Publications

6.1 This chapter analyses the impact of the global crisis on the real sector of the economy through trade and capital flow channels. The widespread nature of the crisis was evident from the decline in growth rates of real GDP across the spectrum of developed, developing and emerging market economies. As many as 130 countries witnessed a decline of GDP growth in 2008 over 2007 and as many as 166 countries in 2009 over 2008 (World Economic Outlook, IMF, April 2010). The significance of the trade channel during the recent crisis was evident in world trade growth decelerating from 7.3 per cent in 2007 to 2.8 per cent in 2008 and eventually to a negative of 10.7 per cent in 2009.

6.2 Like other EMEs, the early impact of the sub-prime crisis on the real sector of the Indian economy was rather muted as the crisis initially was restricted to turmoil in international financial markets. Following the failure of Lehman Brothers in September 2008, there was a sudden change in the external environment which impacted India adversely through the trade, finance and confidence channels, in line with other EMEs. With the crisis in the advanced economies turning more synchronised globally, the impact became severe in terms of shrinking trade and capital flow reversals during the second half of 2008-09. During this phase, the global financial shocks intensified and graduated into unprecedented worldwide economic slowdown and impacted trade, followed by real sector activities. Against the above backdrop, an assessment of the transmission of the global crisis through the trade and capital flows channels to the real sector as also the ultimate impact on saving, investment and growth has been undertaken in this chapter.

6.3 This chapter is organised as follows. A perspective is given on various channels of transmission of global shock to the real sector in Section I. In Section II, the analysis of the impact emanating from the trade channel is given in detail, while an analysis of the spillovers traversing through the financial channel is given in Section III. The impact of the decline in trade and capital flows reversal on saving, investment and growth is covered in Section IV. Section V contains the concluding observations.

I. TRANSMISSION OF GLOBAL SHOCK TO THE REAL SECTOR

Shift in Composition of Aggregate Demand in India

6.4 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. There were several reasons for this resilience. First, domestic demand played a dominant role in the growth process (Table 6.1). Second, domestic demand was led by private consumption during the first four decades of the independence. Third, a large part of investment demand was supported by domestic savings. Fourth, the services sector, led by domestic demand, contributed to the stability of overall economic growth. Fifth, in the financial sector, the banking sector accounted for a major share of the financial intermediation process which did not have significant exposure to international financial markets.

6.5 Unlike the episode of the late 1990s, the recent global crisis led to a change in perspective on the Indian economy. Global developments became important for the economy due to the significant increase in trade and finance openness (Subbarao, 2009; Reddy, 2007 and 2008). The share of exports and imports in the aggregate demand in India has risen sharply during the current decade compared to the 1980s and 1990s; on the other hand, the share of private consumption has fallen during the same period (Table 6.1). As a result of the compositional shift in aggregate demand, the Indian economy has become more vulnerable to external shocks compared to the earlier period. This is clearly visible in the decline in the growth rate of the Indian economy as the recent global crisis gathered momentum with widespread impact across sectors. The growth rate of the Indian economy moderated sharply to 6.7 per cent in 2008-09, declining by 3.0 percentage points from the peak in 2006-07. At the same time, there was also significant moderation in the growth rates of private consumption and investment activities.

Tenability of Decoupling Hypothesis

6.6 Decoupling of an economy entails significant decline in its business cycle synchronisation with that of other countries, meaning that its business cycle moves independent of the business cycle of another economy/group. During the recent global crisis, policymakers and researchers across the globe were debating in theinitial phase whether emerging markets economies including India have decoupled from advanced economies. However, as the global financial crisis accentuated and graduated into a full-scale economic slowdown encompassing almost all countries including EMEs, this debate seems to have settled against the decoupling of emerging market economies.

6.7 It has been argued that the decoupling hypothesis runs against the idea that globalisation enhances trade linkages and international financial integration, allowing for a stronger transmission of country-specific shocks across countries and hence, stronger business cycle co-movements (Walti, 2009). Kose, Otrok and Prasad (2008) also mention that greater openness to trade and financial flows should make economies more sensitive to external shocks and increase comovements in response to global shocks by widening the channels for these shocks to spill over across countries¹. In contrast, the proponents of the decoupling hypothesis hold that emerging market economies have become increasingly less vulnerable to developments in advanced economies on account of strengthening domestic policy frameworks and achieving stronger domestic demand growth, leading to lower business cycle co-movements with advanced economies.

6.8 Walti (2009) investigated empirically the degree of business cycle synchronisation between emerging market economies and four aggregate groups – all advanced economies, the G7, the United States and the European Union – with annual data from 1980 to 2007. It was concluded that decoupling is largely a myth as business cycle synchronisation has generally not declined over time and certainly not during recent years and, thus, emerging markets have not decoupled from advance economies². Similarly, Rose (2009) investigated the degree of cross-country synchronisation of business cycles in 64 countries taking annual data from 1974 through 2007 and found that countries across the world seem to be moving more closely over time and not less. It was also argued that the evidence presented as indicative of a divergence in economic performance, referred to as decoupling, is not definitive (Kohn, 2008).

6.9 The increased global integration has rendered the Indian economy’s growth movements more correlated with growth movements in the world economy particularly during 2001-2008 compared to the 1980s and 1990s (Table 6.2). It is noteworthy that a large part of increased association between growth in India and world has emanated from emerging and developing economies as reflected by the substantial increase in the correlation compared with advanced economies.

6.10 The increased synchronisation of the Indian economy with the rest of the world was also discernible during the recent global economic slowdown wherein India’s growth also decelerated following the global trend despite having unimpaired banking and financial systems unlike some advanced and emerging market economies (Chart VI.1). 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.

6.11 The decoupling hypothesis in the case of India has been investigated by estimating synchronisation of its growth in GDP and trade with other countries. It has been found that India was not decoupled from the unfolding financial crisis and recession/ slowdown in the USA and other advanced economies as is evident from its very high degree of business cycle synchronisation in income growth with the world economy, advanced economies and emerging & developing economies during recent periods, ranging from the first quarter of 2005 to the second quarter of 2009 (Chart VI.2). The findings of Walti (2009) also reveal that India has not decoupled with respect to any of the four aggregate groups of advanced economies, viz., all advanced economies, the G-7, the United States and the European Union³ .

6.12 Further, the decoupling of the Indian economy from advanced economies and emerging market economies has been explored estimating the evolving bilateral business cycle synchronisation over the periods with quarterly GDP and consumption data from the second quarter of 1996 to the first quarter of 2009. It is found that business cycle synchronisation (in terms of GDP) of the Indian economy with most of the advanced and emerging market economies has increased over time, in particular during recent periods (2006Q1-2009Q2) (Table 6.3).

