How European crisis could impact India? Understanding the linkages..

By Amol Agrawal Though this has taken longer than I wanted, but here it goes. The analysis is still in a very crude form. Will try and refine it as it goes: (Warning: it is a very very long post) A crisis in an economy impacts other economies via three channels: Trade Channel: When an economy falls into a recession, it impacts the affected countrys trading partners too. Falling household and business demand in the slump-hit economy hits the exports/imports of its trading partners. The share of exports to EU (excluding UK) and imports from EU has fallen over the years. In 1987-88, exports to EU constituted about 18.6% of total exports. This has declined to 17.5% by 2008-09. The decline of imports is higher from 25% in 1987-88 to 12% in 2008-09. Hence, total trade between India and EMU is about 29.5% and could be impacted due to the crisis. (Source: RBI) However, trade channel can impact Indian external sector indirectly as well. When the recent crisis gripped the world 2008, most policymakers, economists and experts put forth the view that India would be only marginally affected. Two reasons were cited for th

First, India was a virtual non-entity in global trade as its share was less than 0.5%-0.7% of the total global trade volumes. Hence, it was assumed that its economy was largely insulated from the turmoil. Second, share of developed economies in trade had declined. In 1987-88 developed economies contributed 59% of exports and in 2008-09 their share has declined to 37%. The share of developing economies has increased from 14% in 1987-88 to 37% in 2008-09. In case of imports developed economies share has again fallen from 60% in 1987-88 to 32% in 2008-09 while developing economies has risen from17% to 32%. (Source: RBI)

Because of this shift it was felt that impact of global crisis on Indian economy would be limited. As crisis originated in US and developed economies with developing economies still growing, it was felt Indian trade will continue to grow. However once the crisis struck in September 2008, Indian trade sector declined sharply and growth was negative for 13 straight months from Oct-08 to Oct-09.

The above analysis looks at trade in goods. What about trade in services? We do not have country-wise data of trade in services so we just analysed the broad trend. Unlike trade in goods which declines immediately, we see a decline in services trade with a lag. It declines visibly in Jan-Mar 2009 quarter when the global crisis started in September 2008. Software exports decline marginally from USD 11.2 bn levels to 10.4 levels which is great given the global nature of the crisis. Hence, impact of crisis was more on goods and muted on services. (in USD India Services Software Billion) trade Receipts Jan Mar 10.8 10.9 2008 Apr 11.6 11.3 Jun 2008 Jul Sep 14.4 11.2 2008 Oct-Dec 13.9 10.7 2008 Jan - Mar 11.0 10.7 2009 April-June 9.7 10.6 2009 Jul-Sep 7.2 10.4 2009 Oct-Dec 7.7 12.7 2009 Software exports are more than services trade as we import more in case of other services like travel, transport etcSource: RBI Moreover, World Trade volumes declined for the first time in 60 years. IMF says the decline in world trade in 2009 was around 12.3%. The Indian government had to intervene and provide stimulus to exporters. Trade volumes declined as world economy is far more integrated than we assume it to be. Demand in developing economies also declined leading to overall slump in world trade.

So, the overall impact of European crisis on Indian trade could be much more than direct linkage indicates. Financial Channel: The current crisis has shown the power of finance channel (though trade channel was also very strong as above analysis points). The impact of turmoil in one economys financial markets is not merely transmitted to other markets, the quantum and direction of the movement is also more or less similar (decline in equity markets, rise in corporate bond spreads and depreciation in currency). This is because cross border financial linkages have increased substantially over the years. Besides, the correlation between assets too has been rising across the world. If you plot the BSE Sensex with other advanced economy stock indices, you more or less see the same trend. So much so, one can determine the trend in the Indian equity market by just looking at movements in other global indices. Apart from movement in financial markets, three kinds of financial flows could impact Indian financial markets:

