The Global Financial Turmoil and Challenges for the Indian Economy


Mr. Rahul Verma
Skyline Institute of Engineering & Technology
Gr. Noida


This article provides an outlook for the Indian economy in the light of the extraordinary global financial crisis, that started in the US, but which has now transformed into the worst economic downturn since the Great Depression. The Indian economy was slowing down even before the onset of global crisis and so the timing of this external shock could not have been worse. The analysis undertaken for this paper shows that the global crisis is likely to bring the Indian GDP growth rate down considerably. This will pose a big challenge requiring urgent and sustained policy attention to prevent this downturn from becoming unnecessarily prolonged. There is real downside risk that the growth rate could plummet to the pre-1980s levels if appropriate countercyclical measures are not taken immediately and are not urgently followed by necessary structural reforms. The paper provides a short-term forecast for GDP growth based on a model of leading economic indicators. We present three scenarios in the paper assuming differentiated impact of the external crisis. Finally the paper suggests a set of policy measures to get the Indian economy back on the path of sustained rapid and inclusive growth.

Key Words: Economic downturn, Depression, Countercyclical, Economic Indicators

Indian Economy Overview

India has been one of the best performers in the world economy in recent years, but rapidly rising inflation and the complexities of running the world's biggest democracy are proving challenging.

India's economy has been one of the stars of global economics in recent years, growing 9.2% in 2007 and 9.6% in 2006. Growth had been supported by markets reforms, huge inflows of FDI, rising foreign exchange reserves, both an IT and real estate boom, and a flourishing capital market. Like most of the world, however, India is facing testing economic times in 2008. The Reserve Bank of India had set an inflation target of 4%, but by the middle of the year it was running at 11%, the highest level seen for a decade. The rising costs of oil, food and the resources needed for India's construction boom are all playing a part.

India has to compete ever harder in the energy market place in particular and has not been as adept at securing new fossil fuel sources as the Chinese. The Indian Government is looking at alternatives, and has signed a wide-ranging nuclear treaty with the US, in part to gain access to nuclear power plant technology that can reduce its oil thirst. This has proved contentious though, leading to leftist members of the ruling coalition pulling out of the government. As part of the fight against inflation a tighter monetary policy is expected, but this will help slow the growth of the Indian economy still further, as domestic demand will be dampened. External demand is also slowing, further adding to the downside risks.

The Indian stock market has fallen more than 40% in six months from its January 2008 high. $6b of foreign funds have flowed out of the country in that period, reacting both to slowing economic growth and perceptions that the market was over-valued. It is not all doom and gloom, however. A growing number of investors feel that the market may now be undervalued and are seeing this as a buying opportunity. If their optimism about the long term health of the Indian economy is correct, then this will be a needed correction rather than a downtrend.

The Indian government certainly hopes that is the case. It views investment in the creaking infrastructure of the country as being a key requirement, and has ear-marked 23.8 trillion rupees, approximately $559 billion, for infrastructure upgrades during the 11th five year plan. It expects to fund 70% of project costs, with the other 30% being supplied by the private sector. Ports, airports, roads and railways are all seen as vital for the Indian Economy and have been targeted for investment.

Further hope comes from the confidence of India's home bred companies. As well as taking over the domestic reins, where they now account for most of the economic activity, they are also increasingly expanding abroad. India has contributed more new members to the Forbes Global 2000 than any other country in the last four years.

Recent Growth Trends in Indian Economy

India's Economy has grown by more than 9% for three years running, and has seen a decade of 7%+ growth. This has reduced poverty by 10%, but with 60% of India's 1.1 billion population living off agriculture and with droughts and floods increasing, poverty alleviation is still a major challenge.

The structural transformation that has been adopted by the national government in recent times has reduced growth constraints and contributed greatly to the overall growth and prosperity of the country. However there are still major issues around federal vs state bureaucracy, corruption and tariffs that require addressing. India's public debt is 58% of GDP according to the CIA World Fact book, and this represents another challenge. During this period of stable growth, the performance of the Indian service sector has been particularly significant. The growth rate of the service sector was 11.18% in 2007 and now contributes 53% of GDP. The industrial sector grew 10.63% in the same period and is now 29% of GDP. Agriculture is 17% of the Indian economy.

Growth in the manufacturing sector has also complemented the country's excellent growth momentum. The growth rate of the manufacturing sector rose steadily from 8.98% in 2005, to 12% in 2006. The storage and communication sector also registered a significant growth rate of 16.64% in the same year. Additional factors that have contributed to this robust environment are sustained in investment and high savings rates. As far as the percentage of gross capital formation in GDP is concerned, there has been a significant rise from 22.8% in the fiscal year 2001, to 35.9% in the fiscal year 2006. Further, the gross rate of savings as a proportion to GDP registered solid growth from 23.5% to 34.8% for the same period.

US Financial Crisis: Effect on Indian Corporates

Globalization today seems like a double edged sword. If we were celebrating the big way in which major FIIs of the world were queuing up to invest in the Indian stock markets and also in major projects through FDIs, today, that same investment looks like a big burden. What we used to say with pride yesterday of "being globally aligned" seems like a curse now.

