How bad is the global economic situation, and how long will the problem last?

In the first three to four months, what we have seen is comparable to the Great Depression. That does not mean it is going to become as bad as the Great Depression over the next two years, because corrective policies are taking place all over the world. So I don't expect to see the output drops that that we saw in the Great Depression.

So when will the recovery begin?

The most optimistic outcome is that the recession in the industrialised world might come to an end by the end of the second quarter of calendar 2009. We will then begin a slow recovery. No one expects a fast recovery, it is generally agreed that 2009 as a whole will be worse than 2008, and growth will be at least a percentage point lower.

Then you have the worst case scenarios, though no one is making precise forecasts. I tend to take the more optimistic view of the outcome in a difficult situation.

It has taken the US 25 years to get here, by accumulating enormous debt, continuing with the twin deficits. The US has to correct for all that and it will be long-term correction. So will a recovery in the second half of 2009 mean very much?

That situation is still consistent with the beginning of a recovery in the second half of 2009. What it will do is affect the pace of the recovery. It is no longer a reasonable assumption to make that US demand will create growth momentum for the rest of the world. On the other hand, the US is still a source of technology. So you can view growth in the US as being constrained by demand, but you can also see growth as being driven by supply-side issues like technology.

It is quite clear that growth in demand should come from other parts of the world, certainly from India, with much higher levels of investment. The problem is, how do you finance such investment? The financial system of the world is a bit broke, and will take some time to fix it.

Would it be correct to say that what began as a financial meltdown has rapidly morphed into a general economic recession, for which economics has answers - whereas no one really knows what to do about a meltdown. So the world has pulled back from staring into the abyss.

I think that would be fair (to say). But the notion that it began as a financial meltdown is also a little bit exaggerated. You might say that there was a series of macro-economic imbalances and those imbalances were sustained because of a great flush of liquidity, which hugely encouraged innovation and leveraging. In itself, excess liquidity lowers returns, so there was a search for higher returns. The innovation was designed to produce higher returns, which in turn were the result of a mispricing of risk. So the long chain began with the macro-economic imbalances, which everybody knew was there but no one was able to coordinate policies to avoid them.

So have we pulled back from the abyss?

It's still not totally clear that the problem of toxic assets has been correctly identified. With recession, many non-toxic assets will become problematic. So, many people saw we have not reached the bottom. I also would say that this is not the bottom. The question is if this is a meltdown, or further financial hits which the system is capable of taking.

There are three other problems. To what extent will the recession create more problematic assets? Second what is the extent of credit card risk? And third, have house prices really bottomed out?

You mean a meltdown is still possible?

It does not mean a meltdown. What it does mean is massive capital erosion of the financial system in the west. What that will mean is de-leveraging, and that will have consequences. By the end of the second quarter of 2009, they will be able to say that we have seen the worst. But the banks need to recapitalise, which is essential. We hear that the new US administration is going to put in a huge amount of money. If the banks are adequately able to function�the question is how will they get the capital.

The recapitalisation is being done by governments, so there is the issue of the character of the banks. Most people see this as nationalisation. I think it is a pouring in of government money, and the banks will go back at some point to private sector owners. But to achieve that transition, it could well take two or three years. What we should not expect is more bank collapses, because governments will step in.

What does all this mean for us?

There will clearly be an interruption in the flow of capital. But people will realise that the high returns in the west were really Ponzi schemes. What we would hope is that people will realise that the high returns are in India. That is the opportunity. If the US is going to grow at 1 per cent instead of 3 per cent, and we grow at 7 per cent or even 8 per cent, then at some point the differential rates of return should come up. So we could get capital flowing into India, even in a world that is massively de-leveraged.

What do we need to do to make this happen?

We need to send the message that we are not about to shut our doors. You occasionally see people saying these are the costs of integrating. In one sense, they are; if you keep yourself open, you are vulnerable to other people's mistakes, which occur once every 20 years. But now that the mistake has occurred, we should keep ourselves open, and we are doing that.

Second, our actual need of capital is not very high. The current account deficit is 3 per cent of GDP this year; next year it will be 2 per cent. That is $22 billion, and it is not a very big sum of money. Even if capital flows were to collapse to one-fifth of last year, that would be enough. So we need to focus on quality investors, people who bring in technology and take a long-term view.

Are you saying we should look more to FDI than FII money?

We've always held that view. But the notion that FII money is pure speculation is wrong. People are buying a piece of the Indian action but not getting directly into management. It helps spread the India story, and it improves the functioning of our capital market, and our corporate have to observe certain standards (this was before the Satyam [Get Quote] collapse). Many investors are long-term investors, and don't want to get into management.

(Tomorrow � Part II, focussing on the domestic situation: "Next year will be worse")