Foreign Direct Investment: There are many European companies which have investments in India. So, there could be a possibility of slowdown in FDI in India. We looked at top 15 FDI investors in India which constitute about 92% of total FDI (Source: DIPP). EU economies have contributed about 12.8% of total FDI since April 2000. But again FDI remained robust throughout this crisis. Given the severity of the crisis it was felt there will be little FDI investment. However, in case of India, FDI inflows remained positive throughout the crisis. The FDI inflows actually helped keep maintain capital account when all other categories showed sharp decline. Gross FDI Gross FDI Net FDI inflows Outflows (Inflows minus Outlflows) 13.7 -7.4 6.4 -2.9 -3.9 -5.9 -4.8 9.0 4.9 0.4 3.2

(in USD billion)

Jan Mar 2008 Apr 11.9 Jun 2008 Jul Sep 20088.8 Oct-Dec 2008 6.3 Jan - Mar 8.0 2009

April-June 8.7 2009 Jul-Sep 2009 10.7 Oct-Dec 2009 7.1 Source: RBI

-2.6 -4.2 -3.2

6.1 6.5 3.9

Foreign Institutional Investment: Unlike FDI, it is difficult to pinpoint the origin of FII investment. However, the linkage here is pretty direct. With a turmoil in global financial markets, FII inflows will decline. We have a large number of global financial firms which operate across the world and in case of a decline in one major market, there is a pull out from other markets as well.

(in USD FII billion) Jan Mar -3.7 2008 Apr -4.2 Jun 2008 Jul Sep 2008 -1.3 Oct-Dec 2008 -5.8 Jan - Mar -2.7 2009 April-June 8.3 2009 Jul-Sep 2009 9.7 Oct-Dec 2009 5.7

External Commercial Borrowings: External commercial borrowings could also decline if the European crisis spreads to other economies. ECBs declined in the first stage of the crisis as well. ECB 4.8 1.5

(in USD billion) Jan Mar 2008 Apr Jun 2008

Jul Sep 2008 1.7 Oct-Dec 2008 3.8 Jan - Mar 1.1 2009 April-June -0.5 2009 Jul-Sep 2009 1.2 Oct-Dec 2009 1.5

Remittances and NRI deposits: Another important flow is NRI deposits and Remittances. Former shows whether NRI depositors withdrew funds in wake of crisis and latter shows whether Indians living abroad stopped sending funds to their homes again because of the crisis. We see an interesting trend in the case of NRI deposits. The deposits increase in the crisis periods OctDec 2008 and Jan- Mar 2009 and decline thereafter. It could be that NRI preferred to invest higher proceeds in India seeing crisis in their own economies!In case of remittances, we see a decline in crisis period Oct 08 Mar 09 but see improvements as crisis eases. There were huge concerns of remittances collapsing because of the crisis. In some countries they did collapse worsening poverty status. In India, despite the decline it manages to remain in positive. (see this study on remittances) Remittances 13.4 11.6 13.0 10.0 9.5 12.9 13.8 12.8

(in USD NRI billion) Deposits Jan Mar 1.1 2008 Apr 0.8 Jun 2008 Jul Sep 0.3 2008 Oct-Dec 2008 1.0 Jan - Mar 2.2 2009 April-June 1.8 2009 Jul-Sep 2009 1.0 Oct-Dec 2009 0.6

Again like in the trade channel, the impact of financial markets could be more via the indirect linkage. Financial markets are far more integrated than the trade channel. Even both trade and finance are interlinked. First, domestic banks can lend to companies in other economies as well. A problem in latter could lead to worsening of the conditions of domestic banks/financial firms as well (this was seen in the case of Swedish banks). Second, Banks are at the center of the international trade as they provide trade finance and other financing facilities that facilitate trade. A problem in financial markets will disrupt the international trade as well. In the initial phase of post September 2008 crisis, WTO and World Bank chiefs raised concerns over trade finance in numerous forums. Confidence channel This channel shows confidence declines in business and households seeing the global uncertainty. So even if an economys macroeconomic conditions and outlook look favorable, the decline in confidence can disrupt the economic conditions. Decline in confidence is also one of the reasons for decline in business investments which led to decline in overall Indian GDP growth. Credit growth also declined because of decline in business investments. RBI Governor Mr Subbarao has stressed on this channel on numerous occasions (see this speech in 2009). Role of confidence channel in crisis has grown overtime. Bank of Japan Governor Masaaki Shirakawa in a recent speech said confidence cycle plays a crucial role in all crises: Why do financial crises, and for that matter bubbles which precede them, occur repeatedly? Many reasons are given lax risk management, excessive leverage, existence of financial institutions which are perceived to be too-big-to-fail, failure of supervision, excessively accommodative monetary policy and the list goes on. I generally agree with such assessments, but we also need a holistic perspective which cannot be captured just by focusing on individual causes. From this perspective, I would like to emphasize that, what one could term as a cycle of confidence which evolves over a very long time horizon, plays a decisive role. Success breeds confidence which unfortunately turns into over-confidence or even arrogance. Complacency also sets in. The collapse of the bubble based upon this

