India’s Financial Secret Weapon

January 29, 2009

Editor’s Note: Originally thought to be immune to effects from the U.S. economic slowdown, many emerging economies have been hard hit. However, India has escaped the worst of the financial crisis, but how long can it last? In an article in Foreign Policy Magazine, Arvind Panagariya examines ways in which the Indian economy has not remained entirely immune to the tremors in the world economy.

Although it may now seem a lifetime ago, it has only been a few months since the so-called “decoupling” hypothesis dominated media coverage of the global economy. The dominant view held that emerging markets were growing independently of the United States and therefore were immune to a U.S.-born economic slowdown. Yet the second half of 2008 was not kind to this hypothesis. Indeed, the orthodox view that countries must prosper and perish together in today’s interconnected world has returned with vengeance.

In the immediate aftermath of the fall of Lehman Brothers and the takeover of AIG, countries such as South Korea, Mexico, Brazil, and even normally well-governed Singapore found their internationally exposed banking systems in shambles. The U.S. Federal Reserve was forced to open $30 billion worth of swap lines of credit to these countries’ central banks. South Korea had to even put together a megapackage worth $130 billion to rescue its banks in October 2008.

But one emerging economy managed to defy the trend. More than four months after the fall of Lehman, India’s banks remain in sound financial condition. They have required no bailouts or recapitalization. The country’s economy is expected to grow at a rate of 7 percent this year. Although this figure represents a nontrivial 2 percent decrease from its five-year average, it is hardly the disaster one would predict going by the gloomy news and forecasts for the U.S. economy. How did India manage to beat the odds?

One key reason is its tight regulation of banks and external capital transactions, largely the result of the sound management and foresight of one man: Yaga Venugopal Reddy, the former governor of the Reserve Bank of India (RBI).

Interestingly, India’s central bank lacks the independence from government that the Federal Reserve enjoys. It is administratively subservient to the Finance Ministry. Yet, by sheer force of his personality, Reddy, who served as RBI governor from 2003 until the end of his term in September 2008, successfully resisted government pressure to deregulate banks and hastily open India to external capital account transactions. In contrast to former U.S. Federal Reserve Chairman Alan Greenspan who believed in the fundamental integrity of market agents, Reddy is reported to have held the view that if bankers were given the opportunity to sin, they would.

As a result, whereas banks and financial institutions around the world were massively lured into investing in assets and derivatives backed by U.S. subprime mortgages, banks and financial institutions in India were largely kept out of them. Under the watchful eye of Reddy, only $1 billion out of India’s total banking assets of more than $500 billion slipped into toxic assets or related investments. When the crisis came and financial institutions around the world found themselves writing off almost $1 trillion in assets from their books, Indian banks had at most a few hiccups.

Nevertheless, the Indian economy has not remained entirely immune to the tremors in the world economy. Investment in toxic assets represents only one (albeit the most lethal) of the three ways that the crisis in the U.S. economy has infected the rest of the world. The other two are the withdrawal of investments by U.S. firms abroad and the sharp decline in U.S. demand for foreign goods and assets. India might not be able to escape these tremors quite so easily.

The drying up of liquidity within the United States led U.S. investors to withdraw their investments in the Indian economy at lightning speed. In October alone, India saw its foreign exchange reserves decline a staggering $39 billion, leading directly to a tightening of liquidity in India. These withdrawals also indirectly caused a precipitous fall in equity prices, adding to the liquidity crunch. Finally, Indian corporations, which had been able to borrow at attractive rates in the United States and other markets in the past, could no longer do so and returned to borrow in the domestic market.

The global fall in demand for Indian goods is also beginning to bite. India’s merchandise exports tripled between 2002 and 2008. Even between April and September 2008, exports rose more than 30 percent over their level during the corresponding period of the previous year. But since October, exports have started to fall.

The story on the foreign investment front is similar. Between 2002 and 2007, annual direct foreign investment and portfolio investment together rose 10-fold from $6 billion to $62 billion. But between April 1 and Oct. 31 of 2008, this figure stands at $10 billion. The figure for the corresponding period in the previous year was $37 billion.

The Indian government has acted to unfreeze liquidity by aggressively cutting interest rates, the cash reserve ratio, and the statutory liquidity ratio. It has also announced fiscal stimulus in two stages, though on a much smaller scale than in many other countries. This is appropriate for two reasons: India already has a very large fiscal deficit on top of a massive debt-to-GDP ratio of more than 80 percent. Also, the forthcoming national elections, expected in May 2009, are bound to accelerate government spending independently of the stimulus package.

Can India’s good fortune continue? The jury is still out on how the economy will perform in 2009 and beyond. Some pessimists see India returning to the 5 to 6 percent growth rate of the early 2000s. I do not share this view. Even with the global financial crisis, India is likely to sustain growth of 8 to 9 percent in the coming decade thanks to its top-class entrepreneurs, more competitive markets, high savings rate, and increasingly younger population. But as India toasts its continued economic success, it would be unwise to overlook the careful regulation of financial markets that at least partially protected it from the worst effects of the financial crisis.