Impending recession

India unlikely to escape its impact
by Arun Kumar
The world economy is faced with a downturn. The issue is how deep and how quick it will be. The Prime Minister and the Finance Minister are trying to keep the flag flying and rallying the troops so that the rout is delayed. It is variously being suggested that India will not be affected by the downturn in the US economy which, according to some analysts, is already in a recession but since the data comes with a delay, it has not been officially acknowledged that the recession has started. The cuts in advertising expenditures in the US are an indication of the downturn.
The stock markets the world over are indicative of the negative mood of the investors. Adverse news is being greeted by huge declines in the indices. The US Central Bank, the Fed, has already cut interest rates twice in quick succession by a total of 1 per cent (unprecedented in recent history) signalling/acknowledging that indeed things are bad. In the US, for the first time in many years, employment is falling.
The Indian stock markets have also followed the overseas markets in the rapid fluctuations and more so because it was way beyond what the fundamentals justified. Indian industry and exports have been showing signs of slowing down. Due to rising inequality, the market in India is narrow and dependent for growth on investments and exports. Without doubt, exports will be adversely affected by the slowdown in the US.
Investments are likely to slowdown because of the industrial downturn and also because of the international trends. Both these factors will result in unutilised capacity appearing and leading to slowdown in investments and in the rate of growth. The rate of growth of the economy which rose on the back of a rise in the investment rate (from 25 per cent to 32 per cent) can show an equally dramatic fall. We may be back to a 4-5 per cent rate of growth which prevailed five years back.
The economy has been facing infrastructure bottlenecks, like in power and transportation. The food prices have been rising resulting in inflationary pressures and political problems. Oil prices have been high and even if they moderate due to the recessionary tendency, they will cause pressure on prices and profit margins. In other words, the problems already confronting the Indian economy leading to its slowdown will be aggravated by the international trends.
The optimists have been suggesting a decoupling between the US economy on the one hand and the EU and Asian economies on the other hand. It was being suggested that the growth momentum in the latter would compensate for the downturn in the US so that the world economy would still sail through with a minor slowdown. Indian analysts depending on this have been arguing that India would not be badly hurt by the slowdown in the US economy. They argue that India is not a large exporter and so the affect of slowdown would be small.
This line of argument misses the central point that now many of the markets are fairly integrated with the international markets. That has been the central point of the Structural Adjustment Package (SAP) being implemented in India since 1991. Even without full capital account convertibility, we have had elements of it. FIIs and NRI funds can come in and go out. Indian businessmen have been allowed to keep capital abroad, etc. Thus, the financial and real estate markets have been substantially integrated with the world markets. No wonder what happens abroad has immediate impact on Indian markets.
We have known that energy and food markets are integrated the world over. We have been witness to the impact of oil prices and rise in wheat prices. Thus, many of our markets are now open to influences from abroad. While it is true that we are not as open as many other economies (like Germany or Sri Lanka), we are twice as open today as we were in 1991. Hence the US economy has a much bigger impact today than earlier. Given the size of the US economy, a 1per cent reduction in its rate of growth would be bigger than a 10 per cent increase (to 20 per cent and that is unlikely) in the rate of growth of the Indian economy.
It may be argued that the cutting of the interest rates in the US and actions elsewhere will have a positive effect and prevent a downturn there. President Bush has announced a $150 billion package. He is putting purchasing power into the hands of individuals to boost demand. This would be about 1 per cent of the US GDP. However, what individuals may have lost in the sub-prime markets may be much larger and hence inadequate. Further, the decline in the stock markets and the fall in the paper wealth is also likely to far exceed this amount.
In other words, some feel that this effort may be too little, too late. There is nothing unusual in this since in business cycles it has been mostly found that in the downturn, intervention is usually too little too late so that the downturn becomes inevitable. In Japan, in the nineties when the interest rates even turned negative, the economy could not pull itself up.
The reason is that once the investors’ sentiments turn negative, there is little that the government can do to turn them around. This situation is currently aggravated by the free market philosophy where any form of government intervention is seen to be bad and, therefore, resisted till it is too late. Even when it does come, it is of the wrong variety. Governments following free market philosophy give concessions to the investors, hoping that they would invest more. However, because demand does not rise and unutilised capacity continues to rise, they invest little and the concession simply ends up raising unutilised capacity further. The medicine aggravates the disease.
Usually, in the downturn, the poor and the poorer countries are affected worse than the rich ones. For instance, the impact of the sub-prime crisis has been the greatest on the poor and the blacks in the US. The situation is being aggravated by the environmental consequences of the development path being followed in the recent past. With environmental costs of growth rising in a recession, the poor will suffer even more.
In India, where large infrastructure projects had been planned and companies were rushing to raise capital from the booming stock markets, there would be over-capitalisation and consequent losses. Indian companies have also been rushing to acquire expensive overseas assets. Such companies are likely to suffer substantial losses.
For India, the negatives seem to far outweigh any positives. Further, the impending slowdown/recession/depression in the world economy is likely to be quite different than the earlier ones since it is being driven by substantial unresolved problems in the financial sectors. No one, not even the largest actor on the scene, the Fed, understands what is going on so that correctives are hard to devise. Once the economy starts going downhill, many actions that would have been normal in a rising economy, like acquisitions through leveraging, investments in risky instruments, turn out to be mistakes. The various mistakes cumulatively amount to huge mistakes. Indian financial markets, substantially integrated into the world markets, are unlikely to be able to escape the impending crisis.