The Indian Economy -- Where Do We Stand

This is probably not the right forum to put up a post such as the present one. It is linked to my profession -- which is academic economics. :hide:
I wrote the article at the invitation of the Indian Chamber of Commerce for their Monthly Review, November, 2008 issue.
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Economic historians generally agree that October 29, 1929, exactly seventy nine years ago today, was the day that flagged off the Great Depression. Wall Street crashed, precipitating a mammoth turmoil for the rest of the industrialized world. Unprecedented fall in share values, coming in the wake of an equally unprecedented bubble, led to sustained losses for the general public, which in turn gave rise to a curtailment of overall expenditures. Industrialists, faced with a dried up demand for their produce, automatically revised their expectations of future streams of profits. As a result, real investment collapsed in the affected economies. The overall weakening of investment and consumption demand caused production to contract and the dreaded phenomenon of unemployment emerged. The depression lasted several years in parts of the world, causing acute human misery, not to speak of the Second World War.

It is once again October 29 today. Societies are immensely more globalized now compared to the Great Depression days and far more prone to catching economic infections that have afflicted others. The Indian stock market crash is an obvious case in point. As our policy makers gradually opted for capital account convertibility, our stock markets had their first taste of financial inflows in the form of FII investments. Within a relatively short period of time the share market boomed and mutual funds floated by respectable institutions began to promise returns as high as 25 - 30%. The real economy was growing handsomely around the same time too and the Economic Survey for 2007-08 announced a real GDP growth rate of 9.4 per cent in 2006-07.

A 9.4 per cent growth rate, though impressive according to any evaluation criterion, was nonetheless way below the returns promised by financial instruments in stock markets. A 25 per cent return on financial investment emerging out of a 9.4 per cent economic growth rate, it would seem, was a contradiction in terms. However, this simple truth escaped the policy makers, who, in their wisdom, goaded the public to invest in mutual funds by according incomes from such investments a tax free status. Of course, the instruments in question carried a clearly stated caveat that they were not risk-free. However, the information had no more relevance for investors than the mandatory warning on packets of cigarettes that smoking is injurious to health. Besides, the fact remains that taxes on cigarettes are increased every year, not to curtail the menace, but to ensure higher revenues for the Government.

It is no secret now that the boom in our stock markets had little to do with our own economic performance. The FII’s were showering dollars on us like manna from heaven. Stock prices soared up to mind boggling heights, producing opportunities for the lay public to reap harvests far out of proportion to the quantity of seeds they had sown.

There is little need anymore to explain the nature of the subprime crisis in US. Suffice it to say that, faced with the liquidity crisis in home countries, the FII’s are now withdrawing most of their investments from India and the sizes of Indian investments are far too small to prevent the markets from sliding. The phenomenon, even if unpleasant, is a blessing in disguise. One hopes that we shall soon be discovering the valley, the lowest plane at which Indian investors by themselves can keep the market running.

Till that moment arrives though, people will need to bear with the suffering. And an unavoidable feature of the misery is the liquidity crisis. Lending institutions are wary of lending money, despite the fact that the Central Bank is pumping money into the system. The problem arises from a lack of confidence. Banks do not wish to bring succor to mutual funds crushed under the burden of redemption pressure. Industrialists too are credit squeezed, thereby deprived of working capital necessary for daily operations. Consumption loans are scarce so that demand for industrial produce (in particular for durable consumer goods) is taking a solid beating.

As demand falls, one cannot help asking if this is a sign of depression. In the US aggregate output did fall by 0.3 per cent in the latest quarter, while UK fell by 0.5 per cent and that is not happy news. India, on the other hand, expects to keep growing (even if at a lower rate than the recent past) and if that expectation is fulfilled, our economy will not enter a recessionary phase. Retrenchment and unemployment cannot perhaps be avoided in certain sectors, depending on the pattern of demand. However, so long as aggregate output keeps growing, total employment will grow too. In other words, in a growing economy, the number of people who will find employment is likely to exceed the number that loses out.

To the extent that our growth rate remains positive, the price that we shall be paying on account of our acceptance of free market principles would appear to be somewhat less than what critics generally claim. A fall in the Re/$ exchange rate on account of FII outflow or a dip in the growth rate are not happy signals. But they are not as fatal for the economy as was the Great Depression.

The Government’s infatuation with monetary policy techniques though may not produce too many results. It seems that the economy is now caught in a Keynesian Liquidity Trap. An increase in money supply might merely cause the public to hoard money rather than spend it. Till the growth rate picks up, the Government will be well-advised to adopt fiscal policy measures involving direct expenditure on infrastructure and other important projects to keep employment growing. Fortunately, the PM’s latest observation on the issue points in this direction too. He has emphasized that the Government ought to keep spending on its flagship projects as a policy complement to the RBI’s monetary stance. If indeed the economy is stuck with a liquidity trap, the PM’s policy suggestion could save the Indian economy from the evil of contraction. However, if the entire world sinks, then India too will gasp for a while, given that its economy has never been as open as it is now.

