Recent developments in the US, the euro zone and even China hold out the depressing prospect that the global economy may be heading towards another financial and economic crisis, perhaps even more serious than that of 2008. In the United States, massive stimulus packages totalling over $1.5 trillion in the past three years, coupled with a negative real rate of interest, have failed to kick-start growth in the economy and unemployment remains at a disappointing nine per cent level. These economic woes are exacerbated by a political gridlock in Washington, with a beleaguered President Obama unable to provide effective and credible leadership.
The situation in Europe is worse. In the euro zone, the financial and banking crisis has been followed by much more dangerous sovereign debt crisis, with several governments on the verge of default. What began as a problem affecting the smaller peripheral economies of Ireland, Greece and Portugal is now buffeting Spain and Italy, with even France facing investor anxieties. The disconnect between a single European currency, the euro, a single European Central Bank and a fragmented fiscal arrangement, comprising 17 sovereign and independent governments, has now reached an inflection point. Either the European Union (EU) moves rapidly towards a de facto fiscal union or else abandon the single currency. So far, EU countries and its most powerful members, Germany and France, have avoided confronting this challenge head-on by various Band-Aid solutions such as bailout packages for Ireland, Greece and Portugal. However, if Italy, whose exposure to the global banking system is $262 billion, also needs to be bailed out, there will simply not be enough cash to go around.
China appears to be in relatively better shape with a GDP growth rate near the 10 per cent mark, booming exports and still rising foreign exchange reserves. The latter are now near the $3 trillion mark. But China’s vulnerabilities are real even if they are masked by these impressive figures. Inflation is officially around five per cent but the real rate is estimated to be much higher. This is partly the result of a massive $600 billion liquidity injected into China’s economy in 2008 to avoid a major deceleration in its growth following the global economic downturn. Non-performing assets of banks are reportedly rising quite rapidly, while spare capacity in the real estate sector, a major engine of growth over the past several years, is said to be as high as 30 per cent in metropolitan cities like Shanghai. China’s economy continues to be largely export-driven and any major disruption in the major export destinations such as the US and Europe will inevitably have knock-on effects on China. Were the US dollar to decline steeply in value, as is being predicted by several analysts, much of China’s largely dollar-denominated assets would evaporate into thin air.
It is true that China’s foreign trade with Asian, African and Latin American countries has been increasing rapidly in the past few years. If there were a gradual and steady decline in China’s trade with the traditional Western markets, the incremental rise in trade with newer markets would facilitate a relatively smooth transition. In the short run, however, decoupling is simply not realistic, whether for China or for other emerging economies.
Why is the next round of global financial and economic crisis likely to be more serious than the previous one? This is because the armoury of monetary and fiscal tools available to governments of key economies now lies virtually empty. Most of the arrows were fired in the immediate aftermath of the 2008 crisis, in a desperate attempt to avoid a catastrophic meltdown. This succeeded to some extent, particularly in view of the urgent and co-ordinated response which was launched by G20. Were another crisis to hit tomorrow, there is simply too little policy space available for countries to launch another massive rescue operation. Added to this grim reality is the fact that today confidence in the ability of governments to deal effectively with persistent economic problems is at an all-time low. And G20 is nowhere in sight.
What does this mean for India? There is satisfaction over the demonstrated resilience of the Indian economy after the 2008 crisis and early recovery of rapid growth. But we need to be cautious in drawing conclusions from the post-2008 experience. One, the huge stimulus injections into all the major economies of the world, the US, EU and China, meant that demand for Indian exports in these markets could recover their trend line quite rapidly. Two, India adopted its own stimulus package by allowing fiscal deficit to rise to nearly six per cent, though this led to severe inflationary pressures in the economy. If another crisis hits the global economy, the cushions available in 2008 no longer exist. If western economies are unable to reflate, our exports will be severely affected. Given the already high level of inflation, any increase in fiscal deficit may be harmful to the economy and politically risky. A steep decline in our GDP growth rate may be unavoidable.
It is sometimes argued that India is better prepared to ride out a global downturn because it is still a mostly domestic-demand driven economy. This is only partially true.
India’s foreign trade in goods and services is already over 50 per cent of its GDP. We have seen recently how sensitive Indian securities and currency markets are to global cues. We are not as insulated from global developments as we would like to believe.
To face the next crisis, some urgent contingency planning is essential, including thinking of the unthinkable, such as a collapse of the US dollar or the break-up of the euro zone and how these may impact the Indian economy both in the short and the long run. Perhaps China may emerge as an even more serious competitor. Government and business will need to work together to draw up co-ordinated strategies to minimise adverse consequences. The crisis may even provide an incentive to fast-track long-pending economic reforms which are, in any case, critical to sustaining the long-term growth prospects of the Indian economy.
The author is a former foreign secretary and currently chairman, RIS and senior fellow, CPR
