Though this has taken longer than I wanted, but here it goes. The analysis is still in a very crude form. Will try and refine it as it goes: (Warning: it is a very very long post)
A crisis in an economy impacts other economies via three channels:
Trade Channel: When an economy falls into a recession, it impacts the affected country’s trading partners too. Falling household and business demand in the slump-hit economy hits the exports/imports of its trading partners.
The share of exports to EU (excluding UK) and imports from EU has fallen over the years. In 1987-88, exports to EU constituted about 18.6% of total exports. This has declined to 17.5% by 2008-09. The decline of imports is higher from 25% in 1987-88 to 12% in 2008-09. Hence, total trade between India and EMU is about 29.5% and could be impacted due to the crisis. (Source: RBI)
However, trade channel can impact Indian external sector indirectly as well. When the recent crisis gripped the world 2008, most policymakers, economists and experts put forth the view that India would be only marginally affected. Two reasons were cited for th
- First, India was a virtual non-entity in global trade as its share was less than 0.5%-0.7% of the total global trade volumes. Hence, it was assumed that its economy was largely insulated from the turmoil.
- Second, share of developed economies in trade had declined. In 1987-88 developed economies contributed 59% of exports and in 2008-09 their share has declined to 37%. The share of developing economies has increased from 14% in 1987-88 to 37% in 2008-09. In case of imports developed economies share has again fallen from 60% in 1987-88 to 32% in 2008-09 while developing economies has risen from17% to 32%. (Source: RBI)
Because of this shift it was felt that impact of global crisis on Indian economy would be limited. As crisis originated in US and developed economies with developing economies still growing, it was felt Indian trade will continue to grow. However once the crisis struck in September 2008, Indian trade sector declined sharply and growth was negative for 13 straight months from Oct-08 to Oct-09.
The above analysis looks at trade in goods. What about trade in services? We do not have country-wise data of trade in services so we just analysed the broad trend. Unlike trade in goods which declines immediately, we see a decline in services trade with a lag. It declines visibly in Jan-Mar 2009 quarter when the global crisis started in September 2008. Software exports decline marginally from USD 11.2 bn levels to 10.4 levels which is great given the global nature of the crisis. Hence, impact of crisis was more on goods and muted on services.
|(in USD Billion)||India Services trade||Software Receipts|
|Jan – Mar 2008||10.8||10.9|
|Apr – Jun 2008||11.6||11.3|
|Jul – Sep 2008||14.4||11.2|
|Jan - Mar 2009||11.0||10.7|
|Software exports are more than services trade as we import more in case of other services like travel, transport etcSource: RBI|
Moreover, World Trade volumes declined for the first time in 60 years. IMF says the decline in world trade in 2009 was around 12.3%. The Indian government had to intervene and provide stimulus to exporters. Trade volumes declined as world economy is far more integrated than we assume it to be. Demand in developing economies also declined leading to overall slump in world trade.
So, the overall impact of European crisis on Indian trade could be much more than direct linkage indicates.
Financial Channel: The current crisis has shown the power of finance channel (though trade channel was also very strong as above analysis points). The impact of turmoil in one economy’s financial markets is not merely transmitted to other markets, the quantum and direction of the movement is also more or less similar (decline in equity markets, rise in corporate bond spreads and depreciation in currency). This is because cross border financial linkages have increased substantially over the years. Besides, the correlation between assets too has been rising across the world. If you plot the BSE Sensex with other advanced economy stock indices, you more or less see the same trend. So much so, one can determine the trend in the Indian equity market by just looking at movements in other global indices.
Apart from movement in financial markets, three kinds of financial flows could impact Indian financial markets:
- Foreign Direct Investment: There are many European companies which have investments in India. So, there could be a possibility of slowdown in FDI in India. We looked at top 15 FDI investors in India which constitute about 92% of total FDI (Source: DIPP). EU economies have contributed about 12.8% of total FDI since April 2000. But again FDI remained robust throughout this crisis. Given the severity of the crisis it was felt there will be little FDI investment. However, in case of India, FDI inflows remained positive throughout the crisis. The FDI inflows actually helped keep maintain capital account when all other categories showed sharp decline.
