indian economy

Indian Economy after Recession
XE "Introduction"
Abstract
During the past decade, India has witnessed rapid economic growth, which slowed down only slightly towards the end of the decade. However, given the uncertain global conditions and the U.S global crisis followed by the Euro-zone crisis, the high growth trajectory of the Indian economy is likely to fall, at least to some extent. This paper discusses the global economic situation, the recent economic crisis which has affected almost all the countries in the world, in one way or another, and its possible impact on India. The paper makes an initial effort to understand what a recession is and how India’s economy is linked to the global economy, particularly the United States of America and Europe. Given the background of the recent crisis, the paper makes an attempt to address the problems facing the Indian Economy and also tries to provide effective solutions for the same. Based on certain assumptions, this paper
ings forth the future prospects for the Indian economy, the challenges facing it and the major benefits which the economy stands to gain in the near future.
The structure of the paper is as follows: Firstly, we try to understand the basics of a recession, its causes and likely effects. Secondly, we focus on the recent changes in the global economic environment. This will have two major components: the U.S economic crisis, and the Euro-zone crisis. Next, we turn to the effect of these global conditions on the Indian economy. In order, to be able to say anything about future prospects of India, it is important to discuss the recent developments in the Indian economy, which would be our next topic of discussion. Here, we would focus on the recent depreciation of the rupee as against the U.S dollar. We conclude this section with an outlook on the Rupee. Next, we discuss the prospects for the Indian economy, the gains to be made and the challenges to be faced in the near future. We turn our attention to the problems that plague the nation and what can be done to solve these problems. We conclude with a summary of our analysis and a note on the future of India.
Contents
1Abstract
31. Introduction
52. Understanding a recession
52.1. What is a Recession?
62.2. Causes of a Recession
72.3. Effects of recession
83. Recent changes in global economic environment
124. Global Economy Prospects
175. Impact on India
216. Depriciation of the indian rupee
26Outlook on the Rupee:
277. Future Prospects for the indian economy
28Prospects for Growth
29Fiscal Deficit
30Prospects for Inflation
30Monetary Changes
31Policy Prospects
31External Secto
378. A few suggestions
439.Conclusion
46REFERENCES
1. Introduction
Since 2007, the global economy has been experiencing a severe downturn, in terms of a low real Gross Domestic Product (GDP) and high unemployment. The problem started in the United States of America and it is well known that when USA sneezes, the world catches a cold. During 2008-2009, USA witnessed what is now known as the Great Recession. During this period, not only USA but many other countries of the world also went through a major economic slowdown. This is because USA is linked economically to practically all other countries in the world. The US Dollar, which was earlier considered to be the safest cu
ency, now became a cu
ency in which investors no longer wanted to invest. Investor confidence everywhere was very low and many investors fled from USA to Europe. The effect on India of this was much less as compared to that on other countries. In fact, much of the developing world was insulated from this recession. However, by 2010, the Great Recession, which is also called the global financial crisis, was not yet completely resolved, and problems started in Europe. After the Euro-zone debt crisis, which is still continuing, GDP growth rates in most parts of the globe declined substantially. The developing world has also been affected by this crisis as is seen from the declining growth rates in 2011. India’s growth rate also declined in 2011 and is predicted to be below 8% in 2012 and 2013. However, the condition is still better in India as compared to the major developed nations of the world. Economists and financial analysts across the world have diverse views on the post recession economic conditions in India. Some believe that this is an opportunity for India to tilt the power balance in its favor while others believe that this crisis could dampen domestic markets, reduce investments and slowdown India’s economic growth. The recent depreciation of the rupee against the U.S dollar also seems to further the latter belief. We discuss these issues in detail, later in this paper.
2. Understanding a recession
In order to make any analysis about the future of the Indian economy post recession, it is important to understand what a recession is and what are its probable causes and likely effects.
2.1. What is a Recession?
A recession may be defined as a steady decline in a country’s Gross Domestic Product. Usually, if the GDP declines for two or more quarters consecutively, it is considered as a recession. Before the recession, the economy will usually show signs of slow down. A recession is a part of the normal business cycle. However, when the recession becomes prolonged and heightened in magnitude, it might lead to greater losses than those of a normal business cycle recession. The figure below shows a business cycle.
The economy typically expands for 6 to 10 years, reaches its peak, and then starts slowing down. This slow down which lasts usually from 6 months to 2 years is the recessionary phase of the economy.
2.2. Causes of a Recession
The most prominent cause of a recession is a decline in consumption spending and investment spending. This leads to a downward shift in the aggregate expenditure function and causes the equili
ium level of GDP to fall. This is shown in the figure below. Aggregate expenditure is also refe
ed to as the aggregate demand in the economy.
The decrease is demand takes place because people lose confidence in the economy and spend less. This leads to a decrease in production, more employee lay-offs and an increase in unemployment. Rising unemployment means that people have less money to spend, which further reduces aggregate demand in the economy. Also, investors perceive an increase in risk associated with securities and fearing that the value of their stocks will decrease, they invest less. Thus, the market is driven by a negative investor and consumer sentiment.
