The Eye Financial... · vii Recession is an economic instability that touches every person, the economy, and society. It ultimately also affects other economies depending upon the

Recession and Its Aftermath

N.M.P. VermaEditor

Recession and Its Aftermath

Adjustments in the United States, Australia, and the Emerging Asia

EditorN.M.P. VermaDepartment of EconomicsBabasaheb Bhimrao Ambedkar UniversityLucknow, India

ISBN 978-81-322-0531-9 ISBN 978-81-322-0532-6 (eBook)DOI 10.1007/978-81-322-0532-6Springer Dordrecht Heidelberg New York London

Library of Congress Control Number: 2012943593

© Springer India 2013This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, speci fi cally the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on micro fi lms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. Exempted from this legal reservation are brief excerpts in connection with reviews or scholarly analysis or material supplied speci fi cally for the purpose of being entered and executed on a computer system, for exclusive use by the purchaser of the work. Duplication of this publication or parts thereof is permitted only under the provisions of the Copyright Law of the Publisher’s location, in its current version, and permission for use must always be obtained from Springer. Permissions for use may be obtained through RightsLink at the Copyright Clearance Center. Violations are liable to prosecution under the respective Copyright Law.The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a speci fi c statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use.While the advice and information in this book are believed to be true and accurate at the date of publication, neither the authors nor the editors nor the publisher can accept any legal responsibility for any errors or omissions that may be made. The publisher makes no warranty, express or implied, with respect to the material contained herein.

Printed on acid-free paper

Springer is part of Springer Science+Business Media (www.springer.com)

In honor of Kamta Prasad

vii

Recession is an economic instability that touches every person, the economy, and society. It ultimately also affects other economies depending upon the intensity of cross-country integration, openness, and trading. Therefore, bringing out a book like this is de fi nitely the need of the hour when the world has just witnessed a global recessionary crisis.

The initial thoughts for creating this volume arose during my visit to Wisconsin, Madison, USA, in the post recession year of 2010. There, a few contributors to this book and many other academicians informally deliberated on the issue of fi ghting the recession which took place during 2007–2009 in the USA. The US economy was trying its best to recover by taking expansionary measures. It was also delibe-rated by some that the US recession had probable impacts on Europe, Australia, emerging Asia, and other continents. After my return from the USA, I formally started this project, had discussions with a large number of researchers, and invited many economists from this fi eld to contribute a chapter. Some of them have con-tributed and some wanted much more time to contribute. As time is a very important factor for this kind of study where the book should be published on time, only 11 contributions could be compiled in this volume. The chapters in this volume mostly focus on the USA, Australia, China, India, and Malaysia. However, the contributors also discuss European economies and Asian economies, such as those of Pakistan, Nepal, Bhutan, the Maldives, South Korea, Indonesia, and a few other core countries for a general description of recession.

In creating this volume we were assisted by a large number of people and institu-tions. First and foremost we must thank the contributors, whose unconditional commitment and prompt submission of their chapters made my job as the editor quite smooth and easy. I am also thankful to many of my colleagues and friends, including Nirankar Srivastava, P.K. Sinha, several colleagues from various other institutions, and Ejaz Ghani, who is currently at the World Bank, for motivating me to convert this dream project into reality.

Sagarika Ghosh, Sahadi Sharma, and their colleagues at Springer came forward to bring out this volume. Their valuable comments on the preliminary draft further reduced many shortcomings. I am extremely thankful to them for their work on the

Preface

viii Preface

production of this volume in about 5–6 months. I also thank Madhu Patel, Atul Kumar, and Vinit Kumar for typesetting and computational work. Lastly, I am thankful to our postgraduate students and PhD scholars, to whom I have been teaching macroeconomics for many years, for raising many complicated questions. This helped to re fi ne the project.

I dedicate this book to Kamta Prasad, with whom I had a research association and from whom I learned the workings of a complex economy. I expect this volume to be of immense help as a reference book for postgraduate students, research schol-ars, academicians, corporate consultants, fi nancial experts, and other members of universities and research institutions in the fi elds of economics, management, and commerce across the globe.

N.M.P. Verma

ix

1 Understanding Recession: Conceptual Arguments and US Adjustments ........................................................... 1N.M.P. Verma and V. Dutta

2 The Financial Crisis and the Great Recession in the United States ................................................................................. 23Mukti Upadhyay and Tim Mason

3 Dynamics of Deflation and Unemployment: Fall into an Abyss of Depression ............................................................ 47Anson Wong and Michael Chu

4 Market Fluctuations and Country Risk Relationships for Australian and Indian Energy ................................. 67John Simpson

5 The Chinese Economy After the Global Crisis .................................... 81Liang-Xin Li

6 The Role of Macroeconomic Fundamentals in Malaysian Post Recession Growth .................................................... 113Lee Chin

7 Impact of Global Financial Crisis on Economic Wellbeing: A Case of South Asia ............................................................................... 129Nikhil Chandra Shil

8 The Asian Economic Crisis and Malaysia’s Responses: Implications for the Banking Sector...................................................... 157Balakrishnan Parasuraman, Beatrice Lim, Fumitaka Furuoka,Catherine Jikunan, and Lo May Chiun

Contents

x Contents

9 Output Growth in Post Liberalized India: An Input–Output Structural Decomposition Analysis ........................ 179K.K. Saxena, Sarbjit Singh and Rahul Arora

10 The Recent Recession: Impact and Future Prospects for the Indian Banking Sector .............................................. 215D.K. Yadav

11 Impact of the Global Downturn on the Indian Economy .................... 233Basanta K. Sahu

About the Book ................................................................................................ 257

Index ................................................................................................................. 261

xi

Rahul Arora Department of Humanities and Social Sciences, Indian Institute of Technology , Kanpur , India

Lee Chin Department of Economics, Universiti Putra Malaysia , Serdang , Malaysia

Lo May Chiun Universiti Malaysia Sarawak , Kota Samarahan , Malaysia

Michael Chu School of Continuous Education, Baptist University of Hong Kong , Kowloon , Hong Kong

V. Dutta School of Public Policy, University of Maryland , College Park , MD , USA

Fumitaka Furuoka Universiti Malaysia Sabah , Kota Kinabalu , Malaysia

Catherine Jikunan Fumitaka Furuoka , Institute of Asia-Europe Centre, University of Malaya , Kuala Lumpur

Liang-Xin Li Catherine Jikunan, Malaysian Trade Union Congress, Kota Kinabalu , Sabah , Malaysia

Beatrice Lim Universiti Malaysia Sabah , Kota Kinabalu , Malaysia

Tim Mason Department of Economics, Eastern Illinois University , Charleston , IL , USA

Balakrishnan Parasuraman Faculty of Entrepreneurship and Business , Universiti Malaysia Kelantan, Kota Bahru , Malaysia

Basanta K. Sahu Indian Institute of Foreign Trade , New Delhi , India

K. K. Saxena Department of Humanities and Social Sciences, Indian Institute of Technology , Kanpur , India

Nikhil Chandra Shil Department of Accounting, American International University , Bangladesh

Contrib utors

xii Contributors

John Simpson School of Economics and Finance, Curtin University , Perth , Western Australia

Sarbjit Singh Department of Humanities and Social Sciences, Indian Institute of Technology , Kanpur , India

Mukti Upadhyay Department of Economics, Eastern Illinois University , Charleston , IL , USA

N. M. P. Verma Department of Economics, Babasaheb Bhimrao Ambedkar University , Lucknow , India

Anson Wong School of Account and Finance, Hong Kong Polytechnic University , Kowloon , Hong Kong

D. K. Yadav Department of Economics, Babasaheb Bhimrao Ambedkar University, Lucknow , India

xiii

Market failure at medium intervals is inevitable in a capitalist economy. Such failures may not be seen in a serious light in the short run because the market adjusts to demand through hoarding of inventory or import of required goods and services. The market also adjusts in the long run to demand through expansion of industrial output and also by entry of new fi rms to the market. The crucial variable is price, which also adjusts the commodity and labor market. A problem arises when there is overproduction, overcapacity utilization of plants, excess liquidity and excess supply of money, and a change in demand because of change in tastes and habits of consumers, households, and the public. All these create knife-edge disturbances in the economy. As a consequence, they need adjustment through variables such as employment and growth of the population, saving propensity, technology, exhaustion of existing inventory, and monetary and fi scal balancing.

In this volume an attempt has been made to appraise the working of a market economy where short-term disturbances may occur, the market fails, a recessionary cycle emerges, and after certain fundamental measures have been taken the market recovers. Starting with a brief theory and recent history of the US crisis and the recession in the fi rst, introductory chapter, the discussions in the second chapter turn to the area of the fi nancial crisis and recession in the US economy. In this chapter the authors have highlighted the fi nancial factors responsible for the severe historic crisis. The third chapter relates de fl ation to unemployment. It discusses theories about the relationship between de fl ation, price levels, and unemployment and the reason why de fl ation is a bigger threat than in fl ation, and recommends recovery by adopting appropriate policy measures. The chapter analyzes the cases of a few European economies as well. The fourth chapter examines energy and resources trade and equity investment relationships between Australia and India. The chapter investigates macroeconomic and fi nancial economic risk. The study utilizes macro-economic data. In the fi fth chapter, attention is diverted to the dragon, the biggest economy, that of China. Here the author discusses the slowing of growth caused by the recession and how to achieve and maintain a faster rate of growth in the future.

In the sixth chapter we focus on the Malaysian economy. The macro variables chosen are exports, imports, price level, money supply, interest rate, exchange rate,

Introduction and Overview

xiv Introduction and Overview

and government expenditure. The co-integration method was used to assess the long-run equilibrium linkages among the selected variables. For the short-run causality, the study uses the Granger tests based on the vector error-correction model. In the seventh chapter, the global fi nancial crisis is seen from the South Asian perspective. The author has tried to show the extent of the global fi nancial crisis and its effects on South Asia. In this chapter, the impact of recession is dis-cussed for core Asian countries such as Bangladesh, Pakistan, Nepal, Bhutan, and the Maldives. In the eighth chapter the authors have tried to relate the Asian crisis and the Malaysian economy. The retrenchment of workers is critically examined here exclusively for the Malaysian economy. Further, the authors also examine the recessionary impact in South Korea, Indonesia, and other Eastern countries.

In the ninth chapter, the focus is on the Indian economy. In this chapter input–output analysis is done with the help of time-series data. In the tenth chapter, challenges and opportunities facing the Indian banking sector are examined. The chapter states that the banking sector could perform miracles in the Indian economy because it is better regulated and a plethora of service demands exist. The last chapter is again con fi ned to the discussion of fi nancial sector activities and reforms. The chapter highlights the experiences of India and the way other countries have reacted to the recent global economic slowdown. This slowdown provides some challenges and opportunities for the Indian economy. Since India is one of the emerging economies, it has the potential to increase its exports to advanced economies. This way, India can earn more foreign exchange. This will act as a cushion and dilute the effects of a slump on the economy. The chapter concludes that despite India’s high economic growth performance, it has not been able to remain insulated in this global decline.

Each chapter concludes with deliberations on macroeconomic results, and the implications for speci fi c policies, some of which have been tried and others have still to be examined. Further, in this volume we examine the policies necessary for the regulation of the economic system and give a brief assessment of the extent to which global policy coordination has been discussed in policy circles even if it has not been seriously implemented. Concluding remarks appear in all 11 chapters on the relevant themes and speci fi c to the economies concerned. With this overview of the following analysis, we present a summary of each chapter.

The opening essay by N.M.P. Verma and V. Dutta conceptualizes the working of a market economy and the frequent occurrences of business cycles in a country or in many economies simultaneously. The chapter reviews many dimensions of economic activities, such as the issue of frequent market failure, various approaches of cyclical movements, and conceptual concern for controlling reces-sion. The authors have reviewed the opinions of classicalists and new classicalists and the modern approaches. The classicalists were concerned with medium-term fl uctuations in real GNP. This fl uctuation was explained through a few theories of the business cycle. With the advent of Keynesianism, business cycle theories were not being accepted. During the post-Keynesian period many economists, such as Harrod, Domar, Hicks, Samuelson, Frisch, and Goodwin, gave their own views on adjustments of market fl uctuation. With the introduction of new-classicalist

xvIntroduction and Overview

approaches, “short run” could not be a suitable duration for a macro study. Hence, a new business cycle theory was developed which was based on rational expectations and sustained market clearance. In the end, conceptual arguments have been linked with the US slump. It has been argued that inadequate information and lack of regulations in the fi nancial sector caused the US recession. A recession caused by fi nancial factors lasts longer than a recession caused by other factors.

In the second chapter, Mukti Upadhyay and Tim Mason examine the US reces-sion. The chapter provides the historical background to the fi nancial crisis. The recent recession is termed the “Great Recession.” The recession lasted for about 2 years, and its intensity was severe. After the Great Depression of the 1930s, the present recession showed the longest contraction of the US economy. The federal government became indifferent in protecting the investor Lehman Brothers. Because of this, uncertainty started in the credit market. As a consequence, the credit market showed freezing tendencies. Other major fi nancial institutions are also reviewed, including Citigroup, American International Group, and Bank of America, which faced insolvency. Although many monetary and fi scal policies were adopted by the government, the actual output of the economy still deviated signi fi cantly from the potential output. The authors trace how the fi nancial system, left for all intents and purposes to its own devices, has deepened the instability inherent in capitalist systems found in the USA and many other countries. The chapter is full of discus-sions on the macroeconomic dilemma. Finally, regulation of the fi nancial system is examined. The chapter concludes with the need for global policy coordination.

The dynamics of de fl ation and unemployment globally is reexamined by Anson Wong and Michael Chu in the third chapter. This chapter examines global economic issues of de fl ation and unemployment after the fi nancial crisis of 2008. It starts with an overview of recent economic performance around the world. A number of fi gures visualize the recent development of GDP, in fl ation, and unemployment in the USA, the UK, and European countries. Then, it applies theories such as the quantity theory of money to illustrate the relationship between de fl ation and unemployment. It also discusses a number of determinants of the de fl ation and recession after the crisis, so that readers can understand more easily the global issues. The examples of de fl ation in Japan and Hong Kong during the 1990s and 2000s are reviewed. Besides, the chapter describes the threats that de fl ation and depression pose to the economy. A number of possible solutions to solve the problems of de fl ation and recession are given, and the chapter concludes with examples of successful recovery from the curse of recession.

In the fourth chapter, John Simpson examines energy and resources trade and equity investment relationships between Australia and India. This chapter recog-nizes the logic of the growing strength of trade and investment relationships in the energy sector between India and Australia as a basis to build upon this relationship for mutual economic bene fi t. India is a large and powerful economy with a depen-dence on coal to generate electricity for domestic and industrial use. Australia is a developed, low-political-risk country. Australia is well endowed with natural gas as well as coal and other resources, such as iron ore. The opportunity exists here for India to diversify its supplies of cleaner-burning natural gas through its imports and

xvi Introduction and Overview

through foreign direct investment in Australia in natural gas and coal. India has a dynamic and rapidly growing share market and economy, and this also presents opportunities for Australian foreign direct investment in the resources sector. Australia needs to diversify its inward and outward foreign direct investment as well as its exports of natural gas, coal, and iron ore.

Econometric analysis of sectoral stock market and country risk data reaf fi rms a strong basis for a substantial increase in two-way trade and investment. The caveat for increased foreign direct investment in India’s electricity sector is that microeco-nomic reforms need to continue to assist in making state electricity boards more viable. The increase in economic cooperation is all the more important in the uncer-tain times that have followed the global fi nancial crisis. Western Europe and the USA are burdened by public debt problems, and their growth projections have subsequently suffered. India and Australia share a regional location and both are democracies with a belief in free enterprise. India’s growth rate is very high and Australia’s growth rate is consistently the highest of the OECD countries. India and Australia are not part of the European Monetary Union and have less exposure to the same debt problems, either by accident or by design. They have a unique opportunity to expand their cooperation over the ensuing decades.

Liang-Xin Li focuses attention on the Chinese economy since the global crisis in the fi fth chapter. Since the Chinese economy took a fast growth path toward the top of the world economy, it is interesting to examine China’s way of development. He demonstrates what China was doing, is doing, and will do to achieve economic expansion during and after the global crisis. Many thoughts and theories about Chinese economic reforms are analyzed. The road map and goal of Chinese economic growth are examined and outlined. How to keep the Chinese economy growing faster after the recession is the chapter’s key issue.

The role of macroeconomic fundamentals in Malaysian post recession growth is presented by Lee Chin in the sixth chapter. The Malaysian economy experienced contraction during the 1997–1998 Asian fi nancial crisis. Nevertheless, the economy started to recover in 1999 and grew steadily in the following years. The Malaysian government has made much effort to help the economy recover, such as adopting monetary policies that aim to promote monetary stability and suf fi cient liquidity in the economy, keeping the in fl ation rates low, and adopting currency control which pegs the ringgit at the rate of RM 3.80 to one US dollar. As a result of the stable exchange rate, the external sector also achieved a good surplus. Thus, it is the aim of this chapter to fi nd out the roles of monetary policy (money supply and interest rate), fi scal policy (government expenditure), the external sector (exchange rate, exports, and imports), and the general price level in Malaysian post recession growth. The techniques of co-integration and Granger causality are employed to examine the relationships between economic growth and these macroeconomic variables. The results show that an increase in exports and government expenditure or a depre-ciation of the exchange rate will promote long-term economic growth, whereas an increase in in fl ation, the interest rate, and imports will reduce economic growth. Furthermore, the price level and government spending in fl uence economic growth in the short run. In a nutshell, the fi ndings suggest that fi scal policy is probably the

xviiIntroduction and Overview

most appropriate tool in promoting economic growth in Malaysia during the post recession period.

Nikhil C. Shil examines the fi nancial crisis from a South Asian perspective in the seventh chapter. The global fi nancial crisis came as an economic devil and swiped away a lot, imposing a signi fi cant toll on the world economy. The crisis that started in September 2008 lasted for about 2 years, but by now most of economies have started reviving. Thus, now is the time to look back and evaluate what happened. Initially, the South Asian countries were affected much owing to a high level of integration with economically advanced countries, but later they managed to mitigate their problems. The author tries to present a complete picture, covering the back-ground to the global fi nancial crisis, its impact on South Asian countries, the present status, and future challenges. The contribution is a conceptual one depending on different secondary sources of information combined with the author’s own judgments. The scenario of recessionary impact is shown in the case of core Asian countries such as Pakistan, Nepal, Bhutan, Bangladesh, and the Maldives.

The Asian economic crisis and Malaysia’s responses and the implications for the banking sector are studied by Balakrishnan Parasuraman , Beatrice Lim , Fumitaka Furuoka , Catherine Jikunan , and Lo May Chiu . This chapter examines the Asian economic crisis which occurred during 1997–1998 and the Malaysian economy’s responses. The chapter chooses the Asian fi nancial crisis as a case study to examine its impact on the Malaysian economy and describes how the Malaysian government responded to the crisis. It also focuses on the impact of the Asian fi nancial crisis on employment in the banking sector in Malaysia. The Asian fi nancial crisis created havoc in countries such as Thailand, Indonesia, and South Korea, where these countries had to seek assistance from the International Monetary Fund in order to save their economies. However, Malaysia took a different step in saving the country by refusing the International Monetary Fund package and aiming for a stricter fi nancial adjustment. What is important here is how the crisis affected a number of people, most of whom were workers. During the Asian fi nancial crisis, many workers lost their jobs because of the closure of many businesses (manufac-turing, construction, etc.), mergers and acquisitions, and other forms of reducing the workforce in order to save costs. The unemployment rate in the country increased from 2.6 % in 1997 to over 5 % in 1998. In the fi nance, insurance, real-estate, and business service sectors, 6,596 workers were retrenched. As a result of the crisis, the banking sector in Malaysia began to experience increasing nonper-forming loans, bringing about tight liquidity conditions. This situation forced the banks into merger and consolidation exercises initiated by the government. Besides mergers and acquisitions, the banks also embarked on downsizing, lean-trimming, organizational changes, and the introduction of new technologies. In other words, many small banks were forced into merging with bigger banks and many excess workers were offered a “voluntary separation scheme.” These retrenched workers became the urban poor, facing the high costs of living and no opportunity to obtain jobs as there was no safety net.

The sources of output growth during the postliberalization and recessionary era in India through an input–output structural decomposition analysis are described in

xviii Introduction and Overview

the ninth chapter by K.K. Saxena , Sarbjit Singh , and Rahul Arora. They have made an attempt to decompose the changes in output growth in the Indian economy. The study highlights four key components:

1. Mean growth of fi nal demand 2. Variations in the composition of fi nal demand 3. Fluctuations in input–output coef fi cients 4. Interface of both change in fi nal demand and technological change

Input–output tables have been utilized for this purpose. Owing to the unavailability of recent input–output tables, the analysis of recent years (2007–2008 to 2009–2010) was done using data from different economic surveys provided by the Ministry of Finance, Government of India. The modi fi ed method of decomposition of output growth from the demand side was utilized to calculate the percentage share of each component in the total fi nal demand change. From 1993–1994 to 2006–2007, the total change in output was approximately 200 %. Of this change, 89.27 % (87.46 % + 1.81 %) is explained by a change in fi nal demand by assuming constant input–output relations. For the share of the interaction factor where changes in both the fi nal demand and the input–output relations were assumed, the contribution is just about 7 %. To better understand the changes, the growth in output was further divided into fi ve more factors, that is, private consumption, government consumption, gross investment, exports, and imports. Among these fi ve demand categories, domestic demand (sum of private consumption, government consumption, and investment expenditure) is the dominant source of output growth in the postlibera-lization era, which supports the hypothesis that the Indian economy is a domesti-cally demand driven economy. From 1993–1994 to 2006–2007, the contribution of investment demand was highest and afterward, owing to the fi nancial crisis, con-sumption expenditure took the lead, with increased government consumption expenditure to overcome the negative impact of the crisis. The economy again came back on track in the later half of 2009–2010, with more growth of investment demand in the economy.

The recent recession and the challenges and opportunities for rebalancing Indian banking are considered in the tenth chapter by D.K. Yadav . India is an emerging economy. Its growth rate was close to 10 % in prerecession years and was 7–8 % even during the recession. This high growth rate of the economy is supported by the Indian fi nancial system. After 1991, when the structural reform process was imple-mented, Indian companies became global, and multinational companies also entered the Indian economy. This changing structure of the Indian economy is providing an opportunity for the Indian banking and fi nancial system to expand its business at the world level. According to the Indian Bank Association report “Banking Industry Vision 2010,” there will be a greater presence of international players in the Indian fi nancial system and some of the Indian banks will become global players in the coming years. The current competitive position of the Indian banking system, however, is not satisfactory in terms of numbers and ranks. Only 20 Indian banks, including private sector banks, appear in the list of the top 1,000 world banks, as listed by the London-based magazine The Banker . However, the current recessionary

xixIntroduction and Overview

problem, which started with the fi nancial crisis in the US economy and which now has European countries in its grip, has revealed the strong competitive position of Indian banks in terms of qualitative factors such as asset quality, capital adequacy position, and ef fi cient responsive regulatory structure. When the leading large banks of the world are collapsing, Indian banks are not only safe but have also produced signi fi cantly positive returns in terms of pro fi t. This chapter is an effort to evaluate the competitive position of Indian banks in the postreform period, particularly in the post recession period. It was found that Indian banks are competitive enough in comparison with their foreign counterparts and the current recessionary problem has improved their competitiveness in the global fi nancial market. However, increas-ing their size by the well-structured process of bank consolidation, cost manage-ment, legal aspects of recovery management, improving risk management skills of banking staff, and speedy reform on the policy front are some of the challenges to be overcome to make a world-class competitive banking system a reality.

In the fi nal chapter, Basanta K. Sahu examines the impact of the global downturn on the Indian economy. Owing to increased integration of world markets, transmis-sion of the economic crisis from one country to the rest of the world has become easier. Although the recent global economic slowdown has taken center stage in policy debates and discussions across the world, the variability and volatility of economic growth and trade performance are worrying and differ for different economies. An impact has been experienced in almost all regions and sectors, with different degrees and dimensions. This chapter seeks to analyze how the recent global downturn has impacted the Indian economy and resulted in an increasing sense of insecurity. For India the crisis made matters much worse by causing sharp declines in exports of goods, reversal of capital fl ows, reduction in the volume of remittances, worsening balance of payments, increasing joblessness, rising prices, and deteriorating socioeconomic development scenarios. Within the economy the performance of different regions and sectors has been different. In this context, the chapter highlights the experiences of India and the way different economies reacted to the recent global economic slowdown, which provides some challenges and opportunities for India. India, being one of the emerging economies, has relied heavily on advanced countries for its exports and has experienced diverse impacts of global slowdown. Despite its good economic growth performance, India has not been able to remain insulated in this global decline. In real terms, the growth in India’s exports and imports of both goods and services has declined and joblessness has been experienced owing to contraction of output in the export sectors. However, transmission of the impacts through different channels seems to have been different for the Indian economy in comparison with other economies. The chapter also discusses the precrisis macroeconomic scenario in India and critically analyzes the argument that the Indian economy has been less affected owing to its lesser integra-tion with the world as compared with its size and potential.

The impacts of the crisis are differentiated spatially and sectorwise because many core sectors of the economy are driven by huge domestic demand and are able to absorb some kind of shocks originating from the global slowdown. However, there are some important lessons for policy makers to consider, such as the balance

xx Introduction and Overview

between development of the export sector and development of the nonexport sector, to achieve and maintain the desired growth with strong macroeconomic fundamentals, especially in a crisis situation such as the recent global slowdown. The chapter con-cludes with some policy suggestions, especially for developing economies, based on trade and service sector led growth like in India.

Thus, an attempt has been made to cover the broad perspectives of the global recession in all 11 chapters. The volume starts with conceptualization of the issue. It highlights the US scenario and its probable effects on other larger economies, which include those of Australia, China, Malaysia, and India. Nevertheless, it does not mean that European and other Asian economies have been left out. While analyzing various issues, the authors have substantiated the arguments by citing the cases of a few European and many Asian economies.

1N.M.P. Verma (ed.), Recession and Its Aftermath: Adjustments in the United States, Australia, and the Emerging Asia, DOI 10.1007/978-81-322-0532-6_1, © Springer India 2013

1 Introduction

Recession is an economic phase when various sectors of the economy re fl ect working at the bottom for at least two quarters of a calendar year. Investment declines, unem-ployment increases, income declines, the growth rate falls, asset values collapse, consumption falls, and overall the economy is in crisis. Conventionally, a recession is said to occur when GDP falls for at least two consecutive calendar quarters. For the US economy, a recession is of fi cially indicated by the National Bureau of Economic Research. “Recession” is also termed “contraction” or “slump.” Following a recession, there is often a boom, i.e., expansion, and thus this reverses the effects of a recession. In a recession, there is a reduction in production, resulting in high unemployment. During a boom, however, there is a rapid rise in prices. The period from recession to recovery and boom is called a business cycle or trade cycle. There are short-run macro problems but these do not last long because of corrective measures taken by one or many market players, including interventions by the government.

Recession is also known as failure of a market because its ef fi ciency declines. The market is really a place of complex transaction relations. A large number of buyers and sellers gather in a market and submarkets for clearing products and inventories. In classic economic theory, there was a small market and, therefore, there was hardly any effect on short-run macroeconomic balances. The adjustments in cases of deviations from output and full employment take place through price and wage variations. The classicalist was, however, concerned with medium-term fl uctuations of real GNP.

N. M. P. Verma (*) Department of Economics, Babasaheb Bhimrao Ambedkar University , Lucknow , India e-mail: [email protected]

V. Dutta School of Public Policy, University of Maryland , College Park , MD , USA

Chapter 1 Understanding Recession: Conceptual Arguments and US Adjustments

N. M. P. Verma and V. Dutta

2 N.M.P. Verma and V. Dutta

This fl uctuation was explained by a few theories of the business cycle (Van der Ploeg 1985 ). With the advent of Keynesianism, business cycle theories were not accepted. During the post-Keynesian period, many economists such as Harrod, Domar, Hicks, Samuelson, Frisch, and Goodwin gave their own views on adjustment of market fl uctuation. With the introduction of new-classicalist approaches, “short run” could not be a suitable duration for a macro study. Hence, a new business cycle theory was developed which was based on rational expectations and sustained market clearance. This opinion was developed by Lucas ( 1975 , 1977 ) . The market plays a crucial and ef fi cient role in coordinating production and distribution of goods and services. It is a concept that is virtually a few decades old. After the failure of the central planning system of the Soviet Union in 1992, the market economy suddenly became important. The central planning of Russia was burdened with bureaucracy. It neglected consumers and the agricultural sector. It concentrated seriously on big industry and defense products. Market exchange was partly decentralized and producers received many incentives to ful fi ll consumer desires. Therefore, this led to a more ef fi cient system. A market economy also provides choices to ful fi ll desires. There is no coercion in a market economy. Therefore, it is considered superior and ef fi cient, and the new clas-sicalists believe in “free markets” for major economic decisions. However, Keynesians emphasize how real-world markets might differ from the coherent activities of markets in theory. The real-world markets require illustrious institutions to work. Markets on their own often cannot address numerous economic problems. Thus, for very ef fi cient working of a market there should be prevalence of societal trust, infrastructure for smooth fl ow of goods and services (including information), and money as a medium and measure of exchange (Suresh 2009 ) . 1

In this introductory chapter, the theoretical literature is critically analyzed. The recent US recession is described in the light of theoretical developments. The chapter ends with a description of the various macroeconomic measures already taken and likely to be taken by the US government to achieve economic recovery.

2 Frequent Market Failures

The mechanism of a market is constrained and becomes less ef fi cient because of reasons such as public goods, externalities, transaction costs, market power, complex information, and escalating expectations (Akerlof and Allen 1985 ; Barro and Sala-i-Martin 1995 ; Varian 1979 ; Zarnovitz 1985 ) and concerns for consumer welfare and equity. The failure of a market is thus a condition where the market produces inef fi cient and below-optimum outcomes. Since public goods are unrivaled, nondiminishable, and nonexcludable, it is generally not possible to transact in the market. In the situation of free riders, public goods can be provided and even delivered through public outlets and agencies. Often, they may be delivered by levying various taxes so that the cost is virtually borne by the public. Externalities both positive and negative also affect the market. They create problems in the measurement of the real social value of goods or services, which differs from the market value. Externalities often damage the natural environment because of negative side effects. Since damage

31 Understanding Recession: Conceptual Arguments and US Adjustments

is not priced, it does not have a price tag. Similarly, higher transaction costs may lead to higher prices, which may discourage demand. This may thus also lead to market imbalances. Further, every fi rm wants to grow and get more market share. Even in the case of military goods and defense services, the major part of the market is shared by government agencies. These growing market shares may lead to their affecting the price of inputs and outputs and also employment in a market. This way, the market is less ef fi cient (Goodwin et al. 2009 ) .

In neoclassical analysis, there is no discussion of resources being allocated in such a way that people can satisfy their basic human needs. If platinum can result in more pro fi t than medicines, then a fi rm would invest in platinum production and marketing rather than in medicines. This makes the market inef fi cient. Further, the market does not consider social obligations, such as caring for the sick, elderly, children, the otherwise able, widows, and other needy persons. Lastly, information systems and investment expectations also create market failure. In a neoclassical model, decentralization leads to ef fi cient consequences. The consumers and producers have easy access to all the relevant information they need to make the best choices. In a static macro analysis, this is possible because there is a low data requirement. In a dynamic analysis, however, a lot of data and information are required relating to choices and expectations. This complicates the analysis based on market data and the results deviate from the expectations and choices. As a result, the market is less ef fi cient and, therefore, it is termed a market failure. The classical macroeconomists believed that a market generally operates smoothly as long as various government agencies do not intervene. But often government intervention is necessary for the welfare of people when a market fails, and various service deliveries do not take place. In contrast, Keynesian economists believe that market economies need more interference from the government side. In the case of both shortage and surplus of marketable goods and services, the government has to intervene rationally for stabilization (Sloman and Sutcliffe 2004 ) .

Unemployment in a recession is like a cyclical unemployment which is caused by fl uctuations in many macro variables. There is a fall in aggregate demand for goods and services in the national boundaries. In the USA in the period from 1961 to 2007, the unemployment rate was 3.4% in 1969 and 10.8% in 1982. According to the National Bureau of Economic Research, the recession ended in 1991 but reap-peared in 2001. The continued loss of employment up to 2003 was a period of “job-less recovery” because GDP grew but its growth rate was too slow for jobs to be created for new entrants. During the phase of contraction, unemployment rises, whereas in a recovery or boom, unemployment falls. When production in an economy is falling, producers require fewer workers. The opposite of this is true for a boom. According to Okun 1981 , a 1% fall in the unemployment rate causes an approxi-mately 3% boost to real GDP. Thus, there is a direct relationship between the rate of unemployment and rapid real GDP growth. Monthly data from the Bureau of Labor Statistics for 1990–1991, 2001, and 2007 show that unemployment increased swiftly in the US economy. During a recession, the rate of in fl ation falls or even becomes negative. As an economy moves toward a boom, investors invest more. The demand for raw materials and labor increases; these factors raise the cost of production and thus the rate of in fl ation increases. During a recession, this process is reversed and


thus the rate of in fl ation falls. So during a recession there is rising unemployment and a falling rate of in fl ation, whereas during a boom there is falling unemployment and an increasing rate of in fl ation (Goodwin et al. 2009 ) . These tendencies are often analyzed by the theory of the trade cycle or business cycle.

In Fig. 1.1 , GDP contracts from an upswing to a downswing and expands from a downswing to a boom. Y

0 Y

1 , or the dotted block, shows the full employment range.

If the output is outside this area, then there is macroeconomic instability. To stabi-lize the economy, a few corrective policy measures are required. There are many theories concerning the economic cycle (Begg 1977 , 1982 ; Black 1982 ; Blinder 1981 ; Farmer 1998 ; Fischer 1988 ; Frisch 1933 ; Hansen 1985 ; Harrod 1963 ; Hicks 1950 ; Kalecki 1935 , 1937 ; Macmallium 1988 ; Mellander 1993 ). In the following analysis, many key theories are critically discussed.

3 Macroeconomic Theoretical Dynamics

In the multiplier–accelerator information theory, consumption depends on previous income. Investment can be either autonomous investment or induced investment. Autonomous investment is a function of infrastructure and other basic needs of the economy and thus is virtually determined by the rates of growth of consumers and technical prosperity. It is not governed by various market forces and operations. In contrast, an induced investment is guided by market operations and accelerator-

Contraction Expansion

GDP

Upswing Upswing

Y1

Y0

Downswing

O Year

Fig. 1.1 Formation and movement of the economic cycle


related forces. If sales are increasing, then induced investment will also follow an increasing tendency. A recession will occur if sales are decreasing followed by induced investment.

As shown in Fig. 1.2 , there is a minimum output which is consistent with zero induced investment. Since there is always some amount of autonomous investment, output cannot go below this point. If income goes up, the induced investment line would move upward. In another situation, the maximum output is given by full employment at a different time point. If income goes up, then full employment output will also go up, that is why lines II and FE are parallel to each other. Both of these lines are moving upward (see Jha 1991 for details).

The output rises after point N. There line II becomes positive through the impact of the accelerator. Since the multiplier is effective, with the rise in investment, output increases. Such a phenomenon further increases the investment and thereafter the output. This leads to a situation of boom or expansion. The economy touches the full employment zone. From now onward, the output can grow slowly, pushed by the rate of growth of autonomous investment. In the next period, income falls, and line II drops through the accelerator effects. This decreases the GDP through the multiplier effect. This again lessens the investment. As a consequence, the economy is confronted by recession. Capitalists do not intend to invest, a II becomes zero. Output cannot fall further because of autonomous investment. This would raise II

FE

Full employment limit

S1 S2 II

S3 S4

N1

N

N0 Zero induced investment area

O

log Y

t

Fig. 1.2 Multiplier–accelerator interface and cyclical change. FE full employment


from zero. This tendency would further increase income. The economy would recover from the recessionary phase. If we deal with the dynamic state, N to S is the duration of the boom or expansion. Along the line S

1 to S

2 , we would have the full

employment situation. Along the opposite path, S 2 to S

1 , the economy goes into

recession, and along S 3 to S

4 , the economy proceeds toward zero for II. At point S

4 ,

however, the recovery would be established. Thus, the fl uctuation and fl exibility in the economy is caused by multiplier–accelerator interactions, which are also affected by consumption and investment behaviors. Consumption is changed by consumers and investment is altered by capitalists. The dynamic economy, in a dynamic situa-tion, thus moves like a clock pendulum where one side is in recession and the other side is a boom. This cycle keeps on moving on short intervals. The market fails and recovers through reformatory actions of various market and nonmarket agencies.

In this model of Hicks ( 1950 ), Samuelson, and Frisch, the issue of inventory does not emerge; therefore, Metzler used the “inventory” factor to explain the business cycle in an economy. Normally, every fi rm maintains a buffer stock of raw materi-als, assets, goods, and services because of uncertain future demand. There is autono-mous investment. Firms produce to meet estimated demand as well as to keep a fraction of produce as a shock absorber stock of inventories. The following situation may develop:

1. The projected demand may be equal to the physical demand. 2. The expected demand may be higher than or lower than the real demand. If the

estimated demand is equal to the actual demand, then a full employment equilib-rium will be established. If there is a deviation from this point of equality, there will be fl uctuation. This happens because sales expectations do not materialize. Thus, the actual buffer stock will be different from the desired one. This discrepancy will produce fl uctuations in the market which we term a case of “market failure.” The higher inventories will lead to low labor demand and production. This creates a recessionary situation. The recovery starts once this condition is exhausted. Once it is over, an “upswing” in the economy will occur. However, Kaldor ( 1940 ) gave another reason for this kind of occurrence.

To show contraction and expansion in the economy, Kaldor ( 1940 , 1960 ) chose saving and investment as the determining factors of nonlinear dynamics in the economy. In every economy there is always a traditionally determined mean rate of investment. If there is low level of real national income, then a situation occurs where pro fi t oppor-tunities are being missed. When for a fi rm income is higher than the decreasing returns of scale and the rising costs of fi nancing, this results in less investment propensity. There is also a negative association between capital stock and investment. An increase in capital stock reduces the marginal ef fi ciency of capital, so investment is lower for each income level. If the capital stock falls, the investment will move upward. As regards the saving function, like for investment there is a mean saving propensity which is historically determined on the basis of earlier economic behavior.

If income is higher than the normal level, pro fi t will also be higher. Since saving by capitalists exceeds saving by workers, saving propensity will increase. Similarly, in the case of falling income relative to the normal level, pro fi ts will decline. This


will result in a greater fall in savings. To conclude, the marginal propensity to save is higher at low levels of income (Solow 1956 , Solow et al. 1966 ) .

At the point of equilibrium, the level of income saving will be equal to the level of investment. Again there is scope for saving being higher or lower than investment. Thus, as shown in Fig. 1.3 , there are three equilibrium points A, B, and C. Here A and C are a stable equilibrium and B is an unstable equilibrium because a minor slip from B will force the equilibrium to either A or C. The only difference is that at point A income is low and investment is low (zero). If capital depreciates, investment shifts upward toward B. If this trend continues further, then A will move to C after passing through B. The economy will maintain expansion at C. If the economy moves from C to A through B, a reverse movement, then recession occurs. At point A, employment will be low. 2 Thus, according to Kaldor ( 1940 , 1960 ) the reason for recession is the discrepancy between investment and saving. To the right of B, investment is greater than saving. This shows there is a rise in income. On the left side of B, investment is less than saving. This shows that income will fall. Even if either investment or saving is linear, this type of cycle will still occur .

Goodwin (1951) used capital stock and investment as the determining factors for contraction and expansion of the economy. If the real and desired capital stocks are equal, then net investment will be zero. Gross investment will be equivalent to depreciation. If the expected capital stock is less than the actual capital stock, then gross investment will be zero. The capital stock can only decrease by the extent of depreciation, which is fi xed. Conversely, if the expected capital stock is more

S(Y)

I,S

C I (Y)

B

A

O Y

Fig. 1.3 Saving–investment function and economic fl exibility


than the actual capital stock, then difference of the two will be matched through investment. Thus, gross investment will be a positive value in this situation. The periodic dissimilarity in actual and expected capital stock will bring about boom and recession. The period of boom or even recession may vary depending upon the amount of depreciation of capital goods and investment.

In this analysis, K a is the actual capital stock K

e is the expected capital stock, I is

investment, and D is depreciation. In Fig. 1.4 , the actual capital stock is equal to the expected capital stock at A

5 . If because of disturbance Δ K

a > 0,then K

a > K

e and

the total investment will be zero since I − D = 0. Net investment will be negative until the actual capital stock is larger than the intended capital stock. At point A

1 , K

a = K

e ,

and the desired stock shifts to a higher equilibrium point. Since the actual stock at A

1 is smaller than this new desired stock, the net stock shifts to A

4 from A

1 . Until

the capital stock is lower at A 3 , net investment will be I − D . Once it reaches A

3 , the

same mechanism shifts in the amount of intended capital stock. It will appear along A

1 to A

4 . The boom and recession may not necessarily be of similar intensity and

length. 3 Alternatively, there can be three cases as follows:

Case 1: If K a > K

e , there is zero gross investment, and capital stock can decrease by

the amount of D . Case 2: If K

a < K

e , gross investment equals I .

Case 3: If K a = K

e , net investment ( I − D ) is zero, and gross investment equals I = D .

Thus, in this model the cause of the business cycle is the deviation of the actual capital stock from the desired or intended capital stock, which is further reduced by depreciation and investment behavior. This argument was further re fi ned.

K* A3

O K a, K e

A1 A2

A5

A4

Fig. 1.4 Capital variation and cyclical movements


According to Blinder and Fischer (1981), a chronic business cycle appears because of monetary shocks. An increase in money stock will escalate prices and sales. As a result, investment will fall. Once this investment is exhausted, there will be a higher level of production and investment. Thus, the upswing and downswing in the market is caused by unexpected monetary shock. Naturally, if there is an expansion or contraction of the money supply then it will affect prices and even the interest rate. If people expect a change in the supply of money, they may also expect an escalation in prices. If the initial interest rate does not change substantially, then a fall in interest rate may cause a rising real interest rate. As a result, investment will fall. Thus, monetary shock will cause a business cycle. However, this opinion was again re fi ned by Long and Plosser ( 1983 ) . They argued that a business cycle is possible without considering complete information. The decision regarding labor and capital inputs is considered at the beginning. The actual output is, nevertheless, not exactly known at that particular point of time. As a result, there is a variation in inputs applied which is fi xed and expected, but output hardly coincides with expectations. Such fl uctuations and resultant business cycles are independent of monetary shock.

A political business cycle was introduced by Nordhaus ( 1975 ) and Lachler ( 1978 ) . In this model, the economy is moving without any change over time. It is the govern-ment agencies and their operational policies which encourage monetary policies or fi scal policies. There is also coincidence of election dates, recession, and recoveries. The government makes certain policies before the election date which may bring about a business cycle. Prior to the Obama administration coming to power in the USA, there was a recession. After normal functioning of the government had resumed, 1 year later, the US economy started showing symptoms of recovery. Even in India, prior to the election, there was a mild recession, partly because of US effect, which turned into a boom once the new government took charge. Enough money was pumped into the economy through Sixth Pay Commission arrears given to nearly 3.8 million central government employees. Later, several states also revised salaries and distributed arrears to the respective state employees. Thus, a change in monetary policy contains business cycles (Sims and Zha 1996 ; Smets 1997 ). However, there can be deviations from the rule either by changing the systematic components of monetary policy or by considering an exogenous shock which leaves systematic monetary policies unchanged. Nevertheless, the monetary transmission mechanism has been criticized on the basis of the role of the central bank (Favero 2001 , p. 172). This may be termed structural distress.

To show the slump, two growth models are also worth mentioning: one pro-pounded by Harrod and Domar and the other by the neoclassicalist Solow. Either there is an upswing or a downswing, but ultimately it is a question of a fl exible “rate of growth.” Domar (1946) and Harrod ( 1948 ) were very much concerned with growth and instability. They experienced the effects of the Second World War. The economies which were damaged were trying to recover fast; the underdeveloped economies were trying to take initiatives for faster economic growth. The advanced capitalist economies which were free from slumps were attempting to achieve a long-run rate of growth and the socialist economies were trying to take a lead,


expand, and surpass the richer capitalist economies. Both Harrod and Domar raised three questions pertaining to economic growth and instability. First, the possibility of steady growth, which will be equal to the saving–output ratio ( s ) divided by the capital–output ratio ( C ), where both s and C are fi xed. Second, if growth is steady, then there may be the possibility of instability in steady growth. If s / C is realized as expected by capitalists, then it is “warranted” rate of growth. If it dos not material-ize, in other words, if there is a growth rate other than that warranted, then instabil-ity problems will occur in the economy. Thus, instability will lead to recession. It all depends on the anticipation of investors. If investors anticipate more than warranted growth ( s / C ), the actual rate of demand will be more than the high expected growth rate and then investors will realize that they expected less. In another situation, if investors anticipate a growth rate lower than the warranted one, then the actual growth rate will be lower than the expected growth rate, and investors will realize that they expected more rather than very little. Under these two situations, the mar-ket gives a red signal of disequilibrium to capitalists. If actual demand falls short of expected demand, then utilization of potentiality may be underused. This will lead to a slump if it prevails for quite some time, followed by de fl ation. If actual demand is higher than expected demand, then fi rst dishoarding of inventory will take place. Once inventory is exhausted, prices will rise. Then the economy will have to be bal-anced between cumulative de fl ation and cumulative in fl ation. To have an adjust-ment in the economy, capitalists may raise or reduce growth expectations in conformity with prices, either higher or lower than expected. If we want to link it with employment, then in the case of a warranted growth rate higher than the natural growth rate of the labor force ( n ), full employment will occur once the initial shock has been absorbed. Otherwise, if the warranted growth rate is lower than rate of growth of the labor force, then mass unemployment will occur in the economy. Thus, for adjustment in the economy there are only three variables, s, C , and n . Here n includes technological change as well. Because of technology ( m ), labor can be absorbed or replaced by machines. In this Harrod–Domar model the saving–output ratio and the capital–output ratio are fi xed and therefore the model cannot properly explain market fl uctuation in a dynamic economy. Suppose

-= - 1( ) ,t t tI X Y C

where I t is investment, X

t is the expected demand in period t , and Y

t − 1 is the actual

demand in the last period, or

1 /= ´tY s I

or

-= - 1/ ( ) / ,t t t tY X X Y C s

or

/ /t tY X geC s=

where g e is the expected growth rate of demand.


Similarly, the actual growth rate of demand g a = ( Y

t − Y

t − 1 )/ Y

t , and g

a = g

e = s / C = g

w ,

where g w is the warranted growth rate. This is a case of stable growth.

If g a > g

e , this situation will lead to fi rst dishoarding, and then in fl ation will occur.

If g a < g

e , this will lead to undercapacity production or recession and a fall in prices

and unemployment. Besides Harrod and Domar, Cambridge economists such as Kaldor ( 1960 ),

Pasinetti ( 1965 ) , Kalecki (1954), and Robinson (1956) felt the instability problem in the economy was because of a difference in income and saving propensities among workers and investors. They agreed on adjustment through savings. Pasinetti, while correcting Kaldor, incorporated returns on the accumulated value of a worker’s sav-ing. If the rate of return is the same for workers and for capitalists, then the economy will ultimately converge on a growth path which will be affected by the propensity of capitalists to save under certain assumptions. In the case of a rise in saving by workers, there would be a fall in the income of capitalists. The economy will be balancing off the initial impact. Thus, investment will decline if the income of capitalists declines. This will lead to constrained investment and a slump in the economy. Thus, the Cambridge version uses income distribution as a factor for balancing the economy.

The neoclassical economists tried to resolve the instability problem of Harrod and Domar. The capital–output ratio is the reason for instability here (Solow 1956 ) . If the warranted growth rate is greater than the natural growth rate including technology, then wages will be costlier than capital because of the full employment barrier. Capitalists will search for labor-saving techniques. Then the retrenchment of labor will begin. This will increase the capital–output ratio and reduce s / C until it coincides with the natural and technological rate of growth. Conversely, if the warranted growth rate ( s / C ) is lower than the natural and technological growth rate, then real wages and real interest rates will fall, more labor intensive technologies will reduce the capital–output ratio, and s / C will increase until it equals the natural and technological growth rate. Thus, in the neoclassical model (Solow 1956 and Swan 1956 ) the capital–output ratio ( C ) adjusts the economy and brings about equi-librium, whereas s , n , and m (technology) remain constant.

4 Methodology of Estimation

To study business shocks, we need data of continuous nature. Time-series data are useful for this purpose. Time-series data can be written as

{ } { }1 2 3, , or , 1 .¼ = ¼t tx x x x X t t

Here t symbolizes an index of a period of time where X appears. X t is a random

variable written in an ordered manner of sequence. This sequence is termed a stochastic process. X

t is normally independently distributed over time. It has constant variance

and zero mean. It is not an ideal model for a macroeconomic time series because it hardly re fl ects “persistence” property. To study a realistic model, autoregressive


moving average models are generated by using a linear combination of stochastic processes. Furthermore, a stochastic process becomes stationary if its joint density function does not depend on time. This means a stochastic process becomes stationary when for each J

1 , J

2 , … J

n , the joint distribution, F ( X

t , X

t + j 1 , X

t + j 2 … X

t + jn ), does not

depend on t . The Cowles Commission (CC) approach is a conventional method of econometric

modeling for monetary transmission. It helps evaluate quantitatively the impact by monetary factors. In this traditional analysis, there are three stages 4 :

1. Speci fi cation and identi fi cation of the model 2. Estimation of parameters of the model 3. Simulation of effects of policies formulated by monetary authorities

This CC approach for identifying macroeconometric models failed in 1970 because it did not represent data and theory. It was also not effective for forecasting and thus policy-framing. That is why the London School of Economics (LSE) approach, pro-pounded by Lucas ( 1975 ) and Sims ( 1980 ) , the intertemporal optimization (real busi-ness cycle approach), was developed. The LSE approach for macroeconomic modeling shows the ineffectiveness of the CC approach for the practical purposes of forecasting power as well as policy-framing. This happens because the CC approach does not represent data and logical theoretical orientations. The CC approach hardly takes projections into account explicitly. Therefore, the CC approach mixes into the economy “deep parameters” such as preference and technology factors and “expected parameters” which are unstable across different policy authorities. Because of insta-bility problems, the CC approach is useless in policy formulation and simulation, (Lucas 1976 ) . There are several causes for our omission of relevant variables or the dynamics for the included variables, including the static equation. The LSE solutions to solve these problems use the theory of reductions. Here modeling is interpreted as a very simpli fi ed representation of the unseen statistics-generating process. The ade-quacy of the statistical model is evaluated by analyzing the reduced form, and the LSE approach starts its speci fi cation and identi fi cation procedure with a general dynamic reduced form model. The congruency of such a model cannot be directly assessed against the data-generation process, which is unobservable.

However, a series of investigative tests are proposed as criteria for evaluating the validity or congruency of the baseline model. The congruent model should feature true random residuals; hence, any departure of the vectors of residuals from a random normal multivariate distribution signal indicates a misspeci fi cation. Once the baseline model has been validated, the reduction process begins by simplifying the dynamics and reducing the dimensionality of the model by omitting the equations for those variables for which the null hypothesis of exogeneity is not rejected. The LSE approach re fi nes it by decomposing it into different categories, determined by the purpose of the estimation by the model (Favero 2001 , p. 92). After the last investigation for the validity of the reduction process is complete, the econometric model is used to make forecast and policies.

The LSE approach hardly questions the potential of macroeconometric modeling for simulation and policy evaluation. At the juncture of simulation and policy evaluation


there is hardly any difference between the traditional CC approach and the LSE approach, but the LSE approach provides better identi fi cation and speci fi cation of the model, and the importance of estimation is deemphasized. No innovation is proposed at the phase of simulation and policy evaluation. The vector autoregressive (VAR) approach has much in common with the LSE method; however, it differs from the LSE method as regards the purpose of the speci fi cation and estimation. In the CC approach the typical question asked within a macroeconometric model is as follows: “What is the optimal response by the monetary authorities for movement in variables to achieve given targets for the same variables?” The VAR method knows about the Lucas critique and puts a question such as “How should a central bank react to shocks on macroeconomic variables?” This has to be answered within the framework of quantitative general equilibrium models of the business cycle (Favero 2001 , p. 162). So the answer will depend on the theoretical model rather than an empirical model. The VAR method is con fi ned to deviations from the monetary rule which gives solution to the problem of endogeneity of money. The fi rst type of deviation is obtained by modifying the response of the central bank rates to macro-economic conditions such as fl uctuations in output, prices, and the consumer price index. The other deviation is seen by considering an exogenous shock which does not alter the response of the monetary authority. VAR models have concentrated on simulating thoughts, leaving the systematic component of monetary policy unal-tered. Nevertheless, the VAR approach has been criticized because it views central banks as “random number generations.” This is not correct since monetary rules are explicitly estimated in structural VAR models. However, the focus is not on rules but on deviations from rules. Deviations from monetary rules help detect the response of mac-roeconomic variables to monetary incentives unexpected by the markets. The mon-etary impulses (such as policy rate and interest rates) relevant to the transmission analysis are, therefore, structural shocks (Favero 2001 , p. 172).

The LSE and VAR models of monetary transmission mechanism have a common structure, which is as follows (Favero 2001 , p. 163):

1

1

( ) ,Y

t t tM

t t t

Y Y vA C L B

M M v-

-

æ öæ ö æ öç ÷ç ÷ ç ÷è ø è ø è ø

= +

where Y and M are vectors of macroeconomic (nonpolicy) variables (e.g., output and prices), and variables controlled by monetary aggregates and other factors, respectively. Matrix A shows the contemporaneous relations among the variables. C ( L ) is a matrix fi nite-order lag polynomial.

Y

M

vv

v

æº

öç ÷è ø

is a vector of structural disturbances to the nonpolicy and policy variables; non-zero off-diagonal elements of B allow some shocks to affect directly more than one endogenous variable in the system. The main difference between the two methods lies in the objectives for which both models are intended.


5 Inadequate Information and Downswing

Information about the structure and activities of markets has a great bearing on business fl uctuations. If markets are decentralized and buyers, sellers, and other agents have limited and incomplete information about other markets, price signals do not give correct information. This leads to frequent failure of markets and shocks appear. These shocks could have been avoided in the case of perfect and unlimited information about the markets (Phelps et al. 1970 ) . The world market is composed of many country-speci fi c markets (islands in Phelps’s analysis). Shocks affect the demand in each market. They affect nominal money and productive sector. The suppli-ers may react to these shocks. They do not have complete information to distinguish between them.

In this model of Lucas, nominal monetary shocks and real output shocks are totally caused by decentralized markets and imperfect market information. In this model, however, there is no issue of maximization. This was dealt with by Barro (1976, 1981 ) . Further, there is no dynamics in this model. Unexpected money affects output for one period. Thus, it is a static analysis. The central points of limited infor-mation and lack of proper coordination in decentralized markets are, nevertheless, very important. Two opposite directions of research have been followed since this contribution of Lucas. The belief that aggregate demand movements have an important effect on output by explaining the comovements in money and output in terms of reverse casualty and dismissing the rest of the evidence on the effects of demand shocks as weak has been dislodged. Imperfections can lead to strong effects on aggregate demand and output (Blanchard and Fischer 1989 ; Prescott 1987 ) .

6 Self-Regulating Stabilization

Fiscal measures have enough potential to reduce fl uctuations in a market. Taxes and (the government) transfer payments (TTP) reduce fl uctuations in income. In the case of a change in income, TTP change automatically. Subsequently, with the vari-ation in TTP-led income, the multiplier is also reduced. This means fl uctuations in income due to a variation in investment lead to lower spending and bring about a stabilization effect on the economy. This way fl uctuations in economic activities are moderated and automatic stabilization becomes possible provided actions taken on fi scal policies are timely. A delayed action on fi scal policies may not counter the fl uctuations when it is desired. Therefore, TTP are supposed to be a better method of stabilization because they directly vary with income. During a recession, various activities in the economy are at a low level. With a fall in output and employment, taxes also fall automatically and the government transfer payments increase. As a result, disposable income is not reduced, and consumption is not lowered. The economy does not feel a severe attack on various activities. It is also worth mentioning that since TTP change automatically with income and bring about rapid changes in the


economy, for instance, if an employee retires, taxes are no longer withheld from the employee and his/her tax liability will be reduced. Further, he/she may be entitled to other or compensatory bene fi ts governed by transfer payment rules. This brings about automatic stabilization. If the TTP are of a discretionary nature for which the government has to make provisions in the time of recession, then TTP occur slowly because the government takes time to frame rules and enforce them in the economy effectively. The only drawback with TTP-led automatic stabilization is that as income and employment rise, taxes increase and transfer payments decrease. Such changes reduce the rate of rise in disposable income. This means automatic stabilizers help retard the economic recovery from recession. However, there is evidence that these TTP stabilizers contained the length and intensity of the US recessions in 1953–1955, 1957–1959, 1960–1961, 1969–1970, and 1973–1975 US (Lewis 1962 ; Sharp and Khan 1980 ) .

If we link fi scal policies and TTP, then the budget de fi cit is considered as an expan-sionary policy of the government. Similarly, a surplus is considered as contractionary policy. In this situation, de fi cits and surpluses are not a true measure of fi scal policy because TTP vary with income. During a recession, income from taxes is reduced and transfer payments increase. This pattern causes a budget de fi cit. As a consequence, the de fi cit is due to the recession, and is not due to expansionary fi scal policies. Thus, a budget de fi cit occurs in a recession because of the effects of TTP, which are self-regulating stabilizers of a market. If the policies of the government are contractionary, then the full employment budget shows a surplus. The full employment surplus is a better indicator of the effect of fi scal policies than the actual surplus or de fi cits since it shows that fi scal policy is contractionary (Edgmand 1985 ) .

7 US Super Slump: Mid-2007

The estimated time of the beginning of the US recession was mid-2007. In 1 year, between September 2007 and October 2008, 16 banks in the US went bankrupt. Further, more than 100 banks of the approximately 7,000 banks were in the danger zone. The Federal Reserve was very alert to this situation. First, the recession affected the USA and then spread over Europe and emerging Asian countries. For example, the gross external liabilities of the three major Icelandic banks were estimated to be equal to almost fi ve times the GDP of Iceland. During this period a few other esti-mates were made. For instance, as per the UN baseline survey in 2008, the world output grew by 2.5 %, but in 2009 it grew by 0.4% to 1.0%. There was a −0.5 % growth rate in developed countries taken together. The corresponding fi gure was 4.6 % in 2009, which is relatively low in comparison with 5.9 % in 2008 (Kumar 2009 ) . The ILO provided unemployment data for the duration of the recession. It estimated that unemployment at the world level increased from 5.7 % in 2007 to 7.1 % in 2009. As a result, about 51 million more people were unemployed in 2009 in comparison with 2007. In South Asia the unemployment rate grew from 5.3 to 6.4 %. As a result, seven million more people were retrenched. This increased the


poverty in South Asia and the world. The other effect of rising unemployment and the recession was a fall in the average wages of workers. The average monthly wages declined by 0.26 % to 3.45 % in October to December, 2008 and by 0.26 % in January 2009. In India also, negative growth rates were estimated in the farming and allied sectors (−2.2 %) and in manufacturing sectors (−0.2 %). To improve the situation, public interventions were made. The government used public funds to buy tainted assets. The euro region contracted by 1.5 %. Japan contracted by 12 % per annum. The UK, Russia, and Canada are in recession. The economies of China, Brazil, South Asia, and India slowed down. Other economies such those of as Spain, Mexico, Ireland, Iceland, Singapore, Greece, Ecuador, Hungary, and Latvia are in deep eco-nomic trouble. The US extended its bailout package to US $8.38 trillion ( New York Times 2009 ) . OECD countries also offered large stimulus packages to big business houses. The main reason for the global downturn was the economic activities adopted during the phase of global integration. A crisis in one economy will certainly affect other economies because of externalities. The markets of the USA and other coun-tries have accepted the uniform model of major operations. Many people suspect there are fi nancial irregularities because banks work on the basis of mutual con fi dence of borrowers and lenders. When investment bankers joined the fi nancial market, they were regulated for a long period. Investment banks along with some other fi nancial banks buy huge amounts of assets by borrowing from others to make high returns. Shareholders were assured of high pro fi ts. They earned good credibility in asset transactions and wanted fewer regulations for such transactions. Even US stock mar-kets aligned with the desires of these fi nancial institutions and investment bankers and deregulated several provisions. The trading of fi nancial assets increased rapidly. As a result, asset prices rose and capital gains accrued. Wealth and assets increased on paper. This mechanism can continue automatically if the asset values keep rising. The capital gains were invested back into the fi nancial sector. However, this chain of appreciation of assets and capital gains could not go on forever. It was later observed that the hiatus started in subprime lending for mortgages of housing assets and credit cards. As a consequence, the value of assets started falling. Investment gains started reducing; lending was no longer pro fi table, and the market started losing business. This generated a reverse gear from boom to recession. Bailouts and other types of stimulus packages were extended by the relevant governments in all countries in a Keynesian manner (Godley & Izurieta 2002 ; Kumar 2009 ) .

The slump has affected the US economy. In 2010, poverty was more than 15 %, which accounts for nearly 46 million people. The poverty rate has been estimated as the highest since 1993. This rate is also the highest in developed countries. According to the de fi nition of poverty, a household with four persons including two children having an annual income of $22,113 or below is a poor household. Racewise there is also immense disparity in poverty. Blacks and Hispanics together accounted for 54 % of the poor, with whites accounting for 9.9 % and Asians for 12 %. The unem-ployment rate hovered above 9 % for the second year. Even insurance cover has declined, from 16.3 to 16.1 %. The US economy is facing the lingering effects of recession, with high unemployment, high poverty, high numbers of uninsured persons, large cuts in public spending, high in fl ation, and an energy crisis (Census Bureau


Annual Report 2011 ) . In total, a recession caused by inadequate fi nancial information and unethical responses normally continues for a slightly longer duration. This happens because fi nancial market activities take more time to be absorbed clearly in the economy or economies

8 US Instability, 2011 August: Public Debt Discourse

The US economy was coming out of the great global recession of 2008–2009 (Pollin 2010 , 2011 ; S&P 2011 ). The economy was recovering and trying to make an upswing. On August 5, 2011, there was a historic downgrading of US debt by credit rating agency Standard and Poor’s (S&P) from AAA to AA+. Many agencies have tried to challenge this rating, which seems to be fallacious. Meanwhile the product and money market has started giving a bad signal. The USA is likely to face recession. It may be said that the mid-2007 slump and the 2011 likely expectation of recession will intensify the downswing in the US economy. As a consequence, its effects may be seen on Indian and other economies as well. It can be further added that other credit rating agencies, Moody’s and Fitch, rated US government bonds as AAA. The downgrading of US debt is really the second global distress signal and therefore needs close perusal because the rating announcement somehow appeared just after the US government managed to reach a ceiling on the budget cutting agree-ment on August 2, 2011, after successful discussions. The present scenario is hardly identical to the global fi nancial crisis of mid-2007 or the crisis following the fall of Lehman Brothers in September 2008. At this juncture the issue is linked to debt discipline. This is expected to be a laudable approach by the US government. A large number of core countries maintain a policy of disciplined expenditure. But these countries do not have a sound and scienti fi c borrowing policy. In that context, the present initiative of the USA seems a genuine and post recessionary disciplined step for economic adjustment. The debt ceiling deal is up to US $2.4 trillion; how-ever, a debt reduction of only $2 trillion has been decided by the US government. There are three types of US debt:

1. The gross public debt at present amounts to approximately 95 % of US GDP. 2. After subtracting the “debt to itself” category from the gross public debt, the US

government has a debt burden of 60 % of GDP, which has been borrowed from private and external sources.

3. If “ fi nancial” assets such as gold reserves, foreign exchange reserves, public bonds, and other assets are subtracted or discounted, then net public US debt is about 40 % of GDP at the end of 2010 (Weeks 2011 ) .

The debt payment of the US government was 1.6 % of GDP in 2010. Even for Japan this was 1.4 %. The S&P statement has been rejected by the US government for at least two reasons. First, the debt burden reduction is less than the higher limit. Second, it is constitutionally and hence legally correct to pay the debt and reduce the burden in the due course of time. Third, the calculation of S&P is full of statistical


errors. In the past, S&P made a similar mistake, which raised the debt burden by almost US $2 trillion (Bellows 2011 ) . Thus, this time there is no need to panic. This is merely a budgetary adjustment. During the years before the recession there was approximately $2.1 trillion a year of private borrowing. For the household sector, borrowing reduced substantially because of the collapse of asset values during the recession. For the business sector, however, this was not the trend. The government debt creation from mid-2008 to mid-2010 was $1.7 trillion per annum on average. During the same period, private sector debt contraction was $2.5 trillion below the norm for the previous period (for details, see Table 1.1 ). Thus, it can be concluded that the problem with public debt creation in the USA since the recession took hold is that “it is inadequate rather than excessive” for the task at hand (Izurieta 2011 ) . Implementation of the Buffett Rule is also in the pipeline in the USA. Warren E. Buffett has on many occasions suggested that the richest Americans normally pay a smaller fraction of their income in federal taxes than do the middle-income work-force. This happens because investment gains are taxed at a lower rate than wages. To reduce the long-term de fi cit, imposition of higher taxes on investment gains may be a better fi scal solution. The other way of de fi cit reduction is by reforming bene fi cial programs such as Medicare, Medicaid, and Social Security. Taxing the investment gains may lead to a reduction in investment. Just after the recession, a proper rebalancing is needed. The government is also presently planning to curtail public expenditure drastically.

9 Conclusion

We reach the conclusion that market instability is caused by many factors, such as changes in consumption, production, investment, inventory, saving propensity, cap-ital–output ratio, labor force, technology, and various services, including fi nancial services. In addition, monetary and fi scal policies of the government also play a crucial role in maintaining an ef fi cient market. Even externalities and public goods lead to market failure. In this chapter we have theorized about the downswing and upswing of the market and deduced an appropriate VAR method to estimate it. US recessionary situations that were caused by unregulated fi nancial networking and collapse of assets have been analyzed.

It has also been argued that estimation of public debt in August 2011 by the credit rating agency S&P created panic. Actually, the public debt data generated by the agency are fallacious. Merely small public debt repayment may not result in a heavy loss in investment and hence a fall in employment and consumption, and may not lead to a recession. This is a post recessionary budgetary adjustment because the US economy has kicked off the downswing phase. There are many other factors for balancing the US economy. However, frequent market failures are symptoms of a capitalist economy. Their frequency and intensity can be contained by alert market monitoring and prompt public interventions. Simple rules, transparent management, and proper computation of data can help check a recession. A minor slip from the full employment equilibrium can push the economy again into a recessionary cycle.

Table 1.1 Debt fi gures of the main domestic sectors in the USA

Households Firms State and local governments

Federal government

Percent growth of debt stock (annualized) Average 2005–2007 9.0 10.4 9.1 5.2 2008Q1 3.5 8.6 5.1 9.5 2008Q2 −0.1 7.0 1.6 7.4 2008Q3 −0.4 4.9 3.7 37.0 2008Q4 −2.1 1.0 −1.1 36.1 2009Q1 −0.7 −0.3 5.6 24.4 2009Q2 −1.8 −2.3 4.2 28.9 2009Q3 −2.3 −4.3 5.7 19.0 2009Q4 −1.9 −3.9 3.6 11.9 2010Q1 −3.0 −0.4 5.7 20.5 2010Q2 −2.2 −1.3 −1.4 24.4 2010Q3 −2.0 1.1 5.4 16.0 2010Q4 −0.6 1.9 7.9 14.6 2011Q1 −2.0 4.0 −2.9 7.8

Borrowing fl ow by sector (annualized, billion US dollars) 2005Q1 1,027 593 201 394 2005Q2 1,248 644 129 241 2005Q3 1,212 615 215 244 2005Q4 1,211 833 142 348 2006Q1 1,392 913 107 319 2006Q2 1,355 899 135 195 2006Q3 1,071 632 160 99 2006Q4 900 1,139 212 121 2007Q1 948 1,013 237 291 2007Q2 939 1,302 213 109 2007Q3 842 1,349 163 320 2007Q4 721 1,226 152 229

Average (2005–2007) 1,072.1 929.8 172.2 242.5 2008Q1 485 910 111 485 2008Q2 −9 759 37 390 2008Q3 −51 535 82 1,978 2008Q4 −293 109 −24 2,104 2009Q1 −103 −32 125 1,550 2009Q2 −252 −259 95 1,951 2009Q3 −310 −478 132 1,371 2009Q4 −266 −423 84 903 2010Q1 −409 −47 134 1,602 2010Q2 −295 −139 −34 2,003 2010Q3 −271 123 129 1,396

Average (2008Q4–2010Q3) −417.9 − 1,690.2 − 2010Q4 −76 205 191 1,320 2011Q1 −271 435 −72 736

“Debt de fl ation 2011Q1”: contraction of borrowing relative to average 2005–2007 (billion dollars, annualized)

1,343 495 244 −493

Source: Izurieta ( 2011 )


Now the US economy is out of recession. That is why the US government is planning to overhaul its monetary and fi scal policy. A cut in public borrowing, debt repayment, taxing investment gains, and cutting public expenditure are some of the recent adjustment mechanisms for balancing and rebalancing the economy.

Notes

1. For more historical theoretical literature, see Suresh ( 2009 , pp. 139–164). 2. For a similar diagram on stable points of equilibrium, see Solow ( 1956 ) . 3. For mathematical analysis, see Jha ( 1991 ) . 4. For details on time series, see Koutsyannis (1996) and Favero ( 2001 ) .

References

Akerlof, G. A., & Yellen, J. (1985). A near rational model of the business cycle with wage and price inertia. Quarterly Journal of Economics, 100L , 823–828.

Barro, R. (1981). The equilibrium approach to business cycles. In Money expectations and business cycles . New York: Academic.

Barro, R. J., & Sala-í-Martin, X. (1995). Economic growth . Cambridge, MA: The MIT Press. Begg, D. (1977). Rational expectations of in fl ation and the behaviour of asset returns in a stochastic

macroeconomic model. Ph.D. dissertation, Department of Economics, MIT. Begg, D. (1982). The rational expectation revolutions in macroeconomics . Oxford: OUP. Bellow, J. (2011, August 6). Just the facts: S&P’s $2 trillion mistake . US Department of the

Treasury Notes. Black, F. (1982). General equilibrium and business cycles (NBER Working Paper 950). NBER:

National Bureau of Economic Research, USA. Blanchard, O. J., & Fischer, S. (1989). Lectures on macro economics (Indian ed.). New Delhi:

PHI. Blinder, A. S. (1981). Retail inventory behaviour and business fl uctuations. Brookings Papers on

Economic Activity, 2 , 443–505. Blinder, A. S., & Fischer, S. (1981). Inventories, rational expectations and the business cycle.

Journal of Monetary Economics, 8 , 277–304. Edgmand, M. R. (1985). Macro economics: Theory and policy . New Delhi: PHI. Farmer, R. (1998). Macroeconomics . Cincinnati: South Western Publishing. Favero, C. A. (2001). Applied macroeconometrics . Oxford: Oxford University Press. Fischer, S. (1988). Recent developments in macroeconomics. The Economic Journal, 98 ,

294–339. Frisch, R. (1933). Propagation problems and impulses problems in dynamic economics. In

Economic essays in honour of Gustav Cassel (pp. 171–205). London: Allen & Unwin. Godley, W., & Izurieta, A. (2002, March–April). The case for a severe recession. Challenge

Magazine 45 (2), 27–51. Goodwin, N., Nelson, J. A., & Jonathan, H. (2009). Macro economics in context . New Delhi:

PHI. Hansen, G. (1985). Indivisible labour and the business cycle. Journal of Monetary Economics,

1 (3), 309–328.


Harrod, R. F. (1948). Towards a dynamic economics . London: Macmillan. Harrod, R. F. (1963). Themes in dynamic theory. The Economic Journal, 73 , 401–421. Hicks, J. R. (1950). A contribution to the theory of the trade cycle . Oxford: Clarendon. Izurieta, A. (2011, August 20). Instability in the US: It is not debt but the lack of it. Economic and

Political Weekly , XLVI (34), 34–38. Jha, R. (1991). Contemporary macroeconomic theory and policy . New Delhi: Wiley Eastern. Kaldor, N. (1940). A model of the trade cycle. The Economic Journal, 50 , 78–92. Kaldor, N. (1960). Essays on economic stability and growth . London: Duckworth. Kalecki, M. (1935). A macroeconomic theory of the business cycle. Econometrica, 3 , 327–344. Kalecki, M. (1937). A theory of the business cycle. Review of Economic Studies, 4 , 77–97. Kumar, A. (2009). Global fi nancial crisis and government interventions. In IPEA (Ed.), Global

economic crisis . Delhi: Daanis Books. Lachler, U. (1978). Political business cycles . Unpublished Ph.D. thesis, Columbia University, New

York. Lewis, A., Jr. (1962). Federal fi scal policy in the post-war recession . Washington, DC: The

Brooking Institution. Long, J. B., & Plosser, C. I. (1983). Real business cycles. Journal of Political Economy, 91 (1),

39–69. Lucas, R. E. (1975). An equilibrium model of the business cycle. Journal of Political Economy,

83 (6), 1113–1144. Lucas, R. E., Jr. (1976). Econometric policy evaluation: A critique. In K. Brunner & A. Meltzer

(Eds.), The Phillips curve and labour markets . Amsterdam: North Holland. Lucas, R. (1977). Understanding business cycles. In K. Brunner & A. Meltzer (Eds.), Stabilization

of the domestic and international economy (Carnegie – Rochester conference series, Vol. 5). Amsterdam: North-Holland.

Macmallium, B. (1988, January). Real business cycle models (NBER Working Paper 2480). NBER: National Bureau of Economic Research, USA.

Mellander, E., Vredin, A., & Warne, A. (1993). Stochastic trends and economic fl uctuations in a small open economy. Journal of Applied Econometrics, 7 , 369–394.

New York Times . (2009, February 4). Adding up the government’s total bailout tab. New York Times.

Nordhaus, W. (1975). The political business cycle. Review of Economic Studies, 42 , 169–190. Pasinetti, L. (1965). A new theoretical approach to problems of economic growth. In Economic

approaches to development planning . Amsterdam: North Holland. Phelps, E. S., et al. (1970). Microeconomic foundations of employment and in fl ation theory . New

York: Norton. Pollin, R. (2010, November). Austerity is not a solution. Challenge Magazine , 53 (6), 63–97. Pollin, R. (2011, August). US Government de fi cits and debt amid the great recession: What the

evidence shows (PERI Working Paper Series, No. 263). PERI: Political Economy Research Institute, USA.

Prescott, E. (1987). Theory ahead of business cycle measurement. Federal Reserve Bank of Minneapolis, Quarterly Review (fall), 9–22.

S&P. (2011, August 5). United States of America long- term rating lowered to ‘AA+’ on political risks and rising debt burden; Outlook negative . Global Credit Portal- Ratings Direct.

Sharp, A. M., & Khan, M. (1980). Automatic fi scal policy, 1966–75. Nebraska Journal of Economics and Business , 19 (Summer), 5–20.

Sims, C. A. (1980). Macroeconomics and reality. Econometrica, 48 , 1–48. Sims, C. A., & Zha, T. (1996). Does monetary policy generate recessions ?. Mimeo. Available at

ftp://ftp.econ.yale.edu/pub/sims/mpolicy Sloman, J., & Sutcliffe, M. (2004). Economics for business . Delhi: Pearson. Smets, F. (1997). Measuring monetary policy shocks in France, Germany and Italy: The role of the

exchange rate (BIS Working Paper No. 42). Basel: BIS: Bank for International Settlemants, USA.

ftp://ftp.econ.yale.edu/pub/sims/mpolicy


Solow, R. M. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics, 70 , 65–94.

Solow, R. M., Tobin, J., von Weizsacker, C. C., & Yaari, M. (1966). Neoclassical growth with fi xed factor proportions. Review of Economic Studies, 33 , 79–115.

Suresh, R. R. (2009). Capitalist economic crises under theoretical lenses. In IPEA (Ed.), Global economic crisis . Delhi: Daanis Books.

Swan, T. W. (1956). Economic growth and capital accumulation. The Economic Record, 32 , 334–361.

US Government. (2011, August). Central Bureau Annual Report . Washington, DC: US Government.

Van der Ploeg, F. (1985). Classical growth cycles. Metroeconomica, 37 , 221–230. Varian, H. (1979). Catastrophe theory and the business cycle. Economic Inquiry, 17 , 14–28. Weeks, J. (2011). The size of the US Public debt: Are the rating agencies fools or knaves? Social

Europe Journal , 12th August. Zarnovitz, V. (1985). Recent work of business cycles in historical perspective: A review of theories

and evidence. Journal of Economic Literature, 23 (2), 523–528.


1 Introduction

The Great Recession in the USA began in December 2007. When it formally ended 18 months later (June 2009), it proved to be the longest economic contraction since the Great Depression. The 16-month recessions of 1973–1975 and 1981–1983, although close in duration to this Great Recession, did not parallel the severe fi nancial crisis of the kind the USA experienced throughout 2008. The federal government’s refusal to rescue the collapsing investment giant Lehman Brothers in September 2008 heightened the level of uncertainty regarding the depth and duration of the new recession, which in turn led to a freezing of the credit market. Giant fi nancial institutions such as Citigroup, Bank of America, and American International Group (AIG) were in imminent danger of insolvency. Within 2 years, a signi fi cant gap (8%) opened between the economy’s potential and actual output despite efforts of the monetary and fi scal policymakers to reverse the decline.

Notwithstanding the inability of central bankers or macroeconomists to forecast such a huge recession, the quick actions taken by the government and the Federal Reserve helped avert a major economic slump. 1 The danger of a new depression passed and a forgotten lesson was remembered: leaving market forces largely unregulated can bring a capitalist economy to the brink of disaster. Pushing and prodding such a system on a path of long-run stability, and monitoring its progress, are tasks that governments, we believe, should have taken up vigorously. When the economy was demonstrably in crisis, policymakers made promising initial progress in reforming the system but have since failed to complete their task. In 2009, as recovery loomed near the horizon, the enthusiasm for fi nancial market reform

Chapter 2 The Financial Crisis and the Great Recession in the United States

Mukti Upadhyay and Tim Mason

M. Upadhyay (*) • T. Mason Department of Economics, Eastern Illinois University , Charleston , Illinois 61920 , USA e-mail: [email protected]

1 See Blinder and Zandi ( 2010 ).

24 M. Upadhyay and T. Mason

started to fade. The federal government’s newly formed Financial Crisis Inquiry Commission (FCIC) lacked the budget to rigorously pursue the people and institutions who were at the center of the storm. The FCIC’s report of January 27, 2011, concluded that the crisis had been avoidable. Zealous deregulation, intense corporate greed, and a naïve belief that risk had been virtually eliminated, in the FCIC’s words, “the systemic breakdown of accountability and ethics,” were cited as major causes of the crisis (Financial Crisis Inquiry Commission 2011 , xxii). At the time of this writing, no action is planned against the major culprits nor is comprehensive regu-latory reform likely. The hard lesson remembered during the throes of the Great Recession has been quickly pushed aside and forgotten; the likelihood of yet another fi nancial meltdown wreaking havoc on the US economy remains strong.

Succumbing to the power of their infamous “animal spirits,” investors easily become overcon fi dent, disregarding the uncertainty of future events. The observa-tion voiced by former Council of Economic Advisers chairman Herb Stein is too often forgotten: “If something cannot go on forever, it will stop.” It is the role of the public institutions tasked with preventing swings in economic activity to moderate the heedless bullishness (“irrational exuberance,” if you will) and unwarranted bearishness of large market participants. When there is failure of these public institutions to ascertain the need for such moderation, this results in widespread economic suffering in the form of output and employment losses, and other policy tools must come into play. Fiscal and monetary stabilization policies are designed to provide a stimulus when the economy is slowing down and a deterrent when it is in high gear. We believe the fi scal stimulus promulgated during the Great Recession was inadequate to accomplish its objective. The wide 8% gap that emerged between the potential and actual output could not be and will not be closed by the policies instantly. For its part, the economics profession was not uni fi ed in terms of the size of the stimulus nor the method to apply it, and so politics intervened.

Macroeconomic policy economists widely agree that a nation’s budget should be balanced over the course of a business cycle. This rule was not observed during the 2000s, when unfunded mandates were instituted in health and education and the defense budget was signi fi cantly expanded. One would presume such increases in the budget would be at least partly matched by growing tax receipts. However, on the revenue side, taxes were reduced twice. The tax cut in 2001 could be justi fi ed by the mini recession of that year. The second tax cut, coming 2 years into an expansion (in 2003), could not. Thus, fi scal de fi cits continued during the expansionary phase of the cycle in 2003–2006, and as a consequence the public debt soared. When the recession struck, the rising tax gap handicapped the Obama administration, preventing it from pushing forward a stimulus package suf fi ciently large to deal with the fi nancial market meltdown. Subsequently, when the fi rst stimulus proved too small, opposition to a second stimulus strengthened vigorously.