|(in USD billion)||Gross FDI inflows||Gross FDI Outflows||Net FDI (Inflows minus Outlflows)|
|Jan – Mar 2008||13.7||-7.4||6.4|
|Apr – Jun 2008||11.9||-2.9||9.0|
|Jul – Sep 2008||8.8||-3.9||4.9|
|Jan - Mar 2009||8.0||-4.8||3.2|
- Foreign Institutional Investment: Unlike FDI, it is difficult to pinpoint the origin of FII investment. However, the linkage here is pretty direct. With a turmoil in global financial markets, FII inflows will decline. We have a large number of global financial firms which operate across the world and in case of a decline in one major market, there is a pull out from other markets as well.
|(in USD billion)||FII|
|Jan – Mar 2008||-3.7|
|Apr – Jun 2008||-4.2|
|Jul – Sep 2008||-1.3|
|Jan - Mar 2009||-2.7|
- External Commercial Borrowings: External commercial borrowings could also decline if the European crisis spreads to other economies. ECB’s declined in the first stage of the crisis as well.
|(in USD billion)||ECB|
|Jan – Mar 2008||4.8|
|Apr – Jun 2008||1.5|
|Jul – Sep 2008||1.7|
|Jan - Mar 2009||1.1|
- Remittances and NRI deposits: Another important flow is NRI deposits and Remittances. Former shows whether NRI depositors withdrew funds in wake of crisis and latter shows whether Indians living abroad stopped sending funds to their homes again because of the crisis. We see an interesting trend in the case of NRI deposits. The deposits increase in the crisis periods Oct-Dec 2008 and Jan- Mar 2009 and decline thereafter. It could be that NRI preferred to invest higher proceeds in India seeing crisis in their own economies!In case of remittances, we see a decline in crisis period Oct 08 – Mar 09 but see improvements as crisis eases. There were huge concerns of remittances collapsing because of the crisis. In some countries they did collapse worsening poverty status. In India, despite the decline it manages to remain in positive. (see this study on remittances)
|(in USD billion)||NRI Deposits||Remittances|
|Jan – Mar 2008||1.1||13.4|
|Apr – Jun 2008||0.8||11.6|
|Jul – Sep 2008||0.3||13.0|
|Jan - Mar 2009||2.2||9.5|
Again like in the trade channel, the impact of financial markets could be more via the indirect linkage. Financial markets are far more integrated than the trade channel.
Even both trade and finance are interlinked. First, domestic banks can lend to companies in other economies as well. A problem in latter could lead to worsening of the conditions of domestic banks/financial firms as well (this was seen in the case of Swedish banks).
Second, Banks are at the center of the international trade as they provide trade finance and other financing facilities that facilitate trade. A problem in financial markets will disrupt the international trade as well. In the initial phase of post September 2008 crisis, WTO and World Bank chiefs raised concerns over trade finance in numerous forums.
This channel shows confidence declines in business and households seeing the global uncertainty. So even if an economy’s macroeconomic conditions and outlook look favorable, the decline in confidence can disrupt the economic conditions. Decline in confidence is also one of the reasons for decline in business investments which led to decline in overall Indian GDP growth. Credit growth also declined because of decline in business investments.
RBI Governor Mr Subbarao has stressed on this channel on numerous occasions (see this speech in 2009).
Role of confidence channel in crisis has grown overtime. Bank of Japan Governor Masaaki Shirakawa in a recent speech said confidence cycle plays a crucial role in all crises:
Why do financial crises, and for that matter bubbles which precede them, occur repeatedly? Many reasons are given — lax risk management, excessive leverage, existence of financial institutions which are perceived to be too-big-to-fail, failure of supervision, excessively accommodative monetary policy and the list goes on. I generally agree with such assessments, but we also need a holistic perspective which cannot be captured just by focusing on individual causes. From this perspective, I would like to emphasize that, what one could term as a “cycle of confidence” which evolves over a very long time horizon, plays a decisive role. Success breeds confidence which unfortunately turns into over-confidence or even arrogance. Complacency also sets in. The collapse of the bubble based upon this over-confidence leads now to under-confidence, which is followed by rebuilding efforts. Then the cycle begins once again.
Increasing integration of India with global economy
Apart from these three channels, Indian economy has become more global over the years. The business and trade cycle of India has started to follow the cycles of advanced economies. RBI Executive Director Deepak Mohanty in his speech explained the increasing correlation:
With increased global integration, the Indian economy now is subject to greater influence of global business cycles. The correlation between the cyclical component of the index of industrial production (IIP) of the advanced economies and India has risen to 0.50 during the period 1991-2009 from 0.20 in during the period 1971-1990
The traditional conduit of transmission of global shocks is through trade cycles. The cyclical movement in India’s exports and world imports during the earlier period 1970-91 was not significantly synchronised with a relatively low correlation of 0.38. However, with rising exports alongwith a transition from primary article exports to manufacturing exports, the correlation between India’s exports and world imports has increased significantly to 0.80 during the recent period 1992-200.