6.13 On the contrary, the movement in business cycle synchronisation of India in terms of consumption with advanced and emerging economies remained mixed as it has increased over time with some countries, particularly the advanced economies, while declined with others (Table 6.4).

6.14 The degree of co-movements of business cycles of different sectors of an economy with other countries may vary primarily depending on their extent of external openness and exposure through various indirect channels. India’s industrial sector has been increasingly exposed to the world economy with rising merchandise trade and capital from international financial markets. Therefore, an attempt has been made to analyse the comovement of industrial cycles with advanced economies in the wake of contagion emanating from the recent global financial crisis and consequent economic slowdown. The results show that industrial cyclical synchronisation of India with advanced countries, which had fallen sharply from 1995-2000 to 2001-2005 except for Germany, improved substantially in recent periods (2006- 2009)⁴. During recent periods, India’s industrial cycle synchronisation was the highest with Germany, followed by Italy and the US. Another noteworthy feature is the significant increase in industrial synchronisation in recent periods (2006- 2009) with major advanced countries (Chart VI.3). Thus, the strengthening of synchronisation with advanced countries made it difficult for India’s industrial sector to remain unaffected from the spillover effects of the global financial crisis and economic slowdown.

Financial Crisis and Potential Output

6.15 Besides directly affecting potential output through dampening demand and drying up of funding, a financial crisis can also have an impact through indirect effects as crises usually trigger policy responses to counter the damaging effects emanating from the economic downturn (Reinhart and Rogoff, 2009). Such policy responses target the increase in investment in infrastructure in order to boost potential output; at the same time, they may introduce distortions or encourage excessive risktaking. Temporary fiscal measures can lead to permanent increases in the size of government expenditure and in debt levels, which in turn will have negative effects on growth (Afonso and Furceri, 2008). Eventually, the nature and design of policy responses would decide the outcome of the potential output during crisis periods and subsequently. Hoj et al. (2006) mention that financial crises can also foster the implementation of structural reforms that can, in turn, enhance potential output by moderating political opposition to reforms.

6.16 Using the potential output based on the Hodrick-Prescott method, it is observed that the global shocks seem to have marginally impacted India’s trend output growth from the pre-crisis trajectory. It should, however, be emphasised that some of the slowdown in the potential output growth in India was on account of the cyclical slowdown which had already set in before the global crisis started affecting the economy. While in the short run the output path may be impacted by the drop in productivity growth, over the longer horizon, the capital-to-labour ratio and employment growth would determine the loss in potential output. Thus, if an economy witnesses a decline in output relative to its previous trend over the medium term, it could be a decline in potential output but may also represent a persistent decline in aggregate demand.

6.17 It is argued that long-run employment loss may be attributed to the response of labour, capital and factor productivity to the financial crisis (IMF, 2009). If the shocks are significant enough to cause structural unemployment, given the institutional rigidities in the labour markets it may take longer to reach the pre-crisis level of employment, which may drag down productivity in the economy over the medium-term. Second, the crisis may slow down credit expansion and, hence, investment rate through various conduits, such as tighter credit standards, higher borrowing costs, and an adverse impact of asset prices on corporates’ balance sheets through reduction in collaterals. Third, productivity levels may fall due to loss of speed of innovations and reduction in research and development as companies attempt to restructure due to the impact of the crisis. Although it is difficult to quantify the above factors, the impact of the external shocks on investment rate in India may not be as adverse as in the advanced economies (Box VI.1).

Box VI.1

Loss of Potential Growth in India vis-à-vis Emerging Market Economies (EMEs)

Potential output is generally the optimal level of output that can be achieved within natural and institutional constraints without putting pressure on inflation. Potential output has also been called the “natural gross domestic product” and, if the economy is at its potential, the unemployment rate equals the NAIRU or the natural rate of unemployment. The financial crisis often tends to affect the output of an economy through lowering financial intermediation, consumption and investments, and adversely affecting business sentiments; the extent of damage, however, depends on the severity and duration of the crisis. A recent empirical study on OECD countries over the period 1960 to 2007 by Furceri and Mourougane (2009) concludes that financial crises are estimated to lower potential output by around 1.5 to 2.4 per cent on an average. Similarly, Cerra and Saxena (2008) studied the output behaviour in 190 countries and found large and persistent actual output losses associated with financial crises, with output falling by 7.5 per cent relative to trend over a period of 10 years in the event of a banking crisis. If output loss is temporary, prompt and corrective policy initiatives are able to repair the damage and bring the output to the previous trajectory over a shorter span. On the other hand, in case output loss tends to be permanent, i.e., potential output has a structural break and has shifted to a lower trajectory, policymakers have to strive very hard and it might take longer than expected to shift back to the previous trajectory.

During the recent global crisis, the level of financial intermediation decelerated significantly in India, both in terms of bank credit and dent in equity markets. Second, the unemployment rate also went up, especially in exportoriented sectors, although official estimates are not available. Third, merchandise exports contracted at a rapid pace, possibly rendering a significant part of their capital stock and labour force idle if export-oriented enterprising units failed to shift their focus on domestic markets. Hence, in light of the above, it would be worthwhile to estimate the loss of output growth, temporary or permanent (potential), in the case of India vis-à-vis other emerging market economies.

Although, there are various methodologies to estimate potential output, obtaining a reliable measure is fraught with difficulty and, hence, the issue of appropriateness remains unsettled. Nonetheless, the Hodrick-Prescott (HP) filter has been used for deriving a long term “trend” growth using annual as well as quarterly data to assess the loss of output growth during the current crisis. The shift in potential output growth, if any, should be construed preliminary and any inferences from the same need to be made with caveats.

The quarterly estimates of the potential growth based on the HP filter methodology shows that loss in growth, which started from the second quarter of 2008, albeit marginal, followed through the subsequent quarters with around 2.0 percentage points in Q4 of 2008 and Q1 of 2009 and 1.4 percentage points during Q2 of 2009. The trends in potential growth suggest that actual growth in industry has almost caught up with the potential level in Q2 of 2009, indicating a temporary loss of growth. In contrast, loss of growth in the services sector continued to widen. Nevertheless, as mentioned above, these results are preliminary and, therefore, should be used with great caution. Since services contribute about 60 per cent to the GDP, the potential growth in GDP seems to be following the trend in the services sector (Chart 1).

