Global financial market turmoil and the Indian economy

The current turmoil in the United States’ financial markets has turned out to be a lot more serious than what Fed Chairman thought during Government’s fiscal transfer program in the early 2008.

People watch a large screen displaying India's benchmark share index on the facade of the Bombay Stock Exchange (BSE) building in this September 8, 2008 file photo. REUTERS/Punit Paranjpe

Even after passing of $700 billion rescue package, some feel this package would turn out to be smaller than the final estimates (which might not come out for another 2-3 years).

The immediate question is - what could be the impact of this turmoil on the Indian economy?

Prime Minister Manmohan Singh has already said that India is not immune to this global crisis as the economy, or at least the financial sector, is increasingly integrating with the global economy. In my view the impact needs to be separated between short and long term and between negatives and positives.

In the short term, the market regulators have already said that Indian banks’ exposure to troubled US financial firms is not very much. If one has to believe this, then the impact is expected to be minimal.

The other positive is a likely moderation of the ‘irrational exuberance’ that was witnessed in the Indian stock market (when the BSE Sensex galloped to above 21000) and was almost becoming an asset price bubble.

The crisis has also brought down the high oil price burden on the world economy, particularly the under developed economies that were on the verge of an economic crisis due to double-digit inflation rates and food shortages.

For India, these developments have brought down the inflationary expectations in the medium term, which is a very positive development.

But all is not well. We have seen and might see a further drying of short term foregin capital which, in turn, will affect new or expansion of exisitng project plans.

The current crisis will have an impact on the real economy too as there could be some moderation in the overall GDP growth in this financial year and also in 2009-‘10. This is because the service sector, which is contributing more than 55 pct of overall GDP, is largely dependent on the global economy (US economy in particular).

Some segments such as business and financial serivices are expected to be badly hit. Our own forecasts show that, for the year 2008-‘09, the GDP growth is expected to decline to less than 7.5 pct, from above 9 pct growth last year.

On the policy front, the markets were expecting the new RBI Governor to take up some of the impending financial sector reforms such as those relating to the derivatives market. There was some expectation, within the government, on pushing the insurance and pension sector reforms. But this crisis would definitely put those reforms on the backburner. These reforms would at the very least be re-looked in the light of the present crisis.

In the long run, the impact could be minimal as the domestic growth drivers remain very strong and intact. If there are no supply shocks such as high world oil prices, the economy is expected to bounce back to a medium term growth of 9 pct.

The gradualist approach that the Indian financial market regulators follow seems to have averted the contagious affects of the global financial turmoil on India in a significant way. As was the case during the Asian currency crisis in the late nineties, the Indian economy is expected to weather this one as well. This would make India as a safe haven and could attract more foreign private capital in the future.

But there are many lessons to be learnt from the present crisis. There is no doubt that we need to liberalise, broaden and widen the financial sector with more instruments and channels to mitigatge the risks that are perceived to be inherently present in the system. But before doing that, there’s a pressing need for development of a strong regulatory and disclosure system.

With a large informal economy in India, any crisis of this sort cannot be mitigated if there is no system of reaching out quickly to the poor and downtrodden who will be affected adversely, as they are not included in the financial system.

Can we undertake a cash transfer program similar to what the U.S. did in the beginning of 2008 during crisis situation?

Hence, any discussion on developing India’s financial sector or “Mumbai” cannot be done without formalising the large scale informal sector.

It is not because there is a lack of faith in market principles. Many concluded after the present crisis that it’s the ‘capitalists’ who destroy the markets with their excesses and irresponsible acts.

The Speaker of the US House of Representatives, Nancy Pelosi, rightly said during the voting of bailout package that “the era of golden parachutes for high-flying Wall Street operators is over. No longer will the U.S. taxpayer bail out the recklessness of Wall Street.”

There’s an important lesson for Indian regulators and also ‘Dalal Street operators.’