Concluding thoughts and possible scenarios
The above analysis looks at some preliminary evidence of the linkages of Indian economy with European economies. Again, I must emphasize that we need to look beyond the direct impact of European economy on India. As this crisis has shown that world economy is far more global with many complex interlinkages. Hence, if the European crisis continues to spread, it could impact Indian economy via other indirect linkages as well.
Given this global uncertainty, it puts Indian policymakers in a peculiar situation. If we look at Indian economy alone fundamentals look quite strong. GDP growth is expected to be around 8.5% in 2010-11, IIP is increasing in double digits, credit growth has increased to 17%, export markets are picking up and capital inflows have been robust.
However, because of the global uncertainty all these calculations can easily go wrong. Infact, sentiment has already reversed in some cases:
- The investments might not increase seeing the global uncertainty. Investment was a key driver in Indian 9% growth period (2003-08). Again it is expected to play the key. We have seen business confidence evaporating in thin air quick time
- IIP could again decline as it did post September 2008 crisis
- Credit growth could decline both because of banks becoming uncertain and business not demanding credit
- Foreign capital inflows could reverse to an outflow position. Infact this has already started to happen with FII showing outflows worth USD 1.65 billion in May (from May 1 2010 to May 24 2010) from equity markets. Till April 2010, we had nearly USD 6.65 billion of capital inflows.
- The decline in inflows along with global uncertainty has led to decline in equity markets. The expectations of BSE Sensex reaching soon to 21,000 levels are being revised downwards.
- The volatility is again increasing. If we see the NSE VIX index. It had increased from 20 level in Jan 2008 to 85 levels in Nov-08. It then declines to go back to pre-crisis level of 17-18. It has again started increasing to touch 34 levels now.
- Yields in bond markets have eased considerably to 7.35% levels looking at the global crisis. This is quite a turnaround as most market participants expected yields to touch 8-8.25% levels after April Monetary Policy. The market participants were also expecting RBI to increase interest rates even before its monetary policy in July 2010. This crisis has reversed the sentiment and most now expect RBI to keep interest rates unchanged in July policy.
- Export markets could also decline for reasons explained above.
- If the crisis situation worsens, Indian government might again have to intervene to ease the crisis situation. Though the probability is remote, but it is till there. There are expectations that fiscal deficit and government borrowing program could be lower than budgeted amount. This is because of the higher than expected proceeds from 3-G auctions. If crisis worsens, the government borrowing and fiscal deficit could get worse.
- Oil and commodity prices have declined as well. This could be a positive factor as inflation might just become lower.
The above is a worse-case scenario and all will depend on the nature of European crisis. We still do not know where the crisis is headed. Comparisons have been made on how the crisis is similar to earlier US crisis but we have a far more complex problem here. In US you have one government and here you have 16 governments who are trying to resolve the issue.
The recent events show the situation is quite severe. There is little coordination between European policymakers as daily edition of eurointelligence shows. Germany recently imposed ban on naked short selling without taking other European governments in confidence. This angered other European governments who said why Germany should make standalone policies when we are all fighting this crisis together. And just after saying this, European policymakers have again showed resolve to fight this crisis. Germany was seen as the economy which could support falling Eurozone but its government has been severely criticised for its dilly-dally approach. So, overall it is all very chaotic and complex at the moment.
Finally a reminder for all those who forget/prefer to forget economic history so quickly. I mean it is just amazing. Before the crisis in Sep-08 we kept saying we will not be impacted because of the global crisis for all kinds of reasons. This was especially the case for financial market players. And then the crisis hit and hit them hard with equity markets declining from 21000 levels to 8000 levels. And again, it rose not because of some Indian economy wonders but because global financial markets started picking up (or stopped declining). Infact much of the gains in Indian economy did not come from some economy wonders but government wonders. And as global crisis eased, we preferred to call it a one time event etc.
As Europe started to decline, we again laughed off when asked whether we could be impacted. And again it is the same set of people expressing confidence over Indian economy etc. And now we are seeing some strains on equity markets, capital inflows etc. We may not be impacted by the European crisis as much as previous crisis, but forgetting history so quickly is a crime. It drives you nuts really.