The Great US Meltdown
The deepening Us recession is caused by generalised credit crunch generated by US financial system initiated by bursting of housing bubble in 2006 resulting in subprime mortgage market melting down in 2007. The housing bubble was only the most prominent feature of a more generalized overvaluation of financial assets. The "irrational exuberance" (a phrase coined by the then FED-Reserve Chairman Alan Greenspan during stoc market of 1990's stating that the market at that given point of time might be somewhat overvalued. Source: wikipedia) displayed by investors was produced by a number of interacting factors: the choice of CPI (and not a price index that included asset prices) as the paramount target to guide monetary policymaking, the Panglossian attitude of the economics profession that asset markets are most rational in its use of information (the "efficient markets" hypothesis), negligence by the financial regulatory bodies (e.g. turning a blind eye toward reports about the Madoff Ponzi scheme), inadequate supervision of new financial instruments (e.g. subprime mortgage bonds), and the complicity of the rating agencies in understating risks. The front page report in the New York Times of December 26, 2008, “Dollar Shift: Chinese Pockets Filled as Americans' Emptied”, reported the claim by some analysts that the US housing bubble was able to continue only because China prevented the long term interest rate from rising by continually investing its large trade surpluses into Freddie Mac and Fannie Mae bonds. I reject this claim that the flow of Chinese financial opiate through its chronic trade surpluses is a cause of the US financial crisis that is significant enough to be ranked together with erroneous money target, faulty bond rating, incompetent financial oversight, and complacency toward financial innovations. Pogo's verdict of "We Have Met The Enemy and He Is Us" is a more convincing explanation.
For someone who believes that the US financial crisis cannot be solved without staunching the intravenous flow of Chinese financial opiate through the trade channel, he will have to insist that the $787 billion stimulus package of the US Treasury, the expanded financial lifelines of the Federal Reserve, and the reorganization of the Securities and Exchange Commission will not work until the Obama administration also implements one of the following two proposals that have floating around in Washington for some a number of years: impose a 27.5 percent tariff on all imports from China, and force China to appreciate the yuan by 40 percent. (A first step to implementing either measure is to declare China guilty of currency manipulation.) However, even if Pogo is wrong (i.e. I am wrong in rejecting Chinese trade imbalances as a necessary factor in causing the US financial crisis), I believe that starting a trade war in the middle of a global recession will worsen, not improve, the prospects for economic recovery in the US.
The impact of global financial crisis has made an impact over Indian economy through 3 major channels I.e the financial sector, exports and exchange rates. As a matter of fact the financial sector, banking industry was never ever exposed to the sub prime crisis. The exports of goods and services definitely not as high as Chinese exports the multiplier effect of the decline in the same can affect the GDP growth. The third transmission rate is exchange rate as Indian rupee has come under pressure.
The financial crisis that began sometime around the August of 2007 in Western world had since affected the developing countries. My study will focus on current financial crisis and its impact on the two of the worlds most promising and fastest growing economies: India and China. The economies of these countries are still in transitional phase, which means they are still in the process of moving towards an open market economy. I think examining the impact of global financial crisis and its critical analysis on these two countries is merely necessary as one-third of the worlds population reside in India and China.
When the financial downturn actually took its course it was largely believed by the economists and mainstream international financial institutions that it would have no major impact on India and China because of the “decoupling effect”. It was also believed that these economies have with their restricted and more policy governed financial system which almost have no exposure to sub prime crisis have insulated themselves by making their economies more efficient and competitive to withstand any such challenges.(The Economist 2008a;Wolf 2008; Boothe 2008; Bradsher 2009b; Dyer 2009b) I will try to study the external factors that have/could have/may have become the reason behind slowdown in emerging markets.
The term financial crisis is a broad term that covers crashes in the housing markets, financial markets and of course recession. The harmful and multiplying virus called “Recession” in financial dictionary developed after economic crisis first surfaced in the US sub prime mortgage market in August of 2007. Within few months the virus took its toll when a huge financial meltdown was witnessed I.e. the worlds largest and biggest financial firms falling prey to the deadly virus.
