The Monetary, Fiscal and External Trade Policy in face of the Global Slowdown: The Indian Context The global economic outlook deteriorated sharply over the last quarter. In a sign of the ferocity of the down turn, the IMF made a marked downward revision of its estimate for global growth in 2009 in purchasing power parity terms – from its forecast of 3. 0 per cent made in October 2008 to 0. 5 per cent in January 2009. In market exchange rate terms, the downturn is sharper – global GDP is projected to actually shrink by 0. 6 per cent.
With all the advanced economies – the United States, Europe and Japan – having firmly gone into recession, the contagion of the crisis from the financial sector to the real sector has been unforgiving and total. Recent evidence suggests that contractionary forces are strong: demand has slumped, production is plunging, job losses are rising and credit markets remain in seizure. Most worryingly, world trade – the main channel through which the downturn will get transmitted on the way forward – is projected to contract by 2. 8 per cent in 2009. Contrary to the “decoupling theory”, emerging economies too have been hit by the crisis.
The decoupling theory held that even if advanced economies went into a downturn, emerging economies will remain unscathed because of their substantial foreign exchange reserves, improved policy framework, robust corporate balance sheets and relatively healthy banking sector. In a rapidly globalizing world, the ”decoupling theory” was never totally persuasive. Reinforcing the notion that in a globalized world no country can be an island, growth prospects of emerging economies have been undermined by the cascading financial crisis with, of course, considerable variation across countries.
After clocking an average of 9. 4 per cent during three successive years from 2005-06 to 2007-08, the growth rate of real GDP slowed down to 6. 7 per cent (revised estimates) in 2008-09. Industrial production grew by 2. 6 per cent as compared to 7. 4 per cent in the previous year. In the half year ended March 2009, imports fell by 12. 2 per cent and exports fell by 20. 0 per cent. The trade deficit widened from $88. 5 billion in 2007-08 to $119. 1 billion in 2008-09. Current account deficit increased from $17. 0 billion in 2007-08 to $29. billion in 2008-09. Net capital inflows at US$ 9. 1 billion (0. 8 per cent of GDP) were much lower in 2008-09 as compared with US$ 108. 0 billion (9. 2 per cent of GDP) during the previous year mainly due to net outflows under portfolio investment, banking capital and short-term trade credit. As per the estimate made by the RBI in its Annual Policy announced on April 21, 2009, GDP is expected to grow by 6 per cent in 2009-10. The contagion of the crisis has spread to India through all the channels – the financial channel as well as the real channel.
Effects of the Crisis on India 1. GDP Growth is slowing down •GDP growth exceeded 9. 0% in the last three years but is expected to slowdown in the current year in view of the global financial crisis and slowdown •However, India would still remain the second fastest growing major economy in the world •Given the inherent strengths of the economy, the slowdown is unlikely to be very deep or protracted – recovery is expected much faster than other parts of the world. 2. Industrial Production has Moderated Industrial growth has moderated to 4. % during the Apr – Oct 2008 compared to 9. 9% in the same period of the previous year. 3. Decline in Export Growth •India is a much more externalised economy now than ten years back. •Using an expanded measure of globalisation – ratio of total external transactions (gross current account flows + gross capital flows) to GDP the figure is 117. 4% in 2007-08 compared to 46. 8% in 1997-98. •Therefore, it is only expected that the global economic slowdown would start reflecting in India through India’s externalisation. . Exchange Rate Volatility 5. Decline in Foreign Exchange Reserves With the global de-leveraging and also owing to the reduced inflow of foreign exchange the Reserve Bank of India has seen a depletion in its holding of reserves. However, the current levels are still way over the comfortable levels of import cover. Policy Responses The policy responses in India since September 2008 have been designed largely to mitigate the adverse impact of the global financial crisis on the Indian economy.
Both the government and the Reserve Bank of India responded to the challenge in close coordination and consultation. The main plank of the government response was fiscal stimulus while the Reserve Bank’s action comprised monetary accommodation and counter cyclical regulatory forbearance. Monetary policy response The Reserve Bank’s policy response was aimed at containing the contagion from the outside – to keep the domestic money and credit markets functioning normally and see that the liquidity stress did not trigger solvency cascades.
In particular, we targeted three objectives: first, to maintain a comfortable rupee liquidity position; second, to augment foreign exchange liquidity; and third, to maintain a policy framework that would keep credit delivery on track so as to arrest the moderation in growth. This marked a reversal of Reserve Bank’s policy stance from monetary tightening in response to heightened inflationary pressures of the previous period to monetary easing in response to easing inflationary pressures and moderation in growth in the current cycle.
Till August 2008, the RBI followed a tight monetary stance in view of the inflationary pressures arising from crude, commodity and food prices. In mid-September 2008, severe disruptions of international money markets, sharp declines in stock markets across the globe and extreme investor aversion brought pressures on the domestic money and forex markets. The RBI responded by selling dollars consistent with its policy objective of maintaining orderly conditions in the foreign exchange market. Simultaneously, it started addressing the liquidity pressures through a variety of measures.
