India’s quick recovery from the post-Lehman slump of late 2008 is usually attributed to the relatively low global exposure of the country’s economy. On the basis of subsequent research and analysis, this is an incomplete and perhaps misleading interpretation of what actually happened. The work of Ajay Shah and Ila Patnaik in particular has made it clear that, capital controls notwithstanding, the links between India’s financial and corporate sectors and global financial markets were multifarious and deep, and that this “financial” channel was a powerful mechanism for transmitting global shocks to the Indian economy. This was in addition to the better-understood aggregate demand, trade and confidence channels.
Accordingly, the so-called resilience of the Indian economy that was demonstrated in 2009 and 2010 did not so much reflect a minor initial impact as it did the fruits of nimble policy, both fiscal and monetary. The UPA-I government, which was in power at that time, had available to it four shock absorbers that had been assiduously built up in the “fat” years before the crisis. These were: a strengthened fiscal position; a large stock of international reserves; relatively high nominal interest rates; and confidence in its competence in economic management symbolised by sustained fast growth. One should perhaps add two other “structural” features of the policy framework at that time: the insulation of the banking system from volatile capital movements via the Reserve Bank of India’s (RBI’s) creative Market Stabilisation Scheme and the well-established doctrine of a market-determined nominal exchange rate, with considerable experience in operating such a scheme despite relatively thin foreign exchange markets.
While the authorities demonstrated considerable foresight in developing this framework for managing risk, it still required nerve to use these assets to counter the slump. Based on the experience of past crises in emerging markets, the dominant view in the international financial press at that time was that adopting expansionary, counter-cyclical policies in times of financial stress and uncertainty would aggravate, and not alleviate, skittishness. There was real uncertainty on how the actual use of our foreign exchange reserves would be received by the markets.
India was of course not alone among emerging markets in its boldness: the pace was set by China, and other countries followed suit. India, though, was in a particularly awkward position politically, with the Mumbai attack occurring in this period and a general election on the verge of being announced. But as often happens, fortune favoured the brave, and the government was not only rewarded by the markets, it also succeeded in winning re-election with an enhanced majority.
This experience is worth recounting as a new year begins, both for the international parallels with 2008-09 and for the domestic differences. On the international front, the euro crisis is temporarily off the boil, but there are few knowledgeable commentators who are convinced that a durable solution has been found. Reports in the international press, as well as comments from the Asian Development Bank in Manila, suggest that Asia will be substantially affected as European banks retrench so as to build up their capital ratios, and that India’s corporate sector is among those likely to be most affected. While the recent depreciation of the rupee is probably good for the corporate sector in the medium term, the combination of a weak stock market and a depreciated rupee is imposing strain on a number of corporate houses with foreign currency convertible bonds coming due. India’s domestic banks have already experienced a sharp increase in gross non-performing assets, while those owned by the state have to wait in a queue to receive infusions of government capital, one of the factors that led Moody’s to downgrade the stand-alone credit rating of State Bank of India. Perhaps as damaging as any of these technical factors is the severe knock that the government has suffered in its reputation for economic and political management.
To use a term from American football, what might the government’s “playbook” be if, once again, the global financial system hurls its thunderbolts at India? In particular, under these changed domestic circumstances, will the government once again have the option of counter-cyclical easing, or will it have to follow a more conventional path of fiscal and monetary tightening? There is, unfortunately, no easy answer.
In 2008, the world’s financial institutions were themselves so scared and battered that the risk of a speculative attack on the rupee was slight. I do not think one can be quite so sanguine this time round. Indeed, with its large current account deficit and substantial external financing needs, India would very much be in the sights of global hedge funds. From this perspective, the recent swap line concluded with Japan is a useful additional line of defence. But in general, India would need to be more cautious in throwing reserves at the problem this time round. In this respect, I am one of the few commentators who would endorse the RBI’s logic in remaining on the sidelines in the recent plunge of the rupee. Irrespective of the proximate cause of the depreciation, it has been effective in signalling that, in a turbulent global and domestic environment, the RBI is willing to allow the nominal exchange rate to take the burden of adjustment.
A harder question is whether it can now afford to ease up on interest rates given the slowing economy. Other things being equal, a depreciating rupee calls for monetary tightening rather than loosening, as does the need to reaffirm the role of the RBI’s inflation target as a credible nominal anchor for the system. The contribution we can expect of monetary policy this time round will be less than in the past.
What, then, of fiscal policy? Again, unfortunately, 2012 is unlikely to permit a repeat of 2008-09. Both our fiscal “marksmanship” and our reform credibility are severely challenged, and an attempt to replace foreign demand by domestic stimulus is likely to go down badly with the markets. The conclusion is that we are in for a period of consolidation for some time yet, and that it will take time – and a stronger global economy – before the halcyon days of nine per cent growth once again become likely.
The author is country director, International Growth Centre. These views are personal