over-confidence leads now to under-confidence, which is followed by rebuilding efforts. Then the cycle begins once again. Increasing integration of India with global economy Apart from these three channels, Indian economy has become more global over the years. The business and trade cycle of India has started to follow the cycles of advanced economies. RBI Executive Director Deepak Mohanty in his speech explained the increasing correlation: With increased global integration, the Indian economy now is subject to greater influence of global business cycles. The correlation between the cyclical component of the index of industrial production (IIP) of the advanced economies and India has risen to 0.50 during the period 1991-2009 from 0.20 in during the period 1971-1990 The traditional conduit of transmission of global shocks is through trade cycles. The cyclical movement in Indias exports and world imports during the earlier period 1970-91 was not significantly synchronised with a relatively low correlation of 0.38. However, with rising exports alongwith a transition from primary article exports to manufacturing exports, the correlation between Indias exports and world imports has increased significantly to 0.80 during the recent period 1992-200. Concluding thoughts and possible scenarios The above analysis looks at some preliminary evidence of the linkages of Indian economy with European economies. Again, I must emphasize that we need to look beyond the direct impact of European economy on India. As this crisis has shown that world economy is far more global with many complex interlinkages. Hence, if the European crisis continues to spread, it could impact Indian economy via other indirect linkages as well. Given this global uncertainty, it puts Indian policymakers in a peculiar situation. If we look at Indian economy alone fundamentals look quite strong. GDP growth is expected to be around 8.5% in 2010-11, IIP is increasing in double digits, credit growth has increased to 17%, export markets are picking up and capital inflows have been robust. However, because of the global uncertainty all these calculations can easily go wrong. Infact, sentiment has already reversed in some cases:

The investments might not increase seeing the global uncertainty. Investment was a key driver in Indian 9% growth period (2003-08). Again it is expected to play the key. We have seen business confidence evaporating in thin air quick time IIP could again decline as it did post September 2008 crisis Credit growth could decline both because of banks becoming uncertain and business not demanding credit Foreign capital inflows could reverse to an outflow position. Infact this has already started to happen with FII showing outflows worth USD 1.65 billion in May (from May 1 2010 to May 24 2010) from equity markets. Till April 2010, we had nearly USD 6.65 billion of capital inflows. The decline in inflows along with global uncertainty has led to decline in equity markets. The expectations of BSE Sensex reaching soon to 21,000 levels are being revised downwards. The volatility is again increasing. If we see the NSE VIX index. It had increased from 20 level in Jan 2008 to 85 levels in Nov-08. It then declines to go back to pre-crisis level of 17-18. It has again started increasing to touch 34 levels now. Yields in bond markets have eased considerably to 7.35% levels looking at the global crisis. This is quite a turnaround as most market participants expected yields to touch 8-8.25% levels after April Monetary Policy. The market participants were also expecting RBI to increase interest rates even before its monetary policy in July 2010. This crisis has reversed the sentiment and most now expect RBI to keep interest rates unchanged in July policy. Export markets could also decline for reasons explained above. If the crisis situation worsens, Indian government might again have to intervene to ease the crisis situation. Though the probability is remote, but it is till there. There are expectations that fiscal deficit and government borrowing program could be lower than budgeted amount. This is because of the higher than expected proceeds from 3-G auctions. If crisis worsens, the government borrowing and fiscal deficit could get worse. Oil and commodity prices have declined as well. This could be a positive factor as inflation might just become lower.

The above is a worse-case scenario and all will depend on the nature of European crisis. We still do not know where the crisis is headed. Comparisons have been made on how the crisis is similar to earlier US crisis but we have a far more complex problem here. In US you have one government and here you have 16 governments who are trying to resolve the issue.

