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Mainstream, Vol XLVII, No 15, March 28, 2009

Global Meltdown and its Impact on the Indian Economy

Thursday 2 April 2009, by Ruddar Datt

With the collapse of Lehman Brothers and other Wall Street icons, there was growing recession which affected the US, the European Union (EU) and Japan. This was the result of large scale defaults in the US housing market as the banks went on providing risky loans without adequate security and the repaying capacity of the borrower. The principal source of transmission of the crisis has been the real sector, generally referred to as the ‘Main Street’. This crisis engulfed the United States in the form of creeping recession and this worsened the situation. As a consequence, US demand for imports from other countries indicated a decline.

The basic cause of the crisis was largely an unregulated environment, mortgage lending to subprime borrowers. Since the borrowers did not have adequate repaying capacity and also because subprime borrowing had to pay two-to-three percentage points higher rate of interest and they have a history of default, the situation became worse. But once the housing market collapsed, the lender institutions saw their balance-sheets go into red.

Although at one time it was thought that this crisis would not affect the Indian economy, later it was found that the Foreign Direct Investment (FDI) started drying up and this affected investment in the Indian economy. It was, therefore, felt that the Indian economy will grow at about seven per cent in 2008-09 and at six per cent in 2009-10. The lesson of this experience is that India must exercise caution while liberalising its financial sector.

A redeeming feature of the current crisis is that its magnitude is much lesser than that of the Great Depression of the 1930s when unemploy-ment rate in the United States exceeded 25 per cent. Currently, it stands at 6.5 per cent and is predicted to remain around eight per cent in 2009.

Impact on Indian Economy

The industries most affected by weakening demand were airlines, hotels, real estate. Besides this, Indian exports suffered a setback and there was a setback in the production of export-oriented sectors. The government advised the sectors of weakening demand to reduce prices. It provided some relief by cutting down excise duties, but such simplistic solutions were doomed to failure. Weakening demand led to producers cutting production. To reduce the impact of the crisis, firms reduced their workforce, to reduce costs. This led to increase in unemployment but the total impact on the economy was not very large. Industrial production and manufacturing output declined to five per cent in the last quarter of 2008-09. Consequently, a vicious cycle of weak demand and falling output developed in the Indian economy.

A weakening of demand in the US affected our IT and Business Process Outsourcing (BPO) sector and the loss of opportunities for young persons seeking employment at lucrative salaries abroad. India’s famous IT sector, which earned about $ 50 billion as annual revenue, is expected to fall by 50 per cent of its total revenues. This would reduce the cushion to set off the deficit in balance of trade and thus enlarge our balance of payments deficit. It has now been estimated that sluggish demand for exports would result in a loss of 10 million jobs in the export sector alone.

To lift the economy out of the recession the Government announced a package of Rs 35,000 crores in the first instance on December 7, 2008. The main areas to benefit were the following:

(a) Housing—A refinance facility of Rs 4000 crores was provided to the National Housing Bank. Following this, public sector banks announced to provide small home loans seekers loans at reduced rates to step up demand in retail housing sector.

(i) Loans up to Rs 5 lakhs: Maximum interest rate fixed at 8.5 per cent.

(ii) Loans from Rs 5-20 lakhs: Maximum interest rate at 9.25 per cent.

(iii) No processing charges to be levied on borrowers.

(iv) No penalty to be charged in case of pre-payment.

(v) Free life insurance cover for the entire outstanding amount.

This means a borrower can get a loan up to 90 per cent of the value of the house. The government hopes to disburse Rs 15,000 to 20,000 crores under the new package.

The housing package is the core of the government’s new fiscal policy. It will give a fillip to other sectors such as steel, cement, brick kilns etc. Besides, the small and medium industries (SMEs) too get a boost by manufacturing all kinds of fittings and furnishings.

The success of the housing package will, however, depend on the State governments efforts to free up surplus land so that land prices come down and the cost of housing becomes reasonable.

(b) Textiles—Due to declining orders from the world’s largest market the United States, the textile sector has been seriously affected. An allocation of Rs 1400 crores has been made to clear the entire backlog in the Technology Upgradation Fund (TUF) scheme.