The potential growth in India as well as in some of the emerging market economies (EMEs) was also estimated using the HP filter with annual data from 1980 to 2008. Most of the EMEs including India have experienced loss in actual growth when compared with potential growth during 2008, whereas these countries witnessed gains in actual growth in recent years (Table 1). Russia had the highest growth loss followed by China, Argentina, India, Philippines, and Malaysia during 2008.

References:

1. Cerra, V. and S.C. Saxena. 2008. “Growth Dynamics: The Myth of Economic Recovery”. American Economic Review, 98: 439-457.

2. Furceri, D. and Annabelle Mourougane. 2009. “The Effect of Financial Crises on Potential Output: New Empirical Evidence from OECD Countries”. OECD Economic Department Working Paper 699.

6.18 The shift in the composition of aggregate demand towards exports during the current decade has made the Indian economy more susceptible to global developments. Again, India’s bilateral synchronisation along with business cycle synchronisation with three groups, viz., world economy, advanced, and emerging & developing countries, conclusively reflects the strengthening of the co-movement of India’s business cycle with the rest of the world and, hence, the decoupling hypothesis is not found to be tenable during the recent global financial crisis. Further, during this crisis, several economies including India suffered loss of potential growth. In the next section, the impact of trade channels on the Indian economy is discussed.

II. IMPACT ON INDIA THROUGH TRADE CHANNEL

Impact through Exports

World Income and Exports

6.19 The outlook for international trade was strongly affected during the crisis and world trade performance weakened considerably from the last quarter of 2008. The rising trend witnessed in the growth of world trade was reversed during the crisis and it fell sharply and traversed to the negative zone from the fourth quarter of 2008. Advanced economies led this sharp deterioration in the initial period; however, the emerging and developing economies also caught the downswing (Table 6.5).

6.20 The contracting external demand from advanced economies on account of falling disposable income and heightened uncertainty spilled over to emerging markets and developing countries, concomitantly manifested in the declining international trade of these countries. India’s merchandise trade was also impacted by the falling consumption, particularly in advanced countries, and the slump in trade credit following tightening of international credit market conditions in the aftermath of the collapse of Lehman Brothers in mid-September 2008. The cyclical co-movements between growth in India’s exports and external demand (GDP in world and advanced economies) were highly synchronised during the current global crisis (Chart VI.4). This shows that during normal times, other factors besides world income also play a pivotal role in driving the growth in exports, while the impact stemming from world GDP becomes overriding during a crisis.

6.21 In view of India’s exports being highly elastic to world income, the effect of the contracting world income was reflected in the overall decline in merchandise exports from the third quarter of 2008-09. As per the export demand function estimated by Agarwala (1970), the income and price elasticity coefficients were 0.35 and -0.44, respectively. Another study by RBI (2003) found that short-term and long-term elasticity of demand for India’s exports with respect to world GDP growth was at 0.8 and 1.5, respectively. Further, with the latest data, the long-term elasticity of India’s exports demand was estimated at 3.7 with respect to world GDP (RBI, 2009). This confirms that with high global growth, the pull factor operating on India’s exports could be sizeable. The high income elasticity of exports with respect to world income is reflected across various commodities, with their elasticity improving significantly during the reform period (1993-2008) compared with the 1980s (Table 6.6).

Export and Economic Growth

6.22 As discussed in the previous section, despite the dominant role of domestic demand in shaping the growth path, the role of trade in conditioning the growth process became increasingly important over time, which was also evident from a significant rise in the trade-GDP ratio in the recent period. The direct impact of exports on economic growth could be determined by trade openness and the acceleration in the growth of exports, which in turn could be determined by the elasticity of exports with respect to world income (Box VI.2).

6.23 Within the framework of growth accounting, the contribution of exports to economic growth was negligible during the first two decades after independence. Though it showed some improvement in the 1970s, this could not be sustained during the 1980s. During the reform period, the contribution of exports to economic growth increased during the 1990s and more than doubled during the 2000s (Table 6.7).

Box VI.2 Exports and Domestic Growth Relationship: The Growth Accounting Approach

6.24 In order to further explore the relationship between exports and growth, the Granger causal analysis between GDP growth and exports growth and trade deficit to GDP ratio was undertaken based on annual data during 1950-2008. The Granger Causality results⁵ provided two insights: first, the direction of causal relation between exports and GDP growth rates was from the former to the latter but not vice versa and, second, the direction of the causal relationship between the trade deficit ratio and economic growth was from the latter to the former, which is attributable to the role of imports demand driven by domestic economic activity. The compositional shift in the exports baskets towards technology-intensive commodities during the past few years, spurred by the prominence of exports in the Indian economy, is reflected in their increased contribution to growth.

Exports and Consumption

6.25 The direct contribution of exports to aggregate demand assumed a critical mass and has become a crucial conduit of the trade channel of transmission. Several domestic and external developments which followed the global crisis contributed to the moderation of private consumption growth (Table 6.8). Apart from the direct impact of exports on aggregate demand and growth, exports could indirectly affect growth through consumption and investment. In India, exports and private consumption demand seem to have displayed a close relationship during the recent period.

6.26 There could be a number of indirect channels through which export demand could affect consumption. First, the manufacturing sector has become export-intensive over the period. The share of manufactured exports in manufacturing GDP in India has risen from 27.1 per cent in 1990-91 to 52.2 per cent in 2000-01 and further to 72.3 per cent in 2008-09. This significant export-orientation of manufacturing has also exposed the sector to external demand shocks. Furthermore, a large part of manufacturing exports (42 per cent) is accounted for by leather and manufactures, textile and textile products, gems and jewellery and handicrafts, which are employment-intensive, and a major part of exports in these sectors is contributed by smallscale industries (SSIs). Thus, an external demand shock has a larger impact on output and employment in such industries, which has a direct bearing on domestic consumption demand. Furthermore, there are a number of SSIs that are dependent on the supply chain of the manufacturing export firms, which are also indirectly affected by the external demand shocks.

Impact on Exports: Trend, Composition and Direction

6.27 The trade channel of the contagion that intensified in the post-September 2008 phase of the crisis adversely impacted India’s merchandise trade, with exports declining with greater intensity and more swiftly than during the recession of the early 2000s, in tandem with the steeper recession in the developed countries (Table 6.9).

6.28 An analysis of the shift in the composition of India’s commodity exports reveals some interesting facts. Before the reforms, India’s exports were significantly driven by exports of primary agricultural commodities and manufacturing commodities such as textiles, gems and jewellery; while the commodity composition at the global level was shifting to technology-intensive manufacturing commodities such as engineering goods and chemicals. Thus, despite the growth momentum in the 1980s, India’s share in world exports declined to about 0.5 per cent.

