B.L. Pandit The Global Financial Crisis and the Indian Economy The Global Financial Crisis and the Indian Economy B.L Pandit The Global Financial Crisis and the Indian Economy 13 B.L Pandit Department of Economics, Delhi School of Economics (DSE) University of Delhi New Delhi India ISBN 978-81-322-2394-8 ISBN 978-81-322-2395-5 (eBook) DOI 10.1007/978-81-322-2395-5 Library of Congress Control Number: 2015938729 Springer New Delhi Heidelberg New York Dordrecht London © Springer India 2015 This work is subject to copyright All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed The use of general descriptive names, registered names, trademarks, service marks, etc in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made Printed on acid-free paper Springer (India) Pvt Ltd is part of Springer Science+Business Media (www.springer.com) Preface As a result of economic reforms in the post-1991 period, India became a favourite destination for foreign investment and transfer of new technology Integration of Indian economy with the rest of the world scaled new peaks in terms of large capital inflows and high rates of growth especially during 2003–2007 The global financial crisis of 2008 dealt a severe jolt to this process Some attempts have been made to explain the global financial crisis and its impact on the Indian economy, and one may well ask why another book on the same subject In comparison with other books on the global crisis, this book is organized in a different way It goes deeper into the issues—both at the “policy” and the “impact” levels For examining the role of monetary policy during the recession which accompanied the crisis, an econometric model is specified For quantifying the impact of the crisis on stock prices in India, an empirical model rooted in the theory of portfolio selection is set up and tested The systemic issues responsible for the crisis are treated separately in the book One such issue is that after the collapse of the Bretton Woods system in 1971, the US Dollar became de facto reserve currency for the world; something, that Finance Minister to French President Charles de Gaulle had called an “exorbitant privilege” for the USA This systemic problem turned out to be an important reason responsible for the global crisis On this count, therefore, there is a need for working towards a new international monetary system Another systemic issue is that unlike the commodity markets, financial markets are no candidates for unfettered and unregulated market mechanism Market failures of financial institutions carry huge negative externalities Even the diehard votaries of free markets cannot dismiss the merits of prudential regulation of financial markets Financial innovations by highly trained specialists keep on creating new financial products which at times promise very high expected returns Low rates of interest often lure profit-seeking firms to indulge in trading financial derivatives and other assets involving unknown levels and types of risk This makes it necessary to regulate and monitor investments in financial markets Inept and dishonest rating agencies contributed to the global crisis by handing down false ratings The regulators, some of whom were also under the spell of v vi Preface regulatory capture, did a bad job of regulation and further messed up the situation On top of this, both regulators and rating agencies were virtually incapable of accurately assessing the risks of newly engineered complex financial products The number of unsecured and risky financial securities in circulation increased which triggered the financial crisis For ensuring financial stability, therefore, tackling these problems is an important systemic issue In preparing the manuscript, research support by Pankaj Vashisht of ICRIER (New Delhi, India) and Divya Tuteja of Delhi School of Economics is gratefully acknowledged Sanjeev Sharma, chief systems administrator, Centre for Development Economics, Delhi School of Economics, deserves special thanks for providing programming support Contents 1 Introduction Part I The Systemic Issues of the Global Crisis Genesis of the Global Financial Crisis 2.1 Introduction 2.2 Origin and Manifestation of the Crisis 2.2.1 Easy Money Policy and Increase in Risk Appetite 2.2.2 