Assessing the Role of Trade in Transmission of Global Financial Crisis to the Indian Economy

By Rajesh, Raj; Bordoloi, Sanjib et al. | Indian Journal of Economics and Business, December 2011 | Go to article overview

Assessing the Role of Trade in Transmission of Global Financial Crisis to the Indian Economy


Rajesh, Raj, Bordoloi, Sanjib, Bharti, Nalin, Indian Journal of Economics and Business


Abstract

Over the past few decades, while trade has contributed significantly to economic growth in various economies including India, openness has also exposed them to vagaries of external shocks. While recent global financial crisis (GFC) essentially originated in advanced economies, it got transmitted to emerging market economies through three main channels viz., financial, trade, and confidence channel. Relatively, while financial channel had a more dominant role in transmitting global shocks to Indian economy, its growing trade openness had led to decline in both exports and imports from the latter half of 2008 till 2009. Against this backdrop, this study primarily focuses on studying the impact of trade shock emanating from GFC on the Indian economy. In empirical analysis, it is found that the impact of recent trade shock on the economy remained minimal and short-lived. Under S-VAR framework (quarterly data from 1996-97 to 2009-10), impulse response analysis suggests that the impact of export demand on India's gross domestic product (GDP) persists for a short while, which is validated by recent strong rebound of the economy in the aftermath of global financial crisis. This is in line with our expectations as GDP growth in India is primarily driven by domestic consumption, while external demand plays a minimal role.

Key words: Trade, Financial Crises, Open economy, India

I. INTRODUCTION

In the series of financial and currency crises of the 1990s (Mexican crisis, 1994; East Asian crisis, 1997-98; Brazilian crisis, 1999) including the recent global financial crisis, the crises first originated in a country or a region but got transmitted to other economies as a contagion. In all these crises, trade had been an important channel of transmission of crisis to other countries. In the recent global financial crisis, three main channels of transmission of crisis to the emerging market economies (EMEs) including India were the financial channel, trade channel, and confidence channel. Financial channel caused wild disruptions in the financial markets impacting the equity and money markets badly. Trade channel impacted the roots of the real sector causing decline in real economic activity following a decline in production and investment activities, which resulted in unemployment, largely in trade dependent sectors. The confidence channel operated through the equity markets, wherein sharp decline in prices of scrips across the board caused decline in business and consumer confidences. In India, all these transmission channels operated; albeit their strengths varied. In the Indian case, financial channel was found to be more dominant as compared to trade channel (RBI, 2010). While the adverse impact of global financial shocks were felt immediately by the Indian economy in mid-2007 as the capital market started jolting, trade sector was not impacted immediately. Rather, the trade channel of the contagion intensified only in the aftermath of collapse of the investment bank--Lehman Brothers--in mid-September 2008. It was at this time that the crisis adversely impacted India's merchandise trade as both exports and imports declined swiftly and substantially.

Of the three channels, the present Study primarily focuses on the role of trade in spreading the contagion of global financial crisis to the Indian economy. This assumes importance as a better understanding of how the trade shock affected the Indian economy would help policy makers in designing counter-cyclical policies. The trade channel transmitted the adverse global shocks to the Indian economy both through merchandise trade and services (invisibles) trade. Nevertheless, for the sake of brevity and simplicity, our study is primarily focused on analyzing the trade comprising only the merchandise trade.

Though there is an abundant literature on trade and growth linkages, literature on the area as to how shocks in trade (export) might affect economic growth of a country is scanty. …

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