India’s Economy Needs to be Fortified Against a Potential Global Financial Meltdown

With the world’s economies growing ever more interconnected and the current recession-like conditions in many key economies, India needs to build a robust firewall in the event of a global crisis.

The Reserve Bank of India. Photo: PTI.

The Reserve Bank of India. Photo: PTI.

It is difficult to imagine that only two years ago economic pundits across the globe were supremely enthusiastic about the prospects of the Indian economy. India was projected as a stalwart, an emerging economy which could propel global economic growth due to its inherent demographic advantages, along with a strong government which could break away from the policy failings of the past. The frenzied enthusiasm has tempered significantly with the somewhat mixed results of the government’s performance in the last two years. This reality check should serve as an important lesson for policymakers to not get carried away by the hysteria which a historical mandate can bring about.

The experiences of the past two years also reinforce the role and importance of global factors in our domestic economy. With the advent of financial technology, economies are getting more and more interconnected and intertwined with every passing day. This phenomenon is making economies increasingly vulnerable to financial shocks which can emanate from a different part of the globe. In August 2015, stockmarkets all over the world went into a downward spiral post the Yuan devaluation by Chinese authorities. The Indian policy framework should be fortified in such a way that the potential damage from global financial problems are contained and limited. This is especially relevant in the current scenario where a recession-like environment is already developing. There is a high possibility that the problems being faced by major economies can balloon into a much larger economic crisis due to the inherent interconnectedness of global finance.

The global scenario

A closer look at systemically important economies portends a very disturbing scenario. China is facing the unenviable situation of over-production and under-consumption, which can lead to potentially destabilising effects for its domestic economy. This, coupled with increasing inequality and decreasing global demand, suggests that Chinese authorities are grappling with the uphill battle of transitioning the country’s production-driven economy to a consumption-oriented one. The other Asian economic giant, Japan, is perhaps dealing with an even bigger problem. For the greater part of the last three decades, Japan has been attempting to reflate its economy with little success. Its central bank has recently resorted to desperate measures like negative interest rates, which have only made the situation worse. Ultra-accommodative measures are barely managing to keep Japan out of recession territory but have left the country in an increasingly vulnerable situation.

Europe too is struggling to come out of the economic stupor which it fell into post the Great Recession of 2008. In spite of numerous bailouts by the troika led by the International Monetary Fund, Greece is as close to bankruptcy as it was before the bailouts. The bailouts have only managed to magnify the contagion risks in the event of ‘Grexit’ and bail-ins. The economic situation of the rest of Eurozone is still unwieldy and lethargic with social unrest reaching its peak due to prolonged austerity measures. The migration of Syrian refugees is also being exploited as an issue by nationalist forces that are fomenting further social unrest. Extensive quantitative easing and negative interest rates recently undertaken by the European Central Bank have managed to sweep the dirt under the carpet for the time being. Yet, it is a matter of time before the deeper structural issues come out in the open to truly test the resilience of European economy.

In South America, the trinity of Brazil, Venezuela and Argentina is facing the brunt of the decline in the prices of commodities like oil. The double whammy of lower global demand and lower prices has taken a huge toll on these economies, as they are heavily dependent on the export of commodities. Venezuela especially is extremely vulnerable as it is unlikely to meet its $10.5 billion in debt servicing demand this year which may trigger an eventual bankruptcy of the nation similar to Argentina in 2002. However, such bankruptcy can have widespread implications this time around as its repercussions can create ripple effects across the globe. Brazil too is facing huge economic headwinds due to deep recession and corruption charges against the government.

When it comes to USA, the most systemically important country for India, the economic situation looks to be under control on the surface but a deeper analysis also shows severe cracks in the economy. Trillions of dollars of stimulus in the form of printing money and asset purchases have managed to keep the American economy afloat by acting as life support. But the true state of the economy will only be understood once the government and federal reserve decide to pull the plug on fiscal and monetary stimulus. Already, in spite of extraordinary measures like Zero Interest Rate Policy and extensive quantitative easing, there are indicators that all is not well with the economy. Corporate earnings and sales have been declining consistently, bankruptcies have been on the rise and the GDP grew by just 0.5% in the first quarter of 2016. These are signs that a recession may be around the corner which in itself can trigger massive financial collapse all over the globe.

Safeguards for India

It is imperative for Indian policy makers to be prepared for a financial onslaught which can dwarf even the 2008 crisis by a long margin. After all, in 2008 the crisis was triggered by corporates like the Lehman Brothers going bankrupt. In the present scheme of things, countries rather than companies are facing structural and acute stress. The policy response framework to the current situation should be proactive rather than reacting after the event, which may be too late to adequately cover the consequences and impact of a global financial meltdown.

The policy framework should look to prudently hedge risks and protect the government, financial institutions and commodity exporters who will be affected the most by a financial crisis. Exposure to global assets, especially through derivates, should be curtailed and limited. Most importantly, the government should team up with the Reserve Bank of India (RBI) in drafting a contingency plan to counter the impact of a global financial crisis.

Fortunately, we have an RBI governor at the helm who has an innate understanding of complex international financial systems. The government should leverage Raghuram Rajan’s expertise in developing the policy response for a possible economic Black Swan event. It is extremely important for our economy to develop a comprehensive firewall to stave off and insulate us from the potentially debilitating effects of a global financial crisis. This is all the more important given current economic conditions prevalent in major economies all over the world.

Smiran Bhandari is the managing partner of Moneyville Financials, a boutique investment banking firm. He tweets at @smiranb.