Gone are the days when countries used to remain aloof from each other. With increased globalization and liberalization, the world has become shorter and economies are more intermingled.

This is an era of open economy. This is the reason almost all countries have opened the gates for FDIs and FIIs. Trade restrictions have been minimized. Custom duties and other restrictive practices have been questioned in international meetings and discussions and the countries across globe are trying to be as liberalized as possible.

However, all is not well with this ‘fusion’. Now, countries have become more vulnerable to external economic shocks and the recent financial crisis of 2008 is a testimony to this.  There are different transmission channels through which these shocks affect other countries. These can be broadly categorized into real and financial channels.

Real channel includes primary industry, service industry, secondary production, exports and imports, public finance and foreign aid  (Sengupta, 2008). Financial channel includes stock markets, banking sector and foreign direct investment (Sengupta, 2008).

In developed countries like US, the government provides heavy subsidies to some sectors resulting in fall of their prices internationally. It increases the global competition and negatively affects the producers of developing world. For example, oil prices dropped to around 40 percent in 2008 affecting African countries heavily (Seshan, 2008).

Countries are also affected by changing exchange rates resulting from appreciation/depreciation of US dollar against Asian currencies. The equations put an impact on exporters and importers and the whole economy gets affected with major change in exchange rates.

Financial channels were more responsible for the spread of meltdown in 2008.  Stock indices nosedived in Western countries and later this slump engulfed Asian countries as well leading to risk inversion among investors and reduction in capital inflows. The main channel through which financial meltdown spread was the banking sector (Krugman, 2008). The meltdown, started mainly because of sub-prime lending in US, put financial institutions in a heavy loss. Turmoil was witnessed in major Asian economies including Indian and China.

As financial markets of India are well integrated with rest of the world, adverse effects were witnessed in equity market and forex market. Overall decrease in demand impacted macro environment of the country including balance sheets of corporate sector and investment levels (Katju, 2009).

Capital account exhibited a significant change in 2008-09. Net capital flows dropped  by around 4 billion US dollars in 2008 compared to the previous year. FIIs witnessed the net outflow of approximately 7 billion US dollars in 2008 compared to the net inflow of 15 billion dollars in 2007.

All these factors put on stock market and indices fell down heavily because of FIIs withdrawal. As they had obligations to meet in their home country, they started pulling out finds from external markets. As a result, Sensex nosedived to an unexpected level leaving the whole economy in deep abyss. Industrial growth fell down to around 50 percent, and merchandise exporters felt heavy pressure because of the slump in global demand. The adversity in Industrial sector construction, transportation, and the employment levels as a whole.

As per the survey by Ministry of Labor and Employment, around 5 lakhs employees were rendered unemployed (Origin of the crisis, 2009). Thus the crisis transmitted to India through financial, monetary and real channels putting the whole financial set up under pressure.

China, the giant Asian economy, was also badly affected by financial meltdown. Growth of the economy fell down to 6 percent in 2008 compared to 13 percent in 2007 (Yilmaz, 2009). The channels through which the financial crisis hit this economy are:

• FOREX
• Exports
• Cross-border capital flows
• Direct losses in US capital market

The exact data is not available on the loss incurred by the country because of the mortgage-related bonds. Bank of China was the most affected commercial bank in China and it had written off 2 billion dollars of loan -related assets (Sengupta, 2008) .

China only allowed partial liberalization in the capital account which that only FDIs and selected FIIs could enter the country. Despite this control, the stability of Chinese economy came to a big halt during the crisis. In 2008, net capital outflow was witnessed in the country. FDIs dropped by around 30 billion US dollars in 2008 (Stiglitz, 2009).

In 2008, hot money also went out resulting in crash of Stock Exchange .However, the exact figure is unavailable regarding it. The most serious crisis the country faced that time was on the trade. GDP dropped by a massive 4 percent, industrial production dropped by around 50 percent (Origin of the crisis, 2009), and many products witnessed the negative growth in the year. Export market collapsed and steel industry faced the brunt.

In brief, fall in exports was among the major causes of slowdown in the country. The other factor was decline real estate investments. Third factor that contributed to this abyss was ‘inventory management’. The hoarding done by the enterprises in anticipation of rising prices boomeranged making the situation worse.

As the discussion is going on, India and China faced major setback in terms of slowdown in growth. To counter those negative effects, several policy measures were adopted by both countries. Let’s have a brief overlook at some of the measures.

To counter the financial risk, the RBI came forward to maintain sufficient liquidity in forex and domestic currency. Monetary policy was eased to increase liquidity. Taking cue from it, banks in India reduced their lending rates and deposits.

On the Government side, 3 fiscal stimulus packages were launched between December 2008 and January 2009.  Also, it came up with many programs for poor people, waived loans, and increased payouts following 6th pay commission (Katju, 2009).

China also applied similar approaches to overcome the crisis. The Government announced a major stimulus package in November 2008. In addition, an expansionary monetary policy was followed.  A massive stimulus package of 4 trillion Yuan was announced for 2009 and 2010. Provincial governments also came up with stimulus packages of around 18 trillion Yuan in total. Infrastructure investment was the main component of this huge package.

Investment in fixed assets was the main driver of the economy since many years and played a dual role: demand creation in short run and supply creation in long run. This was a judicious move as overcapacity was the major problem that time and investment in infrastructure was intended to increase manufacturing capacity in the country.

However, there were some shortcomings with the approach.  This big push in infrastructure and hasty implementation wasted resources. Secondly, lack of support from local governments was a major constraint. Despite loopholes, both countries witnessed some positive vibes because of these fiscal and monetary policies.

The fiscal measures adopted in India were about 3 percent of GDP. The measures initiated during 2008-09 stabilized the economy to an extent. Real GDP growth was projected to be around 6 percent. The economy remained resilient with well working financial institutions.

On the negative side, the measures posed risks and challenges also. The option of increasing liquidity the RBI resorted to that time can create risk if the liquidity is not absorbed in an orderly and constructive manner. If not, it can create inflationary pressures on the economy. But it was a judicious move as it instilled confidence among banks regarding the availability of funds.

The stimulus packages announced by the government led to increase in revenue and maintained economic activity in the country. Though it was a short term measure, it proved effective in generating demand.

To mitigate the effects fully, some more measures are required. Let’s have a look.

Countries should explore new destinations for exports. Dependence on a specific region or country may curtail the demand in case of any problem in that part of the globe. So, planners should think imaginatively that what more products and services they can sell and what new markets they can reach to.

Experts say that unless there is enough demand at home, it’s difficult to overcome the loss of external demand. But this view is not exactly up to the mark. There is sea-difference between the domestic demand and products and services meant for exports. Still, domestic consumption should be sufficient enough to maintain the pace of the economy.

It’s the key to mitigate effects of external shocks. During the financial crisis, many people were laid off. So, government should try hard for employment generation in different sectors that were hit more. No doubt the efforts have been made, gap is still there. The need is to lessen the gap thorough employment generation.

Structural problems are there with both India and China. For instance, India needs agrarian reforms and more research in environment-friendly projects. China needs to work on pollution, energy efficiency, providing social goods, countering gap between rural and urban areas.

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