A second repo auction in the day under the Liquidity Adjustment Facility (LAF) was also re-introduced in September 2008. The repo rate was cut in stages from 9 per cent in October 2008 to the current rate of 4. 75 per cent. The reverse repo rate was brought down from 6 per cent to 3. 25 per cent. The cash reserve ratio which was 9 per cent in October 2008 has been brought down to 5 per cent. To overcome the problem of availability of collateral of government securities for availing of LAF, a special refinance facility was introduced in October 2008 to nable banks to get refinance from the RBI against a declaration of having extended bona fide commercial loans, under a pre-existing provision of the RBI Act for a maximum period of 90 days. The statutory liquidity ratio requiring banks to keep 25 per cent of their liabilities in government securities was reduced to 24 per cent. These actions of the RBI since mid-September 2008 resulted in augmentation of actual/potential liquidity of nearly $50 billion. In dealing with the slowdown, it has released so far Rs. 3, 85,000 Crores by reducing its rates as follows:
Fiscal Policy Over the last five years, both the central and state governments in India have made a serious effort to reverse the fiscal excesses of the past. At the heart of these efforts was the Fiscal Responsibility and Budget Management (FRBM) Act which mandated a calibrated road map to fiscal sustainability. However, recognizing the depth and extraordinary impact of this crisis, the central government invoked the emergency provisions of the FRBM Act to seek relaxation from the fiscal targets and launched two fiscal stimulus packages in December 2008 and January 2009.
These stimulus packages came on top of an already announced expanded safety-net for rural poor, a farm loan waiver package and salary increases for government staff, all of which too should stimulate demand. The following are the highlights of the fiscal stimulus package unveiled by the government to contain the impact of global financial crisis on the Indian economy: •Plan, non-plan expenditure of Rs. 300,000 crore (Rs. 3,000 billion/$60 billion) in four month •Parliament nod to be sought for Rs. 0,000 crore more toward plan expenditure •Across-the-board cut of four percent in the ad valorem central value-added tax •Interest subvention of two percent on export credit for labour intensive sectors •Additional allocations for export incentive schemes •Full refund of service tax paid by exporters to foreign agents for loans on housing for up to Rs. 500,000, and up to Rs. 2 million •Limits under the credit guarantee scheme for small enterprises doubled •Lock-in period for loans to small firms under credit guarantee scheme reduced •India Infrastructure Finance Co allowed to raise Rs. 00 billion through tax-free bonds •Norms for government departments to replace vehicles relaxed •Import duty on naphtha for use by the power sector is being reduced to zero •Export duty on iron ore fines eliminated •Export duty on lumps for steel industry reduced to five percent Trade Policy India’s BoP position in 2008-09 (April-December) was characterised by a widened trade deficit leading to a higher current account and lower net capital inflows. The rapid contraction in the global trade was reflected in negative growth experienced during the third quarter, which was last observed in 2001-02.
The growth in imports also decelerated to single digit level during the third quarter, led by lower crude oil prices and weakening domestic demand. The merchandise trade deficit further widened to US$ 113. 8 billion during April-February 2008-09 (US $ 82. 2 billion a year ago). Net surpluses under invisibles increased in April-December 2008, primarily led by private transfers and software services, though a moderation in such inflows set in the third quarter. Thus, the current account deficit widened to a level of US$ 36. 5 billion (US$ 15. 5 billion in April-December 2007).
The adverse impact of the global financial market turmoil was also felt in terms of reduced inflow of the long and short-term debt and reversal of portfolio inflows. A positive development was, however, relative resilience of FDI inflows (US $ 31. 7 billion in April-February 2008-09) in the face of reversal of capital flows, reflecting the attractiveness of India as a long term investment destination. Restoring Export Growth •Our exporters by virtue of their close links to the external sector have borne the brunt of the global economic crisis.
It is, therefore, appropriate that we continue to provide all possible assistance to our exporters to help them overcome the short term disadvantages. More specifically: •An adjustment assistance scheme to provide enhanced Export Credit and Guarantee Corporation (ECGC) cover at 95 per cent to badly hit sectors had been initiated in December 2008 to mitigate the difficulties faced by the exporters. In view of the continuing contraction in exports, government of India should extend the benefits of this scheme up to 2nd quarter 2010. The Market Development Assistance Scheme provides support to exporters in developing new markets. With many traditional markets still under financial stress, greater effort is required to identify and develop new markets. •In wake of above fact we can enhance the allocation for this scheme by one and half times to be sure that the desired effect is there and this must be up scaled to above 150 crores. •With a view to insulating the employment – oriented export sectors from the global meltdown, Government had provided an interest subvention of 2 per cent on pre-shipment credit for seven such sectors.
These sectors are textiles including handlooms, handicrafts, carpets, leather, gems and jewellery, marine products and small and medium exporters. This facility should be atleast extended to the interest subvention beyond the current deadline of September 30, 2009 to March 31, 2010. •India’s external debt, debt sustainability indicators and the level of foreign exchange reserves continue to remain at comfortable levels and would ensure external stability therefore government of India through its monetary actions must take steps to ensure that the present scenario is maintained through timely actions in the money market.
Conclusion The close coordination and interaction between the Government and the RBI ensured that appropriate package of measures were put in place promptly to deal with the crisis and restore the growth momentum. India has by-and-large been spared of global financial contagion due to the subprime turmoil for a variety of reasons. India’s growth process has been largely domestic demand driven and its reliance on foreign savings has remained around 1. 5 per cent in recent period. It also has a very comfortable level of forex reserves.
The credit derivatives market is in an embryonic stage; the originate-to-distribute model in India is comparable to the ones prevailing in advanced markets; there are restrictions on investments by residents in such products issued abroad; and regulatory guidelines on securitisation do not permit immediate profit recognition. Financial stability in India has achieved through perseverance of prudential policies which prevent institutions excessive risk taking, and financial markets from becoming extremely volatile and turbulent.