By Jahangir Aziz
One of my more enduring memories of the global financial crisis is the stark contrast in the views of policymakers and that of the market in the initial days about the potential damage the crisis could wreck. At that time, I was between jobs, shifting from the public to the private sector. Few days into my ‘gardening’ leave and about four weeks after the fall of Lehman Brothers, I was asked to join a hastily formed government panel, headed by the then Finance Secretary, Arun Ramanathan, to assess the impact of the unfolding crisis on India’s financial markets and recommend countermeasures. Surprisingly, most market participants saw the crisis as a bad passing storm, although many in the panel were already afraid that it could turn out to be a long cold winter. Unable to bridge the gap, the report reflected both the views (and the attendant policy recommendations) leaving it up to the government to make the final choice.
I am glad that the government at the time weighed in on the side of the latter with unprecedented but orthodox fiscal and monetary easing and eschewed resorting to kneejerk capital and regulatory controls. This helped India to minimise the fallout on growth and allowed the economy to recover in the next 18 months alongside the rest of the world. By 2010, it seemed that the coordinated global policy support had done its job. Alas, it wasn’t to be.
The damage to household, corporate, and bank balance sheets in the developed economies was far more extensive than imagined and it would require much larger and unconventional monetary easing and policy support to eventually pull them out of the crisis.
In India, as in China where the policy support was much larger, the ensuing recession in developed economies and the weakness in global demand were used to justify continued policy support and the 2008-09 stimulus was withdrawn at a glacial pace even as both countries posted double-digit growth rates. In India, the situation was considerably worse as a raging inflation buffeted the economy at the same time. Yet, it took nearly 18 months and about 15 hikes just to return the policy interest rate to where it was before the crisis.
The general government’s fiscal deficit, which was nearly doubled to 10.1 percent of GDP in fiscal year 2009-10 (including oil bonds and excluding privatisation, which is the globally accepted and correct way to measure government balances), is yet to be brought down to its pre-crisis (2007-08) level of 5.4 percent of GDP.
The cost of the policy laxity was punitive. The loose fiscal and monetary policies did what they normally do: keeping the economy, inflation, and credit growth on steroids that eventually ramped up the current account deficit to over 6 percent of GDP by the last quarter of 2012. The whiff of the U.S. slowing its quantitative easing pushed India to the brink by mid-2013.
It took 300 basis points of policy rate increase, substantial fiscal tightening squeezed into the last 6 months of a pre-election year budget, and significant subsidies to Indian banks to allay the cost of hedging non-resident Indian dollar deposits to stave off a full-fledged crisis.
In addition, while difficult to ascertain precisely it is likely that a sizeable portion of today’s mammoth non-performing loans can be traced back to projects undertaken before 2013 when the policy profligacy provided the false sense of security that India defied the laws of economics and was immune to global shocks.
In China, the outsized stimulus sparked an investment boom that kept growth flying high and as in India, it was not withdrawn with any urgency. This led to a massive rise in debt, particularly in corporate foreign borrowing. Eventually, the high debt induced a sharp rise in risk premium in 2015-16 that forced capital outflows of around $1.5 trillion and foreign exchange reserves loss of around $1 trillion, along with significant changes to the exchange rate regime and regulatory tightening to eventually contain the fallout.
So what are the lessons from the last ten years for India? In my view, there are three main ones.
- First, India is far more open than is believed to be. Every time the world sneezes, India catches a cold. It happened in 2008, 2013, and it is happening now.
- Second, India’s much-vaunted regulatory and capital controls played virtually no role in either preventing being hit by the crisis or helping in the recovery. On Friday, Sept. 12, 2008, the call money rate had closed at 6.15 percent and banks had borrowed about Rs 14,500 crore from the Reserve Bank of India. Over that weekend, Lehman collapsed. By next Wednesday, the call rate had jumped to over 13 percent and bank borrowing from the RBI had risen to nearly Rs 60,000 crore! In neighboring Indonesia, with a significantly more open capital account, the interbank rate barely inched up in the first week of the crisis.
In the recovery, not the controls but the outsized orthodox monetary and fiscal easing did all the heavy lifting.
- Third, just as it is important to provide unstinted and early policy support when hit by a shock to growth, it is equally crucial to temper the support when the impact begins to dissipate.
Has India learned these lessons? Not really. Monetary and fiscal policies are still based on the belief that India is a closed economy, e.g., the RBI has rarely linked its policy decision to global interest rates. The market and policymakers remain complacent that India’s capital controls provide a buffer against external financial shocks.
Fiscal policy continues to be loose: instead of falling, as popularly believed, India’s overall fiscal deficit has actually risen from 7 percent of GDP in 2013-14, the year of the taper tantrum, to 7.3 percent of GDP in 2017-18.
While the RBI has begun to lift policy rates in the last few months, it seems to be in no rush to push them higher despite GDP growth clocking 8.2 percent in April-June 2018 and global markets drastically reassessing emerging market risk this August.
2008 was a genuine unexpected shock. One can even justify the pre-2013 policy laxity as the global economy was still languishing. But 2018 is different. And financial markets have already fired a shot across the bow.