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To find a way out of both India's crisis as well as the world's current downturn, it is useful to focus on four areas: First - the origin of the financial crisis, including the problem of excess capacity and why the current fiscal stimulus packages may not be sufficient to pull the world out of its slump;

Second - the impact of the global financial crisis on developing countries; Third - ways to solve the current crisis, and global efforts to help developing countries cope with these trying times and the case for scaling up; Fourth - the impact of the global crisis on India and some policy choices.

The Crisis Creation of Excess Liquidity in US
It is important to keep in mind the origins of the crisis and the problem of excess capacity that is now unfolding. Today's crisis was preceded by six years of global boom. Following the bursting of the US tech-stock bubble in 2000-01, which had a substantial wealth effect on American households, the Federal Reserve aggressively eased monetary policy to minimize the duration and depth of the ensuing recession. There was a lowering in either the Fed funds rate or the discount rate 27 times between January 2001 and June 2003, resulting in the funds rate falling from 6.5 percent to 1.0 percent over that period. This expansionary monetary policy averted a deeper recession by stimulating a boom in the housing market, which soon turned into a housing bubble.

Higher housing prices fueled a consumption boom, and the Fed's continued expansionary monetary policy kept the US economy awash in excess liquidity.

Lack of Supervision of Financial Markets
At the same time, there were high levels of financial innovations on Wall Street, driven by a search for higher yields in a low-interest-rate environment. Much of this innovation was carried out by firms whose activities were not regulated, and through new instruments that were too complex to be effectively regulated. Financial markets were deregulated and supervision was lax.

Spread of Crisis to Other Major Economies
Other developed economies faced the same adverse impact when the internet bubble burst; their central banks also lowered interest rates, although less rapidly than the Fed, and their economies quickly recovered as well. In several other developed economies, housing bubbles developed, and in some cases became even larger than the US bubble. As a result of this combination of policy and market psychology, the brief global recession of 2001-02 was followed by a period of reasonably dynamic growth in the US and in much of the developed world, accompanied by low capital costs.

Developing Economies & Their Strength
Developing economies also thrived during 2002-07 for a combination of reasons. One important set of reasons related to domestic factors. As a group, the developing economies had entered the decade in a much better policy stance (macroeconomically and otherwise) than they had in the previous two decades, for example with lower inflation and more sustainable fiscal situations. These conditions would likely have predisposed the developing world to more rapid growth, and they also better equip the developing countries to deal with exogenous shocks in the current crisis.

Huge Merchandise Exports
Merchandise export volumes from USA, Japan and Germany (the largest exporters of capital goods) rose on average by 6.6 percent in the period 2002-2007, compared to 5.8 percent in the 1990s. This refers however to total merchandise exports (to both developing and high income countries). In nominal terms, the exports of machinery and transport equipment from high income countries to low and middle income countries increased by an annual average of 16.7 percent over the period 2002-2007, up from 12 percent in 1990s.

Record Growth Rate by Developing Nations
Developing world as a whole achieved its highest growth rates in decades. From 2003 to 2007, the collective GDP of developing countries grew more than 5.0 percent each year; in 2006, the growth rate peaked at nearly 8.0 percent, with all developing regions close to or exceeding 5.0 percent growth. By contrast, average annual growth for 1980-2000 had been just 3.4 percent. In the recent period, investment is estimated to have added about four percentage points to annual GDP growth (World Bank 2006).

At the same time, US demand was stimulated by the substantial swing in the US fiscal position, from a small surplus in 2001 to a sizeable deficit in 2003, which resulted from sharply increasing spending on defense and homeland security while cutting central-government taxes. Combined with a low interest rate and low saving rate, the fiscal deficit contributed to large US current account deficits and higher demand for developing-country exports. This created a feedback loop, by further stimulating developing countries' demand for investment goods and developed countries' capital goods industries.

Problems of Rapid Growth
With rapid growth in developing countries came the emergence of vulnerabilities much like those that were appearing in developed countries. The combination of abundant investment capital and rapid growth helped to inflate real estate prices to bubble-like heights in some emerging markets.

Bubble that Burst
Many equity markets surged as well, some to levels that suggested irrational exuberance. The boom was bound to end, especially given the explosion of sophisticated and unregulated financial derivatives which had sustained the process. In mid-2007, the US housing bubble was bursting beginning with the sub-prime mortgage market. The drop in value of the off-balance sheet assets pushed many financial institutions into insolvency. Even worse, the financial innovations of the past decade - many of which had been sold on the promise that they would diversify and minimize risk - turned out to be transmission mechanisms for instability.

