Global and European crisis: The implications for South Asia

By Dr. Y.V. Reddy

I am thankful to the honourable Chandrika Bandaranaike Kumaratunga for inviting me to this flagship Conference. I congratulate the South Asia Policy & Research Institute (SAPRI), Club de Madrid, and the Centre for Policy Research (CPR) for this excellent initiative.

The presentation is in five parts:

1. Impact of the Global/European crisis on South Asia

2. Short-term outlook and policy implications

3. Longer-term outlook and policy implications

4. Beyond economic crisis: Issues

5. Importance of regional cooperation

It must be noted that this presentation is an overview to get a sense of the issues. Hence, broad generalisations and some informed impressions are inevitable.

Impact of the Global/European crisis on South Asia

The South Asian economies, like other developing countries, felt the adverse consequences of the financial turmoil in the advanced economies in 2007-08. The initial impact was through finance channels, specially the freezing of trade finance and short-term capital outflows. The international trade was also affected, and hence the South Asian economies were also impacted depending on the extent and nature of exposure to international trade. Similarly, the slowdown in global economic activity impacted the overall confidence.

The region had a reasonably robust financial sector essentially dominated by banking. Hence, the financial sector was not seriously affected. The balance sheets, by and large, were not excessively leveraged as in the case of advanced economies. There were no large and unsustainable critical macroeconomic imbalances. Aid flows, however, were impacted, except those associated with geopolitical reasons.

While public debt has been high and fiscal positions generally weak, the exposure to foreign currency private sector debt has been relatively small. Overall, therefore, most of the economies rebounded quickly from the impact of the global crisis, facilitated by prompt policy responses from both monetary and fiscal authorities. On the whole, South Asia has been among the regions which exhibited significant resilience to the global crisis.

The real GDP growth has continued to be high for the region as a whole, with India contributing to high growth and economic activity. Bangladesh has shown impressive growth and stability. Performance of Nepal and Pakistan was subdued and volatile.

Sri Lanka was hit in 2009, but rebounded quickly and continues to perform well. Maldives has been similar to Sri Lanka in terms of serious impact and quick recovery. It is essential to recognise that there were several non-economic domestic factors in some of the countries during the period 2006-2011which could explain the movements in the Gross Domestic Product more than the impact of the global crisis.

It is necessary to recognise that there is significant diversity in the economies of South Asia. The impact of the global crisis and subsequent EU crisis depends on the domestic conditions, both economic and non-economic conditions. It also depends on the nature of linkage between the country and (a) Indian economy; (b) the global economy, and (c) the Euro economy.

For example, Afghanistan has been facing significant domestic political problems. To some extent, Pakistan has also experienced some issues. Bangladesh has performed better than many Asian economies, contributed by several factors including the nature of its basket of exports. Bhutan’s economy is closely tied to India and its macro-economic under-pining is sound.

Similarly, Nepal’s economy is closely integrated with India, but it has been facing some non-economic problems. Maldives dependence on tourism also contributed to its current account deficit, soon after crisis. Considerable impact on the economy of Sri Lanka could be found because of its openness to global economy along with the current account deficit surged and reserves fell as a result of the crisis. However, Sri Lanka has rebounded very quickly.

The Indian economy showed remarkable resilience to the crisis in spite of its large public debt relative to GDP. While it was one of the earliest economies to rebound, the structural-fiscal problems create a very difficult situation for sustaining high growth and manageable inflation. There has been some deterioration in current account deficit. Despite the problems, Indian economy is expected to be one of the best performing large economies in view of its strong fundamentals, despite recent dip in Savings and Investment.

Overall, therefore, it can be held that South Asia has felt the impact of the global financial crisis as well as the crisis in Euro area, but has proven to be resilient and is continuing on strong growth path. There are several dominant domestic issues that would require significant and collective improvements in public policies to manage them in the light of the emerging challenges from a troubled global and Euro economy in future.

Short-term outlook and its implications

For 2012 and, to some extent 2013, the general expectation is that the growth in the global economy may continue to be subdued despite some signs of improvement in the US economy. Slowdown in Euro appears inevitable, while China is planning to moderate its growth rates. Hence, the policy challenges for many emerging economies, including South Asia, relate to ensuring an appropriate generation of domestic demand and domestic supply. At the same time, they need to increase economic linkages with other emerging market economies to partially make-up for the moderation in the overall growth in the global economy as well as Euro economy.