The nonobservance of budgetary norms during the mid-2000s does not, however, address one of the core issues of the crisis that the US polity has recognized but seems unable to address. That issue is income and wealth inequality. These inequalities have been increasing signi fi cantly over the last 30 years. The lack of fair progressivity in income taxation is a central fact of life in the world’s center of capitalism.

252 The Financial Crisis and the Great Recession in the United States

Deregulation of fi nancial markets combined with marginal tax rates for the wealthy which are low relative to rates in the past or in other Western democracies has led to tremendous distortions in the fi nancial system, all in favor of the richest. Saez and Piketty’s pathbreaking studies on income inequality led to calculations that show that the richest 1% of Americans held the highest share of national wealth on the eve of two great crises—in 1928 and again in 2007. During 2002–2007, the income of the top 1% of American households rose by 62% as compared with a mere 4% rise for the bottom 90%. 2 Acemoglu ( 2011 ) 3 points out that the fi nancial sector has used its immense in fl uence over politicians to distort the rules of the game, provided its top executives with enormous bene fi ts, and taken on excessive risk. No wonder instability in the oversized fi nancial industry has made the entire economic system unstable.

We trace how the fi nancial system, left for all intents and purposes to its own devices, has deepened the instability inherent in capitalist systems found in the USA and many other countries. Starting with a brief recent history of the fi nancial crisis and the recession in section 2 , our discussion turns, in section 3 , to how debates and controversies in macroeconomics yield implications for speci fi c policies, some of which have been tried and others have not. Section 4 examines policies necessary for the regulation of the fi nancial system and gives a brief assessment of the extent to which international policy coordination has been discussed in policy circles even if not seriously practiced. Our concluding remarks appear in section 5 .

2 A Brief History of the Recent Financial Crisis and Housing Bubble

The year 2008 witnessed a crisis of enormous proportions. The symptoms of the crisis lay in the huge ballooning of real estate prices aided strongly by the phenom-enon of subprime mortgage lending run rampant. The underlying reasons were several. Perhaps the most important cause of the crisis that rewarded delusionary levels of risk-taking and shady deals was the utter failure of the regulatory system. Although several other reasons probably contributed to deepening the crisis, we believe that the lack of effective regulation in an environment where large fi nancial corporations were viewed by government of fi cials more as wealth creators than as greedy exploiters was at the center of the storm.

Among other important elements contributing to the crisis was the large savings (supply of loanable funds) in countries such as China, Japan, Germany, and the

2 Feller and Stone ( 2009 ) use the Piketty-Saez ( 2003 ) results to calculate the numbers for 2002–2007. 3 See his presentation at the American Economic Association Annual Conference, Denver, January 7, 2011 which was based on http://econ-www.mit.edu/ fi les/6348 . See many blog posts from Krugman on inequality and (lack of) social mobility, including http://krugman.blogs.nytimes.com/2007/12/22/inequality-denial/ and http://krugman.blogs.nytimes.com/2008/02/10/income-and-consumption-inequality/ .

http://baselinescenario.com/2009/03/30/the-g20-communique-a-viewers-guide/






oil-exporting countries searching the world for safe returns. Federal Reserve Chairman Ben Bernanke ( 2005 ) , before he became Federal Reserve Chair, had called the effect of such huge in fl ows of foreign capital into the US asset markets the “global savings glut” hypothesis. Large current account surpluses in these countries and many other emerging markets were due to the lack of corresponding increases in their own domestic demand. All this happened at a time when the US economy was recovering from the 2001 mini recession during which the Federal Reserve (the US central bank) had lowered a key short-term interest rate, the federal funds rate (FFR), to a low 1% and kept it there for many quarters. A loose fi scal policy in terms of a signi fi cant tax cut and a large increase in military spending for the Iraq invasion gave the economy a further kick upward. To these elements should be added the bursting of the technology bubble of the late 1990s which forced the hot money from emerging markets to look for other sectors in which to invest. The stage was set where, were a bubble to form, it would receive prolonged support from many directions. And a bubble did indeed form.

The previous Federal Reserve Chairman, Alan Greenspan, extolled the virtues of self-regulation of markets in the late 1990s, calling such “regulation” “market-stabilizing.” Together with Treasury Secretary Robert Rubin and Deputy Treasury Secretary Lawrence Summers (later to become Treasury Secretary), Greenspan was instrumental in convincing Congress that it was time to usher in a new era of fi nancial market oversight. It was time to replace the old legislation from the 1930s which separated the activities of commercial banks from those of investment banks; since the former were too constrained in their activities, whereas the investment banks continued to expand into newer fi nancial territories. The Glass–Steagall Act of 1933, passed to eliminate the speculative abuses that were rampant among large commercial banks prior to the stock market collapse of 1929, was replaced in 1999 by the Financial Services Modernization Act, which eliminated the regulatory barrier between commercial and investment banking. In 2000, the Commodity Futures Modernization Act, banning all regulation of fi nancial derivatives, was also passed. The wave of deregulation continued during the G.W. Bush administration. In 2004, for instance, investment banks succeeded in their lobbying efforts to disable the Securities and Exchange Commission from enforcing the leverage limits on the investment banking industry. This measure allowed investment banks to ignore normal rules of debt and borrow even more.

The immediate cause of rising home prices was low interest rates. Responding to the 2001 recession, the Federal Reserve reduced its FFR target time and time again, until, by June 2003, it was down to 1%, its lowest level in 45 years, and kept it low for several years thereafter. Greenspan emphasized the Federal Reserve should not be in the business of bursting a housing price bubble because it would be hard to know if a rise in the price is due to irrational optimism or to strengthening funda-mentals. If, however, the housing price rise had been due to a bubble and the bubble bursts, the Federal Reserve would be ready to “mitigate the fallout when it occurs.” Months before he would take over as Federal Reserve Chair, the Chairman of the Council of Economic Advisers, Ben Bernanke, also denied the existence of a housing bubble. Since consumer prices, the most watched price index in the economy, were


low and the expectation of future prices was also contained, the Federal Reserve felt justi fi ed in continuing its expansionary policy.

The Federal Reserve targets short-term interest rates with its policy. In normal times we can view long-term interest rates as the average of the expected future short-term rates, although the yield curve (the relationship between the interest rates and the time to maturity of a bond) also depends on the expectations of future economic performance. When the economy’s growth rate is expected to increase beyond its normal growth rate, investors expect the Federal Reserve to raise short-term rates, and hence the yield curve should slope positively. When growth slows down, the expectation of a rate cut often makes the yield curve slope negatively. However, when the FFR is already close to zero, the yield curve cannot slope downward; future short-term rates can be expected only to rise. Thus, during economic slumps, a positively sloped yield curve raises false hopes of a quick rebound of output and employment. The yield curve can also create uncertainty when the Federal Reserve’s policy is not closely aligned with economic performance or when the long-term rates are shocked by huge in fl ows of foreign capital. The mid-2000s (2003–2005), when the policy of the Federal Reserve was to hold short-term rates low in the face of a moderate to brisk economic growth fueled by the housing bubble, were such a time. The Taylor rule, which we discuss in some detail in section 3.1 , called for a more aggressive contractionary, bubble-bursting, monetary policy (a 4–5% FFR), but the Federal Reserve still prevented the FFR from rising, opting instead to accommodate the ongoing fi scal expansion. The Federal Reserve would not allow the FFR to rise to 5% until the middle of 2006. Since expected in fl ation fi gures prominently in the determination of long-term interest rates, the policy of the Federal Reserve seemed to make some sense if one believed the Federal Reserve was guided by an assump-tion of extremely low actual and expected in fl ation rates.

A gradual tightening of the interest rate policy, initiated in July 2004, was too feeble to break the dynamics of the housing bubble. As housing prices were expected to continue their robust uptrend, and interest rates were held at relatively low levels, the demand for housing increased at a rapid rate. New construction could not, however, satisfy this high demand, thus pushing up the price of existing homes and allowing homeowners to borrow (at low interest rates) against the in fl ated value of their houses. Historically, the purchase of a new home occurs overwhelmingly through new debt, with the home buyers paying around 20% equity (down payment) at the time of purchase. When the psychology of permanently increasing wealth took hold, however, the fi nanciers of home loans felt that a slight relaxation of the borrower’s share would not increase the credit risk. Any default by the homeowner could be handled through the sale of foreclosed property, whose value would be expected to have risen. A gold rush was on. None of the participants—homeowners, the loan originators, and the fi nal holders of mortgages, of whom there were many—were going to miss grabbing handfuls of the money on the table.

Subprime borrowers are those whose credit status is shaky, who cannot fi nance even 20% of the purchase price, and who cannot be reasonably expected to meet their full loan obligations. Housing loans to subprime borrowers were a small fraction of all mortgages before 2001, and stayed less than 10% of mortgages during 2001–2003.


But within the next couple of years, in the fi rst half of 2005, as much as 25% of all mortgages were taken out as interest-only loans, most of these by subprime borrow-ers. That year the median down payment for the fi rst-time homebuyer was just 2% of the purchase price, and 43% of fi rst-time homebuyers made no down payment whatsoever. 4 The fi nancial industry came up with several types of offers to lure subprime customers who had no thought or hope of owning a home until far into the future. Prominent examples were fi rst no income, veri fi ed assets (NIVA) loans, then no income, no assets (NINA) loans, and then no income, no job, no assets (NINJA) loans. In some cases, after mortgage deals had been conducted, even a failure to make the required interest payments was not a problem. The bank would simply add the missed interest payment to the principal and make the loan amount bigger.

Such a dilution of lending standards could not have survived long on its own. The increased risk to which it gave rise would become too obvious to ignore. But again, if one believed home prices would not only not fall but would continue to rise, one could “safely” ignore this aspect of fi nance. There was too much money to lend. The global savings pool that had risen to over $70 trillion in the early 2000s was still swelling. Any return higher than what the US Treasury offered on its bonds was acceptable to investors. Someone just had to rate the new invest-ments as secure. This could be done only by the credit rating agencies, and they duly obliged. There was virtually no regulation in place to oversee these agencies. For their part, the investment bankers also came up with exotic instruments to fool the rating agencies.

The main instrument these banks used to trade assets was the collateralized debt obligation (CDO) which became very popular during 2000–2006. A CDO is an asset-backed security. The assets could be bonds or loans or, as during the 2000s, predominantly home mortgages. An investment fi rm typically creates a security by pooling together thousands of assets (if these assets are just mortgages, then a CDO is just a mortgage-backed security), divides them into many small slices, and sells these slices of the combined, or packaged, assets to different investors. The price of each slice depends inversely on the riskiness—as concurrently perceived—of the payment stream coming from the borrowers (homeowners). The securities are layered in terms of their risk characteristics called tranches. The most senior of these tranches are paid fi rst, from the cash fl ows coming in from the mortgages. The payment then goes to the next tranche down in seniority and so on, the last in line being the equity securities. The process is reversed when there is a loss. If, for instance, some homeowners defaulted, the loss would be borne fi rst by the equity securities, then by different tranches in order of increasing seniority.

Securitization of mortgages and other debt made it harder for investors to prop-erly evaluate the value of a security. The problem would be more severe in the event of a risk associated with the entire fi nancial system. Investment companies routinely assessed “value at risk,” the upper limit on the loss the company would incur in the

4 See USA Today: http://www.usatoday.com/money/per fi /housing/2006-01-17-real-estate-usat_x.htm .



case of a credit risk. The maximum loss so estimated would be valid, say, 99% of the time. It would, however, be no guide for that 1% of the time when systemic collapse occurred, and credit default became pervasive. When faced with systemic failure, the mathematical modeling that underlay risk management practices at large banks, investment companies, and hedge funds would be irrelevant. This is exactly what happened during 2006–2007 when the housing market was declining.

An investment company that owns a mortgage-backed security or a CDO may also purchase a credit default swap (CDS). A CDS is a type of insurance on a bond or a security that one ( fi rm B) can buy to protect against the risk of default by the bond issuer ( fi rm A). The bondholder ( fi rm B) pays a premium on the insurance but will be paid the bond value by the seller of the CDS ( fi rm C) if the original issuer of the bond defaults. The important feature of the CDS is that to purchase a CDS one does not actually have to own the bond; the popular analogy is that of taking out a fi re insurance policy on your neighbor’s house. These CDS contracts are over-the-counter derivative transactions, individually negotiated between buyers and sellers. The buyer of a CDS ( fi rm B) could also sell a CDS on the same bond to another party ( fi rm D). Thus, the total CDS value could amount to many times more than the value of the underlying security. By the end of 2007, the total size of these CDS reached a phenomenal $62.2 trillion, about 17 times their value ($3.8 trillion) in 2003, and over four times the US 2007 real GDP.

One problem with the CDS market was there was no centralized clearing house and hence no transparency. CDS is a contingent liability, so it could easily escape the capital requirements of the balance sheet of a company. There was no agency tasked with regulating this market. Indeed, a law enacted in late 2000 barred the Commodities Futures Trading Commission from regulating CDS operations. In 2008, after Bear Stearns collapsed in March, and Merrill Lynch was bought by Bank of America in September, the exposure of major banks to CDS risk, albeit very large, was not clear, which raised concerns among policymakers. Many stories emerged where large companies had misrepresented the riskiness of their portfolios to induce insurers to sell CDS to them. Thus, Goldman Sachs, Morgan Stanley, Deutsche Bank, and many other investment banks used CDS to bet against the very same mortgage securities that they were selling as extremely safe. 5

Lehman Brothers was a major issuer of CDS. It could not obtain credit to meet the demand to honor its obligations. It was dissolved in September 2008 when neither a large fi nancial institution nor the government came forward to bail it out. The failure to prevent the collapse of Lehman Brothers froze the fi nancial system and turned a possibly manageable crisis with a mild recession into an economic depression. AIG was an even bigger issuer of CDS and faced a liquidity crisis which fi nally triggered a swiftly assembled government program to rescue the fi nancial sector and save the economy from entering a prolonged depression. In September 2008, the US Treasury and the Federal Reserve undertook a fl urry of serious steps.

5 While banks played this strategy everywhere, for their tricks on California’s government see http://www.allgov.com/Top_Stories/ViewNews/Wall_Street_Bets_on_Cities_and_States_Failing_100427 .




Policy measures continued to evolve and strengthen through the fi rst quarter of 2009 as the recession that had begun at the end of 2007 threatened to devolve into a major depression. These measures were also essential to combat emerging trends that had adverse short-run implications. Personal savings that had touched negative rates during the expenditure boom were now turning into solid positive territory. As home foreclosures swelled and uncertainty about economic conditions soared, consumers became thrifty. Investment in real capital suffered in response to sagging sales. Real GDP was headed down and unemployment was on the rise.

In the summer of 2007, as the housing market collapsed and aggregate demand fell, the Federal Reserve started cutting its FFR target in a series of moves. From 5.25% in September, the FFR fell to 2% by the end of April 2008. In October, the Federal Reserve reduced the FFR twice and brought it down to 1% and fi nally on December 16, 2008, it made another major announcement that the FFR would be targeted at 0–0.25%. This virtual 0% short-term interest rate on interbank lending has remained untouched for over 2 years now.

In the 6-month period between September 2008 and February 2009, several more important measures were introduced than any time since the Great Depression. The Federal Reserve would save AIG by lending it up to $85 billion, the Securities and Exchange Commission would ban short-selling of fi nancial company stocks, and the Treasury would guarantee the investments in the money market mutual funds up to $50 billion. The Of fi ce of Thrift Supervision would seize the failed Washington Mutual Bank, another giant bank that had fi nanced huge amounts of subprime mortgages, and would allow J.P. Morgan Chase to acquire the banking operations of Washington Mutual Bank. Although all these activities occurred in September 2008, the biggest policy decision to arrest the precipitous fall in consumer and business con fi dence was made on October 3, 2008, with the creation of the $700 billion Troubled Assets Relief Program (TARP). The TARP allowed the government to inject capital into fi nancial institutions and buy their assets up to $250 billion. Preferred stocks were the vehicle of choice for the Treasury to funnel the TARP money to insurance companies such as AIG or banks such as Citigroup. A small fraction of the TARP money was also used to bail out two automobile companies, General Motors and Chrysler.

Controversies arose immediately. There was a sense among the general public that the government was bailing out the biggest banks and other fi nancial institu-tions, who in turn rewarded themselves with large bene fi ts and bonuses for their top employees—the same top employees who were seen to have brought about the ongoing mortgage crisis and recession. The government was using taxpayers’ money to fi nance these bailouts, knowing that it was running a large risk of all this money disappearing should the banks prove to be beyond redemption after all. The task of convincing a skeptical public, “Main Street” in the parlance of the media, of the necessity of the bailout was made more dif fi cult by careless statements from some bankers who, according to Mike McIntire of the New York Times (January 17, 2009), said that they, the bankers, could take advantage of the bailout program, which looked like “a no-strings-attached windfall that could be used to pay down debt, acquire other businesses or invest for the future.” In retrospect, the program,


aided by further strong measures in the coming months, eventually achieved its purpose without much cost to the government. Financial institutions bought back the stocks the government had initially purchased, or paid interest and dividends to the Treasury. Timothy Geithner, Treasury Secretary since 2009, said the net cost of TARP was much less than $10 billion by mid-2010 and would fall further in the future. The fi nancial support to other types of institutions, such as General Motors and Chrysler, helped signi fi cantly too, in terms of the direct saving of a million jobs or more in the automotive sector in addition to the big psychological boost it surely provided to large fi rms and workers in other industries.

The Federal Reserve also used myriads of tools in its arsenal, new and old. As men-tioned earlier, it reduced its target FFR to close to zero by December 2008. It began paying interest on excess as well as required reserves to induce banks to create more loans, deposits, and money. However, this did not lead to an increase in money supply. The big increases in the monetary base were largely neutralized by declines in money multiplier, leaving the money supply unchanged. On November 25, 2008, the Federal Reserve created the Term Asset Backed Securities Loan Facility to purchase up to $200 billion worth of mortgage-related securities and other assets. Its purpose was to further stabilize fi nancial markets and keep the channel of credit fl owing to the end users. The Term Asset Backed Securities Loan Facility was going to be expanded up to $1 trillion. In November 2009, the Federal Reserve announced it would buy assets from government-sponsored enterprises—Fannie Mae, Freddie Mac, and Federal Home Loan Banks—up to $600 billion for a combination of mortgage-backed securities ($500 billion) and direct obligations ($100 billion). Many of the measures were claimed to be of short-term nature. However, continued weakness in production, expenditures, and employment led the Federal Reserve to extend most of the provisions of these programs for much longer than anticipated.

The economy hit its bottom during the second quarter of 2009. GDP fell in 2008 and the fi rst half of 2009 by an average of 2.3% a year (Bureau of Economic Analysis 2011 ) . The unemployment rate peaked at 10.1% in October 2009. Within 18 months the unemployment rate had doubled (Bureau of Labor Statistics 2011 ) and stayed at 9% or higher for about 20 months from May 2009. For many households and small businesses, credit on precrisis terms never again became available as banks toughened their standards while repairing their balance sheets. From the third quarter of 2009, US real GDP has been rising but has never showed the sharp uptrend that normally occurs during the initial phase of a recovery. The annual GDP growth remained at 2.9% for the period from the third quarter of 2009 to the fourth quarter of 2010.

3 Facts and Debates in Macroeconomics

To a large extent, the crisis of 2008 and particularly its severity took the economics profession by surprise. Just a few prominent economists, including Robert Shiller, Nouriel Roubini, Raghuram Rajan, Paul Krugman, and Dean Baker, warned about the housing bubble possibly causing a macroeconomic crisis. Some economists,


such as Brad deLong, were sympathetic to such an idea. Nevertheless they trusted the judgment of central bankers—Alan Greenspan and later Ben Bernanke—and thought the Federal Reserve would intervene swiftly should the housing bubble start to damage the overall economy. There is one fundamental reason why economists have been largely unable to predict a crisis of large proportions—the analysis of severe frictions in the fi nancial markets has remained nonintegrated with the mainstream macroeconomic literature. 6

3.1 Debates on Monetary Policy

As described earlier, by December 2008 the Federal Reserve had lowered the FFR to close to zero. It attempted to eliminate one source of the ensuing deep recession: monetary contraction or high interest rates. The collapse of the housing market had brought about a signi fi cant reduction in the value of household wealth, which affected consumption. A slowdown in industrial activity further accelerated the process, leading to a precipitous fall in aggregate demand. The situation called for a large interest rate cut to support a consumption and investment rebound.

But the crisis ran deep. Public faith in banks suffered when the viability of the entire fi nancial system came into question. Households and fi rms were reluctant to borrow until con fi dence in the future could be restored. Banks were reluctant to lend until they could assess the real value of their assets. The Federal Reserve kept creating enormous amounts of bank reserves by buying assets. The money multiplier that translates reserves into money supply, however, collapsed as banks began hoarding excess reserves and thus prevented money growth from rising. So the direct effect of increas-ing fi nancial wealth on real activity remained small. The main effect of monetary expansion on the real sector works through a fall in the interest rate. But the nominal interest rate had already hit the zero lower bound. A further fall was impossible. By the end of 2008, it was clear that the Federal Reserve’s conventional weapon of monetary policy had become ineffective as the FFR touched the bottom at 0–0.25%.

A relatively unconventional measure was to force expected in fl ation upward. The real interest rate that partially determines consumption and investment could only be lowered if the Federal Reserve succeeded in inducing people to believe that in fl ation would pick up soon. From r = i − p e where r is the real interest rate, i is the nominal interest rate and p e is the expected in fl ation, when i is stuck at 0, r could fall only if p e rises. When consumer and producer con fi dence is low and actual in fl ation is low and falling below the implicitly targeted 2% rate, raising in fl ationary expecta-tions is extremely dif fi cult. In his analysis of liquidity traps with applications to Japan, Krugman ( 1998 , p. 3) recommended the Bank of Japan become credibly irresponsible by prominently declaring a much higher in fl ation target in order to

6 See Caballero ( 2010 ) , Hall ( 2010 ) , and Woodford ( 2010 ) for a review of the efforts to address such weakness and where research needs to go further to make signi fi cant progress in this direction.


restore GDP to the precrisis level. The model is still appropriate to the USA. Mankiw ( 2009 ) also supported an in fl ationary policy for the USA against alternatives that he claimed to be worse, yet how to achieve a higher in fl ation in a depressed economy without a more activist central bank is not clear. 7 The Federal Reserve has never announced such a shift in its policy, in the hope that economic recovery will proceed at a desirable pace without a bold increase in the in fl ation target. Even with the quantitative easing program that the Federal Reserve started in November 2010, it failed to clarify if the goal of the program was to raise in fl ationary expectations.

One major debate about monetary policy surrounded the Taylor rule. Taylor ( 1993 ) claimed to have discovered the policy rule of the Federal Reserve on the basis of his analysis of data for 6 years (1987–1992). He produced an estimate for the FFR as a function of in fl ation and output gap (percentage gap between the potential and actual output). Taylor argued that the Federal Reserve should target the FFR for late 2009 and early 2010 at 0.75%, not very far from 0% or what the Federal Reserve had actually maintained since the end of 2008. The reason, he said, was in fl ation was no less than 1% and the output gap no more than 5%. The Federal Reserve’s response parameter was 1.5 for in fl ation and 0.5 for output gap. Adding 1 to the result predicts the target should thus be (1.5 × 1.5) + (0.5 × −5) + 1 = 0.75%. Challenging Taylor, deLong ( 2009b ) says that the rule the Federal Reserve likely uses should be based on more recent data. Only an updated rule can provide a better estimate of the desirable FFR than what Taylor suggested way back in 1993. The policy-relevant Taylor rule prescribes a nominal FFR of around −5%, or about six percentage points less than Taylor’s 0.75% even though it is simply not achievable.

Let us use, as does deLong, estimations by Rudebusch ( 2006 ) of the San Francisco Federal Reserve Bank: i

t = 2.04 +1.39π–t + 0.92y

t + ξNI where π–t = the annual average

of core in fl ation for four quarters ending in t , and y t is the output gap, i.e., percent

difference between the actual real GDP and the potential output estimated by the Congressional Budget Of fi ce. The last term in the equation is the residual of the (noninertial) interest rate. The output gap is based on the nonaccelerating in fl ation rate of unemployment, or simply the natural unemployment rate, u n . A reasonable estimate of 5% for u n and the actual current rate of 9.8% (toward the end of 2009) implies a cyclical unemployment of 4.8% of the labor force. Applying Okun’s law, this produces a GDP gap of −9.6%. Regarding the other factor, in fl ation, the core in fl ation for all consumption goods except volatile food and energy has been running low, at about 1%, as compared with an implicit target of 2%. Substituting these numbers into the estimated monetary policy reaction function given above, we get i t = 2.04 + 1.39(1) + 0.92(−9.6) = −5.4%. That is an extremely low desired FFR but is

a direct result of a large output gap and low in fl ation. Since the nominal interest rate cannot fall below zero, the Taylor rule prescribes a 0% FFR for as long as high unemployment rate continues to be a bigger concern than in fl ation.

This raises another point which many conservative macroeconomists (including presidents of the Federal Reserve banks, such as Plosser of Philadelphia, Koenig of

7 See Krugman ( 2009b ).


Kansas City, and Fisher of Dallas) wanted to place on top of the Federal Reserve’s agenda. From early 2009, when fi scal stimulus and monetary easing began to be implemented, they pointed to a risk of the economy entering a high in fl ationary period soon. Although the data did not indicate any move toward a rise in in fl ation in either 2009 or 2010, by the time 2010 drew to a close, it appeared that at least the emergence of de fl ation had been prevented by the combined fi scal and monetary policies in the USA. With no strong economic recovery in sight, the Federal Reserve started a second round of quantitative easing (QE2) when it announced on November 3, 2010, that it would begin purchasing $600 billion worth of longer-term Treasury securities at about $75 billion a month for 8 months (Federal Reserve 2010 ) . Since the nominal interest rate remained stuck against the zero lower bound, QE2 aimed to provide further liquidity to the economy. More importantly, it strongly signaled the desire of the Federal Reserve against raising the FFR above zero.

3.2 Debates on Fiscal Policy

Debates on monetary policy and the central bank’s role during the Great Recession were not as heated as debates on fi scal policy. Mainstream economists agree that, during moderate business cycles, stabilization of economic activity is best left as a task for monetary policy. Fiscal systems are generally understood to provide a cushion to output mainly through institutional arrangements. All Western democracies rely on automatic fi scal stabilizers—progressive taxation and unemployment insurance—to smooth out income fl uctuations. But such a normal fi scal mechanism would clearly fall short of its job during sharp downturns. The 2008–2009 developments called for a more robust fi scal response to complement the strong monetary expansion the Federal Reserve was preparing to launch.

The appropriate size of the fi scal boost to economic activity is where signi fi cant controversy arose among professional economists. Barro ( 2009 ) argued that fi scal multipliers during peace times are essentially zero. On the other hand, to calculate the possible employment effect of the $787 billion stimulus package passed in February 2009, Romer and Bernstein ( 2009 ) estimated the multipliers to be roughly 1.5. This is an enormous difference in the multiplier estimates. Ilzetzki et al. ( 2009 ) added nuances to the multiplier arguments. They said that the long-run fi scal multi-plier for the USA for 1960–2007 was 1.2. Yet since 1980 the multiplier value has not only declined considerably but it is also statistically insigni fi cant. Further, the multiplier for government investment is rather high: 1.83 in the long run and 2.31 on impact. Interpreting the detailed results of Ilzetzki et al. ( 2009 ) , Krugman claims that the USA, although more open than before, is still a relatively closed economy and hence has a larger fi scal multiplier. It is also a large economy, which makes the results for fi xed exchange rates more relevant for the USA. 8 The relevance of the

8 See http://krugman.blogs.nytimes.com/2009/10/01/multiplying-multipliers/



latter result is due to the fact that fi scal expansion in the USA will currently not raise the interest rate since the Federal Reserve will keep it at zero.

Krugman also criticized Barro for failing to note that the reason consumption did not respond to fi scal expansion during World War II was because of government controls. Thus, the wartime trends could not apply to 2007–2009, when the underlying drivers were different. Consumption was now constrained by income and lowered by greater deleveraging due to household debt in the face of job uncertainty. In his support for Krugman’s conclusion, deLong further reminds us that during World War II the economy was at over full employment, and consumer goods were rationed, which also prevented increases in military spending from affecting consumption. Similarly, an International Monetary Fund (IMF) study by Spilimbergo et al. ( 2009 ) supports a multiplier of 1–1.5 for large countries, and a larger multiplier for invest-ment than for other expenditures. Finally, Christiano et al. ( 2009 ) found that when the interest rate is not expected to rise, the government spending multiplier is large. 9

Barro was not alone in denying a fi scal expansion’s ability to make a positive impact on output. The Chicago school of macroeconomics, represented by Robert Lucas, Eugene Fama, and John Cochrane, subscribed to the full crowding-out view without citing any statistical evidence to support the assertions made. It seemed that the views were guided more by ideology that government spending is bad or by the Ricardian equivalence hypothesis that any increase in government expenditure is matched one for one by a reduction in spending by the private sector, which anticipates future tax increases by the government to repay its debt. Needless to say, Ricardian equivalence has been found to be largely false when tested against data.

Many other economists subscribing to the classical view say much the same thing. A dollar of government spending borrowed from the public may create employment but only at the cost of employment that the private sector would have created anyway. The savings that would turn into investment in the private sector is now used as government spending instead. Thus, economic activity can-not receive a boost as a result of fi scal stimulus. These arguments do not allow for the fact that in a depressed economy there are unemployed resources that the government can try to mobilize for greater output. There is no room in such analysis for increased thriftiness of households and fi rms who may want to hold extra cash or government bonds instead of spending their income on investment. Krugman ( 2009a ) points out a basic fallacy in their argument since they are “interpreting an accounting identity as a behavioral relationship. Yes, savings have to equal investment, but that’s not something that mystically takes place, it’s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line.” And it is the change in GDP that brings savings and investment into equality.

9 Christiano et al. ( 2009 ) fi nd that “If it [government spending] comes on line in future periods when the nominal interest rate is zero then there is a large effect on current output. If it comes on line in future periods where the nominal interest rate is positive, then the current effect on govern-ment spending is smaller.”


The classical view summarized under Say’s law 10 would be logical if there were no cyclical unemployment in the economy. Kocherlakota ( 2010 ) , President of the Minneapolis Federal Reserve Bank, asserted that the rise in unemployment in the construction sector could not possibly be eliminated soon because the former con-struction workers could not be immediately used in other sectors; they would not have the necessary skills. Clearly, Kocherlakota believes structural unemployment has surged quickly and thus so has the nonaccelerating in fl ation rate of unemployment. Analysis of industry-wide data, however, shows that unemployment has been high in most sectors of the economy and most states in the USA, and excess demand for labor has been rare for any sector. 11 Valletta and Kuang ( 2010 ) provide evidence that “current imbalances appear largely to re fl ect cyclical rather than structural factors.”

It is possible that once high cyclical unemployment becomes entrenched in the economy, much of it can change into structural unemployment as a mismatch develops between job types and skill losses of workers owing to unemployment. This is another reason why aggressive policies in terms of bigger fi scal and monetary stimuli were necessary in the initial phase of the recession. The actual policies remained no more than moderately expansionary given the size of the problem, and many analysts agreed that the size of fi scal stimulus in particular was not enough to produce the desired effects. 12

3.3 More on Liquidity Trap

The liquidity trap literature started with Keynes ( 1936 ), but was revived more recently by Krugman ( 1998 ) . The essential idea is that when the nominal interest rate hits a lower bound of zero, it cannot fall any further, and hence expansionary monetary policy that, under normal conditions, affects economic activity through a fall in interest rates loses all its potency. Keynes advocated fi scal policy in such a situation. This conclusion was not only accepted in terms of investment–saving/liquidity preference–money supply (IS-LM) models in intermediate-level textbooks (see Section 4 for Gordon’s position) and supported by research on Japan during its long recession (Krugman 1998 ) , but the relevance of fi scal policy has gained more respect in the mainstream macro research.

For example, fi scal policy under constant (including zero) interest rate has been further studied recently by Christiano et al. ( 2009 ) , and the policy under debt de fl ation conditions has been studied by Eggertsson and Krugman ( 2010 ) . The Eggertsson–Krugman article departs from the representative agent models because

10 See an interesting discussion on how Say had later changed his view, in deLong ( 2009a ). 11 See Valletta and Kuang ( 2010 ) . 12 Krugman ( 2009b ), “So, it’s an amazing thing: Obama and company have managed to convince people that big government failed, without actually delivering big government.”


in such models the separation of debtors and creditors does not arise. Everything is dealt with in terms of a single representative agent’s behavior. But if the existence of large debt (liability, which is someone else’s asset) is true of crisis times, the model explaining the crisis must distinguish between the behaviors of debtors and creditors. This is what Eggertsson and Krugman do. When the crisis hits, à la a Minsky ( 1992 ) moment (a sudden binding constraint on credit), debtors start paying their debt, asset values depreciate, and consumption falls. As a de fl ationary situation develops, the real value of debt rises and debtors continue to deleverage. In such a scenario, the aggregate demand slopes upward since falling in fl ation reduces output. The Keynesian paradox of thrift—a rise in the savings rate reduces equilibrium income and hence savings—naturally emerges from the model of Eggertsson and Krugman. The implication of this model is that when signi fi cant savings and debt repayments slow economic activity, there must be someone to close the demand gap. This implies a signi fi cant role for expansionary fi scal policy fi nanced by borrowing at the prevailing low interest rate until the private sector deleveraging has stopped and the crisis has passed.

Christiano et al. ( 2009 ) provide estimates of government spending multipliers and fi nd they are rather large when interest rates remain constant. This also shows that although expansionary fi scal policy may not be effective during normal times, depressed times give fi scal policy much more power to in fl uence output because interest rates are not driven upward.

4 The State of Macroeconomics

Controversies in macroeconomics have arisen for close to a century. The main rea-son for these controversies is that macroeconomic research has not advanced to a level where a satisfactory resolution could be reached. Modern macroeconomics related to economic fl uctuations is dominated by elegant mathematical modeling for a hypothetical world instead of simple models rooted in reality. Gordon ( 2010 ) asserts strongly that “1978-era macroeconomics” can explain both the 1929–1933 depression and the great 2007–2009 recession much better than the modern macro-economic models based on dynamic stochastic general equilibrium. These models make a basic market-clearing assumption and try to merge price stickiness to generate economic fl uctuations. The dynamic stochastic general equilibrium models ignore the fact that a signi fi cant part of the household sector (perhaps a half) has con-sumption expenditure constrained by current income. They fail to explore linkages between fi nancial and real sectors in a way that could generate a fi nancial crisis that in turn could lead to a recession. As a result, these models are limited to explaining swings in output by referencing implausible factors such as negative technology shocks.

Gordon distinguishes “Keynesian economics,” whose image was tarnished by Lucas and Sargent ( 1979 ) , from the “1978-era macroeconomics,” which is essentially Keynesian except that it rejects the primitive version of the Phillips curve analysis.


The 1978-era macroeconomics (re fl ected in two intermediate macroeconomics textbooks fi rst published in 1978 by Gordon, and by Dornbusch and Fischer) had encompassed most elements of reality to explain economic fl uctuations. It includes a dynamic aggregate demand curve re fl ecting consumption that is subject to an income and liquidity constraint, and investment that depends on the rate of change of output, and where externalities and coordination failures can result naturally. The 1978-era macroeconomics includes an aggregate supply that can give rise to in fl ation through its combination of fully fl exible prices of commodities such as oil and sticky prices of other products. This, unlike the original Philips curve, shows that the correlations between in fl ation and unemployment can be positive or negative depending on the relative size of demand and supply shocks.

Caballero ( 2010 ) weighs in by stating that model building must stay with macroeconomics but the profession must move toward a “broad exploration mode” to try new alternative ways of addressing economic problems. He says, “an enor-mous amount of work at the intersection of macroeconomics and corporate fi nance has been chasing many of the issues that played a central role during the current crisis, including liquidity evaporation, collateral shortages, bubbles, crises, panics, fi re sales, risk-shifting, contagion, and the like. However, much of this literature belongs to the periphery of macroeconomics rather than to its core.” He asserts that a good beginning would be to shed the “pretense-of-knowledge syndrome.” In contrast, Hall ( 2010 ) looks at the state of macroeconomics more favorably. He says life cycle consumption theory was still valid for nondurables and services, whereas durables consumption and investment suffered as a result of the collapse of the real estate market. This explanation seems unsatisfactory. It is poor consola-tion for the profession to say that a sharp depreciation of business assets as hap-pened in the 2000–2001 crisis was not a major problem, whereas the economists could just not foresee that a smaller depreciation of housing could lead to a major slump eight years later.

The crisis and the debate on the state of macroeconomics are also beginning to make some welcome changes in the teaching of macroeconomics at universities. New courses are likely to place less emphasis on long-term growth and more on business cycles, and are likely to provide a wider coverage of the credit market and differences in interest rates. We can also expect popularity of heterogeneous agents, analysis of more macroeconomic phenomena such as coordination failures, and discussion of how moving away from high or perfect rationality can help explain macroeconomic events better. In this regard, Woodford ( 2010 ) moves in one direction, namely, how to integrate the interest rate differential between the rates for savers and borrowers resulting from the large role fi nancial intermediation plays in the economy. 13

13 Also see papers from a “Symposium on the Financial Crisis and the Teaching of Macroeconomics,” published by the Journal of Economic Education, Fall 2010.


5 Regulatory Policy and International Policy Coordination

5.1 Regulatory Policy

Across regulated industries, regulators fi nd themselves in a perpetual race to catch up with the industries they oversee. As regulators react to and write new regulations to deal with last year’s exploited regulatory loophole, inventive executives in these industries seek out and too often fi nd new ways of getting around the technicalities of the existing regulations, spurred to action by the lure of large pro fi ts accessible to those who can outwit the regulators. Additionally, the regulators are often at the mercy of the industries they regulate to provide them with the information regarding their newest schemes and fi nancial instruments. As a troublesome child soon learns, there is no bene fi t in offering any more of an answer to its parents than that mini-mally required. If the regulators fail to ask for the right information, they will never see it. Further, government regulatory agencies have come to be regarded as training grounds for future industry executives; newly hired college graduates are trained and educated in the arcane details of the industry by the regulatory body, and these same newly hired regulators cultivate relationships with industry personnel, and are eventually hired by the very companies they regulate at salaries above that which the regulatory agency can afford. Like Sisyphus, the task of regulating industry, and especially fi nancial industries, has been derided as both never-ending and ever fruitless. Nevertheless, the only alternative, as yet, is unregulated markets, hardly a viable option given the effects of Congress’s deregulation of the banking industry through legislation such as the aforementioned Financial Services Modernization Act of 1999.

Mark Zandi, chief economist and cofounder of Moody’s Economy.com, has written, “No part of the nation’s economic life has more legal and regulatory over-sight than housing and mortgages” (Zandi 2009 , p. 145). Yet during the in fl ation of the housing bubble, powered by the extraordinary growth of the subprime mortgage market, regulators said little and did less. It was not until the latter part of 2006 that regulators promulgated any formal guidance on “nontraditional mortgage products” (Zandi 2009 , p. 146). Although this long-needed regulatory guidance was widely adopted by “mortgage-industry regulators at all levels of government … the mort-gages whose defaults would precipitate the subprime fi nancial shock had already been made” (Zandi 2009 , pp. 146–147). Regulators had again arrived on the scene a day late and a dollar short.

A complicating factor in the regulation of fi nancial markets in the USA is the muddle of regulatory agencies overseeing overlapping segments of these markets. Depending on its particular enabling charter and memberships, a commercial bank’s activities would be overseen by the Federal Reserve, the Federal Deposit Insurance Corporation, and either the Of fi ce of the Comptroller of the Currency or its particular state bank regulatory body. Among depository institutions, we must add the Of fi ce of Thrift Supervision, which regulates savings and loan institutions, and the National Credit Union Administration (credit unions). This fractured mosaic of regulatory


agencies is due to (1) the unusual (unique?) “dual banking system” of the USA, under which banks may be chartered by either state authorities or the federal government and (2) American’s native distrust of centralized (monetary) power. Rather than resulting in improved regulatory practices, the activities of fi nancial institutions can be lost in the confusion of regulators. “Clear cracks exist in the regulatory patch-work that oversees mortgage lending, and the most aggressive mortgage lenders exploited them during the housing boom” (Zandi 2009 , p. 149).

Among regulators, the Federal Reserve looms large. Bearing the primary regula-tory responsibility for overseeing fi nancial holding companies (whose existence and growth was, by the by, a result of clever banking executives skirting around regulatory limits to operating across state borders) “which historically account for about one-fourth of all mortgage lending,” the actions of the Federal Reserve ripple across the markets. In the case of the housing bubble, the surface waters stilled by the Greenspan-led Federal Reserve’s inaction belied the dangerous currents below. At the time, Chairman Greenspan was of the opinion that “a well-functioning market with the appropriate incentives could police itself more effectively than could government bureaucrats” (Zandi 2009 , p. 154). Lacking support from the Federal Reserve, other mortgage-industry regulators were reluctant to deal with or were incapable of dealing with the rapid growth of subprime mortgage loans.

For the future, we can expect little in the way of meaningful regulatory reform in the mortgage industry. The combination of entrenched powerful bureaucratic bodies jealously protecting their domains and of newly elected anti-big-government of fi cials will likely prevent a reformation of the outdated and understaffed system of regulatory agencies. 14

5.2 International Policy Coordination

The crisis of 2008–2009 affected the entire world community. Countries either directly experienced a major recession or, facing sagging demand for their products, suffered a substantial growth slowdown. Some observers indicated this required coordination of national policies to successfully combat the effects of the crisis. An ideal place to start would have been the IMF, an agency charged with monitoring macroeconomic policies around the world and recommending suitable changes to them as circumstances warrant. When the US recession was under way in early 2008

14 Simon Johnson nicely relates the disastrous failure of regulation to the theory of regulatory capture fi rst advanced in 1971 by the conservative economist George Stigler in his “The Theory of Economic Regulation”. See Bill Moyers’ interview with Kwak and Johnson: http://www.pbs.org/moyers/journal/blog/2010/04/ fi nancial_regulation_regulator.html . The theory says that individu-als or corporations who are directly affected by a policy decision will devote a great deal of resources to achieve their preferred policy outcomes while general public will ignore it. Regulatory capture occurs when the groups seeking desired (or diluted) regulation succeed in their efforts. The theory seems highly relevant in explaining the evolution of regulatory regime during the decade leading up to the recent crisis.




but had not yet made news, the IMF proposed a coordinated fi scal expansion (Johnson 2010a ) . It was not adopted. Instead, severe staff cuts were implemented at the agency. The IMF still suffers from understaf fi ng while it takes up a major chal-lenge of the kind it had to in 2010 with respect to the crises in Europe. Necessary for implementation of its program in 2009 was a rebalancing of global demand. The countries af fl icted with the Great Recession such as the USA and the UK would be relying on increased foreign demand for their products to keep them a fl oat. The heavy burden of providing a cushion against the downfall could thus be borne only by those countries that kept accumulating large surpluses in their current account for many years prior to the crisis.

Germany and China were ideal candidates to provide such a cushion against a collapse of world economic activity. Both, however, pursued policies in their own interests that were not compatible with a readjustment of cross-national demands. In 2009, the US call for more fi scal stimulus was not adequately answered. China had begun to let the yuan appreciate slightly for a couple of years prior to 2009, but in that year it quickly reverted to depreciating its exchange rate against the dollar and kept it around 6.8 renminbi per dollar through most of 2010. The dollar remained high vis-à-vis the euro most of these years as well. The annual average data show that the 2010 rate was 0.755 euros per dollar compared with 0.731 in 2007. Despite weak US economic performance, investors fl ocked to the safety of US government bonds. At the same time, the high dollar ensured that the external sector would not be a factor in the US economic recovery.

There was not much hope coming from the Group of 20 (G20) economically large and powerful countries either. Although the meeting of G20 government heads has become an annual affair, these countries have not been as successful, or perhaps willing, as one might hope in aligning their macroeconomic policies in order to put the global economy on a more stable footing. Simon Johnson, commenting on the fi rst G20 communiqué since Obama started his presidency, said in his weblog Baseline Scenario (March 30, 2009): “the language on monetary policy and fi scal policy is completely vacuous (paragraphs 3 and 4; the Europeans won big and the US lost on these issues), and the “regulatory reform” initiative amounts to building more ornate structures (we’re to get a new Financial Stability Board?!?) on the same weak foundations, that got us into trouble.” The 2008 IMF proposal for a coordinated fi scal expansion was, as mentioned earlier, not adopted.

In 2009, the USA pushed the same proposal again but it met with resistance from the Europeans, who preferred to seek only strengthening regulatory policies for the fi nancial sector. The emphasis shifted from coordinated antirecession policies to the longer-term macro management of the fi nancial systems. As the government de fi cits and debts began to soar as a result of lower tax collections and higher payments of unemployment bene fi ts, the fi nancial crises overwhelmed many countries, including those in eastern Europe and Greece and later Portugal and Ireland. This has raised questions about the sustainability of the euro. The major countries in the euro area would not adequately support the bailout of those critically injured. This implied that countries such as Greece would have to go through a prolonged period of de fl ationary drops in wages and prices, and high unemployment. Unlike the 50


states in the USA, countries in the euro zone are not fi scally integrated enough to enable the euro to cope with a large variation in country performances. Such integration is a prerequisite for the success of a currency union, and European policymakers will need to seriously address this weakness soon.

6 Conclusion

The fi nancial crisis and the recession of 2008–2009 was deep. The USA has been unable to adequately address the problem of unemployment with fi scal or monetary policy in short order. Economic recovery has proceeded at a slow pace. This means that the output gap will close only after a much longer delay than has been the case with any recession subsequent to the Great Depression. The politics of adjustment have been a lot trickier than the economics of adjustment. Particularly with respect to fi scal policy, the measures taken were not large enough to raise output and reduce unemployment rapidly even though they appeared large in their absolute size.

The crisis has also shown that many economists will not recommend Keynesian fi scal policy as a part of a short-run remedy to recession. Many of them are so enamored of rational expectations and an ef fi cient markets approach to analyzing macroeco-nomic models that they fail to consider the most important dynamics underlying economic crises (Akerlof and Shiller 2009 , p. 161). 15 The evidence, in contrast, has been more favorable to fi scal policy. Government spending, suitably designed, provides a faster and larger impact on output and employment when monetary policy is ineffective in raising money supply or reducing the interest rate. Further, many conservative politicians will resist implementation of increases in government expenditure for economic stabilization although they will go along with further cuts in taxes even if the current tax rates are already extremely low.

A deep division in thinking about the effectiveness of spending and tax policies has a strong implication for the management of national debt. Over a medium to long run, the USA will have to restore its fi scal house to order by reducing its de fi cit and debt. The retirement of the baby-boom generation in the coming decades will put more strain on the government budget unless the bloated military spending is reduced. In the short run, had macroeconomic policies been more aggressive, the economy would have approached full employment faster. The crisis in tax revenues that both the federal government and the state governments are currently facing would have eased by early 2011. But the current political environment is being shaped by the large wins for the Republican party in the November 2010 elections and a fi scal deal that took place the following month between President Obama and the Republican leaders. As a result, the low tax regime started in 2001 will continue for some time. A quick rebuilding of the government budget is now impossible on

15 Akerlof and Shiller ( 2009 ) analyze the substantial effect of psychology behind animal spirits of investors that they claim can engender a crisis of the magnitude the world has just seen.


the tax front, which leaves only further cuts in expenditures to balance the state budgets. And the same path is likely to be followed at the federal level. Clearly, expenditure reduction will have a greater impact on programs such as Medicaid, children’s education, and infrastructure spending, with an adverse long-term effect on productivity.

The events of the 2000s during the run-up to the crisis indicate that an ef fi cient regulation of fi nancial institutions is essential for crisis prevention in the future. Johnson ( 2010 b ) argues “Our megabanks are getting bigger…not because of any kind of legitimate market process, but because they bene fi t from an unfair and non-transparent government subsidy. And these big banks have recklessly dangerous levels of debt relative to equity.” Faced with continued innovations in the fi nancial market, regulatory bodies may feel handicapped to manage the systemic risk that is inevitable when banks become too big. Thus, Johnson advocates limiting the size of big banks. It is a moral hazard argument. Knowing that the government will bail them out when insolvency looms, these banks are tempted to assume large risks in the hope of large pro fi ts.

The relationship between fi nancial crisis and recession, on the one hand, and income and wealth inequality, on the other, is a topic on which rigorous research has not been conducted suf fi ciently. A recent study by Kumhof and Ranciere ( 2010 ) is one example of some progress in this direction. They found that income inequality during the 25 years before the 2008 crisis mirrors the inequality before the Great Depression of the 1930s. However, consumption inequality has grown less in the newer episode mainly because the rich (the top 5%) made loans and the poor and middle class borrowed to fi nance consumption. As a result, the lower 95% of house-holds became overleveraged. Divergence in the rates of income and consumption inequalities implies a signi fi cant increase in wealth inequality in the country. 16 Kumhof and Ranciere did not determine from their general equilibrium model the evolution of income distribution, but they did show how the demand for credit and the supply of credit both increase in response to a shock to income distribution. The result is a large accumulation of debt that increases fi nancial fragility, and makes the economy vulner-able to crises and severe recessions. There have been many less formal studies that show a rise in inequality goes together with a dilution of workers’ collective bargain-ing rights, but has implications for increased social tensions or reduced social cohe-sion. These are problems a civilized democratic society needs to address.

In the end, economists can only recommend policies to avert or contain a severe crisis based on models that are rooted in the realism of their assumptions as well as rigor in their analysis. The Great Recession has induced a fl urry of serious research on risks of fi nancial intermediation and speculation. We hope such a research pro-gram will eventually shed light on the deeper reasons for fi nancial panics and crises and on how to prevent them.

16 Kumhof and Ranciere ( 2010 ) : In 1983, the top 5% exhibited a debt to income ratio of 80% and the bottom 95% a ratio of 60%. Twenty fi ve years later, the situation is dramatically reversed with a ratio of 65% for the top 5% and of 140% for the bottom 95%. (Voxeu.org article, “Inequality, leverage, and crises,” February 4, 2011).


References

Acemoglu, D. (2011). Thoughts on inequality and the fi nancial crisis. http://economics.mit.edu/ fi les/6348 .

Akerlof, G., & Shiller, R. J. (2009). Animal spirits: How human psychology drives the economy and why it matters for global capitalism . Princeton, NJ: Princeton University Press.

Barro, R. (2009, January 22). Government spending is no free lunch. Wall Street Journal , op-ed. http://online.wsj.com/article/SB123258618204604599.html.

Bernanke, B. (2005, March 10). The global saving glut and the U.S. current account de fi cit . Sandridge Lecture, Virginia Association of Economists, Richmond, VA.

Blinder, A., & Zandi M. (2010). How the great recession was brought to an end . http://www.economy.com/mark-zandi/documents/End-of-Great-Recession.pdf

Bureau of Economic Analysis. (2011). GDP change table. Department of Commerce, U.S. Government. http://www.bea.gov/national/xls/gdpchg.xls

Bureau of Labor Statistics. (2011). Unemployment rate . Department of Labor, U.S. Government. http://data.bls.gov/pdq/SurveyOutputServlet?data_tool=latest_numbers&series_id=LNS14000000

Caballero, R. J. (2010, Fall). Macroeconomics after the crisis: Time to deal with the pretense-of-knowledge syndrome. Journal of Economic Perspectives, 24 (4), 85–102.

Christiano, L., Eichenbaum, M., & Rebelo, S. (2009, September). When is government spending multi-plier large? http://www.frbatlanta.org/documents/news/conferences/10 fi scal_policy_christiano.pdf

Cline, W. R. (2010). Financial globalization, economic growth, and the crisis of 2007–09 . Washington, DC: Peterson Institute for International Economics.

deLong, J. B. (2009a, September 29). Recent macroeconomic thought as an interrupted three-cornered cage match: Greenspanists, producerists, punchbowlers – and nihilists . Henry George Lectures I, University of Scranton, PA.

deLong, J. B. (2009b). On the de fi nition of a Taylor rule… . http://delong.typepad.com/sdj/2009/12/on-the-de fi nition-of-a-taylor-rule.html

Eggertsson, G., & Krugman, P. (2010, November). Debt, deleveraging, and the liquidity trap: A Fisher-Minsky-Koo approach (Working Paper). http://www.princeton.edu/~pkrugman/debt_

deleveraging_ge_pk.pdf Federal Reserve. (2010, November 3). Press release . http://www.federalreserve.gov/newsevents/

press/monetary/20101103a.htm Federal Reserve Bank. (2010). FRED Database. St. Louis: Federal Reserve Bank. Feller, A., & Stone, C. (2009, September). Top 1 percent of Americans reaped two-thirds of income

gains in last economic expansion . Center on Budget Policies and Priorities. http://www.cbpp.org/files/9-9-09pov.pdffi

Financial Crisis Inquiry Commission (2011). Financial Crisis Inquiry Report. Downloadable at http://cybercemetery.unt.edu/archive/fcic/20110310173545/http://c0182732.cdn1.cloud fi les.rackspacecloud.com/fcic_ fi nal_report_full.pdf

Gordon, R. (2010). Is modern macro or 1978-era macro more relevant to the understanding of the current economic crisis? http://www-personal.umich.edu/~rudib/bobgordon.pdf . Accessed 16 Dec 2010.

Hall, R. (2010, Fall). Why does the economy fall to pieces after a fi nancial crisis. Journal of Economic Perspectives, 24 (4), 3–20.

Ilzetzki, E., Mendoza, E., & Vegh, C. (2009, October). How big are fi scal multipliers? (CEPR Policy Insight 39).

Johnson, S. (2010a, March 30). The G20 Communiqué: A viewer’s guide. In weblog Baseline Scenario . http://baselinescenario.com/2009/03/30/the-g20-communique-a-viewers-guide/ . Accessed 16 Dec 2010.

Johnson, S. (2010b, December 7). Should megabanks be broken apart? (NYT Room for Debate). http://baselinescenario.com/2010/12/07/should-megabanks-be-broken-apart-nyt-room-for-debate/

http://www.economy.com/mark-zandi/documents/End-of-Great-Recession.pdf





http://www.bea.gov/national/xls/gdpchg.xls

http://data.bls.gov/pdq/SurveyOutputServlet?data_tool=latest_numbers&series_id=LNS14000000

http://data.bls.gov/pdq/SurveyOutputServlet?data_tool=latest_numbers&series_id=LNS14000000

http://www.frbatlanta.org/documents/news/conferences/10fiscal_policy_christiano.pdf

http://delong.typepad.com/sdj/2009/12/on-the-definition-of-a-taylor-rule.html

http://delong.typepad.com/sdj/2009/12/on-the-definition-of-a-taylor-rule.html

http://www.princeton.edu/~pkrugman/debt_deleveraging_ge_pk.pdf

http://www.princeton.edu/~pkrugman/debt_deleveraging_ge_pk.pdf

http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm

http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm



http://www-personal.umich.edu/~rudib/bobgordon.pdf


http://baselinescenario.com/2010/12/07/should-megabanks-be-broken-apart-nyt-room-for-debate/

http://baselinescenario.com/2010/12/07/should-megabanks-be-broken-apart-nyt-room-for-debate/


Keynes, J. M. (1936). The general theory of employment, interest and money . London: Palgrave MacMillan (Paperback, 2007).

Kocherlakota, N. (2010). Inside the FOMC . Speech delivered August 17, 2010. Marquette, MI. Krugman, P. (1998). It’s Baaack! Japan’s slump and the return of the liquidity trap. Brookings

Papers on Economic Activity, 2 , 137–187. Krugman, P. (2009a, January 27). A dark age of macroeconomics. blog post . http://krugman.blogs.

nytimes.com/2009/01/27/a-dark-age-of-macroeconomics-wonkish/ Krugman, P. (2009b). Is in fl ation the answer? http://krugman.blogs.nytimes.com/2009/04/19/

is-in fl ation-the-answer/ Kumhof, M., & Ranciere, R. (2010). Inequality, leverage and crises (IMF Working Paper 10/268). Lucas, R., Jr., & Sargent, T. (1979). After Keynesian macroeconomics. Federal Reserve Bank of

Minneapolis Quarterly Review, 3 (2), 1–16. Mankiw, N. G. (2009, April 18). It may be time for the Fed to go negative. New York Times ,

Economics Scene . http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1 Minsky, H. P. (1992). The fi nancial instability hypothesis (Working Paper No. 74). Jerome Levy

Economics Institute. Piketty, T., & Saez, E. (2003). Income inequality in the United States: 1913–1998. Quarterly

Journal of Economics, February. Romer, C., & Bernstein, J. (2009, January). The job impact of the American recovery and reinvest-

ment plan . Council of Economic Advisers. Rudebusch, G. (2006). Monetary policy inertia: Fact or fi ction? International Journal of Central

Banking. http://www.ijcb.org/journal/ijcb06q4a4.htm Spilimbergo, A., Symansky, S., & Schindler, M. (2009, May). Fiscal multipliers (IMF Staff

Position Note SPN 09/11). Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference

Series on Public Policy, 39 , 195–214. Valletta, R., & Kuang, K. (2010, November 10). Is structural unemployment on the rise? (Federal

Reserve Bank San Francisco Economic Letter, 2010-34). Woodford, M. (2010, Fall). Financial intermediation and macroeconomic analysis. Journal of

Economic Perspectives, 24 (4), 21–44. Zandi, M. (2009). Financial shock . Upper Saddle River: FT Press.

http://krugman.blogs.nytimes.com/2009/01/27/a-dark-age-of-macroeconomics-wonkish/

http://krugman.blogs.nytimes.com/2009/01/27/a-dark-age-of-macroeconomics-wonkish/

http://krugman.blogs.nytimes.com/2009/04/19/is-inflation-the-answer/

http://krugman.blogs.nytimes.com/2009/04/19/is-inflation-the-answer/

http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1

http://www.ijcb.org/journal/ijcb06q4a4.htm


1 Introduction

Business cycles, re fl ected in changes in the rate of growth, consumer spending, and price levels are experienced by all economies. History shows that economic activities accelerate, decelerate, and accelerate again from time to time. However, many policy makers fi nd it very dif fi cult to manage changes in economic activities, particularly changes in price levels and unemployment rates because a dramatic change in these variables can affect the lives of people at large, causing widespread dissatisfaction with the government of the day. The global fi nancial crisis in 2008 had a considerable impact on economies all over the world. Many enterprises were forced to close down because of cash fl ow problems and a large number of jobs were lost. Much of what was believed to be glorious and prospective suddenly became gloomy and retrospective. Many people tried to provide explanations for such abrupt changes. Policy makers are eager to fi nd ways to revive the momentum and growth of economies, such as manipulating money supply and interest rates. Unemployment problems and the pressure of de fl ation make the future even gloomier. Instead of trying to investigate the reasons for such fi nancial crises and why we cannot foresee them, we are attempting to explain the danger and problem of de fl ation, how economic depres-sion happens, and the relationships between domestic de fl ation, unemployment, and wage changes and compare the situations in other economies, for example, those of Europe, Japan, Hong Kong, and the USA.

A. Wong (*) School of Account and Finance, Hong Kong Polytechnic University , Kowloon , Hong Konge-mail: [email protected]

M. Chu School of Continuous Education, Baptist University of Hong Kong , Kowloon , Hong Konge-mail: [email protected]

Chapter 3 Dynamics of De fl ation and Unemployment: Fall into an Abyss of Depression

Anson Wong and Michael Chu

48 A. Wong and M. Chu

In this chapter, we look into trends in GDP growth, price levels, and unemployment during the period after the recession struck in 2008 in several countries. Then, we discuss the theories about the relationship between de fl ation, price levels, and unemployment and the reason why de fl ation is a bigger threat than in fl ation. In the fi nal part of this chapter, we discuss what strategies can boost employment, citing the example of the successful recovery in Hong Kong.

2 The Twist of the Economy in the Financial Crisis

The impact of the global meltdown in the developed world has been quite severe. Initially a lot of people regarded it as just the problem of the USA, and the problem was underestimated by some economists in the early stage. Most countries, however, suffered from the ripple of the crisis without preparation. The UK suffered negative economic growth (as measured by GDP) for six consecutive quarters, from the second quarter of 2008 until the third quarter of 2009, after the fi nancial crisis in 2008 (Fig. 3.1 ). It is commonly agreed that the growth of an economy can be measured by growth of GDP, after adjusting for the change in price level. The negative growth in the UK is mainly attributed to the performance of the service and manufacturing sectors, such as transport, storage, communication, and business services.

During the recession, the fl ow of money slowed down owing to credit problems in Iceland, the USA, and several European countries. About 600,000 jobs (permanent positions) were lost. According to The Telegraph ( 2009 ) , the banking and insurance industry suffered seriously in the early stages of the recession and the trend spread to other industries afterward. Although the economy regained positive growth after the second quarter of 2009, the level of employment (Of fi ce for National Statistics 2010c ) remains at a level of only 98% of that in the fi rst quarter of 2008 (Fig. 3.2 ).

The recession in the UK technically ended in the third quarter of 2009, when there was again growth in GDP. However, unemployment continues to be a major issue. According to fi gures given by the Of fi ce for National Statistics in 2010, total employment had increased by only 0.4% (about 120,000 positions). More important is that all the increase in new employment opportunities has been driven mainly by the increasing number of part-time and temporary workers. After the recession, the number of part-time jobs grew by 2.3% (about 178,000 positions), whereas the number of full-time jobs fell by 0.3% (about 59,000 positions). The number of temporary jobs grew by 10.4% (about 149,000 positions), but the number of permanent jobs still decreased by 0.4% (about 101,000 positions). Many employers changed permanent positions in their companies from full-time employment to part-time employment by reducing the number of working hours per week to reduce costs and to have fl exibility in scale of production in the face of uncertainty on the road of recovery.

During the 18 months of recession, the UK also experienced a continuous decline in the retail price index (RPI; from September 2008 to September 2009). From the fi gures of the Of fi ce for National Statistics ( 2010a ) , the consumer price index (CPI) decreased from 5% in September 2008 to 1% in September 2009 (Fig. 3.3 ). The RPI dropped from 5% in September 2008 to −1.6% in June 2009. According to Grainne

493 Dynamics of De fl ation and Unemployment: Fall into an Abyss of Depression

Fig. 3.1 UK GDP growth rate (Of fi ce for National Statistics 2010b )

Fig. 3.2 UK unemployment rate (Of fi ce for National Statistics 2010c )

Fig. 3.3 UK in fl ation rate (Of fi ce for National Statistics 2010a )


Gilmore ( 2009 ) in the Sunday Times , “This is this is the fi rst time that RPI in fl ation, which includes housing costs and is used as a benchmark for UK wage deals, has turned negative since 1960. CPI… RPI in fl ation was dragged down by the continued decline in mortgage bills. Many homeowners have seen the monthly cost of their mortgage tumble as Bank of England cut interest rates to a historic low of 0.5 per cent.” In other words, the UK edged into de fl ation during this period. In response to the potential risk of de fl ation, the UK government increased money supply and the economy regained its growth momentum to some extent. All price indexes rose again in the fourth quarter of 2009 to 3.1%, compared with the third quarter of 2010.

The situation has been similar in the rest of the developed world. For example, in the USA (Figs. 3.4 , 3.5 , and 3.6 ), where the fi nancial crisis of 2008 began, greed and loose enforcement of fi nancial regulations triggered an unexpectedly high credit risk and liquidity shortfall in the banking system which resulted in large-scale bankruptcies of banks and fi nancial institutions (e.g., the investment bank Lehman

Fig. 3.4 US GDP growth (Bureau of Economic Analysis 2010b)

Fig. 3.5 US unemployment rate from 2008 to 2010 (Bureau of Labor Statistics 2010)


Brothers), leading to a decline in consumer wealth and economic activities and a rise in unemployment. The unemployment rate increased to 10.1% in the third quar-ter of 2009 and the average number of working hours per week decreased to 33. Labor productivity and property market activity declined at an annual rate of around 6% in the fourth quarter of 2008 and the fi rst quarter of 2009, compared with the same period in 2007–2008.

In European countries (other than the UK), the impact of the crisis was great-est in Iceland, Greece, Ireland, Portugal, Italy, and Spain. The governments of these nations had large budget de fi cits. The increasing credit risk resulted in reluctance of lenders to provide money to these countries, which caused a severe liquidity shortage. Other European countries, such as Germany, have had to inject money into the markets to save the economies of these countries from collapsing. Germany has the highest GDP among western European countries, but it still suffered a negative GDP growth rate of 6.9% between the third quarter of 2008 and the second quarter of 2009. Fortunately, the unemployment rate remained relatively stable during the months of dif fi culty. Spain’s GDP contracted by 3.75% in 2009 and the budget de fi cit reached a record high of 11.2% of GDP and the unemployment rate reached 17.9% in 2009. The crisis also affected many other European economies, such as Portugal, Italy, Ireland, and France, to vary-ing degrees. High unemployment and low economic growth created a threat to economies in the entire area (Figs. 3.7 and 3.8 ).

As is evident from Fig. 3.8 , there was a general increase in unemployment all over Europe between 2008 and 2009. The unemployment rate has remained above 10% even after the economy started growing in early 2010. Figure 3.9 shows that there was de fl ation over a short period in the third quarter of 2009 in European countries.

The fi nancial crisis in 2009 caused a worldwide disorder in economies, which has increased the risk of mortgages and loans for investment, and in turn has affected those companies that run de fi cits, and the wealth as well as the livelihoods of millions of people in different parts of the world. Because of its signi fi cant impact on the world and

Fig. 3.6 US in fl ation rate from 2008 to 2010 (Bureau of Labor Statistics 2010)


Fig. 3.7 GDP growth rate of 27 European countries (Commission Services 2010)

Fig. 3.8 Unemployment rate of 27 European countries (Commission Services 2010)

Fig. 3.9 In fl ation rate of 27 European countries (Commission Services 2010)


because the effect may last for several years and even decades, it is better to looked at what recession is from a theoretical point of view and get a better understanding of the relationship between recession, GDP growth, recession, and unemployment. This also gives an idea of the reason behind the fi nancial decisions of any government, and a hint at how to survive in the turbulence of the fi nancial market.

3 Understanding De fl ation and Unemployment

3.1 Recession

According to the Oxford Advanced Learners Dictionary ( 2010 ) , “depression” means “the state of feeling very sad and without hope. A period when there is little economic activity and many people are poor or without jobs.”

According to the Oxford Dictionary of Economics ( 2010 ) , “recession is a situation when demand is sluggish, real output is not rising and unemployment is increasing. A recession is usually identi fi ed when real gross domestic product (GDP) falls for two successive quarters. It is not as severe as a depression.”

From the de fi nitions above, it is obvious that there was a general recession in many countries all over the world from September 2008 to March 2009 owing to the fi nancial crisis since GDP declined for two or more successive quarters in most cases. It is also obvious from the previous fi gures and diagrams that when the growth of GDP turns negative, it usually brings the CPI down. It is also generally believed that there is a close association between recession, unemployment, and de fl ation. What factors cause recession? Why does recession set in so fast? How can we stop the bad effects of recession? What is the relationship between recession, unemployment, and de fl ation?

There are many reasons for recession. Some people think that it is the failure of a market economy, and some believe in economic cycles, i.e., “whatever goes up comes down.” The world economy experienced a long period of growth in the last decade and, therefore, it was normal to have an adjustment; the problem is how fast and how deep is the adjustment. Some people (Anandvijayakumar 2010 ) believe the recession started in the USA in 2008 because of (1) the crash of the US property market, (2) bad debts caused by subprime loans, and (3) large exposure of banks to mortgage-backed securities and collateralized debt obligations which increased credit risk and reduced availability of loans in the market.

It is generally believed that the increase in risk of lending reduced the supply of money, leading to many companies facing bankruptcy. Why did the property market crash? In general, economists believe that economic activities are determined and regulated by market forces, i.e., supply and demand. Market forces signal what is needed in what quantity and where. However, we are living in an imperfect market society, and the ef fi ciency of the market is never good enough. It is true that whatever has high demand will push up the price and pro fi t, resulting in greater production,


but if the product can be traded as an investment tool, the product is not produced for consumption alone; high volumes of trading also generate demand.

Supply of goods often lags behind demand owing to imperfect market informa-tion and long lead times in supply chains. The low interest rates in the fi rst decade of the new millennium attracted many people to purchase durable goods, causing their demand to increase. These sectors attracted more money by way of investments in production, which increased the supply, and were able to maintain prices at an attractive level. However, supply of products reached a point where demand was temporarily saturated. The continuing increase in supply of goods owing to false estimation of market demand resulted in the prices of goods dropping and also gave a signal that there was an oversupply, and then the price started to crash.

It is worse when the product is property that can be traded in the market. When people can get rich by trading property, there is an increase in demand for properties and more investment and labor go into the real estate industry and market. Oversupply eventually results in lower prices. That directly reduces the wealth of the people as a fall in price implies negative income, affecting adversely the willingness to pur-chase more.

When real estate prices decline, banks normally face more bad debts and it becomes dif fi cult for buyers to obtain loans. Also, loans become more expensive because of higher risk perceptions of lenders. As a consequence, money supply decreases and companies dependent on credit and loans as working capital go bankrupt as they run out of cash. Finally, people lose their jobs, wealth, and also purchasing power, and hence GDP declines. A crash of property market can be regarded as a normal adjustment under market forces, but the adjustment has been too large in scale and has occurred too fast. Banks and fi nancial institutes ignore the risk of mortgages as they transfer the risk to other risk takers (such as Lehman Brothers) via structured fi nancial products. The failure of fi nancial institutions and risk takers makes the risk of loans even higher. Hence, the adjustment cannot be regarded as a failure of a market economy, but the ef fi ciency of the fl ow of market information, money, and labor should be improved.

What is so scary about recession? Recession is usually associated with the lowering of values of products, lack of investment opportunities, de fl ation, and unemployment. Unemployment is rather easy to understand. According to the Oxford Dictionary of Economics (2010b), the “unemployment rate is measured by the percentage of the total labor force that is unemployed but actively seeking employment and willing to work.” Once a person loses his/her job, he/she loses income. However there are some jobs that are somewhere between a permanent full-time job and being jobless, called “temporary jobs” and “part-time jobs.” Hiring on a temporary or part-time basis is a common way to cut salary expenses for many companies and to retain fl exibility. As Fig. 3.10 shows, there was an increase in the number of part-time jobs after the recession, after the second quarter of 2008, whereas the number of full-time jobs decreased until the fi rst quarter of 2009. Part-time jobs are a good substitute for full-time employment for companies since part-time employees are employed when needed, and usually they are paid less than full-time staff for the same work. Also part-time workers may feel insecure fi nancially because they are dumped once they


are not needed anymore . Even after the GDP started climbing after the third quarter of 2009, it has been a “jobless recovery” because the number of full-time jobs has risen at a slower rate than the rate of GDP growth.

Another important signal associated with recession is “de fl ation”. According to the Oxford Dictionary of Economics ( 2010 ) , “it is a reduction of the general level of prices in an economy.” However, the word has a deeper meaning than that given in the dictionary. According to Investorwords.com ( 2010b ) , “de fl ation is a decline in general price levels, often caused by a reduction in the supply of money or credit. De fl ation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. De fl ation has often the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy.”

What are the possible causes of de fl ation? A fall in the price level of a particular product can be a result of productivity improvement, advances in technology, dereg-ulation and change of policy, drop in prices of inputs (raw materials), excess capacity, weak demand, or a combination of two or more of these factors. De fl ation associated with improvement in productivity and technology is usually regarded as strong economic growth, indicating an increase in demand and lower prices. On the other hand, if de fl ation is induced by weak demand or a sudden change in fi nancial policy, it may damage society. Many economists believe the threat of de fl ation is greater than that of in fl ation. De fl ation worsens if consumers defer their spending because of the general expectancy of prices falling soon. Prolonged reduction in demand, as

Fig. 3.10 The labor market in recession and recovery (Of fi ce for National Statistics 2010b )


shown in Fig. 3.11 , may lead to reduction in aggregate demand and cause job losses. Hence, if de fl ation is accompanied by increasing unemployment, consumers will further reduce their spending as they become more anxious and worried about their future income and fi nancial security.

Some other people think that the cause of de fl ation and the expectation of a fall in prices is the result of reduction in money supply owing to credit risk. The monetary theory (Copernicus 1517 ) provides a model to explain the relationship between money supply and product prices. To understand better the true nature of de fl ation and money supply, we need to understand supply and demand for “money”. Following the classical monetary theory, price levels are determined by supply and demand for any given item during a given period of time. The same is the case for the value of money used to pay for goods or services when we determine the “price” of money. If there are only ten items in an isolated land, denoted by Q , and there are only 100 units of currency, denoted as M , then an average item will cost ten units of currency, which we denote as P . However, if the supply of currency decreases by 50% and the number of items trading in the land remains unchanged, then each item may cost fi ve units of currency and hence the price declines. In the same case, if money supply increases to 200 units, then the price will double. This relationship is best presented by monetary economics as the quantity theory of money . Monetary economists believe that money supply is directly proportional to the price level. A simpli fi ed equation of exchange accepted by mainstream economists is

=T T ,MV P Q

where P T is the price level associated with transactions in the economy during the

period, Q is an index of the real value of aggregate transactions or fi nal expendi-tures, M is the supply of money, and V

T is the velocity of money in transactions or

fi nal expenditures. M represents currency in circulation plus deposits in checking and savings

accounts held by the public (usually referred to as M2), Q is the real output (which equals real expenditure in macroeconomic equilibrium), P is the corresponding

Price

Quantity

SupplyDemandNew

Demand

P

New P

QNew Q

Fig. 3.11 The fall in price owing to decrease in demand


price level, and P × Q equals the nominal (money) value of output. The velocity of money ( V ) is “the ratio of net national product at current prices to the money stock” ( Friedman and Schwartz 1965 ) .

Decrease in the availability of credit and loans owing to an increase in fi nancial risk reduces money supply, which consequently decreases the general price level of goods and services. That is why some governments try to inject money into the fi nancial market by lowering the interest rate and increasing money supply to maintain the stability of economic activities in terms of price ( P ) and the real value of fi nal transactions ( Q ).

However, the equation also brings to the fore a simple relationship between different factors of economic activities over a longer time horizon. Many economists argue that the applicability of the theory is valid in the short term only. In addition, some economists also believe that to some extent there is interdependence between these variables ( P , Q , V , and M ), and the de fi nitions of these variables are still being discussed and debated. From the equation, an increase in money supply may not increase the value of any or all of P , Q , or P × Q because the velocity of income V may be negatively related to the increase in money supply M . For example, a 5% increase in money supply could be accompanied by a 5% decrease in the velocity of money, while leaving the values of P and Q unchanged. Hence, the effectiveness of increasing money supply to maintain the stability of economic activities is questionable.

What is wrong with de fl ation? De fl ation makes life easier only if income remains unchanged. However, a prolonged period of de fl ation can cause a delay in purchases by consumers and reduce demand for goods and services. People would like to purchase in the future because they are expecting the price will be cheaper if they buy later. Under the “paradox of theft” (Anderson 2009 ) , “saving money might be good for a few people, but if everyone saves, then it retards economic growth and drives the economy into recession.” And recession will create a threat to people investing in business and also job opportunities.

In the gaming theory, under the condition of de fl ation, people gain more in real value if they save money for future expenses because the price is expected to fall. In order words, the same amount of money can buy more in the future, which encourages all individuals to pick the “save more in the present” strategy. However, if all individuals save more money for the future by reducing expenses, the population will adopt the “save more in the present” strategy, and the economy (whole population) will experience a recession owing to a decrease in demand (Fig. 3.12 ).

A long period of economic slowdown may also raise concerns about future income prospects, affecting the willingness to purchase adversely. When the fall in prices lasts for months, it may result in severe contraction in aggregate demand, and from the point of view of accounting, income value decreases even though the quantity of goods sold remains unchanged. It may signal to the people that there is a high level of competition between industries with excess capacity because of overinvestment. As a result, de fl ation can reinforce the fall in output of suppliers and fall in demand from end users. Such reduction in demand, output, and employment could interrupt or damage economic growth in the short term. From the basic supply and demand


theory, when supply exceeds demand, the price falls to retain the equilibrium. However, a continuous decline in prices can lead to shrinking pro fi t margins, lead-ing to business failures when the cost of production cannot decline faster than the price. Business failures create unemployment, which further reduces purchasing power, and further shrinking of demand and prices, and output, and unemployment. Economic activities continue to spiral downward into a recession cycle (Fig. 3.13 ).

De fl ation creates further dif fi culties in the money market because when prices of goods and services fall, the value of the currency rises as the same amount of money can purchase more goods and services. As a result, the real value of debt and debt servicing rises because the debtor pays more in terms of purchasing power. Hence, there is a redistribution of real net wealth owned because of a potential real bene fi t for creditors and an increase in the real cost of debt servicing for debtors. De fl ation is not necessarily bad for an economy as a whole, as it may help raise standards of living for people with a fi xed income. However, in the money market, a higher cost of debt may result in more loan defaults, especially as collateral values fall, which may affect the stability of the fi nancial market when interest rates are low and the number of nonperforming loans is high.

RECESSION

LOW DEMAND

DEFLATION

UNEMPLOYMENT

LOW PROFIT

Fig. 3.13 Spiral effects of de fl ation, unemployment, and recession

During DEFLATION Population

Saving more in present Spend the same amount

Individual Saving

more in

present

Recession

Both Loses

Individuals Win

Population Loses

Spend the

same

amount

Individuals Lose

Population Wins

Unchanged

Fig. 3.12 Decision box for saving more money or spending the same amount when facing de fl ation


De fl ation can become even worse as banks reduce lending owing to high risk and high real cost of money. Also investors defer their investments as there are fewer investment opportunities in the recession period and the return is not attractive. The decrease in investment leads to cutting expenses via layoffs and downsizing the company, which push the unemployment rate higher and weaken the demand in the market.

The spiral of recession and de fl ation is not just a theory, it really happened in the Far East before the 2009 crisis. In this chapter, we shall take two real places, Japan and Hong Kong, as examples to demonstrate how dif fi cult it is to handle the situation: one place entered a “liquidity trap” (liquidity trap will be discussed in Sect. 4 ) and is still struggling to emerge from recession, and the other place struggled through the situation in an unusual way.

3.2 De fl ation in Japan

De fl ationary periods can be quite long. One recent example is Japan. Japan had a long period of de fl ation for nearly two decades starting in the early 1990s. After high economic and fi nancial growth in the 1980s, Japanese banks were exposed to tough competition from global markets. To compete with other banks globally, Japanese banks were forced to extend riskier loans. They lent huge sums of money to property developers and raised signi fi cant funds on the stock market. Consequently, the price of equity and real estate jumped sky high. Together with low interest rates, this suppressed the cost of investment to an extremely low level. Money from loans borrowed as mortgages and hot money from low-interest loans stimulated economic activity, and GDP growth rose to an average of 5% per year after 1985. However, the unreasonably high asset prices affected the living standards of people in Japan as well as the governance of the Japanese government; the period for mortgage repayments was extended to nearly 40 years or more. The Bank of Japan began to increase interest rates in 1989 to cool down the economy. The stock market collapsed almost immediately after the change in monetary policy, the GDP of Japan fell, land prices declined, and in fl ation started to fall and a long period of de fl ation started. The drop in asset values also upset the fi nancial system. Japanese banks found that there was a high possibility of losses from loan defaults since the value of their collaterals had vanished. They started to worry about credit risk and restricted credit. This made it more dif fi cult to borrow money from fi nancial institutions. The shortage of money made the borrowers insolvent and banks were soon over-whelmed by bad debts, which made them restrict the availability of credit even further. Moreover, the collapse in stock prices reduced the possibility of raising capital from the stock market. Many companies faced huge debts and excess production capacity and cut their investment and production. They laid off employees and closed production facilities, and people lost their jobs and livelihoods. Consumers also reduced consumption to save more money for dif fi cult days ahead. The effects of these phenomena were accentuated because of the serious aging problem in Japan;


many retired people live on savings. Demand weakened further, leading to further price declines.

Although the Japanese government lowered interest rates to zero in 1999 to stimulate in fl ation and growth in the economy, this resulted in no improvement. The zero interest rate policy was ended in July 2006, but economic growth is still insigni fi cant.

3.3 De fl ation in Hong Kong

Another example is Hong Kong, a former British colony, which has experienced de fl ation since its return to China in 1997. Hong Kong is an open society without any natural resources, and many of items, such as food and raw materials, are imported from neighboring countries, especially China. Local nominal prices are affected by the prices of imported intermediate goods. From 1990 to 1997, the massive constructions of the new airport and railways stimulated the growth of the economy. The capital came from selling of land and loans, which resulted in pushing up the property market and investment. However, the prices of properties rose so high that this affected the governance of the new Hong Kong government after 1997. The new Hong Kong government suppressed land prices by increasing housing supply and providing second mortgages for housing.