Collapse of Investment Banks
Following the collapse of Lehman Brothers in September 2008, the value of capital eroded dramatically, undermining the creditworthiness of major global financial institutions and triggering massive de-leveraging. Efforts to restore capital adequacy and uncertainty about the underlying value of assets held in the form of sub-prime mortgage backed securities resulted in capital hoarding, causing liquidity to dry up. The ability of borrowers to finance transactions in both the real and financial sectors was then diminished. This in turn reduced demand and employment, undermining consumer and business confidence, and triggering a further contraction in demand. Meanwhile, the total capitalization of world stock markets almost halved by the end of 2008; that is, US$ 30 trillion of wealth has disappeared. In the United States alone, the wealth losses for households related to the fall in home prices are roughly US$ 4 trillion so far, and are clearly bound to increase further as home prices continue to fall - eventually reaching the US$ 6-8 trillion range. Losses of this magnitude also have significant wealth effects on consumption and savings.

It is now widely acknowledged that the world economy is going through a global recession, the like of which we have not seen in eight decades. United States is at the heart of the international financial system, and it involves the world's main global reserve currency. The inability to rely on port stimulus anywhere also makes it evident that one country or group of countries can emerge from the crisis on its own. Cooperation among industrialized and emerging economies and co-ordination of policies across the board are essential.

Action Taken So Far
While commendable, actions taken so far by the US, Euro area, Japan and other wealthy countries might not be sufficient to counter the huge downturn the world finds in. Experience has shown that in general monetary policy is likely to be ineffective to stimulate Investment and consumption in excess capacity situations. There is an urgent need for a global, coordinated fiscal stimulus. As a result of this synchronization in the current crisis, dealing with it alone is beyond the capability of any single country. Instead, decisive, and concerted and co-operative efforts are needed.

Impact on Developing Nations
While developed countries are experiencing some of the sharpest contractions in GDP growth, households in developing countries are much vulnerable, and likely to experience acute negative consequences in the short- and long-term. Declining growth rates combined with high levels of initial poverty leave many households in developing countries highly exposed to the crisis. Vulnerability is heightened if, at the same time, governments are constrained in cushioning the impacts due to limited institutional capacity and fiscal resources. Developing countries are expected to have a financing gap in a range of US$ 270 - US$ 700 billion, depending on the severity of the economic and financial crisis and the strength of the policy response. Existing resources of international financial Institutions cannot currently cover the Shortfall, even at the low end. The supply of capital from private sources is much tighter than in the past.

As a result, in the wake of the crisis, developing countries are likely to face higher interest rates and spreads, and lower capital flows than over the past five years. The supply of capital from private sources will be much less dynamic in the future. Many of the institutions that provided international financial intermediation services over the past 25 years no longer exist. As a result, the post-crisis world developing countries are likely to face higher interest rates and spreads, and lower capital flows than over the past five years.

At the micro level, the global economic crisis is exposing households in almost all developing countries to increased risk of poverty and hardship. Almost one third (29 percent) of all developing countries are highly exposed to the poverty effects of the crisis (that is both declining growth rates and high poverty levels) and an additional 62 percent of countries are moderately exposed (they face either decelerating growth or high poverty levels). Our initial estimates for 2009 suggest that lower economic growth rates will trap 46 million more people on less than US$1.25 a day than was expected prior to the crisis. An extra 53 million will stay trapped on less than US$ 2 a day.

Social Impact of Crisis
The social impact of the crisis on developing countries will be very serious. Already we have seen massive layoffs in both India and China over the past five months, in many cases with urban migrants losing city jobs that had allowed them to send remittances back to poorer relatives in the countryside. According to the ILO, in India, over 500,000 jobs have been lost over the last three months of 2008 in export-oriented sectors - i.e., gems and jewelry, autos, and textiles.

The effects of falling real wages and joblessness impede households' ability to provide adequate food and necessities to their members. Compounding this is the very real risk that, in many countries, fiscal pressures will result in reduced services to the poor. Absent assistance, households may be forced into the additional sales of assets on which their livelihoods depend, withdrawal of their children from school, reduced reliance on healthcare, inadequate diets and resulting malnutrition.

