What began as a financial crisis four years ago has now developed into a full-blown fiscal crisis in the rich nations. The wild gyrations in the global stock markets this month are enough indication that the tentative optimism evident in the first half of this year has been replaced by a new round of fear.
The peripheral countries of Europe have no hope of getting their national finances in shape without a painful restructuring of their economies. They cannot service their sovereign debt given the current rates of interest rates and nominal economic growth. The US, Germany, France and the UK seem to be further away from insolvency than the likes of Greece and Portugal, despite the fiscal strain they are facing, but economic conditions have deteriorated even in these countries in recent months. A double-dip recession at this juncture could also push them closer to the brink.
Despite the recent spike in inflation and slowdown in economic activity, India continues to be one of the most robust economies in a two-track world. But it is also essential to prepare for the next round of global turbulence, because the experience of 2007 and 2008 showed us that decoupling is a myth and global shocks are easily transmitted to India via the trade, finance and confidence channels.
India has some natural insurance against a new crisis in the rich nations since its economic model is more focused on domestic demand compared with the economic model in China. The $300 billion-plus of foreign exchange reserves with the Reserve Bank of India (RBI) also provides those managing the economy with some fire-power to defend the rupee against a sudden outflow of capital or a speculative attack on the currency.
But there are several weak spots in our defence capability as well. India has among the highest fiscal and current account deficits (4.7% and 2.7% of gross domestic product, respectively) among emerging markets, a potential danger at a time when inflation is already too high. These deficits are an indication that fiscal policy is very loose and domestic demand has to cool off. The twin deficits are higher than what they were in 2008, during the panic after the collapse of Lehman Brothers.
As of now, capital inflows have been strong enough to comfortably fund the current account deficits. The fiscal deficit is financed through domestic savings while the public debt burden is coming down thanks to very high nominal GDP growth. So there seems to be no reason for immediate panic. But a severe global shock could expose these weak links in the Indian economy.
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