6.29 The reforms and favourable trade policy brought a shift in the composition of India’s commodity exports. Technology-intensive exports comprising engineering goods such as metals, machinery and transport equipment and chemicals, including pharmaceuticals emerged as the leading export sectors for India, signifying the rising prominence of exports in India’s GDP growth (Table 6.10). Besides a shift towards technologyintensive exports, the exports of petroleum products (which showed spectacular growth) emerged as a major contributor to total exports, reflecting the impact of India becoming the sixth largest refinery in the world.

6.30 During 2008-09, the deceleration was, however, modest in the case of manufacturing goods. As a result, share of non-oil exports as well as manufacturing goods exports in total exports increased by around 8 percentage points during 2008-09 over the past year. In sum, this implies the cost competitiveness of the manufacturing sector on account of enhanced efficiency and productivity. At a more disaggregated level, the major commodities that witnessed a decline in exports during 2008-09 were handicrafts, petroleum products, ores and minerals, and agricultural and allied products. The global crisis, however, had a more pronounce impact on India’s exports during 2009-10 (April-October). All sectors including engineering, chemicals, gems and jewellery and petroleum exports witnessed a decline in export growth (Table 6.11).

6.31 The regional direction of India’s exports has also experienced significant changes between 2000 and 2008. First, India’s exports share in traditional markets such as the EU and North America witnessed a significant decline. Second, there was a structural shift in favour of Latin America, ASEAN, West Asia, North Africa and South Asia. In terms of growth, India’s export to developing countries accounted for the largest downturn to (-0.5) per cent during 2008-09 from 33.6 per cent in 2007-08, which was mainly driven by a sharp fall in exports to China. The second largest deceleration in growth of India’s exports was to OECD countries during 2008-09. The US led the deceleration in exports to OECD countries during 2008-09; nevertheless, the US continued to be the single largest contributor to India’s exports (Table 6.12). The increasing share of India’s trade with the above regions could be attributed to factors such as the distance and size of the economies as described in the Gravity Model of international trade. The Gravity Model of international trade is increasingly used to derive measures of divergence in expected volumes of trade between trading partners and their actual trade (Box VI.3).

Box VI.3
The Gravity Model of Foreign Trade

Borrowing from Newtonian physics, the model consists of a single equation postulating that the amount of trade between two countries depends positively on the joint size of the two trading economies and is negatively related to the distance between them. Over time, the Gravity Model of trade has been extended to incorporate a wide variety of other factors. This approach has the benefits of capturing the overall impact of a country’s policy and institutional environment, including a wide variety of artificial impediments, and not just trade policy. A country is found to “under-trade” if its actual trade across trading partners is, on average, below the level predicted by the Gravity Model without explicit policy variables (IMF, 2002; Rose 2002). An analysis of developing countries’ trading patterns, as per the Gravity Model, suggests the following: (i) balance of payments and trade restrictiveness remain important reasons for developing countries to trade less than industrial countries; and (ii) international vertical specialisation, which had played an important role in East Asia, is likely to become more significant for other developing countries with open trading regimes, abundant labour and flexible economies. Full liberalisation of both trade and balance of payments policies in all countries would increase trade between industrial countries (North-North trade) by about 40 per cent, North-South trade by about 63 per cent, and trade between developing countries (South-South trade) by about 94 per cent (IMF, 2002).

6.32 An empirical analysis is undertaken to assess how the broad direction of India’s exports to emerging market economies relative to developed countries was determined by the relative price competitiveness effect and real demand conditions. The long-run elasticity of the direction of India’s exports with respect to relative price was statistically significant and positive at 1.88, higher than the almost unitary elasticity coefficient with respect to relative real demand conditions⁶. However, a significant structural shift since 1991-92 in the model led to a significant moderation of the relative price effect and improvement in the relative real demand effect. The price elasticity coefficient was reduced to 0.49, while the real demand effect improved to 1.44 (Table 6.13). The contraction in India’s exports since October 2008 was mainly conditioned by real demand effects emanating from the sharp fall in real activities in advanced and emerging market economies during the current global crisis.

Leading Exports by Commodities and Firms

6.33 Engineering goods exports have assumed critical proporation in merchandise exports of India during the post-reforms period (Box VI.4). The critical role of engineering and chemicals goods exports was evident during the global crisis. The exports of engineering goods maintained their growth momentum in 2008-09, with a significant acceleration in the growth of transport equipment. The exports of chemicals also remained resilient in 2008-09, albeit with some moderation in growth. The expansion of exports in these two sectors in 2008-09 accounted for the overall expansion of India’s total exports in 2008-09. In 2009-10 (April-October), the decline in engineering goods exports accounted for about a half of the decline in manufactured exports and a third of India’s total exports.

Table 6.13: Relative Price and Real Demand Effects on India’s Broad Direction of Exports
(Long-run Co-integration Coefficients)

Box VI.4

India’s Exports of Engineering Goods

During the reform period, India’s merchandise exports witnessed a notable shift in terms of commodity composition, led by engineering goods. In an environment of increasing openness of the economy and a supportive policy framework since the early 1990s, exports of engineering goods accelerated from US$ 1.2 billion (9.5 per cent of total merchandise exports) in 1987-88 to US$ 47.3 billion in 2008-09 (25.5 per cent of total merchandise exports).The rapid growth of engineering goods exports at a trend growth rate of 27.7 per cent during 2001-02 to 2008-09 was attributable to the growing competitiveness and increasing technological sophistication of India’s manufacturing exports. In 2004-05, engineering goods emerged as the largest item of manufacturing exports, surpassing exports of textiles and gems and jewellery. Within engineering goods, transport equipment emerged as the key driver of exports growth, attributable to the increasing global competitive advantage of India’s automotive industry. According to the Automobile Components Manufacturing Association of India (ACMA), the Indian auto component industry is characterised by the largest three-wheeler market, the second largest twowheeler market, the fourth largest tractor market and the fifth largest commercial vehicle market in the world and the fourth largest passenger vehicle market in Asia. Since the mid-1990s, India’s automotive industry has witnessed rapid transformation from a low-volume and fragmented sector into a highly competitive sector characterised by world-class technology, large and assured volumes and strict delivery schedules in response to the demand from global vehicle manufacturers. Several Indian companies have entered into technological collaborations and equity partnerships with world leaders in automotive components. Some global vehicle manufacturers have set up subsidiaries for components manufacturing facilities in India, taking into account the lower labour cost and the availability of a highly skilled workforce. Furthermore, India’s automotive components industry is highly diversified with a capacity to produce as many as 150 different products. Notwithstanding the recent surge in engineering exports, the technology intensity of India’s exports compared with emerging economies in East Asia and Latin America has the potential for substantial growth. In terms of the global positioning of the automotive industry, the share of India’s exports in the global automotive market remains small (Table). During 2001-2007, India’s exports of machinery and transport equipments posted a trend growth rate of 33.0 per cent compared with the global trend growth rate of the sector at 12.1 per cent. Thus, the share of India’s exports of machinery and transport equipment and automotive components at the global level increased from 0.10 per cent in 2000 to 0.33 per cent by 2007. According to the ACMA, the automotive components industry has to accelerate measures towards improving quality and its competitive position in the global market.