The recent events show the situation is quite severe. There is little coordination between European policymakers as daily edition of eurointelligence shows. Germany recently imposed ban on naked short selling without taking other European governments in confidence. This angered other European governments who said why Germany should make standalone policies when we are all fighting this crisis together. And just after saying this, European policymakers have again showed resolve to fight this crisis. Germany was seen as the economy which could support falling Eurozone but its government has been severely criticised for its dilly-dally approach. So, overall it is all very chaotic and complex at the moment. Finally a reminder for all those who forget/prefer to forget economic history so quickly. I mean it is just amazing. Before the crisis in Sep-08 we kept saying we will not be impacted because of the global crisis for all kinds of reasons. This was especially the case for financial market players. And then the crisis hit and hit them hard with equity markets declining from 21000 levels to 8000 levels. And again, it rose not because of some Indian economy wonders but because global financial markets started picking up (or stopped declining). Infact much of the gains in Indian economy did not come from some economy wonders but government wonders. And as global crisis eased, we preferred to call it a one time event etc. As Europe started to decline, we again laughed off when asked whether we could be impacted. And again it is the same set of people expressing confidence over Indian economy etc. And now we are seeing some strains on equity markets, capital inflows etc. We may not be impacted by the European crisis as much as previous crisis, but forgetting history so quickly is a crime. It drives you nuts really.

SUMMARY The crisis is having a profound impact on all regions in the world, including the EUs neighbours. However, the extent and timing of the effects differ depending on structural characteristics and policy responses. As regards transmission channels, eastern neighbours have felt the impact of the crisis more directly than Mediterranean neighbours, reflecting the higher dependence on foreign inflows (and for some oncommodity exports which suddenly became much lower priced), stronger financial linkages, and the openness of financial accounts. The direct impact on Mediterranean neighbours appears to have been more muted, reflecting their more closed structure, relatively conservative financing pattern and also due to the rebalancing of Gulf region investment that helped cushion the shock. EU neighbor countries both in the south and the east are at risk of facing a prolonged adjustment process as the feedbacks to the real economy and to public finances weigh in. In addressing the crisis, policy makers in the region face significant challenges in order to ensure economic stability and sustainable development. Whereas the crisis has dented near term prospects, it should not be allowed to derail the structural reforms that are much needed to secure sustainable welfare gains in future. 1.1. INTRODUCTION The global financial crisis which initially emerged in 2007 and which worsened dramatically in the autumn of 2008 has triggered a global recession unprecedented since the Second World War. Although the initial effects of the crisis were mostly felt in the financial systems of advanced economies, emerging and developing economies were affected as heavily or even more so as financial stress compounded in the second half of 2008. The dramatic decline in world trade, falling remittances, rising financing costs, heightened uncertainty, reversals in credit and capital flows and ongoing adjustments in asset prices and exchange rates all affect emerging economies. Both advanced and emerging economies are weathering a very deep and largely synchronous downturn, underlining the

