Indian economy after recession

Indian Economy after Recessions
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    Indian Economy after Recessions
Causes and effects
9/12/2013
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Table of Content
1. Abstract …………………………………………………………3
2. Introduction ……………………………………………………..4
3. Understanding a recession ……………………………………...5
4. The Subprime crisis …………………………………………….9
5. Impact of subprime crisis …………………………………….....10
6. India in the world ………………………………………………..11
7. Pre crisis growth upswing …………………………………….....13
8. Post crisis growth moderation …………………………………...15
9. Euro zone crisis ………………………………………………......21
10. Global economic prospects ………………………………….......23
11. Impact on India ………………………………………………......25
12. Challenges ahead …………………………………………………28
13. A few suggestions …………………………………………….......30
14. Conclusion ……………………………………………………......36
15. References ………………………………………………………...39
Abstract:
The Indian economy experienced acceleration in growth in the early 2000s which was dented by the global financial crisis, particularly after the collapse of Lehman Brothers in September 2008. Though the world economy has recovered from the recession in 2009, it continues to be su
ounded by problems. Apart from the uncertainties in the global economy, Indian economy faces challenges from several other domestic factors. While the global growth has recovered from the trough of 2009, Europe has lapsed into recession again. The continuing uncertainty in the euro area poses a major risk to India and the global economy today. It has affected the growth prospects of both advanced and emerging market economies through trade, financial and confidence channels.
Thus this paper will attempt to discuss about the two major and recent global financial crisis, their respective causes and its effects on the Indian economy, along with the measures taken by the Indian government to dampen its pace.
For this I will compare India’s macroeconomic performance in the post crisis 4-year period of 2008-12 with the preceding high growth 5-year period of 2003-08. Then, will talk about the major crisis, their causes and their impact on Indian economy. After that I will highlight few key challenges and suggestions that Indian economy is required to look upon for regaining its growth process. Finally the conclusion will wind up this research.
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 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.
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.
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.
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.
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. According to him, to keep people fully employed, government has to run deficits when the economy is slowing because the private sector will not invest enough to increase production and reverse the recession. In addition, he assured that with fiscal policy, however, government could provide the needed spending by reducing taxes, increasing government spending and increasing individual’s incomes. With the increase in the incomes people can spend more and multiplier effect would take over and expand the effect on the initial spending. Thus Keynes believes in the power of the fiscal measures over the monetary measures at the time of such crisis. Furthermore, fiscal policies works in short run whereas monetary policies take a long time to show results. However, 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.
The Sub prime crisis:
Sub prime lending is a term that refers to the practice of making loans to bo
owers who do not qualify for normal market interest because of problem with their credit history. These loans are generally considered as risky because of the lethal combination of high interest rates, bad credit history and lack of resources to pay off the loans over a larger time frame. Sub prime lending encompasses a variety of credit instruments, including sub prime mortgages, sub prime car loans, and sub prime credit cards, among others.
The lender however did not wo
y very much about the risk of default because they rolled these mortgages into bonds called mortgage backed securities, which they then sold. These mortgages belonged to other financial organizations. Hedge funds at the other end are always ready to oblige buying the riskiest of these assets, even with leverage.
So until the housing bu
le was swiftly sailing high handedly, more of these packaged bonds were the investor’s delight and thus huge investment were made in stock markets and other emerging economics to provide leverage to these risky investment.
But soon the market crashed due to the housing bu
le whose aftermath is felt worldwide. Actually what happened in the leveraged sub prime market, hedge funds started receiving margin calls when their investment in the sub prime market started going down. This in turn forced hedge fund to liquidate their assets in local and emerging markets which put some downward pressure on stock market worldwide. This has worsened the trade balance due to excessive capital outflows and hit the investor’s confidence badly.
According to IMF, the main culprit of this crisis was the deficient regulation of financial sectors, the failure of market discipline and the systematic flouting of the rules and regulations.
Impact of Sub prime crisis:
· Overall tightening of credit with financial institutions making both corporate and consumer credit harder to get
· Financial markets (stock exchange and derivative market) experienced steep decline
· Liquidity problem in equity funds and hedge funds
· Devaluation of the assets
· Increased public debt
· Devaluation of cu
encies and increased cu
ency volatility
· Collapse of major banks like Bear Sterns, Me
ill Lynch and Lehman Brothers, AIG etc.