My study will primarily focus on the current financial crisis and its impact on the growth, international trade and employment in emerging market economies namely China and India. More recently China and India for example, have witnessed a sharp decline in the demand for exports, foreign institutional investments and the real estate prices (Wade 2009; The Economist 2009a).
It is significant to understand the impact of current global crisis on Asian economies and emerging economies in particular because optimists pointed out earlier these economies would act as the shock absorber that would act as buffer to the Western economic slowdown. It was further suggested that a ‘decoupled Asia' through its own growth and expanding domestic demands would ensure higher imports demands for its growing economies and thus limit the economic slowdown in the developed economies. From the onset of the financial crisis the optimists were of the view that the Asian countries had undertaken market-friendly i.e. neoliberal economic reforms and that had strengthened these economies to withstand such situations. Asian economies so-called “success story” were crucial for the justification of the neoliberal policies as it was said that adoption of these very policies had helped them to achieve higher growths.
The Indian economy looked to be relatively insulated from the global financial crisis that started in August 2007 when the ‘sub-prime mortgage' crisis first surfaced in the US. In fact the RBI was raising interest rates until July 2008 with the view to cooling the growth rate and contain inflationary pressures. But as the financial meltdown, morphed in to a global economic downturn with the collapse of Lehman Brothers on 23 September 2008, the impact on the Indian economy was almost immediate. Credit flows suddenly dried-up and, overnight, money market interest rate spiked to above 20 percent and remained high for the next month.
The economies of India and China have been registering massive growth figures year on year but the economy of China is not yet big enough to pull the rest of the world economy. At current exchange rates the IMF calculates its GDP in 2006 as US$ 2,600 bn - just behind Germany, while less than one-fifth of the size of US. However, GDP can also be measured in Purchasing Power Parity (PPP), which is based on domestic buying power. Meanwhile, China only accounts for 5 % of global buying power and thus will not be able to compensate for the effect of a major economic crisis that accounts for over 20 % (Wolf 2008; Soros 2009). In India despite rapid growth rates, still only 42.1 % of the urban workforce were “regular employees”, while 41.7 % were categorized as “self-employed”, and 16.2 % as “casual employees” in 1993. There is no dramatic change has happened since then, as employment growth is only 1 % annually and even less in the manufacturing sector (Dasgupta and Singh 2006).
It has also been observed that east asian countries which easily presumed that the decoupled Asia would save them from great economic crisis realised that it was at as affected as any other country in the world. The scale and speed of that downturn is breathtaking and broader in scope than in the financial crisis of 1997-98. China's GDP, which expanded by 13 % in 2007, scarcely grew at all in the last quarter of 2008 on a seasonally adjusted basis. In the same quarter Japan's GDP is estimated to have fallen at an annualized rate of 10 %. Singapore's at 17 % and South Korea's at 21 %” (The Economist 2009b:10).
India and China : A look into the past of ancient pillars
Where do we start looking at Chinas and India's Past ? The obvious answer is a long time ago. China and India had a dominant place in the world economy with the rise of Europe, north America and Japan being just a interlude as these giants are once more running the marathon to occupy their dominant position. Two thousand years ago, both India and china had a lot fo economic history behind them. At the dawn of Christanity India was already prosperous. Similar was the case with China. Infact Chinas economic development pre-dates that of India. If one wanders round the forbidden city in the current day capital of China the two things that occupies your mind are 1) the sheer size of the palace - 720,000 sq. mts and 2) the number of exhibits on display.
An intensive descriptive statistical narration of British-born Economist Angus Maddisons The world Economy: A millennial Perspective, shows that China and India held 59% of the world economy between of which India had 33% and china 26%. The precise numbers can be debated but the broader picture according to him remains unchallenged.
Both India and china had made significant progress 2000 years ago. The worlds centre of gravity was asia, with three quarter of worlds population of about 230 million was in Asia.
