corporations (Sauvant and Pradhan 2010, 5) with outward foreign direct investment flows peaking at 18.5 billion in 2008 (Unctad 2010) (See Figures 2 and 3)

• Patnaik and Shah (2010) and Aziz, Patnaik, and Shah (2008) find that many Indian multinational (financial and non-financial) corporations set up global treasury operations in London in order to evade India’s capital controls and gain access to the cheaper funds available from global markets.

• When Lehman Brothers failed on September 14, 2008, liquidity in London dried up and the LIBOR-linked rates at which the Indian firms borrowed skyrocketed.

• With global credit no longer available at reasonable prices, Indian multinationals turned to the domestic money market, converting these funds into dollars in order to meet their foreign obligations.

• In the last quarter of 2008, capital leaving India through banks and non-bank corporations amounted to $10.8 billion, exceeding the overall net capital outflow of $3.7 billion and the net portfolio investment exodus of $5.8 billion. (Patnaik and Shah 2010, 18)– This caused the liquidity of domestic money markets

to tighten and interest rates to rise– It also placed downward pressure on the rupee’s

exchange rate

• Local firms who placed short-term funds with mutual funds because of tax advantages, began redeeming their investments to meet their own needs.

• The sell-off along with investors’ reevaluation of Indian MNC’s and the flight of foreign capital to less risk, resulted in a precipitous drop of prices on the Indian equity market.

• Fortunately, Indian policy makers dealt with these issues in a competent manner

• In the area of monetary policy, they lowered interest rates and increased the supply of funds in the money markets by reducing the reserve requirements for banks

• They enacted fiscal stimulus through the budget for FY 2009-10. This had a positive effect given that India’s domestic market remains the main driver of its economy.

• India drew on its ample foreign reserves amounting to $310 billion at the end of March 2008 to sell an estimated $30 billion to limit the depreciation of the rupee.

• Before the crisis, the Reserve Bank of India (India’s central bank), sensing the possibilities of a real estate bubble, intervened to limit loans to land developers by raising risk weights and provisioning requirements for such loans.

III. India’s Debate Over the Lessons of the Global Crisis• The global crisis has given the debate popular

notoriety. Former RBI Governor Y.V. Reddy published a best-selling book (2009) expressing a conservative view advocating a “calibrated approach” (2007)

• Nonetheless, baring other crises, the decisive politics of reform is within the central government bureaucracy pitting the Finance Ministry versus the RBI.

Key issues include

• Capital account convertibility• Whether foreigners should be allowed to invest in

Government of India securities• Restrictions on foreign investment in India’s

financial sector• The role of public banks• Whether the RBI should “manage” the exchange

rate• The degree to which the RBI should allow

innovation of financial products

IV. Concluding Remarks• The global financial crisis strengthened the Reserve Bank

of India and its conservative approach• India’s ambition to become a center for global financial

services (GOI 2007) will motivate more reforms.• The Ministry of Finance has the upper hand. It has the

authority to appoint the Governor of the RBI, and in Fall 2008 it used it to replace the retiring conservative Y.V. Reddy with the finance secretary D. Subbarao.

• Issues to watch are:– Whether the politics of reform will enable India to

relax capital controls while minimizing the risks of opening to foreign finance

– Whether the financial sector can develop the regulatory capacity that facilitates innovation while minimizing its risk

List of Works Cited

Aziz, Jahangir, Ila Patnaik, and Ajay Shah. 2008. “The current liquidity crunch in India: Diagnosis and Policy Response,” New Delhi: National Institute of Public Finance and Policy, Research Program on Capital Flows and their Consequences. Available at: http://www.mayin.org/ajayshah/PDFDOCS/APS2008_crisis_and_response.pdf.

Chinn, Menzie, and Hiro Ito. 2006. “What Matters for Financial Development? Capital Controls, Institutions and Interactions,” Journal of Development Studies 81:1, pp. 45-66.

Edwards, Sebastian. 2007. “Capital Controls, Sudden Stops and Current Account Reversals,” in Sebastian Edwards (ed.) Capital Controls and Capital Flows in Emerging Markets. Chicago: University of Chicago Press, pp. 73-120.

Government of India. Ministry of Finance. 2011. Economic Survey, 2010-2011. Available at: http://indiabudget.nic.in/index.asp.

Government of India. Ministry of Finance. 2007. Report on Making Mumbai an International Financial Centre. Available at: http://finmin.nic.in/reports/.

Kose, M. Ayhan and Eswar S. Prasad. 2010. Emerging Markets: Resilience and Growth Amid Global Turmoil. Washington, DC: Brookings Institution.

Miniane, Jacques. 2004. “A New Set of Measures on Capital Account Restrictions,” IMF Staff Working Papers 51:2. Available at: http://imf.org/External/Pubs/FT/staffp/2004/02/miniane.htm.

Patnaik, Ila and Ajay Shah. 2010. “Why India choked when Lehman broke,” New Delhi: National Institute of Public Finance and Policy, Working paper 2010-63 (January) Available at: http://www.nipfp.org.in/working_paper/wp_2010_63.pdf.

Prasad, Eswar. 2009. “Some New Perspectives on India’s Approach to Capital Account Liberalization,” National Bureau of Economic Research Working Paper 14658. Available at http://www.nber.org/papers/w14658.

Reddy, Y.V. 2009. India and the Global Financial Crisis: Managing Money and Finance. Delhi: Orient Black Swan.

Reddy, Y.V. 2007. “Converting a Tiger: Lessons from India’s gradualist approach to capital account convertibility,” Finance and Development 44: 1 (March) pp. 1-9.

Sauvant, Karl P., Jayaprakash Pradhan, Ayesha Chatterjee, and Brian Harley. 2010. The Rise of Indian Multinationals: Perspectives on Indian Outward Foreign Direct Investment New York: Palgrave.

UNCTAD. 2011. UNCTADSTAT Database. Available at: http://unctadstat.unctad.org/ReportFolders/reportFolders.aspx?sCS_referer=&sCS_ChosenLang=en>.

World Bank. 2011. World Development Indicators, 2010. Available at http://data.worldbank.org/data-catalog/world-development-indicators