The collapse of the USA financial markets has unleashed a wave of uncertainty, we don't know which bank or financial institution or mutual fund or insurance company might announce bankruptcy. If Lehman and Merrill could collapse, nothing more would now come as surprise, its just that people want this precipitation to get over and done with, so that we can salvage what we can from the debris and once again look at rebuilding.

For the Indian markets, this crisis of confidence is huge. We are still trying to ascertain the damage and like the rest of the world, do not know what more lies ahead. The day the news broke, there was a virtual meltdown across the board but the maximum brunt was borne by the banking, finance or NBFC stocks, realty and IT stocks. It was too early for the banks to come forth and state their damage but the markets knew that it would be substantial.

Effect on Indian Banks

The worst affected is the private sector bank, ICICI Bank, its exposure is to the tune of $80 million, which it invested in Lehman's senior bonds. The bank has issued a statement saying that it had already made provisions of $12 million on these bonds and a further $28 million worth of provisioning might be required if 50% recovery is assumed. SBI has an exposure of around $55 million (Rs256 crore) and PNB $5 million to Lehman. Bank of Baroda's exposure is less than $10 million. Bank of India is stated to have a direct exposure of $11.33 million.

One will soon seen banks issuing statements, stating that its exposure is minimal and its impact on the profitability would not be too much. But surely, the impact would be there and profitability will take a hit. At such times, we cannot help but wonder how our hard earned money, which we park with the banks, manages to earn such losses?

Effect on NBFCs

The effect on portfolio management services is expected to be huge. Even when Bear Stearns had collapsed, there wasn't this sense of panic and surely confidence was intact. Today, investors have lost complete faith. They are just too scared to go even bottom fishing in this market. The feeling is that this bear phase is for the long run, no one knows where the bottom is, so they feel why invest now when there might be an opportunity later? This psyche of the investors is bound to hit the business of these NBFCs. As such these NBFCs were seeing a slowdown due to lower demand from customers and challenging market conditions, the collapse just made things worse.

Effect on Realty/Infra Projects

Now this is going to be the most troubled. Lehman and Merrill have invested through FDIs in many projects in India, in realty and infrastructure. Those projects which have received the full amount earmarked for the project are safe. But what about those, who are yet to get the promised funds? Surely their projects lay in a lurch today. Unitech has also gone on record stating that it has received Rs.740 crore and has closed the deal with Lehman Brothers. DLF Assets raised US$200 million in 2007 as equity from Lehman Brothers, the company says that the money has been received but equity is yet to be transferred. In HDIL, Lehman, through its Hong Kong subsidiary, had signed a written agreement to float a SPV for developing a project in Dharavi. That lies in uncertainty now.

Lehman had also invested $80 million in Bangalore-based SEZ Gandhi City and was likely to hike its share to $300 million. Ashok Piramal's Peninsula Land has inked a JV with Lehman, which will have a stake of 75% is to bring in Rs.5 billion, to invest in various realty projects of Peninsula. What happens to that now?

Lehman has a 28.41% stake in KSK Energy. The above shares are locked in for a period of one year from July 05, 2008 (the date of IPO allotment) and cannot be sold in the stock market till the expiry of the said period. But does this rule hold true when Lehman goes bankrupt?

Effect on Pre-IPO Placements

Apart from the projects, the biggest threat is for projects which currently seeking pre-IPO placements. With a fear psychosis gripping all, and FIIs yet to ascertain the losses on which they are sitting on, it is going to become difficult for companies, vying to set up mega projects but seeking pre-IPO placements with reputed FIIs. Lack of any takers for pre-IPO stakes would mean delays. Yes, there will be other investors who would be willing to buy stakes but would now expect it at far below the prevailing market rates. But will that again be economically viable?

Adani Power is currently looking at placing 4.4-5% stake of its equity with private equity investors. Jet Airways had planned to raise $400 million from private placement with institutions. ICICI Securities planned to offload 15% of its stake to raise $1 billion. What happens to their IPOs now? Morgan Stanley Private Equity is to pick up a 30.4% stake in Biotor Industries for Rs.240 crore ($53 million). Will that happen now? Tata's Ginger Hotel chain planned to offload 20% of its stake to raise $75-100 million for expansion of its no-frills hotel chain Ginger. Retail chain group Subhiksha which also nurtures plans of going public is seeking FII investment for its 9% stake and was hoping to raise $80-100 million(Rs.400 crore). Will these investments come through?

This does not bode well for the market as it is the primary which feeds the secondary market. The primary market is an indicator of the economic activity and now, with pre-IPO funding also expected to face an uphill task, IPO markets could come to a grinding halt for some time.

AIG might have been pulled back from the brink of bankruptcy but it indicates the deep rooted trouble in the US financial markets. The collapse of Lehman and Merrill is sure to have far reaching consequences in India. We can only hope that this is the end of the dark tunnel though the road to light is dark, long and winding.