6.34 The significance of the engineering goods, chemicals and textiles industries within the manufacturing sector is evident from their principal economic characteristics. According to the Annual Survey of Industries 2007-08, the engineering goods sector accounted for about a third of aggregate investment, output, value added and employment in the manufacturing sector. Engineering goods, chemicals and textiles together accounted for more than 50 per cent of investment, output, value added and employment in the manufacturing sector (Table 6.14). Therefore, engineering goods assume a critical proportion in the growth of the manufacturing sector in India and the relative resilience displayed by the performance of engineering good exports somewhat insulated the Indian industry from the shocks stemming from sagging external demand during the crisis.

6.35 In order to further ascertain the role of the trade channel in India’s growth, firm-level exportorientation information was examined. The firmlevel export orientation also demonstrates the growing importance of trade channels in the growth of India’s manufacturing sector. An analysis of 1,500 companies from the CMIE database showed that the number of companies with exports-to-sales ratios of 20 per cent or above more than doubled between 1993-94 and 2007-08 (Table 6.15). Their share in manufacturing exports also increased substantially during this period. This trend in firmlevel export orientation was the outcome of the increasing internationalisation of Indian companies. On the back of an increased export orientation, the global shocks spilled over to firms in the manufacturing sector through declining external demand for their products from the third quarter of 2008-09.

Impact through Imports

6.36 Merchandise imports also caught the global downswings in the second half of 2008-09, offsetting some of the adverse impact of contracting exports. The growth in India’s imports plunged sharply during the third quarter of 2008-09, and subsequently contracted from the last quarter of 2008-09 to 2009-10 (April-October). A massive weakening of imports was witnessed in the case of crude oil, capital goods, and gold and silver (Table 6.16).

6.37 There have been a number of subtle compositional shifts in imports within the broad aggregation during the past decade that need to be recognised. For instance, within petroleum imports, there has been a shift from petroleum products to crude oil, following the large-scale increase in refinery capacity within the country. Further, since 2001-02, India has transformed itself from a net importer of petroleum products to a net exporter of the same. Another significant development during the 1990s has been the channelising of gold imports through official routes (Table 6.17). Since 1997 when banks were allowed to import gold, the import of gold through passenger baggage has declined significantly. Industries that have shown the least import propensity since the 1990s and, thereby have gradually been phased out of the import commodity basket, were mainly in the mediumto low-technology, labour-intensive sectors. Similarly, industries with the highest growth rate of imports in the past decade have been largely those with a medium- to high-technology content that produced intermediary products needed for exports.

6.38 Since the opening up of the Indian economy, imports are increasingly sourced from a wider range of countries. Traditional key trading partners like Germany, Japan, UK, and US have subsided in terms of their market share and new import partners from East Asia (especially China) have emerged (Table 6.18). Another important development has been a gradual dissipation of the East European countries as a major source of India’s imports. The high share of OPEC countries in the recent period reflects the magnitude of crude oil imports due to the rising oil-intensity of the Indian economy and high oil prices. Finally, imports from China have increased significantly during recent years from almost minuscule level in the early 1990s.

6.39 Imports, especially those of capital goods, are often considered a leading indicator of industrial activity and the near-term investment climate (Chart VI.5). A sizeable portion of imports gets channelised as inputs for industrial production. A definite relationship between imports and industrial production, however, may be difficult to establish as imported commodities could be either complements or substitutes to domestic industry. As a result, an empirical test of these relations remains largely country-specific. In the Indian case, however, non-oil imports, thus far, have been mostly in the form of capital goods, raw materials and intermediate goods, which complement industrial production.

6.40 An analysis of import elasticity of output in India suggests that imports have grown at a much faster rate with respect to GDP in the 1990s compared to the 1980s, which is consistent with the liberalisation of external trade. The vital importance of imports for the producing sector was evident from the firm-level evidence. According to the CMIE database, the top 100 importing companies accounted for about half of the manufacturing exports in the late 1990s. By 2008, these companies accounted for 80 per cent of manufacturing exports. The import intensity of these firms, as percentage to sales, almost doubled during 1999 to 2008 (Table 6.19).

Impact through Commodity Price Channel

6.41 Another component of the trade channel transmission is global commodities prices, which, inter alia, affects imports and cost of production. Before the unfolding of the recent crisis, global prices of commodities such as crude oil and primary commodities surged significantly due to soaring demand and supply-side constraints and strained the balance of payments of the importing countries across the world. The crude oil prices of the Indian basket peaked at US$ 147 per barrel in July 2008. The significant hardening of global commodity prices, especially crude oil, generated inflationary pressures. The global crisis, however, drastically reduced the demand for these commodities globally and their prices fell sharply, easing the inflationary pressure significantly in the second half of 2008-09.

6.42 The impact of change in prices on value of imports depends on price elasticity of imports and the extent of trade openness. For instance, if merchandise imports are highly price elastic and trade is fairly open, then declining global commodity prices may lead to a rise in imports. The effect of global commodity prices, however, on the cost of production remains unambiguous. In India, oil imports, which constitute a large part of total imports, are critical input for real activities. Oil imports in India are relatively price inelastic and, hence, are highly correlated with their prices. Accordingly, oil imports fell sharply in India during the second half of 2008-09, reflecting declining crude oil prices (Chart VI.6). Imports of non-oil primary commodities are also fairly correlated with their prices as manifested by the declining value of non-oil imports when prices of non-oil primary commodities were declining (Chart VI.6).