The Apparel Export Promotion Council (AEPC) Chairman, however, said: “It is a disappointing package. The allocation of Rs. 1,400 crores has been pending for many years and thus, it is the payment of arrears only. There is nothing new in it. It would have been much better if more concrete measures have been taken to reverse the downturn in the exports of readymade garments and avoid further job losses in the textile sector.”

(c) Infrastructure—The government has been proclaiming that infrastructure is the engine of growth. To boost the infrastructure, the India Infrastructure Finance Company Ltd. (IIFCL) has been authorised to raise Rs 14,000 crores through tax-free bonds. These funds will be used to finance infrastructure, more especially highways and ports. It may be mentioned that ‘refinance’ refers to the replacement of an existing debt obligation with a debt obligation bearing better terms, meaning thereby at lower rates or a changed repayment schedule. The IIFCL will be permitted to raise further resources by the issue of such bonds so that a public-private partnership (PPP) programme of Rs 1,00,000 crores in the highway sector is promoted.

(d) Exports—Exports which accounted for 22 per cent of the GDP are expected to fall by 12 per cent. The government’s fiscal package provides an interest rate subsidy of two per cent on exports for the labour–intensive sectors such as textiles, handicrafts, leather, gems and jewellery, but the Federation of Indian Export Organization (FIEO) felt the measures are not enough as they will not make the exports price-competitive and, therefore, will not boost exports. G.K. Pillai, the Commerce Secretary, has estimated a loss of 1.5 million jobs in the export sector alone during 2008-09 on account of the $15 billion decline in the expected exports.

(e) Small and Medium Enterprises (SMEs)—The government has announced a guarantee cover of 50 per cent for loans between Rs 50 lakhs to Rs 1 crore for SMEs. The lockin period for loans covered under the existing schemes will be reduced from 24 months to 18 months to encourage banks to cover more loans under the scheme. Besides, the government will instruct state-owned companies to ensure prompt payment of bills of SMEs so that they do not suffer on account of delay in the payment of their bills.

In short, the fiscal package is aimed at boosting growth in exports, real estate, auto, textiles and small and medium enterprises. The aim is to encourage growth and boost employment which have been threatened by the recession in the world economy, more especially in the United States.

Just within a month, the government announced another package to bail out the Indian economy. Dr Montek Singh Ahluwalia said: “We should expect, from all global projections that the next year (2009) is going to be a very difficult year for the global economy.”

The purpose of the new package announced on January 1, 2009 was to minimise the pain. With this end in view, the new package included the following measures:-

1. To boost investment and spending to revive growth, the RBI cut the repo rate, which it charges on short-term loans to banks from 6.5 per cent to 5.5 per cent and also reduced the Cash Reserve Ratio (CRR)—the share of deposits which has to be kept with the RBI from 5.5 per cent to five per cent.

2. To revive exports which has resulted in a contraction of industrial output, drawback benefits have been enhanced for some exporters. Export-Import Bank also gets Rs. 5000 crores as credit from the RBI.

3. To help the realty sector, realty companies have been allowed to borrow from overseas to develop “integrated townships”.

4. To boost infrastructure, the India Infrastructure Finance Company Ltd. (IIFCL) has been allowed to raise Rs 30,000 crores from tax-free bonds. Besides, Non-Banking Finance Companies (NBFCs) need no government approval to borrow from overseas for infrastructure projects. This will sustain the growth momentum on infrastructure.

5. To make more funds available, ceiling on foreign institutional investments (FIIs) in corporate bonds has been increased to $ 15 billion from $ 6 billion. The purpose is to seek much bigger FII investment.

6. To stimulate the Commercial Vehicles (CVs) sector, depreciation benefit on commercial vehicles has been increased form 15 per cent to 50 per cent on purchases. Besides, the States will get one-time funding from the Centre to buy buses for urban transport. In addition, public sector banks would provide finance firms funds for commercial vehicles. It is hoped that Tata Motors and Ashok Leyland’s sales would revive.