In view of injection of large and assured liquidity by the advanced economies and uncertain prospects of revival of economic activity, the financial markets are likely to be somewhat volatile. In addition, due to the socio-political tensions in several parts of the world and the disturbing developments with regard to oil supplies from Iran, increased volatility in financial markets should be expected.

The remittances of non-residents from outside the South Asian region could correspondingly face some uncertainties. The current account deficit itself is liable for shocks in view of the dependence of many countries of the region on imported oil. This poses a special challenge for South Asian economies that have large current account deficits, since there will be increased uncertainty about the capital inflows to finance the current account deficits.

Commodity markets are also likely to face significant volatility due to two competing factors. The moderation in economic activities in advanced economies is likely to depress the demand, while the large assured liquidity need conditions of anaemic growth in advanced economies may add to the financialisation of commodities. Those economies, including India, which are already facing large current account deficits, will have to be in readiness to manage the possible drying-up of capital flows. The region is particularly vulnerable to volatility in oils prices.

Finally, the unconventional policy responses of advanced economies are likely to have spill-over effects on the developing economies. In view of the relatively low level of integration of South Asia with global finance, the spill-over adverse effects may be less than in other emerging market economies, but their vulnerability in regard to both fiscal and external sectors may cause undue stress on their economies.

Longer-term outlook and policy challenges

South Asia is relatively a late comer in terms of taking advantage of the potential benefits of integration with global economy, though in the process it has been able to reduce risks of contagion of recent crisis in a significant manner. However, the challenges of global integration in the future are likely to be very different from those of the pre-crisis period, and hence it is necessary for the policy makers to take cognisance of three factors, viz., the future of globalised trade, the future of globalised finance, and the future of global governance.

First, there is considerable pressure in advanced economies to resort to protectionism, in view of the large scale unemployment that is visible in some of the leading advanced economies. While it is recognised that productivity growth in economies would enable growth in employment, such growth in productivity is difficult to achieve in the medium-term, and in any case, the age profile of the working force may not be conducive to such rapid increases in productivity. In fact, it is difficult to assert that the growth in global economy post-crisis will be similar to that in the pre-crisis period. It is also necessary to recognise that the growth in world trade is likely to be less than the normal growth in world trade during the pre-crisis years.

Second, the global allocation of capital in the near future is likely to be characterised by huge demand for global savings, on the part of the advanced economies to finance their public debt. In addition, many of the advanced economies have to protect their social security, and demography is inclined towards utilising past savings. In a way, uphill movement of savings from developing economies to advanced economies may continue. Under these circumstances, there may be need for strengthening the movement of capital between developing economies than expecting significant flows from advanced economies to developing economies.

Third, as regards global governance, it is difficult to bring about significant improvements in global financial architecture as well as the governance arrangements on the basis of the experience since the crisis. In any case, changes in governance are likely to be slow and somewhat complex when a great shift in economic activity takes place. Hence, improvements in global governance may not be able to keep pace with potential risks due to enhanced global integration.

In terms of policy response, South Asia will have to find its own answers for several paradoxes that appear to be emerging.

First, growth of output in the recent years has not been accompanied by growth of employment.

Second, the distributional implications of globalised trade have not been adequately captured in economic analysis.

Third, the expectations of people about the future appear to be very different from the reality since the post crisis normal is likely to be less rosy than pre-crisis boom. There is also a divergence between expectations in advanced economies which are characterised by hope.

Fourth, there is less clarity about what may be described as optimal macro-policies and regulation of financial sector. Many of the beliefs in terms of appropriate economic policies for developing countries are being reviewed even by IMF.

Fifth, the expectations of the desirable lifestyles for large segments of population in South Asia are close to the current US lifestyles. It is universally recognised that such lifestyles are unsustainable in terms of water, energy and environment, unless there is quantum jump in technology. This would require virtual review of the desirable life styles, and this, indeed, means a total change in the goals of the public policy and instruments of economic policy.

Beyond economic crisis: Issues

As already mentioned, challenges for most of South Asia are more domestic than global, both by virtue of the level of integration with rest of the world, and by virtue of domestic vulnerabilities. These challenges are, in fact, considerably broader than strictly economic issues. For this purpose, a careful evaluation of the following factors appears necessary by each country, and also in terms of inter-relationships among the South Asian countries.