6.43 Commodity price cycles have played an important role in conditioning business cycles in the global economy. The recent global commodity price cycle that set off in 2002 reached another peak in mid-2008, which had associated implications for asset prices, investment, trade balances and growth across countries (Chart VI.7). According to the commodity price index data of the IMF and the World Bank, all commodities price indices witnessed an average 18.4 per cent increase during 2003-07 compared with a deceleration, albeit marginally, during the 1990s, spurred by metals, energy, and food commodities. The World Bank’s commodity price index of lowand middle-income countries has also shown a sharp acceleration during the current decade compared with deflation trends in the 1980s and the 1990s. Food price inflation was the highest since the late 1970s, whereas prices of metals and non-fuel commodities were the highest since the late 1980s. This has been driven by the relatively strong and stable performance of the world economy, rapid growth and structural changes in a number of large developing economies and increasing attention by policymakers and market participants to the challenges of climate change and shrinking oil reserves (UNCTAD, 2008). Furthermore, the commodity price cycle was relatively more prolonged compared to earlier cycles, led by the sustained expansionary phase of the business cycle (Box VI.5).

6.44 For commodity price importers, the implications of the commodity prices shocks could be distinctly different. An expansionary phase of commodity price cycles could work through various channels. First, commodity price shocks could directly affect domestic prices given the degree of pass-through and exchange rate movements. Further, given that primary commodities such as oil and metals enter as inputs for manufacturing and transportation, the rise in import prices has a second-round effect on the domestic prices of manufactured goods and higher transportation costs. Second, a rise in global commodity prices would adversely affect the trade balance of the importing countries. Particularly, in the case of oil, where the demand is relatively less price elastic, price shocks could lead to wider current account deficit (CAD). At the same time, given the competitive pressures in exports of manufactured products, a rise in primary commodity prices could adversely affect the input cost and, hence, export competitiveness. Third, the indirect effect of the commodity price could be higher inflationary expectations, which in turn could push up nominal interest rates in the economy. Further, a rise in commodity priceinduced inflation could create more volatility in domestic prices and, hence, bring in more uncertainty about the investment climate, which could adversely affect the investment decisions of corporates and firms.

Box VI.5

Affect of Commodity Prices on Asset Prices, Investment, Trade and Economic Activity

The overall impact of commodity price movements on economies differs considerably, depending on the composition of foreign trade, the relative weight of commodity exports and imports in their gross national income and price responsiveness. Higher prices of primary commodities for commodity-exporting countries have a favourable impact through improved export earnings. This, in turn, augments the potential for financing new investments in infrastructure and productive capacities that spurs domestic productive activities, consumption and employment. However, the impact of commodity price booms on domestic activity would also depend on the allocation of export surpluses for domestic consumption versus investment. The diversion of export surplus arising from commodity price booms could help in inter-temporal distribution of incomes and consumption smoothing. Notwithstanding the beneficial effects of the expansion in the commodity price cycle, a sudden rise in price cycles and its persistence can cause Dutch disease, which, through sharp appreciation in the real exchange rate, can result in diminishing competitiveness of the nontradable sectors.

6.45 During the recent phase of commodity cycles between 2000 and 2007, the greatest improvement in the terms of trade occurred in developing and transition economies that are exporters of crude oil and minerals. The developing countries that have emerged as important exporters of labour-intensive manufactures and are net oil importers, however, experienced a significant deterioration in their terms of trade. The pass-through of international oil prices to export prices of industrial countries and emerging market economies, as evident from the Granger causal relationship arising from the vector auto-regression model, provided crucial insights about underlying global trade in inflation across the countries. For industrial countries, export price inflation was caused by oil price inflation, but for emerging market economies it was caused by both oil price inflation as well as the export price inflation of advanced countries. This implied that in the absence of an administered price mechanism, industrial countries were in a position to pass on some of the burden of the oil price impact through higher prices of goods exported to emerging market economies. The latter, however, were not in a position to trade in inflation to industrial countries. Further, the interaction between the prices of tradable and nontradable commodities was evident from the causal relationship among export prices, import prices and domestic consumer prices inflation for industrial and emerging market economies. For industrial countries, the prices of tradable items had a significant causal association with domestic consumer prices; in the case of emerging market economies, the prices of exports rather than imports had a significant causal relationship with domestic prices (Table 6.20).

6.46 The pass-through of global to domestic prices in India takes place in two stages. First, the export prices of trading partners at global and regional levels percolate to import prices of India. Second, changes in import prices affect costs of production and domestic supply of goods and services, thus, affecting aggregate domestic inflation measured by producers’ prices, which in India relates to wholesale prices. In the Indian context, the most direct impact of the global commodity cycle on the economy comes through the prices of primary commodities.

6.47 The aggregate import price inflation in terms of domestic currency in the 2000s softened significantly compared with the trends in the decades of the 1960s through the 1990s. Second, it is interesting to gauge the foreign prices of India’s imports (prices of imports in foreign currency such as the US dollar), since the import price in the domestic currency is affected by the exchange rate. The latter reveals that except for the decade of the 1970s when there was an oil price shock, India’s import price inflation in US dollar terms remained subdued through the 1950s to the 1990s. In the current decade so far, however, such a measure of import price inflation averaged 5.2 per cent, in contrast to a declining trend in the 1990s and the subdued trend in the 1980s.

6.48 The correlation of India’s import price inflation in US dollar terms with export price inflation at global and regional levels for industrial, developing and oil-exporting countries based on annual data reveals that export price inflation of oil economies has a greater correlation with India’s import price (Table 6.21). This suggests that the oil price shocks are the most significant external shocks for price stability in India.

6.49 The correlation of India’s import prices in domestic currency with domestic prices suggests that the import price index has a near-perfect correlation with the domestic price index (Table 6.22). Since such a correlation could be exaggerated due to trend components in the variables, it is appropriate to consider the correlation of inflation rates. The import price inflation also has a significant correlation with domestic inflation.

6.50 One key channel for transmission of global commodity price shocks to India is oil imports. The rising share of oil imports is attributable to the sharp increase in international crude oil prices and volume growth of oil imports. According to the Petroleum Planning Analysis Cell (PPAC), Ministry of Petroleum & Natural Gas, Government of India, oil imports in volume terms grew on an average of 7.9 per cent per annum during 2000-01 to 2008-09. In quantity terms, growth in domestic consumption of petroleum products in India remained subdued at 3.6 per cent during the same period (Table 6.23).

These stylised facts about oil consumption demand and the import intensity of oil consumption amply reveal that major price shocks in India have been significantly caused by global oil price shocks (Chart VI.8). In 2008-09 also, the price shocks mainly emanated from international crude oil prices.

6.51 Another important channel of price shocks, particularly during recent years, has been volatile movements in international food prices. The rise in international food prices has been transmitted in varying degrees from international to local markets (IFPRI, 2008). This varied transmission of price changes from international to domestic markets is attributed to import dependence, exchange rate behaviour, domestic policies and discretionary market segmentation, transportation costs and natural market segmentation and imperfect transmission related to market structure and the existence of monopolistic/monopsonistic power. Depending upon the weight of food prices in the price index, the impact on the overall inflation has also varied across countries.

