Global turmoil and the threats it holds for the Indian economy

Last Updated: Fri, Aug 26, 2011 04:57 hrs

Indian policy makers were quick to insist that the Indian economy is not likely to be very adversely affected by the latest evidence of volatility and fragility in global financial markets.

Finance Ministry sources have been continuously pointing out that the Indian growth story is robust and continuing, and that the current uncertainty will cause no more than a blip in the rapid economic expansion in the country.

Of course it is the job of economic officialdom to "talk up" the markets. But even so, the complacent tone adopted in some of the responses so far is a little surprising.

It may be that in private the same government representatives will be more circumspect and more aware of the complicated risks facing the Indian economy, so it is wrong to presume too much just on the basis of formal public pronouncements.

Even so, it might even be more reassuring for the rest of us if we knew that our policy makers are at least fully aware of the various risks and potential problems, and are therefore making some preparations to deal with them.

Consider just a few of the implications of the recent turmoil in the world economy.

The first important takeaway from the statistical evidence is the diminished role of the US as net importer.

This is no longer a future possibility - it is already a process that is well under way and is likely to get even more accentuated in the near future. It means that the rest of the world - including India - can no longer rely on exporting to the US as the means of generating growth in their own domestic economies.

Yes, the US current account deficit increased slightly in 2010 compared to 2009, and has been increasing slightly in the first half of 2011. Even so, in 2010 the deficit was 30 per cent lower than it was in 2008, amounting to $2 trillion less. 

More significant for countries like India, which have put so many eggs into the service exports basket, is the pattern of US imports of services. They fell quite sharply in 2009 compared to 2008, recovered in the following year but were still below the 2008 level.

In the first six months of 2011, US service imports were only 5 per cent higher than they were in the first six months of 2008, which implies a fall in real terms because of the depreciation of the US dollar in the intervening period.

All this occurred while the stimulus packages still included some amount of fiscal expansion in the US.

Unfortunately, the political charade around the debt ceiling that just played out in Washington has almost completely ruled out the possibility of more government expenditure to combat the current fragility - instead, the current watchword is austerity and budget cuts.

Quite apart from the implications for employment, welfare and inequality in the US, this is a further constraint on import expansion in the US economy. And the growing resentment among the people in the US that is bound to be associated with these cuts will generate further protectionist pressures that will rebound on outsourcing and related tendencies.

Since fiscal measures are being ruled out by the politics, the only means left for the US to come out of this current stagnation is through monetary policy, though the effects of this are unlikely to be very positive.

The real problem with the expansionary and low interest monetary policy being followed by the US Fed in the wake of the crisis has been that it has contained no measures to ensure that banks actually lend out in ways that improve economic activity, employment and the financial condition of the mass of consumers. But still no course correction is planned.

Instead, Ben Bernanke has just announced that interest rates will remain at their very low levels (close to zero) for the next two years at least.

This may be fun for banks, but is not likely to stimulate domestic output in the US directly. But it will surely contribute to a weakening of the US dollar, which indeed may be part of the intention.

It will also lead to yet another problem for emerging markets like India: the increased tendencies for inflow of mobile capital, in the form of carry trade to take advantage of interest rate differentials and because of perceptions of greater growth potential in these countries.

In Brazil, this is already seen as a major economic concern, as inflows of hot money push up the currency despite some attempts at capital controls.

But policy makers in India are not necessarily as wise, and they may rather interpret the renewed inflows of footloose capital as a sign of the continued economic strength of India.

That would be a mistake, because financial inflows in the current context will push up the exchange rate and further increase the trade deficit, which is already of significant proportions.

It will further shift incentives in the economy away from tradable goods to non-tradable activities including real estate, construction, stock markets and debt-based personal consumption.

These are classic signs of a bubble economy. As long as the bubble is in progress, it feels like a boom, but all bubbles do burst eventually.

In the Indian case, the bursting of the bubble is likely to be even more painful, because even in the boom the growth process is simply not generating enough productive employment.

So, a quick "recovery" from the current volatility need not be something to celebrate in India if it is because of renewed capital inflows, with their attendant unfortunate consequences.

The other potentially dangerous effect of the loose monetary policy, which has unleashed lots of cheap liquidity on global markets, has to do with primary commodity prices.

At this moment, oil prices have fallen globally, but this may be just a temporary respite, and for other important commodities there is no clear decline.

Gold prices are rising because of a flight to safety, but investing in other commodities may also keep increasing simply because investors do not know where else to go with their money, and because interest rates are so low that there is little to lose.

This may well lead to further increases in global food prices, which will create havoc and threaten consumption across the developing world.

In India, in particular, the pressure on food prices is already so intense that we really cannot afford another trigger in the form of renewed global price increases.

All in all, it seems that there are many potent sources of future instability that are implicit in the current global scenario.

This does not mean, of course, that we should sit around wringing our hands with doomsday talk.

But it certainly does mean that we - or rather, Indian policy makers - should be fully aware of these possibilities and develop strategies to cope with them.

At the moment, this does not seem to be the case.

Earlier columns:

The scariest thing about the world economy

Is Europe rushing headlong into economic destruction?

The finance minister has failed the common man

Also See: Two burning issues the budget must tackle

Renowned economist Jayati Ghosh is the Professor of Economics at the Jawaharlal Nehru University in New Delhi. She is also a member of the National Knowledge Commission set up by the Indian Prime Minister.

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