However, in 1997, there was an Asian fi nancial crisis which affected the exchange rate of the Hong Kong dollar, and pushed up the interest rate and caused the prop-erty market to collapse because people could not afford to make repayments at the high interest rate after the hot money had left the Hong Kong market. In addition, the crash of the stock market owing to the collapse of the IT bubble and the spread of severe acute respiratory syndrome (a viral respiratory system infection which causes many deaths) in the following years made the economy of Hong Kong even weaker. From 1997 to 2003, the CPI fell by 15% compared with the price level in the fourth quarter of 1997. The unemployment rate increased from 2.1% in 1997 to 8.7% in 2003. The situation was fi nally reversed after 2003, and Hong Kong regained its GDP growth owing to the more open door policy of China which allows people in certain regions to travel freely to Hong Kong. Because of the currency value dif-ferences and consumption-tax-free policy in Hong Kong, Hong Kong attracts tour-ists from mainland China to shop in Hong Kong and thus creates new retailing business and tourism opportunities.

4 Struggle from the Negative Swirl of De fl ation

How do we regain our economic growth once de fl ation and recession occurs? This is not an easy question to answer and it is an objective of this section to explain why it is so dif fi cult to resolve. From the previous cases, no one will deny that the biggest


threat to an economy is not de fl ation, as it may be caused by an increase in supply due to improvement in productivity. People do not worry about de fl ation at all, but they are afraid of unemployment and a decrease in income and wealth. People vote for the political party which can create more jobs and bring them more fortune. Hence, one of the primary missions of a government is to avoid unemployment by maintaining stability of price levels and economic activities. In addition, many governments try to stimulate economic growth to counter recession and the curse of unemployment by lowering the interest rate, and encouraging investment and money supply by purchasing government securities via a central bank. This seems a good strategy because it is easy to do, and achieves an increase in money supply via gov-ernment spending. It also can make the government play an active role in ensuring there is a recovery.

Furthermore, the quantity theory says a “rise in money supply can stimulate in fl ation and demand.” An increase in price level can provide an essential lubricant for sustained recovery because businesses increase prices of goods sold, produce higher pro fi ts, and the real cost of their debt declines. Furthermore, governments earn more from taxes and are able to spend more to further stimulate economic growth.

However, the world does not work in such a simple way. As mentioned earlier, an increase in money supply may not increase real output because the velocity of money is not stable; an increase in money supply may have no effect if the velocity of income decreases by the same amount in percentage terms. Hence, an increase in money supply can often, but not always, help an economy escape from de fl ationary pressures. Moreover, low-interest loans may stimulate people to invest in other countries with higher economic growth or higher interest rates to earn higher returns from overseas markets instead of creating more jobs locally. This makes the road to recovery uncertain. Moreover, in fl ation may not help jobless people and may create more problems, such as stag fl ation, a situation when recession and in fl ation happens.

Therefore, a monetary policy using money supply as an incentive is like “pushing on a string.” In other words, the economy may be cooled down by reducing the money supply, but it may not be stimulated again by inverting the money supply strategy. “In terms of IS-LM analysis, in a liquidity trap the LM curve is horizontal and changes in the money supply do not shift it. Then it may be necessary to alter people’s in fl ationary expectations upward, something beyond the usual realm of monetary (or fi scal) policy in recent years. Then again, unusual times may call for unusual measures” (Douglas and Piliphinas 2002 ) .

Also, when a country reduces its interest rate to zero, selling government bonds is a way to increase its money supply. However, government bonds will become unattractive to investors unless there is an expectation that the currency of that country will go up in the future. Therefore, the current value of its currency must be depreci-ated beyond its long-term value in order to create an expectation of a rise in real value, even if there is an increase in money supply. On the other hand, the way to address de fl ation when in a liquidity trap is to increase money supply because when the value of money falls below its real value in the future because of an increase in


money supply, it will suppress spending in the current period and very likely it will suppress investments. Also, it is dif fi cult to fi nd an opportunity to invest in such a low-demand and low-return business environment. It is very likely that the situation will be what it exists in many euro zone countries, the USA and Japan. Therefore, to restore and sustain economic growth, structural reforms in the banking sector and possibly the corporate sector may be required as well.

When a government has a high level of debt and a large de fi cit, as is presently the situation in the UK and the USA, the central bank may need to demonstrate a strong commitment to persist with aggressive quantitative easing measures, such as low interest rates and an increase in money supply, to restore positive in fl ation and in fl uence the expectations of consumers and investors for the future. If an expecta-tion of in fl ation is created, demand (Krugman 1998 ; Rogoff 2002 ) will rise again. If an economy increases its real money supply but fails to affect real spending, it will fall into a “liquidity trap.” A liquidity trap may also be thought of as “a situation with zero interest rates, persistent de fl ation and persistent de fl ation expectations” (Svensson 2000 ) . Hence, the effectiveness of increasing money supply to save an economy in recession is not guaranteed. Some monetarists even believe that it may not stimulate real demand.

What can an unusual measure be? The central bank can undertake open-market operations in assets other than short-term government debt. The government can purchase assets directly from certain declining markets to reduce the expectation of excess supply, but it may risk stag fl ation if there is no other policy to stimulate growth of the economy. Since de fl ation is the result of an economy “trying” to get the in fl ation rate it needs, to avoid de fl ation, one must achieve the expected in fl ation by credibly promising that future price levels will be suf fi ciently high compared with present price levels. A government can increase spending to create demand in the short term to create such an expectation of in fl ation. However, the government must determine in what way the money is spent otherwise the growth will not be sustained and the effectiveness will be in doubt.

Furthermore, although there is an equation between prices and the supply of money, there is no simple equation between money supply and unemployment. Insuf fi cient money supply and de fl ation do create unemployment, but the process may not work in the reverse direction. In the other words, adjustment of monetary strategy (increased money supply and in fl ation) may not stimulate growth of jobs. It is quite obvious from Fig. 3.10 that unemployment has remained high even after the UK economy regained positive GDP growth in the last quarter of 2009.

Unemployment can be a problem of the structure of an economy. Mobility of labor between industries often faces several barriers. During the period of high economic growth, labor is expensive (highly paid) and scarce. Thousands of people fi ll up the positions in a particular growing industry (e.g., investment market) and acquire the related skills (e.g., corporate fi nance and investment). However, once economic activities decline, many people lose their jobs owing to the reduction in demand in the labor market. Even if an economy recovers again, a different skill set may be needed and people may fi nd it dif fi cult to fi nd a new job owing to the burden of working experience, career path, and old salary level. Also, surviving companies


may fi nd a new way (usually using technology) to cut their operational costs (especially labor cost) during the recession, and it may not be easy to employ the same number of employees again.

The world’s production capacity is now growing more rapidly than ever before, because of globalization, high rates of investment, and rapid productivity increases. There is too much money invested in particular industry segments, such as housing, and owing to false estimation of demand and the imperfection of the market, production may exceed what is really needed during the recovery. A simple increase in money supply may not push demand to the same level as there is excessive supply of products in the market for a while during the early recovery stage, which makes the road to recovery uneasy.

Furthermore, in any economy, small and medium-sized enterprises (SME) play an important part in maintaining the stability of economic activities and employment. However, they usually do not have the same amount of respect and bargaining power to compete for the resources. Contraction of the money supply results in many SMEs collapsing because these companies cannot obtain loans easily from the money market. Once the SMEs have disappeared, a long time is needed to attract people to set up new companies and create more jobs.

Optimists believe that recapitalizing banks and fi nancial institutions can save society from unemployment and recession, but this is only a leap of faith based on very little supporting logic or evidence. According to Keynesian economists, the savings–investment gap can be closed by increasing government expenditure. The trouble with this solution, of course, is that it poses problems for the long-term solvency of the government. Without a direction, we cannot expect all the money to be spent ef fi ciently to rebuild economic growth, and government spending may lead to a de fi cit unless it can generate further wealth for the country.

5 Pandora’s Box

From previous discussions, it seems that there is no simple solution to the recession. However, there is one thing in the de fi nition of “depression” in the Oxford Advanced Learners Dictionary that can save the situation: “People feel hopeless and sad about the future.” In a Greek legend, the gods gave Pandora a box that contained all the bad things in humans, such as fear, poor, and anger, but the box was accidentally opened and all these bad things came to the human world, and only one good thing was left in the box, and that was “hope.” It is important to create a feeling of positive expectation and investment opportunities in the economy, instead of a vicious spiral of decline in economic growth during a recession. Investors also need a reason to hire people and people need a reason why they should spend their money.

From the discussion on the previous cases, Hong Kong is a good example of recovering from the curse of recession. Hong Kong, China, and Taiwan are places that recovered from the 2009 fi nancial crisis fast. In Hong Kong what is happening is, in effect, that changes in the economy’s external environment mandate


a depreciated real exchange rate, i.e., the economy “wants” a depreciated real exchange rate. However, since the nominal rate is fi xed, this can only be accom-plished by a decline in the price level. After 2003, with a passive money supply policy, the government of Hong Kong could not control the value of money, and hence the only way to recover from the recession was to fi nd a way to make people earn their livelihood. Owing to the close relationship with China, controls on travel by mainland Chinese to Hong Kong were eased. Millions of visitors from China each year are attracted by Hong Kong’s variety of products and value-for-money products owing to the VAT-free policy. This has created a huge market from tourism as well as retailing and services industries. In addition, Hong Kong has found its way out as a bridge between China and the rest of the world by providing services in different areas, such as fi nance, education, and medical care. The Hong Kong Stock Exchange has become the largest initial public offering platform. It has also created an expectation of a rise in prices or in fl ation. The society is once again focused on demand, and money is being invested in reeducation of labor to increase the mobility of labor to cater for the changes in the business environment. Hong Kong has found it is the Pandora’s box by showing people ways to earn a livelihood.

An economy must be focused on creating new demand and opportunities in the market to provide people with a way to earn their living and give investors and the government an investment opportunity. This is the reason why an increase in money supply cannot stimulate economic growth. It cannot be done by simply adjusting the monetary policy without providing the people with a map to where the “hope” is. An economy has to pursue structural reforms that eliminate the savings–investment gap. Each economy has its unique structure and strengths and weakness, and it is dif fi cult to give a panacea for the problem. However, we can give some criteria for how growth can be stimulated effectively:

1. An economy can focus on growth in areas where the economy has local competi-tive advantages, for example, high-technology areas, service sectors, recycling industries, and natural resources. Otherwise, the growth of economy may not be sustainable and can be taken away by others. For example, the UK has a long and attractive history from the Middle Age which attracts tourists, and it also has a tradition of being a fi nancial center for over a century, which cannot be replaced easily by other countries.

2. Any stimulus aimed at creation of demand and job opportunities and business investment will not be effective unless consumer and government demand picks up. Demand can be increased not only by government spending, it can also be generated by tax reduction. However, it is necessary to provide con fi dence to the public to spend money with a necessary in fl ation expectation, for example targeted rebates can create demand and short-term loan schemes for SMEs can result in an increase in supply.

3. Policies and incentives are needed to help people switch from their previous jobs to their new positions, and this helps to reduce the unemployment rate. It can also create job opportunities in education and demand for education.


6 Conclusion

In conclusion, a recession is terrible but it is also an opportunity to rebuild a new economy and redistribute the wealth in a society. Monetary policy can give the economy the in fl ation expectations it needs, or the economy may get that in fl ation after suffering grinding de fl ation. As can be observed from the example of Japan, most such attempts usually end up in failure. Unconventional thinking is not as easy as one expects; there is a real risk that recession and de fl ation can indeed become a global scourge. There are threats in the conventional monetary policies that were used by govern-ments. The most important is the creation of a true and creditable in fl ation expecta-tion and jobs, and to give the money generated from the incremental money supply a way to generate real value and productivity for society. It is the “hope” that makes people happy.

References

Anandvijayakumar. (2010). Yahoo Answers.com . http://wiki.answers.com/Q/What_is_prime_reason_for_the_current_economic_recession . Accessed 1 Nov 2010.

Anderson, W. (2009). The fallacy of composition . Foundation for Economic Education. http://fee.org/articles/not-so-fast/the-fallacy-of-composition/ . Accessed 1 Nov 2010.

Copernicus, N. (1517). Memorandum on monetary policy. http://mises.org/daily/4071 . Douglas, H. B., & Piliphinas, F. Q. (2002). Dangers of de fl ation (ERD Policy Brief No. 12, pp. 7–8).

Economics and Research Department, Asian Development Bank. Friedman, M., & Schwartz, A. J. (1965). The great contraction 1929–1933 . Princeton: Princeton

University Press. Gilmore, G. (2009, April 21). UK falls into de fl ation for fi rst time in 50 years. The Sunday Times .

http://business.timesonline.co.uk/tol/business/economics/article6138997 . Accessed 1 Nov 2010.

Investorwords.com. (2010a). Unemployment de fi nition . http://www.investorwords.com/1376/unemployment.html . Accessed 1 Nov 2010.

Investorwords.com. (2010b). De fl ation de fi nition. http://www.investorwords.com/1376/de fl ation.html . Accessed 1 Nov 2010.

Krugman, P. (1998). Japan’s trap. Available: http://web.mit.edu/krugman/www/japtrap.html . Accessed 1 Nov 2010.

Of fi ce for National Statistics. (2010a, October 12). National Statistics Online – In fl ation . Of fi ce for National Statistics. http://www.statistics.gov.uk/cci/nugget.asp?id=2294 . Accessed 1 Nov 2010.

Of fi ce for National Statistics. (2010b, October 26). National Statistics Online – GDP growth . Of fi ce for National Statistics. http://www.statistics.gov.uk/cci/nugget.asp?id=192 . Accessed 1 Nov 2010.

Of fi ce for National Statistics. (2010c, October 26). National Statistics Online – Employment . Of fi ce for National Statistics. http://www.statistics.gov.uk/cci/nugget.asp?id=2294 . Accessed 1 Nov 2010.

Oxford Advanced Learner Dictionary. (2010). De fi nition and pronunciation of depression, “Depression” . Oxford University Press. http://www.investorwords.com/1376/de fl ation.html . Accessed 1 Nov 2010.

http://wiki.answers.com/Q/What_is_prime_reason_for_the_current_economic_recession

http://wiki.answers.com/Q/What_is_prime_reason_for_the_current_economic_recession

http://fee.org/articles/not-so-fast/the-fallacy-of-composition/

http://fee.org/articles/not-so-fast/the-fallacy-of-composition/

http://mises.org/daily/4071.

http://business.timesonline.co.uk/tol/business/economics/article6138997

http://www.investorwords.com/1376/unemployment.html

http://www.investorwords.com/1376/unemployment.html

http://www.investorwords.com/1376/deflation.html


http://web.mit.edu/krugman/www/japtrap.html

http://www.statistics.gov.uk/cci/nugget.asp?id=2294





Oxford English Dictionary. (2010). De fl ation . Oxford University Press. Rogoff, K. (2002). Revitalizing Japan: Risks and opportunities . Available: http://www.imf.org/

external/np/vc/2002/110702.htm . Accessed 1 Nov 2010. Svensson, L. E. O. (2000). How should monetary policy be conducted in an era of price stability?

(Working Paper No. 7516). Cambridge, MA: National Bureau of Economic Research. The Oxford Dictionary of Economics. (2010). Recession: The Oxford dictionary of economics.

enotes.com, http://www.enotes.com/econ-encyclopedia/recession . Accessed 1 Nov 2010. The Telegraph. (2009, December 3). Jamie Dunkley, Financial crisis: UK job losses. The Telegraph .

( http://www.telegraph.co.uk/ fi nance/ fi nancialcrisis/3542572/Financial-crisis-UK-job-losses.html ). Accessed 1 Nov 2010.

Tradingeconomics.com. (2010a). United States GDP growth rate. Trading Economics . http://www.tradingeconomics.com/economics/gdp-growth.aspx?symbol=usd . Accessed 1 Nov 2010.

Tradingeconomics.com. (2010b). United States unemployment rate. Trading Economics . http://www.tradingeconomics.com/Economics/Unemployment-rate.aspx?Symbol=usd . Accessed 1 Nov 2010.

Tradingeconomics.com. (2010c). United States in fl ation rate. Trading Economics . http://www.tradingeconomics.com/Economics/In fl ation-CPI.aspx?Symbol=usd . Accessed 1 Nov 2010.

Tradingeconomics.com. (2010d). Euro area GDP growth rate. Trading Economics . http://www.tradingeconomics.com/Economics/GDP-Growth.aspx?Symbol=EUR . Accessed 1 Nov 2010.

Tradingeconomics.com. (2010e). Euro area unemployment rate. Trading Economics . http://www.tradingeconomics.com/Economics/Unemployment-rate.aspx?Symbol=EUR . Accessed 1 Nov 2010.

http://www.imf.org/external/np/vc/2002/110702.htm

http://www.imf.org/external/np/vc/2002/110702.htm

http://www.enotes.com/econ-encyclopedia/recession

http://www.tradingeconomics.com/economics/gdp-growth.aspx?symbol=usd

http://www.tradingeconomics.com/economics/gdp-growth.aspx?symbol=usd

http://www.tradingeconomics.com/Economics/Unemployment-rate.aspx?Symbol=usd

http://www.tradingeconomics.com/Economics/Unemployment-rate.aspx?Symbol=usd

http://www.tradingeconomics.com/Economics/Inflation-CPI.aspx?Symbol=usd

http://www.tradingeconomics.com/Economics/Inflation-CPI.aspx?Symbol=usd

http://www.tradingeconomics.com/Economics/GDP-Growth.aspx?Symbol=EUR

http://www.tradingeconomics.com/Economics/GDP-Growth.aspx?Symbol=EUR

http://www.tradingeconomics.com/Economics/Unemployment-rate.aspx?Symbol=EUR

http://www.tradingeconomics.com/Economics/Unemployment-rate.aspx?Symbol=EUR


1 Introduction

Indians and Australians have a great deal more in common than a love of the game of cricket. A recent Australia–India energy and minerals forum (Australian Ministry for Foreign Affairs and Trade 2010 ) acknowledged that there exists a mutual respect for democracy and the rule of law. In both countries pluralism and human rights are important social objectives. Australia and India are cooperating increasingly on matters relating to trade and investment, international security, climate change, science and education, but also in the areas of resources and energy. The forum made the point that India is soon to become Australia’s third largest export market, after China and Japan (e.g., two-way trade between India and Australia had grown to 22 billion dollars in 2008–2009).

India is a large, fast-developing, and robust economy with strong demand for energy supply in proven resources such as coal, oil, and natural gas. India has a predominant household and industrial reliance on locally sourced coal- fi red power generation. Natural gas is cleaner-burning. Australia is a small developed economy with an established net export capacity, not only in coal and other commodities such as iron ore, but increasingly in natural gas. Australia has not yet appropriately diversi fi ed its export markets for natural gas.

The issue is whether or not India and Australia should engage in the prioritiza-tion of further diversi fi cation of their global trade and equity foreign direct investment (FDI) relationships in energy resources. The answer is fi rmly in the af fi rmative. An important and logical objective is to reduce further the global country-speci fi c or unsystematic risks relating to energy resources and power generation markets, exports, imports, and equity investment for both countries. However, in power generation in India, it is important that microeconomic reform continues. The various state energy

J. Simpson (*) School of Economics and Finance, Curtin University , Perth , Western Australiae-mail: [email protected]

Chapter 4 Market Fluctuations and Country Risk Relationships for Australian and Indian Energy

John Simpson

68 J. Simpson

boards need to continue striving for fi nancial solvency in order to attract equity FDI from overseas and reduce problems of lack of infrastructure investments as initially observed by Reineberg ( 2006 ) and supported by Sharma and Vohra ( 2008 ) . The latter posit that the Indian approach to power sector reform has been more haphazard than the models employed in Singapore and Latin American economies.

In the 2010 Australia–India energy forum referred to earlier, speci fi c mention was made of Australia’s fi rst ever long-term liquid natural gas contract between ExxonMobil and Petronet LNG. Indian companies have invested in Australian copper and coal mines, new and renewable energy projects, and downstream gas processing (e.g., Tata’s investment in Geodynamics for hot rock geothermal energy development). The forum went on to say that Australia can offer particular expertise in mine safety and new techniques for the extraction of coal seam methane and that an Australia–India Strategic Research Fund is now in place with strategic action plans in the areas of coal, mining, petroleum and natural gas, new and renewable energy, and power. In addition, the forum identi fi ed the importance of natural gas as a clean source of power, but also acknowledged the continuation of joint work in second-generation biofuels, liquid petroleum gas for vehicles, hydrogen fuel cells, geothermal energy, and low-emission coal as well as carbon capture, use, and storage.

The forum mentioned that, for Indian investors, Australia can offer a stable political system, sound regulation, good governance, transparency, and competitive markets. For example, the forum cited Australia’s second ranking, according to the World Economic Forum, among 55 of the world’s leading fi nancial systems and capital markets and the fact that of the world’s nine largest banking groups rated AA or better, four are Australian; Australia is the regional headquarters for around 900 multinational companies; and Australia is the only advanced country, according to the IMF, to report positive through-the-year growth during the middle of the global fi nancial crisis.

The Bombay Stock Exchange is the oldest in Asia and number one in the world in terms of the number of listed companies (there are over 4,900 listed fi rms). It is the world’s fi fth most active in numbers of transactions in electronic trading. 1 Like the Australian stock exchange, 2 it is in the top ten of global exchanges in terms of market capitalization. The SENSEX is India’s fi rst and most popular benchmark index, and in Australia the equivalent is the S&P/ASX 200 All Ordinaries Index. Trading on the Australian and Indian stock exchanges in the energy sectors is very active, but with greater activity in Australia due to Australia’s leading global posi-tion as a mining products and energy resources exporter.

In Australia, these sectors comprise companies involved in the exploration and development of coal, uranium, oil and gas, and renewable energy assets and the sector constitutes around 11% of total market capitalization. Metals and mining sectors account for an additional 22% of market capitalization. 3 Companies in the energy utilities sectors are involved in water, electricity, and gas distribution, generation,

1 Bombay Stock Exchange ( 2010 ) . 2 Australian Stock Exchange ( 2010 ) . 3 Australian Stock Exchange ( 2010 ) .

694 Market Fluctuations and Country Risk Relationships…

and infrastructure. In India, coal accounts for more than 50% of total commercial energy supply and for about 70% of total electricity generation 4 and much of the activity in the energy sector is devoted to coal exploration, development, and power distribution.

In terms of FDI, India has been ranked third globally as an FDI recipient. Various surveys rank India very highly in terms of a desirable FDI area. In 2009, Japanese investors ranked India as the second most promising country for overseas business operations, after China. The British rank India among the top three countries for better business activity for the immediate future in 2012–2014. The Europeans ranked India in the top four desirable destinations of FDI in 2010, but the second most attractive destination following China in the following 3 years. The percentage of Canadian companies interested in investing in India rose from 8% in 2005 to 13.4% in 2010.

However, the ranked most attractive areas of inward FDI in 2010, rather than the energy sector as such, were services, construction (including rail and road), housing and real estate, telecommunications, the automobile industry, and fi nally power. It is evident that there is great scope for an increase in FDI for energy and power. 5 Australia, with its heavy involvement in mining and energy resources, is a logical source of increased Indian FDI in those areas.

The Australian mining industry continues to be the largest recipient of FDI into Australia, which re fl ects a strong demand for mineral commodities and also re fl ects the high level of competitiveness of Australia’s resource industry. Recent numbers show that mining makes up around 45% of total FDI growth in Australia. Australia ranks in the top ten countries as a destination for global FDI fl ows. Australia remains the largest market for mergers and acquisitions in the Asia Paci fi c region and particular interest and investment is focused on the mining and energy sectors. 6 There are obvious energy investment opportunities for Indian companies in Australia. Australia’s opportunities for export of energy to India will probably involve assisting India to diversify away from a strong reliance on coal- fi red power to cleaner-burning natural gas over the next decade.

Economic, fi nancial, and political risks and risk management for exporters, importers, and investors are important business considerations. The inevitable trade-off in business is that between risk and return. Will countries have the political will to service external obligations? From an economic and fi nancial view, do countries have the ability to service external obligations? Not all risks can be diversi fi ed. There is a systematic component of total risk that cannot be avoided. It is based on economic and fi nancial factors that are similar for all investors and traders. There is, however, an unsystematic or country-speci fi c component that can be avoided or mitigated through portfolio diversi fi cation. Risk ratings from agencies such as Dun and Bradstreet, Fitch, Institutional Investor, Euromoney Country Risk, Moody’s,

4 Chikkatur et al. ( 2009 ) . 5 IBEF ( 2010 ) . 6 Australian Foreign Direct Investment Flows ( 2010 ) .

70 J. Simpson

S.J. Rundt, Standard and Poor’s, and International Country Risk Guide (ICRG), although they employ slightly different risk rating methods (CountryRisk.com 2010 ) , are similar or highly correlated.

This study selects a database of monthly risk ratings for economic risk, fi nancial risk, and political risk for both India and Australia commencing from November 2000 to October 2009 from ICRG ( 2010 ) , with con fi dence that the ratings are generally similar to those of other ratings agencies. The study in this chapter also employs market models and models to test the relative importance of risk ratings in country energy stock market sectors as its theoretical bases. In addition, the chapter continues past research into the importance of country and sovereign risks in determining stock market prices and returns.

2 Literature

The literature review draws on substantive evidence of signi fi cant relationships between stock markets, economic and fi nancial information, and sovereign risk, country risk, and political risk (e.g., Holthausen and Leftwich 1986 ; Hand et al. 1992 ; Maltosky and Lianto 1995 7 ; Erb et al. 1996 8 ; Diamonte et al. 1996 9 ; Hooper and Heaney 2001 10 ; Brooks et al. 2004 11 ; Busse and Hefeker 2005 12 ). Most researchers—except, for example, Busse and Hefeker ( 2005 ) and Simpson ( 2007 ) —examine country and sovereign risk ratings rather than disaggregate the components of economic, fi nancial, and political risk.

However, most evidence indicates that country/sovereign risk has a signi fi cant relationship with stock market price changes. These price changes include those of the important energy industry sector. It should be noted that some evidence has been produced that indicates that fi nancial crises re fl ected in reduced stock market price

7 Sovereign risk rating downgrades are informative to equity markets, but upgrades do not supply markets with new information. 8 Country risk measures are correlated with future equity returns but fi nancial risk measures re fl ect greater information. They also found that country risk measures are also highly correlated with country equity valuation measures and that country equity value oriented strategies generated higher returns. 9 Country risk represents a more important determinant of stock returns in emerging markets rather than in developed markets. They also found that over the past 10 years country risk had decreased in emerging markets and increased in developed markets. They speculated that if that trend contin-ued, the differential impacts of country risks in each of those markets would narrow. 10 They concluded that multi-index models should be tested that incorporate a regional index, an economic development attribute, commodity factors, and a political risk variable in order to more effectively price securities. 11 Equity market responses to country/sovereign risk rating changes revealed signi fi cant responses following downgrades. 12 Government stability, the absence of internal con fl icts and ethnic tensions, basic democratic rights, and the ensuring of law and order are highly signi fi cant determinants of foreign investment fl ows.


changes are the main in fl uences on sovereign risk ratings. If this is the case, and if this is also applicable to country energy industry markets, risk ratings agencies cannot contribute new information to those markets for investors and nor could they be useful to government policy makers.

Many multifactor models may not be fi rmly founded in capital market or economic theory, and there are many different speci fi cations (Reilly and Brown 2003 ) . Ultimately, if political, social, legal, and cultural factors are also to be taken into account in a model of country stock market prices, it is necessary to assume that they are incorporated in such a basic market model. This avoids the myriad of problems encountered in more advanced versions of the capital assets pricing model and the arbitrage pricing model (Sharpe 1964 ; Roll 1977 ; Ross 1976 ) or the various multifactor models. Reilly and Brown ( 2003 ) imply that it is feasible to apply a basic market model to a fi nancial system using systemic stock price index data provided the constituents of the indices used are representative of the industry in the country concerned.

This chapter takes a fi nancial economic approach and fi rst establishes the simi-larity of Indian and Australian stock market and energy market sector behavior over the period prior to and during the global fi nancial crisis, from November 2000 to October 2009. This period is inclusive of a period of market stability from November 2000 to the end of 2004 and then rapid upward movement in price indices to late 2008, when downward price movements signaled the commencement of the global fi nancial crisis, to the end of the sample period.

A thorough examination of the current literature reveals no similar study of the impact of disaggregated country risk factors on Indian and Australian energy stock market sectors using a cointegration approach. The objectives of the chapter therefore are fi rst to highlight the similarities between Indian and Australian stock markets and energy stock market sectors using a preliminary analysis of the prices in India and Australia in those sectors. Then an examination is conducted into univariate models that verify the similarity in price movement in both markets over time. It is deemed that the similarities between markets in India and Australia are suf fi cient reason to promote increased trade and investment between India and Australia.

Finally, the chapter examines multivariate models in each country with the energy stock market sectors in terms of prices interacting with economic, fi nancial, and political risk ratings for each country. This enables a comparison of the most impor-tant risk factors for each country that traders and investors can consider when making business decisions. Insights should be provided that suggest the most appropriate risk management foci for export, import, and equity FDI transactions.

3 The Method

Preliminary analysis involves an analysis by inspection of graphical price data for the Indian and Australian stock markets and energy sectors. The importance of the movement in global oil prices is also graphically represented. As part of the main

72 J. Simpson

analysis, lagged univariate models 13 combining fi rst stock markets and then energy stock market sectors for India and Australia are examined to verify the similarity of these markets in terms of price movements over time as a basis for increasing the pace of trade and investment between India and Australia.

Finally, lagged multivariate models, where country energy stock market price indices interact with economic, fi nancial, and political risk ratings for each country, are examined by running tests of cointegration, causality, and variance decomposi-tion 14 to ascertain the most important risk management areas for Indian and Australian importers, exporters, and investors.

4 The Models

On the basis of the literature and background information in the context of the objectives of this study, the following models are promulgated:

( ) ( ) ( )Is 1 Is 2 As 3 As ,α β β β

- -= + + + +

t t n t t nP P P P e

(4.1)

( ) ( ) ( )Ie 1 Ie 2 Ae 3 Ae ,α β β β

- -= + + + +

t t n t t nP P P P e

(4.2)

where Is Ie As, ,P P P , and AeP are price index values for the Indian stock market, the Indian energy stock market sector, the Australian stock market, and the Australian stock market energy sectors at times t with an optimal lag order of time -t n in months.

Written in a functional form,

( )Ie Ie I I I I I I,ER ,ER FR ,FR ,PR PR ,

t t n t t n t t n t t nP f P

- - - -=

(4.3)

( )Ae Ae A A A A A A,ER ,ER FR ,FR ,PR PR ,

t t n t t n t t n t t nP f P

- - - -=

(4.4)

where I A I A IER ,ER ,FR ,FR ,PR , and

APR are economic risk ratings, fi nancial risk ratings, and political risk ratings for India and Australia, respectively, at times t with an optimal lag order of -t n in months.

13 Vector autoregressive (VAR) models are speci fi ed so that VAR-based tests of co integration can be examined. 14 VAR models with VAR-based Johansen cointegration tests (Johansen 1988 ) and causality tests (Granger 1988 ) and variance decomposition.


5 The Data

Monthly stock market and energy stock market sectorial indices for the Bombay Stock Exchange and the Australian Stock Exchange were obtained from SENSEX and the S&P/ASX 200 from November 2000 to October 2009. These index values were extracted from DataStream, which calculates its own aggregate sectorial and market price indices with associated market aggregations weighted by market val-ues using a representative list of shares.

Economic risk information is based on objectively assessed trade performance data from current account/balance of payments data. Financial risk information is objectively assessed from debt serviceability information from capital account/balance of payments information. The political risk ratings are a composite of subjectively quanti fi ed opinions on such factors as history of law and order, quality of bureaucracy, and levels of corruption (ICRG 2010 ) . Risk ratings are ascribed as a score out of 100, where the lower the score, the higher the level of risk.

6 Preliminary Findings

Inspection and comparison of price graphs provide an initial indication of the similarity in the movement of Indian and Australia stock markets, energy sectors, and risk ratings. The strong relationship between the energy sectors in each country and global oil prices is also indicated in graphical and correlation analysis. The prices in the stock market sectors in Australia and India are highly correlated at 0.8938. The prices in the energy sectors of each stock market are highly correlated at 0.9043. Figures 4.1 and 4.2 illustrate the similarity in the movement of prices in Australia and India over the full period of the study and the logical similarity in the movement of both with global oil prices with OPEC prices obtained from DataStream as a proxy over the full period of the study (Fig. 4.3 ). It is clear that the price of oil, being the major global source of energy, has a strong in fl uence on stock markets and energy sectors.

In addition the correlation between Australian and Indian raw risk ratings is shown in the matrix in Table 4.1 .

The numbers in Table 4.1 show that India and Australia do have different economic, fi nancial, and political risk pro fi les; however, the economic risk correlation between the countries is not insigni fi cant at 0.4455. This is also the case with fi nancial risk, where the correlation is 0.3592. Political risk correlation is not substantial at 0.0409.

However, unit root tests con fi rm that price series and country risk ratings and the errors of the price and risk relationships are time-dependent (nonstationary pro-cesses). First, differencing removes time dependency in the data where fi rst differ-enced prices, country risk ratings, and the errors of these relationships are stationary (see Appendix ). The study thus con fi rms integrated nonstationary processes leaving the path free to specify a VAR model and test for cointegration (Johansen tests; Johansen 1988 ) and exogeneity using Granger -causality tests (Granger 1988 ) and con fi rm the results using variance decomposition analysis.

74 J. Simpson

Overall, preliminary analysis reveals that the Australian and Indian markets possess similar characteristics, whereas country risk pro fi les differ, particularly in the component of political risk.

7 Main Findings

The VAR stability condition tests for Eqs. 4.1 and 4.2 show that both VARs are stable, with no root lying outside the unit circle. The results of the cointegration testing of Eq. 4.1 are illustrated in Table 4.2 . In the case of the VAR for the Indian stock market (Eq. 4.1 ), the optimal lag order according to various information criteria is 6 months. In the case of the VAR for Eq. 4.2 (the Australian stock market), the optimal lag order is 2 months.

2,000

3,000

4,000

5,000

6,000

7,000

Panel a

Panel b

01 02 03 04 05 06 07 08 09

AUSS

0

500

1,000

1,500

2,000

2,500

3,000

01 02 03 04 05 06 07 08 09

INDS

Fig. 4.1 Australian and Indian stock market price indices. AUSS in Panel a and INDS in Panel b are the stock price indices for Australian and Indian markets, respectively


Table 4.2 indicates that Australian and Indian stock markets and the energy sectors of their markets are cointegrated. That is, they behave in terms of prices in a similar way (the Indian and Australian price series have similar stochastic trends and together achieve equilibrium in the long term for both the stock markets and for the energy sectors of those stock markets). It is evident that in models where the markets interact, exogeneity lies in the Australian markets, where the Australian markets are the major drivers in such models on a lag of 6 months in the case of the stock markets and 2 months in the case of energy sectors.

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Panel a

Panel b

01 02 03 04 05 06 07 08 09

AUSE

0

100

200

300

400

500

600

700

800

01 02 03 04 05 06 07 08 09

INDE

Fig. 4.2 Australian and Indian energy sector stock market price indices. AUSE and INDE in Panels a and b are the energy sector price indices for Austral and India, respectively

76 J. Simpson

The analysis moves to the results of the testing of Eqs. 4.3 and 4.4 (see Table 4.3 ), where VARs are investigated in turn to test for cointegration of energy sectors in each country with country risk ratings. A VAR stability condition check reveals that the VARs for each equation are stable. In the case of each of the Australian and the Indian sector models, the optimal lag, according to information criteria is 1–2 months.

Exogeneity of economic risk and fi nancial risk ratings of India is con fi rmed in variance decomposition analysis where a shock of one standard deviation is imparted to the Indian energy prices. After 2 months the Indian energy sector explains 95.67% of its own variance in the Eq. 4.3 model where the Indian energy sector interacts with Indian economic, fi nancial, and political risk ratings. After 2 months, Indian economic risk explains 0.9697% of the variance of the Indian energy sector and Indian fi nancial risk explains 3.2844%. Indian political risk explains only 0.0742%. After 10 months, economic risk exogeneity increases to 2.6476%, fi nancial risk

0

20

40

60

80

100

120

140

160

01 02 03 04 05 06 07 08 09

OILOPEC

Fig. 4.3 OPEC oil prices

Table 4.1 Relationship between Australian and Indian risk ratings

ERAUST ERINDIA FRAUST FRINDIA PRAUST PRINDIA

ERAUST 1.000000 0.445459 0.664240 0.232998 −0.250140 −0.044252 ERINDIA 0.445459 1.000000 0.419861 0.519081 0.053162 0.328127 FRAUST 0.664240 0.419861 1.000000 0.357232 −0.128200 −0.046596 FRINDIA 0.232998 0.519081 0.357232 1.000000 0.041276 0.728499 PRAUST −0.250140 0.053162 −0.128200 0.041276 1.000000 0.040905 PRINDIA −0.044252 0.328127 −0.046596 0.728499 0.040905 1.000000

ERAUST , ERINDIA , FRAUST , FRINDIA , PRAUST , and PRINDIA represent economic, fi nancial, and political risk ratings for Australia and India, respectively, over the full periods of the study from November 2000 to October 2009


Table 4.2 Cointegration and exogeneity in the relationship between Indian and Australian stock market prices as well as Indian energy sector and Australian energy sector prices

Index data Test assumptions

Number of cointegrating equations

Exogeneity: c 2 statistic (lag order in months)

Indian against Australian stock market index (Eq. 4.1 )

Quadratic deterministic trend

2** Two-way Granger causality at the 5% level of signi fi cance, with the Australian stock market indicating stronger Granger causality of the Indian stock market: 20.3645 ** compared with 13.2628** (1–6)

Indian against Australian energy sector index (Eq. 4.2 )

Linear deterministic trend

1** Australian energy sector Granger-causes the Indian energy sector: 5.2711*** (1–2)

The number of cointegrating equations is indicated by trace tests and maximum eigenvalue tests at the 5% level of signi fi cance. Granger-causality tests con fi rm directional in fl uences **Signi fi cance at 5%; ***Signi fi cance at 10%

Table 4.3 Cointegration and exogeneity test results for lagged models for Australian and Indian energy stock market sectors

Index Test assumptions

Number of cointegrating equations

Exogeneity: c 2 statistic (lag order in months)

Australian energy sector index


1** No Granger causality is evident from Australian country risk ratings to the Australian energy prices on a 1–3 month lag order

Indian energy sector index


1** Granger causality runs from economic risk ratings to the Indian energy sector: 6.2939** (1–2). Granger causality runs from fi nancial risk ratings to the Indian energy sector: 9.2930* (1–2). There is no signi fi cant Granger causality running from political risk ratings in India to the Indian energy sector

The number of cointegrating equations is indicated by trace tests and maximum eigenvalue tests at the 5% level of signi fi cance. Granger-causality tests con fi rm directional in fl uences *Signi fi cance at 1%; **Signi fi cance at 5%

exogeneity decreases to 1.6474%, and political risk exogeneity increases to 12.1333%.

In the case of Australia, exogeneity can be identi fi ed running from the risk ratings to the Australian energy sector, but Granger-causality tests show that this is

78 J. Simpson

not statistically signi fi cant. However, variance decomposition analysis shows that Australian economic risk contribution to variance of the Australian energy sector increases from 0.8554% after 2 months to 2.7947% after 10 months. Australian fi nancial risk and political risk exogeneity remain at a similarly very low level after 10 months.

Evidence is thus produced that the variables in each model, in each case of the Australian and the Indian energy sectors interacting with their country risk ratings, behave in a similar way. In the case of India, all components of country risk are important causal in fl uences on the Indian energy sector over a 10-month period. In the case of Australia, a small amount of evidence is produced in variance decom-position analysis that economic risk rating is the dominant risk factor affecting the movement in Australian energy sector prices.

8 Conclusion and Policy Implications

This study provides evidence that Indian and Australian stock markets and the energy sectors of those stock markets behave in a similar way in terms of both lagged and unlagged data over a period that includes stable stock market and oil prices, a period of rapidly rising prices, and a period of downward price volatility from the outset of the global fi nancial crisis to late 2009. This study supports previous research cited in Sect. 2 that country risk ratings do affect stock market prices. The chapter, moreover, provides evidence that all country risk ratings for India affect the Indian energy sector prices and that only economic risk ratings may be a factor affecting Australian energy sector prices.

The policy implications are quite clear: that Australia and India should not put increased energy resource trading and two-directional equity FDI into energy stock market sectors on the back burner. India needs to diversify its supplies of energy away from a reliance on domestic coal to natural gas as a cleaner, more ef fi cient fuel source for households and industry. In Indian power generation, a caveat must be that India needs to continue with microeconomic reforms to make its state electricity boards viable if the fl ow of foreign equity FDI is to increase.

With Australia’s rapid development of its energy resources sector, substantial opportunity exists for Indian companies to invest in Australian companies. Similar opportunities exist for Australian investors in the Indian energy sector as diverse energy sources are developed. The similarities between the two countries in their stock market behavior should induce a prioritized relationship in trade and investment in the uncertain times of the global fi nancial crisis and beyond. For both countries such a strengthening of the relationship will also strengthen the bene fi ts of portfolio diversi fi cation of inward FDI and enhance and optimize the risk and return relationships. Balance of payments numbers for both countries will swell. The risk components driving each market can be managed for import-ers, exporters, and investors on both sides either internally or via market-based derivatives.


For Australian exporters and investors in Indian energy sectors, economic and fi nancial risks might be covered with the use of fi nancial derivatives. Repatriated dividends need to be covered with hedging contracts to, in turn, cover exchange risk and portfolio value risk. Commodity futures contracts may be useful for exports to India. Political risk is an important risk that needs to be covered by Australian exporters with export insurance policies. For Indian investors and importers, exchange risk and portfolio value or dividend repatriation risks may also be covered with currency futures or pure currency options and forward exchange contracts.

Appendix

Augmented Dickey–Fuller unit root test results for price data and fi rst differences of price data (Dickey and Fuller 1981 )

Variable Level series t statistics

First difference series t statistics

Australian energy sector price index −0.7977 −9.4313* Indian energy sector price index −1.4370 −10.6678* Economic risk rating: Australia −1.3246 −11.5675* Financial risk rating: Australia −1.9890 −10.0720* Political risk rating: Australia −3.4042** −11.8873* Economic risk rating: India −2.9588** −10.3904* Financial risk rating: India −2.2075 −8.9656* Political risk rating: India −2.3370 −12.2086* Australian stock exchange price index −1.3375 −7.0473* Indian stock exchange price index −0.8238 −8.7795*

Critical values for augmented Dickey–Fuller unit root tests are −3.4950 at the 1% signi fi cance level (*), −2.8898 at the 5% signi fi cance level (**), and −2.5819 at the 10% signi fi cance level

References

Australian Foreign Direct Investment Flows. (2010). http;?business.nsw.gov.au/aboutnsw/Trade+and+Investment/B7_foreign_dir_on

Australian Ministry for Foreign Affairs and Trade. (2010). http://foreignminister.gov.au/speeches/2010/10067_australia-india-forum.html

Australian Stock Exchange. (2010). http://www.asx.com.au/about/asx/index.htm Bombay Stock Exchange. (2010). http://www.bseindia.com/about/introbse.asp Brooks, R., Faff, R., Hillier, D., & Hillier, J. (2004). The national market impact of sovereign rating

changes. Journal of Energy and Finance, 28 (1), 233–250. Busse, M., & Hefeker, C. (2005). Political risk, institutions and foreign direct investment (HWWA

Discussion Paper 315). Chikkatur, A. P., Sagar, A. D., & Sankar, T. L. (2009). Sustainable development of the Indian coal

sector. Energy, 34 (8), 942–953. CountryRisk.com. (2010). http://www.countryrisk.com/about/archives/000204.html

http://http;?business.nsw.gov.au/aboutnsw/Trade+and+Investment/B7_foreign_dir_on

http://http;?business.nsw.gov.au/aboutnsw/Trade+and+Investment/B7_foreign_dir_on

http://foreignminister.gov.au/speeches/2010/10067_australia-india-forum.html

http://foreignminister.gov.au/speeches/2010/10067_australia-india-forum.html

http://www.asx.com.au/about/asx/index.htm

http://www.bseindia.com/about/introbse.asp

http://www.countryrisk.com/about/archives/000204.html

80 J. Simpson

Diamonte, R., Liew, J. M., & Stevens, R. L. (1996). Political risk in emerging and developed markets. Financial Analysts Journal, 52 (3), 71–76.

Dickey, D. A., & Fuller, W. A. (1981). Likelihood ratio statistics for autoregressive time series within a unit root. Econometrica, 49 , 1022–1057.

Erb, C. B., Harvey, C. R., & Viskanta, T. E. (1996). Political risk, economic risk and fi nancial risk (Fuqua School of Business Working Paper: 9606). Cambridge: Duke University.

Granger, C. W. J. (1988). Some recent developments in a concept of causality. Journal of Econometrics, 39 , 199–211.

Hand, J., Holthausen, R., & Leftwich, R. (1992). The effect of bond rating agency announcements on bond and stock prices. Journal of Finance, 47 (2), 733–752.

Holthausen, R., & Leftwich, R. (1986). The effect of bond rating changes on common stock prices. Journal of Financial Economics, 17 (1), 57–89.

Hooper, V., & Heaney, R. (2001). Regionalism, political risk and capital market segmentation in international asset pricing . AFA New Orleans Meetings.

IBEF. (2010). Foreign direct investment http://www.ibef.org/economy/fdi.aspx ICRG. (2010). International country risk guide. Political Risk Services Group. http://www.icrgon-

line.com?page.aspx?=icrgmethods Johansen, S. (1988). Statistical analysis of cointegration vectors. Journal of Economic Dynamics

and Control, 12 , 231–254. Maltosky, Z., & Lianto, T. (1995). The incremental information content of bond rating revisions:

The Australian evidence. Journal of Energy and Finance, 19 (5), 891–902. Reilly, F. K., & Brown, K. C. (2003). Investment analysis and portfolio management (pp. 176–285).

Ohio: Thomson South Western. Reineberg, H. H. (2006). India’s electricity sector in transition: Can its giant goals be met? The

Electricity Journal, 19 (1), 77–84. Roll, R. (1977). A critique of the asset pricing theory’s tests. Journal of Financial Economics, 4 (2),

129–176. Ross, S. (1976). The arbitrage theory of capital asset pricing. Journal of Economic Theory, 13 (2),

341–360. Sharma, A. K., & Vohra, E. (2008). Foreign direct investment in the electricity sector: The Indian

perspective. The Electricity Journal, 21 (7), 63–79. Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk.

Journal of Finance, 19 (3), 425–442. Simpson, J. L. (2007). Expert political risk opinions and banking system returns: A revised banking

market model. The International Journal of Business and Management, 2 (5), 3–19.

http://www.ibef.org/economy/fdi.aspx

http://www.icrgonline.com?page.aspx?=icrgmethods

http://www.icrgonline.com?page.aspx?=icrgmethods


1 Introduction

Since 2008, the global economy has been experiencing the deepest downturn in the post-World War II period, as the fi nancial crisis rapidly spreads around the world. A large number of advanced economies have fallen into recession, and economies in the rest of the world have slowed abruptly. Global trade and fi nancial fl ows are shrinking, while output and employment losses mount. Credit markets remain frozen as borrowers are engaged in a drawn-out deleveraging process and banks struggle to improve their fi nancial health.

The recovery is being led by strong growth in emerging Asian powerhouses such as China and India, real GDP growth is forecast to reach almost 5% in 2010, up from 1.75% in 2009, and the USA, Europe, and Japan are just beginning to emerge from devastating recessions. Advanced economies are projected to expand sluggishly through much of 2010, with annual growth in 2010 projected to be about 1.25%, following a contraction of 3.50% in 2009, and with unemployment conti-nuing to rise until later in the year. Europe faced an unemployment of nearly 9.8% and possibly 11.0% in the year of 2012, and the US jobless rate peaked at 10.5% in 2010, 8.5% in 2011, possibly 8.1% in the year of 2012, the IMF (2012) said.

Other emerging economies too are staging modest recoveries, supported by policy stimulus and improving global trade and fi nancial conditions, it said (World economic outlook 2010 ). Downside risks to growth are receding gradually but remain a concern.

The recovery is expected to be slow, as fi nancial systems remain impaired, support from public policies will gradually have to be withdrawn, and households in econo-mies that suffered asset price busts will continue to rebuild savings while struggling with high unemployment, the IMF said.

L.-X. Li (*) Business School, Hunan International Economics University , Hunan , Chinae-mail: [email protected]

Chapter 5 The Chinese Economy After the Global Crisis

Liang-Xin Li

82 L.-X. Li

The key policy requirements remain to stabilize and restore fi nancial sector order and health while maintaining supportive macroeconomic policies until the recovery is on a fi rm footing (Baily et al. 2008 ; Ceccgetti 2008 ).

As the world economy comes out of a deep global recession, global activity expanded by 5.2 in 2010, 3.8% in 2011, is forecast to increase by 4.5% in 2012 after contracting by about 1% in 2009, according to the IMF projections.

The Chinese economy, once the star performer on the world stage, is not crisis-proof and damage is already emerging under the pressure of the global downturn.

As a result, Chinese jobs are suffering, and social tensions have brewed. During the crisis, China’s growth has been quick to slide. In the second quarter of 2008, China recorded a growth rate of 10.1%, down from 10.6% in the fi rst quarter. Growth further slowed to 9% in the third quarter, the lowest in 5 years. The fi gure was to further drop to 6.8% in the fourth quarter. The year-on-year growth rate for 2008 was 9.1%. This result may look not too bad in an international context. However, in comparison with its own past, China in 2007 registered a growth rate of 11.4% (China Daily 2010 ) and the average growth rate for the past 30 years was 9.7%. The Chinese economy is clearly dipping.

In the general decline of the economy, the shrinkage of China’s export was particularly dramatic. Whereas the annual growth rate of export was 35.7% in 2004, 23.2% in 2005, 23.8% in 2006, and 23.5% in 2007, Chinese exporters only managed to achieve a growth rate of 17.2% in 2008, the lowest for the period from 2004 to 2008. In real terms, the export growth was merely 8–9%. In the fi rst few months of 2009, the situation continued to worsen, with exports contracting by 21.1% on a monthly basis.

With the slowdown of the economy, Chinese jobs are suffering. The global downturn means falling demand for Chinese exports, resulting in factory closures and layoffs on a daily basis in many parts of China, especially in the southeast. Domestically, overcapacity has long resulted in overproduction, which translates into overemployment. Now the global downturn is exacerbating the situation by throwing out more workers because of decelerating industrial output and reduced foreign investment; hence, unemployment is climbing in China. In addition, there are annual additions to the army of job seekers, including more than six million university graduates and at least ten million immigrant farmers looking for a job in the city. Estimates of how many jobs have already been lost differ, but most estimates put the number at around 20 million ( Economist 2009 ) . To make the situation worse, the Chinese economy is decelerating. According to the World Bank, the forecast growth for China is 8.2% in 2012, after 9.1% in 2009, 10.4% in 2010, and 9.2% in 2011, which will further reduce job opportunities. By any standards, it is no small task for China to cope with the growing pressure of unemployment.

There is another social aspect to the effects of the crisis. The grim economic conditions and rising employment have stirred up questions on the wisdom of China’s current policy that seeks bene fi ts from globalization with minimum costs by decoupling from the US and world economy. Indications are that political debates are raging among Chinese elites about this position (Prasad 2009 ; Mile 2009 ) . The bigger picture is that resentment is brewing within the Chinese population. To many,

835 The Chinese Economy After the Global Crisis

the market-oriented reform and Western-oriented opening up have brought about more suffering than paybacks. The popular opinion is thus divided regarding the future direction of the nation, with very strong calls for returning to the good old days (Mile 2009 ) .

This is a more worrisome development in all aspects. Emerging from the closed doors of the central planning era, China has strived to open its economy to the rest of the world and to transform its economic system into a market one so as to achieve economic growth and balanced social development. The strategic thinking behind this drive is the profound belief that China stands to gain from economic and fi nancial globalization. This conviction has led to China having formulated and adhered to a national policy that seeks to increasingly integrate China into the existing world system and to realize economic and social development within the framework of established world order ( Dan 2008 ) .

The unfolding of the crisis has revealed that the current world order is fl awed (Li 2009c ) . It has also exposed the structural weaknesses and vulnerabilities of the Chinese economy under the direction of opening up ever wider to the rest of the world (Yu 2008 ) . The crisis and its fallout have shown that in a world of growing integration and globalization China cannot remain untouched by external shocks and downturns in the world economy. These facts have pushed the Chinese authorities into a two-front battle: to combat the calamitous effect of the ongoing crisis from outside and to prevent internal fragility evolving into a full- fl edged crisis from within. The vital battle has just begun (Li 2009d ) .

Over the past several years, China has enjoyed one of the world’s fastest growing economies (Fig. 5.1 , Table 5.1 ) and has been a major contributor to world economic growth. However, the current global fi nancial crisis threatens to signi fi cantly slow China’s economy. Several Chinese industries, particularly the export sector, have been hit hard by the crisis, and millions of workers have reportedly been laid off. This situation is of great concern to the Chinese government, which views rapid economic growth as critical to maintaining social stability. China is a major economic power and holds huge amounts of foreign exchange reserves, and thus its policies could have a major impact on the global economy.

Although the future of the world economic downturn continues to be unforeseeable, only the Chinese economy appears to be an exception. The Chinese economy began

Fig. 5.1 Chinese GDP growth rate (%) from 1978 to 2010 (projected for 2010)

84 L.-X. Li

to recover from the bottom of the business cycle in February or March in 2009, and will continue to achieve rapid growth in 2010 as well.

What China as an important economy entity has done, is doing, and will do will have a signi fi cant in fl uence on the global economy. Much therefore hinges on how well China is coping with the devastating effect of the current crisis (Prasad 2009 ) . If China can successfully muddle through, the world will see a more con fi dent China that opens its arms wider for globalization. However, if it fails, the rising tide of nationalism within the nation may drag China into a state in which the wheels of reforms are reversed. The world then will have to face a China that is

Year Growth rate (%)

1978 11.7 1979 7.6 1980 7.8 1981 5.2 1982 9.1 1983 10.9 1984 15.2 1985 13.5 1986 8.8 1987 11.6 1988 11.3 1989 4.1 1990 3.8 1991 9.2 1992 14.2 1993 13.5 1994 12.6 1995 10.5 1996 9.6 1997 8.8 1998 7.8 1999 7.1 2000 8.0 2001 7.5 2002 8.3 2003 9.5 2004 10.1 2005 10.4 2006 11.6 2007 13 2008 9 2009 9.1 2010 10.4 2011 9.2 Average 9.72

Table 5.1 The growth rate for each year from 1978 to 2009


resistant to globalization with mighty forces. The implications of this are huge and the world will be affected in many ways by its adverse consequences (Yep 2009 ) . This chapter will provide comprehensive insights on the following aspects on the Chinese economy: the in fl uence of the global crisis; China’s response to the global crisis; the Chinese economy in the long run; the fast growth of the Chinese economy; Chinese economic reforms; China as a global economic growth engine. It is my goal to provide broad views on the Chinese economy and some thoughts on the global economy after the global crisis.

For the rest of the chapter, we will fi rst introduce the impacts of the global fi nancial crisis on the Chinese economy in Sect. 2 , which sets the background for understanding China’s responses for crisis management in Sect. 3 . Section 4 is devoted to China’s fi nancial policy and its role in the Chinese economy in the long run. In Sect. 5 , we discuss international dimensions of China’s strategy to sustain fast growth of the Chinese economy. Section 6 presents the Chinese economic reforms before, during, and after the crisis. China as a leading growth engine of the world economy is discussed in Sect. 7 . The summary remarks are in given in Sect. 8 .

2 The Impact of the Global Crisis on the Chinese Economy

The growth rate of the Chinese economy reached a peak in 2007; it started to slow down from the third quarter of 2007, but has remained above 10%. The effect of the global emerged from the third quarter of 2008: the growth rate in the fourth quarter was just 6.8%, and decreased to 6.1% in the fi rst quarter of 2009. Some analysts contend annual economic growth of less than 8% could lead to social unrest in China, given that an estimated 20 million people seek jobs every year (including migrant workers who move to urban centers and high school and college graduates). According to the IMF, China was the single most important contributor to world economic growth in 2007. Thus, a Chinese economic slowdown (or recovery) could also have signi fi cant global implications.

As for the real economy, the real-estate market in several Chinese cities has exhibited signs of a bubble that is bursting, including a slowdown in construction, falling prices, and growing levels of unoccupied buildings. This has increased pres-sure on the banks to lower interest rates further to stabilize the market. For the fi rst 4 months of 2009, industrial output rose by 5.5% year on year, well below the 12.9% growth rate in 2008.

The effect of the global crisis on the Chinese fi nancial market has small because the Chinese capital market is not completely open to international funds (foreign capital cannot fl ow into the Chinese capital market freely), Chinese banks did not purchase many subprime debts, and foreign reserves are mostly in dollar-valued US government debts; therefore, the direct in fl uence of the global crisis on the Chinese banking sector has been light and most Chinese banks are doing very well. China’s main stock market index, the Shanghai Stock Exchange Composite Index, lost nearly two-thirds of its value from December 31, 2007 to December 31, 2008.

86 L.-X. Li

The in fl uence of the global crisis on the Chinese export industry is very great. From October 2008, Chinese exports started to decrease. China exported $1.43 trillion worth of goods, and the growth rate slowed by 8.6%; in the fi rst quarter of 2009, China exported $245.5 billion worth of goods; 19.7% less than in the same quarter of the previous year. At the same time, imports amounted to $183.2 billion, 30.9% lower than in the previous year.

China’s economic growth is overdependent on the growth of net exports. In 2008, its exports-to-GDP ratio reached 32%, and its exports and imports to GDP ratio was 59%. The contribution of net exports (goods and services) to GDP growth was over 20% in 2007. Moreover, as a labor-intensive sector, exports absorbed a mass of nonskilled workers from rural areas.

The G3, which account for 46% of the external demand for China’s exports, have all slipped into recession owing to the impact of the global fi nancial crisis. Emerging markets, such as Hong Kong, Taiwan, South Korea, and the ASEAN countries, which are China’s major export markets, have also slowed down dramatically. As a result of the weakening external demand, China’s exports have declined signi fi cantly since the fourth quarter of 2008. Both exports and imports have registered a contrac-tion since November 2008 (see Fig. 5.1 ). However, owing to the decline in world energy and commodity prices and owing to China’s shrinking internal demand, imports have decreased much faster than exports, causing a surge in the trade surplus.

As a result of the global fi nancial crisis, a large number of export-led private enterprises in China’s coastal provinces have gone bankrupt, with around 20 million unskilled workers losing their jobs. Furthermore, the slowdown in China’s exports, along with the decline in real-estate investments, led to a decrease in GDP growth from 13% in 2007 to 9% in 2008.

The main characteristics of the effect of the global crisis on Chinese exports are as follows:

(a) Labor-intensive products have maintained a relatively fast growth rate. For example, clothing grew by 9.9%, shoes by 7.7%, and bags by 11.7%. This shows China still has some advantage in these products.

(b) Exports of electronic goods and machines, fertilizers, and steel decreased greatly. For example, steel exports decreased by 59.5%, and exports of elec-tronic goods and machines decreased by 18.8%.

The exact reason why the Chinese government has put export growth at the top of its list of priorities is that the export sector can absorb excess labor. The huge number of workers released from bankrupt or poorly operated enterprises has caused a surge in the real unemployment rate, which could lead to social unrest. Hence, the Chinese government has continued to apply tax rebates to export goods, increasing its intervention (Geiger 2006 ; Genberg et al. 2007 ; Green 2009 ; He et al. 2007 ) in the foreign exchange market to prevent the further appreciation of the renminbi against the US dollar, and lowering its environmental and energy-consumption


criteria. However, external demand is an uncontrollable variable, so the Chinese government’s capacity to stimulate exports is facing great challenges, especially in an environment of protectionist pressure.

China’s economy is heavily dependent on global trade and investment fl ows (He and Zhang 2008 , 2009 ). In 2007, China overtook the USA to become the world’s second largest merchandise exporter, after the European Union (EU). China’s net exports (exports minus imports) contributed to one-third of its GDP growth in 2007. China’s exports of goods and services as a share of GDP rose from 9.1% in 1985 to 37.8% in 2008 (see Fig. 5.2 ). The Chinese government estimates that the foreign trade sector employs more than 80 million people, of which 28 mil-lion work in foreign-invested enterprises. Foreign direct investment (FDI) fl ows to China have been a major factor behind its productivity gains and rapid economic growth. FDI fl ows to China in 2007 totaled $75 billion, making it the largest FDI recipient among developing countries and the third largest overall, after the EU and the USA. The current global economic slowdown (especially among its major export markets—the USA, the EU, and Japan) is having a signi fi cant negative impact on China’s export sector and industries that depend on FDI fl ows.

China’s trade and FDI have plummeted over the past 6 months or so. China’s total exports and imports for the year 2011 was up 22.5% from the previous year. FDI fl ows to China increased 9% in the year 2011 from previous year.

The effect of the global crisis on Chinese job market has been great: it resulted in about 30 million job loses in the fi rst quarter of 2009, mostly due to the huge decrease in the Chinese export industry.

Fig. 5.2 Chinese trade of goods and services as a percentage of GDP: 1993–2008 (Source: Statistical Year Book of China, various issue, Chinese national bureau of statistics)

88 L.-X. Li

The impact on China’s foreign currency reserves ha been strongly negative (IMF 2008 ). At the end of 2008, China’s foreign exchange reserves had reached US$1.95 trillion. Although the People’s Bank of China (PBC) does not disclose the proportion of currency and assets of its foreign exchange reserves, it is possible to make a rough estimate based on external data. For instance, according to the IMF’s COFER statistics, up to the third quarter of 2008, assets denominated in US dollars (Hu 2009 ; Lardy 2008 , 2009a , b ), euros, pound sterling, and yen in the portfolios of developing countries’ reserves totaled 61, 28, 6, and 3% respectively. There is no evidence to show that China’s reserves are signi fi cantly different from those of other developing countries. The asset composition of China’s foreign exchange reserves can also be estimated through the statistics disclosed by the US Treasury on the overseas holdings of US securities. According to a preliminary report on foreign portfolio holdings of US securities at the end of June 2008, China held US$535 billion in US treasury bonds, US$544 billion in US agency bonds, US$27 billion in US corporate bonds, and US$100 billion in US equities. Even consider-ing that the PBC sold agency bonds and bought short-term treasury bonds in the second half of 2008, it can still be concluded that China’s foreign exchange reserves are heavily allocated in US-dollar-denominated assets, especially US Treasury and agency bonds (Table 5.2 ).

Since the subprime crisis, the US government has applied very loose fi scal and monetary policies. Paulson’s US$700 billion Troubled Asset Relief Program, US$789 billion stimulus package, and US$2 trillion fi nancial stability plan will together create a record-high fi scal de fi cit, and $1.3 trillion in 2010 and in 2011, around 10.6% of US GDP. The Federal Reserve has cut the benchmark rate from 5.25 to 0–0.25% and has been pumping money and credit into the economy through various types of innovative mechanisms. From the bankruptcy of Lehman Brothers in mid-September 2008 to the end of 2008 the Federal Reserve’s balance sheet grew from US$950 billion to US$2.27 trillion.

To fi nance the rescue package, the US government has only two choices (Morrison 2008 ). The fi rst is to issue more Treasury bonds, at least US$2 trillion

Table 5.2 China’s purchases of Fannie Mae and Freddie Mac bonds and the bonds of other agencies (billion dollars)

Industrial and Commercial Bank of China

Construction Bank of China

Bank of China

Merchant Bank of China

China Investment Trust Bank

Minsheng Bank Total

Fannie Mae and Freddie Mac related bonds

2.716 3.25 17.286 0.255 1.584 0.227 25.318

Other agency bonds

0.465 2.555 10.637 0.18 0.43 NA 14.24

Sources: Chinese national bureau of statistics NA not available


in 2009. If the demand for US Treasury bonds is unable to keep pace with the supply, their market value will decrease. As the largest holder of US Treasury bonds, the PBC (Mu 2008 ) will therefore suffer a signi fi cant loss. The second choice is that, if other investors are unwilling to continue buying US Treasury bonds, the Federal Reserve will become the buyer of last resort, meaning that the US government will take up the printing of bills. Unavoidably, the in fl ation rate will surge and the US dollar will depreciate against other major currencies. Therefore, the international purchasing power (Mile 2009 ) of China’s portfolio of US-dollar-denominated assets will shrink markedly.

An indirect but critical effect of the global fi nancial crisis on the Chinese economy is that, to mitigate the impact on the domestic economy and to stimulate short-term economic growth, the Chinese government might postpone or even cancel some of its structural adjustment policies. However, these structural adjustments are absolutely necessary for the sustainable growth of the Chinese economy. One example is that, to stimulate short-term economic growth, the Chinese government might resort to reviving real-estate investment, which means that it might give up trying to burst the property price bubble. Obviously, since the third quarter of 2008, both central and provincial governments have loosened the controls on the property sector. The percentage of down payments and the interest on loans to buy a second home have been reduced. The criteria by which commercial banks grant loans to developers have been lowered. Property developers can again obtain easy fi nancing, reducing the possibility for them to drive down property prices. Considering that there are still obvious bubbles in the property markets of many coastal cities, to loosen controls means that the Chinese government will postpone the necessary adjustment in property prices. However, bubbles always burst at some point. The longer the adjustment is postponed, the greater the fi nal impact of the collapse will be. The Chinese government will take note of the Japanese experience in the late 1980s.

The misalignment (Peng 2006 ; Prasad 2009 ) of the renminbi’s exchange rate has been one of the major that have caused external and internal imbalances in the Chinese economy. To solve this problem, the Chinese government started to reform the renminbi’s exchange rate mechanism in July 2005. Its de facto pegging to the US dollar was replaced by managed fl oating with reference to a basket of curren-cies, and the pace of the renminbi’s appreciation against the dollar accelerated from July 2005 to the fi rst half of 2008. However, after the aggravation and spreading of the global fi nancial crisis, China’s exports declined signi fi cantly. To sustain the rela-tive competitiveness of China’s export goods, the PBC increased its intervention in the foreign exchange market to prevent the further appreciation of the renminbi from the third quarter of 2008. In an environment of declining external demand and increasing trade protectionism, it is doubtful that managing the renminbi’s exchange rate will help stimulate China’s exports. To make things worse, the PBC’s heavy intervention in the foreign exchange market will sustain or even aggravate the country’s external and internal imbalances (Huang 2009 ; Li 2009a ).

Obviously, China is not crisis-proof. As an open economy, China has to handle the damage from the crisis without losing the bene fi t from the openness and going backward to being a closed economy.

90 L.-X. Li

3 China’s Responses to the Global Crisis

To reduce the effects of the global crisis and recover quickly, the Chinese government has taken many decisive and highly ef fi cient actions to tackle the fi nancial turmoil, including the following:

1. Implementing expansionary monetary policy, which includes

(a) Lowering the deposit reserve rate. To stimulate banks to release loans, the government lowered the deposit reserve rate four times consecutively from September, 2008.

(b) CuttiTng the interest rate for deposits and loans. The 3-year loan rate lowered from 7.56% in December of 2007 to 5.4% at present which is 6.9% in 2012 .

(c) Encouraging loans. In the fi rst quarter of 2009, total loans increased by 4.58 trillion yuan, as shown in Table 5.3 ; total loans grew by 4.91 trillion yuan in the whole year of 2008. The growth rate of national loans has remained at a rate above 27% per month, mostly fi nanced by commercial papers.

2. Increasing government spending heavily. The central government made a 2-year plan to invest four trillion yuan (Li 2009c,d ). This is equivalent to 16% of Chinese 2007 GDP. The plan included central government investment of 1.18 trillion yuan, and the rest was from the local government. The package (Maidment 2008 ; Mckinnon 2009 ) would fi nance public transport infrastructure (including railways, highways, airports, and ports), affordable housing, rural infrastructure (including irrigation, drinking water, electricity, and transport), environmental projects, technological innovation, health and education, and rebuilding areas hit by disasters (such as areas that were hit by the May 12, 2008 earthquake, primarily in Sichuan province). Shortly after the central government announced its stimulus package, numerous local government of fi cials announced their own stimulus package. Thus, the total level of China’s economic stimulus could be much higher than the of fi cial fi gure of four trillion yuan (US$586 billion). China’s stimulus, if fully implemented, would likely constitute one of the largest economic stimulus packages (both in terms of spending levels and as a percent-age of GDP) that have been announced by the world’s major economies to date, although it is unclear to what extent the stimulus package represents new spending versus projects that were already in the works before the economic downturn hit China. Table 5.4 provides a breakdown of the spending priorities of the stim-ulus program.

Table 5.3 Credit and monetary expansion (billion yuan and as a percentage)

May April March February January

Growth of M1 18.7 17.5 17.0 10.9 6.7 Growth of M2 25.7 26.0 25.5 20.5 18.8 Credit 664.5 591.8 1890 1070 1620 Growth of credit 30.6 29.7 29.8 24.2 21.3

Source: People’s Bank of China (Yu 2008 )


Table 5.4 China’s November 2008 domestic stimulus package

In Chinese yuan (billions)

In US dollars (billions)

As a percentage of total stimulus package

As a percent-age of China’s 2008 GDP

Transport infrastructure investment

1,500 220 37.5 5.0

Postearthquake reconstruction

1,000 146 25.0 3.3

Public housing 400 59 10.0 1.3 Rural infrastructure 370 54 9.3 1.2 Research and Development

and structural change 370 54 9.3 1.2

Environmental development 210 31 5.3 0.7 Health care and education 150 22 3.8 0.5 Total 4,000 586 100.0 13.3

Source: Global Insight Ranked according to planned spending levels

Fig. 5.3 The breakdown of the stimulus package

The Chinese stimulus program (Fig. 5.3 , Table 5.4 ) includes steps the govern-ment intends to take to assist ten pillar industries (i.e., industries deemed by the government to be vital to China’s economic growth) to promote their long-term competitiveness. These industries include automobiles, steel, shipbuilding, textiles, machinery, electronics and information technology, light industry (such as consumer products), petrochemicals, nonferrous metals, and logistics. The govern-ment support policies for the ten industries are expected to include tax cuts and incentives (including export tax rebates), industry subsidies and subsidies to con-sumers to purchase certain products (such as consumer goods and automobiles),

92 L.-X. Li

fi scal support, directives to banks to provide fi nancing, direct funds to support technology upgrades and the development of domestic brands, government pro-curement policies, the extension of export credit, and funding to help fi rms invest overseas. On May 18, 2009, China’s State Council announced plans to create three million new jobs in light industry over the following 3 years by providing fi nancial support to small and medium-sized light industry fi rms with good development potential.

On April 7, 2009, the Chinese government announced plans to spend $124 bil-lion over the following 3 years (Setser 2009 ) to create a universal health care sys-tem. The plan would attempt to extend basic coverage to most of the population by 2011, and would invest in public hospitals and training for village and community doctors. A number of efforts have been made to boost rural incomes and spending levels and to narrow the gap in living standards between rural and urban citizens (as well as between coastal and western regions of the country). For example, since February 2009, an estimated 900 million Chinese rural residents have been eligible to receive a 13% rebate for the purchase of home appliances. Public housing proj-ects, education, and infrastructure projects are largely targeted at rural areas. The government has also announced plans to boost agricultural subsidies to farmers.

3. Structural reduction of taxes. This procedure includes favorable tax reforms for small to medium-sized enterprises and the housing industry, eliminating and stopping 100 administration services fees. Together, the policy will reduce the cost to businesses and individuals by 500 billion yuan each year.

4. Undertaking reform and promotion of industry. The central government outline are reform and promotion plan for the following sectors steel, automobiles, equipment, electronics and information technology, textiles, chemicals, oil, nonferrous metal, shipping, light industry, and the logistics industry. The major goals are taking decisive steps to regroup industry, to get rid of production of low technology, to develop advanced productivity to intensify enterprises , and to raise the ef fi ciency of resource allocation.

Chinese economic policy efforts (Table 5.5 shows the record of China’s handling of the crisis, 2008–2009) are beginning to produce results. For example, in 2009 (June 2009) the Shanghai Stock Exchange Composite Index rose by 45%. Industrial output rose by 7.3% in April 2009 on a year-on-year basis (it was up 8.3% in March 2009). In addition, retail sales in April 2009 were up 14.8%, whereas investment in real estate was up 6.4% (year on year). However, China’s trade and FDI fl ows con-tinue to show sharp declines. Many analysts contend that China’s large-scale bank lending and infrastructure spending projects have helped boost the domestic econ-omy, but warn that these cannot be maintained inde fi nitely. Many Chinese analysts have raised concerns that the large level of borrowing by local governments and state-owned enterprises will lead to a rise in nonperforming loans on the balance sheets of China’s major banks and could undermine efforts to reform the banking system. Others are concerned over the long-term effects of expanded local govern-ment debt. China’s long-term economic growth prospects will likely depend on the ability of the government to rebalance the economy by promoting greater domestic consumption.


Table 5.5 Record of China’s handling of the crisis

Time Events

June 2008 The earliest known time that the Chinese leadership ruled the forthcoming global fi nancial crisis would hit China hard and actions needed to be taken to mitigate the adversity

July 25 The Chinese Politburo meeting set the tasks for economic work in the second half of 2008: keep the economy growing smoothly and at a reasonably high pace while combating acceleration of in fl ation

July 31 The Department of Finance and other government bodies jointly announced increasing tax rebates for some textile and garment exports, including silk, wool yarn, chemical fi bers, and cotton products, from 11 to 13%, effective from August 1

August 1–10 The central bank expanded the allowed credit size of commercial banks to alleviate fi nancial dif fi culties and hard-to-contain collateral problems of small and medium-sized enterprises. It agreed to raise the 2008 credit quota by 5% for national commercial banks and 10% for local commercial banks. Minor adjustments were made to re fl ect differing conditions among local banks

August 25 The head of the Chinese Securities Supervisory Committee gave no intention at all to disallow sales of nontradable securities. The Chinese securities regulator also issued four measures to improve the dividend system

August 27 The Chinese Securities Supervisory Committee formally published the revised Methods for Purchasing Listed Companies, which opened the way for big shareholders to increase stakes. Stake increases have become everyday events since then, and more than 100 fi rms have witnessed increased stakes by big shareholders

September 16 The Bank of China decided to cut the base lending rate of fi nancial institu-tions. The 1-year base lending rate of fi nancial institutions was reduced by 0.27 percentage points, from 7.47 to 7.20%. All the other tiers of lending rates were reduced accordingly. In the meantime, it cut back the mortgage loan rate for individuals, from 4.77 to 4.59% for 5 year-loans, a reduction of 0.18 percentage points. For mortgage loans longer than 5 years, the rate was reduced by 0.09 percentage points, from 5.22 to 5.13%. There was no change to the base rate for savings

September 18 The Committee of State-Owned Assets announced it would support central-controlled enterprises to increase holdings of listed fi rms or to repurchase their shares. Central Huijin Investment was the fi rst to buy shares of three banks: Bank of Industry and Commerce, Bank of China, and Bank of Construction. Initial estimates suggest Central Huijin Investment poured a total of 1.2 billion yuan into these three banks, with a signi fi cant effect on supporting the stock market

September 19 Three pieces of good news emerged to promote the stock market. Stamp duty was removed from stock purchases , but on sales it remained at 0.1%. The State-Owned Assets Supervision and Administration Commission said it would support centrally administered enterprises to increase holdings or repurchase shares of their listed subsidiaries. Central Huijin Investment would buy shares of three major Chinese lenders on the secondary market to support their share prices

September 22 The Chinese securities regulator published supplementary rules on listed fi rms repurchasing share through centralized bidding. On October 31, Tianyin became the fi rst company to repurchase its shares. Several others have followed suit

(continued)

94 L.-X. Li

Time Events

September 25 The central bank announced that the required ratio of reserves for all deposit-taking fi nancial institutions was to be reduced by 1 percentage point, except for the Bank of Industry and Commerce, the Bank of Agriculture, the Bank of China, the Bank of Construction, and the Bank of Communication,. Financial institutions in the earthquake-hit areas would see their required reserve ratio reduced by 2 percentage points

October 5 The Chinese Securities Supervisory Committee declared it would soon start margin fi nancing and securities lending on a trial basis. Eleven securities companies took part in a trial run on October 25. This move effectively allowed the securities fi rms to short shares . Non fi nancial fi rms were allowed to fl oat mid-term bonds as of October 6 to help ease their fi nancing dif fi culties

October 8 The central bank announced that, effective from October 15, all deposit-taking fi nancial institutions’ required ratio of reserves would be reduced by 0.5 percentage points

October 9 The central bank announced, in addition to reducing the required ratio of reserves, the base savings rate would be cut from 4.14 to 3.87% for 1-year deposits. The 1-year base lending rate would be cut by 0.27 percentage points from 7.20 to 6.93%. All other tiers of lending and savings rates would be adjusted accordingly. The rate for personal mortgages provided by the Public Housing Fund was cut by 0.27 percentage points. In the meantime, the interest earned by individuals from the settlement funds of securities market transactions would be exempt from income tax

October 17 The Executive Meeting of the State Council decided to adopt fl exible and cautionary macroeconomic policies and to launch as soon as possible well-targeted policies in the fi scal, taxation, credit, and foreign trade sectors to keep the economy growing smoothly and at a relatively high pace. The Chinese government announced that the it would adopt comprehensive measures and allocate fi scal funds in the fourth quarter to expand domestic demand, improve living conditions, and stimulate economic development

October 20 The State Development and Reform Committee said it would continue to intensify its policy of strengthening and bene fi ting farmers, making full effort to organize procurement of stable agricultural goods, raising by a relatively margin the minimum procurement price of grains in order to increase subsidies to grain-growing farmers. It would convene a meeting to analyze the economic and fi nancial conditions and continue to guide fi nancial institutions to increase their credit provisions to key areas or to-be-strengthened weaker areas such as projects concerning farmers, rural communities, agricultural production, small and medium-sized enterprises, and rehabilitation of earthquake-hit areas

October 21 The executive meeting of the State Council was held to analyze the ways to intensify construction of infrastructure projects. The meeting approved a series of construction projects, including highways, airports, nuclear power stations, and pumped storage power stations. It was decided at the meeting that the construction of the middle and eastern lines of the South-to North Water Diversion Project should be quickened

(continued)

Table 5.5 (continued)


Time Events

From October 21

The Department of Finance and the State General Administration of Taxation jointly announced that, effective from November 1, the tax rebates for exports would be raised appropriately. This covered labor-intensive goods such as textiles, garments, and toys, as well as high-tech goods or goods with high added value. The next day, the Department of Finance announced that, to improve living conditions and expand domestic demand, it would increase fi nancial support to students in need, disabled or widowed persons, housing protection, etc. It provided assurance of a basic standard living to people of low-income groups or people with special needs through increased input to projects that aimed at improving living conditions of these groups

October 22 The People’s Bank of China said that, effective from October 27, the allowable range for the downward fl oating of the rate of lending for personal housing on commercial terms was to be expanded to 0.7 times the base lending rate (meaning the fl oor for interest rates was lowered to 70% of the central bank’s base rate). Meanwhile, the mortgage down payment was lowered from 20 to 30% for fi rst-time buyers of residential houses smaller than 90 m 2 . The lending rate for personal mortgages provided by the Public Housing Fund was accordingly cut by 0.27 percentage points

October 25 China adjusted its macroeconomic policies to put as the top priority keeping the economy growing steadily and in the meantime to take care of the needs of containing in fl ation and balance of payments equilibrium

October 30 The central bank decided to change both deposit and lending rates of fi nancial institutions. The 1-year base savings rate was cut by 0.27 percentage points from 3.87 to 3.60%. The 1-year base lending rate was reduced by 0.27 percentage points as well, from 6.93 to 6.66%. All other tiers of lending and savings rates would be adjusted accordingly. There were no changes to the rate for personal mortgage loans provided by the Public Housing Fund

November 1 New tax rebates became effective for 3,486 export items, accounting for 25.8% of products covered by customs tariffs. Rebate rates were roughly from 9 to 14%

November 9 The Chinese government launched a large package to stimulate growth and employment. The package would spend four trillion yuan (estimated US$586 billion) by 2010 on infrastructure and social welfare projects, including constructing housing, rural infrastructure, railways, highways, airports, and rebuilding communities devastated by the earthquake in southwest China in May. At the same time, the government promised to reform the VAT system and the central bank was to promote bank lending to support growth, with priority being given to key projects of national importance. Also, the government formally changed the fi scal stance from “prudent” to “proactive” and the monetary policy stance from “moderately tight” to “moderately easy”

November 10 The government decided to roll out the reform of the VAT covering the whole nation. Under this reform, capital spending could be deducted from the VAT. This is in line with international practice and reduces the corporate tax burden by about 120 billion yuan (0.4% of GDP)

November 19 China rolled out 6 measures for promoting healthy development of the light and textile industries

(continued)


96 L.-X. Li

Time Events

November 26 The State Council mapped out 6 measures for helping enterprises resolve the dif fi culties they were facing because of the fi nancial crisis. The People’s Bank of China also decided that, from November 26, the required ratio of reserves of big savings fi nancial institutions would be lowered by 1 percentage point. These institutions included the Bank of Industry and Commerce, the Bank of Agriculture, the Bank of China, the Bank of Construction,

The Bank of Communication, and the Postal Savings Bank. For small and medium-sized deposit-taking fi nancial institutions, the required ratio of reserves was reduced by 2 percentage points. Preferential required ratio of reserves continued to apply to fi nancial institutions in the earthquake-hit areas and rural fi nancial institutions

November 27 The central bank decided to change the rates. The 1-year deposit rate was cut by 1.08 percentage points, from 3.60 to 2.52%. The 1-year lending rate dropped from 6.66 to 5.58%, also down by 1.08 percentage points. Other tiers of lending and savings interest rates were subject to changes accordingly. The lending rate for 5-year personal mortgages provided by Public Housing Fund was cut by 0.54 percentage points to 3.51%. For loans whose maturity is 5 years or longer, the rate was cut by 0.54 percentage points to 4.05%. In the meantime, the central bank’s lending rates to fi nancial institutions were reduced. Of these rates, the deposit rate for required reserves dropped from 1.89 to 1.62%, down by 0.27 percent-age points. The deposit rate for excess reserves declined from 0.99 to 0.72%, a reduction of 0.27 percentage points. The relending rate for 1-year liquidity was reduced from 4.68 to 3.60%; other relending rates were adjusted downward accordingly. The rediscount rate was reduced from 4.32 to 2.97%

December 3 The State Council held its executive meeting to discuss and formulate 9 measures aimed at promoting economic growth through fi nancial channels

December 10 The State Council made arrangements for farming work and decided to increase subsidies for agricultural machines and equipment purchased by farmers

December 17 The government rolled out a reform program for reforming the prices of oil products, and related taxes and fees. Arrangements were also made to map out measures to promote healthy development of the property markets

December 20 The General Of fi ce of the State Council issued opinions on promoting healthy development of the property market. The opinions have 6 sections and 13 clauses. It stressed that greater efforts must be made to intensify construc-tion of housing for social security. The government further clari fi ed its position that consumption of common commercial housing is to be encouraged. Property fi rms should be responsive to market changes and should take initiatives to promote sales of commercial housing at reason-able prices. The responsibility of local governments in stabilizing the property market was to be stressed. Monitoring of the property market should be intensi fi ed

December 22 The central bank decided to lower the required ratio of reserves by 0.5%, effective from December 25

(continued)



Time Events

December 23 The central bank decided to change the base rates of deposits, lending, and the central bank’s relending and rediscount rates to fi nancial institutions. The 1-year deposit rate was cut by 0.27 percentage points, down from 2.52 to 2.25%. The 1-year lending rate dropped from 5.58 to 5.31%, also down by 0.27 percentage points. Other tiers of lending and savings interest rates were subject to changes accordingly. The lending rate of less than 5-year personal mortgage loans provided by the Public Housing Fund was cut by 0.18 percentage points to 3.33%. For loans of 5 years or longer, the rate was cut by 0.18 percentage points to 3.87%. In the meantime, the central bank’s lending rates to fi nancial institutions were reduced. Of these rates, the relending rate for 1-year liquidity was reduced from 3.60 to 3.33%, a reduction of 0.27 percentage points. The 1-year relending rate to rural credit societies (excluding emergent loans) was reduced from 3.42 to 2.88%, a decline of 0.54 percentage points. Other tiers of relending rates were adjusted downward accordingly. The rediscount rate was reduced from 2.97 to 1.80%, a cut of 1.17 percentage points

December 24 The executive meeting of State Council analyzed and then made arrangements for adopting measures to revitalize goods distribution, expand consump-tion, and maintain stable growth of foreign trade. Also considered were measures for ensuring production and supply of fertilizers and to promote reform and development of the fertilizer industry. The executive meeting also examined and passed, in principle, the special major science and technology program for computer numerically controlled machine tools and basic manufacturing equipment

December 31 The Chinese government proclaimed its views about reviving distribution and expanding consumption, according to which the campaign of sending household electronic goods to the countryside would be extended from more than 10 provinces to the whole county. In the meantime, motor bicycles, computers, hot water boilers (including all types powered by solar energy, gas, and electricity), and air conditioners were now included in the list to qualify for receipt of policy subsidies

January 1, 2009

China abolished quantity controls and licensing management for textile exports to the USA and licensing management of textile exports to Europe. Enterprises are no longer subject to examination of operational quality and quali fi cations

January 7 In the face of a grim job market, the State Council discussed and formulated 7 measures for intensifying works in relation to graduate employment

Mid-January to end of February

Successive executive meetings of the State Council wee held to examine and pass the program for adjustment and revitalization of ten industries: automobiles, steel, textiles, equipment manufacturing, shipbuilding, electronics and information technology, household goods, oil and related chemicals, nonferrous metal, and goods distribution. Details of the programs were being drafted out and would be launched in due course. Various locations and departments were taking measures complementary to the programs, including schemes of consumption coupons and training vouchers

March 4 Chinese leaders appealed to the non-state-owned economy to avoid laying off workers, reducing salaries, and delaying their pay

(continued)


98 L.-X. Li

Despite some concerns about China’s response package, as a result of these procedures, the Chinese economy grew by 9.1% in 2009, and was the fastest growing economy in the world after the recession. China is eyeing double digit growth for 2010. China harvested an 10.4% growth in 2010, 9.2% growth in 2011, and expect a 8.5% growth (estimated) in 2012. Now all the macroeconomic indicators are showing that the Chinese economy is shaking off the in fl uence of the global crisis and is running at full swing toward high growth.