International Macroeconomic Imbalances 2.2.3 Housing Finance for the Low-Income Households 10 2.2.4 Securitisation—originate-to-distribute Model 11 2.2.5 Role of Financial Engineering 14 2.2.6 Problems in Assessment and Pricing of Risk 14 2.2.7 Governance Failure and/or Market Failure 15 2.2.8 Laxity in Supervision and Regulation of Financial Institutions 15 2.2.9 Regulatory Capture 16 2.2.10 Financial Instability Hypothesis 16 2.2.11 The Financial Cycle Hypothesis—A BIS Perspective 17 2.3 Global Impact of the Financial Crisis—A Synoptic View 18 2.4 Concluding Remarks 19 References 20 Financial Liberalization, Economic Development and Regulation 23 3.1 Introduction 24 3.2 Micro-economic Issues in Regulating a Financial Firm 24 3.3 Indian Experience in Public Ownership of Financial Institutions—A Digression 25 vii Contents viii 3.4 Financial Development, Liberalization and Economic Growth 27 3.4.1 Financial Liberalization, Rate of Interest and Savings 30 3.4.2 Financial Growth and Economic Development—The Causality 31 3.5 Regulation of Financial Markets 32 3.5.1 How Financial Markets Differ from Commodity Markets 33 3.5.2 Negative Externalities and Financial Regulation 34 3.6 Concluding Remarks 35 References 35 Towards a New International Monetary System 37 4.1 Introduction 38 4.2 Some Developments in International Finance 38 4.3 US Dollar as De Facto International Currency 39 4.4 SDR as International Reserve Currency 40 4.4.1 SDR in the Post-Crisis Period 41 4.5 Post-Crisis Scenario in International Finance 42 4.5.1 A Multi-Currency System in a Multi-Polar World 42 4.5.2 Need for Reforms 43 4.5.3 Benefits of Multipolarity 44 4.6 Concluding Remarks 47 References 47 Part II Global Crisis and Indian Economy Monetary Policy Transmission: Cointegration and Vector Error Correction Analysis 51 5.1 Introduction 51 5.2 Transmission of Monetary Policy 52 5.3 Estimation Framework 54 5.3.1 DF-GLS Test for the Presence of a Unit Root 54 5.3.2 KPSS Unit Root Test 54 5.3.3 Cointegration and VECM Framework 55 5.4 Data and Empirical Model 58 5.5 Empirical Results for the Crisis Period 58 5.5.1 Model A 60 5.5.2 Model B 62 5.5.3 Model C 65 5.6 Empirical Results for the Entire Period 68 5.6.1 Model D 68 5.7 Concluding Observations 72 References 73 Contents ix Monetary Policy and Credit Demand During the Crisis 75 6.1 Introduction 76 6.2 Research Questions 77 6.3 Role of Monetary Policy: Open Cum Developing Market Economies 82 6.4 Impact of Changes in Policy Rate on Lending and Deposit Rates 83 6.5 Model Specification, Data and Estimation Methodology 84 6.6 Empirical Results 86 6.7 Conclusions 89 References 89 Global Financial Crisis and the Indian Stock Market 91 7.1 Introduction 92 7.2 Objective of the Study 92 7.3 Recent Studies: A Review 94 7.4 World Markets in Crisis 95 7.5 Global Integration of Indian Economy 97 7.6 Indian Stocks During the Crisis 97 7.7 Analytics of Stock Pricing in a Financial Crisis—Our Model 102 7.8 Empirical Model 103 7.9 Empirical Results 104 7.10 Summing Up 105 References 106 Indian Economy Through the Global Crisis 107 8.1 Introduction 107 8.2 Transmission Channels 108 8.3 Immediate Impact of the Crisis on Indian Economy 109 8.4 Monetary Policy Response to the Global Crisis in India 114 8.4.1 Monetary Policy Measures 114 8.5 Fiscal Policy Response to the Global Crisis in India 116 8.5.1 Union Budget 2008–09—Major Counter Cyclical Fiscal Policy Measures 116 8.5.2 Union Budget 2009–10—Major Counter Cyclical Fiscal Policy Measures 117 8.6 RBI Policy Interventions and Financial Stability 118 8.7 Post-crisis Inflation in India 119 8.7.1 Opening of the Economy and Imported Inflation 119 8.7.2 Policy Perspectives in an Open Economy 121 8.7.3 Is the Recent Inflation Rooted in High Rate of Growth of M1 or M3? 