India & China : Emerging Giants of the Emerging World
As defined, Emerging markets are the nations with social or business activity in the process of rapid growth and industrialization with income per head of population of $ 9,65 or less. These are countries into transition, moving from closed to open economy ti integrate with the world of developed economies. The term was coined in 981 by Antonie W. Van Agtmael of International Finance Corporation of the World Bank, an economy with low to middle per capita income. These are the countries which make up for the 80% of the world population. Even though, China is already considered as one of the worlds leading powerhouse, it fall into this classification with the likes of Tunisia because of its great deal of lesser resources. The emerging markets economies are considered to be transitional. Both China and Tunisia belong to this category and have opened up their markets. The ideology of behind the open market theory is transparency and efficiency in the capital markets along with reforms in exchange rate system which helps builds confidence specially when foreigners are investing. The investment of foreigners simply means that world has started noticing the potential of emerging markets. The inflow of foreign currency into the local economy adds volume to countrys stock market.
China adopted neoliberal policies in the late seventies while India adopted the same in early nineties. Neoliberalism basically means transferring the part of the control ot the economy from public to private sector under the belief that it will produce more efficient government and improve the economic indicators of the nation. This again categories both the economies as emerging market economies because both prior to economic reforms have had closed and centrally planned economies. The Figure below shows how following the same approach the GDP of India and China have increased dramatically. Though, India lags in the rate of increase in growth.
Source: China and India: Opportunities and Challenges for UK Business, 2009. BERR Economic
Paper 5, February, London: Department of Business Enterprise & Regulatory Reform, pp.5
It would be interesting to have a look at the GDP of these two countries on a larger time scale and compare with various countries of the world. One interesting studies that I came across while reading a book on these emerging giants was that India and China accounted for half of the world GDP between them for last two millenia. The studies by the same prominent British economic historian, Professor Madisson are shown below. The economies of India and China went through a period of relative decline at the start of eighteenth century which coincided with the rise of European power and colonization.
Historical Share of World Economies
Source: Maddison 2007; China and India: Opportunities and Challenges for UK Business (2009)
BERR Economic Paper 5, page 4, February, London: Department of Business Enterprise &
Regulatory Reform. (http://www.berr.gov.uk)
Projected GDP Growth
The rapid growth of India and China in recent years have had a considerable impact on the world economy. Not only the exports of India and china have increased but also their imports have risen sharply opening ip new opportunities for capital investments. Measured at PPP, China and India now account for 10.8% and 4.6% of world GDP respectively, compared to 3.3% for UK. After China's implementation of neoliberal policies, its trade with rest of the world increased rapidly. Similar progress came India's way in 1990's. India and China have accounted for 10% of the growth of worlds trade between them. India's trade has started to increase off late, but remained constant till last decade whereas China doubled its share of world trade every ten years since 1980's.
Source: also quoted in China and India: Opportunities and Challenges for UK Business, 2009. BERR
Economic Paper 5, February, London: Department of Business Enterprise & Regulatory Reform, pp.7
The Decoupling Theory
On the onset of the the global financial crisis the leading international financial insitutions and the ecnomist were of the opinion that the ongoing crisis would have least effect on economies of India and China. Decouling Theoru - as the name suggest decouples emrging world markets from the US economies. The basis of the theory is that because of the high growth rate of GDP of the emerging economies, specially India and China, these markets were theoretically supposed to remain bullish even in the times of US recession. It was believed that the European and Asian economies have broadened and deepened to an extent where they no longer depend on US economy for growth.
This theory was supposed to be right and the opinion of economists solidified till the end of last year or to be precise on the onset of US recession. The stock markets of these countries collapsed with the collapse of DOW JONES (DJIA) SEARCH FOR FIGURES FOR MARKET CRASH. One of the drawbacks of decoupling theory was that it did not consider the multiple economic relationships and globalization trends. The major trading partner of all the asian countries is US , specially in the case of China and any signs of recession in US economy would affect these countries tremendously. IT was believed that the domestic activity of these countries was so strong and robust that the decline in exports would not become a matter of concern for emerging economies. (www.nobletrading.com/.../decoupling-theory-of-emerging-markets.htm )
"Decoupling is yesterday's story," Stuart Schweitzer, a global strategist at JP Morgan Private Bank, said. "Last year, when the U.S. slowdown was driven almost entirely by housing, it made sense that the rest of the world kept right on going. Housing is a domestic story, plain and simple.