4 The Chinese Economy in the Long Run

Since 1978, free market reform has been the major task of the Chinese economy. Since then, the Chinese economy has kept growing at a rate of around 9.6% each year for more than 30 years. Now China has overtaken Japan as the second largest economy in the world, which is an obvious economic miracle. To secure a fast and sustainable development of the Chinese economy, China now is taking many important measures to facilitate economic growth. The strategy of sustainable development is considered as the centerpiece of guidelines for future development. In China, all

Time Events

March 6 The Department of Commerce adjusted the authorization power allowance in the Notice about Delegating the Examination and Approval Power for Foreign Invested Companies to Set Up Investment Firms, effective immediately. According to this notice, for investment fi rms established by foreign investors with a capitalization of less than US$100 million, their establishment and changes are to be approved by a provincial commerce bureau. The provincial commerce bureau should not delegate the power further down

March 17 The Department of Finance said that China will allow issuance of local government bonds for the fi rst time across the country. The Department of Finance will issue such bonds totaling 200 billion yuan on behalf of local governments, with maturity of 3 years. The bonds are open to all investors. The Department of Commerce, the Department of Finance, the People’s Bank of China, the Banking Regulatory Commission, and the State Insurance Regulatory Commission jointly issued views on promoting healthy development of credit sales. The notice advocates using credit sales as an important avenue for expanding domestic demand to ensure economic growth. Powerful measures should be taken to proactively promote such sales.

The State General Administration of Taxation extended the preferential tax treatment for reemployment. With a certi fi cate of reemployment, a person undertaking an individual business operation can enjoy tax cuts up to 8,000 yuan for 3 years, in relation to the business tax, tax for city construction and maintenance, educational surtax and surcharge, and personal income tax

March 19 The central bank issued ten billion yuan central bank bills on the open market

Source: Li ( 2009b )



enterprises must make a plan for their own sustainable fast growth. The central government and local governments are working jointly to make sure sustainable development is the major policy-making strategy. According to the strategy, all governments must outline an operational plan, stimulate creativity and eagerness of enterprises and individuals, ef fi ciently allocate resources, encourage free market reform, enhance intensive management, and encourage participation of enterprises and individuals.

The ability to achieve sustainable growth must be enhanced. China is now training its governing body and advertising the ideology of sustainable development to build it into its political system, market mechanisms, and public and enterprise decision-making procedures. The goal is obviously to enhance the decision-making ability of all aspects of the nation’s economy to achieve the highly ef fi cient realization of the sustainable development strategy.

Environmental protection and management are to be reformed to facilitate the free market requirements. The procedures include (a) setting up and completing the environmental legal system and laws, (b) using market procedures to protect the environment, such as pollution fees and environmental taxes, and (c) enhancing public service in the environmental protection sector, such as providing clean drinking water, clean air, and clean living conditions.

Traditional industry society must be changed to a knowledge-based-economy information society. Technology and knowledge will overtake natural resources as the major factor of economic growth. In the information age, sustainable development goes with a new development direction: (a) a global net of information will lead to a complete open and sustainable development system, which will lead to ef fi cient allocation of global resources; (b) the high-technology industry will be the leading growth point of the economy; (c) growth of the knowledge-based economy will lead the change in production from consumption of natural resources to the production of knowledge.

International cooperations and channels are becoming more diversi fi ed. China as a WTO member will be an equal trade partner with all other members (Qishan 2009 ; Shao 2008 ; Wilder 2009 ). This will widen China’s cooperation channels and strongly enhance China’s development opportunities.

For effective long-term growth, China will attach greater importance to long-term optimization of the economic structure. For this, workable measures have to be adopted to expedite the country’s social construction in an all-round way in order to clear the path for sustained and healthy economic development.

A number of emerging Asian economies had to face the so-called middle-income trap (Sharma 2009 ) during their economic development because of their sluggish social construction process. Some countries (World development report 2006 ), such as Brazil, Argentina, Mexico, Chile, and Malaysia, have suffered even a long economic slowdown or stagnation because of their failure to resolve economic contradictions, or because of their ill-conceived development strategies or outside impacts.

One of the main reasons why such a situation arose in those countries was because they attached too much importance to economic growth and failed to pay enough attention to social construction. As a result, the rich–poor income gap widened further,

100 L.-X. Li

leading to slackened domestic demand. The formation of a new dual social structure during their accelerated urbanization process and the absence of a social security net aggravated the existing severe social contradictions. Besides, inadequate expen-diture on education and human capital aggravated the imbalance in their industrial structure and fuelled an extensive economy.

Entering this economic stage (Fig. 5.4 ), a related problem is the widening gap between rural and urban income. At the beginning of the 1980s, the rural–urban income gap in fact narrowed, since agricultural income was boosted by the imple-mentation of the household responsibility system in the countryside, whereas urban reforms were slow to gather momentum. Over time, however, the gap has widened sharply. In 1981, urban income was on average about two times rural income. In 2005, this ratio rose to 3.2. This is probably the result of institutional restrictions on migration and faster productivity growth in the urban economy.

China will expedite its social construction and overcome the “middle-income trap” as an important part of the task of the scienti fi c development outlook. China is striving to complete its building of a harmonious society, from employment generation and social security to housing and health care to improve people’s liveli-hoods, although its expenditure on public services and other social areas is still far from enough. Another important way to sustain its high growth is that China will put more emphasis on raising people’s quality of life by educating them in scienti fi c matters and strengthening the ideology governing the country by law.

Greater efforts will be made to reduce the country’s excessive dependence on investments (Fig. 5.5 ) for economic growth. The government adopted an unprece-dented expansive fi scal policy in the fi rst quarter of the year 2008 to stop the economic slide, with investments into fi xed assets reaching 2.8129 billion yuan (US$412.33 million), a 28.8% increase year on year. In fact, investments have been used as a forcible tool to sustain the country’s fast-paced economic growth over the past three decades. It is true that large investments have bolstered the country’s decades-long rapid growth. But it is also true that they have consumed huge amounts of natural resources and energy. To reverse the trend, the government needs to take

3.53.33.12.92.72.52.32.11.91.71.5

1985 1988 1991 1994

Urban-Rural Income Ratio(L) Gini Coefficient (R)

1997 2000 2003 2006 2009

0.50

0.45

0.40

0.35

0.30

0.25

0.20

Fig. 5.4 Gini coef fi cient among households and the urban–rural income gap (Sources: Chinese national bureau of statistics )


some concrete and viable measures for boosting technological innovation and accelerating and cultivating a more effective human capital market and improving its investment ef fi ciency. This will help prevent the buildup of surplus production capability under the investment-fuelled-growth model.

Besides, the existing national income distribution pattern should be modi fi ed to raise the ratio of people’s consumption to GDP. The fast-paced economic growth of the past three decades has boosted China’s wealth accumulation. But the growth in people’s wealth has been far behind the nation’s level. An imbalance in wealth distribution has been a key factor in the rising economic structural imbalance and soft demand. Statistics show people’s consumption level has fallen on a yearly basis during the past three decades, with its ratio to the country’s GPD being less than 60%. From 1998 to 2005, the average income of laborers grew by an average of 9.9% year, less than one-third of the 30.5% annual growth in the country’s industrial pro fi ts. Between 1995 and 2007, the shares of the corporate sector and the government in total national income increased steadily. As a result, the income share of house-holds decreased from 68 to 50%. This trend could be important for explaining the declining share of consumption in GDP.

The lack of a synchronous growth is to blame for the value of labor being under-estimated for long and for laborers getting a low proportion of enterprises’ income. To rectify this, an overhaul of the country’s wealth distribution mechanism is needed through a series of steps, ranging from increasing laborers’ share in the country’s primary income distribution, strengthening the country’s fi nancial transfer payment and tax cuts to boosting people’s income and ensuring they get their due share of the expanding national wealth.

Apart from that, greater efforts have to be made to ensure industrial interests are distributed fairly. In January and February of 2008, the lion’s share of the country’s fi xed assets investment went into state-owned enterprises or the monopoly indus-tries. In actual terms, the investment growth for them was 35.6% year on year, whereas for other sectors it was only 20%. To break such a distribution pattern, the government should encourage more competition in the petroleum, power, rail-way, fi nance, telecommunication, education and some service sectors.

50%

45%

40%

35%

30%

25%

20%1995 1996 20031998 1999 2001 2002 20042000 2005 2006 20071997 2008

Fig. 5.5 China’s investment rate (Source: Chinese national bureau of statistics )

102 L.-X. Li

China’s strategy is to reform all those sectors that restrict its sustainable growth without sacri fi cing its high growth rate with controllable, well-regulated reforming approaches.

5 Fast Growth Toward the Top of the Global Economy

The Chinese economy has grown at an average rate above 9.6% since 1978, when the free economy reform started. How to keep the high growth rate for the next 20–30 years is the key issue of any policy making in China. But improving the quality of Chinese people’s living standards is the only fundamental driving force for growth of the Chinese economy. To satisfy this goal, China will realize the modernization of Chinese people’s lives by industrialization, urbanization, informationization, and use of technology, driving the economy toward an all-round modernized and homog-enous economy for a new China.

The industrialization process will be a leading driving force for Chinese economic growth:

1. Regional cooperations as a driving force . Because China is a huge territory, this leads to nonhomogeneous economic development. China will push for regional cooperations to utilize complementary advantages to speed up the growth of the industries. Regional corporation will take advantage of resource reallocation, production redistribution, position advantage, infrastructure development, raw material supplies, and movement of labor in a large-scale fashion to stimulate demand, improve the industrial structure, and drive fast economic growth.

2. Industrial structure reshaping as a driving force . China will push for its growth and modernization of its service industry. At the same time, the high-technology manufacturing industry is also a direction for further Chinese industrialization. Chinese manufacturing industry will put its development strategic emphasis on advanced and high-tech sectors such as advanced equipment manufacturing and aerospace equipment manufacturing. This kind of industry restructuring will stimulate new growth rounds of Chinese industrialization and the economy. Speci fi cally, China will do the following two things to achieve its high growth of industrialization:

(a) Integration and strengthening of strategic industries. China will push for fast growth of strategic industries, such as advanced equipment manufacturing, aerospace equipment manufacturing, information technology industry, resources industry, logistics industry, and nanotechnology industry.

(b) Development of resource industries. China is full of all kinds of nature resources, such as minerals, forestry and agriculture, and sea and ecological resources. China will develop large-scale resource-based industries. The goal is to further develop and utilize Chinese natural resources, extend the production chain, enhance the added value, and change the resource advantage to industries and fast economic growth.


3. Modernization of the fi nancial system as a driving force . China will complete its fi nancial system modernization process, which includes completing the laws for the fi nancial system, developing more instruments for the fi nancial market, reducing government control of investment and fi nancing, pushing for a global free conversion of the renminbi, participating in international capital fl ow, and building a more ef fi cient and high-level-information fi nancial system. The mod-ernization of the Chinese fi nancial industry (Yi 2009 ; Zhang 2008a , b ) will be a factor supporting China’s economic growth.

Urbanization will be key for China’s economic growth. In 2009, China’s urban-ization rate was just 46.6%. China will try to reach the goal of a rate of 65% by 2030, which will complete the Chinese basic urbanization process. To realize this goal, China will raise 1% of its population each year into the urban living standard. Because of this process, China will maintain a high growth rate of its economy. The reasons are:

1. Urbanization will increase the size of cities and their populations. This process will build more infrastructure, houses, and highways, which will eventually expand demands and cause the economy grow.

2. Newly urbanized people will produce new demands for durable consumption products, such as houses, cars, TVs, computers, and schools. The new demands will stimulate the growth of the economy.

3. Urbanization will produce more service industries. In 2009, the Chinese service industry accounted for just 43.3% of GDP, which is lower than the world average of 68% much. Urbanization will produce more demand for the service industry and stimulate its fast growth.

4. Urbanization will leave a smaller population of farmers, which will improve the production ef fi ciency and income of individual farmers. Eventually, it will enhance the productivity and technology of the agriculture industry.

Informationization will be an important way to speed up Chinese economic growth. Information technology is the key modernization criterion for every country. How to obtain and use the information is a key issue for all modern life.

Information will enhance the ef fi ciency of modern decision making, management, and living. So a push for informationization, i.e., to use information to decide what to do, will basically change people’s management ability and signi fi cantly reduce the cost of all production, consumption, and living processes. Information is a product which leads to high-quality growth of the economy.

Building up a Chinese information system will stimulate demand, speed up Chinese modernization, and support Chinese economic growth.

Technology is the key factor for Chinese economic growth. By using high tech-nology, China can reduce the cost of its products, produce a new product, which leads to new broad consumption market, raise the ef fi ciency of its production, and enhance the competitiveness of its goods. Discovery and innovation will take place each every day, which will change lives on a daily basis. China can maintain a sustainable and ef fi cient road to growth in the long run through technological innovation. China is

104 L.-X. Li

0

5

10

15

20

25

30

35

40

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

GD

P [

in $

trill

ion

]

Fig. 5.6 Projected Chinese and USA GDP in the near future. Red line US GDP, blue line Chinese GDP. The crossing point is at the year 2026

Table 5.6 Projected GDP for China (growth rate 10%) and the USA (growth rate 3%) Year

GGP (trillion dollars)

China USA GDP

2008 4.222 14.333 2009 4.642 14.76 2010 5.106 15.203 2011 5.617 15.659 2012 6.179 16.129 2013 6.796 16.612 2014 7.476 17.111 2015 8.224 17.624 2016 9.046 18.153 2017 9.951 18.697 2018 10.95 19.258 2019 12.04 19.836 2020 13.24 20.431 2021 14.57 21.044 2022 16.03 21.675 2023 17.63 22.326 2024 19.39 22.995 2025 21.33 23.685 2026 23.46 24.396 2027 25.81 25.128 2028 28.39 25.882 2029 31.23 26.658 2030 34.35 27.458


pushing its industry to build up its research and development sectors, and will invest more money into those strategic high-tech industries, such as nanotechnology, aerospace, genetic engineering, new energy, and new materials. China will produce more scientists and engineers by investing more in its education system and push-ing for research-oriented universities. To lead the world in technological innova-tion in the long run, China will use its huge population resource as an innovation resource. A technology-driven economy will be a key for China to succeed.

These driving forces will support a high growth rate of the Chinese economy. China will take many rational policies to use all these driving forces to keep its growth rate above 8% for the next few decades. By 2030, China will be the leading economy in the world. China has already passed Japan as the world’s second largest economy. The road toward the top is bright (Fig. 5.6 , Table 5.6 ) and fast although China will have to face many challenges, such as energy shortages, political reforms, and international competitiveness. As projected, China will pass the USA and become the world’s leading economy in 2026.

6 Chinese Economic Reforms

Since 1978, China has undertaken many decisive reforms of its old-style political and government-controlled economy. From an economic point of view, the reforms can be viewed as having taken place in four stages:

1. The starting stage, 1978–1984. This was the period when the free market idea emerged and broke through from the government-planned economy.

2. All-round reforming stage, 1984–1992. China took steps to reform its state-owned enterprises toward private enterprises.

3. System innovation, 1992–2003. This was a stage to fi nd a new and suitable economic system to release Chinese economic productivity.

4. Perfection of reforms, 2003 to the present. This is a stage to improve and perfect the free market reforms.

To guide this historical reform of a huge-population, long-history country, China used many useful and effective theories, such as the theory to build a Chinese characteristic society, the theory to develop a Chinese-style free market, the theory to reform the Chinese economy stage by stage, and the theory to form a harmonious society. Speci fi cally, China put its reform emphasis on the following fi elds: (1) reform the management of the agricultural economy and rural peasants; (2) open up the economy and set up many special economic regions for a free market; (3) privatize enterprises and develop other economic systems for a free economy; (4) reform public fi nance and modernize the fi nancial system (Zhen 2008 ; Zhen 2009 ); (5) reform the price-setting mechanism and the market system; (6) reform employment and income distribution and build up an ef fi cient social security system; (7) Restructure education, science and technology, and the culture system; (8) reform the health and human services sector.

106 L.-X. Li

As the reform goes on, it also seems clear that the Chinese economy has reached a turning point. The growth machine that has brought China this far needs to be retooled if it is to keep up its remarkable record. The structural reform of the Chinese economy is much needed. China’s economy is sometimes described as being dependent on its export machine. It is certainly true that China cannot keep expanding exports at 20% a year in the face of a prolonged global recession. But the real story of the last 5 years has been the investment binge at home, most notably in heavy industry. Production of aluminum, of steel, of cement, and of glass have nearly doubled in the past few years—which was also one of the root causes of the boom in commodity and energy prices. But this turbo-charged investment has had negative side effects that make it hard to sustain. Energy use has become more inef fi cient, pollution is rising—causing political instability—and these heavy indus-tries create fewer jobs than services.

For the past 5 years, China has recognized the need to shift the balance of the economy. China will place less emphasis on investment and low-cost exports and more on consumption, services, and innovation. The transition can no longer be delayed. There is already a laundry list of policy proposals to boost consumption. The top priority for many economists is health care reform. Yet shifting the balance of the economy will demand more than well-executed policies. It will require shifts in political culture and in the institutions that govern the economy. In much of the service sector, from fi nance to telecommunications, the state still dominates. Even creative industries are trapped in its shadow. The privatization process is a long-lasting reform.

The key approaches for Chinese reform are threefold:

1. Reform from the local to central government: this kind of reform includes the rural peasant and non-state-owned economy.

2. Reform from the central to the local government: such as public fi nance, fi nancial system, foreign currency system, and administrative examination and approval system reform.

3. Reform by the cooperation of central and local government: such as state-owned enterprises, price reforms, market system building, and an open economy.

Since 2003, China has used a new theory named scienti fi c development out-look to guide economic reform. The central pieces of this theory are human-oriented ideology and sustainable development. That is to say, Chinese economic reforms are based on improving peoples’ lives and will take a road to develop the Chinese economy in a sustainable fashion. After more than 30 years of reform, Chinese economic reform is going further into a new stage, which is characterized by the following changes: (1) from government control to a market-oriented econ-omy; (2) from large numbers of public enterprises to a small number of quality public corporations; (3) from ef fi ciency and fair to a free market; (4) from manag-ing the state-owned economy well to developing all the economy in the country effectively; (5) from reform of the state-owned economy to reform of public administration.


So far, Chinese reform has been a success and a miracle of economics in Chinese and world history. With the guidance of the new theory, China is endeavoring to become a stable, progressive, harmonious nation. It is China’s ambitious goal to enable its people live in a prosperous and peaceful environment and in the world’s leading economy and innovation center in about 20 years.

7 Leading the World Economy as a Major Economic Growth Engine

After the recession, China quickly and strongly restored its high economic growth. China achieved a 9.1% growth rate in the 2009, which was the fastest recovery in the world. In 2010, China achieved a 11.9% growth rate in the fi rst quarter. China’s growth rate was 10.4% growth in 2010, 9.2% in 2011 and is expecting a 8.5% growth in 2012. With the huge potential of the Chinese market, the Chinese econ-omy will be able to expand fast for the next few decades. Eventually, not in a long time, China will overtake the USA and become the world’s leading economy. And naturally China will become the major growth engine of the world economy. According to the IMF’s calculation, China accounted for a 25% share of world eco-nomic growth in 2008, and is already the leading driving force in the world. At the same time, in 2009, the economy of the USA declined; the USA was the largest growth-driving force for the last few decades.

To lead the world economy effectively, China will enhance the size of its GDP and its competitiveness. In 2008, US GDP was around US$14.3 trillion; Chinese GDP is about US$4.2 trillion. US GDP is around four times bigger than Chinese GDP. China has just passed Japan to become the second largest economy in the world. It will take another 10–20 years to overtake the USA if China has an average growth rate of 8–10%. Even if China becomes the world’s leading economy, its GDP per capita will still be far below that of the USA. This means as the world leading economy, China’s potential to develop will still be huge.

The advantages for the Chinese economy to compete and grow fast are as follows:

1. The low cost of fundamental production factors. The cost for workers is just 1/30 of that of Japan, and 1/40 that of the USA. China has a college-level-educated workforce of around 40 million, with three million college graduates each year. Chinese workers are diligent and hard-working, which is attractive for many big international companies.

2. Huge potential and volume of the Chinese market. China is now growing rapidly, and demand for its products and services is strong. This means many Chinese products will be huge in terms of numbers and scale even though the share may be low in the Chinese market, for example, the number of cell phones in China has already passed the number in the USA but the cell phone owners still account for a lower portion of the population than in the USA. The huge growth potential is attracting many famous companies and large investments to the Chinese market, which will speed up transfer of high technology and capital to China.

108 L.-X. Li

3. Jump start many products by using advanced skills. By using advanced and already existing skills and management experiences, China will take a straighter path toward the ef fi cient production of many high-tech goods and services. This will reduce the high cost and long time needed for China to catch up. In the catch-up process, China will grow rapidly and this will cause the economy grow. But eventually, with China’s own innovation power, China will lead technologi-cal innovation.

To strengthen China’s competitiveness, China will take the following steps:

1. Raise productivity and lower the unemployment rate 2. Improve state-owned enterprises’ ef fi ciency and scale up private enterprises 3. Push for improvement of products and enterprises 4. Modernize the education and scienti fi c research system 5. Protect the environment and peacefully utilize world energy resources 6. Form a stable fi nancial and political environment 7. Strengthen its defense power to protect China’s national interests 8. Push for a multipolarized world for a peaceful growth environment 9. Build up a rational social security system to narrow the differences between the

poor and the rich 10. Develop a homogeneous economy for the whole nation

China’s in fl uence will become more and more important. China has the biggest foreign reserves, is the largest consumer of energy, produces and uses the larg-est number of cars, computers, TVs, and cell phones, generates more electricity than any other country in the world, etc. With all appropriate and rational efforts, after the USA, China will be the leading driving force in the economy for next 100 years.

8 Conclusions

China is using expansionary fi scal and monetary policies to deal with the global crisis, by investing huge amounts of capital in infrastructure, reducing taxes for individuals and small businesses, cutting bank loan interest rates, lowering deposit reserve rates, etc. China achieved a GDP growth rate of 9.1% in 2009, which is a demonstration of its effective policies against the global recession. In 2010, China will enjoy an 11% growth rate as it is on the right track now. The global crisis forced China to reform its economic structure to put more emphasis on domestic consump-tion instead of exports, which will signi fi cantly reduce the reliance of the Chinese economy on foreign economies and will protect the Chinese economy against future international crises. All these policies will not only keep the Chinese economy expanding as fast as usual, they will also will have the long-term effect of enabling the Chinese economy to grow effectively.

In the long run, China’s economic development can be classi fi ed in two stages. First, China will try to achieve a modern living standard for all its people as fast as


possible. That is to say, China will be a manufacturing center for modern products. The Chinese economy will expand very fast in this stage owing to its huge population and its large demand for good living. I call this stage the quantitative expansion period. In the second stage, China will expand its market and economy by techno-logical innovation mainly, which I call the qualitative expansion stage. In this stage, China will use new technology products to create consumption and keep its people abreast with the brand new technology frontier. In the second stage, Chinese economic growth will rely signi fi cantly on scienti fi c and technologic breakthroughs and will be slower than in the fi rst stage. But with its larges human resources, China will be able to create more new products if the Chinese education, scienti fi c, and research systems are effective.

In about 20 years, China will reach the top of the world economy by overtaking the USA. But the average living standard in China will still be one quarter of that of that in the USA. Urbanization has been one of the main driving forces and by some calculations the process is only half-complete. Despite all the progress since 1978, China is still a much poorer country than most people realize—it is not even in the top 100 in the IMF’s ranking of GDP per capita. That means there is plenty of room to keep playing catch-up. The 11% growth in the third quarter of 2010 is still exceptional by historical standards, higher than growth in Japan or South Korea during their boom years. The last time the USA grew that quickly was more than half a century ago.

China will maintain its fast growth for another 20 years and will be the main driving force for the world economy. China’s modernization is a long and fast process. By fi nishing this process, China will contribute to the world 1.3 billion people with good living standards and a stronger economic growth engine than for any other country in the world’s history. It is a beautiful thing to see China’s run toward its modernization era.

References

All data are from Chinese national bureau of statistics. Baily, M. N., Elmendorf, D. W., & Litan, R. E. (2008, May 21). The great credit squeeze: How it

happened, how to prevent another (Brookings Institution Discussion Paper). Washington, DC: Brookings Institution.

Ceccgetti, S. G. (2008, June). Crisis and response: The Federal Reserve and the fi nancial crisis of 2007–2008 (NBER Working Paper 14134).

China Daily . (2010, March 10) . China economy toward a sustainable, healthy development. China Daily .

Dan, X. (2008). The challenges post by the global fi nancial crisis to China’s peaceful development. World Economics and Politics , No. 12, pp. 21 – 23, (in Chinese).

Geiger, M. (2006). Monetary policy in China (1994–2004): Targets, instruments and their effectiveness (Wurzburg Economic Papers No. 66).

Genberg, H., & He, D. (2007). Monetary and fi nancial cooperation among central banks in Asia and the Paci fi c (Working Paper 15/2007). Hong Kong Monetary Authority.

Global Insight. http://www.ihs.com/products/global-insight/

http://www.ihs.com/products/global-insight/

110 L.-X. Li

Green, S. (2009, March 26). China: Beijing calls time on the USD, on the ground . Standard Chartered Bank.

He, X., & Cao, Y. (2007). Understanding high saving rate in China. China and World Economy, 15 (1), 1–13.

He, D., & Pauwels, L. L. (2008). What prompts the People’s Bank of China to change its monetary policy stance? Evidence from a discrete choice model. China and World Economy, 16 (6), 1–21.

He, D., & Zhang, W. (2008). How dependent is China’s economy on exports and in what sense is its growth export-led? (Working Paper 13/2008). Hong Kong Monetary Authority.

He, D., Zhang, Z., & Zhang, W. (2009). How large will be the effect of China’s fi scal stimulus package on output and employment? (Working Paper 05/2009). Hong Kong Monetary Authority.

Hu Xiaolian. (2009, March 24). Purchase of US Treasuries to continue. China Daily . Huang, Y. (2009). Global fi nancial crisis and China’s coping strategy (Working Paper). Centre for

the Chinese Economy, Peking University (in Chinese). International Monetary Fund (IMF). (2008, October). Global fi nancial stability report: Financial

stress and deleveraging — Macro – Financial implications and policy. Washington, DC. Lardy, N. (2008). Financial repression in China (Policy Brief 08–8). Washington, DC: Peterson

Institute for International Economics. Lardy, N. (2009a, February 17). China’s role in the origins of and response to the global recession .

Testimony at the hearing before the US-China Economic and Security Review Commission. Lardy, N. (2009b, March 23). Is China stepping up to the plate? Peterson Perspectives, Interviews

on Current Topics. Li, W. (2009a). The correlated effects of money and asset returns: Evidence from the de fl ationary

and in fl ationary periods. Study of Finance and Economy, No. 12, pp. 27 – 32, (in Chinese). Li, W. (2009b, March). Effectively deal with shocks of international fi nancial crisis: Evidence from

regional correlation of Hong Kong and Singapore Markets (Working Paper, No. 3) (in Chinese). Li, X. (2009c, January). Outlook for international fi nancial crisis and the global economy. Seeking

Truth , pp. 3 – 5 (in Chinese). Li, Z. (2009d, February 11). Is the end of the tunnel? (Policy Brief No. 09004). Research Centre

for International Finance, Institute of World Economics and Politics, Chinese Academy of Social Sciences (in Chinese).

Li, L.-X. (2010). Research on the quantitative dynamic structure of shocks in macroeconomics business cycle. International Journal of Business and Management , 5 (6), 123–128.

Maidment, P. (2008). China announces massive stimulus package . http://www.forbes.com/business/2008/11/09/china-stimulus-economy-biz-cx_pm_1109notes.html . Accessed 11 Nov 2008.

McKinnon, R. (2009, January–February). Can China and America become co-operators in the management of the global crisis. International Economic Review , 1–3 (in Chinese). Original paper in English was presented at the international conference on The World Economy and China 2009: Grasping trends under uncertainty, November 14, 2008, Beijing.

Mile, J. (2009, March 19). A time for muscle- fl exing. The Economist. Morrison, W. M. (2008, November 13). China and the global fi nancial crisis: Implications for the

United States (CRS Report for the Congress, RS22984). Congressional Research Service and Library of Congress.

Mu, L. (2008). Institutional arrangements of China’s Central Bank for preventing and dealing with fi nancial crisis. Commerce Times, No. 1, pp. 25 – 30, (in Chinese).

National Bureau of Statistics. (2008). Chinese 30 years’ reform (1st ed.). China: People’s Press. Peng, W., Chen, H., & Fan, W. (2006, June). Interest rate structure and monetary policy implementation

in Mainland China. China Economic Issues . Hong Kong Monetary Authority. Prasad, E. S. (2007). Is the Chinese growth miracle built to last? (IZA Discussion Paper No. 2995).

Available at SSRN: http://ssrn.com/abstract=1012561 Prasad, E. (2009, February 17). The effect of the crisis on the U.S.-China economic relationship .

Testimony to the U.S.-China Economic and Security Review Commission, US Congress. Qishan, W. (2009, March 27). G20 must look beyond the needs of the top 20. The Times.

http://www.forbes.com/business/2008/11/09/china-stimulus-economy-biz-cx_pm_1109notes.html

http://www.forbes.com/business/2008/11/09/china-stimulus-economy-biz-cx_pm_1109notes.html

http://ssrn.com/abstract=1012561


Setser, B., & Pandey, A. (2009, January). China’s $1.7 trillion bet: China’s external portfolio and dollar reserves (Council on Foreign Relations Working Paper).

Shao, F. (2008, December). The effects of the fi nancial crisis on international relations and China’s response. World Economics and Politics , pp. 23 – 26, (in Chinese).

Sharma, S. D. (2009). Dealing with the contagion: China and India in the aftermath of the subprime meltdown. China and World Economy, 17 (2), 1–14.

The Economist. (2009, March 19). How China sees the world: And how the world should see China. The Economist , Leader article.

Wilder, D. (2009, April 2). How a “G-2” would hurt. The Washington Post . Woo, W. T. (2007). The challenges of governance structure, trade disputes and natural environment

to China’s growth. Comparative Economic Studies, 40 (4), 572–602. Woo, W. T. (2009, February 17). China in the current global economic crisis . Testimony before the

U.S.-China Economic and Security Commission in Panel II: China’s short term and long term economic goals and prospects at hearing on “China’s role in the origins of and response to the global recession”. Room 562, Dirksen Senate Of fi ce, US Congress.

World development report , Equity and Development. (2006). Beijing: Tsinghua University Press. World economic outlook , A Policy-Driven, Multispeed Recovery. (2010). IMF January 26, 2010. Yep, R. (2009). Economic downturn and instability in China: Time for political reform? (Brookings

Northeast Asia Commentary, No. 28). Yi, X. (2009, March 24). China deserves greater role in IMF’s reform. China Daily . Yu, Y. (2007). Global imbalances and China. Australian Economic Review, 40 (1), 3–23. Yu, Y. (2008, November 14). Macroeconomic challenges China is faced in 2009 . Paper presented

at the international conference on The World Economy and China 2009: Grasping trends under uncertainty, Beijing.

Yu, Y. (2009, January). Origins and development of America’s Sub-prime mortgage loans. China Report , pp. 28–31, (in Chinese).

Zhang, B. (2008a, October 23). The Chinese Economy under the sub-prime loan crisis (Policy Brief No. 08071). Research Centre for International Finance, Institute of World Economics and Politics, Chinese Academy of Social Sciences (in Chinese).

Zhang, M. (2008b, December 16). Kick-start of the regional fi nancial cooperation in East Asia (Policy Brief No.08086). Research Centre for International Finance, Institute of World Economics and Politics, Chinese Academy of Social Sciences (in Chinese).

Zhen, Z. (2008). Keep on guard on international capital creating fi nancial crisis in China. Enquiry in Decision Making , No. 6, pp. 20 – 23, (in Chinese).

Zhen Lianshen (2009). Re fl ections on the institutional regulation of America’s fi nancial crisis (Working Paper No. 0903). Research Centre for International Finance, Institute of World Economics and Politics, Chinese Academy of Social Sciences (in Chinese).


1 Introduction

Before the currency crisis, Malaysia was considered the best “development success story” among the second-tier newly industrializing economies in East Asia. From 1987 to 1996, the Malaysian economy grew at an average annual rate of 9%, several times faster than the economies of the USA and many other Western industrialized nations. The economy was virtually at full employment for the last 6 years before the crisis, with modest in fl ation, rapid export growth, manageable external debt, and improvement in current account de fi cits. However, this impressive growth changed dramatically with the onset of the currency crisis. Economic growth contracted in 1998. Nevertheless, the economy showed some recovery, with an economic growth rate of 3–4% for 1999–2001. The Malaysian government has made much effort to help the economy recover, such as a monetary policy that aims to promote mon-etary stability and suf fi cient liquidity in the economy, keeping in fl ation rates low, and maintaining the exchange rate at a stable level owing to the pegging to the US dollar. The external sector also had a good surplus, and the stock market has per-formed steadily in the past several years. As a result, Malaysian real GDP grew at an accelerated pace of 6–8% from 2003 to 2010. It is the aim of this study to fi nd out the role of macroeconomic fundamentals in Malaysian post recession growth. The macroeconomic variables selected are exports, imports, price level, money supply, interest rate, exchange rate, and government expenditure.

The remainder of this chapter is organized as follows. Some empirical studies on interrelationships between economic growth and macroeconomic variables are reviewed in Sect. 2 . The methodology and data set used are described in Sect. 3 . Empirical results are presented in Sect. 4 . Finally, conclusion and some policy implications are provide in Sect. 5 .

L. Chin (*) Department of Economics, Universiti Putra Malaysia , Serdang , Malaysia e-mail: [email protected]

Chapter 6 The Role of Macroeconomic Fundamentals in Malaysian Post Recession Growth

Lee Chin

114 L. Chin

2 Literature Review

This section will brie fl y review some related studies regarding dynamic causal interactions between economic growth and macroeconomic fundamentals, namely, exports, imports, price level, money supply, interest rate, exchange rate, and government expenditure.

2.1 Export and Economic Growth

In recent years, the role of international trade as an engine of growth has generally been accepted. Many studies have tried to establish the causal link between expan-sion of exports and economic growth. Ghirmay et al. ( 2001 ) used the co-integration test and the Granger-causality test to investigate the export-led and investment-led growth for 19 less-developed countries. They found the direction of causality behaves differently across countries. For Malaysia, they noticed a unidirectional causal relationship running from economic growth to exports. Ghatak et al. ( 1997 ) also provided evidence that exports Granger-cause real GDP growth in Malaysia. In addition, Tan and Lean ( 2010 ) analyzed the dynamic linkages between domestic investment, exports, and economic growth in Malaysia. The empirical fi ndings suggest that domestic investment and economic growth Granger-cause each other, but that there is unilateral causality running from exports to economic growth and from exports to domestic investment.

In addition, Doraisami ( 1996 ) found a bidirectional relation between exports and national output and a positive long-run relationship between exports and growth. Khalafalla and Webb ( 2001 ) used vector autoregression (VAR) to analyze Malaysian trade and GDP growth from 1965 to 1996. Statistical tests con fi rmed export-led growth for the full period and for the period to 1980, but tests on the 1981–1996 period showed growth causing exports. In contrast, Liwan and Lau ( 2007 ) found the absence of a causal relationship between exports and economic growth in Malaysia. Similarly, Ahmad and Harnhirun ( 1996 ) also found no support for the export-led growth hypothesis for ASEAN countries.

2.2 Import and Economic Growth

Compared with the empirical studies on export-led growth, less attention had been devoted to test the import-led growth hypothesis. Awokuse ( 2007 ) examined the impact of export and import expansion on growth in three central and eastern European transition economies, namely, those of Bulgaria, the Czech Republic, and Poland. The empirical results suggest that trade stimulates economic growth. Overall, the Granger-causality test results suggest that imports play as much of a role as exports in stimulating economic growth in these countries. Marwah and

1156 The Role of Macroeconomic Fundamentals in Malaysian Post Recession Growth

Tavakoli ( 2004 ) analyzed the impact of foreign direct investment (FDI) and imports on economic growth for Indonesia, Malaysia, the Philippines, and Thailand. The results show that both foreign capital and imports have a marked effect on the economic growth of these countries.

2.3 In fl ation and Economic Growth

The relationship between economic growth and in fl ation is one of the most important macroeconomic problems. The relationship between in fl ation and economic growth in Turkey was examined by Erbaykal and Okuyan ( 2008 ) . Using the bound test developed by Pesaran et al. ( 2001 ) , they found no statistically signi fi cant long-term relationship. Whereas with the causality test developed by Toda and Yamamoto ( 1995 ) , a causality relationship was found between in fl ation and economic growth.

Gomme ( 1993 ) conducted research in this area which covered 100 countries between 1960 and 1990, and found that a negative relationship between in fl ation and economic growth. Barro ( 1995 ) , Kormandi and Meguire ( 1985 ) , Fischer ( 1993 ) , DeGregorio ( 1993 ) , Gylfason and Herbertsson ( 2001 ) , Valdovinoz ( 2003 ) , and Guerrero ( 2006 ) detected a similar relationship, that is, in fl ation has negative effects on economic growth. Generally, most of the studies found that an increase in in fl ation reduces economic growth.

However, Mallik and Chowdhury ( 2001 ) , who examined the relationship between in fl ation and growth in short term and the long term for four Asian countries using time series analysis, stated the positive effect of in fl ation on growth. Generally, the views stating that the effect of in fl ation on economic growth is positive are based on the idea that in fl ation increases compulsory savings.

2.4 Output Growth and Money Supply

In the empirical literature, the relationship between money and output has been investigated by researchers for different countries over different sample periods, and con fl icting fi ndings have been provided. Das ( 2003 ) examined the long-run relationship between prices and output in India and provided evidence that (1) both money and price affect each other and there exists bidirectional causality, (2) output affects price and there is feedback causation between price and output, and (3) money unidirectionally affects output. In addition, Okpara and Nwaoha ( 2010 ) examined the relationship between government expenditure, money supply, prices, and output in Nigeria. Their results show that money supply is positively and signi fi cantly related to real GDP, whereas real GDP is a negative and signi fi cant function of the consumer price index (CPI). Total government expenditure was found to exert no signi fi cant in fl uence on the growth of real GDP. Similarly, Omoke and Ugwuanyi ( 2010 ) in their study of money, price, and output in Nigeria found that money supply Granger-causes both output and in fl ation.

116 L. Chin

However, Khan and Siddiqui ( 1990 ) showed there is a unidirectional causality from income to money and bidirectional causality between money and prices in Pakistan. Nevertheless, some studies detected there was bidirectional causality between money supply and output. For instance, Mishra et al. ( 2010 ) investigated the relationship between money, price, and output for India. The estimation of the vector error-correction model (VECM) indicates the existence of long-run bidirectional causality between money supply and output and unidirectional causality from price level to money supply and output. But, in the short run a bidirectional causality exists between money supply and price level and unidirectional causality exists from output to price level. Similarly, Bengali et al. ( 1999 ) demonstrated a bidirectional causality between money and income and unidirectional causality from money to prices in Pakistan. In addition, Tan and Cheng ( 1995 ) , using Geweke’s approach to Wiener–Granger causality, found a bidirectional causation between money supply and nominal output for Malaysia.

2.5 Output Growth and Interest Rate

As the interest rate is one of the crucial monetary policy instruments, with the liberaliza-tion of fi nancial markets in most of the developing economies in upswing, the last two decades have witnessed a surge of empirical literature examining the real effects of changes in short-term interest rates. Warman and Thirlwall ( 1994 ) analyzed the interrelationship between real interest rates, savings, investment, and growth in Mexico over the period from 1960 to 1990, and concluded that there is no evidence that high real interest rates lead to higher total savings, investment, and economic growth. Similarly, Craigwell ( 1990 ) found that interest rate policies had little effect on fi nancial and economic growth in Barbados. Using the autoregressive distributed lag approach, Mallick and Agarwal ( 2007 ) found that the short-term real interest rate does not have a direct impact on the growth rate in India. In addition, Taylor ( 1999 ) found a mixed link between real interest rates and the growth rate.

2.6 Output Growth and Exchange Rate

The relationship between output growth and exchange rate has been a matter of considerable interest. Wang et al. ( 2007 ) found that China’s productivity has a positive relationship with the real equilibrium exchange rate. On the other hand, Chen and Hsing ( 2005 ) found that the exchange rate reacts negatively to a shock to output in Korea. Contrary to the fi ndings of previous studies, the results of Miles ( 2008 ) indicate that exchange rates themselves exert no signi fi cant impact on in fl ation or output. Koccat ( 2008 ) studied the relationship between economic growth, exchange rate movements, and Turkey’s exports based on the Johansen method. The basic fi nding of this study is that there is no long-run equilibrium relationship between real income per capita, real exchange rates, and real exports of goods and services in


Turkey. Lee et al. ( 2010 ) investigated the relationship between FDI in fl ows, exchange rate, and economic growth for Kazakhstan. The results indicate that FDI has no signi fi cant impact on GDP growth and FDI has a minimal effect on improving economic growth.

2.7 Government Expenditure and Economic Growth

Fischer ( 1991 ) stated that macroeconomic policy preferences such as budget de fi cits and foreign exchange systems are important for economic growth. Fischer ( 1993 ) also showed that a negative relationship exists between economic growth and in fl ation and budget de fi cits. He found the direction of causality was from macroeco-nomic policies (such as in fl ation and budget de fi cits) to economic growth. According to the study of Fischer ( 1993 ) , in fl ation reduces growth, and public de fi cits reduce both capital accumulation and productivity. Sulaiman et al. ( 2009 ) in their study of money supply, government expenditure, output, and prices in Pakistan found that government expenditure and in fl ation are negatively related to economic growth in the long run, whereas M2 positively impacts on economic growth.

On the other hand, Wu et al. ( 2010 ) reexamined the causal relationship between government expenditure and economic growth by conducting the panel Granger-causality test recently developed by Hurlin ( 2004 ) and by utilizing a richer panel data set which includes 182 countries that cover the period from 1950 to 2004. Their results strongly support the hypothesis that government spending is helpful to eco-nomic growth regardless of how we measure the size of government spending and economic growth.

However, a few recent studies found no signi fi cant relationship between govern-ment expenditure and output. Okpara and Nwaoha ( 2010 ) examined the relationship between government expenditure, money supply, prices, and output in Nigeria, and showed that money supply is positively and signi fi cantly related to real GDP, whereas real GDP is a negative and signi fi cant function of the CPI. Total govern-ment expenditure was found to exert no signi fi cant in fl uence on the growth of real GDP, corroborating with the fi ndings of Olukayode and Onabanjo ( 2009 ) and Olayeni ( 2009 ). Kogid et al. ( 2010 ) investigated the factors that stimulate and maintain economic growth in Malaysia using co-integration analysis. Using annual data from 1970 to 2007, they found that only consumption expenditure and export cause economic growth, whereas this is not so for government expenditure, the exchange rate, and FDI.

Previous studies generally found mixed empirical evidence for a relationship between government spending and economic growth. For example, Kneller et al. ( 1998 ), Cooray ( 2009 ), Wu et al. ( 2010 ) concluded that increased in government spending can improve economic growth, however, Fischer ( 1993 ), Folster and Henrekson ( 2001 ) and Suleman et al. ( 2009 ) found otherwise. There is, however, no unanimous verdict on the productivity of government spending even though unpro-ductive spending generally impacts negatively on growth whereas productive spend-ing impacts positively (Barro and Martin 1992 ).

118 L. Chin

3 Methodology and Data

A standard procedure of time series analyses will be conducted accordingly. First, the unit root test is used to determine whether each data series is nonstationary (unit root exists) or stationary (unit root does not exist) by taking into consideration both with and without a trend variable in the regression. The augmented Dickey–Fuller (ADF) unit root test is used to discern whether the series are nonstationary and are integrated of the same order. 1

The next step in the analysis is to test for the presence of co-integration among the variables. In this study, the popular Johansen and Juselius procedure of testing for a multivariate is employed. 2 The tests used are the trace statistic, which tests for at most r co-integrating vectors among a system of n time series (where r = 0, 1, 2, . . ., n − 2, n − 1) and the maximum eigenvalue statistic, which tests for exactly r co-integrating vectors against the alternative hypothesis of r + 1 co-integrating vectors (Johansen 1988 ) . If we are able to reject the null hypothesis of no co-integrating vectors based on the maximum eigenvalue and trace statistics, this indicates these variables have a long-run relationship.

According to the Granger representation theorem, if a co-integrating relationship exists between a series of I (1) variables, then an error-correction model also exists. The presence of co-integration also rules out noncausality among the variables. In other words, there must be at least a unidirectional causality from one variable to the other variables. The Granger-causality test must be conducted in the environment of the VECM where the relevant error-correction terms are included in the model to avoid misspeci fi cation and omission of the important variables. Granger causality tests the null hypothesis that the lagged values of the independent variables are jointly signi fi cant in the equation of the dependent variable. This can be done by running a VECM on the system of equations and testing for zero restrictions on the lagged values of the independent variables’ coef fi cients.

The sample period covers quarterly data from the third quarter of 1998 to the third quarter of 2010. 3 The data were obtained from International Financial Statistics published by the International Monetary Fund. For the primary variable of interest, economic growth is represented by GDP. The data for exports (EX) and imports (IM) of goods and services are used to gauge the trade effect. The CPI is used as a proxy for in fl ation in the country, where the base year for the CPI is 2000 (2000 = 100). The exchange rate is measured as the real effective exchange rate (REER). As proxies for monetary and fi scal policy, monetary policy tools (i.e., money supply and domestic interest rate) and a fi scal policy tool (i.e., government expenditure) are used. The money supply variable used is M2 and is measured in local currency units, whereas the money market rate (MRATE) is used to represent the domestic interest rate.

1 Dickey and Fuller ( 1979 , 1981 ) 2 Johansen and Juselius ( 1990 , 1992 ) 3 The sample period was chosen as such for two reasons. First, Malaysia had pegged its exchange rate at RM 3.80 to the US dollar from 1 September 1998. Second, the Malaysian economy experienced contraction in 1998 and the economy had shown some recovery in 1999. Therefore, the third quarter of 1998 is an appropriate date to consider as a starting period for the post recession period.


The government expenditure (GOV) is measured in local currency units. To compress the scale, all the series (except for the domestic interest rate) are transformed into natural logarithmic form and are used in all cases.

4 Empirical Results

The order of integration of the series was determined using the standard ADF unit root test. It is generally known that the results of this test often depend on the num-ber of lags included. For this purpose, we adopted the minimum Akaike information criterion to determine the optimal lag structure. The results of the ADF tests are presented in Table 6.1 . The t statistic suggested that most of the series (except for MRATE) are statistically insigni fi cant in the level form. Hence, the null hypothesis of nonstationarity cannot be rejected at even the 10% signi fi cance level except for the interest rate. Therefore, on the basis of the t statistics, one can conclude that most of the series are nonstationary in their level form except for the interest rate. However, in the fi rst difference, the null hypothesis of the unit root for all the series can be rejected at the 5% level of signi fi cance. This result is consistent with the results of previous studies that have shown most macroeconomic series contain a unit root and thus are integrated of order one, I (1).

After ascertaining that all the variables are stationary after the fi rst difference, one can proceed to the co-integration test. A related issue regarding co-integration tests is the determination of appropriate lag lengths. Long lag lengths quickly consume a degree of freedom; therefore, the optimal lag length can be very critical. On the basis of VAR lag order selection criteria, all four criteria, namely, fi nal prediction error, Akaike information criterion, Schwartz information criterion, and Hannan–Quinn information criterion, suggested an appropriate lag length of 3.

Table 6.1 Augmented Dickey–Fuller unit root tests

Series

Level First difference

Constant Constant with trend Constant Constant with trend

LGDP −0.15 (10) −2.14 (9) −3.02 a (9) −4.11 b (6) LCPI 0.09 (2) −2.31 (1) −5.93 a (1) −5.86 a (1) LEX −1.53 (5) −2.31 (8) −4.25 a (4) −4.41 a (4) MRATE −8.04 a (9) −7.21 a (9) −2.94 b (9) −3.91 b (10) LIM −1.29 (9) −2.67 (8) −3.65 a (6) −3.66 b (6) LGOV −0.48 (8) −2.79 (8) −3.95 a (6) −3.84 b (6) LM2 0.21 (1) −1.52 (1) −5.63 a (0) −5.57 a (0) LREER −2.05 (1) −1.97 (1) −5.23 a (0) −5.20 a (0)

The numbers in parentheses are the lag length. The tests employ a null hypothesis of a unit root. For constant without trend, the critical values for rejection are −3.57 and −2.92 at 1% and 5%. For con-stant with trend, the critical values for rejection are −4.15 and −3.50 at 1% and 5%. All series (except for the money market rate, MRATE ) are log-transformed. LGDP log-transformed GDP, LCPI log-transformed consumer prices index, LEX log-transformed exports, LIM log-transformed imports, LGOV log-transformed government expenditure, LM2 log-transformed M2, LREER log-transformed real effective exchange rate a Signi fi cance at the 1% level b Signi fi cance at the 5% level

120 L. Chin

The Johansen–Juselius likelihood co-integration tests are reported in Table 6.2 . The series were tested using the co-integrating VAR with intercepts and no trend. Since the sample size is small in this study, thus following Reinsel and Ahn ( 1992 ) , the trace and maximal eigenvalue statistics have been adjusted by a factor of ( T − np )/ T , where T is the effective number of observations, n is the number of variables, and p is the lag order. 4 From Table 6.2 , the trace statistics indicate that the null hypothesis of no co-integrating vector can be rejected using a critical value of 5%. This suggests the presence of a unique co-integrating vector. Similarly, the maximal eigenvalue statistic also indicates the presence of one co-integrating vector. In sum, both the maximum eigenvalue statistic and the trace statistic indicate that there exists one unique co-integration vector. Accordingly, economic growth, exports, imports, price level, money supply, interest rate, exchange rate, and government expenditure are tied together in the long run and their deviations from the long-run equilibrium path will be corrected.

The presence of co-integration also rules out noncausality among the variables. In other words, there must be at least a unidirectional causality from one variable to the other variables. Before we proceed to the Granger-causality test, it would be interesting to look at the long-run relationship between Malaysian output growth and the macroeconomics variables selected. The estimated co-integrating vector is as follows:

( ) ( ) ( ) ( ) ( ) ( ) ( )GDP 20.65 8.29CPI 7.08EX 0.31MRATE 3.98IM 0.72GOV 0.24M2 6.49REER

7.35 12.77 17.13 7.96 8.39 1.09 14.06

= - - + - - + - +

- - - -t t t t t t t t

(6.1)

where t statistics are reported in parentheses. The t statistics suggested that all the variables, except for money supply, are statistically signi fi cant at the 1% level; hence, all these economic fundamentals (except for money supply) are important determinants for long-term economic growth. The results tend to suggest that money supply is not an effective tool in promoting long-run economic growth. The signs of the long-run coef fi cients for all variables are reasonable and acceptable from the theoretical point of view. As shown in Eq. 6.1 , a positive long-run relationship is detected for the coef fi cients of output growth and export, output growth and government expenditure, and output growth and exchange rate. This means that increases in exports and government expenditure or a depreciation of the exchange rate promotes economic growth. However, there is a negative long-run relationship between output growth and price level, interest rate, imports, and money supply. This demonstrates that increases in in fl ation, the interest rate, and imports temper Malaysian economic growth. 5

4 This is to correct for bias toward fi nding evidence for co-integration in a fi nite or small sample. 5 The negative coef fi cient between money supply and economic growth tends to suggest that an increase in money supply would depress economic growth, which is contradictory to the theory; however, it is not statistically signi fi cant.


Tabl

e 6.

2 Jo

hans

en–J

usel

ius

co-i

nteg

ratio

n te

sts

Nul

l hyp

othe

ses

Eig

enva

lue

Tra

ce s

tatis

tic

Cri

tical

val

ue

of 5

%

Cri

tical

val

ue

of 1

%

Max

imum

ei

genv

alue

sta

tistic

C

ritic

al v

alue

of

5%

C

ritic

al v

alue

of

1%

( r =

0)

0.95

15

6.85

b 15

6.00

16

8.36

61

.28 a

51.4

2 57

.69

( r £

1)

0.79

95

.57

124.

24

133.

57

32.5

5 45

.28

51.5

7 ( r

£ 2

) 0.

65

63.0

2 94

.15

103.

18

22.2

4 39

.37

45.1

0 ( r

£ 3

) 0.

53

40.7

8 68

.52

76.0

7 15

.80

33.4

6 38

.77

( r £

4)

0.46

24

.98

47.2

1 54

.46

12.8

8 27

.07

32.2

4 ( r

£ 5

) 0.

28

12.1

0 29

.68

35.6

5 6.

83

20.9

7 25

.52

( r £

6)

0.22

5.

27

15.4

1 20

.04

5.25

14

.07

18.6

3 ( r

£ 7

) 0.

00

0.01

3.

76

6.65

0.

01

3.76

6.

65

r in

dica

tes

the

num

ber o

f co-

inte

grat

ing

vect

ors.

Tra

ce a

nd m

axim

um e

igen

valu

e st

atis

tics

have

bee

n ad

just

ed b

y m

ultip

lyin

g th

em b

y th

e fa

ctor

( T - n

p )/ T

, whe

re

T is

the

eff

ectiv

e nu

mbe

r of

obs

erva

tions

, n i

s th

e nu

mbe

r of

var

iabl

es, a

nd p

is

the

lag

orde

r, w

hich

is

sugg

este

d by

Rei

nsel

and

Ahn

( 19

92 ) .

The

eff

ectiv

e nu

mbe

r of

obs

erva

tions

is 4

5, th

e la

g or

der

is 3

, and

num

ber

of v

aria

bles

is 8

a R

ejec

tion

of th

e hy

poth

esis

at a

cri

tical

val

ue o

f 1%

b R

ejec

tion

of th

e hy

poth

esis

at a

cri

tical

val

ue o

f 5%

122 L. Chin

Since the Johansen–Juselius co-integration test shows that there is one co-integrating relationship, one can proceed to test the VECM. Table 6.3 reports the results of the Granger-causality test in the environment of the VECM. From Table 6.3 , the c 2 statistics of the Granger-causality test clearly indicate that the domestic money supply (M2) and the exchange rate (REER) are weakly exogenous. This fi nding is consistent with the fact that the money supply and exchange rates of Malaysia are mainly determined outside this system. The results show the economic growth (GDP) is Granger-caused by the price level (CPI) and government spending (GOV). This indicates that in the short run Malaysian post recession growth is highly dependent on government spending. In addition, in fl ation also signi fi cantly affects short-run economic growth. The results also show that besides economic growth (GDP), government expenditure (GOV) also Granger-causes Malaysian exports (EX), imports (IM), and the domestic interest rate (MRATE). This suggests that government expen-diture is the main force of many economic activities during the post recession period in the short run. The c 2 statistics indicate that money supply (M2) and domestic interest rate (MRATE) Granger-cause the CPI only. These fi ndings revealed that the monetary policy tools of money supply and domestic interest rate are not effective in stimulating short-run economic growth and other economic activities. On the other hand, the expansionary monetary policy may create in fl ationary pressure on the economy in the short run. The results also show that economic growth (GDP), exports (EX), the interest rate (MRATE), and money supply (M2) Granger-cause the Malaysian price level (CPI). This suggests that the general price level is very sensitive and responds quickly to changes in the economy. Granger-causality tests showed that there is a unidirectional causal effect running from economic growth (GDP) and government expenditure (GOV) to exports (EX), whereas there is a bidirectional relationship between exports (EX) and the price level (CPI). For imports, it is shown that Malaysia imports (IM) are determined by the general price level (CPI) and government spending (GOV) in the short run. In addition, the Granger-causality results showed that both exports (EX) and imports (IM) together with government expenditure Granger-cause the interest rate (MRATE). This fi nding seems to imply that the external sector (exports and imports) as well as fi scal policy in fl uenced the country’s short-run interest rate behavior. Finally, the exchange rate system (REER) does not seem to affect the other macroeconomic variables in this study. This may be consistent with the fact that the pegged exchange rate is mainly designated to prevent short-run massive capital out fl ows. The Granger-causality relationships among Malaysian economic growth and the macroeconomic variables during the post recession period are sum-marized in Fig. 6.1 .

5 Conclusions

This study adopted a series of statistical tests to assess the relationship among macroeconomic variables and post recession growth for Malaysia. The technique of co-integration was employed to assess the long-run equilibrium relationships among


Tabl

e 6.

3 G

rang

er-c

ausa

lity

resu

lts

Dep

ende

nt

vari

able

Inde

pend

ent v

aria

ble

D(L

GD

P)

D(L

CPI

) D

(LE

X)

D(M

RA

TE

) D

(LIM

) D

(LG

OV

) D

(LM

2)

D(L

RE

ER

)

D(L

GD

P)

– 6.

53 a

2.89

2.

13

0.12

17

.39 b

1.72

0.

004

D(L

CPI

) 6.

36 a

– 15

.78 b

9.57

b 5.

09

1.78

13

.35 b

0.41

D

(LE

X)

10.4

9 b 10

.22 b

– 1.

34

3.06

13

.64 b

5.71

0.

41

D(M

RA

TE

) 4.

36

2.49

10

.02 b

– 15

.96 b

29.6

4 b 0.

37

3.17

D

(LIM

) 4.

64

12.9

1 b 2.

69

1.56

–

14.4

5 b 0.

90

0.03

D

(LG

OV

) 8.

07

0.59

1.

02

1.67

1.

26

– 3.

45

4.84

D

(LM

2)

1.94

4.

51

3.65

3.

36

3.07

3.

59

– 0.

35

D(L

RE

ER

) 0.

48

2.37

3.

30

2.76

2.

91

0.94

0.

87

–

The

num

bers

are

the

c 2 sta

tistic

s fo

r te

stin

g th

e nu

ll hy

poth

esis

that

ther

e is

join

t sig

ni fi c

ance

of

the

lagg

ed v

alue

s of

the

inde

pend

ent v

aria

bles

in th

e eq

uatio

n of

the

depe

nden

t var

iabl

e. A

ll se

ries

(ex

cept

for

the

dom

estic

inte

rest

rat

e) a

re lo

g tr

ansf

orm

ed a

nd in

the

fi rst

dif

fere

nce

a Sig

ni fi c

ance

at t

he 5

% le

vel

b Sig

ni fi c

ance

at t

he 1

% le

vel

124 L. Chin

the variables, namely, economic growth, exports, imports, price level, money supply, interest rate, exchange rate, and government expenditure. Then, this study estimated a VECM and performed the Granger-causality tests based on the VECM to establish the long-run and short-run causality among the variables. The evidence of co-integration among the variables tends to suggest that these economic fundamentals are bound together by common trends or long-run equilibrium relationships. This implies that although these co-integrated variables will have short-run or transitory deviations from their long-run equilibrium, the forces will eventually drive them together again. This fi nding of co-integration or a long-run equilibrium relationship among all the variables is very important for policy makers.

The long-run co-integrating relationship shows that an increase in exports and government expenditure or a depreciation of the exchange rate will promote long-term economic growth, while an increase in the rate of in fl ation, the interest rate, and imports will temper Malaysian economic growth. A few policy implications can be drawn from this fi nding. First, the Malaysian government should support export-oriented industry by providing updated market information, export incen-tives, as well as zero-interest loans to encourage small and medium-sized enter-prises to venture into foreign markets. Second, since the exchange rate seems to play a crucial role in long-term economic growth in Malaysia, the government needs to maintain a low and stable exchange rate to ensure exports are competitive in foreign markets. Third, in a time of recession, the government should start the ball rolling in stimulating economic activities by implementing an expansionary fi scal policy. It is believed that the increase in government spending will increase business con fi dence as well as spill over to the private sector, and then it will have a multiplier effect in the economy. Fourth, the Malaysian government needs to watch out for in fl ation, which may harm the economy. The in fl ation rate needs to be kept low to promote economic growth. Fifth, since imports may weaken economic growth, the policy makers should consider formulating rules and regulations that may reduce imports or lead to a shift in consumption from imports to domestic output. For example, they could stipulate the minimum percentage of a product’s total value to be produced domestically to qualify for zero tariff rates. Finally, an expansionary monetary policy of lowering the interest rate is more effective than increasing the money supply in the economy to combat recession.

GDP

EX

CPI

M2

MRATE

GOV

IM

Fig. 6.1 Short-run relationship among economic growth and macroeconomic variables. CPI consumer prices index, EX exports, GOV government expenditure, IM imports, MRATE money market rate


The results of short-run Granger causality indicated that the price level and government spending Granger-caused economic growth in the short run. On the basis of these fi ndings, it seems that fi scal policy is an appropriate way to stimulate Malaysian short-term economic growth after a recession. Besides, efforts to strengthen economic growth also rested on the controllable and low in fl ation rate. The fi ndings also revealed that the monetary policy tools of money supply and domestic interest rate are not effective in stimulating short-run economic growth and other economic activities. On the other hand, an expansionary monetary policy may create in fl ationary pressure on the economy in the short run.

In conclusion, on the basis of the results of long-run and short-run analysis, fi scal policy is probably the most appropriate tool in promoting economic growth in Malaysia during the post recession period. The role of the government in the pro-cess of economic growth for a developing country such as Malaysia is very impor-tant. The government not only needs to provide basic services such as electricity power supply and roads, it also needs to provide better telecommunications services such as broadband Internet access as well as well-trained skilled workers to attract investment and act as a catalyst for the establishment of a high-tech industry.

References

Ahmad, J., & Harnhirun, S. (1996). Co-integration and causality between exports and economic growth: Evidence from the ASEAN countries. Canadian Journal of Economics, 29 , 413–416.

Awokuse, T. (2007). Causality between exports, imports, and economic growth: Evidence from transition economies. Economics Letters, 94 , 389–395.

Barro, R. (1995). In fl ation and economic growth (NBER Working Paper, No: 5326). Cambridge, MA: National Bureau of Economic Research.

Barro, R., & Martin, X. (1992). Public fi nance in models of economic growth. Review of Economic Studies, 59 , 645–661.

Bengali, K., Khan, A., & Sadaqat, M. (1999). Money, income, prices and causality: The Pakistani experience. Journal of Developing Areas, 33 , 503–514.

Chen, Y., & Hsing, Yu. (2005). The fi nancial implications of a VAR model of the determinants of exchange rates: The case of South Korea. International Journal of Management, 22 , 332–342.

Cooray, A. (2009). Government expenditure, government and economic growth. Comparative Economic Studies, 51 , 401–418.

Craigwell, R. (1990). Interest rate policies, fi nancial and economic growth in Barbados: 1973–1986. Money Affairs, 3 , 69–80.

Das, S. (2003). Modeling money, price and output in India: A vector autoregressive and moving average (VARMA) approach. Applied Economics, 35 , 1219–1225.

DeGregorio, J. (1993). In fl ation, taxation and long-run growth. Journal of Monetary Economics, 31 , 271–298.

Dickey, D., & Fuller, W. (1979). Distribution of the estimators for autoregressive time series with a unit root. Journal of the American Statistical Association, 74 , 427–431.

Dickey, D., & Fuller, W. (1981). Likelihood ratio statistics for autoregressive time series with a unit root. Econometrica, 49 , 1057–1072.

Doraisami, A. (1996). Export growth and economic growth: A re-examination of some time-series evidence of the Malaysian experience. The Journal of Developing Areas, 30 , 223–230.

Erbaykal, E., & Okuyan, A. (2008). Does in fl ation depress economic growth? Evidence from Turkey. International Research Journal of Finance and Economics, 17 , 40–48.

126 L. Chin

Fischer, S. (1991). Growth, macroeconomics and development (NBER Working Paper 3702). Cambridge, MA: National Bureau of Economic Research.

Fischer, S. (1993). The role of macroeconomic factors in growth (NBER Working Paper 4565). Cambridge, MA: National Bureau of Economic Research.

Folster, S., & Henrekson, M. (2001). Growth effects of government expenditure and taxation in rich countries. European Economic Review, 45 , 1501–1520.

Ghatak, S., Milner, C., & Utkulu, U. (1997). Exports, export composition and growth: Co-integration and causality evidence for Malaysia. Applied Economics, 29 , 213–223.

Ghirmay, T., Grabowski, R., & Sharma, S. (2001). Exports, investment, ef fi ciency and economic growth in LDC: An empirical investigation. Applied Economics, 33 , 689–700.

Ghosh, S., & Gragorious, A. (2008). The composition of government spending and growth: Is current or capital spending better? Oxford Economic Papers, 60 , 484–516.

Gomme, P. (1993). Money and growth revisited: Measuring the costs of in fl ation in an endogenous growth model. Journal of Monetary Economics, 32 , 51–77.

Guerrero, F. (2006). Does in fl ation cause poor long-term growth performance? Japan and The World Economy, 18 , 72–89.

Gylfason, T., & Herbertsson, T. T. (2001). Does in fl ation matter for growth? Japan and The World Economy, 13 , 405–428.

Hurlin, C. (2004). Testing granger causality in heterogeneous panel data models with fi xed coef fi cients, mimeo . University of Orléans.

Johansen, S. (1988). Statistical analysis of co-integration vectors. Journal of Economic Dynamics and Control, 12 , 231–254.

Johansen, S., & Juselius, K. (1990). Maximum likelihood estimation and inference on co-integration with applications to the demand for money. Oxford Bulletin of Economics and Statistics, 52 , 169–210.

Johansen, S., & Juselius, K. (1992). Testing structural hypotheses in a multivariate co-integration analysis of the PPP and the UIP for UK. Journal of Econometrics, 53 , 211–244.

Khalafalla, K. Y., & Webb, A. (2001). Export-led growth and structural change: Evidence from Malaysia. Applied Economics, 33 , 1703–1715.

Khan, A. H., & Siddiqui, A. N. (1990). Money, prices and economic activity in Pakistan: A test of causal relation. Pakistan Economic and Social Review, 28 , 121–136.

Kneller, R., Bleaney, M., & Gemmel, N. (1998). Growth, public policy and the government budget constraint: Evidence from OECD countries (Discussion papers in economics 98/14). University of Nottingham.

Koccat, H. (2008). Exchange rates, exports and economic growth in Turkey: Evidence from Johansen co-integration tests. International Journal of Economic Perspectives, 2 , 5–11.

Kogid, M., Mulok, D., Beatrice, Y., & Mansur, K. (2010). Determinant factors of economic growth in Malaysia: Multivariate co-integration and causality analysis. European Journal of Economics, Finance and Administrative Sciences, 24 , 123–137.

Kormandi, R., & Meguire, P. (1985). Macroeconomic determinants of growth: Cross-country evidence. Journal of Monetary Economics, 16 , 141–163.

Lee, J. W., Baimukhamedova, G., & Akhmetova, S. (2010). Foreign direct investment, exchange rate, and their roles in economic growth of developing countries: Empirical evidence from Kazakhstan. Journal of International Business Researcher, 9 , 75–90.

Liwan, A., & Lau, E. (2007). Managing growth: The role of export, in fl ation and investment in three ASEAN neighboring countries. ICFAI Journal of Managerial Economics, 5 , 7–16.

Mallick, H., & Agarwal, S. (2007). Impact of real interest rates on real output growth In India: A long-run analysis in a liberalized fi nancial regime. Singapore Economic Review, 52 , 215–231.

Mallik, G., & Chowdhury, A. (2001). In fl ation and economic growth: Evidence from four south Asian countries. Asia-Paci fi c Development Journal, 8 , 123–135.

Marwah, K., & Tavakoli, A. (2004). The effect of foreign capital and imports on economic growth: Further evidence from four Asian countries (1970–1998). Journal of Asian Economics, 15 , 399–413.


Miles, W. (2008). Exchange rates, in fl ation and growth in small, open economies: A difference-in-differences approach. Applied Economics, 40 , 341–348.

Mishra, P. K., Mishra, U. S., & Mishra, S. K. (2010). Money, price and output: A causality test for India. International Research Journal of Finance and Economics, Issue, 53 , 26–36.

Okpara, G., & Nwaoha, W. (2010). Government expenditure, money supply, prices and output relationship in Nigeria: An econometric analysis. International Research Journal of Finance and Economics, 54 , 125–133.

Olayeni, O. R. (2009). A bayesian analysis of government expenditure in Nigeria. MPRA paper No. 18244. Germany: The Munich Personal RePEc Archive, Munich University Library.

Olukayode, E. M., & Onabanjo, U. O. (2009). Does government spending spur economic growth in Nigeria? MPRA paper No. 17941. Germany: The Munich Personal RePEc Archive, Munich University Library.

Omoke, C., & Ugwuanyi, U. (2010). Money price and output: A causality test for Nigeria. American Journal of Scienti fi c Research, 8 , 78–87.

Pesaran, H., Shin, Y., & Smith, R. (2001). Bounds testing approaches to the analysis of level rela-tionships. Journal of Applied Econometrics, 16 , 289–326.

Reinsel, G., & Ahn, S. (1992). Vector autoregressive models with unit roots and reduced rank structure: Estimation, likelihood ratio tests, and forecasting. Journal of Time Series Analysis, 13 , 353–375.

Suleman, M., Wasti, K., Lai, I., & Adnan, H. (2009). An empirical investigation between money supply government expenditure, output & prices: The Pakistan evidence. European Journal of Economics, Finance and Administrative Sciences, 17 , 60–68.

Tan, K. G., & Cheng, C. S. (1995). The causal nexus of money, output and prices in Malaysia. Applied Economics, 27 , 1245–1251.

Tan, B. W., & Lean, H. H. (2010). An analysis of dynamic linkages between domestic investment, exports and growth in Malaysia. European Journal of Social Sciences, 16 , 150–159.

Taylor, M. (1999). Real interest rates and macroeconomic activity. Oxford Review of Economic Policy, 15 , 95–113.

Toda, H., & Yamamoto, T. (1995). Statistical inference in vector auto regressions with possibly integrated process. Journal of Econometrics, 66 , 225–250.

Valdovinoz, F. (2003). In fl ation and economic growth in the long run. Economic Letters, 80 , 167–173.

Wang, Y., Hui, X., & Soo fi , A. (2007). Estimating renminbi equilibrium exchange rate. Journal of Policy Modeling, 29 , 417–429.

Warman, F., & Thirlwall, A. P. (1994). Interest rates, saving, investment and growth in Mexico 1960-90: Tests of the fi nancial liberalization hypothesis. Journal of Development Studies, 30 , 629–649.

Wu, S. Y., Tang, J., & Lin, E. S. (2010). The impact of government expenditure on economic growth: How sensitive to the level of development? Journal of Policy Modeling, 32 , 804–817.


1 Introduction

The fi nancial crisis that began with problems in the subprime mortgage market in the USA and spread around the world in September 2008 marked the fi rst global fi nancial crisis of the twenty- fi rst century. After the Second World War, it is considered as the most severe fi nancial and economic crisis the world has witnessed (Akyüz 2010 ). The devastating impact on the balance sheets of many of the leading investment banks, despite the “virtues” of transferring risk from bank balance sheets under the “originate and distribute” model of banking, quickly propagated across major fi nancial centers. In an attempt to reduce the large counterparty credit risk, banks began calling in loans, including those in seemingly riskier emerging markets. The credit squeeze and the ensuing impact on real estate and housing asset markets led US fi rms and households to reduce spending, resulting in a sharp economic slowdown. The fi rst-round effects gave way to a second round through slower export demand, further weakening global economic growth. The economies that were highly integrated with US economy suffered much owing to the contraction economic policy of the US government.

Governments across the world have already taken multiple efforts to mitigate the impact of the fi nancial crisis. The governments of the USA, the UK, Ireland, and other countries have virtually “nationalized” giant fi nancial institutions, including banks, insurance companies, and mortgage houses, to save them from being wiped out. In the USA, Congress adopted a massive bailout plan with taxpayers’ money. It initially approved a law to buy $1.5 trillion worth of bad mortgages and other assets from the troubled banks to reduce the adverse effect on fi nancial institutions, reviving them again to a successful lender’s position. Overall, a $2.4 trillion dollar rescue package has been put into motion in the USA, the EU, and Asia. India cut its key interest rates by one percentage point from 9 to 8%. China also cut interest

N. C. Shil (*) Department of Accounting, American International University , Bangladesh e-mail: [email protected]

Chapter 7 Impact of Global Financial Crisis on Economic Wellbeing: A Case of South Asia

Nikhil Chandra Shil

130 N.C. Shil

rates and announced a $586 billion stimulus package focusing mainly on infrastructure and social programs. The International Monetary Fund (IMF) has urged the major central banks to provide direct support to the banking system.

If we compare the economic integration of Bangladesh, India, and Pakistan with the rest of the world, we fi nd that in 2006, trade as a percentage of GDP was highest in India (48.78%), followed by Bangladesh (44.22%) and Pakistan (38.61%). Pakistan received the highest foreign direct investment (FDI) in fl ow as a percentage of GDP (3.37%), followed by India (1.19%) and Bangladesh (1.13%). From the exchange rate side it is clear that the Pakistani rupee has depreciated the most against the US dollar, followed by the Indian rupee, while the Bangladeshi taka has remained relatively stable. The IMF data and projections indicate that all three countries are expected to experience some slowdown in GDP growth rates compared with those of the previous years (Ghosh and Ghosh 1999 ). The government of Bangladesh expected over 6% growth for Bangladesh in the 2008–2009 fi nancial year. The Indian government forecast growth to be between 7 and 8% for India. Pakistan’s economy has grown by 7–8% over the past few years but most of this growth has taken place in sectors such as consumer fi nancing. The situation of other countries in the South Asia region is not isolated, but is rather closely related. Thus, the econ-omies of South Asian countries depend on the advanced economies to a larger extent. As the advanced economies faced troubles, South Asian economies were initially affected, and this chapter attempts to highlight the troubles that South Asian countries faced with the assessment of the corrective measures taken by the respective authorities.

2 The Global Financial Crisis: Issues and Challenges

The global fi nancial crisis is deeply rooted in several issues pertinent to political econ-omy considerations, the bank regulation framework, and weak corporate governance. The main cause of the current fi nancial turbulence is attributed to the subprime mort-gage crisis that originated in the USA during mid 2007 with the collapse of two Bear Stearns hedge funds. The traditional model and the subprime mortgage model is presented in Fig. 7.1 , re fl ecting the adverse effect of subprime mortgages on the fi nancial market. During boom times, mortgage brokers tried to attract buyers with poor creditworthiness because of fi nancial motives in the form of higher amounts of commissions. As the creditworthiness of the buyers was poor, there was high risk in offering housing mortgages with little or no down payment. Lenders sought addi-tional pro fi ts through these higher-risk loans and they charged interest rates above prime rates in order to compensate for the additional risk they assumed. Consequently, once the rate of subprime mortgage foreclosures skyrocketed, many lenders experi-enced extreme fi nancial dif fi culties, and even bankruptcy (Bairoch 1993 ).

At a fundamental level, however, the crisis could also be ascribed to the persistence of large global imbalances, which, in turn, were the outcome of long periods of excessively loose monetary policy in the major advanced economies during the early part of the

1317 Impact of Global Financial Crisis on Economic Wellbeing…

fi rst decade of this century (Mohan 2007 ; Taylor 2009 ) . Global imbalances were manifested through a substantial increase in the current account de fi cit of the USA, mirrored by the substantial surplus in Asia, particularly in China, and in the oil exporting countries of the Middle East and Russia (Lane 2009 ) . These imbalances in the current account are often seen as the consequence of the relative in fl exibility of the currency regimes in China and some other emerging countries. According to Portes ( 2009 ) , global macroeconomic imbalances were the major underlying cause of the crisis.