121 8.7.4 Structural Aspects of Current Inflation 123 8.7.5 Inflation, Per Capita Expenditures, Wage Rates and Corporate Wage Bill 124 x Contents 8.7.6 Trading of Agricultural Commodity Futures 125 8.7.7 Recent Inflation in India—A Summing up 126 8.8 Globalization, Economic Growth and Employment 126 8.8.1 Survey Data on Unemployment in India 127 8.8.2 Recent Scenario of Employment 128 8.9 Post-Crisis Post-Script 131 8.10 Concluding Remarks 134 References 136 9 Conclusions 137 9.1 Part I 138 9.2 Part II 138 Index 141 8.8 Globalization, Economic Growth and Employment 127 In a period of globalization and market led growth with new labour- saving technology as the driver, profit maximization is achieved at the cost of employment (for an excellent discussion at the industry level, see Mitra 2013) Adopting new technology is expensive for a firm The logic of the market suggests that cost-cutting can be achieved by attrition of workers and making the best use of new technology However, it must be emphasized that at the economy-wide level, growth in output and keeping unemployment under control are two distinct objectives and have to be treated as such by policy makers At the micro-level of a firm, increase in labour productivity and the number of workers employed are inversely related by definition At an economy-wide level, this need not be so The reason is that under globalization, growth in overall labour productivity results in growth of output As a result, income levels go up creating the second-round multiplier cum accelerator impact on consumption and investment and thereby on effective demand and employment It is generally observed that in most of the developing economies under globalization, demand for new jobs exceeds their availability This is because of (a) worsening comparative advantage of the domestic firms due to severe competition from MNCs leading to attrition of workers or even closure of firms, (b) larger displacement of labour following use of new imported technology which is labour saving and (c) new jobs available with MNCs and high-end domestic firms asking for higher skills, not fulfilled by large number of new entrants in the job market Can market forces ensure creation of enough additional jobs to take care of the new technologically unemployed workers under globalization? This is the first important question Stiglitz (2002) very clearly states that this does not happen always and may not happen soon enough unless the state tailors its policies to heal the wounds inflicted by globalization Second inter-related issue is, will wage rates and salaries fall and as per the neo-liberal/free-market view, would it induce firms to hire additional workers? Third, would an elected government intervene to reduce the rate of unemployment and poverty ratios, especially when there are no unemployment benefits in place? Last, in a market led economy would trade unions make an attempt and succeed in thwarting the employers’ moves for attrition of workers? These are some of the important issues which may not have quick solutions 8.8.1 Survey Data on Unemployment in India There are four ways in which the unemployment status of the unemployed labour force is reported in the survey rounds conducted by National Sample Survey Organization (NSSO) of Government of India Usual Principal Status: A person is considered unemployed according to this concept if available for work but without work for major part of the reporting year Usual Principal and Subsidiary Status: includes besides the unemployed labour force under usual principal status, those available but unable to find work on a subsidiary basis during the reporting year 128 8 Indian Economy Through the Global Crisis Current Weekly Status: A person is considered unemployed if available for work, but unable to find work even for one hour during the reference week Current Daily Status: It measures unemployment in terms of person days of all persons in the labour force during the reference week The survey data of NSSO on employment status of the work force given below, starting from 43rd round to 66th round, cover the period from the reference year, July 1987–June 1988 to reference year July 2009–June 2010 The 68th Round of NSSO has also released some data for the period July 2010 to June 2012 (Table 8.12) 8.8.2 Recent Scenario of Employment In a low-income economy like India with high levels of deprivation and poverty and no social security benefits for the jobless, unemployment is a curse Has the short honeymoon with globalization helped India to generate more jobs? Based on the NSS Surveys, the comparison of some facts is given here for us to draw our conclusions In the reference period July 2009–2010, 66th round of NSSO has shown that as per the data on