2.3. Effects of recession
Since the stock markets and the economy are closely linked, the effects of a recession are clearly visible in stock market transactions. During a recession, the value of stocks goes down, number of investors decrease and the stock markets crash down. The financial sector is characterized by poor credit worthiness and as more and more people flock to the banks and demand their money back, the banks have a tough time in meeting these demands. If the recession is severe enough, it may cause certain banks to go bankrupt leading to an eventual shut down or government bailout for these institutions. As demand is low, firms see their inventories rising and profits falling. As a result, depending on the severity of the recession, companies and firms may have to shut down. Off course, the eventual outcome of all this is a sharp increase in unemployment levels in the economy and a sharp decline in GDP. As argued by Keynes, the role of the government is important during a recession. If we take the classical approach and leave the economy to itself, it is unlikely that the economy will return to its full employment or potential GDP level, and even if it does it would take a very long time to do so. Thus, government must interfere to ensure that there is sufficient demand in the economy. The government may use fiscal or monetary tools to boost aggregate demand in the economy. As demand increases, unemployment will also start reducing. Adam Smith’s famous theory of the market economy as an “invisible hand” fails during a recession.
3. recent changes in global economic environment
Let us start with the global financial crisis which began in the United States of America in 2007. This was primarily a subprime mortgage crisis which was aggravated by increases in oil prices. It was an American dream that every American should own a house. It was thought that this could be made possible by giving easy loans to people. This resulted in subprime mortgages. Subprime loans are given to people who have low and unstable incomes and who run a higher risk of defaulting on the loans. These loans typically have a higher interest rate in order to compensate for the higher risk associated with these loans. Loans were given to one and all, even to people with poor credit worthiness. With availability of a large number of loans, the housing market boomed and a housing bu
le was formed. However, the momentum could not be sustained for long and soon, the housing bu
le burst when people started defaulting on these loans. The assets which were kept as mortgages did not even cover the principal value of the loans let aside the interest payments on these loans. This led to a liquidity shortfall in the economy. It was this credit crunch that triggered the financial crisis. With more and more defaults, the economy sensed negative investor sentiment, interest rates on bo
owing increased, investments decreased, production declined and unemployment shot up. This was further intensified by higher oil prices. The oil prices reached an all time high in the first two quarters of 2008 and as a result, the prices of major products like food, clothing and other consumer items shot up. So, consumption spending decreased and aggregate demand in the economy fell to very low levels. The unemployment rate increased to as much as 9% and the industrial growth reached a low level of 1.1% in the U.S in 2009-10.The banks were interested in meeting short term goals and ignored warnings of absence of long term sustainability. This resulted in an acute credit shortage. The liquidity shortfall in the banking system resulted in collapse of major financial institutions. For example, companies like Lehman Brothers, Me
ill Lynch, Freddie Mac and Fannie Mae had very high proportions of “bad assets”. This resulted in closing down of many companies and bail out of banks by the government. In this way, the downward spiral of the economy began.
By, 2010, the problems in the U.S had not yet been resolved and trouble started in Europe. The European economy is now in the midst of a sovereign debt crisis. Such a crisis emerges when the government bo
ows hugely from outside. When the government’s budget deficit is high, it means that it is spending much more than it is receiving through taxation and other sources and so the government needs to bo
ow. The government does so by issuing bonds to investors outside the country. The interest rates on such bonds are typically low since the risk of the government defaulting is very low. The Euro-zone crisis started with problems in Greece. Greece was a very fast growing economy during the early years of the last decade, and so a lot of investors, having faith in Greece’s economy, invested in Greek government bonds. As a result, Greece could bo
ow easily and kept bo
owing until the debt had reached dangerous levels. However, the world was unaware of the debt issues of the Greek government until October, 2009, when the government disclosed its public debt levels. As a result, investors lost confidence in the Greece government and higher interest rates were required to attract investors. Therefore, Greece was unable to generate any bo
owings to fill up for the budget deficit. Now, in order to
ing things on track, the European Union (EU) and the International Monetary Fund (IMF) offered Greece a bailout, on condition that Greece would reform its tax structure and improve its fiscal sustainability. This, however, was not agreeable to the people of Greece who had got accustomed to paying low taxes and enjoying greater public benefits. This resulted in riots on the streets and people demanding that the taxes should not be increased. Not increasing taxes obviously meant that the condition of the Greek economy would worsen further, but it was difficult to make the general public understand this. Problems spread quickly from Greece to Portugal, Ireland, Italy and Spain, as all these economies are highly interconnected.
Source: International Labor Organization (ILO), World of Work Report 2011 (Geneva)
It is the developed countries which have suffered the most due to these two crises. The growth rates had considerably slowed down during 2011 in most parts of the developed world. As, stated in the United Nations, the forecasts for 2012 and 2013 point towards continued slow economic growth in the coming years. After the U.S financial crisis, the developing countries were more or less insulated from the negative impacts of the financial recession. However, after the Euro-zone crisis, even the developing countries have experienced slowing down of economic growth. Growth rates in developing countries are still strong, at an average of 6% but they have decelerated in 2011.
