The panic of an unprecedented order that has struck the crisis-ridden Indian economy brings to the fore a question. What led to this massive downturn, especially when the country was clubbed, not long back, as one of the high-growth emerging economies of Asia?
A volte face — from scenes of apparent stability, marked by high growth of the gross domestic product and a booming financial sector, to a state of flux in the economy —can completely change the expectations of those who operate in the market, facing situations with an uncertain future. Possible transformations as those mentioned above were identified by Charles P. Kindleberger in 1978 as a passage from manias that generate positive expectations to panic that head to a crisis. While manias help continue a boom in the asset market, it is sustained by using finance to hedge and even speculate in the asset market, as Hyman Minsky pointed out in 1986. However, bubbles generated in the process in asset markets eventually turn out to be unstable, especially when the financial deals rely on short-run speculations rather than on the prospects of long-term investments in real terms.
With asset price bubbles continuing for some time under the influence of what was described in 2000 as irrational exuberance by Robert Shiller, and also with access to liquidity in liberalized credit markets, unrealistic expectations of the future under uncertainty sow the seeds of an unstable order. This leads to Ponzi deals, as noted by Minsky, with the rising liabilities on outstanding debt no longer met, even with new borrowings since borrowers are nearing insolvency. Situations such as these trigger panic among private agents in the market who fear possible crisis situations. They are led by herd instincts or animal spirits in the market, as noted by John Maynard Keynes in 1936. In absence of actions to counter the market forces, a possible crisis finally pulls down what in hindsight looks like a house of cards.
Indeed, when markets have the freedom to choose the path of reckless short-run financial investments with high risks and high returns, the individual’s profit calculus eventually proves wrong as a collective. This leads to a path of downturn, not just for the financial market but for the economy as a whole. This is how manias lead to panics and then to a crisis in the economy.
Such characterizations in the economic discourse help explain the slippages in the Indian economy, which has seen its GDP growth decelerate from the annual average of around 9 per cent during 2005-2006 to 2010-2011 to the currently observed rate of less than 5 per cent . The changing scene has also seen a sharp decline in the index of industrial production to less than 1 per cent in 2012-13. The stock of official exchange reserves, which was above $300 billion till 2010-2011, is today less by $30 billion. There has also been a worsening in both the current account deficit as well as the fiscal deficit as proportions of the GDP. The two are today at the respective levels of 4.8 per cent and 5.1 per cent, considered too large to assure financial stability.
The changing scene in the Indian economy has also witnessed a classic bursting of bubbles in asset prices over the decade. With rising capitalizations in the stock market that doubled between 2009-2010 and 2011-2012 and the rising price-earnings ratio that reduced the costs of new investments on financial assets, the expansionary spate in India’s financial asset market continued as long as the main agents in the market, including the foreign institutional investors, continued to invest. Turnovers in India’s secondary market of stocks were considerably facilitated by FII entry, fully liberalized since 1999, and with transactions in exchange-traded derivatives, treated at par with equities since 1999. Inflows of short-term capital also entered the market for real estates and commodities, including gold, thus inflating transactions as well as prices. Liberalization of future trade in commodities worked to initiate use of derivatives in the commodity market, often leading to spiralling prices.
Marker expectations in India — that has turned adverse over the last two years — rest on the sharp depreciation of the rupee (hitting a record low of nearly Rs 69 per dollar in August 2013 followed by a moderate recovery). Also, outflows of FII-led short term funds, steady decline in the stock of official reserves, rising current account deficit and fiscal deficit, stock market volatility with a drop in turnovers as well as prices, rise in external debt (to nearly 21 per cent of the GDP, and short-term debt by residual maturity at 60 per cent of official reserves), and, finally, a state of stagflation that is ineptly handled by the state machinery, are all aspects which similarly affect such expectations.
Facts such as these have created concerns of an impending insolvency with further downgrading of credit ratings — to even below the current rating that is hovering at the lowest investment grade of “Baa3” by Moody’s. With volatile FII flows, the lifeline of all short-lived booms in asset markets, expectations have further worsened. One can notice here the sharp drop in the net FII flows from $19 billion in the first five months of 2013 (January-May, 2013) to an outflow of $13 billion from June-August, 2013.
Worsening of the financial scene gets reflected in the sharp decline in the financial balance of India’s international accounts. The balance nearly halved between the third and fourth quarter of 2012-2013. Much of that was owing to the decline in portfolio investments driven by the FIIs. Rise in pre-payment of short-term trade credits abroad and bank-lendings from India, both to avert further downfall in the rupee rate, were also there, as reflected in the drop in ‘other investments’ on a net basis. Net capital flows fell miserably short of what was needed to meet the rising current account deficit, which is fed by unrestricted imports.
Concern over the sagging financial market in India reinforces itself as one witnesses the slump in the real sector. Not much is forthcoming in the near future from fiscal expansion, given the stringent clauses of the Fiscal Responsibility and Budget Management Act that seems to have been already violated by the current fiscal deficit. Nor is much respite offered by the Reserve Bank of India, the country’s central bank, which continues to be bothered about its prior goals of inflation and exchange rate management in the face of free capital flows (or even the whims of the monetary authorities of the United States of America in its quantitative easing programme).
None of this permits much autonomy for the bank in setting monetary policy in the interests of domestic growth. The recent use of the stop-go policies by the RBI have so far been incapable of reversing the current slide in the economy. These have only tinkered with the cash reserve ratio, the statutory liquidity ratio and the prime-lending rate, all to deal with domestic liquidity in the face of the volatile swamps of short-term finance from overseas. Also, the RBI’s recent attempt to control liquidity by using the bond market was rather limited an attempt to influence the exchange rate volatility and the state of expectations.
Looking back, the current scene of a discredited Indian economy, which has lost its past glory as a major investment destination in terms of stability and growth, can be traced back to the process of formation of a bubble economy in India. This originated from both the welcome signals provided by the State to speculation and short-term finance, and the irrational exuberance on the part of agents in the market to make a fortune while the sun shines. The run on the system was avoidable with timely interventions to stop the build-up of the bubble economy. These could have been supplemented by policies to direct finance in the direction of long-term investments for growth.