Long Term Impact
The long-run consequences of the crisis may be more severe than those observed in the short run. When poor households withdraw their children from school, there is a significant risk that they will not return once the crisis is over, or that they will not be able to recover the learning gaps resulting from lack of attendance. And the decline in nutritional and health status among children who suffer from reduced (or lower-quality) food consumption can be irreversible. The middle class will also be hit hard by soaring joblessness, losses in equity markets, currency depreciation, and anxiety over the safety of local banks.

Ways to Solve the Crisis
Finding a way out requires putting the interests of our interlinked global economy as high as national interests. Such a policy stance is what will get the world out of the current downward spiral. What should be considered are expanded mechanisms for channeling support in the form of funding from developed countries to projects and programs that release bottlenecks to growth in developing countries. Some of this is already planned via the Vulnerability Fund being advanced by World Bank Group President Robert Zoellick.

For countries with large foreign exchange reserves, investing in projects in developing countries with high returns could help restore stability in global trade and manage their surpluses in the most efficient way possible. For poor countries, such funding would provide the much needed resources for domestic or regional projects that meet the market test - i.e. those projects that release bottlenecks to growth.

Given the tough times faced around the world, I think making fiscal stimulus plans work by releasing bottlenecks to growth in developing countries offers a potential win-win solution. To overcome global recession characterized by excess capacity, fiscal stimulus efforts must be bold, global, and generate an immediate and sustained increase in global demand and productivity.

Major fiscal stimulus packages are being implemented around the world to complement monetary policy. But in environments where firms face large adverse shifts in demand, some fiscal policy features such as tax cuts and subsidies may have little effect.

Projects to Generate Returns
If policymakers can design a system that allows public projects and programs to generate enough returns to repay themselves, the chance of success is high. Developing country economies provide good opportunities for such type of projects. In developing countries, there are many bottlenecks that constrain the growth of their economy. If the government uses fiscal stimulus to invest in projects that release these bottlenecks, economic growth will be enhanced after the crisis and the marginal returns to private sector's investment will also increase. If the gains in the government's revenues from the above sources - both direct and indirect - are large enough, these investments may indeed be self liquidating. This would ensure that precautionary concerns and expected future tax rises will no longer inhibit spending.

Global Efforts to Support Developing Nations
The magnitude of the current global crisis requires a bold response that focuses on preventing the economic crisis from becoming a human crisis as well as the needs to address the global crisis with a global view in designing the coordinated fiscal stimulus. The Vulnerability Fund and the "1 percent solution" proposed by World Bank President Robert B. Zoellick, are a good start. What is envisioned under the "Vulnerability Fund" is for each developed country to assign 0.7 percent of its stimulus package to the fund. Priority areas for support would include: safety net programs, infrastructure investments, and, support for small and medium-sized enterprises and microfinance institutions. The separate "1 percent solution" proposal entails having reserve rich nations allot 1 percent of their sovereign wealth funds to support African infrastructure and other investments in lower income countries.

Urgent collective efforts are needed to support such investments in developing countries. As mentioned earlier, efforts along these lines are already under way, through the World Bank Group and other international finance institutions. The World Bank Group has been quick to offer expanded, innovative products and services to assist developing countries. First, IBRD has the capacity to make new commitments of up to US$ 100 billion over the next three years. This year, lending will almost triple to US$ 35 billion to meet additional demand from our developing country partners. Second, an IDA fast-track initiative is now in place with US$ 2 billion available to help the poorest countries deal with the crisis - money to be used for safety nets, infrastructure, education and health which is part of the US$ 42 billion IDA 15 fund for the poorest people. This follows a US$ 1.2 billion Global Food Response Program (GFRP) set up in May 2008 to speed assistance to the neediest countries to cope with the food crisis. Third, the IFC, an affiliate within the World Bank Group that focuses on theprivate sector, has launched new facilities to provide around US$ 30 billion over the next 3 years and ramping up support to the private sector through the launch or expansion of five initiatives.

Impact on India
The global economic crisis has hit India hard in terms of exports, remittances and portfolio investment funds. Exports declined for the fourth consecutive month in January, falling by 16 percent in January, the biggest decline since May 1998. While imports are contracting more sharply than exports, India's current account deficit is widening as remittances from Indians working abroad are slowing down due to the crisis. Large withdrawals of portfolio investment funds and purchases of US dollars by Indian banks to fund their overseas operations also created pressures on the exchange rate.