worker–population ratio (principal and subsidiary status), only 39 persons/person days out of every 100 persons or person days in India are employed This includes people with jobs and the self-employed The employment intensity shown by number of persons employed per lakh of real GDP declined to 1.05 in 2010 from 1.71 in 2005 In the manufacturing sector during 2005–2010, employment declined by 7 % despite faster growth in the manufacturing output In the services sector, employment growth slowed in financial intermediation and business services Between 2005 and 2010, addition to jobs was 27.7 million But the number of self-employed declined by 25.5 million This restricted the increase in the number of employed persons to 2.2 million (compares unfavourably with the number of new job seekers during five years) Employment in the construction sector during 2005–2010 increased by over 70 % but it was mainly in casual jobs Does globalization inevitably lead to increase in unemployment? Joseph Stiglitz in his book “Globalisation and Its Discontents” (p 248) says “Globalisation has helped hundreds of millions of people attain higher standards of living… Countries that have benefited the most have been those that took charge of their own destiny and recognized the role government can play in development… But for millions of people globalization has not worked Many have actually been made worse off as they have seen their jobs destroyed… They have felt increasingly powerless against forces beyond their control.” Survey period July 1987–June 1988 July 1989–June 1990 July 1990–June 1991 July–December 1991 January–December 1992 January–June 1993 July 1993–June 1994 July 1994–June 1995 July 1995–June 1996 January–December 1997 January–June 1998 July 1999–June 2000 July 2000–June 2001 July 2001–June 2002 July–December 2002 January–December 2003 January–June 2004 July 2004–June 2005 July 2005–June 2006 Round Rural 43 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 739 716 705 748 753 749 739 752 746 757 755 712 688 672 685 704 654 662 648 Male Primary sector PS 123 120 123 112 106 110 113 104 115 106 103 127 137 148 140 143 163 157 167 Secondary sector PS 138 164 172 140 141 141 148 144 139 137 142 161 175 180 175 153 183 181 185 Tertiary sector PS 825 800 842 859 858 862 847 862 854 875 876 841 812 819 834 841 820 814 798 Female Primary Sector PS Table 8.12 Employment situation in India—per 1000 employed. Distribution of usually employed by sectors 112 130 83 79 78 77 91 88 87 77 70 93 139 124 91 99 102 108 121 Secondary sector PS 63 70 75 62 64 61 62 50 59 47 54 66 49 57 75 60 78 76 82 (continued) Tertiary sector PS 8.8 Globalization, Economic Growth and Employment 129 July 2007–June 2008 July 2009–June 2010 64 66 Male Primary sector PS 662 625 Secondary sector PS 164 195 Tertiary sector PS 175 180 Female Primary Sector PS 816 789 PS Principal status Primary sector Agriculture and allied activities Secondary sector Mining and quarrying, manufacturing, electricity, water, etc., and other services Tertiary sector Trade, hotels and restaurants, transport, storage and communication and other services Note Data on NSS round 66 relate to quinquennial rounds Source National sample survey organization, ministry of statistics and programme implementation, government of India Survey period Round Table 8.12 (continued) Secondary sector PS 103 121 Tertiary sector PS 82 91 130 8 Indian Economy Through the Global Crisis 8.9 Post-Crisis Post-Script 131 8.9 Post-Crisis Post-Script In this chapter, we have focused on the immediate impact of the global financial crisis on the Indian economy and the monetary and fiscal policy measures implemented in the immediate aftermath of the crisis The severest impact was experienced from September 2008 to March–April 2009 An interesting question is how did the Indian economy behave in, say, 2010–11 and 2011–12—the period immediately following the crisis for which data on the broad parameters are available Figure 8.6 shows exports, imports, net invisibles and current account balance- all as per cent of GDP After registering a fall during the crisis, all these variables have shown an unmistakable upward trend The stock indices NIFTY and BSE Sensex are shown in Figs. 8.7 and 8.8 Both these indices register