India and the Lessons of the Global Financial Crisis John Echeverri-Gent Department of Politics University of Virginia March 15, 2011

I. India managed the crisis very well relative to other emerging markets Though the crisis caused a bigger decline of growth in 2008 (4.5%) than the average (2.4%), India’s growth rate (5.1%) remained higher than the average (4.7%) (See Table 1) While the growth rate of all other countries declined in 2009, India’s GDP rebounded. The average GDP growth for all other countries dropped from 4.7 to 1. India’s increased from 5.1 to 7.7. India’s economy is projected to continue to grow. The GOI’s Economic Survey projects that India’s GDP will grow by 8% in and 8.6% in

II. Two channels through which the global crisis affected India A. Trade India has become a more open economy in recent years with its trade to GDP ratio increasing from 27.4% in 2000 to 46.3% in This ratio remains much below Asian exporters with smaller economies such as South Korea (103%) and Thailand (127%) but not that far behind China (51.4%). (Kose and Prasad 2010, 134) India’s export growth at 19.8% and 29.7% in 2008 is considerably faster than the average for emerging and developing economies (EDE’s) (16.9% and 25.3%) (See Table 2) It share of world trade doubled from , a pace of increase that is twice as great as that for EDE’s.

In the wake of the global crisis, Indian exports (-15.2%) fared better than the EDE average (-24.8%) Exports of all Asian countries in Table 2 – with the exception of Malaysia – fared much better than EDE and world averages. The impact of the global crisis on Indian exports was limited by the growing share of Asia in total Indian exports. From to (April-Sept) this share increased from 40% to 53.5%. (GOI 2011, 170) (See Figure 1) India’s economy was also helped by its $54 billion surplus in its trade in services. (GOI 2011, 173) (See Figure 2) However, after years of rapid growth -- the compound annual growth rate was 28.7% from to and 22% in service export growth moderated to 17% in In exports declined by 9.6%. India’s surplus in service trade dropped from $53.9 billion to $35.7 billion due to less in demand for business (-7.5%) and financial services (-5.6%) and an increase in imports of these services. (GOI 2011, 172-3)

B. Finance Was India’s success in managing the financial crisis due to its capital controls? According to several indicators of de jure capital account openness, (Table 3) India is more closed than other emerging markets, though it has been slowly catching up. Many contend that the lesson of India’s experience is that countries should open their capital account with great caution, if at all. Others have argued that India’s experience demonstrates the virtues of public sector banks and limitations on foreign banks.

Prasad (2009) argues that it is important to consider de facto as well as de jure integration. Using the ratio the sum of gross external liabilities and gross external assets to GDP as a measure of de facto financial openness, Prasad (2009) finds that though India’s ratio increased from less than 20% of GDP in 1980 to just under 70% in 2006, it remains one of the least financially integrated emerging market countries

How did the problems of global financial come to India? Despite capital controls and relatively limited financial integration, by 2007, India had an estimated 2104 multinational corporations (Sauvant and Pradhan 2010, 5) with outward foreign direct investment flows peaking at 18.5 billion in 2008 (Unctad 2010) (See Figures 2 and 3) Patnaik and Shah (2010) and Aziz, Patnaik, and Shah (2008) find that many Indian multinational (financial and non-financial) corporations set up global treasury operations in London in order to evade India’s capital controls and gain access to the cheaper funds available from global markets. When Lehman Brothers failed on September 14, 2008, liquidity in London dried up and the LIBOR-linked rates at which the Indian firms borrowed skyrocketed.

With global credit no longer available at reasonable prices, Indian multinationals turned to the domestic money market, converting these funds into dollars in order to meet their foreign obligations. In the last quarter of 2008, capital leaving India through banks and non-bank corporations amounted to $10.8 billion, exceeding the overall net capital outflow of $3.7 billion and the net portfolio investment exodus of $5.8 billion. (Patnaik and Shah 2010, 18) – This caused the liquidity of domestic money markets to tighten and interest rates to rise – It also placed downward pressure on the rupee’s exchange rate

Local firms who placed short-term funds with mutual funds because of tax advantages, began redeeming their investments to meet their own needs. The sell-off along with investors’ reevaluation of Indian MNC’s and the flight of foreign capital to less risk, resulted in a precipitous drop of prices on the Indian equity market. Fortunately, Indian policy makers dealt with these issues in a competent manner

In the area of monetary policy, they lowered interest rates and increased the supply of funds in the money markets by reducing the reserve requirements for banks They enacted fiscal stimulus through the budget for FY This had a positive effect given that India’s domestic market remains the main driver of its economy. India drew on its ample foreign reserves amounting to $310 billion at the end of March 2008 to sell an estimated $30 billion to limit the depreciation of the rupee. Before the crisis, the Reserve Bank of India (India’s central bank), sensing the possibilities of a real estate bubble, intervened to limit loans to land developers by raising risk weights and provisioning requirements for such loans.

III. India’s Debate Over the Lessons of the Global Crisis The global crisis has given the debate popular notoriety. Former RBI Governor Y.V. Reddy published a best-selling book (2009) expressing a conservative view advocating a “calibrated approach” (2007) Nonetheless, baring other crises, the decisive politics of reform is within the central government bureaucracy pitting the Finance Ministry versus the RBI.

Key issues include Capital account convertibility Whether foreigners should be allowed to invest in Government of India securities Restrictions on foreign investment in India’s financial sector The role of public banks Whether the RBI should “manage” the exchange rate The degree to which the RBI should allow innovation of financial products

IV. Concluding Remarks The global financial crisis strengthened the Reserve Bank of India and its conservative approach India’s ambition to become a center for global financial services (GOI 2007) will motivate more reforms. The Ministry of Finance has the upper hand. It has the authority to appoint the Governor of the RBI, and in Fall 2008 it used it to replace the retiring conservative Y.V. Reddy with the finance secretary D. Subbarao. Issues to watch are: – Whether the politics of reform will enable India to relax capital controls while minimizing the risks of opening to foreign finance – Whether the financial sector can develop the regulatory capacity that facilitates innovation while minimizing its risk