Economists at the world’s major financial institutions believe India is better placed than many other nations to ride out any storm caused by a deepening global financial crisis, which India’s prime minister and finance minister warned darkly about during their recent visit to the United States.
A team undertaking the International Monetary Fund (IMF) and World Bank’s periodic Financial Sector Assessment Program, or FSAP, has arrived in India, and will meet with various stakeholders in the country’s financial sector.
|One of the members of the team is James P Walsh, senior economist for India at the Asia-Pacific Department of the IMF.|
Talking about the possible impact of Europe’s financial crisis in an interview before he left for Mumbai, he said, “The Fund believes that the Indian financial sector is very well capitalised and relatively insulated from a lot of developments in the rest of the world.”
Walsh explained the spillovers would likely be relatively small because “India’s financial system is largely domestically financed, very focused on deposits, the banks tend to be very liquid, and the RBI (Reserve Bank of India) has quite a bit of flexibility, as it showed both in the run-up to and during the 2008 crisis.”
In its World Economic Outlook released before the annual meetings of the IMF and World Bank in Washington, DC in September, the IMF had trimmed India’s growth forecast to 7.8 per cent in 2011 and 7.5 per cent the next year, down from 8.2 and 7.8 per cent, respectively. While noting that the recent debt crisis in the US and the euro zone could impact growth in Asia, the report added that India’s domestic demand would be resilient.
India’s exporters are also managing external demand efficiently, according to Kalpana Kochhar, chief economist for South Asia at the World Bank.
She said during an interview, “I think Indian exporters have been very prescient. China now tops the list of India’s trading partners, the US has gone into second place, and Europe even below that. You’re seeing a steady rotation of export markets away from the West towards the Middle East, towards East Asia, China, and Africa.”
Asked if there were any lessons for Indian policymakers from the euro zone crisis, Kochhar said the parallels between the two were not strong. She pointed out that India’s public deficit, unlike that of several European countries including Greece, was financed domestically through banks, and not through foreign sources. Still, she said, the lessons for India predated the European crisis: “You have to have your public finances in order. India has done reasonably well on raising tax revenues, but look at the composition of your expenditure — 2-3 per cent of gross domestic product on wasteful subsidies, and not enough on education and infrastructure.” Kochhar said she was more concerned at present about the composition of India’s deficit than its magnitude.
Walsh also predicted India would be insulated from a lot of global shocks, as it had a relatively well-balanced economy, and was not as dependent on either foreign financing or foreign demand as some other countries. Problems like fiscal overextension or relatively weak financial systems were also not the case in India. “Our baseline scenario for India is that even if the global situation is worse than we envision, India will be relatively well protected against a lot of these forces,” said Walsh.
Both economists pointed to inflation as an immediate challenge. While RBI has increased interest rates by 350 basis points over the last 18 months, Walsh sees a case for further tightening to bring inflation back toward the central bank’s longer-term goals.
“We believe India’s economy is operating at slightly above capacity right now which means that companies still have pricing power and there’s still quite a bit of pressure in the system.”
Finance Minister Pranab Mukherjee had complained in Washington, DC that “easing out policies by some advanced countries” were leading to inflation in emerging markets. But Walsh disagreed with this view, saying inflation in India was primarily driven by domestic demand and supply constraints, and not due to high global energy or food prices. “India is not so open to the rest of the world that foreign factors can have a huge impact on inflation,” he said. In fact, Walsh argued, RBI’s success with its monetary tightening showed the factors were within its control. “It’s very clear from what has happened to bank credit, lending rates and deposit rates recently that RBI is having traction in the process of tightening that’s going on, and if India’s inflation were due to foreign factors there wouldn’t be as much of an impact as there has been,” said Walsh.
Kochhar said RBI was still dealing with the inflation sparked by stimulatory fiscal policies and monetary easing around the 2008 crisis. She believes while the policies were needed at the time, the pullback should have been quicker once the recovery took hold. “Now you have fiscal policy that’s still stimulating, and monetary policy that’s trying to take out stimulus, and the job is pretty hard to do.”
Despite the challenges, Kochhar says India is in fact, in a good position, and needs to capitalize on it: “The single most important thing India needs to do is to distinguish itself as an emerging market as it did a few years ago but has lost that position now. It needs to break away from the pack and tell people ‘We’re open for investment, we have a clean and stable regulatory system, come and invest’.”
IMF also believes India will remain an attractive place for foreigners to invest for the long term. Walsh said, “I think the challenge is for India to set up a framework for foreign investors and investments in general that will encourage stable and long-term flows in foreign direct investment rather than very short-term flows, particularly debt-related short-term flows which, at the moment, are very closed.”