India's Experience during Current Global Crisis: A Capital Account Perspective

It is generally believed that the global financial crisis left India virtually unaffected. However, the events that unfolded especially after the collapse of Lehman Brothers showed the vulnerability of the Indian economy. In this paper we analyze the experience of the Indian economy during the crisis from a capital account prospective. Our analysis shows clearly that, because of the increased openness of Indian economy in the past two decade, the financial crisis spilled over to India through financial as well as real channels. After record capital inflows until 2007, a sudden reversal of the short-term capital flows thereafter affected Indian economy in many ways. The Indian stock market appeared to be highly dependent on the foreign institutional investors. The exchange value of rupee depreciated as a consequence of the capital withdrawals from India. Not only that, the global liquidity crisis squeezed the external borrowings of the Indian corporate and banking sectors considerably. Signs of recovery can be noticed from second quarter of the 2009-10. However, the exposure of Indian economy has increased over time and there are still some areas of concern that will have to be addressed. Our analysis shows that the effects of the crisis, which came through trade and capital outflow, were contained by effective use of fiscal and monetary policy. We also look at the gradualist approach adopted by India towards capital account liberalization. An analysis of the composition of capital flows proves the fact that debt flows are more prone to crisis than equity flows. In our opinion, the debt-creating flows, especially short-term debts, could be detrimental to the health of an economy because of their pro-cyclical nature.