a fall during the crisis but subsequently bounce upwards The Index of Industrial Production (IIP) based on the three different base years is shown in Fig. 8.9a–c The general index has shown a rising trend in the post-crisis period In Table 8.13, we present rate of growth of GDP at factor cost from 2000–01 to 2011–12 After a sharp dip in rate of growth in 2008–09, in subsequent years rate of growth has been rising The rate of growth of 6.5 % in 2011–12 is low, but excluding China, it is higher than the rates of growth in other countries Foreign portfolio investment (FPI) turned negative in 2008–09 because of reversal of portfolio capital flows in that year but in subsequent years FDI and portfolio investment have shown an upward trend till 2010–11 The data in Table 8.14 give similar information about FDI and FPI for shorter durations 30 28 Exports (%GDP) Imports (%GDP) Net Invisibles (%GDP) Current A/c Deficit (%GDP) 26 24 22 20 18 16 14 12 10 -2 -4 -6 Fig. 8.6 Exports, imports, net invisibles, current account balance (as % of GDP) Fig. 8.8 Bombay Stock Exchange sensitive stock price index BSE SENSEX 17000 15000 13000 11000 9000 7000 5000 Mar-10 Feb-10 Jan-10 Dec-09 Nov-09 Oct-09 Sep-09 Aug-09 Jul-09 Jun-09 May-09 Apr-09 Mar-09 Feb-09 Jan-09 Dec-08 Nov-08 Oct-08 Sep-08 Aug-08 Jul-08 Jun-08 May-08 Apr-08 Mar-08 Apr-10 19000 May-10 BSE SENSEX May-10 Fig. 8.7 Stock price index NIFTY Apr-10 Mar-10 Feb-10 Jan-10 Dec-09 Nov-09 Oct-09 Sep-09 Aug-09 Jul-09 Jun-09 May-09 Apr-09 Mar-09 Jan-08 Feb-08 6000 Feb-09 21000 Jan-09 Dec-08 Nov-08 Oct-08 Sep-08 Aug-08 Jul-08 Jun-08 May-08 Apr-08 Mar-08 Feb-08 Jan-08 132 8 Indian Economy Through the Global Crisis NIFTY 5500 NIFTY 5000 4500 4000 3500 3000 2500 2000 8.9 Post-Crisis Post-Script 133 (a) Base 1980-81=100 300 280 260 240 220 200 180 Mining & quarrying 160 1990-91 Manufacturing 1991-92 (b) Electricity 1992-93 General 1993-94 Base 1993-94=100 250 Mining & quarrying Manufacturing Electricity General 200 150 100 (c) 2004-05 2003-04 2002-03 2001-02 2000-01 1999-2000 1998-99 1997-98 1996-97 1995-96 1994-95 50 Base 2004-05=100 200 Mining & quarrying Manufacturing Electricity General 180 160 140 120 100 80 60 2005-06 2006-07 2007-08 2008-09 Fig. 8.9 a Index of Industrial Production IIP b IIP c IIP 2009-10 2010-11 2011-12 8 Indian Economy Through the Global Crisis 134 Table 8.13 Growth rate % (GDP at factor cost) foreign investment flows (million US dollars) Year 2000–01 01–02 02–03 03–04 04–05 05–06 06–07 07–08 08–09 09–10 10–11 11–12 Growth rate % (GDP at factor cost) 4.3 5.5 4.0 8.1 7.0 9.5 9.6 9.3 6.7 8.4 8.4 6.5 Gross investment Repatriation FDI by India Net FDI Net portfolio investment Total foreign investment 4029 6130 5035 4322 6051 8961 22,826 34,843 41,873 37,745 24,847 46,553 59 65 61 87 116 166 4637 7018 13,598 759 1391 1819 1934 2274 5867 15,046 18,836 19,364 15,143 162,524 10,950 3270 4734 3157 2388 3712 3033 7693 15,891 22,343 17,965 11,305 22,006 2590 1952 944 11,377 9291 12,492 6947 27,434 (−)14032 32,396 30,292 17,171 5860 6686 4101 13,765 13,003 15,525 14,640 43,325 8311 53,361 41,597 39,177 Data Source RBI (2011, 2012) 8.10 Concluding Remarks Indian policy makers implemented a well-thought-out policy package to fight the global financial crisis Due to prudential regulatory measures implemented by Reserve Bank of India since early 1990s, financial stability of the economy was not endangered As we mentioned in Sect. 8.9 above, after registering a dip during the crisis, most parameters like rate of economic growth, foreign investment, stock market activity, exports and imports did bounce back, but the data given in Table 8.15 show that domestic industrial investment has not picked up the earlier tempo In India, a number of uncertainties continue to pose serious challenges to growth and economic stability These include the following: (i) domestic inflation and uncertain behaviour of oil prices, (ii) magnitude of foreign direct investment, (iii) increasing ratio of external debt to GDP, (iv) slowdown in the manufacturing sector contributing to a situation of jobless growth, (v) high level of fiscal deficit and (v) generally falling value of Indian rupee after economic reforms of 1991 Current a/c deficit Net software services exported NFDI NFPI Current a/c deficit