Following the bust of the dot-com bubble in the USA around the turn of the decade, the monetary policy in the USA and other advanced economies was eased aggressively. An empirical assessment of the US monetary policy also indicates that the actual policy during the period 2002–2006, especially during 2002–2004, was substantially looser than what a simple Taylor rule would have required. Excessively loose monetary policy in the post-dot-com period boosted consumption and invest-ment in the USA and, as Taylor argues, it was made with purposeful and careful consideration by monetary policy makers. As might be expected, with such low nominal and real interest rates, asset prices also recorded strong gains, particularly in housing and real estate, providing further impetus to consumption and investment through wealth effects. Thus, aggregate demand consistently exceeded domestic output in the USA and, given the macroeconomic identity, this was mirrored in large and growing current account de fi cits in the USA over the period. The large domestic demand of the USA was met by the rest of the world, especially China and other East Asian countries, which provided goods and services at relatively low cost, leading to growing surpluses in these countries (Yu 2010 ). Sustained current account surpluses in some of these countries also re fl ected the lessons learned from the Asian fi nancial crisis. Furthermore, the availability of relatively cheaper goods and services from China and other emerging countries also helped to maintain price stability in the USA and elsewhere, which might not have been possible otherwise. Thus, measured in fl ation in the advanced economies remained low, contributing to the persistence of accommodative monetary policy.

Traditional Model

HomeBuyer

FinancerBank

Loan sanctioned on Mortgage by the Bank

Home buyer repays the Bank

Subprime Mortgage Model

HomeBuyer Financer Bank Mortgage

Bond MarketMortgage Loan ThroughHome

Appraiser

Repayments Through

MortgageBroaker

Bank raises funds by sellingMortgage Bond

Bank makes payments toBondholders on the basis

of rating done by

RatingAgencies

a

b

Fig. 7.1 Traditional versus subprime mortgage model

132 N.C. Shil

Apart from creating large global imbalances, accommodative monetary policy and the existence of very low interest rates for an extended period encouraged the search for high yields, and relaxation of lending standards. Even as fi nancial imbalances were building up, macroeconomic stability was maintained. Relatively stable growth and low in fl ation have been witnessed in the major advanced economies since the early 1990s, and the period has been dubbed the Great Moderation. The stable macroeconomic environment encouraged underpricing of risks. Financial innovations, regulatory arbitrage, lending malpractices, excessive use of the originate and distribute model, and securitization of subprime loans and their bundling into AAA trances on the back of ratings all combined to result in the observed excessive leverage of fi nancial market entities (Brunnermeister 2009 ). The effect was fi nally exposed through the occurrence of such a crisis that destroys big corporate giants (Table 7.1 ) that were once a symbol of pride and might. However, some points may be listed to characterize the current global fi nancial crisis for better understanding:

1. Most of the crises over the past few decades have had their roots in developing and emerging countries, whereas the current ongoing global fi nancial crisis had its roots in the USA.

2. Owing to the originate and distribute model, most of the subprime mortgages had been securitized in combination with strong growth in complex credit deriv-atives and the use of credit ratings, the subprime mortgages were bundled into a variety of trances, including AAA trances, and they were sold to a range of fi nancial investors.

3. The US Federal Reserve started to withdraw monetary accommodation owing to in fl ationary pressure in the market. Tight monetary policy contained aggregate demand and output, depressing housing prices. With low/negligible-margin fi nancing, there were greater incentives for the subprime borrowers to default, leading to losses by fi nancial institutions and investors alike.

4. The various stress tests conducted by the major banks and fi nancial institutions prior to the crisis period had revealed that the banks were well capitalized to deal

Table 7.1 Global crisis and credit crunch facts (From BBC, October 21, 2008 )

Companies Actions taken Date

Fannie Mae and Freddie Mac Nationalized September 7, 2008 Lehman Brothers Collapsed September 15, 2008 Merrill Lynch Taken over September 15, 2008 American International Group Part nationalized September 16, 2008 HBOS Taken over September 17, 2008 WaMu Collapsed and sold September 25, 2008 Fortis Nationalized September 28, 2008 Bradford and Bingley Nationalized September 29, 2008 Wachovia Taken over September 29, 2008 Glitnir Nationalized September 29, 2008 Hypo Real Estate Rescue package October 6, 2008 Royal Bank of Scotland Part nationalized October 13, 2008 Lloyds TSB Part nationalized October 13, 2008


with any shocks. Such stress tests, it appears, were based on the very benign data of the period of the Great Moderation and did not properly capture and re fl ect the reality (Haldane 2009 ) .

5. The deep and lingering crisis in global fi nancial markets, the extreme level of risk aversion, the mounting losses of banks and fi nancial institutions, the elevated level of commodity prices and their subsequent collapse, and the sharp correction in a range of asset prices, all combined, suddenly led to a sharp slowdown in growth momentum in the major advanced economies, especially since the failure of Lehman Brothers.

6. Global growth for 2009, which was seen as a healthy 3.8% in April 2008, was later projected to contract by 1.3% (IMF 2009a ) . The global trade volume (goods and services) was also expected to contract by 11% during 2009 as against the robust growth of 8.2% during 2006–2007.

3 Background of the Study

According to Amjad and ud Din ( 2009 ) , the shock absorbers are soundness of the fi nancial system, reliance on domestic consumption rather than exports, macroeco-nomic stability, and a healthy foreign exchange reserve position. And the factors that work as shock ampli fi ers are lack of economic diversi fi cation, and high depen-dence on external fi nancing (Amjad and ud Din 2009 ) . Papanek and Basri ( 2009 ) extended estimates of Keynesian multipliers based on a common method of assessing the likely impact of the external shock on South Asian economies based on direct and indirect effects. According to these multiplier projections, Bangladesh would be least affected by the crisis and Sri Lanka would be most affected. In the midst of the global crisis, the IMF ( 2008 ) pointed to the importance of policy measures to increase demand and restore economic con fi dence. The optimal fi scal package, it said, should be timely, large, lasting, diversi fi ed, contingent, collective, and sustainable. The IMF ( 2009a ) highlights three channels through which fi scal costs operate: automatic stabilizers, other nondiscretionary impacts beyond the impact of the cycle, and discretionary fi scal stimulus. Given the plethora of channels, it is dif fi cult to quantify with any precision the amount of active fi scal spending incurred by fi scal authorities to pump up their economies.

The IMF ( 2010 ) raised interesting issues on macroeconomic policy, learning from what worked well and what worked less during the global crisis. One argument suggests that as monetary and credit policy reached its limit, policy makers had no choice other than to rely on fi scal policy more heavily. The other argument is that as the recession across countries was expected to last for a long time, fi scal stimulus would have enough time to yield bene fi cial effects despite conventional implemen-tation lags. According to the IMF ( 2009b ) , policy makers face two challenges. What is the appropriate balance between providing support to these economies until recovery is robust and self-sustaining without undermining in fl ationary pressures and fi scal sustainability? And how do policy makers sustain recovery in a new environment

134 N.C. Shil

where export demand from the Group of Seven industrialized countries may not be as strong as in the past, with factors pointing to some rebalancing of determinants of growth in favor of domestic demand? Whereas the fi rst question is now, indeed, the issue for South Asian policy makers, the second is perhaps less pertinent to South Asia, where the balance between domestic and export-led growth has been better.

The IMF ( 2009b ) argues that Asia is leading the recovery, re fl ecting the region’s rapid, forceful, and comprehensive policy response. This pull factor is explained by the strong condition of many Asian economies going into the crisis. In those countries, governments’ fi scal positions were sounder, monetary policy was more credible, and corporate and bank balance sheets were sturdier than at any time in the past. This may indeed characterize East Asia and Southeast Asia, which may, perhaps, have learned from the 1997–1998 Asian fi nancial crisis. But it is less clear whether it fully re fl ects South Asia, which, perhaps more than coincidentally, was largely unaffected by the Asian crisis. Whereas the initial conditions were important, the Asian Development Bank ( 2009 a) also notes that a country’s ability to withstand shocks depends on a set of variables that may either amplify or absorb them. Countries with strong macroeconomic fundamentals would be better able to withstand or absorb shocks, and those with weak and narrower fi nancial systems would be less able. However, there is no end; crises come again and again at regular intervals. It is wise to know how to handle such a situation. Table 7.2 presents some of the crises the world economy has faced.

4 Impact of the Global Financial Crisis on South Asia

The global fi nancial crisis hit South Asia at a time when it had barely recovered from a severe terms of trade shock resulting from the global food and fuel price crisis. The food and fuel price shocks had badly affected South Asia, with cumu-lative income loss ranging from 34% of GDP (2002) for the Maldives to 8% for Bangladesh. Current account and fi scal balances have worsened sharply and in fl ation has surged to unprecedented levels (Table 7.3 ).

Declining GDP growth rates in South Asia led to a decrease in government revenues. At the same time, public expenditure increased as governments in South Asia attempted to provide succor to the poor as well as to declining industries. Consequently, fi scal de fi cits increased sharply in each of the countries of South Asia, except Sri Lanka (Table 7.4 ).

Pakistan, Sri Lanka, and the Maldives were particularly vulnerable owing to dif fi cult political and social environments that prevented adequate policy measures being taken to adjust to the terms of trade shock. Additionally, their reliance on foreign funding has been relatively large. The global fi nancial crisis worsened their macroeconomic dif fi culties as sources of funding contracted. Although India was well advanced in responding to the food and fuel price crisis and has generally maintained prudent macroeconomic management, the magnitude of the fi nancial crisis has hit India very hard because of its strong connectivity to global fi nancial markets.


Table 7.2 The crisis in retrospect

Year Comments

1637 The speculative “tulip mania” bubble in the Netherlands is reported as an example of a fi nancial crisis although modern researchers dispute this on the ground that its broader economic impact was very negligible, and that it did not precipitate a fi nancial crisis. Tulip mania was a period in the Dutch Golden Age during which contract prices for bulbs of the recently introduced tulip reached extraordinarily high levels and then suddenly collapsed (Dash 1999 ) . At the peak of tulip mania, in February 1637, some single tulip bulbs sold for more than ten times the annual income of a skilled craftsman. It is generally considered the fi rst recorded speculative or economic bubble (Shiller 2005 ) . The term “tulip mania” is now often used metaphorically to refer to any large economic bubble (when asset prices deviate from intrinsic values) (Kindleberger and Aliber 2005 )

1720 The South Sea Company, a British joint stock company, was granted a monopoly to trade in Spain’s South American colonies as part of a treaty during the War of Spanish Succession. In return, the company assumed the national debt England had incurred during the war. Speculation in the company’s stock led to a great economic bubble known as the South Sea Bubble in 1720, which caused fi nancial ruin for many

1772 The credit crisis of 1772 was a fi nancial crisis which occurred in the UK and which also spread to North America

1792 The panic of 1792 was a fi nancial credit crisis which occurred during March and April of 1792 owing to the speculation of William Duer and Alexander Macomb against stock held by the Bank of New York (Fleming 2009 ) . Duer attempted to drive the price of stocks up, whereas the Livingston family attempted to drive the price of stocks down and in so doing caused a bank run. Macomb and Duer were ruined, but Treasury Secretary Alexander Hamilton prevented a national crisis by providing hundreds of thousands of dollars in securities for the troubled banks

1825 The panic of 1825 was a stock market crash that started in the Bank of England, arising in part out from speculative investments in Latin America. The crisis was felt most acutely in England, where it precipitated the closing of six London banks, including Henry Thornton’s bank, and 60 country banks in England, but was also manifest in the markets of Europe, Latin America, and the USA. The panic has been referred to as the fi rst modern economic crisis not attributable to an external event, such as a war, and thus the start of modern economic cycles

1847 The panic of 1847 started as a collapse of British fi nancial markets associated with the end of the 1840’s railroad boom. The Bank of England had to request a suspension of the Bank Charter Act to end the crisis. It was caused by excessive monetary in fl ation caused by the Bank of England and fractional reserve banking. The panic of 1847 cleared away a vast number of unsound business houses, and trade generally became much more sound and healthy; this lasted until the 1855

1893 The panic of 1893 was a serious economic depression in the USA that was marked by the collapse of railroad overbuilding and shaky railroad fi nancing which set off a series of bank failures (Timberlake 1997 ) . Compounding market overbuilding and a railroad bubble was a run on the gold supply and a policy of using both gold and silver metals as a peg for value of the US dollar. Until the Great Depression, the panic of 1893 was considered the worst depression the USA had ever experienced

(continued)

136 N.C. Shil


Year Comments

1896 The panic of 1896 was an acute economic depression in the USA, but was less serious than other panics of the era, and was precipitated by a drop in silver reserves and market concerns on the effects this would have on the gold standard. During the panic, call money would reach 125%, the highest level since the Civil War

1929 The Wall Street Crash of 1929, also known as the Great Crash and the Stock Market Crash of 1929, was the most devastating stock market crash in the history of the USA, taking into consideration the full extent and duration of its fallout. The crash signaled the beginning of the 12-year Great Depression that affected all Western industrialized countries and that did not end in the USA until the onset of American mobilization for the Second World War at the end of 1941

1997 The Asian fi nancial crisis was a period of fi nancial crisis that gripped much of Asia, beginning in July 1997, and raised fears of a worldwide economic meltdown owing to fi nancial contagion

The crisis started in Thailand with the fi nancial collapse of the Thai baht caused by the decision of the Thai government to fl oat the baht, cutting its peg to the US dollar, after exhaustive efforts to support it in the face of a severe fi nancial overextension that was in part real-estate-driven. At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt

2001 The dot-com bubble was a speculative bubble covering roughly 1995–2000 (with a climax on March 10, 2000, with the NASDAQ peaking at 5132.52 in intraday trading before closing at 5048.62) during which stock markets in industrialized nations saw their equity values rise rapidly from growth in the recent Internet sector and related fi elds. Whereas the latter part was a boom and bust cycle, the Internet boom is sometimes meant to refer to the steady commercial growth of the Internet with the advent of the World Wide Web, as exempli fi ed by the fi rst release of the Mosaic web browser in 1993, and continuing through the 1990s.

The period was marked by the founding (and, in many cases, spectacular failure) of a group of new Internet-based companies commonly referred to as dot-coms. Companies were seeing their stock prices shoot up if they simply added an “e-” pre fi x to their name and/or a “.com” suf fi x to the end, which one author called “pre fi x investing”

2007 onward The fi nancial crisis from 2007 to the present is considered by many economists to be the worst fi nancial crisis since the Great Depression of the 1930s. It was triggered by a liquidity shortfall in the US banking system, and has resulted in the collapse of large fi nancial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many areas, the housing market has also suffered, resulting in numerous evictions, foreclosures, and prolonged vacancies. It contributed to the failure of key businesses, declines in consumer wealth estimated in the trillions of US dollars, substantial fi nancial commitments incurred by governments, and a signi fi cant decline in economic activity


Table 7.4 Fiscal de fi cit as a percentage of GDP

Country 2004 2005 2006 2008 2008

Bangladesh −3.2 −3.3 −3.2 −3.2 −4.7 India −7.5 −6.7 −6.4 −5.4 −6.0 Pakistan −2.9 −3.3 −4.3 −4.3 −7.4 Sri Lanka −7.9 −8.4 −8.0 −7.7 −6.8

Source: Asian Development Bank ( 2009 )

Bangladesh, Nepal, and Bhutan have been mostly insulated from the fi rst-round effects of the fi nancial crisis owing partly to sound macroeconomic management, but also because of the underdeveloped nature of their fi nancial markets, which are not well connected to international markets. They are, however, vulnerable to the second-round effects of a global economic slowdown working through export earnings, tourism receipts, remittances, and external fi nancing for infrastructure. The recent slide in food and fuel prices has provided South Asia with welcome relief. But overall, the evidence suggests that growth, investment, exports, and employment have been hurt. The outlook for 2009 was bleak as the global downturn deepened further . Growth in South Asia decelerated in 2008, falling from 8% in 2007 to 6%. It was projected to decline to 5% in 2009, before recovering to 6% in 2010 .

4.1 Pakistan

The economic status of Pakistan is totally unpredictable owing to the political unrest in the country. The global fi nancial crisis has added extra fuel to the fi re. The govern-ment in power has to spend a good portion of valuable time to make compromises to run the government. Pakistan’s economy has been under strain owing to excess

Table 7.3 Capital and fi nancial account (net) and changes in gross international reserves (million dollars)

Country

Capital and fi nancial account (net) Change in gross international reserves

Oct–Dec 2008 Jan–Mar 2009 Total Oct–Dec 2008

Jan-Mar 2009 Total

Bangladesh 334 −321 13 −75 165 91 (−1.3%) (2.8%) (1.5%)

India −3,683 −6,146 −9,829 −30,300 −4,000 −34,300 (−10.6%) (−1.4%) (−12.0%)

Nepal 96 231 328 135 185 321 (5.8%) (7.9%) (13.7%)

Sri Lanka −1,132 −267 −1,399 −1,432 −481 −1,913

Sources: Bangladesh Bank, Major Economic Indicators Monthly Update, Reserve Bank of India Press Release, Nepal Rastia Bank, Current Macroeconomic Situation, Central Bank of Sri Lanka, Selected Economic Indicators The numbers in parentheses indicate changes against reserves outstanding at the end of September

138 N.C. Shil

demand pressures that have been building since 2004. The combined effects of the global food, fuel, and fi nancial crisis took quite a toll on the economy as the current account balance and fi scal de fi cits increased, in fl ation surged, and growth slowed. Economic growth has taken a hit, with growth slowing from 7.3% during 2004–2007 to 5.8% in 2008, and it was projected to slide to around 3% in 2009. The scope for countercyclical fi scal policy is limited at this time, although the country may expect to be in a good position to save the poor from the adverse effects because of the measures taken to protect social spending.

FDI has always been encouraged in Pakistan irrespective of the government in power but at the cost of local investments. In recent times, the sudden reduction of FDI has become a problem for the country, and thus the government needs to revise its policies. The effect of the global fi nancial crisis has not been felt in Pakistan as the country has been passing through its own crisis for the past several years. There are, however, other reasons which may work as a bulwark for Pakistan against such odds. First and foremost is that Pakistan’s economy is not fully integrated with the world economy and, therefore, is less likely to be affected. Second, the system of mortgage banking is still in its infancy in Pakistan, where the banks largely operate in loaning against business. Third, the sharp decline in oil and agricultural prices has helped Pakistan to breathe. According to some analysts, this global crisis may help Pakistan in the short term to control depletion of foreign reserves. The argument is based on the premise that because of the global crisis a sharp decline in the prices of oil and food commodities has been witnessed and this will help Pakistan reduce its import bill, which in turn help boost its foreign reserves. A careful analysis of economic trends in Pakistan shows that despite an impressive growth rate of more than 6% from 2001 to 2007, Pakistan’s economy was not resilient enough to face the economic challenges of the 2008 when the oil and food prices experienced a sudden upward trend.

4.2 Sri Lanka

Sri Lanka has taken actions to reduce monetary growth and contain the fi scal de fi cit. This, along with lower commodity prices, has helped to reduce in fl ation, which has came down sharply from a peak of 28% in June 2008 to 11% in January 2009. But Sri Lanka’s balance of payments is under stress, as the current account de fi cit surged to about 7.5% of GDP in 2008 and reserves have fallen to less than 2 months of imports. Access to foreign commercial credit has also been sharply curtailed by the rapid rise in the cost of borrowing. Economic growth has came down from 7% during 2006–2007 to 6% in 2008 and a further decline is expected.

Rising interest rates and in fl ationary pressures, the US dollar appreciating at the expense of the rupee, coupled with a war budget and high public sector expenditure will make things dif fi cult for Sri Lanka. Meanwhile, the central bank released more than US$22 million into the market in order to defend the rupee. Fewer and fewer dollars coming into the markets is causing pressure on the rupee, thus making it dif fi cult for the central bank to defend the rupee. The cascading effects of global


fi nancial crisis in the USA, the UK and the rest of the wold may bring recession to Sri Lankan economy as a result of its high dependency on those economies. Worse will follow, when foreign investors try to withdraw their funds from Asian markets. However, inward remittances sent by Sri Lanka’s housemaids from the Middle East and expatriates may result in the country achieving a reasonable outcome in relation to the trade de fi cit.

The continuation of economic downturn in the USA and the euro zone will have a negative impact on Sri Lanka’s textile and garment exports. Nearly 50% of Sri Lanka’s textile and garment exports went to the US in 2007, and 45% went to the EU. The sector is the largest source of foreign exchange earnings, accounting for some 43% of the total. The 2009 defense budget was estimated at 177.06 billion rupees, 6.4% higher than the estimated 166.45 billion rupees that were to have been spent in 2008. This can be considered as essential expenditure for the future stability of the country. But this expenditure should not continue beyond 2009. Expected possible gains will not only be lost if the war is prolonged, but will also have a dev-astating affect on the economy. If terrorism is eliminated or controlled at least by the middle to the end of 2009, the positive ripple effect will cause an economic boom in Sri Lanka . In fact 177.06 billion rupees will be hopefully available for development and capital expenditure.

4.3 Maldives

The Maldives is still grappling with major fi scal and current account imbalances, which have been further hurt by a slowdown in foreign private capital in fl ows and a downturn in the tourism sector. The new government is looking at ways to bring the macro economy back on track. The Indian Ocean islands are best known as an upmarket tourist destination, where the rich spend thousands of dollars on expensive beach-side resorts from which they can watch the sun set into the water and forget about the world beyond the horizon. But in this remote paradise, fears over declining tourism and falling revenues have prompted the government to sell off its most ostentatious possessions in a show of solidarity with its citizens. First to go was the presidential yacht, followed by the president’s picnic island. Tourism, which makes up more than a third of the islands’ economy, has made the country by far the richest in South Asia, with a GDP per head in excess of $2,000. Visitor numbers were down by 5% in January 2009 . If this situation continues for an unlimited period, the country will have no hope left of capitalizing.

4.4 Bhutan

Bhutan’s economy is closely tied to India’s economy. Since there are no indications of reductions in aid or delays in the development of the next mega-hydropower projects, the macroeconomic underpinnings appear sound. The banking system has adequate liquidity, reserves are at a high level (exceeding 14 months of imports),

140 N.C. Shil

and the authorities continue to make good progress in implementing their reform program. Second-round effects are expected, however, with growing nonperforming loans and weaker tourism activity later in 2009 .

4.5 Nepal

Nepal is bene fi ting from higher in fl ows of remittances and healthy availability of foreign aid. Along with the decline in global commodity prices, the balance of payments and the fi scal situation are comfortable and there is no evidence of a liquidity constraint on domestic demand. In contrast, the large foreign exchange in fl ows are creating some demand pressure that has contributed to a surge in in fl ation, which requires better management. It will not directly affect the Nepalese fi nancial system, nor will it put strain on monetary policy, as Nepal is largely insulated from the toxic assets of big investments like in the West. However, it will indirectly affect economic growth, revenue collection, and development initiatives carried out by nongovernment orga-nizations. Potential monetary imbalance may arise from changes in Indian monetary policies and the exchange rate of Nepalese rupees and Indian rupees.

The economy could feel the impact of the global fi nancial crisis through four different routes—a slowing down of in fl ow remittances, a recessionary tourism sec-tor, a decline in aid, and a demand-de fi cient manufacturing sector. Whereas a slow-ing of the fi rst three components will affect poverty reduction and development initiatives, the decline in global demand for Nepalese-manufactured products will put direct downward pressure on the growth rate. The rate is expected to hover around 5% during 2009 . However, the rate was 6.1%, 4.9% and 4.6% for the years 2008, 2009 and 2010 respectively. It is estimated to be 3.5% in 2011 and may improve by 5% in 2012.

A global slowdown and recession in Western economies will also affect the Nepalese service industry, which contributed 50.9% of GDP in 2007. Global recovery is not expected any time soon as the Western fi nancial crisis steadily worsens. This means potential tourists are likely to postpone or cancel travel plans. By working with the government and launching promotional packages, the Hotel Association of Nepal is hoping to entice about a million tourists in 2010. If the global economic slowdown continues past 2010 , this dream seems unachievable. Meanwhile, the aid industry will also not be spared from the crisis. Nongovernment organizations operating in Nepal receive funding from corporate donors, governments, and large foundations in the West. The global slowdown will limit this funding, forcing the organizations to scale back development initiatives. This will have a negative impact on the fi ght against poverty and other development challenges. The manufacturing sector will also suffer. Export to major Western countries is expected to slow in the coming years. The Confederation of Nepalese Industries recently estimated that the manufacturing sector would incur a loss of $256.16 million as a result of the global economic slowdown. Combining this with a further downward spiral in demand from the already distressed garment and textile industry, with the continued decline in global prices of key commodities exported by Nepal, the total loss could be much higher than that anticipated by the Confederation of Nepalese Industries.


On the monetary front, the balance of payments surplus will decline owing to the potential decline in remittances. In addition, if imports and exports decrease by a large amount, the estimated revenue target (129 billion rupees) would be virtually unachievable. There will also be downward pressure on the total foreign exchange reserve held by the central bank. It will try to tame the in fl ation rate, currently over 13%, by raising interest rates. As has been indicated recently, it will increase regulatory oversight of the fi nancial system as well. The banking system may be in trouble if the bubbling real estate market slows down.

4.6 Bangladesh

Bangladesh has held up remarkably well owing to deft economic management that helped to absorb the pressure of the global food and oil price crisis of the January 2007 to May 2008 period without jeopardizing macroeconomic stability. Although stock prices have fallen, domestic liquidity seems adequate. Domestic interest rates, both long term and short term, are stable. Exports for the fi rst 6 months of the fi scal year (July to December) have grown at a healthy pace of 19% and remittance in fl ows show a 31% increase . The recent decline in global commodity prices, especially food and fuel, is helping ease in fl ationary pressure while also providing a welcome increase in the fi scal space and balance of payments.

Bangladesh depends signi fi cantly on foreign trade. More signi fi cantly, its exports, including ready-made garments, shrimps, an leather, are heavily dependent on Western consumer demand. Therefore, falling employment and hence the declining income of average consumers in the USA and Europe are bound to have serious impacts on Bangladesh’s export potentials. Similarly, there could be a negative impact on the export of Bangladeshi low-skilled manpower following the ever-declining oil price with potential depression of infrastructural development activities in the Middle East.

However, the crisis has several downside risks for the economy of Bangladesh. The impact will depend on the nature, scope, severity, and duration of the crisis. Although the economy of Bangladesh has become increasingly integrated with the global economy in recent years, the country’s fi nancial sector is not as globally integrated as that of its neighboring countries. Private foreign players are important players in the banking sector; however, foreign portfolio holdings in the equity market are relatively small at only 2.6%. Also, international currency transfers are restricted, leaving no question of large-scale capital fl ight. Risks remain mainly in the areas of export earnings, remittances, and foreign aid. The fi nancial sector is in relatively good health, underpinned by cautious regulation and several reforms. It is highly insulated from foreign markets and lacks sophisticated fi nancial derivatives linked to Western capital markets. The number of nonperforming loans is decreasing and the capital base is relatively comfortable.

In Bangladesh, over the last 2 years, there has been a positive current account balance that has reduced the risks emanating from short-run fl uctuations in the exchange rate and the foreign reserve situation. Net in fl ow of FDI has remained

142 N.C. Shil

relatively stable in recent times, whereas private debt transactions are limited and strictly monitored by the central bank. One potential threat for the banking sector is the likely occurrence of payment default by foreign buyers for export orders, especially of ready made garments, in the event of their going bankrupt.

Nearly 87% of Bangladesh’s exports are destined to markets in developed coun-tries. Ready-made garments make up over 75% of all exports, mostly to US and EU markets. The impact on exports of ready-made garments will therefore determine the impact on the country’s overall exports. With the ongoing recession in the USA and the EU, it is likely that exports will be hurt. There are some moderating factors that should be considered.

Bangladesh is a net importer of essential food commodities and fuel. In recent months , prices of commodities such as rice, wheat, edible oil, fuels, and fertilizer have dropped signi fi cantly on the global market, which favors Bangladesh. The settlement of LICs for consumer goods during July to October 2008 declined by 19% (Raihan and Chowdhury 2009 ). On the other hand, settlement of LICs for capital machinery has increased by about 8.5% which is a positive sign for future industrial growth and productivity. The taka has appreciated against many currencies, such as the euro, the Australian dollar, and the Canadian dollar, so this makes imports from those countries cheaper. Of fi cial general in fl ation fi gures were 7.26% in October, down from 10.19% in September. Food in fl ation is 8.08%, down from 12.09% (these are point-to-point calculations).

Remittance receipts during July to October 2008 were up by around 36.5% com-pared with the same period of the previous year. Most remittances to Bangladesh are from the Middle Eastern Gulf states, whose fi nancial health has not yet been severely affected by the crisis.

However, the price of oil has fallen very sharply, from $147 a barrel in July to under $50 at present . If this continues, the demand for labor from Bangladesh is bound to fall as new construction projects are halted, and the recent evidence suggests such indications.

Bangladesh has little FDI and most of this is longer term in nature. Tighter global credit markets have raised the cost of capital in the international market and are likely to reduce FDI in developing countries. Increasing FDI to Bangladesh depends more on domestic factors such as improvements in infrastructure, power supply, and governance and business practices. Most of Bangladesh’s aid sources (nearly 80% of the total) come from multilateral sources. Aid in fl ows are likely to remain unaffected in the short run although the promises of signi fi cant aid increases may not materialize. Aid during the 2009–2010 fi nancial year is not likely to increase as developed countries mobilize resources to tackle their domestic economic problems.

4.7 India

The global fi nancial crisis and its effect on India are multifaceted. Policy makers and analysts differ signi fi cantly in explaining the situation. However, so far as the discussion goes and situations exist, the feeling is mixed, a mixture of positive and


negative impacts. It was argued that India would be relatively immune to this crisis because of the “strong fundamentals” of the economy and the supposedly well regu-lated banking system.

The global fi nancial crisis could also affect India through the exposure of Indian banks or banks operating in India to the impaired assets resulting from the subprime crisis. Unfortunately, there are no clear estimates of the extent of that exposure, giving room for rumor in determining market trends. ICICI Bank was the victim of a run for a short period because of rumors that subprime exposure had badly damaged its balance sheet, although these rumors have been strongly denied by the bank. So far the Reserve Bank of India (RBI) has claimed that the exposure of Indian banks to assets impaired by the fi nancial crisis is small. According to reports, the RBI had estimated that as a result of exposure to collateralized debt obligations and credit default swaps, the combined mark-to-market losses of Indian banks at the end of July 2009 was around $450 million. Given the aggressive strategies adopted by the private sector banks, the mark-to-market losses incurred by public sector banks were estimated at $90 million, while those for private banks were around $360 million (Reserve Bank of India 2009 ).

Indian nonbank fi nancial institutions (especially mutual funds) and corporate enterprises may also suffer from the crisis as a result of their exposure to domestic stock and currency markets. Such losses are expected to be large, as signaled by the decision of the RBI to allow banks to provide loans to mutual funds against certi fi cates of deposit or to buy back their own certi fi cates of deposit before maturity. These losses are bound to render some institutions fragile, with implications that would become clear only in the coming months. Owing to such an uncertain environment, banks and fi nancial institutions concerned about their balance sheets have been cut-ting back on credit, especially the huge volume of housing, automobile, and retail credit provided to individuals. According to RBI fi gures, the rate of growth of auto-mobile loans fell from close to 30% over the year ending June 30, 2008, to as low as 1.2%. Loans to fi nance consumer durables purchases fell from around 60 billion rupees in the year to June 2007, to a little over 40 billion rupees up to June 2009 . Direct housing loans, which had increased by 25% during 2006–2007, decelerated to 11% growth in 2007–2008 and 12% over the year ending June 2008. It is only in an area such as credit-card receivables, where banks are unable to control the growth of credit, that expansion (43%) was quite high over the year ending June 2008, even though it was lower than the 50% recorded over the previous year.

5 Macroeconomic Assessment

Owing to the fi nancial turmoil, regulators in every country have taken suf fi cient corrective measures to boost their economies. Most of these measures were taken for short-term support that the economy needs for long-term sustainability. In this section, some of the macroeconomic parameters are selectively chosen for better understanding on the logic behind the measures undertaken to combat the crisis.

144 N.C. Shil

5.1 Foreign Direct Investment

The current global fi nancial crisis has gone far beyond the fi nancial sector and has seriously affected the real economy. There is evidence of its negative impacts on FDI. In fl ows are expected to fall from $1.7 trillion to below $1.2 trillion in 2009, with a slow recovery in 2010 (to a level up to $1.4 trillion) and a gain in momentum in 2011 (approaching $1.8 trillion). The global fi nancial crisis started in the devel-oped world, and has been rapidly spreading to developing and transitional econo-mies such as those of Pakistan, India, and Bangladesh. In 2008, India received $41.56 billion in FDI and Pakistan received $5.4 billion, making them top two FDI-receiving countries in the area. Despite a worldwide fi nancial crisis, India, Bangladesh, Sri Lanka, and Afghanistan have made signi fi cant progress in receiving FDI (Table 7.5 ). But the in fl ow of FDI into Pakistan, Nepal, and Bhutan declined during the same time ( Asia News Network 2009).

5.2 Unemployment

The deepening of the global fi nancial crisis entails a heavy toll on employment worldwide. A rapid rise in unemployment has been witnessed since 2008. Initial projections put the rise in unemployment at 50 million over the next 2 years, but as the situation continues to deteriorate, this number could easily double (International Labor Organization 2009 ) . Higher unemployment rates may persist for some time. Lessons from past fi nancial crises indicate that it typically takes 4–5 years after economic recovery has set in for unemployment rates to return to precrisis levels.

5.3 Current Account Balance

There was a sharp decline in exports in South Asian countries following the global recession. However, given their composition, import expenditures did not decline proportionately with the decline in GDP growth rates. Consequently, the current

Table 7.5 Foreign direct investment

FDI inward stock (million dollars) FDI outward stock (million dollars)

1990 2000 2008 1990 2000 2008

Bangladesh 478 2,162 4,817 45 69 81 India 1,657 1,751 123,288 124 1,859 61,765 Pakistan 1,892 6,919 3,105 245 489 1,284

Source: Finfacts Ireland’s Business & Finance Portal ( 2009 ) FDI foreign direct investment


account of the balance of payments worsened in each South Asian country. The sharpest increase in the current account de fi cit occurred in the case of India, where this fi gure as a percentage of GDP doubled from −1.4% in the 2007 to −2.6% in 2008 (Table 7.6 ). Pakistan was close behind, with this fi gure increasing from −4.8% in 2007 to −8.4% in 2008. Sri Lanka’s current account de fi cit increased from −4.3% to −9.3% in the same period. Bangladesh, which had a current account sur-plus in the 2007, merely suffered a decline in this surplus, which fell from 1.4% in 2007 to 0.9% in 2008 .

5.4 In fl ation

In fl ation increased signi fi cantly during 2008 in most of South Asian counties (Table 7.7 ). However, it has gone down again. This means that the economic situation is improving and the monetary and fi scal policies are working.

Table 7.6 Current account balance (percentage of GDP)

Country/region 2006 2007 2008

2009 2010

ADO 2009 Update ADO 2009 Update

South Asia −1.3 −1.7 −3.1 −2.0 −1.7 −2.3 −2.2 Afghanistan −4.9 0.9 −3.0 −3.5 −1.7 −4.7 −2.7 Bangladesh 1.3 1.4 0.9 0.2 2.8 −0.5 0.8 Bhutan −4.4 11.0 3.9 5.5 5.5 9.0 9.0 India −1.0 −1.4 −2.6 −1.5 −1.5 −2.0 −2.0 Maldives −33.0 −41.5 −51.7 −30.0 −30.0 −30.0 −30.0 Nepal 2.0 −0.1 2.9 1.5 3.0 1.0 2.0 Pakistan −3.9 −4.8 −8.4 −6.0 −5.3 −4.5 −4.8 Sri Lanka −5.3 −4.3 −9.3 −7.5 −3.0 −7.0 −5.0

Source: Asian Development Bank ( 2009 ) ADO Asian Development Outlook

Table 7.7 In fl ation (%)


2009 2010


South Asia 5.9 5.6 9.6 5.6 4.7 4.4 4.9 Afghanistan 5.3 12.9 26.7 6.0 −8.9 6.8 6.5 Bangladesh 7.2 7.2 9.9 7.0 6.7 6.5 6.5 Bhutan 4.9 5.2 6.4 3.5 7.0 4.0 4.0 India 5.4 4.8 8.7 3.5 2.5 4.0 4.0 Maldives 3.5 7.4 12.3 4.5 4.5 5.5 5.5 Nepal 8.0 6.4 7.7 10.0 12.8 8.0 9.0 Pakistan 7.9 7.8 12.0 20.0 20.8 6.0 10.0 Sri Lanka 10.0 15.8 22.6 8.0 5.0 6.0 6.0


146 N.C. Shil

5.5 Growth of GDP

Growth of GDP is an important parameter for explaining economic growth. During 2008, the global fi nancial crisis affected the GDP of South Asian countries. (Table 7.8 ) However, it is improving, which re fl ects the recovery on the part of the South Asian countries.

5.6 Fiscal and Monetary Policies

The critical analysis of the impacts of the global fi nancial crisis opens up different avenues to mitigate it. It also improves the preparedness of the world community to face such a crisis in the future. There has been wide debate among economists on their role and the contribution of the large body of work to address shortcomings in economic management (Krugman 2009 ; Cochrane 2009 ; Lucas 2009 ). The US administration intervened directly by injecting a $1-trillion-plus fi scal stimulus to bail out the troubled banks and Federal Reserve has undertaken different decisive and aggressive quantitative programs such as easing to inject liquidity, stabilize markets, and eventually restore the economy to health (Ocampo 2010 ). Fiscal stim-ulus supports aggregate demand through targeting the domestic economy. These measures focused on increasing consumption and investment to compensate for declining external demand. Stimulus measures in Bangladesh and Sri Lanka had a narrower focus, supporting producers (farmers and exporters) through higher subsi-dies. But in India, the stimulus packages were more comprehensive, covering demand-side measures stimulating consumption through lower taxes and supply-side measures including tax cuts and relaxation of constraints to funding. Bangladesh and India were also under added pressure to maintain high growth owing to their political manifesto. On the other hand, the fi scal stimulus measures in Nepal and the Maldives were limited. The latest budget in Nepal focused on some structural issues

Table 7.8 GDP growth rate (%)


2009 2010


South Asia 9.0 8.6 6.3 4.8 5.6 6.1 6.4 Afghanistan 8.2 12.1 3.4 9.0 15.7 7.5 8.5 Bangladesh 6.6 6.4 6.2 5.6 5.9 5.2 5.2 Bhutan 6.4 14.1 11.5 5.5 6.0 6.5 6.5 India 9.7 9.0 6.7 5.0 6.0 6.5 7.0 Maldives 18.0 7.2 5.8 1.0 −3.5 1.5 3.5 Nepal 4.1 2.7 5.3 3.0 3.8 3.5 4.0 Pakistan 5.8 6.8 4.1 2.8 2.0 4.0 3.0 Sri Lanka 7.7 6.8 6.0 4.5 4.0 6.0 6.0



such as the improvement of the investment climate, the energy crisis, and weak bud-get implementation and project management, among others. The latest revised bud-get in the Maldives is trying to rationalize expenditure within a constrained resource envelope while introducing new tax measures to increase and diversify revenues.

5.6.1 Assessing the Effectiveness of Fiscal Policy

Fiscal stimulus measures are more likely to be effective if they are enacted in a timely manner, are well targeted, and are temporary (Elmendorf and Furman 2008 ; Corden 2009 ) . Implementing fi scal policy in a timely manner is often very dif fi cult because of legislation or approval is needed from the parliament. It may happen that the fi scal policy loses its relevance by the time it comes into effect. Another factor that has a strong bearing on the success of fi scal policy is the identi fi cation of the right target. If the policy fails to target the right sectors, areas, measures, or issues requiring intervention;, it cannot bring about the required result. Finally, the fi scal policy should be undertaken on a temporary basis. Fiscal stimulus measures are likely to be more effective if they are temporary and will not contribute to negative effects by necessitating increased taxes on future generations through a disproportionate buildup of debt. It is therefore crucial to have a clear exit strategy for quickly removing the stimulus once economic recovery sets in and before it becomes entrenched among bene fi ciaries.

The rest of this section presents a comparative analysis of the fi scal policies undertaken by Bangladesh, Sri Lanka, and India in terms of the three T’s (timely, targeted, and temporary). Bangladesh announced its fi rst stimulus package, amounting to 34.2 billion takas (0.6% of GDP), in April 2009, with some additional measures in May 2009 (Table 7.9 ). The main focus of the package was increased subsidies for agriculture, enhanced cash incentives for recession-affected sectors such as jute, leather, and frozen foods, and higher allocations for social safety net programs. The budget for the 2010 fi nancial year expanded these measures further, allocating 50 billion takas, or 0.9% of GDP.

The fi rst stimulus package in Sri Lanka addressing the global fi nancial crisis was announced in December 2008 and allocated 16 billion rupees (0.4% of GDP), and was followed by another stimulus package in May 2009 of eight billion rupees (0.2% of GDP) (Table 7.10 ). Measures targeted the fl agging tea, rubber, cinnamon, and garment export sectors for incentives (as well as including a fertilizer subsidy), and boosted rewards under an export development program. They tried to maintain a minimum price of tea leaves and rubber, and kept intact an across-the-board fertilizer subsidy. The VAT refunding period has been reduced to a maximum of 6 months. The stimulus packages are also targeted at agriculture (through a fertilizer subsidy) and the export sector (through rewards under the Export Development Reward scheme), especially the tea, rubber, cinnamon, and garment industries. The actual expenditure to support a minimum price of tea leaves and rubber, however, was below the amount of the initially planned stimulus—six billion rupees (as of August 2009) as the price of tea and rubber recovered and the fertilizer price went down (Carrasco and Seung 2006 ).

148 N.C. Shil

Tabl

e 7.

9 Fi

scal

stim

ulus

mea

sure

s in

Ban

glad

esh

Maj

or fi

scal

stim

ulus

mea

sure

s T

imel

y Ta

rget

ed

Tem

pora

ry

Apr

il 20

09: s

timul

us p

acka

ge

of 3

4.2

billi

on ta

kas

(0.6

%

of G

DP)

Incr

ease

d su

bsid

ies

for

agri

cultu

re,

incr

ease

d ca

sh in

cent

ives

for

re

cess

ion-

affe

cted

sec

tors

(ju

te,

leat

her,

and

froz

en f

oods

), a

nd

furt

her

allo

catio

n fo

r so

cial

saf

ety

net p

rogr

ams

Yes

. The

pol

icy

was

a

reac

tion

to d

eclin

ing

expo

rt. I

mm

edia

te

impa

ct e

xpec

ted

Yes

. It f

ocus

ed o

n ag

ricu

lture

and

re

cess

ion-

affe

cted

se

ctor

s su

ch a

s th

e ju

te, l

eath

er, a

nd

froz

en f

ood

sect

ors

and

vuln

erab

le

peop

le

Yes

. Allo

cate

d re

sour

ce is

lim

ited

May

200

9: a

dditi

onal

mea

sure

s E

xpor

t sub

sidy

(or

cas

h su

bsid

y) w

as

rais

ed f

or th

e re

cess

ion-

affe

cted

se

ctor

s

The

fun

d w

as

imm

edia

tely

di

sbur

sed

No

spec

i fi c

allo

catio

n or

tim

efra

me

was

giv

en

June

200

9: b

udge

t for

the

2010

fi n

anci

al y

ear,

stim

ulus

pa

ckag

e of

50

billi

on ta

kas

(0.9

% o

f G

DP)

Subs

idie

s an

d in

cent

ives

to

be

cont

inue

d an

d ex

pand

ed

Not

cle

ar. T

he g

over

n-m

ent m

ay n

eed

to

cons

ider

pla

nnin

g fo

r a

clea

r ex

it st

rate

gy

Sour

ces:

Min

istr

y of

Fin

ance

, Ban

glad

esh,

and

new

s so

urce

s


The fi rst stimulus package in India was announced in December 2008 and had different policy measures, including additional planned expenditure, tax cuts, a tax-free bond issued by the India Infrastructure Finance Company Ltd and a service tax refund to exporters (Table 7.11 ). The second (January 2009) and third (February 2009) stimulus packages included increased state government borrowing and reduced central excise duty and service tax. The revised federal budget for the 2009 fi nancial year adopted a strategy to revive economic growth over the short term by providing an additional fi scal stimulus, with the expectation of generating addi-tional revenue and reducing the fi scal de fi cit over the medium term (Kumar and Vashisht 2009 ).

The fi scal measures that addressed speci fi c sectors in Bangladesh and Sri Lanka were in general well targeted. Some measures, however, did not have a speci fi c expenditure ceiling or time frame, leaving some concern about temporariness. In the case of India, although the medium-term fi scal policy as of July 2009 was targeted at decreasing the fi scal de fi cit to 5.5% in the 2010 fi nancial year and 4.0% in the 2011 fi nancial year, the actual exit strategy from the general demand stimulus is less clear. In countries such as Sri Lanka, which had large fi scal de fi cits coming into the global crisis, the authorities were responsive to the limited fi scal space available and, to no surprise, introduced much more moderate fi scal stimulus packages.

5.6.2 Assessing the Effectiveness of Monetary Policy

Monetary policy targeted pumping liquidity into the banking system through the central banks, mainly through the call market, as the money markets seized, re fl ecting inherent counterparty credit risks. Later, the monetary authority moved to address the credit crunch once the money market had stabilized (Bhaumik and Mukhopadhyay 1997 ).

Table 7.10 Fiscal stimulus measures in Sri Lanka

Major fi scal stimulus measures Timely Targeted Temporary

December 2008: fi rst stimulus package of 16 billion rupees (0.4% of GDP)

Incentives to tea, rubber, cinnamon, and garment export sectors (including fertilizer subsidy)

Yes. Policy reacted to declining exports. Immediate impact expected

Yes. It focused on sectors that were suffering and were likely to spend

Not clear. The amount is an estimate and it was not intended to limit the expenditure amount

May 2009: second stimulus package of eight billion rupees (0.2% of GDP)

Rewards under the Export Development Reward scheme, including 5% export incentives

Time for processing may be needed, as exporters need to apply and be assessed against eligibility criteria

Sources: Ministry of Finance and Planning, Sri Lanka, and news sources

150 N.C. Shil

Tabl

e 7.

11

Fisc

al s

timul

us m

easu

res

in I

ndia

Maj

or fi

scal

stim

ulus

mea

sure

s T

imel

y Ta

rget

ed

Tem

pora

ry

Dec

embe

r 20

08: fi

rst

stim

ulus

pac

kage

A

dditi

onal

pla

nned

exp

endi

ture

of

up

to 2

00 b

illio

n ru

pees

(0.

4% o

f G

DP)

in

the

2008

fi na

ncia

l yea

r fo

r ru

ral

infr

astr

uctu

re a

nd s

ocia

l sec

urity

Tim

ely

polic

y ac

tions

take

n.

Impl

emen

tatio

n m

ay ta

ke ti

me

Not

targ

eted

at a

ny

spec

i fi c

sect

or

Yes

. Allo

cate

d re

sour

ce

is li

mite

d

Cut

of

cent

ral V

AT

by

4%, a

nd 2

% in

the

serv

ice

tax

Yes

. Im

med

iate

impa

ct e

xpec

ted

Not

cle

ar. C

ould

be

polit

ical

ly d

if fi c

ult

to te

rmin

ate

IIFC

L to

rai

se 4

00 b

illio

n ru

pees

th

roug

h ta

x-fr

ee b

onds

Im

plem

enta

tion

may

take

tim

e Y

es. A

lloca

ted

reso

urce

is

lim

ited

Full

refu

nd o

f se

rvic

e ta

x pa

id b

y ex

port

ers

to f

orei

gn a

gent

s Y

es. I

mm

edia

te im

pact

exp

ecte

d Y

es. F

ocus

on

expo

rter

s Ja

nuar

y 20

09: s

econ

d st

imul

us p

acka

ge

Stat

e go

vern

men

ts b

orro

w a

n ad

ditio

nal

0.5%

of

GSD

P in

the

2008

fi na

ncia

l ye

ar a

nd a

gain

in th

e 20

09 fi

nanc

ial

year

Tim

elin

ess

of im

pact

dep

ends

on

polic

y m

easu

res

of th

e st

ates

N

ot ta

rget

ed a

t any

sp

eci fi

c se

ctor

Y

es. A

lloca

ted

reso

urce

is

lim

ited

Febr

uary

200

9:

thir

d st

imul

us

pack

age

Cen

tral

exc

ise

duty

gen

eral

rat

e an

d se

rvic

e ta

x ra

te r

educ

ed

Yes

. Im

med

iate

impa

ct e

xpec

ted

Not

targ

eted

at a

ny

spec

i fi c

sect

or

No

spec

i fi c

allo

catio

n or

tim

efra

me.

Cou

ld

be p

oliti

cally

dif

fi cul

t to

term

inat

e St

ates

allo

wed

to d

evia

te f

rom

fi sc

al

cons

olid

atio

n ta

rget

s be

yond

M

arch

200

9

Tim

elin

ess

of im

pact

dep

ends

on

polic

y m

easu

res

of th

e st

ates

Y

es. D

evia

tion

is a

llow

ed

for

the

2009

fi na

ncia

l ye

ar

1517 Impact of Global Financial Crisis on Economic Wellbeing… M

ajor

fi sc

al s

timul

us m

easu

res

Tim

ely

Targ

eted

Te

mpo

rary

June

200

9: I

ndia

re

vise

d fi n

anci

al

year

200

9 fe

dera

l bu

dget

fi sc

al d

e fi ci

t re

mai

ns h

igh

(6.8

%

of G

DP)

Acc

eler

ated

pub

lic in

vest

men

t in

infr

astr

uctu

re (

Bha

rat N

irm

an,

JNN

UR

M, N

HD

P, e

tc.)

Tim

elin

ess

of im

pact

dep

ends

on

the

time

take

n fo

r im

plem

enta

tion

Not

cle

ar.

The

act

ual e

xit s

trat

egy

from

fi sc

al e

xpan

sion

is

, how

ever

, not

cle

ar,

alth

ough

the

med

ium

-ter

m fi

scal

po

licy

is ta

rget

ed a

t de

crea

sing

the

fi sca

l de

fi cit

to 5

.5%

in th

e 20

10 fi

nanc

ial y

ear

and

4.0%

in th

e 20

11

fi nan

cial

yea

r

Sour

ces:

Min

istr

y of

Fin

ance

, Ind

ia, a

nd n

ews

sour

ces

GSD

P g

ross

sta

te d

omes

tic p

rodu

ct, I

IFC

L I

ndia

Inf

rast

ruct

ure

Fina

nce

Com

pany

Ltd

, JN

NU

RM

Jaw

ahar

lal N

ehru

Nat

iona

l Urb

an R

enew

al M

issi

on, N

HD

P

Nat

iona

l Hig

hway

s D

evel

opm

ent P

roje

ct

152 N.C. Shil

Central bank liquidity injections in the money markets in India and Sri Lanka helped stabilize the fi nancial system. Ted spreads, representing the difference between the 3-month interbank rate and the T-bill yield of the same maturity, have gradually come down, with the premium in India below the level at the time of the outbreak of the crisis in early September 2008. Credit default swaps, another indicator of credit risk, of banks in India sharply increased in October to November 2008 but have settled down to precrisis levels.

From liquidity management measures, monetary policy then turned to addressing the credit crunch. In an attempt to boost economic activity, monetary authorities cut policy rates to lower lending rates and facilitate bank loans to the private sector, the dominant source of credit in South Asia. In India, for example, the strong retail deposit base accounts for about 75% of total bank funding. In 2009, governments adopted a more accommodative monetary policy stance, aided by the rapid easing of in fl ationary pressures resulting from the decline in global economic activity, including a rapid decline in oil prices, and lowered policy rates to boost investment and growth.

Prompt and decisive action by the RBI led to a lowering of India’s repurchase (repo) rate by 425 basis points from September 2008 (including a 25 basis point decline in April 2009). Sri Lanka’s central bank, with less room to cut given higher and seemingly more persistent in fl ation, cut its repo rate by 200 basis points in April 2009. In September 2009, Sri Lanka’s central bank again reduced its policy interest rates by 50 basis points each, reducing the repo rate to 8% and the reverse repo rate to 10.5%, to encourage lower market interest rates. Bangladesh began reversing its tight monetary policy in March 2009, lowering the repo rate by 25 basis points. In October 2009, Bangladesh Bank reduced the repo rate from 8.5 to 4.5% in a bid to ease the cost of credit and help boost investment in the economy. Countries with a currency peg against the Indian rupee (Bhutan and Nepal) have in general been able to bene fi t from the accommodative RBI monetary policy.

Policy rate hikes (or cuts), however, tend to be associated with a rise (or lowering) of lending rates. To understand how rate cuts impact an economy, it is important to review the main transmission channels of monetary policy. These include:

1. Direct interest rate channel: higher interest rates for fi rms and households discourage spending.

2. Indirect interest rate channel: higher interest rates weaken stock and housing markets, causing a negative wealth effect on consumer spending.

3. Balance sheet channel: higher interest rates reduce the value of homes and stocks, resulting in lower value of collateral.

4. Exchange rate channel: higher interest rates raise the value of the local currency and shift spending from the domestic economy to imports.

Against this backdrop, policy rate cuts in India for various reasons did not lead to a rapid lowering of lending rates. These can be grouped into three broad categories: supply-side factors, demand-side factors, and possibly, institutional and/or structural factors. The supply-side factors include a higher perceived risk of borrowers operating in an uncertain business environment, and a premium on liquid assets following the


liquidity shortage after the crisis. The demand-side factors include increased demand for funds by corporate enterprises shifting from overseas borrowing to domestic sources, by small and medium-sized enterprises to maintain cash fl ow in the eco-nomic slowdown, and by the central government, and reduced demand for bank credit owing to widespread economic uncertainty. The institutional and/or structural factors may include banks’ recent high-cost borrowing, needing some time to adjust to a more accommodative monetary policy, and the downward rigidity of bank deposit rates because of the interest rate fl oor available in small savings schemes run by post of fi ces and provident funds. Moreover, if there is a weakening of assets underlying the value of the collateral following a fi nancial shock, then for a given decline in policy rates, there may not be an associated decline in lending rates.

According to the Government of India ( 2009 ) , credit uptake in the period from October 2008 to March 2009 was sluggish on the supply side owing to global eco-nomic conditions, with many international banks teetering on the edge, and was sluggish on the demand side owing to global economic conditions in which companies did not want to take on additional debt in a climate of uncertainty and where consum-ers were postponing home and automobile purchases given the uncertain economic outlook and in anticipation of further reductions in interest rates.

6 Conclusion

Mostly every country suffered to differing degrees from the wave of the fi nancial crisis, which achieved a global status. South Asian countries also suffered owing to channels such as remittances, trade fl ows, employment, policy dependencies, dona-tions, and capital account balances. India and Sri Lanka were affected most by the global economic crisis among South Asian countries. Although the fi nancial markets in these countries have started to normalize and some capital fl ows have returned, it is not yet clear from the latest indicators whether the recovery is well entrenched.

GDP growth rates in South Asian countries have been lower in recent years but the output gap is less than that across for other countries in the region. Thus, the impact of different stimulus measures remains questionable. These countries initially responded to the crisis by a combination of fi scal and monetary policies to mitigate the impacts and support economic growth. Bangladesh and Sri Lanka adopted a narrower targeted fi scal stimulus, whereas India applied a more across-the-board fi scal stimulus. Fiscal measures that addressed speci fi c sectors were in general well targeted in Bangladesh and, to a lesser extent, in Sri Lanka. But some measures did not have speci fi c expenditure ceilings or time frames, leaving some concern about temporariness. The actual exit strategy from the general demand stimulus in India is also less clear. Monetary policy successfully stabilized the fi nancial sector after the initial shocks of the global crisis. But the effectiveness of support for economic growth through fi nancial intermediation was mixed.

However, it can be concluded that the South Asian countries faced the crisis and combated it successfully with timely strategies. Remittances increased as most of

154 N.C. Shil

them come from the Gulf region. Exports remained unaffected, which ensures there is a capital account balance. Owing to huge local demand in some of the countries, the fi scal de fi cit is manageable. Import payments are made from the export income. Owing to the good environment and cheap labor and friendly policies, some of the countries experienced industrial growth. Thus, the economies became stable and all of the macroeconomic parameters show a positive trend. If this can be maintained and continued, the economy will run at full speed again.

References

Akyüz, Y. (2010, March). Global economic prospects: The recession may be over but what next? (Research Paper No. 26). Geneva: South Centre.

Amjad, R., & ud Din, M. (2009). Economic and social impact of global fi nancial crisis: Implications for macroeconomic and development policies in South Asia . Mimeo: Pakistan Institute of Development Studies.

Asian Development Bank. (2009). Asian development outlook 2009 update . Manila: ADB. Bairoch, P. (1993). Economics and world history: Myths and paradoxes . Chicago: University of

Chicago Press. BBC. (2008). Retrieved from 21 October. http://news.bbc.co.uk/ Bhaumik, S., & Mukhopadhyay, H. (1997, May 3–9). Was the industrial deceleration a result of

credit crunch: A disequilibrium approach. Economic and Political Weekly . Brunnermeister, M. (2009). Deciphering the liquidity and credit crunch 2007–2008. Journal of

Economic Perspective, 23 (1), 77–100. Carrasco, B., & Seung Mo Choi. (2006). An assessment of cross-country fi scal consolidation

(ERD Working Paper Series 79). Manila: ADB. Cochrane, J. (2009). How Did Paul Krugman Get It So Wrong? . 16 September. http://faculty.

chicagobooth.edu/john.cochrane/research/Papers/krugman_response.htm Corden, W. M. (2009). The theory of the fi scal stimulus: How will a debt- fi nanced stimulus affect

the future? (Working Paper Series 15). Melbourne Institute of Applied Economic and Social Research, The University of Melbourne.

Dash, M. (1999). Tulipomania: The story of the world’s most coveted fl ower and the extraordinary passions it aroused . London: Gollancz.

Elmendorf, D., & Furman, J. (2008). If, when, how: A primer on fi scal stimulus. Brookings Institution, The Hamilton Project Strategy Paper .

Finfacts Ireland’s Business & Finance Portal. (2009). http://www.fi nfacts.ie/ Fleming, T. (2009). Wall street’s fi rst collapse (American heritage, winter 2009). New York:

American Heritage Publishing Co., Inc. Ghosh, S., & Ghosh, A. (1999). East Asia in the aftermath: Was there a crunch? (IMF Working

Paper 99/38). Washington, DC: International Monetary Fund. Government of India. (2009). Economic outlook for 2009–2010. Economic Advisory Council

(EAC) to the Prime Minister . New Delhi: EAC. Haldane, A. (2009). Why banks failed the stress test? London: The Bank of England. International Labor Organization. (2009). The fi nancial and economic crisis: A decent work

response. Paper submitted to the ILO Governing Body Committee on Employment and Social Policy (Document GB.304/ESP/2). Geneva: ILO.

International Monetary Fund. (2008). Fiscal policy for the crisis (IMF Staff Position Note, SPN/08/01). Washington, DC: IMF.

International Monetary Fund. (2009a). The state of public fi nances cross-country fi scal monitor (IMF Staff Position Note no. 25). Washington, DC: IMF.

http://news.bbc.co.uk/

http://faculty.chicagobooth.edu/john.cochrane/research/Papers/krugman_response.htm

http://faculty.chicagobooth.edu/john.cochrane/research/Papers/krugman_response.htm

http://www.finfacts.ie/


International Monetary Fund. (2009b). Regional economic outlook, Asia and Paci fi c, building a sustained recovery . Washington, DC: IMF.

International Monetary Fund. (2010). Rethinking macroeconomic policy (IMF Staff Position Note no. 03). Washington, DC: IMF.

Kindleberger, C. P., & Aliber, R. (2005). Manias, panics, and crashes: A history of fi nancial crises (5th ed.). Hoboken: Wiley.

Krugman, P. (2009). How did economists get it so wrong? The New York Times . 2 September. Kumar, R., & Vashisht, P. (2009). The global economic crisis: Impact on India and policy responses

(ADBI Working Paper Series 164). Tokyo: ADB Institute. Lane, P. (2009). Global imbalances and global governance . Paper presented at the global economic

governance: Systemic challenges, institutional responses and the role of the new actors’, Brussels. Lucas, R. (2009). In defence of the dismal science. The Economist . 6 August. Mohan, R. (2007, June). Development of fi nancial markets in India. Reserve Bank of India Bulletin . Ocampo, J. A. (2010). Reforming the global reserve system. In S. Grif fi th-Jones, J. A. Ocampo, &

J. E. Stiglitz (Eds.), Time for a visible hand: Lessons from the 2008 world fi nancial crisis . New York: Oxford University Press.

Papanek, G., & Basri, M. (2009, September 28–30). Estimating the impact of the world economic crisis on Indonesia: Methodology and approach . Paper presented at the 3rd China-ASEAN Forum on Social Development and Poverty Reduction, Hanoi, Vietnam.

Portes, R. (2009). Global imbalances in Mathias Dewatripont. In X. Freixas & R. Portes (Eds.), Macroeconomic stability and fi nancial regulation: Key issues for the G20 . London: Centre for Economic Policy Research.

Raihan, S., & Chowdhury, R. (2009). A short note on global fi nancial crisis and it’s implications for Bangladesh. Bangladesh Economic Outlook, 2 (2), p. 6.

Reserve Bank of India. (2009). Annual Policy Statement for FY2009. Shiller, R. J. (2005). Irrational exuberance (2nd ed.). Princeton: Princeton University Press. Taylor, J. (2009, January). The fi nancial crisis and the policy responses: An empirical analysis

of what went wrong (Working Paper 14631). National Bureau of Economic Research. Timberlake, R. H., Jr. (1997). Panic of 1893. In D. Glasner & T. F. Cooley (Eds.), Business cycles

and depressions: An encyclopedia (pp. 516–518). New York: Garland Publishing. Yu, Y. (2010). Asia: China’s policy response to the global fi nancial crisis. Journal of Globalization

and Development, 1 (1), 1–12.


1 Introduction

The economic meltdown began in Thailand in July 1997 and spread to other countries in the region, such as Malaysia, Indonesia, the Philippines, and South Korea. This phenomenon was later called the “contagion effect.” To improve economic founda-tions, Thailand, Indonesia, and South Korea decided to ask for and received rescue packages from the International Monetary Fund (IMF). However, as the IMF’s condi-tions were very strict, some experts doubted the validity of the IMF’s policies.

Some economists, such as Jeffrey Sachs, criticized the IMF for making a wrong diagnosis and prescribing the wrong medicine to Asian countries. They believed that the IMF’s rescue packages were suitable for the countries whose problems were caused by public sector debts and government overspending. The problems of Asian countries, in contrast, stemmed from the private sector.

These economists believe that the IMF’s measures, such as cutting public spending and tightening of credit, were the wrong medicine for Asian economies. They thought that the IMF’s policies pushed Asian countries into a deeper recession. By contrast, the Malaysian government decided not to borrow money from the IMF. Instead, the

B. Parasuraman (*) Faculty of Entrepreneurship and Business, Universiti Malaysia Kelantan (UMK) , Kota Bahru , Malaysia e-mail: [email protected]; [email protected]

F. Furuoka University of Malaya , Kuala Lumpur

B. Lim Universiti Malaysia Sabah , Kota Kinabalu , Malaysia

C. Jikunan Malaysian Trade Union Congress , Kota Kinabalu, Sabah , Malaysia

L. M. Chiun Universiti Malaysia Sarawak , Kota Samarahan , Malaysia

Chapter 8 The Asian Economic Crisis and Malaysia’s Responses: Implications for the Banking Sector

Balakrishnan Parasuraman , Beatrice Lim , Fumitaka Furuoka, Catherine Jikunan , and Lo May Chiun

158 B. Parasuraman et al.

government imposed capital control in order to overcome fi nancial problems that were caused by the “contagion effect” of the Asian economic crisis.

This chapter examines the Asian fi nancial crisis and Malaysia’s responses to the crisis. It describes in detail the Malaysian government’s economic policies to counteract the “contagion effects” of the Asian fi nancial crisis. With regards to methodology, the case study method is employed. Robson ( 2002 ) de fi nes a case study as a strategy for doing research which involves an empirical investigation of a particular contemporary phenomenon within a real-life context using multiple evidence. In other words, we chose Malaysia as a case study to examine the general characteristics of the Asian fi nancial crisis and Malaysia’s response to the crisis particularly focused on its impact on the banking sector. We focus on the impact on workers of the banking sector in Malaysia.

2 Literature Review: Asian Financial Crisis

There are numerous works on the Asian fi nancial crisis. The Asian fi nancial crisis has had a signi fi cant negative impact on the Malaysian economy. As shown in Table 8.1 , Malaysia’s GDP at constant price amounted to RM 166,625 million in 1995, RM 183,292 million in the following year, and RM 193,422 million in 1999. Before the crisis, Malaysia recorded a growth rate of 9.09%. However in 1998, the growth rate was −7.94%. Following economic recovery, in the 1999, the growth rate was 5.78%.

Table 8.2 shows the GDP per capita at constant price. Prior to the crisis, GDP per capita shows an increasing trend from 1996 to 1998. However, owing to the fi nancial crisis, it declined to RM 8,216 before increasing gradually to RM 8,516.

The most fundamental question is: What are the causes of the Asian fi nancial crisis? There is still ongoing debate on the real causes that triggered the Asian fi nancial crisis. Radelet and Sachs ( 1998 ) explained that “the Asian fi nancial crisis is remarkable in several ways. The crisis has hit the most rapidly growing economies in the world. It has prompted the largest fi nancial bailouts in history. It is the sharpest

Table 8.1 GDP at constant price and growth rate of Malaysia (million ringgit)

1995 1996 1997 1998 1999

GDP 166,625 183,292 196,714 182,237 193,422 Growth rate (%) 9.09 6.82 −7.94 5.78

Source: Department of Statistics, Malaysia (2007)

Table 8.2 Per capita GDP at constant price and growth rate of Malaysia

1995 1996 1997 1998 1999

Per capita GDP (RM) 8,054 8,659 9,079 8,216 8,516 Growth rate (%) 6.99 4.63 -10.5 3.52


1598 The Asian Economic Crisis and Malaysia’s Responses…

fi nancial crisis to hit the developing world since the 1982 debt crisis. It is the least anticipated fi nancial crisis in years.”

Goldstein ( 2001 ) believes there were multiple factors resulting in the fi nancial crisis. He argued that fi nancial sector weakness, external sector problems, and conta-gion are the reason for the crisis. Goldstein went further to explain that some ASEAN countries were experiencing an economic boom in the 1990s, that is, the growth of bank and nonbank credit to the private sector exceeded by a wide margin the already rapid growth of real GDP. This credit boom encouraged private capital in fl ows and investment in real estate and also equities. At least one third of the total banks loans were in Thailand, Indonesia, Malaysia, and Singapore, but more were in Hong Kong. This evidence shows that there was a large extent of exposure to the property sector. Goldstein further emphasized that the overextension and concentration of credit left some ASEAN economies vulnerable to a shift in cyclical and/or credit conditions.

On the external sector problems, Goldstein ( 1998 ) emphasized that there is an ele-ment of poor quality of investment. Although, one third of investments are in place , this is not attractive if the corporate governance is poor. A high proportion of invest-ments were directed toward speculative investments such as investments in real estate. Overambitious infrastructure projects also contributed to this problem as there was an element of monopoly by the government, lack of transparency, and cronyism.

Goldstein ( 1998 ) further argued that there were several more plausible channels of contagion. One is called the “wake up call” hypothesis, where Thailand acted as a wake up call for international investors. These international investors reassessed the creditworthiness of Asian borrowers and found that quite a few of these Asian economies had weaknesses which are similar to those of Thailand. Such weaknesses were weak fi nancial sectors with poor prudential supervision, large external de fi cits, appreciating real exchange rates, declining quality of investment, export slowdown during 1996, and overexpansion in certain key industries.

Wang ( 2005 ) examined the popular explanation about how the East Asian coun-tries fell into the crisis: (1) cronyism, (2) exchange rate policy, (3) weak macroeco-nomic fundamentals, (4) open capital account, (5) poor regulation and supervision of fi nancial institutions, (6) lack of transparency, and (7) weak banks.

The renowned economist and Nobel laureate Joseph Stiglitz ( 2002 ) commented, “I believe that capital account liberalization was the single most important factor leading to the Asian Financial crisis. I have come to this conclusion not just by carefully look-ing at what happened in the region, but by looking at what happened in the almost 100 other economies crisis of the last quarter century….it has also become increasingly clear that all too often capital account liberalization represents risk without reward. Even when countries have strong banks, a mature stock market, and other institutions that many of the Asian countries did not have, it can impose enormous risk.”

Noland et al. ( 1998 ) explained that what causes panic is the herd behavior of investors. They argued that as global investment opportunities increase, investors’ direct knowledge of local situations decreases, and as a consequence, investors are forced to rely more on their observations of other investors rather than their own observations of local fundamentals. Lack of credibility and lack of transparency are connected to moral hazard.


Some researchers believe that rapid fi nancial liberalization caused the Asian fi nancial crisis. Bird and Rajan ( 2000 ) explained that “during the early 1990s, and partly as a consequence of their own growth, East Asian economies experienced persistent current account de fi cits which balance of payments accounting tells us have to be fi nanced either by in fl ows of foreign capital or by running down international reserves. It was also during this period that many East Asian countries took steps to liberalize both the domestic fi nancial sector and the capital account of the balance of payment.”. This period was referred to as the boom period (1990–1996).

On the basis of their research, Kaminsky and Schmukler ( 2008 ) con fi rmed the argument that “liberalization is followed by substantially more pronounced booms and crashes in the short run, which supports the models in which fi nancial liberalization triggers risky behaviour and excesses in fi nancial markets.” Asian countries such as Hong Kong, South Korea, Malaysia, Indonesia, Thailand, the Philippines, and Taiwan have undertaken to liberalize their fi nancial sectors as seen in Table 8.1 and others .

This empirical evidence provided by Kaminsky and Schmukler ( 2008 ) shows that during the early 1990s up until before the crisis, most Asian countries had liberalized their fi nancial sectors, i.e., the capital account and the stock market. Prior to the crisis, South Korea liberalized fully its fi nancial sector, whereas Malaysia liberalized the capital account and stock market but only partially liberalized the domestic fi nancial sector. Thailand prior to the crisis fully liberalized its fi nancial sector. However, Indonesia fully liberalized its fi nancial sector by January 1991, and from February 1991 was in fi nancial recession.

Wang ( 2005 ) says that premature capital account liberalization was the direct cause of various fi nancial crises, including the 1997–1998 Asian crisis. Montes ( 2001 ) argued that most Asian countries have encouraged the in fl ow of foreign investment and the economies of the countries have been open to incoming capital for a long time. Further, he argues that “liberalizing the capital account effectively consisted of (1) providing guarantees to non-residents that they could withdraw their investment effortless, and (2) easing outward investment restriction on and limitations to foreign assets holding by nationals, given that a signi fi cant proportion of non-residents could actually be nationals of the country.” For example, the opening of the capital account of Thailand gave the fi nancial sector and corporations access to offshore funds.

For Indonesia, domestic investment is heavily dependant on external fi nance. Montes ( 2001 ) highlighted that the demand for bonds and securities in Indonesia companies increased and that this made the corporate sector vulnerable when the rupiah began to devalue in late 1997. With the opening of the capital account, foreign fund managers gained access to the domestic stock market and bond markets and the domestic fi nancial system gained access to lower-cost funds from abroad.

Wang ( 2005 ) further emphasizes that it is advisable to delay capital account liber-alization or maintain capital control before countries put in place an effective domes-tic regulatory framework and fi nancial infrastructure. In comparing China and Southeast Asian countries, he further argues that China is unlikely to experience a crisis. China controls and monitors the pace and sequence of fi nancial liberalization and domestic fi nancial regulation. China’s capital account is strictly controlled; the renmimbi is not convertible for capital account transactions. Therefore, the possibility of moving money out of the country during a possible crisis is limited. The restriction


of access to China’s domestic stock by foreigner investors means they were not able to trade renmimbi-denominated shares on the Chinese stock exchange. Foreign investors are only able to trade or purchase shares which is classi fi ed as B shares and are traded in the small-value B share market. This type of share can only be sold or dispose of if the foreign investor is able to fi nd another foreign investor buyer. Wang further elaborates that in contrast with the other Asian countries during the crisis, “foreign portfolio managers all rushed for the exits simultaneously, contributing to a sharp decline in local shares.” They also contributed to devaluation of the currency by dumping the local currency in order to run away.

Some economists think that massive in fl ow and out fl ow of capital was the real cause of the Asian fi nancial crisis. Radelet and Sachs ( 2000 ) stressed that the massive capital fl ows pouring into the Asian region was the main cause of the Asian fi nancial crisis. Table 8.3 shows the net private capital in fl ow in 1996 was 14.5% of GDP for Thailand, 12.7% of GDP for the Philippines, 8.4% of GDP for Malaysia, 4.9% of GDP for South Korea, and 6.1% of GDP for Indonesia. Most of these countries received double the net private capital in fl ow in 1996 compared with 1994. Radelet and Sachs ( 2000 ) noted that in the case of Thailand, the bulk of the capital in fl ow was from offshore borrowing by banks and the private sector. Malaysia received a considerable amount of private capital in fl ow through foreign direct investment.

Grenville ( 2000 ) says that there is a presumption that the market outcome will be bene fi cial, i.e., international capitals fl ows are a good thing. His argument was that the fi nancial fl ows supplement domestic saving; allowing more investment in those countries where returns are highest, foreign direct investment brings the advantages of technological transfer and diversi fi cation of risk. D’Arista and Grif fi th-Jones ( 2001 ) argued that this pattern of in fl ow of foreign portfolio investment became possible when many developing countries began to relax their exchange controls and opened up their capital accounts, which happened at the end of the 1980s and at the beginning of the 1990s. This action increased opportunities for cross-border investment by other countries. Radelet and Sachs ( 2000 ) agree that investors are looking for more pro fi table investments which give them high returns. Low interest rates in the USA and Japan at that time encouraged them to increase their investment in Southeast Asia and other emerging markets.

Furthermore, Radelet and Sachs ( 2000 ) mentioned that “domestically there are four factors that contributed to the capital fl ows such as:(1) continuing, and in some cases increasing high economic growth gave con fi dence to foreign investors, (2) fi nancial sector deregulation was not accompanied by adequate supervision, especially in Thailand. Lax supervision created an environment conducive to high interest rate of foreign borrowing, since it allowed banks to take on substantial

Table 8.3 Private Capital Flow, 1996

Country GDP

Thailand 14.5% The Philippines 12.7% Malaysia 8.4% South Korea 4.9% Indonesia 6.1%

Source: Parasuraman (2003)


foreign currency and maturity risk, (3) nominal exchange rate was effectively pegged to the US dollar, with either limited variation (Thailand, Malaysia, Korea and the Philippines) or very predictable change (Indonesia). Predictable exchange rates reduce perceived risk for investors, further encouraging capital in fl ows, (4) governments gave special incentives that encourage foreign borrowing, even after concern arose about “hot money” fl ows in the early 1990s.”

On the other hand, Radelet and Sachs ( 2000 ) further agree that capital fl ows are important as an engine for growth if they are channeled to productive investment activi-ties. Nevertheless, Radelet and Sachs ( 2000 ) and D’Arista and Grif fi th-Jones ( 2001 ) caution that capital fl ows pose an important policy dilemma for macroeconomic management, especially when they are large, volatile, unsustainable, or poorly utilized.

Some researchers think that a change in investors’ expectations caused the Asian fi nancial crisis. Radelet and Sachs ( 2000 ) noted that panic can change investors’ expectations, with each trying to fl ee ahead of the others.

However, according to Grenville ( 2000 ) , there is an element of “herd behavior” that creates the atmosphere of expectation. Grenville argued that information played an important role. Investors’ information about emerging markets was so super fi cial that it could be overwhelmed by a small amount of new information. Investors without their own knowledge base simply followed the herd. In this case, it is rational for an individual player to shift with the herd when new perceptions arise. Whatever the fundamental is, when the herd is running, you run with it.

3 The Asian Financial Crisis and Malaysia’s Responses

3.1 The Asian Financial Crisis

The Asian fi nancial crisis was preceded by a series of crises dating back to the 1929 crash and the Great Depression in the 1930s. The signs of the impending economic doom surfaced in the mid-1990s, but most people regarded the Latin American crisis and the earlier economic slowdown in Japan as isolated events. The crisis rapidly spread throughout Southeast Asian countries, affecting especially seriously South Korea.

The value of local Asian currencies in the region collapsed, with the Thai baht, the Indonesian rupiah, and the Malaysian ringgit going into freefall. Three quarters of the value of Indonesian and Thai fi nancial assets were devalued owing to the plummeting of stock prices and currencies (Miller 1998 ; Baig and Goldfajn 1999 ) . In Thailand, more than two million workers were jobless in 1998. In Indonesia, “stag fl ation” threatened to double the prices of goods and merchandise and pushed nearly half of the population into poverty.

One of the reasons why the Southeast Asian “miracle” economies collapsed was an export boom halt that occurred at the time when short-term loans were due. This was mainly caused by heavy borrowing from abroad. Most of the af fl icted countries had run budget surpluses or minimal budget de fi cits in the preceding years; at the same time, private sector borrowing increased heavily. For instance,


loans to Thai corporations from international banks had doubled from 1988 to 1994, with half of the debt being short-term loans falling due within 1 year.

Southeast Asian countries export a large variety of manufactured goods, from automobiles to computer chips, steel, and textiles. When the economic crisis hit, foreign investors fl ed with their capital. This led to a tightening of domestic spending, falling bank rates, and rising unemployment. Thus, the Southeast Asian miracle became a story of tremendous human suffering.

The cause of the economic crisis in Southeast Asia was not due to misaligned exchange rates, or mistaken domestic policy, or lack of transparency in the banking sector, but was rather attributed to a combination of an excessively rapid rise of capital in fl ows and falling global demand for the exports from the region that arose from a global economy changing the market rules.

In 1996, there was a net US$78 billion in fl ow into the region from foreign countries in the form of foreign bank loans and short-term portfolio investments such as stocks. However, in 1997, that had turned into a US$38 billion out fl ow, particu-larly from the countries most hit by the crisis, such as Indonesia, Malaysia, South Korea, Thailand, and the Philippines. According to Jan Kregel, an economist, by the end of 1997, the Southeast Asian economies suffered “the equivalents of a massive bank run on the region without any lender of last resort” (Miller 1998 ) .

This sudden fall of the Southeast Asian economies caused many companies in Thailand and Indonesia to be on the receiving end. Besides, both countries had to undergo austerity measures administered by the IMF in return for emergency loans to help repay some foreign debts. Malaysia chose to independently take similar austerity measures.

The IMF’s short-term economic prescriptions have, regretfully, failed to deliver in Asia. The higher interest rates imposed under the IMF plans have choked busi-nesses, and budgets cuts have de fl ated economies. The plan, which seemed virtuous and good in the long run, hardly helped the countries recover from the crisis (Spaeth and Colmey 1998 ) . Kalderimis ( 2004 ) argued that even though the Asian fi nancial crisis had given the IMF a legitimate interest in their operation related to the inter-national monetary system, the legitimate interest does not equate to a power to regu-late. He argued that the reform failed because the IMF had fractured the incipient democracy of the developing countries and plunged the countries into chaos.

3.2 Malaysia’s Response to Its Financial Crisis

In September 1998, former Malaysian prime minister Tun Dr. Mahathir bin Mohamad announced a new economic program meant to stop the outside world from controlling the movement of the national currency, the ringgit. Subsequently, the Malaysian government announced that all ringgits held outside Malaysia had to be returned, which meant that ringgit trading would be done entirely within the country’s own borders. Foreigners were no longer allowed to sell stocks and repatriate funds unless 1 year has passed since the time of purchase. Thus, the ringgit was of fi cially fi xed at an exchange rate of RM 3.8 to the US dollar. According to Mahathir, this plan was meant


to isolate Malaysia’s economy from the international currency speculators and traders whom he blamed for causing the country’s economic crisis. After the announcement, Malaysia’s stock prices fell steeply but the value of the ringgit remained steady.

Mahathir’s strategy was supported by the well-known economist and Nobel laureate Paul Krugman, who endorsed the concept of capital controls as it allowed Malaysian authorities to lower interest rates to counteract the recession without causing the ringgit to collapse. A strong reason to formalize the controls was that the international community had continued to be very reluctant to declare currency trading an illegal activity. Even though the experts at international fi nancial institutions were aware that currency speculation might cause potential harm to the economy of a weaker country, they had chosen to allow the speculation of currency, claiming that it was part and parcel of a free market economy.

Malaysia imposed currency controls because it felt that adopting the IMF formula of raising interest rates and shutting off lending would only worsen and prolong the impact of the crisis. The strategy of currency controls was aimed essentially at elimi-nating offshore trading of the Malaysian ringgit, especially in the Singapore foreign exchange market.