On February 24, 2009, the government announced a slashing down of excise duty from 10 per cent to eight per cent—a reduction by two per cent. Since 90 per cent of the manufactured goods attract 10 per cent excise duty, this measure is designed to reduce the prices of colour TV sets, washing machines, refrigerators, soap, detergents, colas, cars and commercial vehicles. Cement prices are likely to drop Rs 4-5 per bag of 50 kg while steel prices may cost Rs 500-600 per tonne less. In addition to this, the government decided to cut service tax form 12 per cent to 10 per cent—a reduction by two per cent. As a consequence, phone bills, airline tickets, credit card charges, tour packages etc. would cost less. A two per cent reduction in service tax will directly touch the lives of over 500 million persons by reducing monthly expenses. The entire stimulus package of Rs 30,000 crores to boost demand in the economy and thus reduce the impact of recession.

Commerce and Industry Minister Kamal Nath announced a small relief package of Rs 325 crores for leather, textiles, gems and jewellery on February 26, 2009.

Assessment of the Impact of the Fiscal Package

There is no doubt that the government is motivated with good intentions and is thus aiming to spend a huge amount of Rs 1,00,000 crores for developing infrastructure in roads, ports etc. which pose a serious handicap to growth. Besides, the aim of other measures is to boost exports and help sectors like textiles and small and medium industries which are labour-intensive and generate more employment.

But the success of the fiscal package will depend on the quality and speed of implementation so that delays in implementation may not aggravate the economic recession to move into the dangerous zone of depression.

One of the major stumbling blocks which may neutralise the positive effects of large expenditure on infrastructure is corruption. In case corruption is not simultaneously curbed to reasonably low levels, it may delay and reduce the much-desired effect in enlarging infrastructure. It may result in the Indian infrastructure network being geared into a temporary employment generation programme with much smaller impact on the economy as against the intended objectives.

For reducing corruption, two things need to be ensured—transparency and avoidance of arbitrariness. By cutting arbitrariness in decision-making, corruption can be curbed to a great extent. Transparency instills confidence in the government.

Secondly, there is a need to orient the fiscal package towards inclusive growth so that the weaker sections benefit. This would require special emphasis, for instance, on rural infrastructure—rural roads and housing, instead of only highways and urban housing. Similarly, a much larger expenditure on primary and secondary education, health and sanitation can also result in a more inclusive growth process.

Thirdly, the chances of our exports increasing are very limited unless the G-3 economies, namely, the US, EU and Japan, are able to bring about a positive shift in their growth in the near future for which the predictions at present are not very optimistic. The World Bank has projected the world output to grow at 0.9 per cent in 2009 as against 2.5 per cent in 2008. If these predictions come out to be true, there is a fear of the recession in 2008 turning into a depression in 2009. But the Indian economy is predicted to grow at about seven per cent in 2008 and about six per cent in 2009. Since the G-3 economies of the US, EU and Japan are affected seriously by the present recession, the chances of Indian exports increasing in these countries appear to be very dim. The natural conclusion is that the Indian economy should concentrate on developing the domestic market. Thus, inward looking policies should be preferred as against the outward looking approach of integrating the Indian economy to the world economy is followed during the last decade. It is heartening that the Prime Minister intends to insulate the Indian economy from the world economy.

Fourthly, although there is a demand for a much larger Fiscal Package to bail out the Indian economy, there are serious limitations faced by the government because it has to fight terrorism on the one hand and financial meltdown on the other. The government has to undertake a huge expenditure at the Central as well as State levels to enhance security. It is difficult to precisely estimate this expenditure at this stage since it entails larger recruitment of police and paramilitary forces along with equipping them with the most uptodate weapons. But there is a massive increase in expenditure to combat terrorism, along with a fiscal package to boost the Indian economy; there is also likely to be shortfall in tax revenues. Consequently, the Budget deficit is bound to increase. The government will not be able to reduce the fiscal deficit to 2.5 per cent of GDP, it may increase to three to 3.5 per cent during 2008-09. But this is inevitable and the target of reducing it according to the schedule prescribed by the Fiscal Responsibility and Budget Management Act, has to be postponed. But the Finance Minister has not agreed to the abolition of the FRBM Act since it would be imprudent to relax or abrogate the FRBM. To quote Dr Ishar Ahluwalia: “The FRBM is like a chastity belt, but don’t loosen it without a better alternative.”