Net software services exported NFDI NFPI Item Item July– September 2008 ( − ) 39,121 11,435 9552 ( − ) 1301 July– Sept 2010 ( − ) 36,976 11,870 7487 19,252 April–June 2008 ( − ) 25,201 11,237 12,649 ( − ) 4178 April–June 2010 ( − ) 31,908 11,752 6748 4652 6140 7391 Oct– Dec 2010 ( − ) 31,523 14,034 10,937 ( − ) 5787 October– December 2008 ( − ) 34,994 10,694 5509 176 Jan– March 2011 ( − ) 30,187 15,610 8599 ( − ) 2589 Jan– March 2009 ( − ) 20,205 10,370 12,388 2750 April– June 2011 ( − ) 45,009 14,648 8899 8270 April– June 2009 ( − ) 26,281 10,613 9478 ( − ) 1383 July– Sept 2011 ( − ) 44,528 13,633 10,823 9701 July– September 2009 ( − ) 29,591 10,769 6873 1945 Oct– Dec 2011 ( −) 48,704 15,806 9259 5729 Oct– December 2009 ( −) 30,930 12,864 4214 14,098 Jan– March 2012 ( − ) 51,518 16,870 6126 8676 Jan– March 2010 ( − ) 31,402 13,940 Table 8.14 Net foreign direct investment (NFDI) Net foreign portfolio investment (NFPI) Net foreign direct investment (NFDI) Net foreign portfolio investment (NFPI) (Million US dollars) 8.10 Concluding Remarks 135 8 Indian Economy Through the Global Crisis 136 Table 8.15 New capital issued by nongovernment public limited companies (rupees billion) 2008–09 May June April 3.07 12.85 4.39 Nov Dec Oct 1.48 13.70 1.28 2009–10 May June April 0.09 2.27 Zero Nov Dec Oct 8.78 35.87 20.23 2010–11 May June April 24.86 29.47 23.04 Nov Dec Oct 16.86 9.85 24.74 2011–12 May June April 2.03 1.96 20.23 Nov Dec Oct Zero Zero Zero Data Source RBI (2011, 2012) July 2.61 Jan Zero Aug 3.68 Feb 0.24 Sept 96.99 March 6.40 July 31.79 Jan 21.01 Aug 3.66 Feb 52.74 Sept 30.33 March 48.03 July 10.96 Jan 36.18 Aug 9.96 Feb 7.42 Sept 34.46 March 18.52 July 14.47 Jan Zero Aug 9.24 Feb 7.92 Sept 22.75 March 2.91 References Ministry of Finance, Government of India Union Budget 2008–09 Ministry of Finance, Government of India, Economic Survey, various issues Mitra A (2013) Insights into inclusive growth, employment and wellbeing in India Springer, Berlin Mohanty D (2011) Changing inflation dynamics in India Reserve Bank of India, website National Sample Survey Organisation, Ministry of Statistics and Programme Implementation, Government of India National Sample Survey 68th Round Pandit BL, Siddharthan NS (2009) Changing policy regimes and corporate performance Oxford University Press, New Delhi Reserve Bank of India, Macroeconomic and Monetary Developments, various issues Reserve Bank of India (2010) Handbook of statistics on Indian economy, Mumbai Reserve Bank of India (2011) Handbook of statistics on Indian economy, Mumbai Reserve Bank of India (2012) Handbook of statistics on Indian economy, Mumbai Stiglitz J (2002) Globalisation and its discontents Allen Lane (Penguin), London Chapter Conclusions Abstract Origin of the financial crisis of 2008 is traced to two fundamental issues: serious flaws in regulation of the financial sector and dominance of US dollar in international finance It is argued in this book how financial innovations created financial products whose risk assessment was difficult In the absence of efficient regulations, such risky assets were offloaded on investors Increase in circulation of tainted assets intensified the crisis which had begun with subprime loans in the US housing sector Dominance of US dollar created international macroeconomic imbalances in a unipolar international financial system The book argues for regulating the financial sector and gradually establishing multipolarity in international finance Monetary and fiscal policy measures, along with the extant prudential regulation of banking sector, helped the Indian policy makers in successfully reducing the fury of the crisis Nevertheless, India’s stock market and the real sector of the Indian economy had to bear the brunt of the crisis Inward portfolio capital flows reversed, export demand shrank, and stock prices plummeted Large chunks of financial wealth were shaved off and recession set in It is argued that for the Indian economy, the crisis indicated the inevitable flip side of the impact of global integration of Indian economy For more than a decade prior to the crisis, Indian economy had benefitted in a significant way in terms of increase in capital inflows and transfer of new technology The objective of this study is