"The nature of the slowdown has changed in two key respects. The credit crunch that began in midsummer is not just a U.S. phenomenon; the rise in risk aversion is global and will have an impact on credit terms and availability everywhere. And we're finally seeing evidence that the U.S. job market is losing steam and consumer spending is slowing."
"If anything, global interdependence of economies is rising, not falling," said Jeff Applegate, chief investment officer of Citi Global Wealth Management.
"The notion that the U.S. can go into recession with no negative knock-on effect in the rest of the world doesn't hold up.
Andrew Foster, head of equity research for matthews international capital, a specialist in Asian markets opines the possibility of globalization and decoupling to coexist. According to him, it was only because of economic liberalization in these countries that these economies got independent from being interdependent on developed countries, growing enormously, allowing the development of their middle class. "The irony is that these economies are more coupled with the rest of the world than they ever were in the past," he said. "That's why they're so strong, and that has allowed them to become more independent.
As soon as the crisis started intensifying in US, Indian Government reassured its foreign and domestic investors about how safe and strong their financial system is compared to western economies. It was believed that the crisis had begun from US housing market which would not intensify on such huge scale. Secondly, as the emrging economies grew there was more trade happening between these countries than between the US and emerging economies. Emerging Economies were considered to be net savers and not net borrowers.
IMF (2007) notes “…the potential size of spillovers from the United States has increased with greater trade and financial integration, but that the importance of these links should not be overestimated…past episodes of highly synchronized growth declines across the globe were not primarily the result of developments specific to the United States, but rather were caused by factors that affected many countries at the same time…Overall, these factors suggest that most countries should be in a position to “decouple” from the US economy and sustain strong growth if the US slowdown remains as moderate as expected, although countries with strong trade linkages with the United States in the specific sectors may experience some drag on their growth” (IMF 2007). (TRY to type this paragraph in your own words)
Economic activity reduces in the time of economic crisis. It directly affects the economy by lowering of domestic liquidity reducing stock prices to fall which in turns reduces companies access to foreign funds. There will be impact on economy arising from foreign direct investment (FDI) and foreign institutional investment (FII). These inflows have contributed to accretion of foreign exchange reserves. For example, in India, the FII inflows decreased to US$ 6.6 bn in April-September 2008-09 from $15.5 billion in the same period in 2007-08.
On the other hand some argue that chinas US$ 2 Trillion could be well utilised to bailout US financial system. (Jacques 2009; Winters and Yusef 2007; Wolf 2008). But China emerging as an alternative to US economy will not hold true as the Chinese economy is mostly export based where US EU and Japan account for half of China's exports. As the recession deepens it is bound to affect Chinas exports and economic activity. Moreover, China's share of global imports is still too mall for it to serve as a growth engine on the same scale as US economy.
4. Falling Growth and unemployment
Growth forecasts are being revised sharply for the emerging economies across the Asian region by IMF (IMF 2007 and also 2009; The Economist, 2009a and 2009b). The developing economies in Asia, which as a group grew at 10.6 % and 7.8 % in 2007 and 2008 respectively, are estimated to grow only 5.5 % in 2009 (IMF 2009). In china alone, more than 20 million rural migrant workers have lost jobs in manufacturing output as a result of slowdown. The decline in growth rates also adversely affected the demand for electricity and raw materials. For instance, electricity production fell by 6 % in 2008, having grown at 15 % on average since 2003, which suggests that Chinese economy has been growing at slower rates than IMF figures of 9 % in 2008. Even the 5 % growth is not enough to keep unemployment down (Wade 2009).