First, political stability enables appropriate economic policies. More important, stability of the political systems is critical for appropriate economic policies.

Second, economic growth is important, but it should be accompanied by a moderation in the volatility in output and in employment. There are large numbers of poor and vulnerable sections in South Asia who are ill-equipped to manage such volatilities. Unless the pro-growth policies are integrated with broader considerations of equity and fairness, the political stability is often threatened.

Third, the financial stability is important, but its relationship with real sector and political economy cannot be under-estimated.

Fourth, South Asia has been fortunate so far in avoiding deep capture of its political economy by the financial sector, but there are dangers that this may happen soon if adequate precautions are not taken.

Fifth, social cohesion has been a problem in many Asian economies and appropriate economic policies are critical in contributing to social cohesion, provided such policies encompass managing diversity, a characteristic of South Asia.

Sixth, environmental concerns are of particular importance to South Asia because of the large population inhibiting this part of the world. Some countries like Bangladesh are particularly vulnerable to environmental challenges while countries like India may have to consider incorporating water use and energy use as part of broader strategies of development.

Above all, the relative and complementary roles of public policy, private sector and civil society are yet to be fully appreciated in South Asia. Good governance is considered to be a matter that is relevant only to government sector. Global economic crisis has shown that the governance in private sector can be so deficient as to bring about not only an economic crisis but crisis in the confidence in the financial systems.

In the debates relating to corruption, the fact that corruption often arises due to the activities of both public and private sector, is often ignored. Recent initiatives of civil societies in the Region have contributed significantly in highlighting the issues relating to governance in South Asia. There is much that South Asia should learn from each other, in addition to learning from the experience of other countries with regard to global crisis.

Importance of regional cooperation

It is recognised that the largest number of poor people are currently concentrated in South Asia. South Asia is entering a phase where the future path of the global economy may be bumpy and full of uncertainties. These would naturally reinforce the need for regional cooperation within South Asia.

Regional cooperation will have to be at several levels, viz., public policy, private sector, civil society and think tanks.

There are two lessons from the global crisis in regard to the benefits of regional cooperation. Integration in areas like currency and finance are full of risk, as has been demonstrated by the experience of Euro area. At the same time, experience of East Asia has shown the huge benefits that trade integration can bestow upon the nations.

In addition to trade integration, in view of the socio-political complexities of South Asian economies, actions by non-governmental organisations and think tanks in the region could play a very important role in learning the right lessons that are appropriate to South Asia. The civil society can also contribute to policies and practices that promote social cohesion within each country and within South Asia across countries.

Conclusion

South Asia has done well in being resilient to the crisis and rebounding despite domestic issues. Way forward, global economy, polity and society are full of uncertainties, and hence look at global economy with hope and fear. There is huge potential for great benefits, both in short and long-term, for regional cooperation, with negligible downside. South Asia is the safest bet for South Asian economies at this juncture.

Let me conclude by congratulating the organisers for this excellent initiative.



(This presentation was delivered at the inaugural South Asia Policy & Research Institute Summit on Delivering Inclusive and Sustainable Development held last month in Delhi. Website: www.thesapri.org.)



(Dr. Reddy was Governor of the Reserve Bank of India, from 2003 to 2008. Prior to being the Governor, he was Executive Director for India, Sri Lanka, Bangladesh and Bhutan at the International Monetary Fund since August 2002. He has also been Deputy Governor of the Reserve Bank of India and Secretary at the Ministry of Finance and Additional Secretary at the Ministry of Commerce in the Government of India. Dr. Reddy is on the Advisory Board of Institute for New Economic Thinking – INET – and is also on International Advisory Board of the Columbia Program on Indian Economic Policies, Columbia University, New York. He is also on the Advisory Group of eminent persons to advise the Finance Minister of India on G-20 issues. Dr. Reddy is currently Professor Emeritus, University of Hyderabad. He is also Honorary Fellow of the London School of Economics and Political Science. He is a Member of the Network of Political Leaders United to Support Shared Societies – NetPLUSS – of the Club de Madrid. His book ‘India and the Global Financial Crisis: Managing Money and Finance’ was among the best sellers in India – Orient Blackswan 2009. His most recent publication is titled ‘Global Crisis, Recession and Uneven Recovery’ – Orient Blackswan, 2011. Dr. Reddy was honoured with the Padma Vibhushan Award in 2010.)