6.52 There has been a secular decline in India’s dependence on food imports in general over the decades as reflected by the declining share of food imports in total imports over the years (Table 6.24). During the 2000s, though India’s food imports in the total import basket declined in significance, the global integration of food prices through rapid financialisation of commodity markets resulted in an increase in the correlation in domestic and world food price inflation to 0.57. In fact, the global commodity cycle of the 2000s reveals that the expansionary phase in food prices in India closely followed the movements in the global commodity price cycles. The commodity-wise analysis of the correlation coefficient between domestic and international prices reveals that during the period 1995-2008, domestic edible oil prices had the strongest positive correlation with international prices, reflecting the import dependency since a large part of India’s consumption needs are met through imports (over 30 per cent) (Rajmal and Misra, 2009). Domestic prices of both food articles and edible oils have started moving in tandem with international prices, particularly during the latter half, i.e., the period 2002-2008, as trade in agricultural commodities has increased.

6.53 The domestic supply and demand balance also condition the transmission of international price shocks to domestic prices. Demand significantly outstripped domestic supply in the case of edible oils and the deficit is met through imports (Table 6.25). The production of pulses has also lagged behind demand, resulting in dependence on imports to the extent of more than 10 per cent. The complete pass-through of global food price shocks on domestic prices would be ultimately conditioned by trade policy interventions in terms of import quotas and licensing, custom duties and domestic fiscal measures. The sustained movement of international food prices, however, would impact domestic prices despite short-run stability.

6.54 Empirical findings suggest that global factors (import prices, capital flows, and movements in exchange rate) are able to explain about 20 to 30 per cent of the variation in domestic inflation in India (Raj, Jain and Dhal, 2009). In the long run, import prices, capital flows and exchange rates could have a significant positive association with domestic inflation. The interest rate variable has a negative association with domestic prices in the long run, though its statistical significance is not as strong as other variables. The impact of capital flows on domestic prices could be more pronounced than import prices and exchange rates as capital flows affect the latter.

Impact through Trade in Services & Remittances

6.55 The trade channel also transmits the effects of global developments through services export demand. The tradability of India’s services sector has witnessed a significant increase, with the services exports to GDP ratio rising about five-fold from 3.2 per cent in 1990-91 to 15.1 per cent in 2008-09. In services exports, India was among the first ten countries in the world during 2008 (Table 6.26). Among EMEs, the ranking of India was higher, at second place after China, in terms of services exports.

6.56 A large part of the services exports (about 46 per cent) are in the nature of Business Process Outsourcing (BPOs) and Information Technologyenabled Services (ITES), which are driven by the explosion in information technology and are employment-intensive with an estimated direct employment of about 2 million. Since about 80 per cent of the total demand for software exports originates in the US and the UK, a sharp contraction in these economies had an adverse impact on demand for software exports. A contraction in demand for software services adversely affected output and employment growth and, thus, reduced the consumption demand of the workforce dependent on this sector.

6.57 Exports and imports of services linked to merchandise trade have also been affected by the contraction in merchandise trade in India since the second half of 2008-09. The compression in merchandise exports since the second half of 2008-09 impacted the exports of related services such as transportation, insurance, and financial, which is discernible from the synchronised movements among merchandise exports and the exports of these services. Similarly, imports of trade-related services were adversely affected by falling merchandise imports as evident from their co-movements over the years, including the recent crisis period (Chart VI.9).

6.58 Although services exports across the board in India were adversely affected by the recent global crisis, miscellaneous services exports, primarily led by software exports, displayed relative resilience, as manifested by decelerated positive growth, whereas all other sub-groups contracted since the second half of 2008-09. Exports of insurance services recorded the highest decline followed by travel and transportation during this period. In the case of services imports, insurance services exhibited relative resilience, reflected in their positive growth, while the import of other services recorded precipitous contraction during the second half of 2008-09. Among the imports of various services, miscellaneous services, largely driven by business services, declined the most, followed by travel and transportation services (Table 6.27).

6.59 Travel services, which include earnings through foreign tourists in sectors such as food, hotels and transportation, are directly related to the arrivals of foreign tourists in India and affect domestic consumption demand. The growth in foreign tourist arrivals in India decelerated to (-) 4.0 per cent in 2008 from 14.3 per cent in 2007 (Table 6.28). In fact, during second half of 2008- 09, the peak of the global financial crisis, the growth of the trade, hotel, transport & communications sector decelerated from 12.5 per cent to 6.1 per cent, which to some extent seems to have been due to the slowdown in external demand from travel and tourism.

Remittances

6.60 Yet another channel of transmission of global shocks to the real economy in India could be partly through the remittance channel. In the recent past, a subtle shift has been noticed in the geographical sources of inward remittances to India with a significant increase from Gulf region, Europe and Africa a decline from North America and East Asia. However, the two important sources of origin of remittances are the US and the oil-producing Gulf countries. These two regions are estimated to contribute about two-third of India’s workers’ remittance inflows. While the remittance inflows from the US are affected by economic activity in the US, those from the Gulf countries are conditioned by the pace of activity reflected in oil revenues. During the recent crisis, while remittances from the US could have been affected by the sharp contraction in real activity and unemployment among migrants, the adverse effect of the global crisis on remittances from the Gulf countries seems to have worked through a decline in oil prices, which in turn could have affected migrant employment in the construction and services sectors in the Gulf region. Oil prices and remittances witnessed synchronised movement during the recent period, including the crisis, which corroborates the negative impact of oil priceinduced reduction in remittance inflows to India (Chart VI.10). A reduction in remittance inflows, particularly low-value remittances, directly affects the disposable incomes of the dependent households and, hence, affects their propensity to spend. Given that a large part of remittance inflows to India are for family maintenance (above 50 per cent of total remittance inflows to India), negative growth in inflows following the global shock might have adversely affected the consumption demand of the dependent households.

6.61 Accordingly, private remittances to India from advanced countries and the Gulf region, which remained buoyant till the first half of 2008-09, suffered setback and decelerated in the second half of 2008-09. In fact, the growth in private remittances plunged from 46.3 per cent in the first half of 2008- 09 to (-) 19.4 per cent during the second half but recovered to 4.3 per cent in the first half of 2009- 10. During previous international crises, viz., the East Asian crisis (1997 and 1998) and the technology crisis (2000 and 2001) also, private remittances to India behaved in tune with globaleconomic dynamics and decelerated sharply.