4. Global Economy Prospects
Most economists and financial analysts have a pessimistic view as far as the near future of the global economy is concerned. Due to the euro-zone crisis, growth rates in Europe have fallen from 2.7 percent in 2010 to 1.3 percent in 2011. Moreover, the U.S economy is still in the process of recovery, and it will be some time before it bounces back to a healthy growth track. Unemployment continues to remain high and aggregate demand in the economy is still low. Rate of output growth is also extremely low. Such low levels of growth are insufficient to deal with the huge crisis facing the developed economies of the world. Moreover, the debt crisis in Europe has given the final blow to the problems facing the global economy. Thus, the problems facing us are multiple and interlinked, but the solutions are contingent and insufficient. Households and banks are still holding back credit, liquidity is still tight and budget deficits have increased due to the recession and to a lesser extent, due to the fiscal stimulus. Also, now the situation in the developed world has begun to drag the developing world down. Economists are now wo
ied about the risk of another global recession. Due to high debt levels, governments are now reluctant to increase expenditures and this may mean that aggregate demand could fall further. If, this happens, the risk of another recession is heightened.
However, a few economists believe in a more optimistic scenario of the future global economy. Some expect the growth rates in USA to be more than the usual forecast of 1.5–1.8 percent in 2012 and 2013. This will happen as consumer and investor confidence is restored and aggregate demand increases. Also, one positive thing is Japan’s recovery from the earthquake disaster by 2012, with an expected GDP growth rate of 2%. However, Europe is a big problem and it seems quite impossible that the situation will be completely reversed in the next two years. However, the reforms are on their way and the situation might not be as bad as predicted. Also, all these problems of the developed countries may have a positive effect on emerging market economies as investors turn away from USA and Europe.
Source: UN/DESA, based on data from ILO and IMF.
Source: UN/DESA, a: estimates, b: United Nations Forecasts
The above two graphs show two things:
i) A comparison of the world economy before recession and that after recession, and
ii) The future prospects of employment and GDP growth rate in the coming years.
As, we can see, both employment in developed economies and growth of world gross product showed a significant dip in 2009-10
The graph for world gross product shows three kinds of scenarios possible in the future: the baseline scenario, optimistic scenario and the pessimistic scenario. The United Nations report on world economic prospects gives higher probability to the baseline scenario. However, given the unstable global environment and the continuing crisis in Europe, it is likely that the pessimistic scenario could arise with as much probability as the baseline scenario. The optimistic scenario has been rightly attached a lower probability. The three kinds of scenarios are based on certain assumptions regarding the state of the economy that is to follow. The optimistic scenario is based on the assumption that the EU is able to solve its problems, and fiscal deficits in the region are under total control, all the fiscal targets are met, debt to GDP ratios are considerably reduced, employment rates are increased to pre-recession levels, the liquidity problem is resolved and the credit crunch is over, emerging and developing economies are on the path of fiscal stimulus, and targeted growth rates are achieved, and inflation in developing economies is controlled. Under this scenario, the world economy could reach a growth rate of 4% per annum in the next few years. The baseline scenario, on the other hand, assumes that the economy is on the path of recovery, but the magnitude of recovery is much smaller than that assumed in the optimistic scenario. It also assumes that the oil prices are at $100 per ba
el, the euro exchange rate depreciates to around 2.5% from its 2011 level. The baseline scenario makes much more modest assumptions regarding the state of the economy. The pessimistic scenario takes into account the various risks and uncertainties that the global economy might have to deal with in the coming future, while making a forecast.
The following table shows Gross domestic product growth in 2011, and expected GDP growth rates in 2012 and 2013.
Table 1: Global GDP growth (%)
    
     2011 (e)
     2012 (f)
     2013 (f)
    World
     2.8
    2.6
    3.2
    High Income
    1.6
    1.4
    2.0
     Euro Area
    1.5
    0.4
    1.3
     Japan
    -0.5
    2.0
    2.0
     U.S
    1.7
    1.5
    2.0
    Developing
    6.0
    5.6
    5.9
     Brazil
    3.7
    2.7
    3.8
     Russia
    4.0
    3.9
    4.0
     India
    7.6
    7.7
    7.9
     China
    9.3
    8.7
    8.5
Source: UN, World Economic Situation and Prospects, 2012
(e-estimate, f-forecast)
5. Impact on India
The growth rates of GDP have already shown a downward trend in India. This trend began in 2011 and is expected to continue in the near future. The predicted GDP growth rate is below 8%, which is a substantial decline from the high growth rate of 9.3% achieved earlier in the decade. Despite, slowing down of the growth rate, the Indian economy still remains one of the fastest growing economies of the world. As pointed out by the Indian Prime Minister, Manmohan Singh, if the crisis in Europe continues, it would further dampen global markets and this would affect India’s own economic growth adversely. This is very...