The Remedial Actions Taken By India

Globalization has ensured that the Indian economy and financial markets cannot stay insulated from the present financial crisis in the developed economies. 

The debate, therefore, can only be on the extent of impact and how resilient India is to withstand the storm with minimal damage! In the light of the fact that the Indian economy is linked to global markets through a full float in current account (trade and services) and partial float in capital account (debt and equity), we need to analyse the impact based on three critical factors: Availability of global liquidity; demand for India investment and cost thereof and decreased consumer demand affecting Indian exports.

The concerted intervention by central banks of developed countries in injecting liquidity is expected to reduce the unwinding of India investments held by foreign entities, but fresh investment flows into India are in doubt. The impact of this will be three-fold:

* The element of GDP growth driven by off-shore flows (along with skills and technology) will be diluted;

correction in the asset prices which were hitherto pushed by foreign investors
and demand for domestic liquidity putting pressure on interest rates. 

While the global financial system takes time to "nurse its wounds" leading to low demand for investments in emerging markets, the impact will be on the cost and related risk premium. The impact will be felt both in the trade and capital account.

Indian companies which had access to cheap foreign currency funds for financing their import and export will be the worst hit. Also, foreign funds (through debt and equity) will be available at huge premium and would be limited to blue-chip companies. The impact of which, again, will be three-fold:

  • Reduced capacity expansion leading to supply side pressure;
  • Increased interest expenses to affect corporate profitability
  • And increased demand for domestic liquidity putting pressure on the interest rates. 

Consumer demand in developed economies is certain to be hurt by the present crisis, leading to lower demand for Indian goods and services, thus affecting the Indian exports. The impact of which, once again, will be three-fold:

  • Export-oriented units will be the worst hit impacting employment;
  • reduced exports will further widen the trade gap to put pressure on rupee exchange rate
  • and intervention leading to sucking out liquidity and pressure on interest rates. 

The impact on the financial markets will be the following:

  • Equity market will continue to remain in bearish mood with reduced off-shore flows,
  • limited domestic appetite due to liquidity pressure and pressure on corporate earnings; while the inflation would stay under control, increased demand for domestic liquidity will push interest rates higher and we are likely to witness gradual rupee depreciation and depleted currency reserves.
  • Overall, while RBI would inject liquidity through CRR/SLR cuts, maintaining growth beyond 7% will be a struggle. 

The banking sector will have the least impact as high interest rates, increased demand for rupee loans and reduced statutory reserves will lead to improved NIM while, on the other hand, other income from cross-border business flows and distribution of investment products will take a hit. Banks with capabilities to generate low cost CASA and zero cost float funds will gain the most as revenues from financial intermediation will drive the banks' profitability. 

Given the dependence on foreign funds and off-shore consumer demand for the India growth story, India cannot wish away from the negative impact of the present global financial crisis but should quickly focus on alternative remedial measures to limit damage and look in-wards to sustain growth!


India has by-and-large been spared of global financial contagion due to the subprime turmoil for a variety of reasons. India's growth process has been largely domestic demand driven and its reliance on foreign savings has remained around 1.5 per cent in recent period. It also has a very comfortable level of forex reserves. The credit derivatives market is in an embryonic stage; the originate-to-distribute model in India is not comparable to the ones prevailing in advanced markets; there are restrictions on investments by residents in such products issued abroad; and regulatory guidelines on securitisation do not permit immediate profit recognition. Financial stability in India has been achieved through perseverance of prudential policies which prevent institutions from excessive risk taking, and financial markets from becoming extremely volatile and turbulent.

Going forward, developments in the real economy, financial markets and global commodity prices point to a period of moderation in growth with declining inflation. What is heartening though is that the fundamentals of our economy continue to be strong. Once calm and confidence are restored in the global markets, economic activity in India will recover sharply. But a period of painful adjustment is inevitable. It is  collective challenge for the government, and for the RBI to respond to this extraordinary situation effectively and return India to its path of growth and poverty reduction.


1. Henry, Peter Blair 2007), "Capital Account Liberalization: Theory, Evidence, and Speculation", Journal of Economic Literature, Vol. XLV, December.

2. International Monetary Fund (2008a), "Global Financial Stability Report", October

3. Mohan, Rakesh (2006), "Coping With Liquidity Management in India: A Practitioner's View", Reserve Bank of India Bulletin, April.

4. "Development of Financial Markets in India", Reserve Bank of India Bulletin, June.

5. "India's Financial Sector Reforms: Fostering Growth While Containing Risk", Reserve Bank of India Bulletin, December.

6. Prasad, Eswar S., Raghuram G. Rajan and Arvind Subramanian (2007), "Foreign Capital and Economic Growth", Brookings Papers on Economic Activity, 1.

7. Reserve Bank of India (2008), Annual Policy Statement for the Year 2008-09, April.

8. World Bank (2008), "Global Development Finance 2008", June.

Mr. Rahul Verma
Skyline Institute of Engineering & Technology
Gr. Noida

Source: E-mail October 30, 2010


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