It may, however, be mentioned that the quasi fiscal deficit (the deficit left out of the Budget) is presently estimated as six per cent of the GDP. A compre-hensive view of the fiscal deficit (as shown in the Budget and kept outside the Budget) would be in the range of nine to 9.5 per cent of the GDP, though it may now be lower due to a very sharp decline in international crude oil prices from $140 per barrel to about $ 40 per barrel at present. This is a welcome relief. If the government is also able to push the fertiliser prices to lower levels which is possible in the changed circumstances, eventually the total fiscal deficit (shown as well as kept outside the Budget) may come down to 6.5 to seven per cent of the GDP. This is quite large but it is inevitable in the present situation.

To conclude: As against the US package of $ 800 billion to bail out the US economy and the Chinese package to $ 580 billion to salvage its economy, the Indian fiscal package of Rs 35,000 crores ($ 7.3 billion approximately) is a small measure to boost the Indian economy. It is due to this reason that the chieftains of industry want a much bigger package to bail out the Indian economy, as against the minuscule announced by the government.

But the plan to spend more on housing is commendable if it can be implemented in a short time and an effective manner. The government should have transparency and avoid arbitrariness in the implementation so that corruption can be kept within reasonable limits.

The government has been provided relief with the sharp fall in the international price of crude oil and this should be taken advantage of in reducing expenditure to subsidise oil imports. Additional employment generation by helping SMEs will be a step towards inclusive growth since they are labour intensive.

The intention to create infrastructure by expanding highways and ports and to spend Rs 1,00,000 crores through the IIFCL is commendable. However, it may be more prudent to expand rural roads and rural housing so as to promote more inclusive growth. This would require proper planning which may take more time and does not provide immediate benefit.

It may not be possible to reduce the fiscal deficit during 2008-09 since much larger expenditures are needed to combat terrorism and as there is recession in the Indian economy, but international factors will influence the process. As the G-3 economies of the US, EU and Japan pick up, the Indian economy will also benefit from their reversal of recessionary trends. In this situation, the expectation of seven per cent growth of the GDP in 2008-09 and six per cent in 2009-10 reflects a fairly good performance of the Indian economy.

Now that the three packages have been announced, it is high time that the policy-makers in the Ministry of Finance, Commerce, Industry and Rural Development should get together to ensure that the planned expenditure—budgeted and provided in the two stimulus packages—is quickly translated into productive capacities so as to create the much-needed multiplier effect on private investment.

It is easier to provide funds, but it is more difficult to ensure their speedy and proper utilisation. In infrastructure, we suffer from inordinate delays and this results in cost overruns which the nation has to bear. The huge amount of funds placed with the India Infrastructure Finance Company Ltd (IIFCL) would require identification of new projects or expansion of the existing projects. This is not an easy task because the IIFCL is only a funding agency and implementation has to be carried out by other entities, may be the State governments, public sector undertakings or private sector corporations. To upgrade the level of infrastructure spending by a factor of two requires gigantic efforts of co-ordination between different agencies for speedy implementation. The government should, therefore, concentrate its efforts to remove hurdles in the path of implementation.

The package has also provided finances to the non-banking finance companies (NBFCs), but there is serious lack of skill with the NBFCs on project appraisals and to ascertain the credit-worthiness of the borrowers and the accompanying project risks. There has to a national campaign for training the NBFCs in project appraisals.

Similarly, the State governments must improve the share of their implementation and co-operate with the Central Government to improve various infrastructure projects in their domain or in collaboration with the Centre.

It needs to be emphasised that implementation holds the key to bail out the Indian economy from the economic crisis.

Pranab Mukherjee has suggested that to reduce the pain of recession, employers should cut wages all along the line to reduce costs, rather than retrenching workers and thus add to job losses. To quote: “Jobs must be protected even if it means some reduction in compensation at various levels.” This is a useful tool to fight recession and it has also been tried in several countries. This suggestion should be implemented until such time that the economy gets revived.

The author, a well-known economist, is a Visiting Professor, Institute of Human Development, New Delhi.

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