Amidst decelerating investment and consumption, India's economic growth dropped to a worse-than-expected 5.3 percent in the last quarter, down from 8.9 percent in the same period, a year earlier. The latest industrial production figures show a deceleration in investment demand and in consumer spending. Surprisingly, agriculture declined by 2.2 percent in the last quarter, which will negatively affect consumption of 800 million rural Indians that was anticipated to hold up and provide a floor to growth in this downturn. Private consumption will drop to around 4.0 percent this year, as employment falls and real wage growth slows as a result of the downturn. Major job losses due to the financial crisis will occur in sectors such as construction, textile, real estate, financial services, and the car industry.

The recent food and oil price increase followed by the global economic crisis has left most South Asian countries including India with widening twin budget and trade deficits. Coping with a protracted crisis therefore requires a skillful mix of fiscal, monetary, and exchange rate policies. To tackle the economic slowdown, the Reserve Bank of India (RBI) boosted liquidity and loosened monetary policy, and the Government introduced two fiscal stimulus packages. The exchange rate has also depreciated by 22 percent over the past 12 months. With inflation rates dropping, monetary easing provided stimulus to the economy and mitigated the liquidity crisis in the banking sector. Since October, RBI has lowered the repurchase rate five times by a total of 400 basis points, from 9 percent to 5 percent. While the decline in inflation gives the RBI some room to carry out these rate cuts, constraints arise from the ongoing foreign capital outflows, a high trade deficit, and the depreciation of the rupee. As discussed earlier, there are limits to effective monetary policy in the face of a protracted crisis.

On the fiscal side, the deterioration in public finances due to low revenue collections, tax cuts and additional expenditures is expected to bring the Government's fiscal deficit beyond 10 percent of GDP. This limits the traditional counter-cyclical fiscal policy. But India holds sizable foreign exchange reserves and could use them to invest in infrastructure. Of course, the twin deficits, together with inflationary pressures and a high public debt (80 percent of GDP) will reduce room for maneuver, but with skillful economic management, the Government can reduce the impact of a protracted crisis on the Indian economy.

In December the Government announced a fiscal stimulus package of Rs. 300 billion or around 0.6 percent of GDP. A second fiscal stimulus package in January is expected to generate additional infrastructure investment of Rs. 750 billion over the next 18 months. The thrust of the stimulus packages in India is on infrastructure projects. Not only should the implementation of these projects help support aggregate demand under the current circumstances, they should help address infrastructure bottlenecks that are a huge constraint to long term growth in India.

The impact on productivity and growth of these projects is also important from a development strategy perspective. A striking difference between India and China is the relative importance of manufacturing in output and total exports, about 16 percent and 40 percent in India compared to 33 percent and 84 percent respectively in China. India's share of commercial services in total goods and services exports has been much higher than China's, not just since the rapid expansion of export of computing services around 2000 but even earlier, since 1992. This difference could partly be attributed the state of infrastructure. Thus, the investment projects in infrastructure may help also to revitalize the manufacturing sector and change the structure of the Indian economy in favor of this sector.

Safety Net Programmes
India might also be able to make better use of existing Safety Net programs. India has several safety net programs, including the public distribution system, which involves the sale of foodgrains at highly subsidized prices to the poor in the country; food-for-work programs; mid-day meal schemes in schools and feeding programs for children and pregnant women; and various state-level food-based welfare schemes. As the global crisis reverberates and more and more people are out of work, the trade-off between employment generation schemes versus other traditional safety nets becomes important and merits a careful evaluation.

Global experience shows that countries with effective safety nets that target the poor are the most successful in responding to crisis. It is naturally easier to scale up an existing safety net program than to design a new one, particularly to respond to a current crisis. However, some countries have been able to use a crisis as an opportunity to eliminate ineffective programs and replace them with better designed programs.

Lessons to be learnt
There are many lessons to be learned from our recent experience; not least among these lessons is the extent to which we are interconnected. This is a global crisis and we must look for a global solution. We must target stimuli, irrespective of national borders, to where their marginal impact will be the greatest. Right now this means investing in projects that release the bottlenecks that are impeding not just the growth of developing countries, but the growth of the world.