According to former Prime Minister Mahathir, implementation of the monetary policy control was done to ensure the safety of the Malaysian economy and to help Malaysia recover from the economic crisis. The measure discouraged short-term capital fl ows by obliging investors to keep their capital in the country for at least 1 year to allow Malaysia to better adjust to the global fi nancial system.

Dani Rodrik and Ethan Kaplan of Harvard University in an article titled “Did the Malaysian capital controls work?” compared Malaysia’s capital controls with those of South Korea and Thailand, when these two countries were undergoing their IMF programs, with assumptions that changes in the external environment were allowed. They concluded that the Malaysian capital controls led to a faster economic recovery, with smaller declines in employment and wages, and a better turnaround in the stock market. In their analysis, Rodrik and Kaplan pointed out that some of the more pessimistic predictions about the consequences of capital controls were not correct, as it became clear that Malaysia was recovering from the economic crisis, unlike South Korea and Thailand, where interest rates had fallen to single digit, whereas offshore ringgit deposits were paying rates in the range of 20–40% ( Business Times , February 19 2001 ) . In addition, South Korea and Thailand—both of which received fi nancial assistance from the IMF and other multilateral institutions—were subjected to very strict structural reforms. Interest rates in these two countries had to be raised, and their fi scal policies were tightened. The fi nancial markets in South Korea and Thailand had to be opened to foreigners and local banks and fi nancial institutions, whereas those in deep fi nancial trouble had to be closed.

In response to the crisis, Mahathir had to cancel a few “mega” projects, among which had been a plan for a bridge linking Malaysia and Indonesia as well as the massive and controversial Bakun dam project in Sarawak. In the meantime, a group of Malaysian companies launched a global public relations campaign to win back foreign investors’ con fi dence and push up the Kuala Lumpur stock exchange composite index.

As part of the recovery package, Malaysia has incorporated an asset management company known as Danaharta to purchase loans from fi nancial institutions with


the purpose of recapitalizing its banking sector, and a Corporate Debt Restructuring Committee to help companies resolve their debts without intervention from the courts.

Some of the less informed investors were concerned about the Malaysian government’s unorthodox policies as they had an impression that currency controls would limit the movement of their capital and pro fi ts. However, this was not the case, as explained by the United Nations Conference on Trade and Development expert Jan Kregel, who maintained that Malaysia’s move was aimed essentially at eliminating offshore trading of the ringgit, especially in the Singapore foreign exchange market, and, in actual fact, formalizing the controls would help remove the concerns of the investors (Business Times , September 21 2000 ) .

3.3 Economic Recovery Without IMF Loans

Kregel agreed with Malaysia’s selective capital controls programs, as the model has proved successful in protecting the Malaysian economy. He has further elaborated that the measure has allowed Malaysia to incur much lower costs than many of its neighbors in adjusting to the new environment. A fi rm con fi rmation of the validity of the measures came in September 1999, when capital controls were lifted, with only RM 5.2 billion of funds leaving the country ( Business Times , September 22 2000 ) .

The crisis is a story of a market failure. Stanley Fischer, the economic director of the IMF, admitted at a regional meeting in Hong Kong that markets are not always right as sometimes the in fl ows are excessive and sometimes they may not be sustained for too long, and the market sometimes tends to react too late (Miller 1998 ) .

Southeast Asian capital markets failed in three critical ways. Firstly, there was too much capital in fl ow owing to the prospect of continued double-digit growth. In the search for new places to invest, fi nancial capital continued to fl ow into the real-estate sectors even when fi nancial instability was widespread and obvious. Secondly, the capital markets and the banking system failed to convert the funds into a more productive use. Too little money had been spent on productive invest-ments that could sustain the export boom. Instead, a lot of money had been pumped into the real estate sector. Thirdly, too much capital rushed out owing to the excessive in fl ow of capital earlier on.

Malaysia’s unconventional methods of tackling the fi nancial crisis have by now been accepted by a number of experts. Besides, the measures proved that different countries might require different policies. Kalderimis ( 2004 ) stated that IMF condi-tionality is a fl awed regulatory measurement and should not be permitted to entrench itself as a part of a new investment framework.

4 The Asian Financial Crisis: Lessons Learned

Researchers have proposed it is important to examine the turnaround strategy after a fi nancial crisis (Schendel et al. 1976 ; Hofer 1980 ) , whereas others have postulated that studies should be conducted to investigate the survival of fi rms during the period


of economic recession (Pearce and Michael 1997 ) . It is plausible to note that Asian countries were more able to deal with the fi nancial crisis owing to the better state of the domestic fi nancial systems and their international payments positions coupled with their expansionary monetary and fi scal policies (Willett 2010 ) . The followings are plans which are categorized into several major sections focusing on the lessons learned for developing and emerging market countries such as Malaysia.

4.1 Consolidating the Financial System

Many countries realized that as a result of the fi nancial crisis, it is vital to introduce preventive and extraordinary measures to restore con fi dence in the fi nancial system. Generally, the public were not aware of their deposit protection and the importance of a deposit protection arrangement before the fi nancial crisis and hence this resulted in many losing con fi dence with the fi nancial system of the country. Hence, it is suggested to implement new regulatory measures to improve the surveillance of control systems in fi nancial and credit transactions and to reduce speculation in stock markets to regain the con fi dence of the public.

4.2 Reporting of Accounting System

Studies (e.g., Campbell et al. 2009 ) have noted that many authorities were unable to respond to the fi nancial crisis as there were no suitable preventive tools. Hence, policymakers should plan ahead by assessing the present state of legal, prudential regulatory, and especially accounting and disclosure regimes. It is suggested that a separate and independent entity should be established within the fi nancial system to monitor fi nancial institutions and to guard and to protect the interests of depositors. Currently, the suggested independent body is lacking in many Asian courtiers.

4.3 Financial Literacy

The public are generally unaware of the risks that they are facing and the protection they have. The Asian fi nancial crisis has instilled fear in the public as they are afraid to suffer losses again (Dobson 2008 ) . The government has a major role to play in regaining the con fi dence of the public by creating awareness, which plays a crucial part in reinforcing the stability of the fi nancial system. It is important for the public to be fully aware of and understand the risks and protection in order to prepare the public to coordinate with the government at a time of a crisis. The government should be transparent and inform the public about the fi nancial situation and make the public aware of their roles in helping the country to survive the crisis.


4.4 Coordination

Studies have indicated that the differences between individuals and the aggregate interest of fi nancial system could have brought unequal gain and destruction to the fi nancial system. There is a need to investigate the incentives of individuals, and consideration of how they aggregate is one of the economic approaches to social policy and to reform the fi nancial system (Rajan 2010 ) . It was further suggested that this can be done in a political economy context as political pressures will have the capability to in fl uence the practicality of institutional arrangements.

5 Case Study: Impacts of the Asian Financial Crisis on Employees in the Banking Sector

As discussed earlier, one of the main implications of the Asian fi nancial crisis is the increase of unemployment in all countries affected by this crisis. The crisis inevitably caused contraction of GDP, which resulted in retardation of employment growth in Malaysia. Employment growth was steady at 4.9 and 4.6% in 1996 and 1997, respec-tively. However, it contracted by 3% in 1998 (Mohamed and Syarisa Yanti 1999 ) .

The unemployment rate in the country increased from 2.6% in 1997 to over 5% in 1998 (Cheng and Hossain 2001 ) . From Table 8.4 , a total of 83,865 workers were retrenched. This number is a sharp increase from the 19,000 retrenched in 1997. At the same time, the in fl ation rate reached a high of 6.2% in June 1998, before moderating (Mohamed and Syarisa Yanti 1999 ) . It is important to note that some 11% of workers

Table 8.4 Retrenchment of workers according to sector, 1996–1998

Year Total Change (%)

1996 7,773 1997 18,863 143 1998 83,865 345 1998 Agriculture 5,108 6.1 Mining 877 1.1 Manufacturing 45,151 53.8 Construction 9,334 11.1 Electricity, gas, and water 1 0.0 Transportation and communications 2,007 2.4 Wholesale, retail, hotels, and restaurants 10,434 12.4 Financial, insurance, real-estate, and business services 6,596 7.9 Social services 4,242 5.1 Others 115 0.1 Total 83,865 100.0

Source: Norinah ( 2004 )


(or 8,966 workers) were foreign workers (Norinah 2004 ) . The highest retrenchment recorded was in the manufacturing sector, 45,151 workers (this fi gure represents a change of 53.8% as compared with the previous year). This is followed by the wholesale, retail, hotel, and restaurant sector, with 10,343 workers retrenched.

The construction sector recorded retrenchment of 9,334 workers, and 6,596 workers were retrenched in the fi nancial, insurance, real-estate and business service sector. This is an about 7.9% change from the previous year. The decline in the construction sector was mainly due to the government’s postponement of the imple-mentation of several projects to reduce pressure on government de fi cits (Cheng and Hossain 2001 ) .

According to Cheng and Hossain ( 2001 ) , 43,838 workers were retrenched from the start of the crisis in 1997 to the middle of May 1998. In total, 30,152 workers lost their jobs in the fi rst 5 months of 1998. Retrenchment during this period was mainly the result of a sharp slowdown and reduction in production activity and the bank-ruptcies of some fi rms.

With regard to the evolution of the Malaysian banking sector, in the 1960s, Malaysia witnessed the development of strong domestic commercial banks and the widespread branching of banking services. In the 1970s, despite the breakdown of the fi nancial system, Malaysia’s banking sector grew stronger. However, in the 1980s, the fi nancial system faced great challenges owing to the severe global reces-sion in 1985 and 1986.

With regard to banking legislation, commercial banks were governed by Banking Ordinance 1958, later known as Banking Act 1973 and then Banking and Financial Institution Acts (1989), which came into existence on October 1, 1989 (Poon 2002 ) .

Before the crisis, there were 55 banking institutions, consisting of 20 com-mercial banks, 23 fi nance companies, and 12 merchant banks. After the crises, the government proposed mergers of these institutions into ten big banking groups. For example, Maybank merged with medium-sized Phileo Allied Bank, Mayban Finance, Aseambankers Malaysia, Paci fi c Bank, Kewangan Bersatu, and Sime Finance (Poon 2002 ) .

After restructuring and consolidation, the banking sector has continued to contribute to the nation’s economic growth.

In terms of employment, there were 240,500 jobs in the banking sector 2002. The number of job decreased in 2004 to 236,100. Then it increased gradually to 242,300 in 2006 (Table 8.5 ).

In terms of the share of total employment, the banking sector employment accounted for 0.025% in 2002 and 0.023% in 2004,with a slight increase to 0.024% in 2006 (Table 8.5 ).

Table 8.5 Employment in fi nancial intermediaries, 2002–2006

2002 2004 2006

Number of jobs (1,000) 240.5 236.1 242.3 Share of total employment (%) 0.025 0.023 0.024



There is little doubt that trade unions have played an important role in the banking sector. According to McConnell et al. ( 2009 ) , the role of a trade union is to represent, protect, and enhance the interests of workers. A trade union collectively bargains with an employer to seek better employment terms.

Particularly, trade unions play an important role in mitigating the negative impact of economic crises wit regard to employment. For example, trade unions may oppose massive layoffs on behalf of workers or trade unions may voice concerns regarding pay cuts during economic crises. In other words, trade unions make efforts to set wages above market clearance wages. Although this bene fi ts employees, it has a negative effect on employers, especially in terms of reduced pro fi t for the employer. A higher wage rate also creates wait unemployment. At a higher wage rate, an individual will remain unemployed with the hope of being recalled to a higher-paying job (McConnell et al. 2009 ). 1

There are various employment protection legislations (EPL) in Malaysia. According to Garibaldi ( 2006 ), EPL is one of the most important institutions of the labor market. It refers to a set of norms and procedures to be followed in the case of dismissal of redundant workers. EPL forces employers to fi nancially compensate a worker in the case of early termination of a permanent contract.

EPL is aimed at protected the rights of workers, promoting procedural justice at the workplace. Essentially during the economic crises, EPL can play an important role in preventing unnecessary layoffs or excessive destruction of jobs and pay cuts for employees. There are two types of job destruction; consensual and nonconsen-sual separation (Garibaldi 2006 ). During economic crises, EPL prevents noncon-sensual separation.

On the other hand, EPL can cause some economic problems in the labor market. If EPL is stringent, there could be job hoarding. Labor hoarding is de fi ned as a situation in which a fi rm hires a given quantity of labor even though the current marginal pro fi t associated with such labor is negative. In an imperfect labor market, labor hoarding is a common phenomenon (Garibaldi 2006 ). 2

During economic crises, there is intensi fi ed con fl ict between the employer and employees. To mitigate con fl icts of interest, the company needs to implement proper industrial relations practice. In order words, the employer should listen to employees. 3

What was the reason for the loss of jobs in the banking sector then? As a result of the crisis, the banking sector in Malaysia began to experience an increase in the number of nonperforming loans. This increase in the number of nonperforming loans in the banking and fi nancial sector was re fl ected in a sharp downturn in borrowing and fi nancing, bringing about tight liquidity conditions. This situation forced the banking sector to look for an alternative solution in order to maintain the sustainability of the banks.

1 For a more detailed discussion about role of unions in the Malaysia context, see Todd and Peetz ( 2001 ) . 2 For a more detailed discussion of EPL in Malaysia, see Suhanah ( 2002 ) . 3 For a more detailed discussion of industrial relations in Malaysia, see Todd et al. ( 2004 ) and Parasuraman ( 2003 ).


5.1 Trade Union Strategies from the Malaysia Perspective

For trade unions in Malaysia, the strategies will be different because the trade union movement does not always have a good rapport with the government. Malaysian trade unions were still struggling to achieve some goals for the workers (Parasuraman 2003, 2004, 2006, 2007 ; Satrya and Parasuraman 2009 ) . The following are the strategies indicated based on the primary data collection by canvassing the question-naire among employees : (a) training, (b) organizing, (c) tripartisanism, (d) lobbying, (e) coalition with NGOs, (f) working with international trade unions, (g) labor laws and other laws concerning workers.

(a) Training . Malaysian workers are not fortunate in terms of training. Nevertheless, training is vital for upgrading and acquiring skills for workers. Trade unions negotiating for this provision to be included in the collective bargaining. However, the rate of success is very low, thus forcing unions to look elsewhere to train their members. For example, unions in the banking sector provided a huge amount of their budget for training of their members. Unions such as the National Union of Banking Employees (NUBE), Sabah Banking Employees’ Union (SBEU), and Sarawak Banking Employees’ Union (SBEU) have their own training centers and conduct various training to equip their members with knowledge and improve their knowledge not only of trade union and labor matters but also of personal development such as leadership. The Malaysian Trade Union Congress (MTUC), 4 which is the national union, also provides training courses for trade union members at various stages. However, those courses and training costs are paid by the union and there is no assistance from the government. The trade unions in Malaysia also strongly believe that through training and education, workers will be able to better position themselves when there are necessary changes in their employment, such as introduction of new technologies, redesigning jobs, and outsourcing.

(b) Organizing . Organizing is an important issue as trade unions are continuously struggling to increase the rate of organized workers in the country. During the fi nancial crisis in 1997, almost all trade unions in Malaysia lost quite a large number of their members. For example, banking unions lost a huge number of members as a result of mergers, acquisitions, and outsourcing by the banks. Employees in the outsourced company (i.e., the one that is doing the bank’s work) are not allowed to join the bank’s union. Trade unions in Malaysia are determined to expand their recruitment by providing assistance to those employees working in the outsourced company. Trade unions in the banking sector are also amending their unions’ constitution to cater for them. Another strategy that is in place is the formation of a federation of all banking unions in Malaysia with the purpose of working together to tackle the worst to come in the banking sector in Malaysia.

4 This represents the public and private sector and also represents workers in the International Labor Organization (ILO).


(c) Tripartisanism . Although tripartisanism in Malaysia is still weak, the platform that is already in place is needed as this is the only alternative that the trade unions had to voice out issues affecting workers. The government recognized trade unions in a number of representations in tripartite bodies such as National Labour Advisory Council (NLAC), the Minimum Wages Council, the Social Security Act (SOCSO), and the Employees’ Provident Fund (EPF). At the NLAC meeting, decisions concerning labor policy are discussed, such as the formulation of policy for minimum wages, retrenchment, social security, etc.

(d) Lobbying . Lobbying of various organizations, including the government, is important as an alternative for unions to push forward their agenda. This mecha-nism proved successful on a number of occasions. For example, SBEU was confronted in a harsh way when local banks closed their branches and many of the employees were left without any alternative but to be retrenched. SBEU made an aggressive move to lobby the government and other NGOs to support the union to stop the banks from closing the branches or otherwise to fi nd alternatives for the employees. The move proved successful when the govern-ment took side with the union and intervened. Thus, lobbying is a tool that is useful for certain purposes.

(e) Coalition with other NGOs . Malaysian trade unions believe in coalition with other organizations, such as NGOs, for common purposes. For example, MTUC has worked with Tenganita 5 to provide assistance to and protection of migrant workers who are facing problems with local authorities such as the immigration authority and the police and also with their employer. Coalitions with other organizations are important as they can help unions interact, share information, and build strong networks with them.

(f) Working with international trade unions . Malaysian trade unions like those in Singapore are maintaining relationships and working with other trade unions at the international level. MTUC is af fi liated with the International Trade Union Confederation (ITUC), and this af fi liation has bene fi ted the MTUC in various aspects, such as providing funds for training and providing comprehensive information about labor movements. Other unions, such as unions in the bank-ing sector, are af fi liated with a global union federation, namely, Union Network International (UNI). With this af fi liation, the union has the privilege of receiv-ing information, solidarity support, training, etc. UNI has a special section for the fi nancial sector just to look after the affairs of the fi nancial sector unions. The latest information about banks and fi nancial developments can be obtained from UNI and this has greatly helped unions to prepare better for future crises.

(g) Labor laws and other laws concerning workers . Under the leadership of MTUC, the unions are struggling to push to amend certain provisions in the labor laws in Malaysia. One important issue is the Trade Union Act. Under the Trade Union Act, there is a strict provision to limit the scope of recruitment. This has made the trade union movement in Malaysia small and fragmented. The Trade

5 Tenaganita is an NGO for protecting and providing assistance to migrant workers in Malaysia.


Union Act requires the formation of a trade union must be based on a similar industry or similar occupations. Besides, the director general of the trade union also has unlimited power to approve the registration of the union. Thus, amend-ment of the Trade Union Act could provide new hope for organizing and enlargement of the trade union movement in Malaysia. This will also give hope for the rati fi cation of the ILO Convention of Freedom of Association.

Banking unions in Malaysia are putting in place a strategy to monitor the develop-ment of the fi nancial sector in the country. The unions’ strategy is to seek collabora-tion with the corporate social responsibility (CSR) rating agencies. In Europe, UNI has worked intensively with trade unions from the fi nancial sector and also with the CSR rating agencies to monitor the development of the banking and fi nancial sector. Why CSR rating agencies? CSR rating agencies are independent rating agencies that conduct research and evaluation for companies that are potentially interested in investing in banks and fi nancial institutions. On the basis of the research conducted by UNI, CSR rating agencies such as VIGEO Group provide ethical investment research including the social, environmental, and ethical performance of companies and also include core labor standards in their assessment. Hence, working with the CSR rating agencies (in Malaysia, the CSR rating agency is OWW Consulting, which is partner of the VIGEO Group), the union can bene fi t as this is a way to mitigate the reputation risks for a sustainable fi nancial industry in ASEAN countries. The union also can build and strengthen the monitoring mecha-nism in the fi nancial sector.

The second strategy rests more on the inclusion of labor standards or social clauses in trade agreements. For inclusion of labor standards or social clauses in trade agreements, MTUC and the National Trades Union Congress (NTUC), which are members of the ASEAN Trade Union Council (ATUC) 6 have joined together to campaign and push for the inclusion of labor standards in all ASEAN trade agreements. The central reason for the campaign is the concern that, given the serious problem of lack of respect for ILO standards around the world, increased trade and investment risk have negative effects on workers’ rights. On the other hand, MTUC particularly strongly demanded the labor rights clause or social clause be included in the trade agreement for the reasons given below:

1. Fight for job security and employees’ rights in a situation of mergers, acquisi-tions, and consolidation, in the outsourcing of work and services, deregulation and other factors affecting jobs

2. To adhere to CSR by observing labor rights and labor laws and sitting down with the union to thrash out personal as well as competition and productivity issues to avoid a race to the bottom.

3. Demand the government and corporations respect the political and labor rights of workers and citizens, ratify the fundamental ILO convention and recommen-dation for core labor standards (i.e., Freedom of Association)

6 The members are from Malaysia, Singapore, the Philippines, Thailand, Indonesia, Vietnam, Laos, and Cambodia.


4. Social protection in support of workers and disadvantaged sectors, especially displaced workers

MTUC also joined with other NGOs such as the Third Word Organization, a consumer association, to intensify the campaign on the inclusion of the social clause and labor rights in any trade agreement. At the ASEAN level, ATUC has formulated the ASEAN Social Charter. 7 The ASEAN Social Charter is a proposed bill of rights for ASEAN workers. It contains the commitment of ASEAN to:

1. Recognize the universal core labor rights, namely, freedom of association and collective bargaining, nondiscrimination at work, prohibition of forced labor, and elimination of extreme forms of child labor

2. Extend social protection and safety nets to displaced workers and other vulnerable segments of society, especially in the course of corporate restructuring and regional and global integration

3. Give unions a voice on how the regional and global integration process shall proceed

The ASEAN Social Charter is in line with the global trend, where free-trade incorporators are made to recognize labor rights as part of economic integration agreements. Thus, in the North American Free Trade Agreement (NAFTA), a side agreement called the North American Agreement on Labor Corporation (NAALC) was made requiring the USA, Canada, and Mexico to enforce minimum labor standards.

The ideal is to approximate the Social Charter of the European Union, which has formally recognized the core labor rights as well as other workers’ rights, such as freedom of movement, right to vocational training, protection of elderly persons, right to social protection, right to employment and remuneration, and the right to safety and health at the workplace. In addition, the European Union has acknowledged the right of workers to information, consultation, and participation. Through the European Social Directive, European Union unions are able to negotiate framework agreements with transnational corporations operating in two or more European Union countries and form European works councils, where the affected unions are given a say on certain personnel and labor policies.

But whatever shape or form of the ASEAN Social Charter is acceptable to ASEAN governments, the most important thing is that unions in the region—through their national unions, the global union federations, and solidarity networks—are recog-nized. They should be given the opportunity to hold dialogues with ASEAN and its varied instrumentalities on broad social and labor issues related to regional inte-gration, in particular, and economic globalization, in general.

In conclusion, a variety of trade union strategies have been discussed, and although they may differ from country to country, there is still a similarity. Trade unions

7 For ASEAN unions in the campaign for the ASEAN Social Charter, in the struggle for jobs and justice under regional and global integration, see http://www.aseantuc.org/index.htm .

http://www.aseantuc.org/index.htm


use approaches at the local level, the national level, and the international level. Training, organizing, tripartisanism, coalition with other social movements, i.e., NGOs, and coalition with international trade unions are the same form of strategies although the application and implementation are different.

The government, on the other hand, constantly encouraged the banking sector to merge and consolidate for the reason that the bigger the banks and their capitaliza-tion, the more stable they become. The 58 fi nancial institutions, with a total of 2,712 branches in the whole country, were to merge into six “super banks.” This was later expanded to eight and subsequently to ten “anchor banks,” in recognition of the fact that some banks cannot blend with others. Although foreign banks and fi nancial institutions were not bound by the move, they also opted to consolidate their banking system in the same way the local fi nancial institution opted to do so. Besides mergers and acquisitions, the banks also embarked on downsizing, lean-trimming, organiza-tional changes, and the introduction of new technologies.

Fortunately, almost all workers in the banking sector were unionized. Their terms and conditions of work are stated in the collective agreement and this had made it dif fi cult for the banks to reduce the workforce as they like. Other industries such as manufacturing, in response to the fi nancial crisis, resorted to reducing the wages of their employees by 15–20%, citing that this is the only way to save the company from closing and to save job. In extreme cases, many companies fi nally resorted to retrenchment.

What approach then did the banking sector in Malaysia take to reduce the excess of workers due to mergers, acquisitions, outsourcing, organizational changes, and the introduction of new technologies? The banks on approval from the Bank Negara Malaysia offered a scheme called a “voluntary separation scheme.” This scheme was negotiated at a high level between the banks and the banking unions in Malaysia. Bank employees were paid compensation according to the rate agreed.

What was the impact for the retrenched workers? As mentioned earlier, in addition to the existing poor, there is a new group of urban poor. Almost all the retrenched employees from the banking sector came from the cities and they became the urban poor as soon as they lost their jobs. In Malaysia, there is no social safety net to help workers who have lost their jobs. Urban families are experiencing the worst impact owing to the increased cost of living, including the cost of food, household necessities, health care, tertiary education, and transportation (Mohamed and Syarisa Yanti 1999 ) . It is noticeable that most of the banking employees who have been displaced are of an older age and this has create a problem for them to get a new job. Other impacts include no opportunity for jobs and limited opportuni-ties for training for a new skill.

On the other hand, those left behind and still working for the bank are not spared from the effect of the whole restructuring of the banking sector. There is increasing pressure from the job as they have to perform many tasks, results are oriented on selling, overtime is not allowed, there is a lack of training when new technology is introduced, jobs have been redesignated, resulting in them having more respon-sibilities without further compensation, and they have been forced to give up their union membership.


6 Conclusion

The Asian fi nancial crisis created havoc for countries such as Thailand, Indonesia, and South Korea, where these countries sought assistance from the IMF to save their country’s economies. However, Malaysia took a different step to its economy by refusing the IMF package and adopted a stricter fi nancial adjustment. What is important here is how the crisis affected the majority of people, which is the workers.

Many workers lost their jobs because of the closure of many businesses (manu-facturing, construction, etc.), mergers and acquisitions and other forms of reducing the workforce in order to save costs. The unemployment rate in the country increased from 2.6% in 1997 to over 5% in 1998. In the fi nancial, insurance, real-estate and business service sector, a 6,596 workers were retrenched.

As a result of the crisis, the banking sector in Malaysia began to experience increasing numbers of nonperforming loans, bringing about tight liquidity condi-tions. This situation resulted in the banks being forced into merger and consolida-tion exercises by the government. Besides mergers and acquisitions, the banks also embarked on downsizing, lean-trimming, organizational changes, and introduction of new technologies.

The banking sector then offered a “voluntary separation scheme” to reduce the excess of workers due to the merger and consolidation exercise. Bank employees were paid compensation according to the rate agreed. However, these retrenched workers faced dif fi culties as there is no safety net and there is a lack of new job opportunities. With the high cost of living and no income, this group of people has created a new form of poor called the urban poor beside the existing poor.

As an implication of the study, the fi ndings reported in this chapter suggest that during an economic crisis there is intense con fl ict of interest between employers and employees. Therefore, the management of the company should come up with a better industrial relations system and the government should take measures to prevent con fl ict between the employer and employees. Trade unions should represent workers’ interests but not to the extent of harming the employers.

References

Baig, T., & Goldfajn, I. (1999, June). Financial market contagion in the Asian crisis. IMF Staff Papers, 46 (2), 167–195.

Bird, G., & Rajan, R. (2000). Banks, fi nancial liberalization and fi nancial crises in emerging mar-kets . http://www.freewebs.com/rrajan01/liberalfull.pdf . Accessed 27 July 2008.

Campbell, A., LaBrosse, J. R., Mayes, D. G., & Singh, D. (2009). A new standard for deposit insurance and government guarantees after the crisis. Journal of Financial Regulation and Compliance, 17 (3), 210–239.

Capital controls produce faster economic recovery. Business Times , February 19, 2001. Cheng, Ming-Yu, & Hossain, S. (2001). Malaysia and the Asian Turmoil. Asian-Paci fi c Law &

Policy Journal, 2 , 125–140.

http://www.freewebs.com/rrajan01/liberalfull.pdf


D’Arista, J., & Grif fi th-Jones, S. (2001). The boom of portfolio fl ows to ‘emerging market’ and its regulatory implication. In S. Grif fi th-Jones, M. Montes, & A. Nasution (Eds.), Short-term capital fl ows and economic crises . New York: Oxford University Press.

Dobson, W. (2008). Delivering change. Together. In B. Eichengreen & R. Baldwin (Eds.), What G20 leaders must do to stabilize our economy and fi x the fi nancial system. London: A VoxEU.org publication, Centre for Economic Policy Research.

Formalize KL’s measures, UNCTAD expert suggests. Business Times , September 21, 2000. Garibaldi, P. (2006). Personnel economics in imperfect labour markets. UK: Oxford Press. Goldstein, M. (1998). The Asian fi nancial crisis: Causes, cures, and systemic implications .

Washington, DC: Institute for International Economics. Goldstein, M. (2001). The Asian fi nancial crisis: Origins, policy prescriptions and lessons. Journal

of African Economics, 10 , 72–103. Grenville, S. (2000). Capital fl ows and crises. In G. Noble & J. Ravenhill (Eds.), The Asian

fi nancial crisis and the architecture of global fi nance . Beijing: Cambridge University Press. Hofer, C. W. (1980). Turnaround strategies. Journal of Business Strategy, 1 (1), 19–31. In the interest of the vulnerable. Business Times, September 22, 2000. Kalderimis, D. (2004). IMF conditionality as investment regulation: A theoretical analysis. Social

& Legal Studies, 13 (1), 103–131. Kaminsky, G., & Schmukler, L. (2008). Short-run pain, long-run gain: Financial liberalisation

and stock market cycles . Oxford: Oxford University Press. McConnell, C. R., Stanley, B. L., & Macpherson, D. A. (2009). Contemporary labour economics

(9th ed.). Kuala Lumpur: McGraw-Hill. Miller, J. (1998, November/December). Learning from the Southeast Asian Crisis. Dollars & Sense ,

Issue no. 220. Mohamed, Ariff, & Syarisa Yanti, Abu. Bakar. (1999). The Malaysian fi nancial crisis: Economic

impact and recovery prospects. The Developing Economies, XXXVII-4 , 417–438. Montes, F. (2001). The southeast Asian currency crisis . New York: Oxford University Press. Noland, M., Gang, L. L., Robinson, S., & Wang, Z. (1998). Global economic effects of the Asian

currency devaluations . Washington, DC: Institute for International Economics. Norinah, M. A. (2004, August 3–5). Warganegara Asing dan Kemiskinan di Malaysia . Paper presented

in 4th International Malaysian Studies Conference, UKM, Bangi. Parasuraman, B. (2003). Pengurusan Sumber Manusia dan Hubungan Industri: Cabaran dan Isu .

(Human Resource Management and Industrial Relations: Challenges Issues). Petaling Jaya: Prentice Hall.

Parasuraman, B. (2004). Malaysian industrial relations: A critical analysis . Petaling Jaya, Malaysia: Prentice Hall.

Parasuraman, B. (2006). Hubungan Industri di Malaysia: Pendekatan dan Amalan (Industrial relations in Malaysia: Practices and approaches). Kuala Lumpur: Dewan Bahasa dan Pustaka.

Parasuraman, B. (2007) An examination of employee participation in the private sector: Malaysian case studies. Unpublished doctor of philosophy, University of Wollongong, Australia.

Pearce, J. A., & Michael, S. C. (1997). Marketing strategies that make entrepreneurial fi rms recession-resistant. Journal of Business Venturing, 12 (4), 301–314.

Poon, W. C. (2002). Development of Malaysian economy . Kuala Lumpur: Pearson Prentice Hall. Radelet, S., & Sachs, J. (1998). “The onset of the East Asia fi nancial crisis” mimeo . Cambridge:

Harvard Institute for International Development. Radelet, S., & Sachs, J. (2000). The onset of the East Asia currency crisis. In P. Krugman (ed.),

Currency Crises . Chicago: University of Chicago Press. Also available as National Bureau of Economic Research Working Paper.

Rajan, R. (2010). Fault lines: How hidden fractures still threaten the world economy . Princeton: Princeton University Press.

Robson, C. (2002). Real world research (2nd ed.). Oxford: Blackwell. Satrya, A., & Parasuraman, B. (2009, February). The present scenario of Malaysian and Indonesian

industrial relations: Accommodation or con fl ictual. Asian Pro fi le , 37 , 30–45.


Schendel, D., Patton, G. R., & Riggs, J. (1976). Corporate turnaround strategies: A study of pro fi t decline and recovery. Journal of General Management, 3 (3), 3–11.

Spaeth, A., & Colmey, J. (1998). He’s the boss. Time South Paci fi c , Issue 37. Stiglitz, J. (2002). Globalization and its discontent . London: Penguin. Suhanah, S. S. A. (2002). Law and labour market regulations in Malaysia: Beyond the new economic

policy. In S. Cooney, M. R. Lindsey, & Y. Zhu (Eds.), Law and labour market regulation in East Asia . London: Routledge.

Todd, P., & Peetz, D. (2001). Malaysian industrial relations at century’s end: Vision 2020 or a spec-tre of the past. International Journal of Human Resource Management, 12 (8), 1365–1382.

Todd, P., Lansbury, R., & Davis, E. M. (2004). Industrial relations in Malaysia: Some proposals for reform. In Proceedings of the IIRA 5th Asian Regional Congress. Seoul, Korea: Korea Labour Institute.

Wang, J. (2005). Financial liberalization and regulation in East Asia lesson from fi nancial crises and the Chinese experience of controlled liberalization. Paper presented at the international symposium: Law, Culture, and Financial Development May 14, 2005, Shanghai, China.

Willett, T. (2010). Policy focus. Some lessons for economists from the fi nancial crisis. Indian Growth and Development Review, 3 (2), 186–208.


1 Introduction

Over time, with changes in the structure of the economy, economic activities will expand and these structural changes are the prerequisite for development. For the Indian economy, it was in mid 1991 when the process of adjustment and reforms was initiated with greater zeal. The present study analyzes the sources of output growth from 1993–1994 to 2006–2007. The time point falls in the period of the ongoing reforms, and the period since then is long enough to attempt an assessment. The method of demand-side decomposition of output growth within an input–output framework has been utilized. The output growth over the study period has been divided into four components, viz, growth in output due to average growth of fi nal demand, growth in output due to changes in the composition of the fi nal demand, growth in output due to changes in input–output coef fi cients, and growth in output due to interaction of the change in fi nal demand and change in technology.

The fi rst component, i.e., the effect of average growth of fi nal demand, is ana-lyzed in order to reveal how much output in each industry would have changed if all elements of a particular fi nal demand category were growing at the same rate. One can use this component for comparison purposes only in the case of an aggregate change in fi nal demand (i.e., it is not suitable for comparison in the case of the fur-ther disaggregation of fi nal demand category). Guill ( 1979 ) explains that this com-ponent is equivalent to the difference of fi nal expenditure in period t and period zero. The second component of change in fi nal demand, i.e., changes in the compo-sition of fi nal demand, refers to the difference between the actual sectoral fi nal demand element and the sectoral fi nal demand element calculated according to the average growth rate of the related fi nal demand category. Guill ( 1979 ) measures this

K. K. Saxena (*) • S. Singh • R. Arora Department of Humanities and Social Sciences, Indian Institute of Technology , Kanpur , Indiae-mail: [email protected]

Chapter 9 Output Growth in Post Liberalized India: An Input–Output Structural Decomposition Analysis

K. K. Saxena , Sarbjit Singh , and Rahul Arora

180 K.K. Saxena et al.

component by subtracting that vector of fi nal demand of year t which is constructed by distributing the total fi nal demand of year t according to the industrial composition of the fi nal demand in year zero from the actual fi nal demand vector of year t . Thus, this component assumes the assumption of constant technology between two periods. The effects of changes in the composition of fi nal demand categories are analyzed in order to fi nd out how much deviations of actual growth of sectors from the average growth of a particular fi nal demand category have caused structural changes in industrial output. These changes are exogenous to the production system under consideration. Thus, the fi rst effect tells us what would have happened to industrial output if all fi nal demand elements were growing at the average growth rate, whereas the second component explains what actually happened since in actu-ality all fi nal demand elements do not grow at the average growth rate. Both effects assumed that technology remains constant.

The third component of output change measures the effect of a change in tech-nology on output, keeping fi nal demand as constant. In other words, the estimation of this effect reveals how much output in each industry has changed because the input–output coef fi cients have changed. The last component of output change measures the differential effect on industrial output of a change in fi nal demand due to technological change. This component emerges as a residual when the same year weights are used for both the change in fi nal demand and the change in technology components of the total output change and shows the interaction effect of the change in fi nal demand and the change in technology on output change. Venkatramaiah et al. ( 1984 ) de fi ne this component as the measuring rod of the differential effect on industrial output of technological change due to a change in the fi nal demand.

To calculate the share of every component in the change in output growth in a postliberalization period, the present study has been divided into four sections, including the present introductory one. In Sect. 2 , the sources for database utilized and the method of converting raw data into the information form for analysis purposes is presented. The detailed methodology to estimate the percentage shares of different sources of output growth are also discussed in that section. The empiri-cal results are presented and discussed in Sect. 3 . Section 4 concludes the whole study and provides some noteworthy policy implications.

2 Database and Methodology

For calculation of the sources of output growth over the study period (1993–1994 to 2006–2007), the absorption matrices (commodity by industry matrix represent-ing input fl ows) of both the initial and the fi nal years provided by the Central Statistical Organization (CSO), New Delhi, have been utilized. These matrices pro-vide the detailed input fl ow among each sector of the economy. For 1993–1994, data were provided for 115 sectors, whereas for 2006–2007, 15 more sectors were added, which increased the total number of sectors to 130. For the purpose of the study, the input–output tables have been adjusted to aggregate the whole economy into 40 sectors (see Table A14 in the Appendix for details). To neutralize the effect

1819 Output Growth in Post Liberalized India: An Input–Output Structural…

of change in prices, the values in the input–output table for 1993–1994 has been in fl ated to 2006–2007 prices. Hence, all the variables are measured at t year prices (i.e., at 2006–2007 prices).

To fi nd out the sources of output growth in the postliberalization era, four components of output change were calculated. The four components are as follows: increase in output due to average growth of fi nal demand, increase in output due to changes in the composition of fi nal demand, increase in output due to changes in input–output coef fi cients, and increase in output due to interaction of the change in fi nal demand and the change in technology. The present study has utilized the modi fi ed method of calculating the sources of output growth between two periods as used by Dhawan ( 1993 ) . In her doctoral thesis, she modi fi ed the Forssell ( 1998 ) method of calculating the sources of output growth by adding the interaction term. The detailed description of four components of output growth is presented in Table 9.1 . In Table 9.1 , Eq . 9.1 represents the value of output in the current year and Eq. 9.6 , represents the value of output in the fi nal year. The other equations (i.e., Eqs. 9.2 , 9.3 , 9.4 , and 9.5 ) represent the four major components of output growth.

One can also measure the contribution of separate demand factors such as private consumption, government consumption, gross investment, exports, and imports to output growth between the initial and the fi nal year by using the following equation derived from Table 9.1 :

( ) ( ) ( ) ( ) ( )( ) ( ) ( ) ( ) ( )( ) ( ) ( ) ( ) ( )( ) ( ) ( ) ( ) ( )( ) ( ) ( ) ( ) ( )

d P d PL + d PC + d PT + d PB

d G d GL + d GC + d GT + d GB

d I d IL + d IC + d IT + d IB

d E d EL + d EC + d ET + d EB

d M d ML + d MC + d MT + d MB

X X X X X

X X X X X

X X X X X

X X X X X

X X X X X

ü=ï

= ïï= ýï= ïï= þ

(9.7)

It separates certain components and in this way it helps us to understand better that what has happened in the economy. The identities measure the total individual effect of a fi nal demand category on the total output change. The following four steps were followed to calculate the share of the four components in the change in output from the initial year to the fi nal year:

1. The values in both tables were converted into the same base year. 2. The technology coef fi cient matrix was calculated for the Leontief inverse (R). 3. The average growth rate of the different categories of fi nal demand was calculated

by using the following formula:

= =

=

-=å å

å

40 40

01 1

P 40

01

,ti i

i i

ii

P Pg

P

(9.8)

where i refers to sector number, and g P stands for the average rate of private

consumption expenditure between the initial year and the fi nal year. The above formula represents the average growth rate of private consumption expenditure


over the years. Also, the averages for other categories were calculated by using the same formula.

4. The four main equations (Eqs. 9.2, 9.3, 9.4 , and 9.5 ) were estimated to fi nd the percentage share of each factor responsible for the output change over the years and to interpret the results accordingly.

Table 9.1 Components of change in industrial output

Value of output in the initial year 0 0 0 0 0 0 0[ ]X R P G I E M= + + + - (9.1)

Increase in output due to average growth of fi nal demand (or change in the level of fi nal demand)

( ) ( )( ) ( )( ) ( )( ) ( )( ) ( )

0 P 0

0 G 0

0 I 0

0 E 0

0 M 0

) PL

) d GL

) d

.

.

.

.

.

IL

) d EL

) d ML

a X R g P

b X R g G

c X R g I

d X R g E

e X R g M

ü=ï

= ïï

= ýï

= ïï- = þ

(9.2)

Increase in output due to changes in the composition of fi nal demand

( ) ( )( ) ( )( ) ( )( ) ( )( ) ( )

0 0 P 0

0 0 G 0

0 0 I 0

0 0 E 0

0 0 M 0

) d PC

) d GC

) d IC

) d EC

) d

.

.

.

.

.MC

t

t

t

t

t

a X R P P g P

b X R G G g G

c X R I I g I

d X R E E g E

e X R M M g M

üé ù= - +ë û ïïé ù= - +ë û ïïé ù= - + ýë ûï

é ù= - + ïë ûï

é ù- = - + ïë û þ

(9.3)

Increase in output due to changes in input–output coef fi cients

( ) ( )( ) ( )( ) ( )( ) ( )( ) ( )

0 0

0 0

0 0

0 0

0 0

) d PT

) d GT

) d IT

) d ET

) d MT

t

t

t

t

t

a X R R P

b X R R G

c X R R I

d X R R E

e X R R M

= -

=

üïïïý

-

= -

= -

- = -

ïïïþ

(9.4)

Increase in output due to interaction of both change in fi nal demand and change in technology

( ) ( )( )( ) ( )( )( ) ( )( )( ) ( )( )( ) ( )( )

0 0

0 0

0 0

0 0

0 0

) d PB

) d GB

) d IB

) d EB

) d MB

t t

t t

t t

t t

t t

a X R R P P

b X R R G G

c X R R I I

d X R R E E

e X R R M M

ü= - -ï

= - - ïï

= - - ýï

= - - ïï- = - - þ

(9.5)

Value of output in the fi nal year [ ]t t t t t t tX R P G I E M= + + + - (9.6)

From Dhawan ( 1993 ) . d X represents the change in output, whereas of the two letters within parentheses , the fi rst one refers to the fi nal demand category, which generates the output change, and the second refers to the component into which such a change is decomposed. X

0 , P

0 , G

0 , I

0 , E

0 ,

and M 0 are the vectors of gross output, private consumption, government consumption, gross

investment, and exports and imports by industries respectively; subscript 0 represents the initial year and subscript t represents the fi nal year. R

0 is the Leontief inverse matrix of input–output

coef fi cients in the initial year and R t is the corresponding matrix for the fi nal year t . g

P , g

G , g

I , g

E ,

and g M

are the average growth rates of private consumption, government consumption, gross investment, and exports and imports between the initial and the fi nal year, respectively


Thus, the change in output is the result of four different effects: the average growth of fi nal demand, changes in the composition of fi nal demand, changes in the input–output coef fi cients, and interaction of changes in the input–output coef fi cients and fi nal demand. The sum total of the values of all the effects should be equal to the total change in output.

Further, each component was divided into fi ve more components, i.e., the growth of private consumption, the growth of government consumption, the growth of gross investment, the growth of exports, and the growth of imports. The fi rst four of these effects have a positive sign and the last effect has a negative sign because imports are a substitute for domestic output as another source of supply. Any growth of imports was evaluated as if it had been a loss to the domestic production. If the growth effect of imports is large enough or the initial number of imported products is greater than the output, the total growth effect may even be negative (Forssell 1998 ) .

3 Empirical Analysis

This section presents the percentage share of each category (among the four sources of output growth presented in Table 9.1 ) in the total change in output in the post-liberalization period. It also shows the contribution of different fi nal demand categories to output growth sectorwise as well as for the economy as a whole.

3.1 Sources of Output Growth

Table 9.2 presents the percentage contribution of the four sources of output growth mentioned in Table 9.1 . In Table 9.2 , columns 2–5 show the estimated values of Eqs. 9.2, 9.3, 9.4 , and 9.5 in Table 9.1 . It directly depicts that the output in the fi nal year (2006–2007) is approximately twice as large as the output in the initial year (1993–1994).

Of this total change in output over the study period, the average growth of the fi nal demand component contributes 88.29%, followed by the interaction component (6.99%), technological change (3.74%) and compositional change (0.98%). This shows that changes in fi nal demand between 1993–1994 and 2006–2007 have a more signi fi cant effect on production levels. In other words, if the distribution of fi nal demand had not changed between 1993–1994 and 2006–2007 and neither had the interindustry relations changed, total output would have increased by 88.29% from its initial level in the 1993–1994 period.

Table 9.2 also presents the sectoral details of change in fi nal demand over the study period. The average growth effect of all the sectors is positive, expect for two sectors—natural gas and crude petroleum (5) and nonferrous basic metals (27).


Table 9.2 Sources of output growth (%): 1993–1994 to 2006–2007

Sector no. Average growth of fi nal demand (1)

Composition of fi nal demand (2)

Technological change (3)

Interaction factor (4)

Total (1 + 2+ 3 + 4)

1 97.62 0.10 1.34 0.94 100 2 107.79 −0.13 −4.24 −3.42 100 3 117.57 0.74 −5.18 −13.12 100 4 173.92 3.61 −26.04 −51.49 100 5 −114.66 1.07 78.16 135.44 100 6 41.20 0.48 19.96 38.36 100 7 121.26 9.96 −9.20 −22.02 100 8 56.15 −0.10 10.91 33.04 100 9 85.34 −0.08 4.35 10.39 100 10 85.54 −0.04 4.19 10.32 100 11 80.72 0.00 12.83 6.45 100 12 113.74 0.04 −5.17 −8.61 100 13 199.65 2.35 −36.74 −65.27 100 14 449.10 10.99 −86.35 −273.74 100 15 124.92 0.12 −8.85 −16.18 100 16 89.87 0.02 1.37 8.75 100 17 83.37 0.32 6.46 9.86 100 18 38.12 0.15 21.55 40.18 100 19 139.81 7.77 −13.89 −33.68 100 20 47.58 0.53 20.89 31.00 100 21 57.32 0.11 24.37 18.20 100 22 95.12 0.76 1.73 2.40 100 23 125.32 2.44 −8.01 −19.75 100 24 25.20 1.57 19.66 53.57 100 25 154.97 7.43 −12.04 −50.36 100 26 109.63 1.78 −4.16 −7.25 100 27 −13.82 0.86 25.43 87.53 100 28 66.33 0.29 9.04 24.34 100 29 116.27 0.01 −3.53 −12.74 100 30 71.12 0.18 7.32 21.38 100 31 110.30 0.23 −3.08 −7.45 100 32 52.50 0.53 18.33 28.64 100 33 86.54 3.08 3.39 6.99 100 34 181.15 1.39 −28.43 −54.11 100 35 114.45 0.74 −5.07 −10.11 100 36 117.43 1.51 −4.38 −14.56 100 37 100.30 0.51 0.18 −1.00 100 38 57.04 0.26 12.82 29.88 100 39 96.09 −2.55 3.22 3.24 100 40 96.03 3.72 0.76 −0.51 100 Total 88.29 0.98 3.74 6.99 100 Increase in output

176.55 1.95 7.48 13.98 199.96


The wood sector (14) registered the highest growth (449.10%) followed by other textile products (13), electricity (34), and cement (25), with growth of 199.65, 181.15, and 154.97%, respectively. However, the effect of compositional change on output growth is not very signi fi cant.

The largest percentage output growth, i.e., in the wood sector (14), over the study period is due to the growing demand for wood and wood products by the com-mercial and private sectors. According to CWC ( 2006 ) , the Indian market for soft lumber and wood building products is estimated to grow at 6% annually, while some other segments, such as wooden furniture, are growing at a much faster rate. In the case of the Indian textile sector (12 and 13), again the domestic demand is the major factor behind the output growth over the period. Moreover, the cement industry (25) has grown owing to overall growth of the Indian economy with increas-ing industrial and construction activities for growing infrastructural facilities. Its per capita consumption increased from 62 kg in 1993–1994 to 136 kg in 2006–2007 (Burange and Yamini 2008 ) . This supports our fi ndings of a large increase in demand for cement over the period of study. Further, the average growth of 181.15% in electricity sector is also supported by the developmental activities of the country. A country can never achieve the goal of economic development without having suf fi cient and good-quality electrical energy. A number of sectors also depend upon the growth of this sector. Even the cement industry uses much electrical energy in the production process.

Further, the effects of technological change over the study period led to an increase in output by 3.74% of the initial output level of 1993–1994. The percent-age change in input–output relations for natural gas and crude petroleum (5) and nonferrous basic metals (27), where the share of average growth of fi nal demand is negative, is larger. The effect of the fourth component, i.e., the interaction factor, is also highest for these two sectors. On the other hand, changes in input–output relations decreased output over the study period noticeably in sectors such as coal and lignite (4), other textile products (13), wood products (14), cement (25), and electricity (34).

3.2 Contribution of Final Demand Categories

In addition to this, the total change in output was divided into fi ve major demand factors, i.e., private consumption expenditure, government consumption expendi-ture, investment expenditure, exports, and imports. Table 9.3 presents the estimated results from Eq. 9.7, and shows that the major portion of the output growth comes from an increase in gross investment (54.01%) and private consumption (51.87%) whereas the contribution of government consumption is merely 2.17%. Further, the contribution from an increase in exports (37.99%) is smaller than the contribution due to an increase in imports (46.04%).


Table 9.3 Contributions (%) of different demand categories

Sector no.

Private consumption expenditure (1)

Government consumption expenditure (2)

Investment expenditure (3) Exports (4) Imports (5)

Total (1 + 2 + 3 + 4 − 5)

1 81.06 1.92 14.03 14.52 11.53 100 2 82.59 2.10 11.96 9.59 6.24 100 3 89.55 0.81 13.70 23.04 27.11 100 4 35.92 3.24 189.87 71.72 200.75 100 5 316.56 16.93 115.82 142.66 491.97 100 6 26.36 2.09 129.37 94.64 152.46 100 7 43.88 0.59 267.38 340.50 552.34 100 8 85.87 1.57 36.30 16.30 40.04 100 9 90.57 2.67 7.90 13.04 14.18 100 10 93.49 1.33 5.45 3.58 3.86 100 11 118.50 0.00 −18.69 1.03 0.85 100 12 47.93 2.79 5.85 53.52 10.10 100 13 62.51 0.25 55.71 21.16 39.63 100 14 64.36 4.32 59.39 87.79 115.87 100 15 56.44 15.32 52.67 41.00 65.43 100 16 81.38 0.64 14.19 33.31 29.53 100 17 47.96 0.81 53.08 46.10 47.94 100 18 72.02 3.92 21.81 29.95 27.70 100 19 27.22 −0.24 169.36 30.82 127.16 100 20 68.74 3.51 68.79 84.47 125.51 100 21 86.98 1.69 8.99 12.15 9.81 100 22 63.18 1.35 50.16 55.03 69.72 100 23 24.68 0.54 94.86 15.68 35.74 100 24 15.39 1.74 121.70 −0.37 38.46 100 25 16.58 −0.60 122.75 7.28 46.01 100 26 14.66 0.11 93.91 32.46 41.14 100 27 58.69 2.71 286.40 131.14 378.94 100 28 24.29 0.92 96.30 33.92 55.44 100 29 6.74 0.19 83.96 11.45 2.34 100 30 24.09 2.81 83.02 26.98 36.89 100 31 21.75 2.12 70.63 32.88 27.37 100 32 51.43 −3.00 197.10 287.63 433.17 100 33 10.36 0.35 91.00 5.05 6.76 100 34 43.11 7.40 67.21 33.39 51.12 100 35 20.19 51.09 28.48 10.61 10.35 100 36 32.84 2.90 64.66 44.59 44.99 100 37 67.11 2.76 26.57 21.95 18.39 100 38 54.18 6.10 43.96 37.96 42.20 100 39 66.23 2.75 24.99 23.57 17.53 100 40 59.80 1.17 23.38 76.12 60.48 100 Total 51.87 2.17 54.01 37.99 46.04 100


3.3 Sectorwise Analysis

Among the 40 sectors, agriculture (1), allied activities (2), forestry and fi shing (3), sugar and related activities (8), food products (9), beverages (10), tobacco products (11), other textile products (13), leather products (16), petroleum (18), fertilizers (21), water supply (35), other transport services (37), communication (38), and trade, hotels, and restau-rants (39) grew mostly because of increases in fi nal consumption expenditure by private households as well as by the government, whereas rubber and plastic products (17), coal tar (19), paints, varnishes, and lacquers (23), nonmetallic mineral products (24), cement (25), iron and steel Industries and foundries (26), metal products and other nonelectrical machines (28), tractors and agricultural implements (29), electrical and electronic equipment (30), transport equipment (31), construction (33), electricity (34), and railway transport services (36) depended on an increase in investment.

Export demand was a relatively important source of output growth for the textiles 1 (12) and other services (40) sectors, whereas the impact of change in imports led to the growth of coal and lignite (4), natural gas and crude petroleum (5), metallic minerals (6), nonmetallic minerals (7), wood products (14), paper products (15), chemicals (20), pesticides and other products (22), nonferrous basic metals (27), and miscellaneous manufacturing (32) sectors over the study period.

4 Conclusion

The present study decomposed the change in output growth in the Indian economy for the postliberalization era (1993–1994 to 2006–2007). To fi nd out the sources of output growth, four components of output change were calculated. Further, the con-tribution of separate demand factors, i.e., private consumption, government con-sumption, gross investment, exports, and imports, to output growth was also calculated to better understand the factors behind output growth.

The overall analysis reveals that it is the average growth of fi nal demand which has the largest share in the change of output growth over the study period. Further, among the fi ve categories of fi nal demand, domestic demand (sum of private consumption, government consumption, and investment expenditure) is the dominant source of out-put growth in the postliberalization era. This shows the strong domestic market base of the Indian economy. It directly shows that the Indian economy is fueled by its domestic market, which might be the reason why the Indian economy was not much affected by the global fi nancial crisis that emerged in 2007. According to United Nations ( 2009 ) , India’s growth of output was 8.9% in 2006–2007 and owing to the emergence of the global fi nancial crisis it was expected that it would come down to 7.5%. This is still a very impressive number representing the growth of a developing country in bad times if we compare it with growth of the economy in good times. This is only due to the strong base of the domestic market in the Indian economy and higher growth of the service sector. Since the Indian economy is demand-driven, the government has to take care of the supply side to control in fl ation, which was quite evident in the recent past.

1 The export share of this sector is signi fi cant as Indian textiles are world-class textiles.


Appendix

Table A1 Total change in output (in 100,000 rupees)

Sector no. Total output in 1993–1994 (1)

Total output in 2006–2007 (2)

Change in total output (2–1)

1 38,500,000 70,400,000 31,900,000 2 12,900,000 23,000,000 10,100,000 3 3,746,964 6,999,548 3,252,584 4 2,433,722 4,636,818 2,203,096 5 1,626,660 5,426,774 3,800,114 6 351,611.7 1,872,513 1,520,901 7 424,336.9 1,887,617 1,463,280 8 1,953,579 4,102,014 2,148,435 9 6,715,383 23,300,000 16,600,000 10 650,895.2 4,918,061 4,267,165 11 1,357,395 2,198,269 840,873.6 12 10,400,000 24,100,000 13,700,000 13 314,023.5 605,489.5 291,466 14 1,593,256 2,206,367 613,110.6 15 2,697,713 5,928,379 3,230,666 16 1,236,356 2,212,585 976,229.6 17 3,026,021 9,532,509 6,506,488 18 3,111,366 28,000,000 24,900,000 19 500,664.5 1,335,984 835,319.3 20 1,585,144 8,117,453 6,532,310 21 1,813,755 4,780,098 2,966,343 22 7,752,156 21,700,000 13,900,000 23 873,792.9 2,656,856 1,783,063 24 1,719,677 6,624,688 4,905,011 25 1,225,405 3,117,847 1,892,441 26 7,116,478 25,900,000 18,800,000 27 1,949,828 5,634,767 3,684,939 28 6,595,555 27,000,000 20,400,000 29 615,391.9 1,965,765 1,350,373 30 4,794,121 37,400,000 32,600,000 31 5,117,218 15,200,000 10,100,000 32 3,568,981 12,100,000 8,534,612 33 18,300,000 90,600,000 72,300,000 34 8,760,921 18,200,000 9,400,574 35 426,088.3 1,107,027 680,938.4 36 3,067,112 8,247,638 5,180,526 37 17,000,000 54,000,000 37,100,000 38 1,931,795 9,749,668 7,817,874 39 27,500,000 86,600,000 59,000,000 40 41,000,000 106,000,000 64,500,000 Total 256,253,365.9 769,364,735 512,578,732.5


Table A2 Sources of output growth (in 100,000 rupees): 1993–1994 to 2006–2007

Sector no.

Average growth of fi nal demand (1)

Composition of fi nal demand (2)

Technological change (3)

Interaction factor (4)

Total change (1 + 2 +3 + 4)

1 31,200,000 31,150.8 427,999.7 300,893.9 31,960,044 2 10,900,000 −13,329.1 −428,678 −346,205 10,111,788 3 3,824,058 23,988.07 −168,580 −426,883 3,252,584 4 3,831,645 79,581.9 −573,655 −1,134,475 2,203,097 5 −4,357,397 40,561.27 2,969,992 5,146,957 3,800,113 6 626,611.2 7,290.769 303,509.6 583,489.3 1,520,901 7 1,774,397 145,685.1 −134,583 −322,220 1,463,280 8 1,206,297 −2,086.89 234,419.9 709,805.1 2,148,435 9 14,100,000 −12,477.8 718,038.8 1,717,541 16,523,102 10 3,650,209 −1,801.29 178,596.6 440,160.5 4,267,165 11 678,771.1 0.436146 107,875.3 54,226.74 840,873.6 12 15,600,000 5,666.283 −709,355 −1,181,177 13,715,134 13 581,922.1 6,856.38 −107,082 −190,230 291,466 14 2,753,465 67,380.06 −529,392 −1,678,342 613,111.2 15 4,035,601 3,809.035 −285,901 −522,843 3,230,666 16 877,290.7 207.7339 13,336.44 85,394.67 976,229.5 17 5,424,210 20,546.57 420,345.4 641,385.6 6,506,488 18 9,474,386 37,656.18 5,356,230 9,988,368 24,856,640 19 1,167,820 64,873.03 −116,062 −281,312 835,319.2 20 3,107,765 34,690.94 1,364,901 2,024,953 6,532,310 21 1,700,389 3,191.634 722,791.6 539,970.8 2,966,343 22 13,200,000 104,953.9 239,465 333,156.4 13,877,575 23 2,234,514 43,493.09 −142,823 −352,121 1,783,064 24 1,235,899 77,184.39 964,481.3 2,627,446 4,905,011 25 2,932,688 140,555.5 −227,760 −953,042 1,892,442 26 20,600,000 335,101.6 −781,525 −1,363,168 18,790,409 27 −509,302 31,795.09 936,899.2 3,225,546 3,684,939 28 13,500,000 58,370.4 1,840,855 4,953,699 20,352,924 29 1,570,098 72.83224 −47,704.1 −172,093 1,350,374 30 23,200,000 58,963.68 2,386,845 6,974,004 32,619,813 31 11,100,000 22,698.22 −310,336 −749,322 10,063,040 32 4,480,282 45,191.06 1,564,436 2,444,704 8,534,613 33 62,600,000 2,227,634 2,450,393 5,055,101 72,333,128 34 17,000,000 130,664.7 −2,668,484 −5,077,565 9,384,616 35 779,301.5 5,026.164 −34,514.8 −68,874.5 680,938.4 36 6,083,355 78,415.57 −227,087 −754,157 5,180,526 37 37,200,000 189,053.8 68,352.16 −370,356 37,087,050 38 4,459,532 20,142.86 1,002,604 2,335,595 7,817,874 39 56,700,000 −1,504,820 1,900,510 1,913,469 59,009,159 40 61,900,000 2,398,035 490,983.6 −326,924 64,462,094 Total 452,423,808.1 5,005,972.926 19,170,340.02 35,824,556.56 512,424,677.6


Tabl

e A

3 C

ontr

ibut

ions

of

diff

eren

t dem

and

cate

gori

es (

in 1

00,0

00 r

upee

s)

Sect

or n

o.

Priv

ate

cons

umpt

ion

expe

nditu

re (

1)

Gov

ernm

ent

cons

umpt

ion

expe

nditu

re (

2)

Inve

stm

ent

expe

nditu

re (

3)

Exp

orts

(4)

Im

port

s (5

) To

tal

(1 +

2 +

3 +

4 −

5)

1 25

,865

,095

61

1,35

1.4

4,47

7,29

0 4,

634,

137.

045

3,67

9,73

1.92

31

,908

,142

2

8,36

6,68

2 21

2,30

9.6

1,21

1,86

1 97

1,82

1.37

97

631,

792.

14

10,1

30,8

82

3 2,

912,

659

26,4

32.5

9 44

5,66

2.5

749,

476.

2484

88

1,64

6.45

1 3,

252,

584

4 79

1,45

0.4

71,2

87.9

4,

182,

934

1,58

0,09

0.11

4,

422,

665.

26

2,20

3,09

7 5

12,1

45,2

18

649,

641.

6 4,

443,

503

5,47

3,38

0.26

18

,875

,119

.92

3,83

6,62

2 6

400,

902.

8 31

,853

.59

1,96

7,60

3 1,

439,

314.

634

2,31

8,77

3.11

7 1,

520,

901

7 64

2,02

2.5

8,59

1.31

1 3,

912,

515

4,98

2,45

6.24

7 8,

082,

305.

481

1,46

3,28

0 8

1,84

4,86

8 33

,754

.14

779,

950.

3 35

0,17

0.03

67

860,

307.

1 2,

148,

435

9 15

,034

,888

44

3,85

7.6

1,31

0,78

9 2,

164,

583.

24

2,35

3,73

2.65

16

,600

,385

10

3,

989,

502

56,8

91.6

1 23

2,77

3.8

152,

617.

6907

16

4,62

0.22

7 4,

267,

165

11

996,

471.

7 32

.559

65

−15

7,12

3 8,

622.

2368

93

7,13

0.09

9281

84

0,87

3.6

12

6,57

8,28

8 38

3,56

9 80

2,91

0.1

7,34

5,52

1.21

3 1,

386,

369.

407

13,7

23,9

19

13

182,

186.

4 73

1.72

84

162,

385.

5 61

,675

.269

11

5,51

2.96

3 29

1,46

6 14

39

4,61

3.9

26,4

87.0

8 36

4,15

0.7

538,

267.

2988

71

0,40

9.14

61

3,10

9.9

15

1,82

3,41

1 49

4,78

0.6

1,70

1,54

0 1,

324,

676.

462

2,11

3,74

2.65

3,

230,

665

16

794,

483.

7 6,

286.

705

138,

515.

7 32

5,22

7.65

08

288,

284.

2747

97

6,22

9.4

17

3,12

0,41

8 52

,635

.78

3,45

3,35

2 2,

999,

377.

288

3,11

9,29

5.67

4 6,

506,

487

18

17,9

02,1

82

975,

307.

1 5,

421,

648

7,44

3,85

9.33

5 6,

886,

355.

84

24,8

56,6

41

19

227,

332.

4 −

2,03

2.63

1,

414,

688

257,

484.

3636

1,

062,

153.

717

835,

318.

9 20

4,

490,

121

229,

369

4,49

3,87

3 5,

517,

542.

929

8,19

8,59

5.03

7 6,

532,

311

21

2,58

0,23

8 50

,098

.65

266,

577.

4 36

0,35

0.68

45

290,

921.

244

2,96

6,34

3 22

8,

797,

140

188,

114.

6 6,

985,

130

7,66

3,52

0.37

3 9,

709,

081.

13

13,9

24,8

24

23

439,

977.

3 9,

550.

239

1,69

1,33

4 27

9,55

5.04

17

637,

352.

98

1,78

3,06

4 24

75

5,04

9.2

85,4

44.0

2 5,

969,

492

−18

,297

.964

1,

886,

676.

656

4,90

5,01

1 25

31

3,78

6.9

−11

,388

.5

2,32

2,99

8 13

7,72

4.92

42

870,

679.

345

1,89

2,44

2 26

2,

759,

040

20,2

63.8

4 17

,669

,986

6,

107,

393.

062

7,74

0,64

5.49

18

,816

,037


27

2,14

6,33

4 99

,037

.22

10,4

73,5

71

4,79

5,90

9.48

8 13

,857

,818

.93

3,65

7,03

3 28

4,

964,

714

188,

576.

5 19

,679

,616

6,

931,

903.

753

11,3

28,7

87.2

2 20

,436

,023

29

90

,979

.14

2,53

9.39

2 1,

133,

838

154,

626.

1627

31

,609

.392

1 1,

350,

374

30

7,86

3,00

5 91

5,91

6.9

27,1

02,7

42

8,80

6,41

4.82

8 12

,041

,728

.76

32,6

46,3

50

31

2,19

0,04

6 21

3,15

3.9

7,11

1,27

6 3,

310,

474.

8 2,

756,

284.

749

10,0

68,6

67

32

4,41

4,28

2 −

257,

112

16,9

16,1

90

24,6

86,2

95.5

6 37

,177

,091

.43

8,58

2,56

4 33

7,

491,

508

255,

749.

5 65

,783

,372

3,

649,

467.

878

4,88

8,84

5.33

72

,291

,252

34

4,

052,

730

695,

727

6,31

8,27

1 3,

138,

987.

681

4,80

5,14

1.66

9,

400,

574

35

137,

464.

2 34

7,86

6.4

193,

900.

5 72

,215

.982

88

70,5

08.5

833

680,

938.

4 36

1,

701,

119

150,

246.

1 3,

349,

943

2,31

0,09

5.52

6 2,

330,

876.

04

5,18

0,52

7 37

24

,844

,856

1,

022,

024

9,83

6,04

9 8,

125,

464.

272

6,80

6,84

7.64

37

,021

,545

38

4,

235,

632

476,

708.

7 3,

436,

901

2,96

7,98

7.02

6 3,

299,

354.

19

7,81

7,87

4 39

39

,040

,840

1,

620,

317

14,7

28,0

53

13,8

94,0

35.3

10

,336

,245

.9

58,9

46,9

99

40

38,4

95,1

37

756,

115.

3 15

,051

,432

49

,001

,201

.22

38,9

30,6

87.4

64

,373

,198

To

tal

265,

816,

674.

3 11

,142

,086

.02

276,

781,

494

194,

695,

626.

6 23

5,95

5,72

7.1

512,

480,

153.

7


Tabl

e A

4 D

ecom

posi

tion

of fi

rst c

ompo

nent

of

outp

ut c

hang

e (i

n 10

0,00

0 ru

pees

), i.

e., d

ue to

ave

rage

gro

wth

Sect

or n

o.

Priv

ate

cons

umpt

ion

expe

ndi-

ture

(1)

Gov

ernm

ent

cons

umpt

ion

expe

nditu

re (

2)

Inve

stm

ent

expe

ndi t

ure

(3)

Exp

orts

(4)

Im

port

s (5

) To

tal

(1 +

2 +

3 +

4 −

5)

1 24

,400

,000

65

8,59

2.4

5,09

1,23

0 5,

078,

083

4,07

9,80

8 31

,200

,000

2

9,61

7,67

2 25

1,91

3 95

7,58

9.2

1,31

8,00

6 1,

226,

086

10,9

00,0

00

3 2,

982,

507

32,4

30.3

8 1,

018,

719

1,03

9,01

5 1,

248,

613

3,82

4,05

8 4

1,82

7,32

1 15

3,35

4 4,

099,

210

2,03

6,77

3 4,

285,

013

3,83

1,64

5 5

7,31

7,02

3 38

0,42

8.3

1,20

0,77

9 4,

180,

880

17,4

00,0

00

−4,

357,

397

6 17

0,17

0.3

2,90

9.84

4 82

2,48

0.6

1,17

6,85

2 1,

545,

802

626,

611.

2 7

457,

281.

1 −

1,03

2.37

1 4,

285,

133

4,57

5,93

1 7,

542,

916

1,77

4,39

7 8

1,06

5,29

8 14

,157

.85

654,

894.

4 25

3,00

2.7

781,

055.

9 1,

206,

297

9 13

,100

,000

38

1,14

3.3

927,

631.

6 1,

768,

544

2,00

0,03

6 14

,100

,000

10

3,

524,

946

39,0

40.0

7 98

,318

.98

28,6

26.8

8 40

,722

.74

3,65

0,20

9 11

82

6,44

4.1

−4.

4633

05

−14

6,58

7 5,

445.

304

6,52

6.77

67

8,77

1.1

12

7,57

2,51

8 43

5,68

3.3

1,61

2,77

0 7,

982,

591

1,99

4,77

7 15

,600

,000

13

27

5,58

3.6

7,24

6.32

4 32

0,27

5.3

156,

221.

8 17

7,40

4.9

581,

922.

1 14

73

0,74

7.4

64,0

76.9

5 2,

177,

417

869,

143.

6 1,

087,

921

2,75

3,46

5 15

2,

288,

112

497,

408.

1 2,

087,

664

1,68

8,68

5 2,

526,

269

4,03

5,60

1 16

76

8,46

8.1

363.

3521

35

,435

.35

274,

256.

3 20

1,23

2.5

877,

290.

7 17

2,

405,

707

−8,

440.

371

2,93

8,11

4 2,

354,

620

2,26

5,79

1 5,

424,

210

18

8,28

4,38

9 37

9,28

9.1

3,90

4.82

5 4,

230,

454

3,42

3,65

0 9,

474,

386

19

237,

675.

2 2,

050.

025

1,90

6,63

0 59

8,30

5.4

1,57

6,84

1 1,

167,

820

20

1,94

7,12

2 42

,384

.13

3,55

6,64

4 4,

761,

086

7,19

9,47

0 3,

107,

765

21

1,40

9,75

6 37

,535

.04

241,

130.

7 28

8,83

3.5

276,

866.

2 1,

700,

389

22

8,22

3,31

6 62

,165

.07

6,47

3,20

4 7,

167,

584

8,67

9,02

0 13

,200

,000

23

43

8,58

5.3

16,9

03.7

2 2,

103,

018

388,

061

712,

053.

8 2,

234,

514

24

313,

276.

4 8,

577.

64

2,51

8,07

7 −

380,

361.

4 1,

223,

671

1,23

5,89

9 25

15

4,05

7.5

−3,

331.

466

3,47

1,49

2 10

1,24

1.4

790,

771.

5 2,

932,

688

26

2,92

4,58

9 47

,092

.41

21,2

00,0

00

9,35

3,94

6 12

,900

,000

20

,600

,000


27

1,66

5,68

0 24

,124

.84

7,19

0,69

9 5,

582,

289

15,0

00,0

00

−50

9,30

1.5

28

2,94

2,67

7 −

21,9

14.6

6 13

,900

,000

5,

065,

868

8,30

3,53

2 13

,500

,000

29

50

,871

.48

1,35

2.33

1 1,

373,

546

160,

877

16,5

48.7

1 1,

570,

098

30

4,85

8,97

3 47

4,17

9.8

20,0

00,0

00

5,52

2,32

4 7,

628,

938

23,2

00,0

00

31

2,42

5,03

2 21

5,70

1.7

8,03

1,85

9 3,

631,

755

3,19

8,72

1 11

,100

,000

32

2,

815,

916

−48

7,68

2.9

11,4

00,0

00

17,8

00,0

00

27,0

00,0

00

4,48

0,28

2 33

2,

284,

163

−55

,325

.49

60,4

00,0

00

1,79

9,58

0 1,

870,

294

62,6

00,0

00

34

8,51

2,17

2 92

7,44

6.8

9,82

6,21

3 6,

267,

139

8,51

7,01

4 17

,000

,000

35

27

6,75

8 29

3,17

6.5

219,

897.

6 13

7,21

6.1

147,

746.

7 77

9,30

1.5

36

1,70

9,30

8 17

6,58

4.5

4,16

4,76

0 2,

348,

889

2,31

6,18

6 6,

083,

355

37

23,9

00,0

00

908,

334.

4 10

,900

,000

7,

952,

765

6,52

6,60

4 37

,200

,000

38

2,

554,

188

227,

578.

9 1,

756,

958

1,58

7,74

6 1,

666,

939

4,45

9,53

2 39

34

,400

,000

1,

418,

780

16,0

00,0

00

14,0

00,0

00

9,18

0,94

0 56

,700

,000

40

38

,100

,000

21

1,10

3.3

12,7

00,0

00

46,6

00,0

00

35,8

00,0

00

61,9

00,0

00

Tota

l 22

9,75

8,30

3.5

7,81

5,37

5.65

5 24

7,51

9,10

7.6

179,

752,

274.

6 21

2,36

5,78

1.7

452,

423,

808.

1


Tabl

e A

5 D

ecom

posi

tion

of fi

rst c

ompo

nent

of

outp

ut c

hang

e (%

), i.

e., d

ue to

ave

rage

gro

wth

Sect

or n

o.

Priv

ate

cons

umpt

ion

expe

nditu

re (

1)

Gov

ernm

ent

cons

umpt

ion

expe

nditu

re (

2)

Inve

stm

ent

expe

nditu

re (

3)

Exp

orts

(4)

Im

port

s (5

) To

tal

(1 +

2 +

3 +

4 −

5)

1 78

.21

2.11

16

.32

16.2

8 13

.08

99.8

3 2

88.2

4 2.

31

8.79

12

.09

11.2

5 10

0.18

3

77.9

9 0.

85

26.6

4 27

.17

32.6

5 10

0.00

4

47.6

9 4.

00

106.

98

53.1

6 11

1.83

10

0.00

5

−16

7.92

−

8.73

−

27.5

6 −

95.9

5 −

399.

32

99.1

6 6

27.1

6 0.

46

131.

26

187.

81

246.

69

100.

00

7 25

.77

−0.

06

241.

50

257.

89

425.

10

100.

00

8 88

.31

1.17

54

.29

20.9

7 64

.75

100.

00

9 92

.91

2.70

6.

58

12.5

4 14

.18

100.

55

10

96.5

7 1.

07

2.69

0.

78

1.12

10

0.00

11

12

1.76

0.

00

−21

.60

0.80

0.

96

100.

00

12

48.5

4 2.

79

10.3

4 51

.17

12.7

9 10

0.06

13

47

.36

1.25

55

.04

26.8

5 30

.49

100.

00

14

26.5

4 2.

33

79.0

8 31

.57

39.5

1 10

0.00

15

56

.70

12.3

3 51

.73

41.8

4 62

.60

100.

00

16

87.6

0 0.

04

4.04

31

.26

22.9

4 10

0.00

17

44

.35

−0.

16

54.1

7 43

.41

41.7

7 10

0.00

18

87

.44

4.00

0.

04

44.6

5 36

.14

100.

00

19

20.3

5 0.

18

163.

26

51.2

3 13

5.02

10

0.00

20

62

.65

1.36

11

4.44

15

3.20

23

1.66

10

0.00

21

82

.91

2.21

14

.18

16.9

9 16

.28

100.

00

22

62.3

0 0.

47

49.0

4 54

.30

65.7

5 10

0.36

23

19

.63

0.76

94

.12

17.3

7 31

.87

100.

00

24

25.3

5 0.

69

203.

74

−30

.78

99.0

1 10

0.00

25

5.

25

−0.

11

118.

37

3.45

26

.96

100.

00

26

14.2

0 0.

23

102.

91

45.4

1 62

.62

100.

12


27

−32

7.05

−

4.74

−

1,41

1.87

−

1,09

6.07

−

2,94

5.21

10

5.48

28

21

.80

−0.

16

102.

96

37.5

2 61

.51

100.

62

29

3.24

0.

09

87.4

8 10

.25

1.05

10

0.00

30

20

.94

2.04

86

.21

23.8

0 32

.88

100.

11

31

21.8

5 1.

94

72.3

6 32

.72

28.8

2 10

0.05

32

62

.85

−10

.89

254.

45

397.

30

602.

64

101.

07

33

3.65

−

0.09

96

.49

2.87

2.

99

99.9

3 34

50

.07

5.46

57

.80

36.8

7 50

.10

100.

09

35

35.5

1 37

.62

28.2

2 17

.61

18.9

6 10

0.00

36

28

.10

2.90

68

.46

38.6

1 38

.07

100.

00

37

64.2

5 2.

44

29.3

0 21

.38

17.5

4 99

.82

38

57.2

7 5.

10

39.4

0 35

.60

37.3

8 10

0.00

39

60

.67

2.50

28

.22

24.6

9 16

.19

99.8

9 40

61

.55

0.34

20

.52

75.2

8 57

.84

99.8

6 To

ta l

50.7

8 1.

73

54.7

1 39

.73

46.9

4 10

0.01


Tabl

e A

6 D

ecom

posi

tion

of s

econ

d co

mpo

nent

of

outp

ut c

hang

e (i

n 10

0,00

0 ru

pees

), i.

e., d

ue to

com

posi

tiona

l cha

nge

Sect

or n

o.

Priv

ate

cons

umpt

ion

expe

nditu

re (

1)

Gov

ernm

ent c

onsu

mpt

ion

expe

nditu

re (

2)

Inve

stm

ent

expe

nditu

re (

3)

Exp

orts

(4)

Im

port

s (5

) To

tal (

1 +

2 +

3 +

4 −

5)

1 73

,989

.97

0.04

1070

4 15

,565

.43

0.07

4960

1 58

,404

.71

31,1

50.8

2

12,3

36.5

6 −

0.00

9305

5,

247.

424

0.01

9730

2 30

,913

.11

−13

,329

.12

3 27

,596

.54

0.00

2146

28

,85.

849

0.00

8383

5 64

,94.

331

23,9

88.0

7 4

85,1

61.6

6 0.

0017

942

8,36

1.01

8 0.

0104

745

13,9

40.7

9 79

,581

.9

5 46

,237

.53

0.01

6669

8 9,

683.

29

−0.

0397

398

15,3

59.5

2 40

,561

.27

6 7,

089.

461

0.00

0082

7 84

5.62

97

−0.

0061

158

644.

3166

7,

290.

769

7 14

4,95

5.3

0.00

2226

7 4,

308.

132

−0.

0229

397

3,57

8.30

8 14

5,68

5.1

8 70

5.78

86

0.00

0529

5 26

1.79

9 −

0.01

3300

6 3,

054.

462

−2,

086.

887

9 3,

240.

141

0.01

1374

8 75

5.71

54

−0.

0600

975

16,4

73.6

3 −

12,4

77.8

2 10

42

3.09

04

−0.

0013

71

75.2

2326

0.

0007

365

2,29

9.60

7 −

1,80

1.29

4 11

0.

2133

316

0.00

0000

0893

0.

3961

817

−0.

0005

069

0.17

2860

9 0.

4361

455

12

10,9

35.4

9 0.

0010

24

3,74

0.41

8 0.

0134

739

9,00

9.63

7 5,

666.

283

13

7,86

5.15

0.

0003

911

523.

3378

−

0.00

1000

9 1,

532.

107

6,85

6.38

14

73

,508

.08

0.00

2769

5,

892.

245

0.01

8818

7 12

,020

.28

67,3

80.0

6 15

18

,620

.97

0.02

8187

4 17

,369

.89

0.02

2186

5 32

,181

.88

3,80

9.03

5 16

19

4.80

45

0.00

0022

6 77

.063

38

0.00

0753

6 64

.134

74

207.

7339

17

23

,688

.56

0.00

2856

5 4,

369.

382

0.05

7884

6 7,

511.

434

20,5

46.5

7 18

42

,227

.38

0.02

2596

3 7,

734.

378

−0.

0653

414

12,3

05.5

4 37

,656

.18

19

64,5

71.9

2 0.

0008

71

1,99

7.17

7 0.

0036

483

1,69

6.06

7 64

,873

.03

20

28,0

45.8

7 0.

0053

958

12,8

74.6

7 −

0.17

0819

7 6,

229.

437

34,6

90.9

4 21

5,

514.

973

0.00

2417

7 1,

060.

939

0.00

4461

6 3,

384.

284

3,19

1.63

4 22

49

,130

.73

0.03

0751

72

,057

.7

0.02

3234

4 16

,234

.6

104,

953.

9 23

43

,281

.8

0.00

1297

2 2,

057.

676

0.00

1697

1 1,

846.

39

43,4

93.0

9 24

76

,931

.79

0.00

1162

6 2,

286.

111

0.03

6002

2 2,

033.