interdependence of the global economy. The current crisis is also exceptional in that in both advanced and emerging economies, debt, banking, equity and foreign exchange markets are all affected simultaneously. The main emphasis of this chapter is on the impact on financial markets, asset prices, exchange rates, banking systems and external positions in EU neighbouring countries. Issues of financial market development and financial stability are crucial to account for the way the crisis affects the economies to discern risks and vulnerability and to identify policy options to address the situation. The next section describes the main transmission channels of the crisis, whereas section 1.3 assesses empirical evidence of financial exposures and other financial indicators on a range of aspects of the EUs neighbouring region. Section 1.4 gives an overview of policy reactions and addresses some policy issues that arise at this juncture, touching upon protectionism versus free trade, and privatization versus nationalisation. The final section summarises and concludes. 1.2. TRANSMISSION CHANNELS In recent years, emerging markets have benefited from a general strategy of low risk aversion and increased integration and interdependence in the global economy, coupled with booming trade and foreign investment and enhanced financial integration (albeit unevenly spread across regions). EU neighbouring countries, both in the southern Mediterranean and to the east, were no exception. In the past few years, all benefited from robust growth, partly triggered by inflows of capital. However, in 2007 and the first half of 2008 soaring food and commodity prices led to substantial terms-of-trade losses for commodity importing countries, which include most neighbouring countries. By contrast, export revenues for energy exporters soared (of the EUs neighbouring countries this mainly concerned Algeria, Azerbaijan, Libya and Russia). In these countries the proceeds of export revenues fuelled a boom in demand. In addition, recycling petrodollars from the Gulf region added to the external stimulus experienced by several southern Mediterranean countries. With the benefit of hindsight, the dramatic increase in commodity prices and the substantial global imbalances that had built up were symptoms of unsustainable development that led to the sharp and synchronised downturn in the global economy in the second half of 2008, triggered by the crisis in the financial markets. The impact on emerging economies is differentiated according to economic fundamentals, the structure of the affected economies and their linkages with other economies (1), and the kind of policy responses. Transmission channels are further shaped by various feedback loops. They operate simultaneously, determined by factors such as expectations, liquidity needs, and adjustment of external imbalances, flight-to-quality, and portfolio rebalancing. The substantial progress of globalisation, trade integration and dependence on external financing and foreign investment and remittance flows

also meant that the world economy had no good shield against the synchronized downturn which occurred in the recent extraordinary circumstances. Naturally, countries with strong initial conditions are better placed to accommodate the global shock without excessive disruption. Also, strong and coherent policy responses should be able to mitigate the negative consequences. But even in the best of cases, the current downturn will put unusually high pressure on several of the EU neighbor countries in terms of their adjustment as the crisis exposed previously existing vulnerabilities. While some of the feed-through occurred with a lag, the adjustment process can be expected to take several stages, and on the whole to be protracted by historical standards. Most vulnerable to the direct negative impact of the crisis originating in financial markets were emerging economies with a high external exposure depending on leveraged finance, with strong trade linkages and with few restrictions on capital movements. There are several reasons for this. First, the global re-pricing of risk was felt more acutely in markets where risk premia had been compressed more strongly. Second, higher financing costs and capital needs in the financial sector typically led to a more pronounced process of deleveraging and adjustment in crossborder capital flows from which countries with capital restrictions were more insulated. Third, countries with a high dependence on trade, especially on commodities, were particularly hard hit by the slump in commodity prices and/or by the sharp decrease in trade. That said, relative isolation has not come for free. Countries which were less integrated globally and were more shielded from the first impact in past years have suffered the costs of a lack of integration in international markets through foregone investment opportunities and growth. They are affected by the secondary effects of the crisis, with structural weaknesses in their economies reducing the options to limit the negative impact. As regards tracking the impact of the crisis, the analysis focuses on three main channels of transmission: First, on the real side, there is the trade channel, which acts powerfully and with a relatively short lag operating through the negative impact of weakening world demand on exports. Second, lower commodity prices not only reduce export revenues of many emerging and developing economies which rely heavily on commodity exports, but, when compounded by underlying vulnerabilities, have also exacerbated the downward correction in stock markets and exchange rates and affected expectations more generally. Here again, the impact varies considerably depending on whether the countries are either resource-rich economies that are net exporters of commodities, or net importers in that they depend on the relative dependence on commodity imports.