Software Exports

6.62 India continued to remain the top software services exporter, followed by Ireland (Table 6.29).

Since global banks and financial institutions, which were severely hit by the current global financial crisis, were large customers of Indian software providers, the impact of the global crisis seems to have been deceleration in exports to such verticals.

6.63 Although India’s software exports remained strong over the years, the slowdown in global demand due to the crisis affected the export performance of software companies to some extent (Table 6.30). After remaining steady till the first half of 2008-09, despite mounting pressures on the back of the global financial shock they succumbed to the falling external demand since the second half of 2008-09 and exhibited sharp deceleration in growth (Box VI.6).

6.64 To sum up, in view of India’s exports being highly elastic to world income, the effect of contracting world income has been reflected in the overall decline in merchandise trade since the third quarter of 2008-09. Empirically, it was found that declining merchandise trade dented the overall growth of the Indian economy. It was observed that exports of engineering and chemical goods remained resilient during this crisis. The firm-level export orientation also demonstrates the growing importance of trade channels in the growth of India’s manufacturing sector. On the one hand, contracting merchandise imports provided a cushion for the aggregate demand; on the other hand, declining nonoil imports negatively affected growth through investment on the back of the elevated import intensity of the industry. At the same time, the price shocks to the Indian economy were transmitted mainly through oil and food prices.

Box VI.6
Global Crisis and Impact on Software Exports

India’s information technology and business process outsourcing (IT-BPO) industry has emerged over time as a key sector of the economy in terms of contribution to growth, export earnings, investment, employment and overall economic and social development. In view of the significant dependence of this sector on external demand, the current global recession emerged as a key concern for this sector. The current crisis led to mounting losses of financial institutions in advanced countries, mainly in the USA in 2008-09, which depend to a large extent on the information technology (IT) and IT-related services of Indian companies and also employ a large pool of Indians. It is amply discernible that growth in India’s software exports was significantly correlated with the GDP growth of the USA during the recent period (Chart).

Further, the significance of the US’ GDP growth on the growth of Indian software exports has been explored by estimating the co-integrating relationship between India’s software exports, external demand conditions and exchange rate movements. The estimation reveals that over the medium to long run, a one per cent increase in the US real activity level (Log YUS) leads to about a 4 per cent increase in India’s software exports (Log Xsoft). As regards the exchange rate, a one per cent depreciation in exchange rate (Log ERUSD) would lead to about a 2 per cent increase in software exports over the long run (Table 1). It may be mentioned that the US dollar is the major currency of invoicing India’s software exports, accounting for about 75 per cent of total software exports. Thus, the co-integrating relationship underscores the dominance of real activity in the host country in determining the external demand for India’s software exports.

The variance decomposition analysis reveals that the lagged values of software exports (Log Xsoft) predominantly explain the behaviour of India’s software exports during the short run (Table 2). Real activity in the host country (Log YUS) predominantly explains the behaviour of India’s software exports over the medium to long run. The nominal exchange rate impact on India’s software exports demand is also significant over the short to medium term, although its impact diminishes over time. This amply demonstrates that a large external demand shock adversely affected India’s software exports.

Although India’s software exports remained strong over the years, the slowdown in global demand did affect export performance to some extent, corroborating the significance of external demand shocks manifested by the estimated results.

declining merchandise trade dented the overall growth of the Indian economy. It was observed that exports of engineering and chemical goods remained resilient during this crisis. The firm-level export orientation also demonstrates the growing importance of trade channels in the growth of India’s manufacturing sector. On the one hand, contracting merchandise imports provided a cushion for the aggregate demand; on the other hand, declining nonoil imports negatively affected growth through investment on the back of the elevated import intensity of the industry. At the same time, the price shocks to the Indian economy were transmitted mainly through oil and food prices.

6.65 Overall, the spillover effects of the global economic crisis impacted the current account balance mainly through the merchandise trade route during 2008-09. The current account deficit as a percentage of GDP escalated to 2.4 per cent in 2008- 09 on account of widened trade deficit on the back of worsening global conditions. After discussing the impact of the trade channel on the Indian economy, the spillovers effects through the financial channel are investigated in the following section.

III. IMPACT ON INDIA THROUGH FINANCIAL CHANNEL

6.66 The finance channel has pronounced implications for domestic investment activity. In fact, it has been argued that the role of foreign savings has become inportant in the domestic investment in case of India during the post-reforms period (Box VI.7) The transmission of global shocks on investment demand in India could take place through a variety of conduits. These include major channels of capital flows such as FDI, portfolio inflows, external commercial borrowings, trade credit, and overseas borrowings of banks. Besides the interest rate channel, liquidity and credit risks may also impact domestic investment activity. The expectations channels, representing sudden changes in risk perception towards EME assets, uncertainty about the investment climate and sharp turnarounds in exchange rate movements also have an important bearing on domestic investment demand.

6.67 The global shocks propagated through the finance channel could have both a direct and indirect impact on consumption and investment. Such shocks could have affected domestic consumption in India in the following ways. First, a sharp correction in equity prices in response to global shocks eroded a large part of household wealth, which in turn may have adversely affected consumption demand as erosion in household wealth was associated with a sharp deceleration in private final consumption demand during 2008-09. Second, reduced access for banks and financial institutions to foreign markets reduced their lending capacity in the domestic market, including loans to households that, in turn, could have affected consumption demand. Third, contraction in trade finance might have impacted imports and, thus, domestic consumption. Fourth, higher credit spread on overseas borrowings increases the demand for bank credit, which, in turn, leads to a rationing of credit by banks. During the crisis, banks tended to reduce credit for consumption purposes as the risk perception changed significantly.

6.68 The growing financial openness in India was accompanied by a notable shift in the composition of capital flows following the reforms period. The gradual liberalisation of the capital account, the shift in emphasis from debt to nondebt flows, financial market development and stronger growth prospects helped India emerge as an increasingly important destination for foreign investment flows. Accordingly, foreign investment flows, comprising direct and portfolio equity flows, became the dominant source of capital flows in the reform period of the 1990s compared with debt and external assistance in the pre-reform period in the 1970s and the 1980s (Chart VI.11). Although the more recent period witnessed a revival of debt flows, unlike the 1970s and the 1980s when debt flows were largely from official sources, it was spurred by private debt flows reflecting the impact of capital account liberalisation in general and better terms of credit faced by corporates due to lenders’ confidence in the growth of the Indian economy. A unique feature of capital flows to India was that even during the recent global crisis when other sources of funds dried up, FDI inflows remained steady, re-emphasising their long-run stability.

Box VI.7
Foreign Savings and Investment in India