a twin one First, to understand the genesis of the global financial crisis, while focusing on issues in financial sector regulation and problems with dollar-centric international monetary system, both responsible for lighting the fire of the crisis These issues are dealt with in Part I—Chaps 2, and The second objective is to examine how Indian economy faced the crisis in terms of counter cyclical monetary and fiscal policies and the immediate impact the crisis had, on the stock market and on inflation and unemployment These issues are taken up in Part II—Chaps 5, 6, and © Springer India 2015 B.L Pandit, The Global Financial Crisis and the Indian Economy, DOI 10.1007/978-81-322-2395-5_9 137 138 9 Conclusions 9.1 Part I Tracing the genesis of the crisis to irregularities in regulation of the sprawling financial sector in the USA, one observes the dicey role of financial engineering in creating risky financial innovations which made risk assessment difficult Unloading such high-risk financial products on unsuspecting investors down the line was treated as a routine matter The issue of regulation of the financial sector is discussed in detail We start with micro-theoretic models for tackling the question why there are efficient outcomes under free enterprise However, the critical issue is that if outcomes under private ownership are decidedly better in the nonfinancial sector, why should financial sector be regulated at all? Before we attempt to tackle the issue, if efficiency is ownership-neutral, we digress on the role of the state in financial sector in a developing economy like India There is strong evidence that in India, state control of financial institutions and prudential regulation of financial sector have promoted growth of the financial sector, inclusive growth and financial stability We emphasize the information asymmetry between users of finance and financial firms and the well-known externalities associated with normal working of financial sector All these considerations provide a solid basis for regulating the financial sector Next, we highlight the role of a dollar-centric international monetary system in generating imbalances in the current account of various countries The member countries of the IMF have to put their act together in evolving a new international monetary system in which the emerging market economies get their voting power in proportion to their contribution to world trade and income More importantly, efforts have to be made for a new unit of account for international transaction, with all deficiencies of SDR removed Such an international unit of account should have new weights for national currencies, as per the current share of member countries in world trade and income 9.2 Part II In India, monetary and fiscal policy measures have been successfully deployed in controlling the adverse impact of the crisis Among the monetary policy instruments, we find that changes in a quantity variable such as Cash Reserve Ratio along with changes in repo and Reverse Repo rates have been quite significant in transmitting the desired impact to the economy during the crisis Similarly, the timely fiscal bail outs have been useful in stemming the initial fury of the crisis It has to be acknowledged that so far as India is concerned, the global financial crisis cannot be treated as an isolated event The cyclical ups and downs of Indian economy in stock market activity and business, in general, are observed to be closely correlated with USA, as also with rest of the world, During the high-growth phase after globalization, India has benefitted in a big way through 9.2 Part II 139 technology transfers; foreign direct and portfolio investments; and the outsourcing of business by the USA and other developed economies The country has to learn how to negotiate with the downside risks of globalization The adverse impact of the crisis has been felt quite severely in terms of reversal of portfolio investments especially by the FIIs and huge losses in the stock market valuations of financial wealth Exports have suffered a severe jolt due to the recession which followed the crisis Cost-push inflation and unemployment now seem to be persistent problems Latest in the list is the declining value of Indian rupee