Like a shape-shifting monster in a horror movie, the global financial crisis which began in the summer of 2007 has continually morphed into unexpected new dimensions. Governments have repeatedly tried to deal with the proximate problem, but by the time a solution was in play, the nature of the problem had changed into something different. A lot of money is now waiting in the wings, waiting for conditions to stabilise before jumping in to buy assets at fire sale prices. But until conditions stabilise, this money is on the sidelines, and asset prices continue to slump. High volatility and low asset prices are exacting a toll on financial firms. Going beyond the high profile deaths of Bear Stearns or Lehman, a large number of smaller firms are failing worldwide. While the space made by the death of weak financial firms is a welcome growth opportunity for the survivors, it will take some time for capital and labour to fully regroup into new formations. In this interim period, financial intermediation will be adversely affected, which will damage GDP.
The public policy approach of dealing with one firm at a time has been proven to be wrong, for the real problem lay in markets. The approach of dealing with one country at a time has been proven wrong, for decisions by one country have profound implications for the international financial system in this age of interconnectedness. It is fitting that the G-7 countries are now putting their heads together in coming up with coordinated responses. Such interdependence in global financial market regulation is an unprecedented problem. New structures will have to be created to address this need for international coordination. The ?international financial architecture? at present is dominated by the IMF, the World Bank, and a few other institutions. We are perhaps at the cusp of fundamental rethinking of the nature of the international financial architecture.
India?s public policy response
These events have many implications for Indian public policy. First, India needs to bring a new level of thinking and effort in economic diplomacy. India was traditionally an irrelevant corner of the world when important global events took place. India is increasingly coming to the point of often having a seat on the table when momentous decisions are being made in international economic policy. New thinking on the international financial architecture is increasingly likely to envisage giving India a responsibility and a say in this new world. The economic policy process in India needs to build up a commensurate staff capability. The second dimension is on responses to a crisis. Global financial regulators and central banks are facing the challenge of their lives, responding to this fast moving crisis. With the benefit of hindsight, it is possible to identify crucial turning points where the wrong calls were made, with enormous consequences. As India grows up into a mature market economy, the demands on staff quality will rise dramatically. The Indian economic policy establishment will need to bulk up with top quality staff in the Ministry of Finance, RBI and Sebi, who are steeped in modern finance and international macroeconomics, and are able to deal with episodes of this nature with sophistication and speed.
For the last five years, the world economy had enjoyed an unprecedented period of world GDP growth of roughly 5% per annum. In this period, it was relatively easy for India to register growth of 8% and above. It appears likely that world GDP will slowdown in 2008 and 2009. This will impact India?s business cycle conditions. A key channel of propagation lies in the prices of globally traded products. When Chinese manufacturers of (say) steel find that the world demand for steel is soft, they will cut prices. This will reduce the profit margin of Indian steel producers, and reduce their interest in investment. While the investment pipeline visible in the CMIE Capex database is extremely impressive, and the bulk of it will be translated into execution, relatively small changes in the pace of implementation of investment projects will have a substantial impact on GDP growth. This is particularly unlucky for India, because we are about to go into a period of elections and political uncertainty at a time of high fiscal stress. The next few years will perhaps be reminiscent of the 1999-2002 period, where economic conditions were daunting. At the same time, our goal must be to repeat the successes of structural reform of 1999-2002 which was done despite such daunting circumstances. Investment by domestic and foreign investors responds to optimism about good governance in India. Economic reform is thus the most potent tool through which a government can foster investment and thus buoy GDP growth in difficult times. This perspective needs to guide the drafting of manifestos of the two major political parties as they run up to the coming general elections.