 

Absolutely right. However, I also believe that the Govt. should stop acting like a nanny once the private sector shows signs of picking up. And, for a while at least, the complicated derivatives should be avoided. All of us need more information on how these work.

oj

 

Dear Kamalji:

I agree with most of what you say, except for the greed part. See, if we believe in markets, which most of us do these days, then we also believe that markets are driven by the profit motive. Why, I ask, should there be a cap on one's desire for profits if profit making is the driving force of markets? Greed is usually considered a sin. Now, if we advocate profit making, then why do we equate profit with greed and hence, sin? I am not too sure that this is, philosophically speaking, the correct approach to the problem.

On the other hand, if in the name of profit making, one resorts to cheating, then, clearly we can call it greed. Markets too are governed by laws and one must not break them. If these laws are broken, you have a case for the greed explanation of course. Are we sure that there was too much cheating? I tend to believe that the reason for the collapse lay more in inefficiency than in cheating or stealing. I mean more inefficiency than cheating.

We don't understand the instruments we employ ourselves all that well. Or, so I think.

oj

 

Dear Santosh:

Only today I delivered a lecture to the Indian Chamber of Commerce on these issues. It is interesting to find you asking questions I faced from bankers at the forum.

First, I feel you are absolutely right that a cap on loans given out for housing could have prevented the crisis. In the ultimate analysis, oversupply of houses relative to other commodities led to a fall in house prices in the US and mortgaged were foreclosed, not only by the subprime borrowers, but also the prime ones. And then, the banks and financial insitutions ended up with worthless assets, which in turn led to bankruptcy. The problem is that people didn't know that they had overdone the house loan thing. The realization came only after the bubble had burst and then it was too late. It had started a confidence crisis, which is only increasing everyday.

I am not sure I have understood your second question too well. I know that the rest of the world is dependent on the US because they are huge exporters to the US. The US has been running enormous current account deficits (i.e. deficits on merchandize trade) for a long time. People wanted the dollars that they accumulated as a result because oil is priced in American dollars (since the time of President Nixon, who destroyed the Bretton Woods system which had fixed dollar prices in ounces of gold). Now, if the rest of the world hold US dollars, then they need to hold it in some form and, under capital account convertibility, they preferred to hold it in the form of US assets. They didn't foresee that the assets would turn toxic. I think they can create independent funds between themselves, but in a largely open world, their exports would matter a great deal. And US is the largest importer of foreign goods in the world. So, I guess, no country really cares to dissociate itself from the US at this stage.

Third, I couldn't agree with you more that interest tinkering is the silliest of policies if demand is the problem. You cannot generate demand by reducing prices of interest rates when there is a confidence crisis. This is why, for a while at least, the government needs to generate demand of privately produced goods.

Don't konw if I have been able to throw any light at all.

Nice to interact with you though.

All the best.

oj

 

Dear Santosh:

Note first of all that GDP represents an economy's yearly production (as well as income). Money supply on the other hand is not income. It is defined independently of a period of time. For example, we cannot make a statement like "money supply is Rs. x per year". So, the US GDP or the GDP of the rest of the world has no bearing on the amount of dollars or other currencies in the world. At least not directly. But this is a side issue.

When you suggest the other countries get together and build a fund to replace the dollars withdrawn, you must also have in mind the purpose for which this fund will be created. When the FII's withdrew their money from different countries, what was primarily affected was the value of stocks in the share market. And this led ultimately to a confidence crisis, with people losing money on their FINANCIAL investments in shares and debentures.

Now, the fund that you speak of can always be created, but for what purpose? In fact many central banks have got together to create precisely this fund and it is being used to help banks lend to mutual funds and others to pay off their debtors. For example, when the share prices fall, people often wish to sell off their shares and the mutual funds get into trouble because they don't have enough funds to redeem their loans.

This has been done, but not to much effect so far. What the governments and central banks cannot do is start buying shares in stock markets directly, if that's what you mean (but I am not sure if this is what you said). They can give out loans to banks (say) and the banks can use these loans to either bail out mutual funds or buy new financial assets. When stock markets are doing badly, the latter possibility is more or less ruled out. The banks would be too worried about investing in stocks and bonds during stock market recessions. They would rather use the money to buy government bonds, thereby giving back the government's money to the government itself! And the Finance Ministry cannot use its own or borrowed resources to buy shares. The Government, in other words, cannot be a share market operator or speculator.

The only thing it can do is spend on commodities and, to a large extent, this is being attempted. But whether it can do so by borrowing from a common international fund is not too clear. Even now the IMF exists. It is a common fund. Whether the IMF can lend to countries to pull them out of the demand crisis is not too obvious.

oj