The contagion of the crisis has spread to India through financial, real and confidence channels.
The financial channel:
India’s financial market comprising of equity market, money market, foreign exchange market, credit market, stated coming under pressure from all directions. Moreover, Indian banks and corporate overseas financing started drying up. Corporate stated withdrawing their investment from the domestic money market, putting pressure on the mutual funds, which were invested in the non banking financial companies. Furthermore, Foreign exchange market started coming under pressure due to the reversal of capital flows and devaluation of rupee.
The real channel:
India witnessed a slump in its demand of exports. Service export growth also slowdown due to recession especially large users of outsourcing services were restructured. Moreover, the remittances from migrant workers also started decreasing.
The confidence channel:
The tightened global liquidity situation in the period immediately following the Lehman failure in mid September 2008 increased the risk aversion of the financial system and made banks cautious about lending.
India In the world:
Over the period 2000-11, India’s share in world GDP rose from 1.5 per cent to 2.4 per cent in terms of US dollar, and from 3.8 per cent to 5.7 per cent in terms of PPP.
If we compare the pre crisis and post crisis period then it could be seen from the table below that India’s real GDP fell less as compared to the fall in the global GDP growth. Thus, despite growth moderation, India’s contribution to world growth rose from about 10 per cent to almost 16 per cent over the same period (Table 1).
While at the cu
ent level, India’s per capita income is the lowest amongst the BRICS nations, but at the same time it is noteworthy that India has taken less and less number of years to double its real per-capita income.
Pre-Crisis Growth Upswing
India has recorded real GDP growth of 8.7 per cent per annum during the 5-year period of 2003-08, contributed by all the three major sectors: agriculture, industry and services (Table 2).
Where the growth in industries and service sector was mainly due to the past reforms which the Indian government has taken and due to the healthy global economic environment; agricultural growth was partly aided by favorable monsoons. Though the share of agriculture in the economy is progressively shrinking, it is important to recognize that this trend definitely
ings some upward momentum in the overall growth of Indian economy and helped to keep the domestic food prices low and stable.
However, from the expenditure side, India experienced a surge in the overall investment rate which was largely driven by the private corporate sector. Here, Investment was financed mostly by higher domestic saving (Table 3).
Private sector investment increased because of increased availability of resources which also attracted the foreign funds. Internal resources of corporate sector also increased due to higher retained earnings, which was due to improved productivity, lower tax and low debt servicing costs (due to less interest rates), leading to higher profitability. More importantly, Center’s fiscal deficit fell to 3.6 per cent of GDP during the high growth phase from 5.9 per cent during the 1990s and the primary deficit turned into a marginal surplus. Consequently, public sector saving increased to 2.9 per cent of GDP during 2003-08 from a dis-saving of 0.8 per cent in the preceding five years.
Another feature of this period was sustained increase in the household savings, which helped in reducing the saving-investment gaps in the corporate and the public sector. With improved financial sector, there was greater access to bank credit by households, and an increase in household investment rate. The overall gross domestic saving rate of 33.3 percent of GDP during the high growth phase facilitated the increase in overall investment rate to 33.6 per cent without much dependence to external bo
owings. Concu
ently, the productivity of capital was also high as reflected in the incremental capital-output ratio. Thus, the growth acceleration was contributed by high domestic saving accompanied by improvement in productivity.
Post-Crisis Growth Moderation
The global financial crisis occu
ed in U.S in 2008, also known as the sub prime crisis, inte
upted India’s growth adversely. Its effects can be seen on all the channels like finance, real and confidence channels. The impact was visible on India’s financial market as the equity prices fell drastically due to the withdrawal of global investment, cu
ency depreciated, money and credit market also came under pressure of funding the domestic resources. Indian trade and business cycle also got affected. Moreover India’s economic growth fell from 9.3% in 2007-08 to 6.7% in 2008-09 due to the adverse impact of external demand shock.
Total net capital flows fell from US$17.3 billion in april-june 2007 to US$13.2 billion in april-june 2008. There was a net outflow of about US$ 6.4 billion in april-sept 2008.
External bo
owings of the corporate sector decreased from US$ 7 billion in april-june 2007 to US$ 1.6 billion in april – june 2008.
Real estate was badly affected by this crisis as the investment banks had given huge amount of money to real estate companies for development projects. With large investment banks going bankrupt, the project have to be discontinued which lead to a slump in the real estate market as...