India Friday 2 July 2010 - Following the global financial crisis that started in late 2008, the argument that India is decoupled from the rest of the world does not hold good, says a study released on Thursday by the Reserve Bank of India (RBI).
The Report on Currency and Finance, by the department of economic analysis and policy of the central bank, said India and other emerging market economies are now more closely linked to the global economy than in the 1990s.
The effect of this was particularly visible after the global financial crisis that emerged after the collapse of Lehman Brothers Holdings Inc. in September 2008.
“Until the global crisis, the Indian economy exhibited remarkable resilience to various adverse external developments, despite the increasing openness of the economy since the 1990s,” the study noted.
However, “global developments became important for the economy due to the significant increase in trade and finance openness,” it pointed out, adding that while the share of exports and imports in the aggregate demand has risen sharply during the current decade compared to the 1980s and 1990s, that of private consumption has fallen.
The shift in the make-up of aggregate demand led to the Indian economy becoming more vulnerable to external shocks, the report said,
This was reflected in the decline in GDP growth of the Indian economy, which fell 3% from its 2006-07 peak. Interestingly, the slowdown happened despite the banking and financial system in the country remaining “unimpaired”, the report said,
“This intuitively reveals that, in the current context, the decoupling hypothesis may not be tenable in the case of India and other emerging market economies,” it said.
However, RBI deputy governor Subir Gokarn cautioned the study should not be interpreted as representing the central bank’s view.
According to the study, openness in trade has facilitated a higher capital account openness and this “elevated synchronization was eventually reflected in larger transmission of global developments to the Indian economy”.
In particular, financial channels have been “found to be more dominant in transmitting the effects of global developments to the Indian economy during the recent period”, the study pointed out.
The report, quoting RBI governor D. Subbarao, said in the absence of a sufficient cushion of foreign exchange reserves, arresting the pressure on the exchange rate would perhaps have been very challenging.
Indeed, the accumulation of foreign exchange came in handy during the crisis, as the US Reserve extended swap facilities to central banks around the world, underlining the importance of creating a large foreign exchange buffer.
The study also emphasized the importance of strong bond markets and social security nets for emerging markets, including India.
Echoing RBI’s view on government borrowing, the study said “the reversal of monetary accommodation cannot be effective unless there is also a rollback of government borrowing”.
The Union government plans to borrow a record Rs4.57 trillion from the market this year, at a time when the economy is expected to grow at about 8%.
Inflation pressures and strong private demand could be additional constraints. In such a situation, “crowding out”, or when government borrowing hampers private sector borrowing, can become quite real, the study warned.