which is steeply increasing the import bill without necessarily promoting exports Index A Arrow-Debreu assumptions, 24 Asymmetric information, 23, 33 Auto, realty, consumer durable stock prices, 98 B Balance sheet channel, 53 Bank lending channel, 51, 53 Bank stock prices, 100, 101 Basel report on financial stability, 95 Bretton woods agreement, 38 BRICS development bank, 42 Bubble in housing market, Business cycle of advanced economies and India, 113 C Capital asset pricing model (CAPM), 102 Causality between Indian and US stock prices, 112 Changes in policy rates, 114 Co-integrating equation, 55, 60, 63–65, 68, 70 Contestable markets, 32 Corporate demand for bank credit, 75–77, 84, 88, 89 Credit channel, 53 Credit ratings, 7, 20 CRR, 52, 58, 65–67, 69, 70, 72 Current daily status, 128 Current weekly status, 128 D Demand pressure, 77, 84, 88, 89 Dickey-Fuller generalised least squares (DFGLS), 59, 68 Directed lending, 26, 83 Dot com bubble, 19 E Efficient set theorem, 91, 102 Engle-Granger procedure, 55 Exit policy measures, 114, 115 Exorbitant privilege of US dollar, 40 Expenditure, 116–118, 124, 125 F Fast moving consumer goods (FMCG) stock prices, 98, 101 Financial engineering, 8, 14 Financial performance of corporate sector, 112 Fixed effect model, 86–88 Foreign institutional investors (FII) capital inflows, outflows, 103 G Generalized impulse response function, 57 Generalized least squares (GLS) estimates, 86 Genesis, global financial crisis, Geneva report 2009, 24, 34, 35 Glass-Steagall Act, 10 Granger causality test between S&P 500 and BSE Sensex, 91, 97 Granger representative theorem, 56 Great inflation of Vietnam war, 38 I IMF Article IV, 16 IMF surveillance, 16 Immediate impact of crisis, 108, 109, 131 © Springer India 2015 B.L Pandit, The Global Financial Crisis and the Indian Economy, DOI 10.1007/978-81-322-2395-5 141 Index 142 Impact of interest rate on savings, 31 Imported inflation, 108, 109, 119, 120, 126 Incomplete contracts, 25 Information technology (IT) stock prices, 98 International macroeconomic balances, International trade cycle of advanced economies and India, 113 J Johansen procedure, 55, 56 K KPSS (Kwaitkowski, Phiillips, Schmidt and Shin) test, 54, 59, 68 Q QE1, QE2, 45 R Random effect model, 87 Rates of growth of M1, M3 and WPI (wholesale price index), 122 Regulatory capture, 7, 16 Repo rate, 51, 52, 58, 60–63, 72 Repressionist view, 27, 28 Reverse repo rate, 51, 52, 58, 62–65, 72 Risk enhancing features, 91, 103 Risk mitigating features, 91, 103 M Monetary policy measures, 107, 114, 116 Monetary policy transmission, 51–53, 72 Money view of transmission, 52 Multi-polarity in international finance, 44, 45 S SDR, 40 Securitisation, 11 Select economic indicators—world, 113 Stock market volatility, 91, 93–96 Structural aspects of current inflation, 123 Structuralist view, 27, 29 Sub-prime borrowers, Sunk costs, 32 Supervision model, 24, 26 Survey data on unemployment in India, 127 N Negative externalities of financial sector, 24, 34 Neoclassical paradigm, 26, 30 “Non-system” of international finance, 38 T Tax cuts, 116, 117 Teaser loans, 13 Transmission channels of financial crisis, 108 Triffin dilemma, 40, 41 O Oil, gas stock prices, 99, 101 Originate to distribute model, 7, 8, 11, 20 Originate to Hold model, 7, 8, 11 U US fed funds rate, 7, 9, 20 US real interest rate, 7, Usual principal status, 127 Unipolar financial system, 44, 45 L Liquidity injection measures, 115 P Period of great moderation, Pesaran test for unit roots, 86 Post crisis inflation, 119 Priority sector lending, 23, 26 Prudential regulation, 15, 23, 26, 27, 32, 33, 35, 107, 137, 138 V VAR framework, 52 VaR model, 14 Variance decomposition, 57, 61–63, 65, 70, 72 .. .The Global Financial Crisis and the Indian Economy B.L Pandit The Global Financial Crisis and the Indian Economy 13 B.L Pandit Department of Economics, Delhi... Glass–Steagall Act © Springer India 2015 B.L Pandit, The Global Financial Crisis and the Indian Economy, DOI 10.1007/978-81-322-2395-5_2 2 Genesis of the Global Financial Crisis 2.1 Introduction By now,... Genesis of the Global Financial Crisis 18 2.3 Global Impact of the Financial Crisis A Synoptic View The impact of the global financial crisis was transmitted very fast across countries The first