546

77,1

84.3

9 25

13

9,95

6.7

0.00

1709

6 2,

960.

786

0.00

5215

8 2,

361.

925

140,

555.

5 26

33

4,27

8.9

0.00

4298

5 16

,015

.99

−0.

0376

969

15,1

93.2

9 33

5,10

1.6


27

29,3

22.5

0.

0000

933

8,14

5.29

2 0.

0282

539

5,67

2.73

3 31

,795

.09

28

68,0

34.9

8 0.

0042

548

9,10

5.18

2 0.

0525

879

18,7

69.8

2 58

,370

.4

29

159.

4047

0.

0000

86

35.6

9286

0.

0047

433

122.

2701

72

.832

24

30

56,5

57.0

4 −

0.01

6289

7,

331.

991

0.12

8040

6 4,

925.

456

58,9

63.6

8 31

23

,586

.19

0.00

2433

4,

159.

152

0.01

9953

9 5,

047.

149

22,6

98.2

2 32

21

,081

0.

0103

323

39,2

76.4

2 0.

4607

036

15,1

66.8

3 45

,191

.06

33

2,21

8,27

4 0.

0268

103

46,3

19.0

6 0.

0781

432

36,9

59.1

3 2,

227,

634

34

156,

438.

1 −

0.00

3978

34

,704

.52

0.08

0860

8 60

,477

.96

130,

664.

7 35

4,

272.

476

−0.

0153

23

1,62

7.53

4 0.

0028

794

873.

8333

5,

026.

164

36

84,6

63.6

4 0.

0029

994

7,88

1.38

8 0.

0456

979

14,1

29.5

1 78

,415

.57

37

217,

220.

5 0.

0494

205

35,7

33.2

7 0.

2024

527

63,9

00.1

4 18

9,05

3.8

38

27,4

93.2

4 −

0.01

1288

12

,654

.99

0.02

5760

6 20

,005

.39

20,1

42.8

6 39

31

4,34

0.4

0.14

7197

9 52

,416

.36

0.60

1443

3 1,

871,

577

−1,

504,

820

40

206,

859.

6 0.

5444

998

2,41

2,77

3 3.

3783

5 22

1,60

1.7

2,39

8,03

5 To

tal

4,74

8,79

2.44

3 0.

9122

183

2,87

1,17

1.52

2 4.

9939

734

2,61

3,99

6.43

1 5,

005,

972.

926


Tabl

e A

7 D

ecom

posi

tion

of s

econ

d co

mpo

nent

of

outp

ut c

hang

e (%

), i.

e., d

ue to

com

posi

tiona

l cha

nge

Sect

or n

o.

Priv

ate

cons

umpt

ion

expe

nditu

re (

1)

Gov

ernm

ent

cons

umpt

ion

expe

nditu

re

(2)

Inve

stm

ent

expe

nditu

re (

3)

Exp

orts

(4)

Im

port

s (2

) To

tal

(1 +

2 +

3 +

4 −

5)

1 23

7.52

0.

00

49.9

7 0.

00

187.

49

100.

00

2 −

92.5

5 0.

00

−39

.37

0.00

−

231.

92

100.

00

3 11

5.04

0.

00

12.0

3 0.

00

27.0

7 10

0.00

4

107.

01

0.00

10

.51

0.00

17

.52

100.

00

5 11

3.99

0.

00

23.8

7 0.

00

37.8

7 10

0.00

6

97.2

4 0.

00

11.6

0 0.

00

8.84

10

0.00

7

99.5

0 0.

00

2.96

0.

00

2.46

10

0.00

8

−33

.82

0.00

−

12.5

4 0.

00

−14

6.36

10

0.00

9

−25

.97

0.00

−

6.06

0.

00

−13

2.02

10

0.00

10

−

23.4

9 0.

00

−4.

18

0.00

−

127.

66

100.

00

11

48.9

1 0.

00

90.8

4 −

0.12

39

.63

100.

00

12

192.

99

0.00

66

.01

0.00

15

9.00

10

0.00

13

11

4.71

0.

00

7.63

0.

00

22.3

5 10

0.00

14

10

9.09

0.

00

8.74

0.

00

17.8

4 10

0.00

15

48

8.86

0.

00

456.

02

0.00

84

4.88

10

0.00

16

93

.78

0.00

37

.10

0.00

30

.87

100.

00

17

115.

29

0.00

21

.27

0.00

36

.56

100.

00

18

112.

14

0.00

20

.54

0.00

32

.68

100.

00

19

99.5

4 0.

00

3.08

0.

00

2.61

10

0.00

20

80

.84

0.00

37

.11

0.00

17

.96

100.

00

21

172.

79

0.00

33

.24

0.00

10

6.04

10

0.00

22

46

.81

0.00

68

.66

0.00

15

.47

100.

00

23

99.5

1 0.

00

4.73

0.

00

4.25

10

0.00

24

99

.67

0.00

2.

96

0.00

2.

63

100.

00

25

99.5

7 0.

00

2.11

0.

00

1.68

10

0.00

26

99

.75

0.00

4.

78

0.00

4.

53

100.

00

1999 Output Growth in Post Liberalized India: An Input–Output Structural… Se

ctor

no.

Priv

ate

cons

umpt

ion

expe

nditu

re (

1)

Gov

ernm

ent

cons

umpt

ion

expe

nditu

re

(2)

Inve

stm

ent

expe

nditu

re (

3)

Exp

orts

(4)

Im

port

s (2

) To

tal

(1 +

2 +

3 +

4 −

5)

27

92.2

2 0.

00

25.6

2 0.

00

17.8

4 10

0.00

28

11

6.56

0.

00

15.6

0 0.

00

32.1

6 10

0.00

29

21

8.87

0.

00

49.0

1 0.

01

167.

88

100.

00

30

95.9

2 0.

00

12.4

3 0.

00

8.35

10

0.00

31

10

3.91

0.

00

18.3

2 0.

00

22.2

4 10

0.00

32

46

.65

0.00

86

.91

0.00

33

.56

100.

00

33

99.5

8 0.

00

2.08

0.

00

1.66

10

0.00

34

11

9.72

0.

00

26.5

6 0.

00

46.2

8 10

0.00

35

85

.00

0.00

32

.38

0.00

17

.39

100.

00

36

107.

97

0.00

10

.05

0.00

18

.02

100.

00

37

114.

90

0.00

18

.90

0.00

33

.80

100.

00

38

136.

49

0.00

62

.83

0.00

99

.32

100.

00

39

−20

.89

0.00

−

3.48

0.

00

−12

4.37

10

0.00

40

8.

63

0.00

10

0.61

0.

00

9.24

10

0.00

To

tal

94.8

6 0.

00

57.3

5 0.

00

52.2

2 10

0.00


Tabl

e A

8 D

ecom

posi

tion

of th

ird

com

pone

nt o

f ou

tput

cha

nge

(in

100,

000

rupe

es),

i.e.

, due

to te

chno

logi

cal c

hang

e

Sect

or n

o.

Priv

ate

cons

umpt

ion

expe

nditu

re (

1)

Gov

ernm

ent

cons

umpt

ion

expe

nditu

re (

2)

Inve

stm

ent

expe

nditu

re (

3)

Exp

orts

(4)

Im

port

s (5

) To

tal

(1 +

2 +

3 +

4 −

5)

1 59

8,81

8.7

−76

,278

.61

−14

9,58

1 −

28,6

69.6

3 −

83,7

10.1

9 42

7,99

9.7

2 −

515,

380.

7 −

15,9

17.7

3 56

,169

.02

−32

,733

.84

−79

,185

.17

−42

8,67

8 3

−21

,427

.2

−17

,240

.12

−12

4,33

0.5

−31

,489

.56

−25

,907

.58

−16

8,57

9.8

4 −

451,

222.

7 −

46,4

65.5

6 18

,086

.55

−14

1,57

8.9

−47

,525

.63

−57

3,65

5 5

1,96

6,47

1 15

7,33

8.3

696,

483.

4 34

2,12

8.5

192,

428.

4 2,

969,

992

6 75

,912

.71

17,9

45.0

3 27

0,10

2.8

50,0

13.8

4 11

0,46

4.7

303,

509.

6 7

−23

0.56

83

20,4

63.0

9 −

105,

770.

8 −

55,3

77.6

3 −

6,33

3.42

7 −

134,

582.

5 8

175,

151.

3 7,

759.

118

37,7

75.0

2 22

,510

.12

8,77

5.64

8 23

4,41

9.9

9 54

2,32

6.8

24,5

43.9

9 97

,363

.7

96,6

86.2

42

,881

.82

718,

038.

8 10

12

7,72

5.9

9,19

4.62

5 35

,136

.19

24,4

31.2

2 17

,891

.28

178,

596.

6 11

10

4,24

8.2

27.3

0701

99

2.26

55

2,70

2.33

9 94

.849

62

107,

875.

3 12

−

426,

339.

8 −

34,4

34.8

8 −

208,

906.

1 −

127,

554.

9 −

87,8

80.6

3 −

709,

355.

2 13

−

56,2

46.3

2 −

3,09

3.71

9 −

31,2

66.8

1 −

23,7

34.6

3 −

7,25

9.09

4 −

107,

082.

4 14

−

104,

640

−33

,695

.41

−38

7,87

1.5

−40

,531

.82

−37

,346

.84

−52

9,39

1.9

15

−17

0,76

0.6

−5,

876.

796

−10

6,27

3 −

70,7

44.1

6 −

67,7

53.5

3 −

285,

901

16

11,0

54.4

7 3,

918.

028

26,5

65.2

5 −

14,2

61.1

4 13

,940

.17

13,3

36.4

4 17

22

7,34

5 64

,274

.27

132,

270.

1 71

,724

.83

75,2

68.7

4 42

0,34

5.4

18

3,67

2,99

9 32

8,96

1.7

1,24

1,28

6 68

7,89

1.4

574,

908.

3 5,

356,

230

19

−24

,975

.63

−7,

370.

997

−12

0,81

4.1

−39

,822

.34

−76

,921

.45

−11

6,06

1.7

20

1,02

4,90

2 13

5,97

0 30

9,70

8.2

135,

803.

3 24

1,48

2.8

1,36

4,90

1 21

68

1,27

0 −

1,93

1.65

2 2,

225.

334

26,3

78.1

5 −

14,8

49.8

4 72

2,79

1.6

22

131,

950.

3 12

3,23

9.1

29,7

26.0

5 38

,073

.75

83,5

24.1

3 23

9,46

5 23

−

36,3

12.1

8 −

7,41

9.60

9 −

94,0

92.0

2 −

20,5

09.5

−

15,5

10.7

8 −

142,

822.

5 24

16

6,09

1.5

72,0

09.3

69

6,17

3.9

119,

503.

3 89

,296

.71

964,

481.

3 25

24

,460

.17

−11

,984

.23

−23

3,40

6.4

5,46

4.51

9 12

,293

.97

−22

7,75

9.9

26

−17

8,84

0.3

−81

,810

.84

−90

3,04

2.3

−32

0,38

5.9

−70

2,55

4.8

−78

1,52

4.6


27

172,

685.

8 7,

068.

334

962,

189.

6 −

21,6

15.3

4 18

3,42

9.2

936,

899.

2 28

64

7,43

7 13

9,22

5.3

1,26

9,08

6 20

6,12

2.7

421,

016.

4 1,

840,

855

29

20,7

94.5

4 65

8.59

36

−72

,245

.52

1,56

6.25

1 −

1,52

2.06

8 −

47,7

04.0

6 30

88

5,45

7 33

1,72

4.9

1,40

0,75

8 28

7,53

1.7

518,

627.

3 2,

386,

845

31

−10

1,33

1.7

11,8

25.1

6 −

269,

833.

3 −

59,3

59.7

2 −

108,

363.

2 −

310,

336.

3 32

56

3,15

7.4

379,

502.

7 71

5,34

1.8

533,

575.

1 62

7,14

1.6

1,56

4,43

6 33

1,

191,

868

251,

639.

6 1,

126,

869

308,

979.

8 42

8,96

3.2

2,45

0,39

3 34

−

1,60

1,76

6 −

190,

147.

5 −

836,

920.

4 −

509,

378.

4 −

469,

728.

3 −

2,66

8,48

4 35

−

46,4

97.3

5 24

,676

.79

−11

,582

.72

−17

,066

.98

−15

,955

.44

−34

,514

.82

36

−7,

055.

743

−14

,248

.76

−21

1,30

9.3

−56

,134

.46

−61

,661

.38

−22

7,08

6.9

37

218,

140.

6 99

,638

.03

−30

1,67

6.1

−54

,627

.73

−10

6,87

7.3

68,3

52.1

6 38

53

4,04

4.6

201,

280.

2 31

1,70

9.8

115,

826

160,

256.

8 1,

002,

604

39

1,85

5,98

7 11

0,65

5.5

−28

9,27

4.6

42,3

75

−18

0,76

6.9

1,90

0,51

0 40

26

5,04

4.1

597,

664.

1 −

227,

537.

7 −

64,6

37.1

6 79

,549

.7

490,

983.

6 To

tal

12,1

42,3

16.3

2,

573,

286.

653

4,75

0,28

3.81

1,

389,

074.

279

1,68

4,62

2.16

9 19

,170

,340

.02


Tabl

e A

9 D

ecom

posi

tion

of th

ird

com

pone

nt o

f ou

tput

cha

nge

(%),

i.e.

, due

to te

chno

logi

cal c

hang

e

Sect

or n

o.

Priv

ate

cons

umpt

ion

expe

nditu

re (

1)

Gov

ernm

ent

cons

umpt

ion

expe

nditu

re (

2)

Inve

stm

ent

expe

nditu

re (

3)

Exp

orts

(4)

Im

port

s (5

) To

tal

(1 +

2 +

3 +

4 −

5)

1 13

9.91

−

17.8

2 −

34.9

5 −

6.70

−

19.5

6 10

0.00

2

120.

23

3.71

−

13.1

0 7.

64

18.4

7 10

0.00

3

12.7

1 10

.23

73.7

5 18

.68

15.3

7 10

0.00

4

78.6

6 8.

10

−3.

15

24.6

8 8.

28

100.

00

5 66

.21

5.30

23

.45

11.5

2 6.

48

100.

00

6 25

.01

5.91

88

.99

16.4

8 36

.40

100.

00

7 0.

17

−15

.20

78.5

9 41

.15

4.71

10

0.00

8

74.7

2 3.

31

16.1

1 9.

60

3.74

10

0.00

9

75.5

3 3.

42

13.5

6 13

.47

5.97

10

0.00

10

71

.52

5.15

19

.67

13.6

8 10

.02

100.

00

11

96.6

4 0.

03

0.92

2.

51

0.09

10

0.00

12

60

.10

4.85

29

.45

17.9

8 12

.39

100.

00

13

52.5

3 2.

89

29.2

0 22

.16

6.78

10

0.00

14

19

.77

6.36

73

.27

7.66

7.

05

100.

00

15

59.7

3 2.

06

37.1

7 24

.74

23.7

0 10

0.00

16

82

.89

29.3

8 19

9.19

−

106.

93

104.

53

100.

00

17

54.0

9 15

.29

31.4

7 17

.06

17.9

1 10

0.00

18

68

.57

6.14

23

.17

12.8

4 10

.73

100.

00

19

21.5

2 6.

35

104.

09

34.3

1 66

.28

100.

00

20

75.0

9 9.

96

22.6

9 9.

95

17.6

9 10

0.00

21

94

.26

−0.

27

0.31

3.

65

−2.

05

100.

00

22

55.1

0 51

.46

12.4

1 15

.90

34.8

8 10

0.00

23

25

.42

5.19

65

.88

14.3

6 10

.86

100.

00

24

17.2

2 7.

47

72.1

8 12

.39

9.26

10

0.00

25

−

10.7

4 5.

26

102.

48

−2.

40

−5.

40

100.

00

26

22.8

8 10

.47

115.

55

40.9

9 89

.90

100.

00


27

18.4

3 0.

75

102.

70

−2.

31

19.5

8 10

0.00

28

35

.17

7.56

68

.94

11.2

0 22

.87

100.

00

29

−43

.59

−1.

38

151.

45

−3.

28

3.19

10

0.00

30

37

.10

13.9

0 58

.69

12.0

5 21

.73

100.

00

31

32.6

5 −

3.81

86

.95

19.1

3 34

.92

100.

00

32

36.0

0 24

.26

45.7

3 34

.11

40.0

9 10

0.00

33

48

.64

10.2

7 45

.99

12.6

1 17

.51

100.

00

34

60.0

3 7.

13

31.3

6 19

.09

17.6

0 10

0.00

35

13

4.72

−

71.5

0 33

.56

49.4

5 46

.23

100.

00

36

3.11

6.

27

93.0

5 24

.72

27.1

5 10

0.00

37

31

9.14

14

5.77

−

441.

36

−79

.92

−15

6.36

10

0.00

38

53

.27

20.0

8 31

.09

11.5

5 15

.98

100.

00

39

97.6

6 5.

82

−15

.22

2.23

−

9.51

10

0.00

40

53

.98

121.

73

−46

.34

−13

.16

16.2

0 10

0.00


Tabl

e A

10

Dec

ompo

sitio

n of

fou

rth

com

pone

nt o

f ou

tput

cha

nge

(in

100,

000

rupe

es),

i.e.

, due

to in

tera

ctio

n fa

ctor

Sect

or n

o.

Priv

ate

cons

umpt

ion

expe

nditu

re (

1)

Gov

ernm

ent

cons

umpt

ion

expe

nditu

re (

2)

Inve

stm

ent

expe

nditu

re (

3)

Exp

orts

(4)

Im

port

s (5

) To

tal

(1 +

2 +

3 +

4 −

5)

1 79

2,28

6.5

29,0

37.6

−

479,

924

−41

5,27

6 −

374,

771

300,

893.

9 2

−74

7,94

6 −

23,6

85.7

19

2,85

5.6

−31

3,45

1 −

546,

022

−34

6,20

5 3

−76

,017

.1

11,2

42.3

3 −

451,

612

−25

8,04

9 −

347,

553

−42

6,88

3 4

−66

9,81

0 −

35,6

00.5

57

,276

.14

−31

5,10

4 17

1,23

7.1

−1,

134,

475

5 2,

815,

486

111,

875

2,53

6,55

7 95

0,37

1.8

1,26

7,33

2 5,

146,

957

6 14

7,73

0.3

10,9

98.7

2 87

4,17

3.6

212,

448.

8 66

1,86

2.1

583,

489.

3 7

40,0

16.6

4 −

10,8

39.4

−

271,

155

461,

902.

9 54

2,14

4.6

−32

2,22

0 8

603,

712.

8 11

,837

.17

87,0

19.1

3 74

,657

.23

67,4

21.0

9 70

9,80

5.1

9 1,

389,

321

38,1

70.2

7 28

5,03

7.5

299,

353.

1 29

4,34

1.2

1,71

7,54

1 10

33

6,40

7.2

8,65

6.92

99

,243

.42

99,5

59.5

9 10

3,70

6.6

440,

160.

5 11

65

,779

.21

9.71

594

−11

,528

.5

474.

5944

50

8.30

68

54,2

26.7

4 12

−

578,

825

−17

,679

.5

−60

4,69

4 −

509,

515

−52

9,53

7 −

1,18

1,17

7 13

−

45,0

16

−3,

420.

88

−12

7,14

6 −

70,8

11.9

−

56,1

65

−19

0,23

0 14

−

305,

002

−38

,94.

46

−1,

431,

287

−29

0,34

5 −

352,

185

−1,

678,

342

15

−31

2,56

2 3,

249.

218

−29

7,22

1 −

293,

264

−37

6,95

5 −

522,

843

16

14,7

66.2

8 2,

005.

325

76,4

38.0

5 65

,232

.49

73,0

47.4

7 85

,394

.67

17

463,

677.

5 −

3,19

8.12

37

8,59

8.3

573,

032.

4 77

0,72

4.5

641,

385.

6 18

5,

902,

567

267,

056.

3 4,

168,

723

2,52

5,51

4 2,

875,

492

9,98

8,36

8 19

−

49,9

39.1

3,

288.

343

−37

3,12

5 −

300,

999

−43

9,46

2 −

281,

312

20

1,49

0,05

1 51

,014

.89

614,

646.

4 62

0,65

3.8

751,

412.

8 2,

024,

953

21

483,

696.

6 14

,495

.26

22,1

60.4

6 45

,139

.03

25,5

20.6

53

9,97

0.8

22

392,

743

2,71

0.40

6 41

0,14

2.7

457,

862.

6 93

0,30

2.4

333,

156.

4 23

−

5,57

7.64

66

.127

1 −

319,

649

−87

,996

.5

−61

,036

.4

−35

2,12

1 24

19

8,74

9.5

4,85

7.07

7 2,

752,

955

242,

560.

1 57

1,67

5.4

2,62

7,44

6 25

−

4,68

7.46

3,

927.

22

−91

8,04

8 31

,019

65

,251

.95

−95

3,04

2 26

−

320,

987

54,9

82.2

7 −

2,64

2,98

8 −

2,92

6,16

7 −

4,47

1,99

3 −

1,36

3,16

8


27

278,

646

67,8

44.0

5 2,

312,

537

−76

4,76

4 −

1,33

1,28

3 3,

225,

546

28

1,30

6,56

5 71

,265

.82

4,50

1,42

5 1,

659,

913

2,58

5,46

9 4,

953,

699

29

19,1

53.7

2 52

8.46

77

−16

7,49

8 −

7,81

7.09

16

,460

.48

−17

2,09

3 30

2,

062,

018

110,

012.

2 5,

694,

652

2,99

6,55

9 3,

889,

238

6,97

4,00

4 31

−

157,

240

−14

,372

.9

−65

4,90

8 −

261,

921

−33

9,12

0 −

749,

322

32

1,01

4,12

8 −

148,

932

4,76

1,57

2 6,

352,

720

9,53

4,78

3 2,

444,

704

33

1,79

7,20

3 59

,435

.33

4,21

0,18

4 1,

540,

908

2,55

2,62

9 5,

055,

101

34

−3,

014,

114

−41

,572

.3

−2,

705,

726

−2,

618,

773

−3,

302,

622

−5,

077,

565

35

−97

,069

30

,013

.09

−16

,042

−

47,9

33.1

−

62,1

56.5

−

68,8

74.5

36

−

85,7

97.3

−

12,0

89.7

−

611,

390

17,3

40.9

4 62

,221

.91

−75

4,15

7 37

50

9,49

4.4

14,0

51.1

9 −

798,

008

227,

326.

8 32

3,22

0.8

−37

0,35

6 38

1,

119,

906

47,8

49.6

3 1,

355,

578

1,26

4,41

5 1,

452,

153

2,33

5,59

5 39

2,

470,

513

90,8

81.1

9 −

1,03

5,08

9 −

148,

340

−53

5,50

4 1,

913,

469

40

−76

,766

.5

−52

,652

.6

166,

196.

2 2,

465,

835

2,82

9,53

6 −

326,

924

Tota

l 19

,167

,262

75

3,42

2.8

21,6

40,9

31

13,5

54,2

73

19,2

91,3

27

35,8

24,5

57


Tabl

e A

11

Dec

ompo

sitio

n of

fou

rth

com

pone

nt o

f ou

tput

cha

nge

(%),

i.e.

, due

to in

tera

ctio

n fa

ctor

Sect

or n

o.

Priv

ate

cons

umpt

ion

expe

nditu

re (

1)

Gov

ernm

ent

cons

umpt

ion

expe

nditu

re (

2)

Inve

stm

ent

expe

nditu

re (

3)

Exp

orts

(4)

Im

port

s (5

) To

tal

(1 +

2 +

3 +

4 −

5)

1 26

3.31

9.

65

−15

9.50

−

138.

01

−12

4.55

10

0.00

2

216.

04

6.84

−

55.7

1 90

.54

157.

72

100.

00

3 17

.81

−2.

63

105.

79

60.4

5 81

.42

100.

00

4 59

.04

3.14

−

5.05

27

.78

−15

.09

100.

00

5 54

.70

2.17

49

.28

18.4

6 24

.62

100.

00

6 25

.32

1.88

14

9.82

36

.41

113.

43

100.

00

7 −

12.4

2 3.

36

84.1

5 −

143.

35

−16

8.25

10

0.00

8

85.0

5 1.

67

12.2

6 10

.52

9.50

10

0.00

9

80.8

9 2.

22

16.6

0 17

.43

17.1

4 10

0.00

10

76

.43

1.97

22

.55

22.6

2 23

.56

100.

00

11

121.

30

0.02

−

21.2

6 0.

88

0.94

10

0.00

12

49

.00

1.50

51

.19

43.1

4 44

.83

100.

00

13

23.6

6 1.

80

66.8

4 37

.22

29.5

2 10

0.00

14

18

.17

0.23

85

.28

17.3

0 20

.98

100.

00

15

59.7

8 −

0.62

56

.85

56.0

9 72

.10

100.

00

16

17.2

9 2.

35

89.5

1 76

.39

85.5

4 10

0.00

17

72

.29

−0.

50

59.0

3 89

.34

120.

17

100.

00

18

59.0

9 2.

67

41.7

4 25

.28

28.7

9 10

0.00

19

17

.75

−1.

17

132.

64

107.

00

156.

22

100.

00

20

73.5

8 2.

52

30.3

5 30

.65

37.1

1 10

0.00

21

89

.58

2.68

4.

10

8.36

4.

73

100.

00

22

117.

89

0.81

12

3.11

13

7.43

27

9.24

10

0.00

23

1.

58

−0.

02

90.7

8 24

.99

17.3

3 10

0.00

24

7.

56

0.18

10

4.78

9.

23

21.7

6 10

0.00

25

0.

49

−0.

41

96.3

3 −

3.25

−

6.85

10

0.00

26

23

.55

−4.

03

193.

89

214.

66

328.

06

100.

00


27

8.64

2.

10

71.6

9 −

23.7

1 −

41.2

7 10

0.00

28

26

.38

1.44

90

.87

33.5

1 52

.19

100.

00

29

−11

.13

−0.

31

97.3

3 4.

54

−9.

56

100.

00

30

29.5

7 1.

58

81.6

6 42

.97

55.7

7 10

0.00

31

20

.98

1.92

87

.40

34.9

5 45

.26

100.

00

32

41.4

8 −

6.09

19

4.77

25

9.86

39

0.02

10

0.00

33

35

.55

1.18

83

.29

30.4

8 50

.50

100.

00

34

59.3

6 0.

82

53.2

9 51

.58

65.0

4 10

0.00

35

14

0.94

−

43.5

8 23

.29

69.5

9 90

.25

100.

00

36

11.3

8 1.

60

81.0

7 −

2.30

−

8.25

10

0.00

37

−

137.

57

−3.

79

215.

47

−61

.38

−87

.27

100.

00

38

47.9

5 2.

05

58.0

4 54

.14

62.1

7 10

0.00

39

12

9.11

4.

75

−54

.09

−7.

75

−27

.99

100.

00

40

23.4

8 16

.11

−50

.84

−75

4.25

−

865.

50

100.

00

Tota

l 53

.50

2.10

60

.41

37.8

4 53

.85

100.

00

208 K.K. Saxena et al. Ta

ble

A12

Se

ctor

s cl

assi

fi ed

by th

e C

entr

al S

tatis

tical

Org

aniz

atio

n (C

SO)

in 1

993–

1994

Sect

or n

o.

Sect

or

Sect

or n

o.

Sect

or

Sect

or n

o.

Sect

or

Sect

or n

o.

Sect

or

1 Pa

ddy

30

Lim

esto

ne

59

Coa

l tar

pro

duct

s 88

C

omm

unic

atio

n eq

uipm

ent

2 W

heat

31

M

ica

60

Inor

gani

c he

avy

chem

ical

s 89

O

ther

ele

ctri

cal

mac

hine

ry

3 Jo

war

32

O

ther

non

met

allic

m

iner

als

61

Org

anic

hea

vy c

hem

ical

s 90

E

lect

roni

c eq

uipm

ent

(inc

ludi

ng T

Vs)

4

Baj

ra

33

Suga

r 62

Fe

rtili

zers

91

Sh

ips

and

boat

s 5

Mai

ze

34

Kha

ndsa

ri, b

oora

63

Pe

stic

ides

92

R

ail e

quip

men

t 6

Gra

m

35

Hyd

roge

nate

d oi

l (v

anas

pati)

64

Pa

ints

, var

nish

es, a

nd

lacq

uers

93

M

otor

veh

icle

s

7 Pu

lses

36

E

dibl

e oi

ls o

ther

than

va

nasp

ati

65

Dru

gs a

nd m

edic

ines

94

M

otor

cyc

les

and

scoo

ters

8

Suga

rcan

e 37

Te

a an

d co

ffee

pro

cess

ing

66

Soap

s, c

osm

etic

s, a

n gl

ycer

in

95

Bic

ycle

s, c

ycle

-ric

ksha

w

9 G

roun

dnut

38

M

isce

llane

ous

food

pr

oduc

ts

67

Synt

hetic

fi be

rs, r

esin

96

O

ther

tran

spor

t eq

uipm

ent

10

Jute

39

B

ever

ages

68

O

ther

che

mic

als

97

Wat

ches

and

clo

cks

11

Cot

ton

40

Toba

cco

prod

ucts

69

St

ruct

ural

cla

y pr

oduc

ts

98

Mis

cella

neou

s m

anuf

actu

ring

12

Te

a 41

K

hadi

, cot

ton

text

iles

(han

dloo

ms)

70

C

emen

t 99

C

onst

ruct

ion

13

Cof

fee

42

Cot

ton

text

iles

71

Oth

er n

onm

etal

lic

min

eral

pro

duct

s 10

0 E

lect

rici

ty

14

Rub

ber

43

Woo

len

text

iles

72

Iron

, ste

el, a

nd f

erro

us

allo

ys

101

Gas

15

Coc

onut

44

Si

lk te

xtile

s 73

Ir

on a

nd s

teel

cas

ting

and

forg

ing

102

Wat

er s

uppl

y

16

Toba

cco

45

Art

silk

, syn

thet

ic fi

ber

text

iles

74

Iron

and

ste

el f

ound

ries

10

3 R

ailw

ay tr

ansp

ort

serv

ices

17

O

ther

cro

ps

46

Jute

, hem

p, m

esta

text

iles

75

Non

ferr

ous

basi

c m

etal

s 10

4 O

ther

tran

spor

t ser

vice

s


18

Milk

and

milk

pro

duce

47

C

arpe

t wea

ving

76

H

and

tool

s, h

ardw

are

105

Stor

age

and

war

ehou

sing

19

A

nim

al s

ervi

ces

(agr

icul

tura

l)

48

Rea

dym

ade

garm

ents

77

M

isce

llane

ous

met

al

prod

ucts

10

6 C

omm

unic

atio

n

20

Oth

er li

vest

ock

prod

ucts

49

M

isce

llane

ous

text

ile

prod

ucts

78

T

ract

ors

and

agri

cultu

ral

impl

emen

ts

107

Tra

de

21

Fore

stry

and

logg

ing

50

Furn

iture

and

fi x

ture

s—w

oode

n 79

In

dust

rial

mac

hine

ry(f

uel a

nd tr

ansp

ort )

10

8 H

otel

s an

d re

stau

rant

s

22

Fish

ing

51

Woo

d an

d w

ood

prod

ucts

80

In

dust

rial

mac

hine

ry

(oth

ers)

10

9 B

anki

ng

23

Coa

l and

lign

ite

52

Pape

r, pa

per

prod

ucts

, an

d ne

wsp

rint

81

M

achi

ne to

ols

110

Insu

ranc

e

24

Cru

de p

etro

leum

, na

tura

l gas

53

Pr

intin

g an

d pu

blis

hing

82

O

f fi ce

com

putin

g m

achi

nes

111

Ow

ners

hip

of d

wel

lings

25

Iron

ore

54

L

eath

er f

ootw

ear

83

Oth

er n

onel

ectr

ical

m

achi

nery

11

2 E

duca

tion

and

rese

arch

26

Man

gane

se o

re

55

Lea

ther

and

leat

her

prod

ucts

84

In

dust

rial

ele

ctri

cal

mac

hine

ry

113

Med

ical

and

hea

lth

27

Bau

xite

56

R

ubbe

r pr

oduc

ts

85

Ele

ctri

cal w

ires

and

cab

les

114

Oth

er s

ervi

ces

28

Cop

per

ore

57

Plas

tic p

rodu

cts

86

Bat

teri

es

115

Publ

ic a

dmin

istr

atio

n

29

Oth

er m

etal

lic m

iner

als

58

Petr

oleu

m p

rodu

cts

87

Ele

ctri

cal a

pplia

nces


Tabl

e A

13

Sect

ors

clas

si fi e

d by

CSO

in 2

006–

2007

Sect

or n

o.

Sect

or

Sect

or n

o.

Sect

or

Sect

or n

o.

Sect

or

Sect

or n

o.

Sect

or

1 Pa

ddy

34

Oth

er m

etal

lic m

iner

als

67

Fert

ilize

rs

100

Oth

er tr

ansp

ort e

quip

men

ts

2 W

heat

35

L

imes

tone

68

Pe

stic

ides

10

1 W

atch

es a

nd c

lock

s 3

Jow

ar

36

Mic

a 69

Pa

ints

, var

nish

es,

and

lacq

uers

10

2 M

edic

al, p

reci

sion

and

op

tical

inst

rum

ents

4

Baj

ra

37

Oth

er n

onm

etal

lic

min

eral

s 70

D

rugs

and

med

icin

es

103

Gem

s an

d je

wel

ry

5 M

aize

38

Su

gar

71

Soap

s, c

osm

etic

s,

and

glyc

erin

10

4 A

ircr

aft a

nd s

pace

craf

t

6 G

ram

39

K

hand

sari

, boo

ra

72

Synt

hetic

fi be

rs, r

esin

10

5 M

isce

llane

ous

man

ufac

turi

ng

7 Pu

lses

40

H

ydro

gena

ted

oil

(van

aspa

ti)

73

Oth

er c

hem

ical

s 10

6 C

onst

ruct

ion

8 Su

garc

ane

41

Edi

ble

oils

oth

er th

an

vana

spat

i 74

St

ruct

ural

cla

y pr

oduc

ts

107

Ele

ctri

city

9 G

roun

dnut

42

Te

a an

d co

ffee

pro

cess

ing

75

Cem

ent

108

Wat

er s

uppl

y 10

C

ocon

ut

43

Mis

cella

neou

s fo

od

prod

ucts

76

O

ther

non

met

allic

m

iner

al p

rodu

cts

109

Rai

lway

tran

spor

t ser

vice

s

11

Oth

er o

ilsee

ds

44

Bev

erag

es

77

Iron

, ste

el, a

nd f

erro

us

allo

ys

110

Lan

d tr

ansp

ort i

nclu

ding

vi

a pi

pelin

es

12

Jute

45

To

bacc

o pr

oduc

ts

78

Iron

and

ste

el c

astin

g an

d fo

rgin

g 11

1 W

ater

tran

spor

t

13

Cot

ton

46

Kha

di, c

otto

n te

xtile

s (h

andl

oom

s)

79

Iron

and

ste

el f

ound

ries

11

2 A

ir tr

ansp

ort

14

Tea

47

Cot

ton

text

iles

80

Non

ferr

ous

basi

c m

etal

s 11

3 Su

ppor

ting

and

auxi

liary

tr

ansp

ort a

ctiv

ities

15

C

offe

e 48

W

oole

n te

xtile

s 81

H

and

tool

s, h

ardw

are

114

Stor

age

and

war

ehou

sing

16

R

ubbe

r 49

Si

lk te

xtile

s 82

M

isce

llane

ous

met

al

prod

ucts

11

5 C

omm

unic

atio

n


17

Toba

cco

50

Art

silk

, syn

thet

ic fi

ber

text

iles

83

Tra

ctor

s an

d ag

ricu

ltura

l im

plem

ents

11

6 T

rade

18

Frui

ts

51

Jute

, hem

p, m

esta

text

iles

84

Indu

stri

al m

achi

nery

(fue

l and

tran

spor

t)

117

Hot

els

and

rest

aura

nts

19

Veg

etab

les

52

Car

pet w

eavi

ng

85

Indu

stri

al m

achi

nery

(oth

ers)

11

8 B

anki

ng

20

Oth

er c

rops

53

R

eady

mad

e ga

rmen

ts

86

Mac

hine

tool

s 11

9 In

sura

nce

21

Milk

and

milk

pr

oduc

ts

54

Mis

cella

neou

s te

xtile

pr

oduc

ts

87

Oth

er n

onel

ectr

ical

m

achi

nery

12

0 O

wne

rshi

p of

dw

ellin

gs

22

Ani

mal

ser

vice

s (a

gric

ultu

ral)

55

Fu

rnitu

re a

nd

fi xtu

res—

woo

den

88

Indu

stri

al e

lect

rica

l m

achi

nery

12

1 E

duca

tion

and

rese

arch

23

Poul

try

and

eggs

56

W

ood

and

woo

d pr

oduc

ts

89

Ele

ctri

cal w

ires

an

d ca

bles

12

2 M

edic

al a

nd h

ealth

24

Oth

er li

vest

ock

prod

ucts

and

go

bar

gas

57

Pape

r, pa

per

prod

ucts

, ne

wsp

rint

90

B

atte

ries

12

3 B

usin

ess

serv

ices

25

Fore

stry

and

lo

ggin

g 58

Pr

intin

g an

d pu

blis

hing

91

E

lect

rica

l app

lianc

es

124

Com

pute

rs a

nd r

elat

ed

activ

ities

26

Fi

shin

g 59

L

eath

er f

ootw

ear

92

Com

mun

icat

ion

equi

pmen

t 12

5 L

egal

ser

vice

s

27

Coa

l and

lign

ite

60

Lea

ther

and

leat

her

prod

ucts

93

O

ther

ele

ctri

cal m

achi

nery

12

6 R

eal e

stat

e ac

tiviti

es

28

Nat

ural

gas

61

R

ubbe

r pr

oduc

ts

94

Ele

ctro

nic

equi

pmen

t (i

nclu

ding

TV

s)

127

Ren

ting

of m

achi

nery

an

d eq

uipm

ent

29

Cru

de p

etro

leum

62

Pl

astic

pro

duct

s 95

Sh

ips

and

boat

s 12

8 O

ther

com

mun

ity,

soci

al a

nd p

erso

nal

serv

ices

30

Ir

on o

re

63

Petr

oleu

m p

rodu

cts

96

Rai

l equ

ipm

ents

12

9 O

ther

ser

vice

s 31

M

anga

nese

ore

64

C

oal t

ar p

rodu

cts

97

Mot

or v

ehic

les

130

Publ

ic a

dmin

istr

atio

n

32

Bau

xite

65

In

orga

nic

heav

y ch

emic

als

98

Mot

or c

ycle

s an

d sc

oote

rs

33

Cop

per

ore

66

Org

anic

hea

vy c

hem

ical

s 99

B

icyc

les,

cyc

le-r

icks

haw


Table A14 Detailed list of sector aggregation

Sector no. Aggregated sectors Number of sectors (added together to get the aggregated sector value)

1 Agricultural goods 1–20 ( 1–17 ) 2 Allied activities 21–24 ( 18–20 ) 3 Forestry and fi shing 25, 26 ( 21 , 22 ) 4 Coal and lignite 27 ( 23 ) 5 Natural gas and rude petroleum 28, 29 (24 , 101 ) 6 Metallic minerals 30–34 ( 25 – 29 ) 7 Nonmetallic minerals 35–37 ( 30–32 ) 8 Sugar and related activities 38, 39 ( 33 , 34 ) 9 Food products 40–43 ( 35–38 ) 10 Beverages 44 ( 39 ) 11 Tobacco products 45 ( 40 ) 12 Textiles 46–50, 52–54 ( 41–45 , 47–49 ) 13 Other textile products 51 ( 46 ) 14 Wood products 55, 56 ( 50 , 51 ) 15 Paper products 57, 58 ( 52 , 53 ) 16 Leather products 59, 60 ( 54 , 55 ) 17 Rubber and plastic products 61, 62 ( 56 , 57 ) 18 Petroleum 63 ( 58 ) 19 Coal tar 64 ( 59 ) 20 Chemicals 65, 66 ( 60 , 61 ) 21 Fertilizers 67 ( 62 ) 22 Pesticides and other products 68, 70–73 ( 63 , 65 – 68 ) 23 Paints, varnishes, and lacquers 69 ( 64 ) 24 Nonmetallic mineral products 74, 76 ( 69 , 71 ) 25 Cement 75 ( 70 ) 26 Iron and steel industries and foundries 77–79 ( 72 – 74 ) 27 Nonferrous basic metals 80 ( 75 ) 28 Metal products and other nonelectrical

machines 81, 82, 84–87 ( 76 , 77 , 79 – 83 )

29 Tractors and agricultural implements 83 ( 78 ) 30 Electrical and electronic equipment 88–94 ( 84 – 90 ) 31 Transport equipment 95–100 ( 91 – 96 ) 32 Miscellaneous manufacturing 101–105 ( 97 , 98 ) 33 Construction 106 ( 99 ) 34 Electricity 107 ( 100 ) 35 Water supply 108 ( 102 ) 36 Railway transport services 109 ( 103 ) 37 Other transport services 110–113 ( 104 ) 38 Communication 115 ( 106 ) 39 Trade, hotels, and restaurants 116, 117 ( 107 , 108 ) 40 Other services 114, 118–130 ( 105 , 109 – 115 )

Bold numbers show the sectors for 1993–1994


References

Burange, L. G., & Yamini, S. (2008). Performance of Indian cement industry: The competitive landscape (Working Paper, No. UDE (CAS) 25/(9)/3/2008). Department of Economics, University of Mumbai.

CWC. (2006, December). A report on road to India: Wood market feasibility study. Canadian Wood Council (CWC).

Dhawan, S. (1993). Structural change and growth in the Indian economy: An input-output approach. Unpublished Ph.D. Dissertation, IIT, Kanpur.

Forssell, O. (1998). A decomposition technique for analyzing structural changes in production (Discussion Papers on Structural Analysis of Economic Systems, No. 8). Cambridge Growth Project, Department of Applied Economics, University of Cambridge.

Guill, G. D. (1979). Structural changes in the soviet economy. Unpublished Ph.D. Dissertation, Duke University, Durham.

United Nations. (2009). Report on world economic situation and prospects, 2009. New York: United Nations.

Venkatramaiah, P., Kulkarni, A. R., & Argade, L. (1984). Structural changes in Indian economy: An analysis with input-output tables, 1951–1963. Artha Vijnana, 26 (1 & 2).


1 Introduction

The structure of the Indian economy has changed rapidly since 1991. Indian companies are showing their presence in foreign markets and multinational companies are also entering the market. Several reform measures have been implemented and a lot more still have to be implemented. All these measures are fueling the process of integration of the Indian economy in the world economy. Free trade and free fl ow of capital are increasing ef fi ciency and competition and are contributing to the high growth rate.

Looking at the changing structure of the real economy, simultaneous corresponding reform of the fi nancial system is also required. Since 1992, India has implemented the recommendations of the Narasimhan committee reports I (1992) and II (1997) in the Indian banking system. India has freed up its fi nancial system, minimized interference by the government, and to ensure fi nancial stability, has put in place several prudent regulations that commercial banks have to follow. All these measures of monetary reform have improved the ef fi ciency of the fi nancial system and helped to ful fi ll the demand of the real economy in the changed environment.

The opening of the real economy also needs the free fl ow of fi nancial services in order to sustain the growth of the real economy. Thus, globalization of fi nancial services is the need of the time. India is one of the 104 signatories of the Financial Service Agreement of 1997. This made it compulsory to open up fi nancial services under supervision of the World Trade Organization.

Indian banks have to be encouraged to expand fast, both through organic growth and through consolidation, in order to fuel the growth of large fi rms and to strengthen their own competitive position in the world banking system. Various policy measures

D. K. Yadav (*) Department of Economics, Babasaheb Bhimrao Ambedkar University , Lucknow , Indiae-mail: [email protected]

Chapter 10 The Recent Recession: Impact and Future Prospects for the Indian Banking Sector

D. K. Yadav

216 D.K. Yadav

are in progress to help this transition. However, when we look at the global scenario, only 22 Indian banks fi gure in the list of the top 1,000 banks and there are only fi ve Indian banks in the list of the top 500 banks. The Indian banking sector has a long way to go before we can say that Indian banks are relatively signi fi cant players in comparison with their foreign counterparts. Having said that, there are suf fi cient reasons to believe that the Indian banking sector is poised for tremendous growth, and with a proper policy framework in place, Indian banks will very soon match their global counterparts on most of the relevant banking indicators/parameters except their size. Further, the present global- fi nancial-crisis-led recession has provided golden opportunities for Indian banks to strengthen their competitive position in comparison with their foreign counterparts in the world banking system. It is evident that when the top banks of the developed countries are collapsing because of their subprime lending and investment in mortgage-backed securities, Indian banks are safe and in a healthy position because of almost no exposure to these kinds of securities.

This chapter examines the competitiveness of Indian banks in the post recession period against their counterpart foreign banks on the basis of different banking parameters. In Sect. 2 , the Indian banking system and the banking systems of other countries are compared. Nonperforming assets (NPA), the capital to risk-weighted asset ratio (CRAR), the return on assets (ROA), asset size, and the size of market capitalization are the major indicators/parameters used for comparison. In Sect. 3 an attempt is made to look at opportunities and challenges for the Indian fi nancial system, particularly in the context of the present global recession, and increasing integration of the Indian fi nancial system with the rest of the world. Section 4 concludes the chapter.

2 Comparison of the Indian Banking Sector with Its Foreign Counterparts

2.1 Nonperforming Assets

High levels of NPA increase the cost of bank operations and thereby the spread and the efforts needed to be made to bring these down. The Indian banking system has made a signi fi cant stride in this direction. The NPA decreased from 14.4% in 1998 to 8.8% in 2003 and further decreased it to its minimum of 2.3% in 2010. If we compare the performance of Indian banks with that of the banks in other developed countries and developing countries in terms of NPA, we fi nd 2007 was a divider year. Before 2007, most of the developed countries were in a better position than the developing countries in general and India in particular. Some South American developing countries were an exception, and their performance was equal to and in some cases better than that of developed countries. However, since 2007, when

21710 The Recent Recession: Impact and Future Prospects…

the recession started, the situation has reversed. After 2007, the performance of the banking systems of developing countries improved, while performance of the banking systems of developed countries worsened because of defaults in subprime lending and recession. The NPA of the US banking system increased sharply from 0.8% in 2006 to 5.5% in 2010. A similar situation was observed in other developed countries, except Japan, which is an Asian country. How the NPA of the Japanese banking system did not increase is a question of great relevance for researchers, given the very basic nature of the Japanese economy, which is export-led.

From Fig. 10.1 and Table 10.1 , it is very clear that there was a declining trend in the gross NPA (GNPA) of developed countries to 2005, but the GNPA started increasing thereafter and continued increasing up to 2008 (the period of the fi nancial crisis), and then started declining again. But still the GNPA of the banking systems of developed countries are signi fi cantly higher than in the prerecession period.

In the case of developing countries, many of them either improved their performance or sustained their low level of NPA, except for a few countries, such as Pakistan. The NPA of Pakistan’s banking system increased sharply from 6.9% in 2006 to 13.1% in 2010. In the post recession period, Indian banks have registered a huge improvement in their NPA account. Now the Indian banking system is one of the most competitive banking systems in the world in terms of NPA. The level of NPA of Indian banks remained intact in the recession and has declined in the post recession period.

Figure 10.2 and Table 10.2 clearly indicate the declining trend of the GNPA of developing countries. The fi nancial crisis did not negatively affect the performance of the banking systems of these countries; rather their performance seems to have improved and converged in the period of the fi nancial crisis and thereafter.

0

2

4

6

8

10

12

2004 2005 2006 2007 2008 2009 2010

GN

PA

Year

UK

USA

France

Greece

Italy

Russia

Japan

Fig. 10.1 Gross nonperforming assets ( GNPA ) in developed countries (%)

218 D.K. Yadav

Table 10.1 Gross nonperforming assets (GNPA) in developed countries (%)

Country 2004 2005 2006 2007 2008 2009 2010

UK 1.9 1 0.9 0.9 1.6 3.5 – USA 0.8 0.7 0.8 1.4 2.9 5.4 5.5 France 4.2 3.5 3 2.7 2.8 3.6 – Greece 7 6.3 5.4 4.5 5 7.7 9 Italy 6.6 5.3 4.9 4.6 4.9 7 – Russia 3.8 2.6 2.4 2.5 3.8 9.7 9.5 Japan 2.9 1.8 1.5 1.4 1.6 1.7 –

Source: World Bank (2011)

0

2

4

6

8

10

12

14

16

2004 2005 2006 2007 2008 2009 2010

GN

PA

Year

Brazil

Chile

Mexico

China

India

Indonesia

Korea

Malaysia

Philippines

ThailandPakistan

Fig. 10.2 GNPA in developing countries (%)

Table 10.2 GNPA in developing countries (%)

Country 2004 2005 2006 2007 2008 2009 2010

Brazil 2.9 3.5 3.5 3 3.1 4.2 3.8 Chile 1.2 0.9 0.7 0.8 1 3 3.3 Mexico 2.5 1.8 2 2.7 3.2 3.1 2.8 China 13.2 8.6 7.1 6.2 2.4 1.6 India 7.2 5.2 3.3 2.5 2.3 2.3 Indonesia 4.5 7.4 6 4.1 3.2 3.3 Korea 1.9 1.2 0.8 0.7 1.1 1.2 1.5 Malaysia 11.7 9.6 8.5 6.5 4.8 3.7 3.5 Philippines 14.4 10 7.5 5.8 4.5 4.1 Thailand 11.9 9.1 8.1 7.9 5.7 5.3 5 Pakistan 11.6 8.3 6.9 7.6 10.5 12.2 13.1



2.2 Return on Assets

Indian banks are way ahead of their global counterparts when it comes to “return on assets” (ROA)—a parameter which denotes the ef fi ciency (Table 10.3 ). Except for Bank of America and Citigroup, not too many of the global giants can match Indian banks in terms of ROA. In 2004, Bank of America’s ROA was 1.91%, whereas that of Citigroup was 1.63%. Andhra Bank’s ROA was not far behind at 1.59%. Among other Indian commercial banks, Oriental Bank of Commerce’s ROA was 1.41%, HDFC Bank’s ROA was 1.29%, ICICI Bank and Allahabad Bank had an ROA of 1.20%, Punjab National Bank’s ROA was 1.12%, and Canara Bank’s ROA was 1.01%. Last year State Bank of India’s ROA was 0.94%. Among the top four Chinese banks, China Construction Bank had an ROA of 1.29%, and the ROA of the other three banks ranged between 0.5 and 0.81%.Among the top ten global giants, JPMorgan Chase, Crédit Agricole, Mitsubishi Tokyo, Mizuho Financial Group, and BNP Paribas had an ROA of less than 1%.

The Indian banking system has shown consistent performance in terms of pro fi tability even in the recession, when most of the top banks of developed coun-tries have registered huge losses in their account and their respective governments have to come forward to save them from collapsing. The ROA of Indian scheduled banks was 1.05% in 2006, increased to 1.13% in 2008, and then marginally declined to 1.10% in 2010 (Fig. 10.3 , Table 10.4 ). Total earnings exhibited an increasing trend in absolute terms; they virtually more than doubled in a very short span of 4 years. However, total expenses also increased in the same way and mitigated the effect of a signi fi cant increase in total earnings on pro fi tability (ROA). Controlling expenses, particularly operating expenses, will be the biggest challenge for Indian banks in the future. The use of modern technology can play a critical role in this direction.

Table 10.3 Return on assets of the banking systems of different countries

Country 2000 2001 2002 2003 2004 2005

India 0.7 0.6 0.8 0.9 1.1 1 Indonesia −9.1 −4.4 – 0.1 0.8 1.8 Korea −0.9 −3.3 −1.3 −0.6 0.8 0.8 Malaysia – – 1.1 1.1 0.8 – Pakistan −1.2 0.5 −0.2 −0.2 −0.5 – Philippines 1.7 0.8 0.4 0.4 0.4 0.7 Thailand −0.8 −5.1 −5.4 −1.6 −0.2 0.7 USA 1.3 1.1 1.3 1.2 1.1 1.4 Japan 0.0 −0.6 −0.5 0.2 0.0 −0.4 Canada 0.7 0.5 0.7 0.7 0.6 0.5 UK 0.9 0.8 1.0 0.9 0.6 0.7

Source: Ernst & Young

220 D.K. Yadav

2.3 Competitiveness of the Indian Banking System as Assessed by the CRAR

Capital adequacy is an indicator of the fi nancial health of the banking system. It is measured by the CRAR, de fi ned as the ratio of bank’s capital to its total risk-weighted assets. Financial regulators generally impose a capital adequacy requirement on their banking and fi nancial systems in order to provide a buffer which can absorb unforeseen losses due to risky investments. A well adhered to capital adequacy regime plays an important role in minimizing the cascading effects of banking and fi nancial sector crises. 4

The role of the CRAR in the world banking system suddenly became critical because of increasing rates default, initially in the US banking system due to subprime lending and later in other countries because of their off-balance-sheet exposure, which was in mortgage backed securities. If we compare the year 2006 with 2008, we fi nd that the CRAR of many developed countries decreased. This happened

Fig. 10.3 Pro fi tability of Indian banks during the recession

Table 10.4 Pro fi tability of Indian banks during the recession (ten million rupees)

Items 2006 2007 2008 2009 2010

Total earnings 220,756 274,716 368,873 463,702 494,271 Total expenses 166,362 208,739 285,284 352,805 371,852 Provisions and

contingencies 29,812 34,775 40,864 58,147 65,310

Pro fi t/loss 24,582 31,203 42,726 52,750 57,109 ROA 1.12 1.13 1.05 1.1

Source: Statistical tables relating to banks in India, March 4, 2011, Published by Reserve Bank of India (RBI) 8 ROA return on assets


because of an increased risk component in assets of the banking systems of developed countries. However, later in 2009, the CRAR increased in almost all the countries. Huge compensatory packages given by their respective governments to save the banking systems from melt down have played a signi fi cant role in improving their CRAR.

Figure 10.4 and Table 10.5 show that the CRAR of almost all the banking systems of the developed countries shown declined suddenly in 2007, except for Russia. They point out the increased component of risk in the portfolio of banking assets of developed countries. However, the declining trend reversed after 2008, because of the high compensation provided by governments to the banks.

In developing countries, the CRAR remained intact because of their better position in terms of asset quality and the low level of NPA. The Indian banking system has registered consistent growth in the CRAR. According to the Reserve Bank of India, the CRAR of Indian scheduled banks was 13.0% in 2007 (crisis year), and increased to 14.54% in 2009 and then marginally decreased to 14.17% in 2010. This shows that Indian banks are in a stronger position in comparison with their foreign counterparts in terms of the CRAR.

0

2

4

6

8

10

12

14

16

18

2004 2005 2006 2007 2008 2009 2010

CR

AR

Year

UK

USA

France

Greece

Italy

Russia

Japan

Germany

Fig. 10.4 Movement of capital to risk-weighted asset ratio ( CRAR ) in developed countries (%)

Table 10.5 Movement of capital to risk-weighted asset ratio (CRAR) in developed countries (%)

Country 2004 2005 2006 2007 2008 2009 2010

UK 7 6.1 6.1 5.5 4.4 5.4 USA 10.3 10.3 10.5 10.3 9.3 11 10.9 France 5.1 4.4 4.5 4.1 4.2 4.5 Greece 5.3 5.9 6.7 6.6 4.5 6.1 Italy 6.4 7.6 7 7.9 7.6 8 7.9 Russia 13.3 12.8 12.1 13.3 13.6 15.7 Japan 4.2 4.9 5.3 4.5 3.6 4.7 Germany 4 4.1 4.3 4.3 4.5 4.8


222 D.K. Yadav

From Fig. 10.5 and Table 10.6 it is obvious that the fi nancial crisis has not affected the quality of assets of developing countries; except for a few countries, such as Mexico and the Philippines. Many countries have shown consistent performance in terms of the CRAR and it remained almost unaffected by the fi nancial crisis.

0

2

4

6

8

10

12

14

16

2004 2005 2006 2007 2008 2009 2010

CR

AR

Year

Brazil

Chile

Mexico

China

India

Indonesia

Korea

Malaysia

Philippines

Thailand

Pakistan

Fig. 10.5 Movement of the CRAR in developing countries (%)

Table 10.6 Movement of the CRAR in developing countries (%)

Country 2004 2005 2006 2007 2008 2009 2010

Brazil 10.1 9.8 10 9.9 9.3 9.5 9.1 Chile 7 6.9 6.6 6.7 6.9 7.4 7 Mexico 11.2 12.5 13.6 13.8 9.2 9.7 9.7 China 4 4.4 5.1 5.8 6.1 5.6 India a 12.28 13.00 13.98 14.54 14.17 Indonesia 10 9.8 10.2 10.1 9.2 10.3 Korea 8 9.3 9.2 9 8.8 10.9 Malaysia 8.2 7.7 7.6 7.4 8.1 9 9.3 Philippines 12.6 12 11.7 11.7 10.6 11.1 Thailand 8 8.9 8.9 9.5 9.2 9.8 9.9 Pakistan 6.5 7.9 9.4 10.5 10 10.1 10.3

Source: World Bank (2011) a Pro fi le of banks, annual Reserve Bank of India publication ( 2011 )


2.4 Size, Quality of Assets, and Capital Adequacy Standard

The size of the banks plays a very critical role in global competition owing to tech-nology and risk-based banking. Indian banks are very insigni fi cant in comparison with their global counterparts in respect of asset size. In the world’s top 1,000 banks, there are many more large and medium-sized domestic banks from developed coun-tries than from emerging economies. Illustratively, according to a report (2004), of the top 1,000 banks globally, over 200 are based in the USA, just over 100 are based in Japan, over 80 are based in Germany, over 40 are based in Spain, and around 40 are based in the UK. Even China has 16 banks in the top 1,000 banks, of which 14 are in the top 500. India, in contrast has 20 banks in the top 1,000 banks, of which only six are in the top 500 banks. This is perhaps re fl ective of differences in the size of the economies and the fi nancial sector.

Figure 10.6 and Table 10.7 show the top ten banks in the world in terms of asset size along with India’s top ten banks. They clearly indicate that Indian banks are very insigni fi cant in comparison with their foreign counterparts in terms of asset size. Market-driven mergers and acquisitions of small banks by large banks are the only way to have at least three to four banks of the size of foreign banks. This is a must for the internationalization of Indian banks.

From the market capitalization point of view as well, Indian banks are very insigni fi cant in comparison with their global counterparts. The market capitaliza-tion of India’s largest commercial bank, State Bank of India, is just US$10 billion, in comparison with US$259 billion for Citigroup (Table 10.8 ).

So the Indian banking sector has a long way to go before we can say that Indian banks are relatively signi fi cant players in terms of asset size.

0

200

400

600

800

1000

1200

1400A

sset

Siz

e

Banks

Internationalbanks

Indian banks

é

Fig. 10.6 Top ten banks by asset size (billion dollars). SBI State Bank of India, PNB Punjab National Bank, BOI Bank of India, UBI United Bank of India, IOB Indian Overseas Bank

224 D.K. Yadav

There is an immediate need of consolidation in the face of their global counterpart. The annual survey of FICCI survey of Indian Banking system, 2006, indicates that consolidation in the Indian banking industry, followed by technological change, is the key factor currently required to enhance the international competitiveness of Indian banks.

3 Opportunities and Challenges for Indian Banking

3.1 Opportunities

Changing the competitive position of banks in the post recession period, as is obvious from Sect. 2 , has unleashed many opportunities for Indian banks. There are oppor-tunities within the country and internationally as well.

Table 10.7 Top ten banks by asset size (billion dollars)

International banks Size of assets Indian banks Size of assets

Mizuho Financial Group 1,285 State Bank of India 91 Citigroup 1,234 ICICI Bank 28 UBS 1,121 Punjab National Bank 23 Crédit Agricole 1,105 Canara Bank 22 HSBC 1,034 Bank of Baroda 19 Deutsche Bank 1,015 Bank of India 19 BNP Paribas 989 Central Bank of India 14 Mitsubishi Tokyo 975 United Bank of India 13 Sumitomo Mitsui 950 Indian Overseas Bank 11 Royal Bank of Scotland 806 Syndicate Bank 10

Source: EPW December 11, 2004

Table 10.8 Market capitalization of global banks (billion dollars)

Rank Bank Capitalization

1 Citigroup 259.7 2 American Insurance Group 207.4 3 HSBC Holdings 109.7 4 Berkshire Hathaway 100.2 5 Bank of America 99.0 6 Fannie Mae 79.5 7 Wells Fargo 73.5 8 JPMorgan Chase 71.7 9 Royal Bank of Scotland 69.4 10 UBS 67.1 11 Allianz 62.9 12 Morgan Stanley Dean Witter 61.4 13 Lloyds TSB 60.3 14 Barclays 55.2 15 Credit Suisse 51.3

Source: Morgan Stanley Capital International


The changing demographic pro fi le of the population, lifestyle changes in the young population, the increasing in fl uence of Western culture on society, and above all a shift in the basic thinking and moral philosophy of people toward consumerism and self-interest provide ample opportunities for Indian banks within the economy. Now people are not hesitant to take out loans for their personal needs, such as a house, a car, education, and even for holiday tours. They see them as a source of smoothing their consumption pattern and managing their immediate needs by means of their future income. The taboo of borrowing, which was once a very strong institutional factor of society, is now changing and people have more open thinking. According to the latest DSP Merrill Lynch report on the Indian economy , the changing demographic pro fi le of India is poised to push household consumption spending to $510 billion over the next 5 years from the current level of $250 billion. This spurt in household spending will automatically increase the business of banks in terms of retail products such as credit cards, personal loans, and hire-purchase lending. A strong base of domestic demand, which will continue to be a major source of busi-ness for Indian banks, is their strength against their foreign counterparts. No doubt, Indian banks have to improve their technological capacity and the skill of their human resources for ef fi cient delivery of fi nancial services in order to meet the increasing need of domestic customers. If they are unable to improve their performance in this respect, their foreign counterparts will snatch this opportunity from their hands, because in the future the Indian economy will be more open and liberal with the operation of foreign banks.

Opportunities are not limited only to within the country; the increasing integration of the Indian economy with the rest of the world is providing an opportunity for Indian banks to expand their business across borders. Again technology will play a pivotal role in attracting foreign customers. Internet-based banking is the future of the banking industry, and is very convenient and ef fi cient for customers. Indian banks need to develop their competency in this niche. Being the leader in the information technology (IT) sector, the Indian banking system can use this local advantage.

The process of internationalization of Indian banks should be well structured and should be conduced in a phased manner. In the fi rst phase of this process, they need to focus on the Asia–Paci fi c region particularly. With a population of over three billion people, the 23 countries of the Asia–Paci fi c region represent a rapidly growing and lucrative region for business. The number of Internet users is also increasing very fast in this region. According to the market research fi rm Yankee Group, Asia had 374 million Internet users in 2005 . According to International Data Corporation , the Asia–Paci fi c region now accounts for about a third of the world’s total Internet users. If Indian banks could use the competency of the Indian IT sector to deliver Internet-based fi nancial services, the Asia–Paci fi c region would be the next biggest source of their business.

Apart from the Asia–Paci fi c region, Indian banks should also concentrate their efforts in other regions. Owing to the recent fi nancial crisis and recession, large commercial banks in developed countries are reluctant to provide the funds to their domestic fi rms as well as foreign fi rms. This situation provides an opportunity for Indian banks to control the trend of increasing external commercial borrowing

226 D.K. Yadav

by Indian fi rms, on the one hand, and to attract fi rms of other countries by providing them with some lucrative services, on the other. Looking at the business scenario, there is little to doubt the success of Indian banks in this direction. But their ultimate success will depend upon their risk management ability, particularly in managing the risk which is involved in fi nancing the activities of multinational companies or the fi rms of other countries. At this stage, the strategy of Indian banks should be to grasp the maximum available opportunities linked to Indian fi rms which are internationalizing their operations along with the emerging opportunities in the Asia–Paci fi c region. With a cautious approach, effort should also be made in other regions for consistent growth in the long run. The domestic strength of increasing demand for fi nancial services should be used to fuel the process of internationalization of Indian banks.

Along with these broader opportunities in domestic and international markets for Indian banks, some speci fi c and concrete opportunities are discussed in the following sections.

3.1.1 Consolidation of the Banking Industry

With 27 public sector banks, 31 private banks, and 29 foreign banks, a consolidation exercise cannot be kept in cold storage. Owing to diversi fi ed operations and differing credit pro fi les of the banks, mergers and consolidations can help save intermediation costs, improve ef fi ciency, and help in risk mitigation or risk sharing mechanisms.

Table 10.9 shows that consolidation or an increase in the scale of business helps reduce the operating cost and increases the ef fi ciency. Many experts in the Indian banking industry have long been contemplating consolidation, leading to six or seven major players in the market. What India needs is a road map for managed consolidation. Banks need to fi nd ways to voluntarily merge, so that the shareholder value is maximized for both entities. 1 The government is also planning to kick off consolidation in the sector by lining up a series of merger and acquisition proposals for the public sector banks, given that in 2009 the banking sector has been com-pletely opened up. The domestic banks may be in a weak position if mergers and acquisitions are not concluded effectively.

3.1.2 Globalization of Operations

India has huge potential to become a major growth market for traditional banking, investment banking, and securities growth, given its rapidly growing economy and industry. In the FICCI annual survey of 2006 , it was been found that the regulatory system and the risk management system of Indian banks are better in comparison with those of Russian and Chinese banks, and are on par with those of Japanese and Singaporean bank. In terms of technology, Indian banks were rated ahead of Chinese and Russian banks and on par with Japanese banks, and for credit quality Indian banks are better in comparison with Chinese, Japanese, and Russian banks and are on par with Singaporean banks (Table 10.10 ).


3.1.3 Specialized Product Offerings

The competitive environment in the banking sector is likely to result in different strategies of individual player’s based on their strength and niche. For example, if one bank is more competitive in mortgage products, then that should be its focus, and if another bank is competitive in credit cards, then it should focus on credit cards and outsource the service of providing mortgage products to the fi rst bank. This will increase the ef fi ciency of the system. As Indian banks are more competitive in investment banking and traditional banking in comparison with their foreign counterparts, they should focus on these types of banking. The Indian banking system has a very good opportunity in specialized product offerings as product penetration is much less (Table 10.11 ).

Lack of an effective delivery channel and low capability of entry level workers are the major issues of concern issues in this case.

Table 10.9 Operating cost/average assets

Banks Top 5 Next 10 Remaining

Public sector banks 2.4 2.52 2.86 Private sector banks 1.59 – 1.82 Foreign banks 2.91 – 3.03


Table 10.10 Competitiveness of selected countries

Country Return on equity (%) Loan growth

China – 13.4 India 20.38 27.6 Malaysia <20 9.9 Hong Kong <19 8.1 Korea <19 7.7 Thailand <19 6.4 Singapore – 5.1 Indonesia 20.19 –

Table 10.11 Average number of products sold per customer in selected countries

Country No. of products

India 1.4 Spain 1.8 UK 2.6 Norway 2.7 France 3.0


228 D.K. Yadav

3.2 Challenges for the Indian Banking System

Looking at the opportunities and competitiveness of the Indian banking system which were discussed in the last section, we can say that Indian banks can compete and capture the world market. But there are certain issues of concern for improvement.

3.2.1 Technological Change

Cut-throat competition is the reality of the globalization process, not only in banking but in other industries as well. The quality of service during delivery of fi nancial products will ultimately determine the competitive position of Indian banks. Technology has to play a critical role in this respect. Advances in computing and telecommunications has revolutionized the banking industry. They have changed the way of banking: from ledger-based to computerized and online banking. Increasing use of technology has contributed much to improving the ef fi ciency and quality of service delivery. People expect better quality of service at low cost and banks have to meet their expectations. Only those banks who can ful fi ll the expecta-tions of customers will dominate and lead the market. Quality of service delivery is not the only aspect of increasing use of technology, it is useful even for reaching the large populations in rural and remote areas ef fi ciently and in a shorter time. 6

High operating costs are a major problem of the Indian banking system, and use of technology can help reduce operating costs. Indian banks have ef fi ciently implemented the fi rst phase of technological adoption, which includes large-scale computerization of branches and operations and to some extent reorientation of banking staff in terms of new skills. Indian banks have so far successfully imple-mented the technology in their front-of fi ce operations, but this is not suf fi cient in the process of internationalization of their operations. 13 Back-of fi ce operations such as Management Information System (MIS), fraud prevention, value addition, market-ing, and higher business should also be linked with technology and manpower and banks should be given suf fi cient exposure to deal with Practical understanding. Practical understanding of technology and operations. Banks also need to develop their competency in alternative delivery channels such as ATMs, telephone banking, real-time gross settlement, mobile banking, Internet banking, and core banking. Indian banks have local advantages in the form of a very dynamic IT sector and a speedily growing telecommunications sector and they can use these in developing their own core competency in the area of alternative delivery channels for fi nancial services. This is even more relevant when the IT and telecommunication sectors are themselves internationalizing their operations.

3.2.2 Designing a Proper Human Resources Policy

Manpower is going to play a very critical role in the process of internationalization and liberalization of the banking industry. Along with technology, human resources is most important factor determining the competitive positions of banks. The changing


business environment, consumer demands and consumers’ need for fl exibility, the impact of technology, and changing organizational structure are a few reasons why an ef fi cient human resources policy is needed. Technology is changing the scenario and methods of banking. In the changing scenario of the banking business, experience is not going to be helpful for banking staff because in a very short span of time (4–5 years), banking methods will change completely and the old staff will not be able to cope up with the new methods and technology. Technology needs the correct mix of age and skills. Young employees have better skills and exposure of modern technology to tackle the challenges posed by modern technology and thus improve delivery of services to customers. Indian banks have implemented a large-scale lucrative voluntary retirement scheme for their employees to achieve this target and reduce their operating costs. But there is still an imbalance in this aspect, particularly in the case of public sector banks. To overcome this problem, banks need to focus on an ef fi cient training policy for their old staff. The services of consultancies and educational and research institutions could be taken up in this respect. In training programs, it should be ensured that all the staff have suf fi cient understanding of the products and procedures to tackle the problems of business, and to be on par with the best in the industry.

Recruiting only young staff and equipping old staff with the best knowledge in the industry is not suf fi cient; they should also have suf fi cient motivation to pass on their knowledge and understanding. For this, the vision of the organization should be inculcated and made clear to all the employees. The vision of the organization should be exciting, motivating, and should also include the motivation and inspiration of individual employees. Employees need to have appropriate authority to take decisions in fi nancial and non fi nancial matters according to the hierarchical structure; assigning only accountability is not going to be helpful for the organization. There should be the right mix of accountability and authority, and they should go hand in hand. Checks and balances are necessary, but trust and faith should be given preference to develop a good environment and feeling of self-relevance among the employees. Along with this, a proper appraisal and promotion policy is also very important to ensure the motivation of employees. Every employee who joins the organization wants to go up the ladder. Money is not everything in determining the satisfaction of employees; timely recognition of one’s contribution and perfor-mance and suf fi cient reward in the form of promotions and placements also give a sense of satisfaction and motivation to work. It is also helpful to develop an ef fi cient organizational structure with a suitable person in the right place. Only by suitable and objective methods of appraisal can performers and their relative competency be identi fi ed, which is very important for a dynamic organizational structure. Banks should also have proper communication channels at various tiers of the organization so that higher-level managers can understand the problems of lower-level managers and employees and the lower-level staff can convey their problems to the higher authority. For this, fi nding the person with the right aptitude is a must. From time to time banks should organize programs for shaping the right attitude of employees. The success of Indian banks in the long run will depend on designing and imple-menting an ef fi cient human resources policy which should be based on mutuality of objective and developing cohesiveness among staff.

230 D.K. Yadav

3.2.3 Cost Management

Cost containment is the key to sustainability of a bank’s pro fi t as well as its long-term viability. In 2004, operating costs as a proportion of average assets in the UK were 2.12%, in Switzerland they were 2.03%, and in other European countries they were less than 2%. In India, however, in 2004 operating cost as a proportion of total assets of scheduled commercial banks was at 2.24%. Thus, the task ahead is clear and within reach.

3.2.4 Recovery Management

This is the key to the stability of the banking system. There should be no hesitation in accepting that the Indian banking system has done a remarkable job in containment of NPA. GNPA and net NPA have decreased from a very high level in 1991 to 7% to below 2% currently. We must recognize that cost and recovery management supported by an enabling legal framework hold the key to the future health and competitiveness of the Indian banks. No doubt improving the average asset quality by recovery and its management in India is an area requiring expeditious and affec-tive actions in legal, institutional, and judicial processes.

3.2.5 Risk Management

Banking in modern economics is all about risk management. Implementation of Basel norms has also supported this concern. After reform of the banking system and opening of the economy, several new risks and existing risks in new form regen-erating in system . Proper assessment and management of these risks is required for the sustainability of the system. The failure of the top global banks in the USA and other developed countries is a warning to the Indian banks to look again at their risk structure and risk management systems. The Indian banking system has to go a long way to coincide with the modern risk management approach and models. The insti-tution of sound risk management practices would be an important pillar for staying ahead of the competition.

4 Conclusion

The banking industry in India, through a measured, gradual, cautious, and steady reform process, has undergone substantial transformation. Indian banks have been looking for an opportunity to push their operations at a global level. The recent fi nancial-crisis-led recession has provided that opportunity, which Indian banks can use for the consolidation of their operations, and also to come on par with their foreign counterparts. It has been found that Indian banks are performing better than their foreign counterparts in developed countries in terms of different performance


indicators, such as NPA, CRAR, and ROA, in the post recession period. Asset size and the size of the market capitalization are the only parameters where Indian banks are lagging. By an ef fi cient process of consolidation, which must be a market-driven exercise, the problem of size could be overcome. Along with consolidation, increased use of modern technology and improved skills of human resources are some other very important areas where Indian banks need to concentrate their efforts. Indian banks have suf fi cient potential and local advantages in the form of a very ef fi cient and dynamic IT sector, a rapidly growing telecommunications sector, and above all a very successful and cautious regulatory system to overcome these challenges. Indian banks are also supported by their strong and consistent growth in demand for domestic fi nancial services, which they can use to fuel their process of internation-alization and improve their competitiveness. Finally, it can be said that the recent fi nancial-crisis-led recession has provided golden opportunities for Indian banks to internationalize their operations in order to overcome some of their weaknesses.

References

Al Shubiri, F. N. (2010). Impact of bank asset and liability management on pro fi tability: Empirical investigation. Journal of Applied Research in Finance (JARF), 2 (4), 101–109.

Bhaumik, S., & Piesse, J. (2004, April). Are foreign banks bad for development even if they are ef fi cient? Evidences from Indian Banking Industry (Working Paper Number 619). William Davidson Institute.

FICCI Survey on the status of the Indian Banking Industry – Progress and Agenda Ahead (2006) Accessed from googlescholar.

Gopalakrishnan, M. M. (2010). Globalization and recent trend in banking. Global Journal of Business and Management Research, 10 (5), 38–41.

Gopalan, S., & Rajan, R. S. (2009, July 22). Financial sector deregulation in emerging Asia: Focus on foreign bank entry (ISAS Working Paper No. 76). Institute of South Asian Studies, National University of Singapore.

Kamath, K. V., Kohli, S. S., Shenoy, P. S., Kumar, R., Nayak, R. M., & Kuppuswamy, P. T. (2003). Indian banking sector: Challenges and opportunities. Vikalpa, 28 (3), 83–99.

Mohan, R. (2006, June 2). Financial reforms and monetary policy: The Indian experience. Paper presented at Stanford University.

Nitusure, R. R. (2003, December 27). E-Banking: Challenges and opportunities. Economic and Political Weekly, 38 (51/52), 5377–5381.

Reddy, Y. V. (2004, November 10). Banking sector in global perspective . Inaugural address as Governor of RBI at Banker’s Conference, New Delhi.

Reserve Bank of India. (2011). Annual report , various years. Reserve Bank of India. (2011). The report on currency and fi nance , various years. Singh, P. (2007). Global competitiveness of Indian Banks: A study of select banking indicators.

Issues of concern and opportunities . Available at Google search site. Uppal, R. K. (2011, April). Global crisis: Problem and prospectus for Indian Banking Industry.

Journal of Economics and Behavioral Studies, 2 (4), 171–176. “Vision 2020 for India the fi nancial sector” by Rohit, special consultant, planning commission

available at Google search site.


1 Introduction

Since the deceleration in global trade, industrial production and fi nancial fl ows have been extraordinarily high. The recent global economic slowdown has taken center stage in policy debate and discussions around the world. Although its epicenter was in the developed world, particularly in the USA, its impact has been experienced in almost all regions and sectors with different degrees and dimensions. The crisis poses substantial risks to emerging market economies, operating through multiple transmission mechanisms. There are three major channels through which the impact of the global crisis has been transmitted to the rest of the world: the fi nancial sector, exports, and exchange rates. However, the ripples of recession too are being felt in terms of reduction in exports from developing countries to developed countries, decline in remittances and investment, and increasing concern about the availability and cost of credit. The combined impact of all these factors resulted in loss of employment and reduction of income, leading to several socioeconomic–political problems. The ILO ( 2008 ) predicted that the slow or negative economic growth, combined with highly volatile food and energy prices, will erode the real wages of the world’s 1.5 billion wage earners, particularly low-wage and poorer households.

Although transmission of the impact of the crisis in developed countries to emerging market economies has become evident, countries are affected to different magnitudes and intensities. The impact was mainly in the form of contraction of the volume of trade due to falls in global demand, precipitous falls in fi nancial fl ows to emerging market countries, decline in remittances because of retrenching of workers by labor-importing countries, falling commodity prices and reduced incomes of households in emerging countries which export commodities to developed countries, decline in foreign investment fl ows due to the perception of higher risks, and decline in domestic employment.

B. K. Sahu (*) Assistant Professor (Economics), Indian Institute of Foreign Trade , New Delhi , Indiae-mail: [email protected]

Chapter 11 Impact of the Global Downturn on the Indian Economy

Basanta K. Sahu

234 B.K. Sahu

Although many countries are still experiencing contraction of their economic and trade activities due to the economic slowdown, some others have been successful in overcoming its adverse impacts and a few of them are recovering fast. Therefore, the experiences of different countries and sectors offer some plausible lessons for all countries, particularly those that have experienced higher growth rate based on their trade and service sector growth such as India. Interestingly, India has experienced impressive growth but not in a conventional pattern as advocated by growth theories yet it managed to limit the adverse impacts of the current global economic slowdown. However, the variability and volatility of economic growth and trade performance among emerging economies, including India’s economy, was worrying even before the crisis. With this background, it would be interesting to discuss and understand how the global economic slowdown has in fl uenced the Indian economy, where trade-oriented service-sector-led economic growth is dominant, surpassing the manufacturing and agriculture sectors in recent years. It is also important to discuss how the strength of domestic demand can play a crucial role in case of a global economic crisis like the recent one, which has been viewed differently by different scholars.

What is more important is to learn some important lessons from the experiences and the way different economies reacted to the global economic slump in recent years. For India it is an opportunity to learn and prepare better for the future policy adjustment in order to handle a similar kind of situation effectively. This chapter highlights these points and focuses on some key aspects of the global economic slowdown from the Indian perspective. The objective is to present a succinct analysis of the channels through which the fi nancial crisis has impacted the Indian economy and examine the impacts of the slowdown on trade, agriculture, manufacturing, services, employment, in fl ation, and other issues. The chapter delineates the chal-lenges and opportunities emerging from the crisis and emphasizes the need to learn lessons from such situations for suitable policy actions that will diffuse the adverse effects of external shocks in the future.

2 Economic Slowdown from a Global Perspective

During the last few years, declining global domestic product, slowdown and decline in trade, rising unemployment, slowdown in the pace of investment activity, and other factors have resulted in an increasing sense of insecurity. What started as a shock in the fi nancial markets in a few developed economies has spread to all other sectors of the world economy, and the exact depth and breadth of the impact is still unclear. The global economy weakened through 2008, with a noticeable fall in global demand. Massive reversal of private capital fl ows was observed, which has been more severe in emerging markets than in lower-income countries. The impact was fi rst felt in the fi nancial markets of emerging economies. The high dependence on foreign capital in such emerging markets means that the developments in G7 fi nancial markets affect emerging markets almost immediately.

23511 Impact of the Global Downturn on the Indian Economy

There was a decline in trade volume through decreasing demand in industrialized economies. Since remittances are at risk, economies heavily dependent on remit-tances suffered a setback. The fi nancial crisis that began in the USA in 2007 became a full-scale economic crisis affecting virtually the entire global economy. There is little doubt that the geographic spread and depth of this economic crisis is limited and less than for any major global crisis. Although several agencies and organizations 1 had predicted a substantial slowdown in global economic activity, all available lead indicators pointed to a downslide. However, the impact of the slowdown has been felt differently by different countries depending on the nature of their exportable products, the country for which the exports were destined, and the overall depen-dence of the economy on exports. Emerging country exports have consequently lost momentum, a deceleration which has been reinforced by sharp falls in the prices of commodities that emerging countries export. Investment activity in emerging economies also slowed as business con fi dence fl agged and access to debt and equity funding for new projects became more dif fi cult.