Third, financial transmission channels have been at work. There are multiple complex channels operating here, and attention in terms of concrete indicators is focused on equity prices interest rate spreads and thus financing conditions and exchange rates. The impact on capital flows, as well as on the financial sector is more difficult to gauge directly. Changes in cross-border financial exposures partly depend on the pattern of deleveraging and unwinding that has taken place, a process which is also far from finished. Similarly, the structure and institutional set-up of the domestic banking system shape the effect on the real economy. There are severe difficulties in fathoming these transmission channels, especially in the often relatively underdeveloped financial systems of several neighbour countries. Some measures to gauge financial transmissions are presented below, in particular on external debt and the exposure to financial institutions and markets in advanced economies. Finally, feed-back loops to the real economy will occur with a lag, via the effect on credit, balance sheets and financial wealth, public finances, profits, and employment. But they become visible with a longer lag. As regards the scope for policy reactions, initial fiscal positions, monetary and exchange rate frameworks and the level of reserves are important determinants. But across EU neighbour countries, the type and intensity of policy reactions have varied considerably, also in function of the available room for manoeuvre (see section 1.4 on policy issues). 1.3. TRACKING THE IMPACT OF THE CRISIS This section attempts a stock taking of the impact of the crisis on EU neighbour economies through a set of available indicators on the real and financial spheres. The spectacular fall in global trade since late 2008 is comparable only to the 1930s. The trade channel has arguably been the most powerful immediate link through which the downturn in advanced economies dragged down economic growth and growth prospects in neighbor countries, even those with a relatively small external exposure and strong initial positions. Countries heavily dependent on exports to the EU and the US, which are facing a sharp contraction in activity, are particularly affected. Moldova, Morocco, Tunisia and Ukraine are cases in point. Tourism is also negatively affected, which would accentuate the slowdown in countries with a large tourism sector, notably in the Mediterranean. In view of the expected downturn in exports, the slowdown in domestic demand (most pronounced for countries where external funding had been an important driver of growth), current account positions are forecast to continue the adjustment already evident towards the end of 2008. The fall in capital inflows and slowdown in domestic demand are expected to trigger a further adjustment in the current account of neighbour countries with external deficits. For the oil-producing surplus

countries, a marked decrease in the current account surplus is projected, with some moving to deficits. With respect to financial transmission channels, share prices have fallen markedly across the EU neighbours since the start of the crisis (box I.1.1). In the initial stages of financial turmoil (from the summer of 2007 onwards), share prices still increased in many neighbor countries, in particular in those exporting petroleum and natural gas. However, as the crisis intensified in the autumn of 2008, share prices started to slide in most Mediterranean, CIS and Gulf countries, against the backdrop of re-pricing of risk, sharp decreases in international capital flows, and rapid decreases in commodity prices. The recent stabilisation or modest increase in share prices only very partly offset these heavy falls. Relatively low market capitalizations limited wealth effects on the real economy in most eastern neighbour countries. For Russia, this would be due to a high degree of concentration of share ownership and a relatively large share of foreign holdings. A similar reasoning applies to Mediterranean countries, even though some of them have fairly developed stock exchanges (notably Egypt, Jordan and Morocco) with a stock market capitalisation of around 100% of GDP before the crisis. But it is likely that also in those countries any negative impact on the real economy via wealth effects is mitigated by the low diffusion of share ownership among the domestic population. Especially in the Mediterranean, soaring share prices were partly a symptom of a lack of financial investment and diversification outlets in the wake of vigorous economic expansion and foreign inflows that were partly related to oil revenues on the back of the commodity price boom. Nevertheless, the fall in share prices registered among neighbour economies in several cases are as sharp as in advanced economies. They may be evidence of a broadbased worsening in sentiment. Adjustments to exchange rates are another main transmission channel. In several neighbouring countries, this has put the authorities to the test as regards their commitment to prevailing exchange rate arrangements, in some cases putting a drag on reserves. It is revealing that no amount of foreign reserves has proven sufficient to insulate a country from the effects of the crisis. On the whole, exchange rate pressures in the EUs eastern neighbours have been more intense than in its southern neighbours. This is unsurprising in view of their greater dependence on foreign funding, greater openness of financial accounts and hence greater sensitivity to changes in investor sentiment. As a result, significant exchange rate adjustments occurred. Some countries (Armenia, Belarus, Georgia) were forced to realign or adjust de facto pegs to the dollar in response to pressure on the currency.Ukraine suffered intense depreciation pressure at the height of the financial turmoil, resulting in significant devaluation. In Russia, foreign currency

reserves were partly used to accommodate a gradual but quite marked depreciation of the exchange rate. To the extent that the monetary authorities increased policy interest rates to stabilise the exchange rate, monetary conditions tightened. By contrast, the external anchors of exchange rates in Mediterranean neighbours have so far been more resilient. Several southern Mediterranean countries peg their currencies to the US dollar whereas others, notably Morocco and Tunisia, closely shadow the euro. To date, southern EU neighbours have been broadly successful in maintaining stable exchange rates, albeit in some