The global financial crisis has now become the staple offront page news. Banks around the world, including those in India, are in the forefront of managing the challenge of crisis resolution. The turmoil inthe global financial markets is no longer just a concern for bankers andeconomists. There is now almost universal consensus that the global economy isset to weaken, with the debate shifting from whether emerging economies woulddecouple from the advanced economies to whether the slowdown will be shallowand somewhat protracted or deep and very long. While the events of the pastweek underscore the seriousness of the situation, Director John Lipsky,Managing Director of International Monetary Fund (IMF), quoted that "this storm can be weathered without a damaging globalrecession, but attaining such an outcome will require clear and coherent policyresponses from public authorities and institutions around the world, togetherwith the restoration of private market functionality and an end to investors' spiralingcrisis of confidence".


Global Financial Outlook


According to IMF analysis, the most likely outcome is thatthe financial turmoil still underway in many advanced economy markets will notby itself prevent a gradual recovery in economic activity in 2009. Nonetheless,the turmoil is one reason why we expect the recovery to be only gradual. At thesame time, the moderate growth we expect will not be sufficiently powerful toquickly end the deleveraging and sector shrinkage afflicting financial institutionsin many key markets. Furthermore, the dangers created by the financial crisisstill represent the principal risk to near-term growth prospects.


Global Economic Outlook


Many economists are now predicting that this 'GreatRecession' of 2008/09 will be the worst global recession since the 1930s. Byearly November, the IMF had revised its forecast for global growth downwards -from3.9 per cent to 3.7 per cent for 2008, and from 3.0 per cent to 2.2 per centfor 2009. There are two inferences from it that follow are:


  • First that the global situation has deteriorated rapidly, in a space of less than two months.
  • Second that 2009 is going to be a more challenging year than 2008.


Impact of the Crisis on India


India too has to weather the negative impact of the crisis. As theimpact on India unfolds, there are two questions that are on the forefront:


  • First, how is that India is affected when it came out of the Asian crisis relatively unscathed?
  • Second, why is India affected even when its exports account for only 15 % of its GDP?


The answer to both the questions lies in "Globalization". India is certainly more integrated into the world economy today than ten years ago at thetime of the Asian crisis. Integration into the world implies more than justexports.


Going by the common measure of globalization, India's two-way trade (merchandise exports plus imports), as a proportion of GDP, grew from21.2 % in 1997-98 as compared to (the year of the Asian crisis) 34.7% in 2007-08.Ifone  takes an expanded measure of globalization, that is, the ratio oftotal external transactions (gross current account flows plus gross capitalflows) to GDP, this ratio has increased from 46.8 per cent in 1997-98 ascompared to 117.4 per cent in 2007-08. Thesenumbers are clear evidence of India's increasing integration into the worldeconomy over the last 10 years.


Inflation

Headline inflation, as measured by the wholesale priceindex, has fallen sharply, and the decline has been sustained for the past fourweeks, pointing to a faster-than-expected reduction in inflation. Largely, thefalling commodity prices have been the key drivers behind the disinflation;however, some contribution has also come from slowing domestic demand. Thereduction in prices of petrol and diesel announced last week, and a cut in theexcise duties should further ease the inflationary pressures. Consumer priceinflation for the months of September & October 2008 did increase. This ispossibly owing to the firm trend in food-articles inflation and the higherweight of food articles in the measures of consumer price inflation.Historically, there has been a positive correlation between wholesale andconsumer price inflation, and given this correlation, consumer price inflationtoo can be expected to soften in the months ahead.


 

State of Play: The Global Economy on Two Tracks


First of all, economic performance is becoming bifurcated. Advanced and emerging economies are moving in the same direction-that is, growth everywhere is slowing, decisively ending any hopes of a growth decoupling but they are facing two different sets of problems. Nearing the end of the year's third quarter, most advanced economies are either virtually stagnant or on the verge of recession, while underlying inflation risks are becoming increasingly well contained.


The growth slowdown that originated in the United States has spread, as evidenced by declines in activity in the second quarter in both the euro area and Japan. Advanced economies, in general, face a spell of growth well below potential, as they grapple with ongoing strains from the financial crisis that began a year ago, as well as the lingering effects of high oil prices and weaker external demand.


Henceforth, Inflation is still a key problem for some emerging economies and tighter policies are still required in some cases so as to ensure that hard-won gains in monetary policy credibility are not eroded. But for many other emerging economies, downside risks to growth are increasing, while risks to inflation appear more subdued. As the balance of risks shifts, so should policymakers' responses.


The Global Outlook: A Gradual Recovery


There are several factors that provide a degree of reassurance that a severe downturn can be avoided. They are:


  1. First, oil prices have come down sharply in recent weeks. This should reverse a significant portion of the adverse terms-of-trade effects arising from the more than 60% increase in oil prices during 2008 and the erosion in purchasing power and real wages being felt by most advanced economies.
    (In the United States, if oil prices remain at current levels, the implied boost to real disposable income will rival the value of the income tax rebates. Indeed the projections expected a modest rebound in consumption in both the United States and euro area over the course of 2009.)
  2. Second, it is plausible to anticipate that the U.S. housing market will find a bottom in 2009. Already, the inventory overhang is diminishing, while affordability measures are returning to levels that appear much more consistent with past experience.
  3. Third, while financial conditions have tightened in both the United States and in Europe, it does not mean that an economic recovery is thereby excluded. In the United States, for example, corporate finances in general remain relatively healthy. Productivity gains have helped to sustain profits. Time-limited investment tax credits will encourage corporate capital expenditures in the coming months. Moreover, recent IMF analysis suggests that a slowdown in credit intermediation does not necessarily impede economic recovery.
  4. Finally, relatively robust emerging market growth, led by strong domestic demand in several of these economies, has helped boost U.S. exports.


Hence, the challenges facing the global economy and financial system are clear, and downside risks to the outlook have increased notably. The overarching risk revolves around the feedback loop between continuing strains in financial markets and slowing economic activity. Despite aggressive policy actions aimed at alleviating liquidity strains and preventing systemic events, markets remain under severe stress. There is a clear risk that financial conditions could deteriorate further and more aggressive attempts by financial institutions to deleverage balance sheets could imply severe problems of credit availability. There also is a clear risk that emerging market economies that have so far been relatively insulated from the financial turmoil could be subject to large reversals of capital flows, with serious implications for economic activity.


To conclude, the implication is that a more systematic approach may be required to deal with such basic issues as the disposition of distressed assets, the degree of protection offered to depositors, and the scale and scope of liquidity support that is offered to institutions and markets.


"The fact of globalized financial markets means that policy interventions need to be globally coherent and consistent in order to be effective. Although, the global economy will continue to be resilient in the face of significant headwinds, this does not imply that the policy challenges and tradeoffs are not daunting it will be navigating successfully through the turbulent waters ahead".


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