Moreover, some emerging economies have entered the next phase of the crisis, transmission as domestic demand remains weak. The consumers in trade-exposed emerging countries are facing job losses and slow income growth. Even domesti-cally oriented companies have downscaled and postponed or cancelled expansion plans, resulting in reduced job growth and a material slowdown in investment. In this context, the higher the income elasticity of demand for a country’s exports, the higher will be the adverse impact of lower GDP growth of its trading partners. For instance, India is one of the many developing countries which have relied reason-ably on its exports to developed countries. In 2007, around 17% of India’s exports were to the US market, 29% were directed to G7 countries, and around 58% were directed to advanced countries (as de fi ned by the IMF). In this regard, the impact of the slowdown in advanced countries is being felt heavily in India’s trade sector.

However, the data presented in Table 11.1 reveal that the decline in GDP growth has been experienced across all countries and regions of the world but it was more pronounced in advanced countries and regions such as the USA and the European Union than in emerging economies such as those of China and India. The GDP growth of India was estimated to be 9.2% in 2005–2006, which increased to 9.7% in 2006–2007 but declined to 9.2% in 2007–2008 and declined further to 7.2% in 2008–2009. However, its growth performance improved in the later period against major economies other than the Chinese economy.

3 Economic Slowdown from the Indian Perspective

For India the global economic slowdown has made its economic and trade scenarios more dif fi cult and complex by causing sharp declines in exports of manufactures and reversal of capital fl ows such that both current and capital accounts of the balance of payments have worsened. India is more integrated into the world economy than ever before. Whereas exports of goods and services were roughly 12% of GDP in

236 B.K. Sahu

2000, they now account for twice that. Similarly, gross fl ows on the balance of payments (summing across the current account and capital account) were roughly 50% of GDP in 2000, and have been increased by 1.5 times. Therefore, the pace of change of India’s integration into the world economy has been quite fast, which implies that global shocks affect India more. As the global economy weakened, capital in fl ows which helped drive the economy in previous years turned into capital out fl ows, putting pressure on the currency, causing the Indian rupee to reverse its earlier appre-ciation. The impact of the global crisis has been transmitted to the Indian economy through three distinct channels, viz., the fi nancial sector, exports, and exchange rates. The fi nancial sector, including the banking sector, equity markets, external commercial borrowings, and remittances, has not remained unscathed, although fortunately the Indian banking sector was not overly exposed to the subprime crisis.

The crisis impinged the Indian economy through reduced demand for Indian exports. This affected the pro fi tability of many Indian companies owing to lowered prices of their products on the world market and reduced investment owing to the change in the business and economic environment. India’s real GDP growth fell to 5.3% in October to December 2008 and marginally improved to 5.8% in January to March 2009, recording the most dismal performance since 2005. Exports for October 2008 registered the fi rst negative growth in during last seven years prior to the crisis. For the fi rst time the economy showed signs of deceleration and grew at 7.8% in the fi rst half year of 2008–2009 (April to September). However, it is often argued that the Indian economy has been less affected by the global slowdown owing to lesser integration with the world as compared with its size and potential. The impacts are spatially as well as sectorally differentiated because many core sectors are still driven by domestic demand and not yet globally integrated. For instance, the rural and agriculture sector in India appears not to have been affected much; rather it has absorbed some shocks originating from the global slowdown. But this argument needs further quali fi cation. To minimize the adverse impact of global shocks, it is important for policy makers to focus on a proper balance between development of the export sector and development of the nonexport sector and to achieve and maintain a desired growth rate.

Although export-dependent emerging economies are hit the most during a crisis, the Indian economy is one of the least open economies in Asia, but its external trade

Table 11.1 Changes in real GDP in major countries (%) during 2005–2010

Country/region 2005–2006 2006–2007 2007–2008 2008–2009 2009–2010

USA 2.80 2.00 1.10 −4.00 0.00 Euro area 3.00 2.60 0.70 −4.10 0.30 Canada 3.10 2.70 0.5 3.00 0.30 UK 2.80 3.00 0.70 −3.70 −0.20 Japan 2.00 2.40 −0.60 −6.60 −0.50 India 9.70 9.00 6.00 4.30 5.80 China 11.60 13.00 9.00 6.30 8.5

Source: UNCTAD ( 2009 )


still constitutes about one fourth of its GDP. Although the Indian economy has suf fi cient internal resources to withstand the impact of a global recession, because of the overall strength of domestic demand and the predominantly domestic nature of fi nancing of investment and less exposure to exports, some slowdown is inevita-ble. The Indian economy performed better during the 1990s and has performed exceptionally well since 2003. But it has transited from the high growth period of 2007 that threatened overheating, to the deceleration period evident in the later part of 2008. The year 2008 saw the Indian economy being subject to a set of forces. On the one hand, there was the lagged impact of the monetary tightening by the Reserve Bank of India (RBI) and, on the other hand, there was the progressively greater impact of the global fi nancial crisis. Consequently, India experienced a reversal of important trends such as a decline in growth, a shrinking export sector, high in fl ation in early 2008, in fl ation, and constraints on the availability and cost of credit. On the other hand, the fi scal consolidation that was evident in recent years suffered a setback as the government raised subsidies to combat the earlier spike in in fl ation. The number of fi scal stimulus packages provided by the government since 2008 to diffuse the impacts of the crisis resulted in widening the fi scal de fi cit rather than consolidating it. The global slowdown has implications for the domestic economy. Fiscal and monetary stimuli of the economy have hardly succeeded in boosting domestic demand, supporting export-oriented sectors, and even stabilizing the economy.

At the sectoral level, different types of Indian fi rms performed differently during the economic crisis (Table 11.2 ). Pradhan ( 2009 ) analyzed the relative growth performance of Indian fi rms (450 manufacturing and IT companies) during the recent

Table 11.2 GDP breakdown by industry and expenditure—India

3Q07 4Q07 1Q08 2Q08 3Q08

GDP 9.2 8.9 8.9 7.9 7.6 Demand aggregates Private consumption expenditure 7.6 9.4 8.3 8.0 5.0 Government consumption expenditure 10.3 2.3 16.7 7.7 8.6 Gross fi xed capital formation 16.7 14.3 11.2 9.0 13.8 Exports –2.8 15.8 10.1 18.1 13.2 Less imports 0.4 14.2 9.7 23.4 22.6 Supply aggregates Agriculture, forestry, and fi shing 4.7 6.0 2.9 3.0 2.7 Mining and quarrying 5.5 5.7 5.9 4.8 3.9 Manufacturing 9.2 9.6 5.8 5.6 5.0 Electricity, gas, and water supply 6.9 4.8 5.6 2.6 3.6 Construction 11.8 7.1 12.6 11.4 9.7 Trade, hotels, transport, and communications 11.0 11.5 12.4 11.2 10.8 Financing, insurance, real estate, and business

services 12.4 11.9 10.5 9.3 9.2

Community, social, and personal services 7.7 6.2 9.5 8.4 7.6


238 B.K. Sahu

economic slowdown and explored factors which have helped certain Indian companies to do relatively better even in this crisis period. He found that the Indian fi rms which were relatively young and more focused on the global market were better off in terms of sales and pro fi t growth than other fi rms. But some Indian companies have signi fi cantly reduced their technological activities because of falling sales and pro fi t growth during the slowdown, besides slashing their resource allocation for advertising and labor.

The service sector, which contributes more than 50% of GDP and is the prime growth engine, is reported to be slowing down, mainly in the transport, communica-tions, trade, and hotels and restaurants subsectors. In the manufacturing sector, growth reduced to 4.0% in April to November 2008 as compared with 9.8% in the corresponding period of the previous year. The slowdown occurred in all use-based categories, except consumer goods, where it has accelerated.

On the other hand, variability and volatility in the agriculture sector due to poor monsoons and input supply and market constraints affected both the agricultural sector and rural demand. We now discuss some sector-speci fi c issues in India which emerged because of the global slowdown.

4 Macro Impact of the Global Slowdown

4.1 Manufacturing Sector

The manufacturing sector is one of the sectors hardest hit in India because of the global economic recession in recent years (Table 11.3 ). Overall growth and stability of the global economy has become extremely important for the growth performance of Indian fi rms. Some recent studies have found that the sales and pro fi tability growth of Indian manufacturing and IT fi rms has signi fi cantly reversed with the global markets turning adverse since late 2008 (Pradhan 2009 ) . The problem of declining demand for manufacturing products was found to be severe in some sectors, whereas there was found to be considerable variation in inter fi rm growth performance, due to mainly fi rm-speci fi c heterogeneity in competitive capabilities, fi nancial strength, and sources of demand. However, some innovative fi rms man-aged to overcome this in a relatively short time span (Pradhan 2009 ) .

With declining global demand, liquidity shortages adversely affected fi rms that generally had large short-term and other liquid liabilities to meet their current assets. In this regard, many export-oriented Indian fi rms became more vulnerable to the decreasing export opportunities than their domestic-market-oriented counterparts. The growth difference between younger and older fi rms or, for that matter, between large and small fi rms was also in fl uenced by the experience factor in the business and scale of operation, respectively. Similarly, fi rms investing heavily in building their brand products suffered less from the crisis than their counterparts.


4.2 Loss of Employment

One of the key parameters used to measure the impact of an economic slowdown is the change in the nature and pattern of employment. Given the relative dependence on the external trade sector, where exports of goods and services are very important, a global slowdown can have adverse employment effects in terms of loss of employ-ment, shift from regular to casual employment, decline in wage rates, etc., that affect wage earners in particular and the whole economy in general. More impor-tantly, it can lead to unemployment and hence an increase in the number of poor in the country. The job losses may be direct owing to contraction of output in the exportable sectors or indirect through a decline in output of the sectors which provide inputs for the exportable sectors. Despite India’s export sector accounting for less than 20% of the country’s GDP, the decline in exports has affected the total employment in the country. India’s exports had witnessed a phenomenal threefold increase during the period from 2002–2003 to 2007–2008. But this increase did not happen in terms of employment generation in the export sector, which is now threatened by rapid contraction of global demand and weakening labor markets. This is a major challenge for policy makers to neutralize the adverse impact of the global slowdown on employment and build a mechanism for resilience of the economy to such shocks in the future.

According to a report on the impacts of the economic slowdown on employment in India, about half a million workers lost their jobs during October to December 2008 (Government of India 2009 ) . It includes important sectors such as mining, textiles, metals, gems and jewelry, automobiles, transport, and IT/business process outsourcing, which accounted for more than 60% of GDP in 2007–2008. The sectors

Table 11.3 Industry-wise sales growth of Indian fi rms (%), 2006–2009

Select industries

Preslowdown period Slowdown period

2006 2007 2008 2009

Metal 23.7 40.1 34.6 −5.8 Chemical 16.6 11.4 30.4 14.1 Pharmaceutical 12.6 20.1 20.6 −0.2 Electrical 35.2 35.9 68.0 −2.9 Food 24.5 17.1 26.1 3.9 IT and ITES 37.5 39.4 40.3 8.5 Machinery 23.0 29.8 36.6 −4.8 Other manufacturing 24.3 23.1 36.3 7.1 Nonmetallic minerals 14.9 31.8 38.9 −2.1 Rubber 12.5 21.1 29.7 −3.3 Textile 13.7 6.4 30.2 7.1 Transport equipment 20.8 21.3 29.5 −15.3 All Industries 22.4 26.0 36.2 0.60

Source: Pradhan ( 2009 ) ITES IT-enabled services

240 B.K. Sahu

most affected were gems and jewelry, transport, and automobiles, where employment declined by 8.58, 4.03, and 2.42%, respectively, during the period from October to December 2008. In the textile sector, 0.91% of workers have lost their jobs. An adverse impact of the slowdown on employment was noticed in the export-oriented sectors. Similarly, total earnings during the period under review declined by 3.45% and the capacity utilization reduced by 7.05% in the automobile sector and 5.68% in the metal sector. To assess the impact of the global recession on the export sector resulting in a decline in employment, separate data for the export and nonexport sectors were collected by the Ministry of Labour and Employment during 2008–2009. A comparison of the employment data for export and nonexport sectors indicates that employment declined at an average monthly rate of 1.13% in the former case and by 0.81% in the latter case (Government of India 2009 ) . The fi ndings of the survey indicate that the export sector experienced a greater decline in employment and that workers left this sector because of declining wages and insecurity and also sought employment avenues in other sectors. On the supply side, the employers were skeptical about the future course of actions and felt that if the situation did not improve, they would be compelled to retrench their workforce.

Data on sector/industry-level changes because of the impact of the economic slowdown on employment are presented in Table 11.4 . It reveals that a decrease in employment has been experienced in all sectors, except the IT/business process outsourcing sector. The average monthly decline in employment was highest (8.58%) for gems and jewelry, followed by transport (4.03%), automobiles (2.42%), metals (1.91%), textiles (0.91%), and mining (0.33%).

A study by UNCTAD ( 2009 ) 2 tried to estimate the impact of the global slowdown on employment in the economy. The estimates show that in 2008–2009, owing to negative export growth in sectors such as textiles, gems and jewelry, and minerals, the total job loss in India was around 1.16 million. However, the net employment created by exports in that year was positive, i.e., 1.25 million, as many sectors expe-rienced positive export growth. The net employment was estimated as the difference between the sum total of jobs created and the sum total of jobs lost in different sectors over time. In 2009–2010, export growth was predicted to be −2.2%, and the

Table 11.4 Change in employment of export and nonexport sectors and of direct and contract workers by industry

Industry

Type of sector Type of worker

Export Nonexport Overall Direct Contract

Mining −0.32 −0.33 −0.33 −0.06 −0.81 Textile −1.29 0.32 −0.91 −1.11 4.6 Metal −2.6 −1.24 −1.91 −1.04 −4.53 Gems and jewelry −8.43 −11.9 −8.58 −9.27 −3.86 Automobile −1.26 −4.79 −2.42 −0.77 −12.37 Transport 0.0 −4.03 −4.03 1.96 −9.93 IT/BPO 0.33 1.08 0.55 0.51 1.6 Overall −1.13 −0.81 −1.01 −0.63 −3.88

Source: Government of India ( 2009 ) BPO business process outsourcing


total job loss was estimated to be around 1.3 million. But since export growth is positive for some sectors such as the plantation industry and these sectors have high employment multipliers, the net employment loss is estimated to be 0.7 million.

Other than agriculture, the bulk of employment creation since the onset of the economic reforms in the early 1990s has occurred in manufacturing, construction, trade, hotels and restaurants, transport, storage, and communications. It is, therefore, in these sectors that the slowdown in growth hurts the most. However, the effects of the job loss and changes in the nature of employment due to the global slowdown can be different. Whereas the share of wages and salaries in terms of the sales of Indian fi rms suffered signi fi cantly on the eve of the global economic crisis, the wage share for all industries decreased by more than half during the slowdown period relative to the preslowdown period, from 9.5 to 4.4% (see Table 11.5 ). However, this drive to reduce labor costs in order to remain competitive during the slowdown has been prevalent among Indian fi rms in the chemical, electrical and optical equipment, rubber and plastics, other manufacturing, and other nonmetallic mineral product sectors. The other sectors, however, increased spending on wages, indicating that the fi rms in these sectors might be adopting other strategies to keep their competi-tive advantages. The export-oriented handmade carpet industry has a major share in international markets, and provides employment to millions of people in the country. More than two million rural artisans depend on this industry for their sustenance. Over Rs 35 billion worth of handmade carpets are exported to various countries by small and medium-sized carpet manufacturing and supplying units. However, declining demand from international clients has led to an uncertain future for the carpet weavers and exporters. The major impact for the lower-income segments of the population seems to be greatest for those employed in export-oriented sectors, such as diamond polishing, garments, carpets, and hosiery. There have been large-scale job losses and mass unemployment in many such clusters such as Surat, Bangalore, Bhadoi, and Tirupur.

Table 11.5 Allocation of labor in Indian fi rms: wages and salaries (as a percentage of sales)

Preslowdown period (2005–2006 to 2007–2008)

Slowdown period (2008–2009) Growth (%)

Basic metal and metal products 2.89 3.14 8.5 Chemicals and chemical products 3.97 3.54 −10.9 Drugs and pharmaceuticals 8.30 8.97 8.1 Electrical and optical equipment 3.91 3.69 −5.5 Food products, beverages, and tobacco 4.15 4.24 2.2 IT and ITES 41.06 41.94 2.2 Machinery and equipment 5.54 5.63 1.7 Other manufacturing 4.59 4.42 −3.6 Other nonmetallic mineral products 3.95 3.89 −1.6 Rubber and plastics 3.97 3.80 −4.2 Textiles and textile products 6.53 6.85 4.9 Transport equipment 5.74 6.38 11.1 All Industries 9.50 4.44 −53.3

Source: Pradhan ( 2009 )

242 B.K. Sahu

As regard loss of employment in India due to the global economic slowdown, it may be noted that it was more or less con fi ned to speci fi c export-related sectors and sub-sectors, such as IT, IT-enabled services, tourism, and fi nancial services. Much is not yet known about how many jobs were lost and the nature of these job loses outside the export sector on account of the crisis. Since there is a marked uneven export growth throughout the country, it is rather concentrated in a few clusters, where the extent of job losses and their impact might have been severe and for a certain period as the economy was already on the path to recovery. Moreover, to create new job opportunities in these sectors, a threshold level of education and skill is required, which many surplus workforces do not possess owing to poor human development. What is important to note here is that we would have seen a much worse employment situation in India like in other countries where export growth is even and widespread and contributes a sizeable part to GDP. But this does not mean that India can afford to ignore the desired export growth, rather it should carefully select the sector and subsectors in proper sequence, and adopt other policy measures.

As opportunities for paid employment have dwindled, employment in the export-oriented sectors has been progressively casual. In this context, the new entrants to the labor market, most of whom are migrant workers from rural areas without adequate skills, suffered a lot because of the global crisis. Export growth is not evenly spread throughout the country, but is rather concentrated in clusters, where the impact of job losses is felt more acutely. There was an impact among those who earn a living from trade and manufacturing. Job losses might have been concentrated in the unorganized sector, from where about 40–45% of India’s exports originate. Since employment in the unorganized/informal sector is mostly on basis of informal contracts, downsizing adversely affects those who are employed in it.

4.3 Exports and Economic Growth

Since many emerging market economies have employed export-oriented growth strategies during the past few decades, the domestic economy has become more integrated with and more dependent on international demand. Therefore, the nature and pattern of the global demand and changes therein play an important role in determining export growth of a product and the overall economy. Despite world trade growth being projected to contract by −2.8% in 2009 after a peak of 9.4% in 2006 (IMF estimate), economies in South Asia too have become more export depen-dent for growth. In this context, some major factors are worth noting to analyze the impacts of the global slowdown on India. These are South Asia’s trade links with the G7 economies, its trade links with other Asian economies such as those of China, Southeast Asia, and the Middle East, and the composition of the goods exported

Since 2002–2003, exports of goods have grown by more than 20% in dollar terms, exceeding 30% in 2004–2005, but with a sharp decline during the crisis period. Consumption, investment, and exports have driven this growth. This growth also occurred when the external environment was beginning. Since export demand


is largely determined by income elasticity of external demand for the product, the higher the income elasticity of demand for a country’s exports, the higher will be the adverse impact of lower GDP growth of its trading partners. Along with income elasticity, price competitiveness may also determine the impact of a slowdown on exports. If the products exported are less price sensitive, during a global economic slowdown the option of lowering prices to maintain existing market shares may not be feasible. It has also been argued that since India’s exports are in low-value segments, income reduction in developed countries might actually increase the demand for exports from India. This is also a true argument for the declining external demand for high income elasticity items that constitute only a small part of Indian exports such as textiles, garments, gems and costume jewelry, leather, and processed food. Even contraction of external demand for these items may be due to other factors, such as taste, preference, design, and quality, rather than price. Sectors which have high income elasticity but low price elasticity are therefore relatively more vulnerable sectors of the economy in terms of the impact of a global slowdown. In the Indian context, two such sectors are gems and jewelry and textiles, which require targeted interventions.

The impact of the crisis on the trade sector also affects the composition of exports. Generally speaking, labor-intensive industries such as apparel and clothing are likely to be hit earlier in a crisis as these are directly linked to consumer demand in the G7 economies. But within apparel exports, expensive and branded clothing are less resilient as compared with inexpensive and nonbranded clothing. China is the largest exporter of textiles and apparel to the USA, and is suffering a decrease in demand for its exports. This particular factor is applicable to India. The fall in demand might be mitigated to some extent by consumers in the G7 countries and elsewhere downgrading to cheaper garments and other lower-priced consumer goods that are manufactured in these countries. The study by UNCTAD ( 2009 ) shows that India’s exports to the world have been very responsive to income changes. A 1% decline in world GDP growth will lead to a 1.88% decline in India’s growth of exports to the world. Estimates of income elasticity of ten major Indian export sectors (which account for around 95% of India’s total exports) show that income elasticity was high for sectors such as petroleum products, ores and minerals, gems and jewelry, chemical products, and engineering products. India’s traditional export sectors, such as textiles, leather, and the plantation industry, were found to have relatively low income elasticity, with the lowest being for the plantation industry.

The second transmission of the global downturn to the Indian economy has been through the steep decline in demand for India’s exports in its major markets. The fi rst sector to be hit was the gems and jewelry sector, which felt the impact in November 2008 and where more than 300,000 workers have lost their jobs. The adverse impact also surfaced in other export-oriented sectors, such as garments and textiles, leather, handicrafts, and automobile components. The export of gems and jewelry, textiles and leather has experienced a noticeable fall since 2008–2009. There was the steepest fall in exports for the last two decades (21% decline in exports in February 2009). Indian IT fi rms which had grown robustly over the preceding few years suffered a major setback in terms of slowing of their growth. In merchandise

244 B.K. Sahu

exports, India is still suffering a slowdown. The declines re fl ect both lower prices as well as reduced volumes, which has affected India’s current account. However, with the global recession putting substantial downward pressure on oil prices, the Indian economy is receiving some relief on the current account balance.

From the above discussion it is clear that India has not been able to remain insulated from this global decline, especially in the export sector. A closer look at India’s trade sector indicates that real term growth of India’s exports and imports of both goods and services has declined (Table 11.6 ). Growth of exports of goods in real terms declined from 17.8% in 2006–2007 to 5.4% in 2007–2008. The maxi-mum decline was witnessed in exports of services, which grew at a rate of 26.8% in 2005–2006, but experienced a negative growth of −1.8% in 2007–2008. Growth of imports of goods declined from 25.2% in 2005–2006 to 10.6% in 2007–2008. Surprisingly, growth of private remittances in real terms showed a marked improve-ment from 10% in 2006–2007 to 24.1% in 2007–2008.

Intraregional trade in Asia has been expanding rapidly as China has become an assembling platform where components—mainly from Southeast Asia and East Asia—are assembled into fi nal goods meant for fi nal consumption elsewhere, mainly in the G7 counties. This has not been entirely true for India. India exports 6.3% of its exported goods to China, which is comparable with other countries in Southeast Asia, such as Malaysia, Thailand, and Singapore.

However, the postslowdown growth in the trade sector in India has been more satisfactory than in many other countries, which has drawn the attention of researchers

Table 11.6 Growth performance of India’s trade sector (in real terms) (%)

2005–2006 2006–2007 2007–2008

Exports of goods 17.2 17.8 5.4 Exports of services 26.8 27.4 −1.8 Imports of goods 25.2 17.9 10.6 Imports of services 17.8 24.0 −3.7 Private remittances 12.9 10.0 24.1 Real GDP at market prices 9.2 9.7 9.2


Table 11.7 Exports to the G7 countries, India, China, and developing Asia, 2006

Country

Percentage of total exports

G7 counties India China Developing Asia

Bangladesh 71.0 1.6 0.8 5.1 Bhutan 0.1 81.9 0.0 _ India 33.3 – 6.3 20.6 Maldives 30.5 1.8 0.0 48.8 Nepal NA 66.4 NA 69.5 Sri Lanka 54.9 6.7 0.4 14.3

Source: ADB ( 2009 ) NA not available


and policy makers. India’s exports also depend on the supply side and the exchange rate. It has also been argued that since India’s exports are in low-value segments, income reduction in developed countries might actually increase the demand for exports from India. But a speci fi c study is required to qualify this statement. In terms of the impact of the global slowdown disaggregated by regions and states in India, little is known so far. If there is a slowdown in growth, states with accelerated growth should suffer more. But the composition of the growth matters as all sectors are not affected equally. Moreover, if growth is primarily based on agriculture, the state tends to be relatively more insulated from externally triggered slowdowns than its counterparts dependent on export-oriented sectors. In this regard, states such as Andhra Pradesh, Goa, Gujarat, Haryana, Karnataka, Maharashtra, Punjab, and Tamil Nadu would be worse affected, where the manufacturing sector plays a more dominant role than in Orissa, Bihar, and Madhya Pradesh. In fact, some proreform states such as Andhra Pradesh , Punjab, and Tamil Nadu suffered in terms of a decline in growth during the postreform period (1999–2000 to 2004–2005) more than their counter-parts pursuing slow reforms (Sahu 2010 ).

4.4 Impact on Foreign Direct Investment

Foreign direct investment (FDI) has been an important factor for achieving a high growth rate in emerging economies. In the case of individual countries, lower FDI would therefore lead to reduction in investment and subsequently to slower eco-nomic growth. Given uncertainty regarding risks as well as demand and dif fi culties in raising capital, foreign investment into emerging market countries will tend to fall. However, FDI-related vulnerability has been one of the major concerns of the recent global economic slowdown. A few factors associated with the investing country, such as the level of development and location-based proximity, are impor-tant deciding factors. For instance, a large portion of FDI in fl ows into India is from developed economies 8 (Table 11.8 ), which means there is a serious threat in terms of its continuation whenever there is a crisis.

FDI in fl ows to India fall as the access of global companies to capital declines and as their appetite for expansion and risk is weakened. Although India’s long-term fundamentals remain compelling for foreign investors, greater uncertainty as well as the dif fi culty that companies face in raising capital affects FDI in fl ows to India.

The effect of the global economic slowdown on the Indian economy is still debat-able. Nevertheless, exports, foreign investments (direct and portfolio), and of fi cial development assistance fl ows suffer, re fl ected in slower growth. This implies the poverty-reducing effects of growth also suffer and government revenue is also adversely affected, limiting the fi scal space available to governments. There are differential spatial effects, since those who are more integrated and connected with global and national markets suffer more.

246 B.K. Sahu

Tabl

e 11

.8

Fore

ign

dire

ct in

vest

men

t ( F

DI )

in fl o

ws

and

cros

s-bo

rder

mer

gers

and

acq

uisi

tions

( M

&A

s ) in

em

ergi

ng m

arke

t cou

ntri

es

FDI

in fl o

ws

Cro

ss-b

orde

r M

&A

s

2007

(U

SD b

illio

n)

2008

(U

SD b

illio

n)

Cha

nge

(%)

2007

(U

SD b

illio

n)

2008

(U

SD b

illio

n)

Cha

nge

(%)

Wor

ld F

DI

1833

.3

1449

.1

−21

.0

1637

.1

1183

.7

−27

.7

Dev

elop

ing

econ

omie

s 49

9.7

517.

7 3.

6 15

2.9

177.

0 15

.8

Asi

a 24

7.8

256.

1 3.

3 81

.5

89.4

9.

7 C

hina

83

.5

92.4

10

.7

15.5

20

.3

31.0

In

dia

23.0

36

.7

59.6

5.

6 11

.2

100.

0 M

alay

sia

8.4

12.9

53

.6

4.5

5.5

22.2

T

haila

nd

9.6

9.2

−4.

2 2.

9 0.

6 −

79.3

Si

ngap

ore

24.1

10

.3

−57

.3

8.8

17.0

93

.2

Sour

ce: A

DB

( 20

09 )


4.5 Impact on Commodity Prices

The impact of the fi nancial crisis on the poor and the rural sector is translated in terms of commodity prices, mainly in terms of food and fuel price rises. In India, although the in fl ation rate based on the wholesale price index (WPI) is declining, in fl ation based on the consumer prices index (CPI) peaked during the crisis and now is on a declining path. 3 Although actual poverty estimates during this period are not yet available, it is expected that the global crisis might have some adverse poverty-reduction effects on growth, particularly in regions with more export-related activi-ties. Food prices have gone up by several times, leading to high food in fl ation during the crisis period and affecting low-income groups and poor households, for whom food expenditure constitutes a substantial portion of total household expenditure. Any change in investment and consumption in the home market, to emphasize wage-led growth, turns economic adversity to an advantage.

The global slowdown has been accompanied by changes in employment and relative prices that have adversely affected some sectors: small and marginal farm-ers, casual labor in the informal sector, and rural women, who are vulnerable. Volatility of output prices remains a huge problem for farmers. Income elasticity of demand for cereals among low-income groups still shows positive signs and this implies that the demand for farm produce and the demand for labor in agriculture remain strong. Agriculture, despite its low productivity and decline in its labor-absorption capacity, continues to be one of the cushion factors that absorb external shocks like the current global crisis.

The boom in commodities in 2007–2008 was quite broad-based as crude oil prices came close to the USD 150 per barrel mark. The prices of other energy-related commodities, such as coal, natural gas, and palm oil, also increased. Food products such as wheat and rice, which are the most common grains found in coun-tries such as India, also crossed record levels. But only a portion of the total price rise was fed back to the farmers or producers. As commodity prices fall, incomes in commodity-exporting countries will fall, depressing domestic demand. Indian exporters could suffer from a slowdown in demand in their export markets. On the other hand, India is a high-energy-consumption country which needs to import oil for its domestic requirements. Falling oil prices thus imply an improvement in the trade balance as well as reduced domestic in fl ation. Annual consumer price in fl ation averaged 11.5% in 2008 in India, rising from 4.7% in 2007 (see Table 11.9 ).

To keep prices at reasonable levels, the Indian governments increased its fi scal spending to subsidize rising food and oil prices. With the reduced need for subsidies as in fl ation eases, there should also be some relief for fi scal account. But there was no notable relief in terms of food price rise until recently.

Despite the fact that agriculture and the rural sector are less affected because of their limited exposure to external markets, the impact of the crisis on the poor could be much more severe than has been recognized. Exposure to global price volatility was associated with a growing reliance on private debt, because of the lack of exten-sion of institutional credit, coupled with a growing inability to meet debt service

248 B.K. Sahu

payments because of the combined volatility of crops and prices. Higher food prices might have aggravated the situation and pushed back further the possibility of India reaching its macroeconomic targets such as poverty reduction, employment genera-tion, and the millennium development goals.

4.6 Other Sectors

As regards the fi nancial sector, substantial capital out fl ows from India diminish the fi nancial market’s liquidity and depress valuations, raising the cost of capital and reducing the incentive to invest. This re fl ects the increased integration of the Indian fi nancial markets into the global capital market. With the increased correlation of Indian equity price changes with those in the equity markets of the developed world, India no longer provides the same level of diversi fi cation as in the past when India was more insulated from the global fi nancial markets. At a time of rising risks and reduced risk tolerance among the major investment funds of the world, foreign investors are cutting their exposure to Indian fi nancial assets, producing a substantial out fl ow. This puts pressure on the Indian rupee, which has depreciated dramatically. The RBI’s foreign reserves had fallen to USD 123.44 billion in November 2008 from its peak of USD 134.40 billion 2 months earlier.

The rupee has come under pressure with the out fl ow of portfolio investments because of higher foreign exchange demand by Indian entrepreneurs seeking to replace external commercial borrowings by domestic fi nancing and the consequent decline in foreign exchange reserves.

As capital fl owed out of the Indian fi nancial system, credit markets experienced a reduction in liquidity, causing lending rates to rise until the RBI intervened in October 2008, an intervention followed up in mid-December by the central government’s insistence that state-owned banks pass on part of the RBI interest rate reductions to consumers and fi rms. Despite these dif fi culties, the Indian economy did not have to endure the banking sector travails evident in the USA, Europe, and some emerging market countries in Europe. India is one of the highest recipients of remittances in

Table 11.9 Level of in fl ation in Asian regions and countries (%)

2005 2006 2007 2008 2009

Asia 3.4 3.3 4.3 7.8 6.0 Southeast Asia 6.3 7.1 4.0 9.4 6.9 South Asia 5.3 5.9 5.5 11.8 9.2 Bangladesh 6.5 7.2 7.2 9.9 9.0 Bhutan 4.8 4.9 5.2 10.0 7.0 India 4.4 5.4 4.7 11.5 7.5 Maldives 3.3 3.5 7.4 11.0 6.0 Nepal 4.5 8.0 6.4 7.9 8.5 Sri Lanka 11.0 10.0 15.8 24.0 18.0

Source: ADB ( 2009 )


the world. But remittances from both major markets—the Middle East and G7 countries (USA, UK, and Canada) have weakened. The number of overseas Indians has fallen as oil-producing economies in the Gulf and West Asia began to suffer from the decline in oil prices.

Companies in developed economies will have to retrench workers, including foreign ones such as overseas Indian workers, as weaker demand forces them to align their capacity with lower demand. Remittance out fl ows from the Middle East are linked to oil prices: as oil revenues fall substantially below expected levels, spending on construction and related areas where overseas Indians work will fall and reduce the demand for such workers.

5 Is India Insulated from the Global Slowdown?

Given the surprisingly steep fall in global economic activity due to the economic slowdown, the GDP growth in India declined but it was much less than in the other economies of Asia or the rest of the world, which were more exposed to interna-tional trade. Some analysts argued that India managed to overcome the impact of the global slowdown because of its inherent economic features and less exposure to the world. On the fi nancial front, the Indian banking sector was not overtly exposed to the subprime crisis. Despite a steep decline in demand for India’s exports, its exports (both goods and services) only account for about one fi fth of GDP and it is less reliant on imports than are other countries such as China, Taiwan, and Singapore and other trade-based economies with larger trade multiplier effects. Therefore, the overall impact of the global slowdown, through a slump in exports, has not affected India’s economy as happened in the case of several other economies. As regards the exchange rate management, the Indian rupee had come under pressure with the out fl ow of portfolio investments, higher foreign exchange demand by Indian entre-preneurs seeking to replace external commercial borrowings by domestic fi nancing, and the consequent decline in foreign exchange reserves. Perhaps India managed exchange rate well with suitable short-term measures 9 and high foreign exchange reserves, without much affecting investment sentiments. The domestic fi nancial sector was also seen to be immune to shocks from the international fi nancial system.

Transmission of the impacts of the global crisis through all these channels does not seem to have affected the Indian economy to the extent it affected other economies. The timing of the shock from the global economic downturn did matter to India when the external environment was benign. However, to curb adverse impacts of the global slowdown there was little scope on the fi scal front as the country had already initiated some stringent measures to reduce its huge fi scal de fi cit. Confronted with the growing concern of the slow pace of poverty reduction, rising unemployment, and poor social sector development, the country had limited options but to follow some bold measures to diffuse the impacts of the global slowdown. However, several fi scal and monetary measures 4 were announced during the crisis period which are

250 B.K. Sahu

believed to have worked for the country. To counter the problems originating from India’s dependence upon greater global integration, there were some key factors that worked as cushions to absorb external shocks.

It is well documented that the global economic slowdown has not impacted India as badly as those countries which are more globally integrated. Investment remained surprisingly strong. Similarly, resilience in the fi nancial sector has been seen in terms of a well-regulated and strong, if not a robust, fi nancial sector with a relatively sound banking systems. To some extent, the regulated fi nancial sector in India worked as key shock absorber. The Indian banking industry was mostly not exposed to the derivative fi nancial products that caused the fi nancial crisis in the USA. Indian banks are relatively safe, although there was a sudden capital out fl ow especially from US investors, posing a major threat. The main vulnerability in the system was the amount of fi nancially mobile capital, as seen in the level of international claims on Indian banks, which has already impacted the economy. In the trade sector, India’s relatively low export/GDP ratio means that India has been less damaged by the global slowdown than other Asian countries. Still, export-oriented industries such as garments and gems and jewelry were hit badly. The was also a slowdown in the export of services as fi nancial institutions in the West, who are major customers for India, downsize.

Relatively high domestic consumption (60% of GDP) and private investment (30% of GDP) are key to Indian economic growth and are reasons for strong eco-nomic fundamentals and con fi dence. The rural sector, particularly in agriculturally developed areas, seems to have provided some kind of a cushion to India. Despite several arguments for job losses due to the global slowdown, there is little empirical evidence of this having occurred outside the export sector. Although income elastic-ity of demand for cereals for the Indian population as a whole is declining and may now be near zero, low-income groups still show positive income elasticity of demand for cereals. This ensures that the demand for farm produce remains buoyant and thus the demand for labor in agriculture remains strong.

From the above discussion it appears that India is “decoupled” from the global system and is capable of recovering faster with improvement in overall growth perfor-mance. However, other domestic factors important in this context are higher working population, leading to falling dependency ratios, huge social and public spending during the crisis period, and short-term measures taken by the government.

6 Policy Response to the Global Slowdown

Although India has suffered in terms of falls in economic output, loss of employment, and decline in investment as a result of the global slowdown, effective domestic policies pursued to increase domestic demand, expand infrastructure, and to regulate India’s fi nancial sector worked to arrest the overall impact of the crisis. Timely applied strong monetary and fi scal policies focused on the rural and agriculture sector and stepped-up efforts to build social safety nets as well as accelerated spending on


infrastructure are some good policy responses to reduce adverse impacts. The Indian government, in coordination with the RBI, used a three-pronged approach to handle the situation which emerged from the global crisis. The exercise of the RBI in terms of infusion of additional liquidity by cutting the cash reserve ratio, lowering the statutory liquidity ratio, and unwinding the market stabilization scheme proved effective. Further the central bank also signaled its expansionary preference by cutting the repo rate, at which it lends funds to commercial banks. To improve liquidity, the cash reserve ratio has been decreased from 9 to 6.5% since October 2008, releasing liquidity to the banking sector. The RBI has also opened a special repo window under the liquidity adjustment facility for banks, for lending to nonbanking fi nancial companies, housing fi nance companies, and mutual funds. The reverse-repo rate has also been brought down to 3.5% to discourage banks from parking overnight funds with the RBI. 5 Similarly, to improve credit fl ows in trade fi nance, the RBI also extended the period of preshipment and postshipment credit for exporters and offered other countercyclical adjustments to augment the presently abysmal situation of trade fi nancing. Several regulatory measures were undertaken as a quick policy response to the crisis. To facilitate external fi nancing, the government through its various regulatory bodies settled for certain regulatory adjustments. For example, all ceilings on external corporate borrowing were removed in the most recent measures. In addition, foreign institutional investment in corporate debt was also signi fi cantly raised. On the other hand, the weaker rupee should encourage Indian exporters. It is possible that with imports declining as sharply as exports, the country’s trade de fi cit actually improved. The external sector balance did not pose a major policy threat in the short run. On the fi scal policy front, despite having little room and given the already large fi scal de fi cit because of the burden of high subsidies, the government has still managed to introduce important off-budget fi scal changes. These include additional expenditure of INR 2.3 trillion in December 2008, for infrastructure development, 6 encouragement of exports, 7 and promotion.

There were some packages that implied a hefty transfer of purchasing power to the farmers and to the rural sector in general, such as farm loan waivers, funds allocated to the National Rural Employment Guarantee Scheme (NREGS), Bharat Nirman (targeted for improving rural infrastructure), the Prime Minister’s Rural Roads Program, and a large increase in subsidies on account of fertilizers and elec-tricity supplied to farmers. However, all these measures, taken more for political considerations, have, nevertheless, helped to shore up rural demand for consumer durables and nondurables. The government is also faced with some off-budgetary fi scal worries, including oil and fertilizer bonds issued in 2008 to help oil marketing companies cope with the rising crude oil prices at the time. The government’s fi scal balance was under pressure even prior to the outbreak of the crisis, weighed down by major policy decisions such as the farm loan waiver program, payouts recommended by the Sixth Pay Commission, the rural employment guarantee scheme, and the energy subsidies. Under this situation it is important to focus policy attention on removing many structural bottlenecks to realize the potential GDP growth rate than depending more on export-oriented growth. Overdependence on aggressive trade competitiveness, which acted as a robust factor for quick acceleration of growth in

252 B.K. Sahu

some countries in recent years, appears dif fi cult to maintain and may not be suf fi cient to achieve the desired level of growth. Essentially the strength of economic funda-mentals of a country is important in a situation such as the global economic crisis. Policy efforts aimed at improving the investment climate for both domestic and foreign investors in both export and nonexport sectors, expanding physical, fi nancial, and social infrastructure, and improving governance are equally important to handle the impacts of a global crisis in the future, even though they will not provide complete insulation from them. This is an important lesson that India should capi-talize on for the future.

7 Conclusion

The global economic slowdown has affected overall growth of India’s economy. The impacts are spatially as well as sectorally differentiated. The impact of the global crisis has been transmitted to the Indian economy through three distinct channels, viz., the fi nancial sector, exports, and exchange rates. On the fi nancial front, the Indian banking sector was not overly exposed to the crisis. Exports of both goods and services, which account for only about 22% of Indian GDP, have large multiplier effects for economic activity, and the export slump during the crisis has affected the GDP growth rate. Regarding the exchange rate, Indian rupee has come under pressure owing to the global economic slowdown. Although the Indian econ-omy looked to be relatively insulated from the global fi nancial crisis as compared with other emerging economies, differential growth performances by core sectors and regions does support this view. Loss of employment, a slump in exports, a weakening domestic currency, arise in commodity prices, etc., are the critical issues in macroeconomic policy for achieving higher and stable economic growth. The recovery from the crisis in India has been faster but it does not completely support the current policy interventions. In the years of high growth, there was room to ensure that “fallback cushions” for a possible period of downturn were put in place. Perhaps this did not happen, despite the fact that the growth rate was relatively better than that of many other countries. Here is a lesson for policy makers to learn how to use high and diversi fi ed sectoral growth and prepare better strategies to manage globalization and wider integration, which result in greater exposure to uncertainty and external shocks.

Although this chapter offers some interesting fi ndings, they are only a broad understanding of the impacts of the global economic slowdown in the Indian context. Undertaking detailed region- and sector-speci fi c studies would underscore policy strategies to sail through the global economic slowdown. For India, the lesson from the experience of the global downturn is not to be overdependent on export-led growth, but rather to focus on a more balanced growth path in order to achieve and maintain a desired level of growth. The nature and composition of growth should have room to absorb external shocks to the optimum level in the case of exposure


to uncertainty and a global crisis. The advantage that India had was to learn these lessons during the period when the growth rate declined but was substantially higher than in the countries in the developed world. It is worth the lesson being learned, when growth declines marginally from a high growth rate (from 8.5 to 5.5%) rather than slipping to zero or negative growth as in the case of many other economies in the world.

8 Policy Implications

The recessionary impact of the global economic slowdown is far from its fi nal stages and the issues in front of the policy makers are unprecedented. It took some time for policy makers and analysts in India to recognize both the speed and the intensity of the effects of the global crisis. As this crisis is not restricted to any one country or region, policy decisions made in the developed economies will have a visible impact on other economies. As different sectors and different fi rms are acknowledged to be asymmetrically affected by the global slowdown, designing suitable policy options is very important.

Short-term policy measures may be given priority to manage immediate concerns that may reemerge soon. These may include alleviating business concerns, providing short-term relief to exporters, and buffering the effect of the crisis on the consumer. Flexibility in policy actions is very important as India suffers from limited fl exibility of fi scal policy owing to its large fi scal de fi cits burdened by fuel and food subsidies. However, there is not much room for further fi scal policy action as the consolidated fi scal de fi cit of the central and state governments is already high (about 11% of GDP during 2008–2009). It should be more industry-speci fi c, given that the global slowdown affects emerging economies in highly sector speci fi c ways. The IT and IT-enabled services , gems and jewelry, and leather sector, which were affected more by the crisis, need more attention in India. Sector- and state-speci fi c policy orientation could lead to better use of fi scal space. Since large current government subsidies are limiting the government’s ability to react decisively to an external economic downturn, the process of removing these subsidies should be initiated without hurting consumers. On the monetary policy front, focus should be given to increasing the volume and cost of credit available. This can be done through liquidity infusions into the market as well as suitable interest rate cuts. The RBI was active in terms of monetary policy during postcrisis period but there is still room for further interest rate cuts. High food in fl ation and rising fuel prices are some constraints which continue to pose a threat for the effectiveness of policy interventions.

Given India’s reliance on low-cost labor-intensive manufacturing exports, this could back fi re if there is a sudden external shock such as new protectionist policies by trading partners or an increase in competition with other low-cost manufactur-ing hubs. Therefore, domestic policies should also encourage diversi fi cation of the economic base. Focus on infrastructure development is important to make the

254 B.K. Sahu

core sector more responsive and to encourage private and external investment. Encouraging domestic and foreign players in the infrastructure sector is suggested as a long-term policy action and as is preparedness. It is more important to focus on removing some structural bottlenecks to raising potential GDP growth such as improving the investment climate, strengthening the external sector, removing entry barriers, and trade facilitation. Resilience to global shocks would be enhanced if the intraregional trade and fi nancial fl ows were greater and stronger. India needs to initiate and strengthen its trade relations and regional cooperation further by fostering links regarding investments, trade, tourism, labor movements, and aid extensions. .

Notes

1. JPMorgan Global Purchasing Manager Index, which is based on a survey of respondents in over 20 countries, which collectively represent 76% of global economic output, predicted a sharp fall in global output of manufacturing and services. The IMF’s baseline forecasts published in January 2009 predicted global GDP in purchasing power parity terms of just 0.5% in 2009. Forecasts from the United Nations expected global GDP to grow at 1.0% in 2009.The World Bank predicted slow growth with global GDP growth moderating to 2.5% in 2008 and 0.9% in 2009 from 3.7% in 2007.

2. For the period from April 2008 to January 2009, exports grew by 13.2% in US dollar terms. What is more pertinent, however, is what has happened since September 2008. In January 2009, exports declined by 15.9%, compared with January 2008.

3. The major reason for a difference between WPI and CPI trends is the relatively higher weight in the latter given to food products and high food in fl ation.

4. Farm loan waivers are funds allocated to the national level fl agship programs such as NREGS, Bharat Nirman (targeted at improving rural infrastructure), the Prime Minister’s Rural Roads Program, and a sizeable increase in subsidies on account of fertilizers and electricity supplied to farmers.

5. The repo rate was cut from a peak of 9.0% in September 2008 to 5.5% in January 2009 and the reverse repo was cut from 6.0% in November 2008 to 4.0% in January 2009

6. Taxation incentives for the Indian Infrastructure Finance Company Ltd which will help supply fi nancing for infrastructure projects

7. The stimulus packages paid special attention to exports through refunding imported raw materials and a fi nancing facility as mentioned earlier.

8. High investment fl ow into India from Mauritius is due to tax minimization measures and the share of G7 countries investing in India has become signi fi cantly higher.

9. The RBI had infused huge additional liquidity by cutting the cash reserve ratio and lowering the statutory liquidity ratio, and also signaled its expansionary preference by cutting its repo rate.

References

ADB. (2009). The impact of the global economic slowdown on South Asia . Manila: Asian Development Bank (by Manu Bhaskaran Centennial Asia Advisors PTE LTD).

Government of India. (2009). Report on effect of economic slowdown on employment in India . Chandigarh: Ministry of Labor and Employment Labor Bureau.


ILO. (2008). Global wage report 2008/09: Minimum wages and collective bargaining: Towards policy coherence . ILO: Geneva.

Pradhan, J. P. (2009). Firm performance during global economic slowdown: A view from India (MPRA Paper No. 17145, posted 07. September 2009).

Sahu, B. K. (2010). Growth & Poverty Nexus in India: Experiences of some backward states dur-ing post-liberalization period’. A paper presented in National Conference on ‘Recent Poverty Debate in India: Measurement, Issues and Relevance’ held at Allahabad University , Allahabad, India, 20-21, November 2010.

UNCTAD. (2009). Impact of global slowdown on India’s exports and employment . A report prepared under UNCTAD- Govt. of India- DFID Project ‘Strategies and Preparedness for Trade and Globalization in India’.

257N.M.P. Verma (ed.), Recession and Its Aftermath: Adjustments in the United States, Australia, and the Emerging Asia, DOI 10.1007/978-81-322-0532-6, © Springer India 2013

Recession is a serious symptom of market failure. Market failure at medium inter-vals is inevitable in an advanced capitalist economy. Such failures may not be seri-ously seen in the short run because the market adjusts demand through inventory of goods and services or even through import as per requirements. Occasionally, the market also removes imbalances in the long-run demand through overcapacity utilization, expansion of plants, and also entry of new fi rms. The crucial variable is price, which adjusts the commodity and labor markets. Panic occurs when there is overproduction, overcapacity utilization of plants, overliquidation, excess supply of money, and change in demand because of changes in tastes and habits of consumers, households, and the public. All these variables singly or collectively create knife-edge nuisances in the economy. As a consequence, they need adjustment through key variables such as employment, saving propensity, technology, existing inven-tory, and monetary and fi scal balancing. In this volume an attempt has been made to appraise the working of a market economy where medium-term disturbances may occur, market ef fi ciency is reduced, a recessionary cycle emerges, and after certain fundamental measures have been taken the market recovers.

The recent global recession originated in the USA. It started during mid-2007, the economy recovered moderately by 2010, but still the economy has not reached full upswing. The downswing was the gravest one in the USA in last seven decades. It further infected other advanced and developing economies. The US downswing was mainly caused by fi nancial openness, lack of regulations, subprime mortgages of assets, and other similar factors, including lack of suf fi cient infor-mation. These situations led to bankruptcy of fi nancial institutions and big banks. This also caused losses to many fi rms, including General Motors and Lehmann Brothers. Because of all these cumulative effects, the US economy took a reverse turn and headed toward recession. By mid-2007, a recessionary crisis had been seriously diagnosed. The situation was also felt with different degrees in euro zone and Asian economies. The aim of editing this volume is to bring out a refer-ence book which can provide competent and authoritative essays on a recess-ion and how to control it in numerous economies, including those of the USA,

About the Book

258 About the Book

Australia, and core Asian countries. A few chapters have also analyzed the comparative case of Europe and the USA.

There are 11 chapters in this volume. Starting with a brief theory and recent history of the US crisis and the recession in the fi rst, introductory essay, discus-sion in the second chapter exhaustively turns to the area of the grave fi nancial crisis in the US economy. In this chapter the authors highlight the fi nancial factors responsible for the severe historic crisis. The third chapter relates de fl ation to unemployment. It discusses theories about the relationship between de fl ation, price levels, and unemployment and the reason why de fl ation is a bigger threat than in fl ation, and recommends recovery by adopting appropriate policy mea-sures. The chapter analyzes the cases of the UK and US economies as well. The fourth chapter examines energy and resources trade and equity investment rela-tionships between Australia and India. The chapter investigates macroeconomic and fi nancial economic uncertainty. The study is based on macroeconomic data. In the fi fth chapter attention is diverted to the dragon, the biggest economy, that of China. Here the author discusses the slowing of growth in China, and how to achieve and maintain a faster rate of growth in the future. In the sixth chapter, the impact of the recession on the Malaysian economy is examined. The macro vari-ables considered are exports, imports, price level, money supply, interest rate, exchange rate, and government expenditure. The co-integration method is used to assess the long-run equilibrium linkages among the variables identi fi ed. For the short-run causality, the study performs Granger tests based on the vector error-correction model. In the seventh chapter, the global fi nancial crisis is considered from the South Asian perspective. The author has tried to show the extent of the global fi nancial crisis and its effects on core South Asian countries. In this chap-ter, the impact of recession is discussed for Bangladesh, Pakistan, Nepal, Bhutan, the Maldives and other countries, including India. In the eighth chapter, the authors relate the Asian crisis to the Malaysian economy. The retrenchment of workers is critically examined here. Further, the authors also examine the reces-sionary impact in South Korea, Indonesia, and other Eastern countries. In the ninth chapter, the focus is on the Indian economy. In this chapter, input–output analysis is done with the help of time-series data to show output growth. In the tenth chapter, challenges and opportunities facing the Indian banking sector are examined. This chapter suggests that the banking sector could perform miracles in the Indian economy because it is well regulated and a plethora of service demands exist. The concluding chapter discusses the impact of the recession on fi nancial sector activities. This chapter highlights the sectorwise experiences of India and the way other economies reacted to the recent global economic slow-down. This slowdown provides some challenges and opportunities for the Indian economy. India, being one of the emerging economies, can depend on advanced economies for its exports and thus dilute the impacts of the global slowdown. The chapter concludes that despite its good economic growth performance, India has not been able to remain insulated in this global decline. Each chapter concludes with deliberations on macroeconomic results, and the implications for speci fi c policies, some of which have been tried and others still need to be examined.

259About the Book

Further, in this volume we propose policies necessary for ef fi cient regulation of the economic system, and give a brief assessment of the extent to which global policy coordination has been discussed in policy circles even if it has not been seriously executed. We hope this volume will be of immense help to students, scholars, researchers, academicians, consultants, and market analysts in the fi elds of fundamental economics, management, and commerce.

261

A AA+ , 17 AAA , 17, 132 ADF. See Augmented Dickey–Fuller (ADF) American Insurance Group (AIG) , 29, 30, 224 Animal spirits , 24, 42 ASEAN. See Association of Southeast Asian

Nations (ASEAN) ASEAN Trade Union Council (ATUC) ,

172, 173 Asian Financial Crisis , xiv, xvi, xvii, 60, 131,

134, 136, 157–175 Asset size , 216, 223, 224, 231 Association of Southeast Asian Nations

(ASEAN) , 86, 114, 159, 172, 173 Augmented Dickey–Fuller (ADF) , 79,

118, 119 Australia , vii, xiii, xv, xvi, xx, 67–79, 142, 258 Autonomous investment , 4, 5 Autoregressive , 11, 116 Average growth of fi nal demand , 179–185,

187, 189

B Baker, D. , 31 Balance of payments , xix, 73, 78, 95, 101,

138, 140–142, 145, 160, 235, 236 Banking sector , xiv, xvii, xviii, 62, 85, 141,

142, 157–175, 215–231, 236, 248, 249, 251, 252, 258

Banking union , 170, 172, 174 Bank of America , xv, 23, 29, 219, 224 Bernanke, B. , 26, 32 Buffett Rule , 18 Business cycle , xiv, xv, 1, 2, 4, 6, 8, 9, 12, 13,

24, 34, 38, 47, 84

C Caballero, R.J. , 32, 38 Capital adequacy , xix, 220, 223–224 Capital fl ows , xix, 26, 27, 153, 159–164,

234–236, 245 Capitalist economies , xiii, 5, 6, 9–11, 18,

23, 257 Capital out fl ows , 122, 161, 236, 248, 250 Capital-output ratio (C) , 10, 11 Capital to risk weighted asset ratio (CRAR) ,

216, 220–223, 231 Causal interaction , 114 Causality , xiv, xvi, 72, 73, 77, 114–118, 120,

124, 258 Causal link , 114 CC. See Cowle’s Commission (CC) CDO. See Collateralized debt obligation

(CDO) Challenges , xiv, xvii, xviii, xix, 17, 87, 105,

130–133, 138, 140, 168, 216, 219, 224–231, 239, 258

Chinese economy , xvi, 81–109, 235 Christiano, L. , 35–37 Citigroup , xv, 23, 30, 219, 223, 224 Classicalist , xiv, 1–2 Coal , xv, xvi, 67–69, 78, 185, 187, 208, 209,

211, 212, 247 Co-integrating vector , 118, 120, 121 Cointegration , xiv, xvi, 71–77, 114, 117–124,

258 Collateralized debt obligation (CDO) , 28, 29,

53, 143 Commercial borrowings , 225, 236, 248, 249 Commodities Futures Trading

Commission , 29 Commodity prices , xiii, 86, 106, 133, 138,

140, 141, 233, 247–248, 252

Index

N.M.P. Verma (ed.), Recession and Its Aftermath: Adjustments in the United States, Australia, and the Emerging Asia, DOI 10.1007/978-81-322-0532-6, © Springer India 2013

262 Index

Competitive capabilities , 238 Competitiveness , xix, xviii, 57, 59, 68, 69, 89,

91, 101, 103, 105, 107, 108, 124, 172, 215–217, 220–224, 227, 228, 230, 231, 238, 241, 243, 251, 253

Compositional change , 183, 185, 196, 198 Consolidation , xvii, xix, 150, 158, 166, 168,

172, 174, 175, 215, 224, 226, 230, 231, 237, 253

Consumer price index (CPI) , 13, 26–27, 48, 50, 53, 60, 115, 117–119, 122, 124, 247, 254

Contraction , xv, xvi, xix, 1, 3, 4, 6, 7, 9, 15, 16, 18, 19, 23, 27, 29, 32, 51, 55, 57, 63, 68, 79, 81, 82, 113, 118, 129, 133–135, 167, 169, 233, 234, 239, 240, 242, 243

Corporate social responsibility (CSR) , 172 Correlation , 38, 70, 73, 248 Cost management , xix, 103, 230, 249 Council of Economic Advisers , 24, 26 Country , vii, xiv, xv, xvi, xvii, xix, 14, 42, 43,

61, 63, 67–79, 89, 92, 97–101, 103, 105, 106, 108, 109, 118, 122, 125, 134–139, 141–143, 145, 146, 160–161, 164–167, 170, 172–175, 185, 187, 217–219, 221, 222, 224, 225, 227, 235, 236, 239, 241–245, 247, 249–253

Cowle’s Commission (CC) , 12–13 CPI. See Consumer price index (CPI) CRAR. See Capital to risk weighted asset ratio

(CRAR) Credit crunch , 132, 149, 152 Critical value , 79, 119–121 CSR. See Corporate social responsibility

(CSR) Cumulative de fl ation , 10 Cumulative in fl ation , 10 Currency , xvi, 39, 42, 56, 58, 60, 61, 79, 88,

89, 106, 113, 118, 119, 131, 136, 141, 143, 152, 161–165, 236, 252

Current account balance , 73, 134, 138, 141, 144–145, 160, 244

D Data , xiii, xiv, xvi, xviii, 3, 11, 12, 15, 18,

33–36, 41, 71, 73, 77–79, 88, 113, 117–119, 130, 133, 180, 225, 235, 240, 258

Debt contraction , 18, 19 Decomposition , xvii, xviii, 72, 73, 76, 78,

179–212

Decoupled , 250 De fl ation , xiii, xv, 10, 34, 36, 37, 41,

47–65, 258 deLong, J.B. , 32 Demand categories , xviii, 180, 183,

185–187, 190 Demand-side decomposition , 179 Deregulation, fi nancial markets , 25, 26, 39 Deutsche Bank , 29, 224 Domestic product , 53, 151, 234 Downgrading , 17, 70, 243 Downscaled , 235 Downsizing , xvii, 59, 174, 175, 242, 250

E Economic , vii, viii, xiii–xx, 1–4, 6, 7, 9–12,

15–17, 23–27, 29–31, 33–42, 47, 48, 50, 51, 53–64, 68–73, 76–79, 81–83, 85–87, 89–96, 98–103, 105–109, 113–120, 122, 124, 125, 129, 130, 133, 135–142, 144–147, 149, 152–154, 157–175, 179, 185, 230, 233–245, 247–250, 252–254, 258, 259

crisis , xix, xvii, 113, 129, 135, 153, 157–175, 234, 235, 237, 241, 252

growth , xiv, xvi, xvii, xix, 9, 10, 27, 48, 51, 55, 57, 60–64, 83, 85–87, 89, 91, 92, 96, 98–103, 107–109, 113–118, 120, 122, 124, 125, 129, 138, 140, 146, 149, 153, 161, 168, 233, 234, 242–245, 250, 258

policy , 92, 124, 129, 157, 252 slowdown , xix, xiv, 57, 85, 87, 99,

129, 137, 140, 162, 233–235, 238–240, 242, 243, 245, 249, 250, 252, 253

slump , xiv, 9–11, 16, 17, 23, 27, 38, 234, 249, 252

Eggertsson, G. , 36–37 Elasticity of demand , 235, 243, 247, 250 Emerging market economy , 26, 233, 234,

242, 245 Employees’ Provident Fund (EPF) , 171 Employment , xiii, xvii, 1, 3–7, 10, 11, 14, 15,

18, 24, 27, 31, 34, 35, 42, 48, 54, 57, 63, 81, 82, 95, 97, 100, 105, 113, 137, 141, 144, 153, 164, 167–170, 173, 233, 234, 239–242, 247, 248, 250–252, 257

Employment Protection Legislation (EPL) , 169

Endogeneity , 13

263Index

Energy , xiii, xv, 16, 33, 67–79, 86–87, 97, 100, 105–106, 108, 146–147, 185, 233, 247, 251, 258

EPF. See Employees’ Provident Fund (EPF). EPL. See Employment Protection Legislation

(EPL) Equation , 12, 33, 56, 57, 62, 76, 77, 118, 123,

181, 182 Equilibrium , xiv, 7, 8, 13, 18, 20, 37, 43, 56,

58, 75, 95, 116, 120, 122, 124, 258 Equity , xiii, xv, 2, 27, 28, 43, 59, 67–68, 70,

71, 78, 136, 141, 159, 227, 235, 236, 248, 258

Error-correction term , 118 Euro zone , 42, 62, 139, 257 Exchange rate , xvi, xiii, xiii, xvi, 34, 41, 60,

64, 89, 113, 114, 116–120, 122, 124, 130, 140, 141, 152, 159, 161, 163, 233, 236, 245, 249, 252, 258

Exogeneity , 12, 73, 75–78 Exogenous shock , 9, 13 Export growth , 82, 86, 113, 120, 124, 240–245 Exports , xiii–xiv, xvi, xviii, xix–xx, 67–69, 71,

72, 78, 79, 82, 83, 86, 87, 89, 91–93, 95, 97, 106, 108, 113, 114, 116–120, 122, 124, 131, 133–134, 137, 139–142, 144, 146, 147, 149, 150, 154, 159, 162, 163, 165, 181, 183, 185–187, 190, 192, 194, 196, 198–200, 202, 204, 206, 217, 233, 235–245, 247, 249–254, 258

Exports and imports , xiii, xvi, xviii, 67, 86, 87, 113, 114, 120, 122, 124, 141, 181–183, 185–187, 190, 192, 194, 196, 198, 200, 202, 204, 206, 237, 244, 251, 258

External commercial borrowings , 225, 236, 248, 249

External demand , 86, 87, 89, 146, 160, 242, 243

Externalities , xvi, 2, 15–18, 38, 41, 63, 69, 83, 86–89, 113, 122, 133, 135, 137, 146, 158–160, 164, 225, 234, 236, 239, 242, 243, 245, 247–254

External shocks , 83, 133, 234, 247, 250, 252, 253

F Fannie Mae , 88, 132, 224 FCIC. See Financial Crisis Inquiry

Commission (FCIC) FDI. See Foreign direct investment (FDI) Federal Deposit Insurance Corporation , 39

Federal funds rate (FFR) , 26, 27, 30–34 Federal Home Loan Banks , 31 Federal Reserve , 15, 23, 26, 27, 29–36, 39, 40,

88, 89, 132, 146 FFR. See Federal funds rate (FFR) Final demand , 185–186, 231 Final prediction error , 119 Financial , xviii, 26, 31, 39, 73, 79, 93–95, 98,

132, 149, 151, 166–168, 215, 219, 220, 224, 237, 254

crisis , 23–43, 48–53, 163–165 markets , xix, 16, 17, 23–26, 31, 32, 39,

43, 53, 57, 58, 73, 85, 103, 116, 130, 132–135, 137, 153, 160, 164, 234, 248

Financial Crisis Inquiry Commission (FCIC) , 24

Financial Services Modernization Act , 26, 39 First difference , 73, 79, 119 Fiscal policy , 24, 34–36, 147–149 Food and oil prices , 138, 141, 247 Foreign direct investment (FDI) , xvi, 67–69,

71, 78, 87, 92, 114–115, 117, 130, 138, 141–142, 144, 161, 245–246

Freddie Mac , 31, 88, 132 Free markets , 2, 85, 98, 99, 105, 106, 164

G Gas , xv–xvi, 67–69, 78, 97, 167, 183, 185,

187, 208, 209, 211, 212, 237, 247 GDP. See Gross domestic product (GDP) Geithner, T. , 31 GFC. See Global fi nancial crisis (GFC) Gini coef fi cient , 100 Glass-Steagall Act , 26 Global crisis , xvi, 81–109, 132, 133, 138,

149, 153, 233, 235, 236, 242, 247, 249, 251–253

Global fi nancial crisis (GFC) , xiv, xvi, xvii, 17, 47, 68, 71, 78, 83, 85, 86, 89, 93, 129–154, 187, 216, 237, 252, 258

Globalization , 63, 82–85, 173, 215, 226–228, 252

Goldman Sachs , 29 Gordon, R. , 37 GOV. See Government expenditure (GOV) Government consumption , xviii, 181–183,

185–187, 190, 192, 194, 196, 198, 200, 202, 204, 206, 237

Government expenditure (GOV) , xiii–xiv, xvi, 35, 42, 63, 113–115, 117–120, 122–124, 185, 258

264 Index

Granger causality , xvi, 73, 77–78, 114, 117, 118, 120, 122–125

Granger cause , 77, 114, 115, 122, 125 Great Recession , xv, 23–43 Gross domestic product (GDP) , xv, 1, 3–5,

15, 17, 29–33, 35, 48–55, 59, 60, 62, 81, 83, 86–88, 90, 91, 95, 101, 103, 104, 107–109, 113–115, 117, 118, 122, 130, 134, 137–140, 144–151, 153, 158, 159, 161, 167, 235–239, 242–244, 249–254

Gross investment , xviii, 7, 8, 181–183, 185, 187

Growth , 1, 27, 47, 69, 81, 113, 130, 158, 179, 215, 234

H Hannan-Quinn information criterion , 119 Harrod-Domar model , 10 Hong Kong , xv, 47, 48, 59, 60, 63–64, 86,

159, 160, 165, 227 Human Resource Policy , 228–229 Hypothesis , xviii, 12, 26, 35, 37, 114,

117–121, 123, 159

I ILO. See International Labor Organization

(ILO) IMF. See International Monetary Fund (IMF) Imports , xiii–xvi, xviii–xx, 60, 67, 69, 71, 72,

78, 79, 86, 87, 113–115, 118–120, 122–124, 138–142, 144, 152, 154, 181–183, 185–187, 190, 192, 194, 196, 198, 200, 202, 204, 206, 237, 244, 247, 249, 251

Income elasticity , 235, 242–243, 247, 250 Index , 11, 26, 48, 50, 56, 68, 70–73, 77, 79,

85, 92, 164, 247 India , 9, 67, 81, 115, 129, 187, 215, 234 Indian economy , xix, xiv, xviii, xiv, xviii,

xix, 179, 185, 187, 215, 225, 233–254, 258

Indonesia , vii, xiv, xvii, 114–115, 157, 159–164, 172, 175, 218, 219, 222, 227, 258

Induced investment , 4–5 In fl ation , xiii, xv, xvi, 3–4, 10, 11, 16–17, 27,

32–34, 36–39, 48–52, 55, 59–62, 64, 65, 89, 93, 95, 113, 115–118, 120, 122, 124, 125, 131–135, 138, 140–142, 145–146, 152, 167, 187, 234, 237, 247, 248, 253, 254

In fl ation GDP growth rate , 3 Information criterion , 74, 76, 103, 119 Information economy , xvii, 2, 54, 99, 102,

103, 124, 225 Information technology (IT) , 60, 91, 92,

97, 102, 103, 225, 228, 231, 237–243, 253

Input-output coef fi cients , xviii, 180–183 Input-output tables , xviii, 180–181 Interest rate , xiii–xiv, xvi, 9, 11, 13, 26, 27,

32–38, 42, 47, 50, 54, 57–62, 85, 90, 95–97, 108, 113, 114, 116, 118–120, 122–124, 129–132, 138, 141, 152, 153, 161, 163, 164, 248, 253, 258

Inter fi rm growth , 238 Internationalization , 223, 225, 226, 228, 231 International Labor Organization (ILO) , 15,

144, 170, 172, 233 International Monetary Fund (IMF) , xvii, 35,

40–41, 68, 81, 82, 85, 88, 107, 109, 118, 130, 133, 134, 157, 163–165, 175, 235, 242, 254

International policy coordination , 25, 39–42 International trade , 67, 114, 241, 242,

249, 250 International trade union , 170, 171, 174 International Trade Union Confederation

(ITUC) , 171 Interrelationship , 113, 116 Investment , xiii, xv–xvi, xviii, 1, 3–11, 14,

16, 18, 20, 23, 26, 28–30, 32, 34, 35, 38, 50–51, 53–55, 59–64, 67–72, 78, 87, 88, 91, 92, 98, 100–101, 103, 106, 107, 114, 116, 125, 129, 131, 135, 137, 138, 140, 146–147, 151, 152, 159–163, 165, 172, 181–183, 185–187, 190, 192, 194, 196, 198, 200, 202, 204, 206, 216, 220, 226, 227, 233–237, 242, 245, 247–254, 258

Irrational exuberance , 24 IT. See Information technology (IT) IT-enabled services , 242, 253 ITUC. See International Trade Union

Confederation (ITUC)

J Japan , xv, 16, 17, 25–26, 32–33, 36, 47,

59–60, 62, 65, 67, 69, 81, 87, 89, 98, 105, 107, 109, 136, 161, 162, 217–219, 221, 223, 226, 236

Job loss , 3, 55–56, 59, 169, 235, 239–242, 250

265Index

Johansen–Juselius co-integration test , 120–122

K Keynesianism , xiv, 2 Keynes, J.M. , 36 Krugman, P. , 31–33, 35, 36, 62, 146, 164

L Lagged , 71–72, 77, 78, 118, 123, 231, 237 Lag length , 119, 225 Lehman Brothers , xv, 17, 23, 29, 50–51, 54,

88, 132, 133, 257 Leontief inverse , 181, 182 Liberalization , 116, 159, 160, 228 Liquidity , xvi, xiii, xvii, xiii, xvi, xvii, 29, 34,

36, 38, 50–51, 68, 96, 97, 113, 136, 139–141, 146, 149, 152–153, 169, 175, 238, 248, 251, 253, 254

Liquidity trap , 32–33, 36–37, 59, 61–62 Lower-income countries , 234, 241, 243 Lucas, R.E. , 2, 12

M Macroeconomic assessment , 143–153 Macroeconomic fundamentals , xvi, xix–xx,

113–125, 134 Macroeconomic variables , xvi, 13, 113,

122, 124 Mahathir bin Mohamad , 163, 164 Malaysia , vii, xiii, xiv, xvi–xvii, xx, 99,

113–125, 157–175, 218, 219, 222, 227, 244, 246, 258

Malaysia Trade Union Congress (MTUC) , 170–173

Mankiw, N.G. , 33 Manufacturing sector , 16, 48, 102, 140, 168,

187, 234, 238–239, 241, 242, 245 Marginal ef fi ciency , 6 Market , 1, 23, 51, 67, 81, 113, 129, 159, 185,

215, 233 Maximum eigen value ( l MAX) statistic , 118,

120, 121 MBS. See Mortgage backed security (MBS) Minimum Wages Council, the Social Security

Act (SOCSO) , 171 Mining , 68, 69, 167, 237, 239, 240 Minsky, H.P. , 37 Model , xiv, 3, 6, 8–14, 16, 29, 33, 36–38, 42,

43, 56, 68, 70–73, 75–78, 118, 129–132, 160, 165, 230

Monetary aggregates , 13, 14, 32, 56, 131, 132, 146

Monetary policy , xvi, 9, 13, 27, 32–34, 36, 41, 42, 59, 61, 64, 65, 90, 95, 113, 116, 118, 122, 124, 125, 130–132, 134, 140, 149–153, 164, 253

Monetary stimuli , 36, 237 Money demand , 14, 27, 53–59, 61–64,

149, 257 Money market rate (MRATE) , 118, 119,

122, 124 Money supply , xiii–xiv, xvi, 9, 31, 32, 42,

47, 50, 54, 56, 57, 61–65, 113–118, 120, 122–125, 258

Morgan Stanley , 29, 224, 227 Mortgage backed security (MBS) , 28, 29,

31, 53, 216, 220 Moving average models , 11–12 MRATE. See Money market rate

(MRATE) MTUC. See Malaysia Trade Union Congress

(MTUC) Multivariate , 12, 71, 72, 118

N NAALC. See North American Agreement on

Labor Corporation (NAALC) NAFTA. See North American Free Trade

Agreement (NAFTA) NAIRU. See Nonaccelerating in fl ation rate of

unemployment (NAIRU) National Labor Advisory Council (NLAC) , 171 National Trades Union Congress (NTUC) , 172 National Union of Banking Employees

(NUBE) , 170 New-classicalist , xiv–xv, 2 NGOs. See Non-governmental organizations

(NGOs) NLAC. See National Labor Advisory Council

(NLAC) Nonaccelerating in fl ation rate of

unemployment (NAIRU) , 33, 36 Non-governmental organizations (NGOs) ,

140, 170, 171, 173, 174 Non-performing assets (NPA) , 216–219, 221,

230–231 Non stationary , 73, 118, 119 North American Agreement on Labor

Corporation (NAALC) , 173 North American Free Trade Agreement

(NAFTA) , 173 NPA. See Non-performing assets

(NPA)

266 Index

NTUC. See National Trades Union Congress (NTUC)

NUBE. See National Union of Banking Employees (NUBE)

O Obama Administration , 9, 24 Of fi ce of Thrift Supervision , 30, 39 Oil , 38, 67, 68, 71, 73, 76, 78, 92, 96, 97,

131, 138, 141, 142, 152, 244, 247, 249, 251

Okun’s law , 33 Opportunities , xiv–xix, 48, 54, 57, 59, 60,

62–65, 69, 78, 82, 99, 159, 161, 173–175, 216, 224–231, 234, 238, 242, 258

Output , xiii–xv, xvii–xix, 1, 3–5, 9, 13–15, 23, 24, 27, 33–35, 37, 38, 42, 53, 56–58, 61, 81, 82, 85, 92, 114–117, 124, 131, 132, 153, 179–185, 187, 188, 192, 194, 196, 198, 200, 202, 204, 206, 239, 247, 250

Output growth , xvii–xviii, 115–117, 120, 179–212, 258

P Path to recovery , 6, 242 Phelps’s analysis , 14 Philippines , 114–115, 157, 160, 161, 163, 172,

218, 219, 222 Piketty, T. , 25 Policy interventions , 147, 252, 253 Political , 9, 42, 61, 68–74, 76–79, 82, 99, 105,

106, 108, 130, 134, 137, 146, 150, 167, 172, 251

Post liberalization era , xviii, 181, 187 Post recession , vii, xvi, xvii, xix, 17, 18,

113–125, 216, 217, 224, 230–231

Price elasticity , 243, 247 Price level , xiii–xiv, xvi–xvii, 47, 48, 55–57,

60–62, 64, 113, 114, 116, 120, 122–125, 258

Prices , 1, 25, 47, 70, 81, 113, 131, 158, 181, 233 Private consumption , xviii, 181–183, 185–187,

190, 192, 194, 196, 198, 200, 202, 204, 206, 237

Q Quality of asset , xix, 221–224, 230 Quantitative easing , 33, 34, 62, 146

R Rajan, R. , 31, 160, 167 Ratings , 17, 18, 28, 69–73, 76–79, 132, 172 RBI. See Reserve Bank of India (RBI) Recession , 1, 23, 48, 81, 113, 133, 157,

216, 233 Recovery management , xix, 137, 164, 230 Reform , xiv, xvi, xviii, xix, 18, 23–24, 40,

41, 62, 64, 67, 68, 78, 82–85, 89, 92, 94–100, 102, 105–108, 139–141, 163, 164, 167, 179, 215, 230, 241, 245

Regression , 118 Relationship , xiii, xv, xvi, 3, 27, 35, 39, 43,

47, 48, 51–53, 56, 57, 64, 67–79, 114–117, 122, 124, 258

Remittances , xix, 137, 139–142, 153–154, 233, 235, 236, 244, 248–249, xix

Reserve Bank of India (RBI) , 137, 143, 152, 220–222, 237, 248, 251, 253, 254

Resilience of the economy , 239 Resources , xiii, xv, xvi, 3, 35, 40, 60, 63, 64,

67–69, 78, 92, 99, 100, 102, 105, 108, 109, 142, 147, 148, 150, 225, 231, 237, 238, 258

Retrenchments , xiv, 11, 167, 168, 171, 174, 258

Return on assets (ROA) , 216, 219–220, 231 Ringgit Malaysia (RM) , xvi, 118, 158,

162–165 Risk , xiii, xvi, 24, 25, 27–30, 34, 43,

50–51, 53, 54, 56, 57, 59, 62, 65, 67–79, 81, 129, 130, 132, 133, 141, 149, 152–153, 159–161, 166, 172, 220–221, 230, 233, 235, 245, 248

Risk management , xix, 29, 69, 71, 72, 226, 230

RM. See Ringgit Malaysia (RM) ROA. See Return on assets (ROA) Roubini, N. , 31 Rudebusch, G. , 33

S Sabah Banking Employees’ Union (SBEU) ,

170, 171 Saez, E. , 25 Sarawak Banking Employees’ Union

(SBEU) , 170, 171 Saving–output ratio , 10 Schwartz information criterion , 119 Sectoral growth , 179, 183, 237, 252

267Index

Sectors , xix, xvii, 1, 16, 26, 36, 37, 54, 64, 68–73, 75, 76, 78, 79, 92, 101, 102, 105, 130, 147, 149, 153, 159, 160, 165, 173, 180, 183, 185, 187, 228, 233, 234, 236–243, 245, 247–249, 252, 253

aggregation , 212 classi fi cation , 208, 210

Securities and Exchange Commission , 26, 30 Securitization , 18, 28, 29, 31, 34, 56, 61, 67,

88, 93, 94, 96, 100, 106, 108, 132, 135, 150, 160, 171, 172, 216, 226

Service-sector-led economic growth , xx, 64, 234

Shiller, R. , 31 Singapore , 16, 68, 159, 164, 165, 171, 226,

227, 244, 246, 249 South Asia , xiv, xvii, 15, 16, 129–154, 242,

248, 258 Southeast Asia , 82, 134, 136, 160–163, 165,

242, 244, 248 Spatial effects , 245, 252 Specialized products , 227 Stability , xvi, 23, 57, 58, 61, 63, 71, 74, 76,

83, 88, 113, 131–133, 139, 141, 166, 215, 230, 238

Standard and Poor’s (S&P) , 17, 18, 68, 70, 73

Static macro analysis , 3 Stationary , 12, 73, 118, 119 Stein, H. , 24 Stochastic , 11, 12, 37, 75 Structural changes , 36, 91, 179, 180 Structural decomposition , xvii, 179–212 Sub-prime crisis , 26, 86, 89, 129–132, 143,

236, 249 Sub-prime lending , 16, 132, 216, 217, 220 Subprime mortgage effect , 25, 30, 39, 40,

130, 132 Supply side , 146, 152, 153, 187, 240, 245

T TARP. See Troubled Assets Relief Program

(TARP) Taylor rule , 27, 33, 131 Thailand , xvii, 115, 136, 157, 159–161,

163, 164, 175, 218, 219, 222, 227, 244, 246

Trace statistic , 118, 120, 121

Trade , xv, xvi, xix, xiii, 1, 4, 28, 67, 69, 71–73, 78, 81, 86, 87, 89, 114, 130, 133, 134, 139, 141, 161, 169–175, 215, 233–239, 241–244, 247, 249–251, 254, 258

Trade facilitation , 254 Trading partners , 99, 235, 243, 253 Transmission mechanisms , 9, 13, 233 Troubled Assets Relief Program (TARP) ,

30, 31, 88

U Unemployment , xiii, xv, xvii, 1, 3, 4, 10,

11, 15, 16, 30, 31, 33, 36, 38, 41, 42, 47–65, 81, 82, 86, 108, 144, 163, 167, 169, 175, 234, 239, 241, 249, 258

UNI. See Union Network International (UNI)

Union Network International (UNI) , 171, 172 United Kingdom , xv, 16, 41, 48–50, 62, 64,

129, 135, 139, 218, 219, 221, 223, 227, 230, 236, 249, 258

Unit root , 73, 118, 119 Univariate , 71, 72 Unlagged , 78 Unorganized sector , 242 Urbanization , 100, 102, 103, 109

V Value at risk , 28 Variance , 11, 72, 73, 76, 78 VECM. See Vector error-correction model

(VECM) Vector autoregressive , 13, 18, 74, 76, 114,

119, 120 Vector error-correction model (VECM) ,

xiv, 116, 118, 122, 124, 258

W Warranted rate of growth , 10, 11 Washington Mutual Bank , 30 World economic engine , 85, 107–108

Z Zaandi, M. , 39, 40

Download more eBooks here: http://avaxhome.ws/blogs/ChrisRedfield

Documents

The Eye Financial... · vii Recession is an economic instability that touches every person, the economy, and society. It ultimately also affects other economies depending upon the