Global Financial Crisis: Causes, Consequences and Indias Prospects

By

RAKESH MOHAN Deputy Governor Reserve Bank of India

At

London Business School April 23, 2009

Scheme of Presentation

Global Financial Crisis Impact on India Difference between US/Europe and India RBIs Policy Response and Impact Lessons from the Crisis Medium-term Issues and Challenges

Scheme of Presentation
Global Financial Crisis

Impact on India Difference between US/Europe and India RBIs Policy Response and Impact Lessons from the Crisis Medium-term Issues and Challenges

Global Financial Crisis (1)

Proximate causes

Sub-prime lending Originate and distribute model Financial engineering, derivatives Credit rating agencies Lax regulation Large global imbalances
Excessively accommodative monetary policy in the US and other advanced economies (2002-04)

Fundamental cause

Global Financial Crisis (2) Current Account Balance (per cent to GDP)
Country 1990-94 1995-99 2000-04 China 1.4 1.9 2.4 India -1.3 -1.3 0.5 Russia 0.9 3.5 11.2 Saudi Arabia -11.7 -2.4 10.6 United Arab Emirates 8.3 4.6 9.9 United States -1.0 -2.1 -4.5 Memo: Euro area n.a. 0.9 0.4 Middle East -5.1 1.0 8.4
Source: World Economic Outlook Database, April 2009, International Monetary Fund. Note: (-) indicates deficit.

2005 7.2 -1.3 11.0 28.7

18.0 -5.9 0.4 19.7

2006 9.5 -1.1 9.5 27.9

22.6 -6.0 0.3 21.0

2007 11.0 -1.0 5.9 25.1

16.1 -5.3 0.2 18.2

2008 10.0 -2.8 6.1 28.9

15.8 -4.7 -0.7 18.8

Global Financial Crisis (4)

US Monetary Policy (1)
9 8 7 6 5 4 3 2 1 0

Effective Federal Fund Rate in the US

Per cent

Volatility in monetary policy in advanced economies Large volatility in capital flows to EMEs Again very loose MP in US likely surge in capital flows to EMEs?

Jan-90 Dec-90 Nov-91 Oct-92 Sep-93 Aug-94 Jul-95 Jun-96 May-97 Apr-98 Mar-99 Feb-00 Jan-01 Dec-01 Nov-02 Oct-03 Sep-04 Aug-05 Jul-06 Jun-07 May-08

Global Financial Crisis (5)

US Monetary Policy (2)

US Monetary policy too loose during 2002-04; aggregate demand exceeded output; large current a/c deficit; mirrored in large surpluses in China and elsewhere.

Global Financial Crisis (6)

US Monetary Policy (3)

Large Fed cuts in 2007: strong boost to oil, other commodity and asset prices

Global Financial Crisis (3)

Capital Flows to Emerging Market Economies
800 600 400 US $ billion 200

0 1992
-200 -400 -600 Direct investment, net Other private capital flows, net Private portfolio flows, net Private capital flows, net

Very large capital flows to EMEs now outflows in 2009 - large volatility - implications for monetary management and financial stability

2008

1980

1982

1984

1986

1988

1990

1994

1996

1998

2000

2002

2004

2006

Global Financial Crisis (7) Worsening Global Economic Outlook

Growth Forecast of IMF (per cent) Region

April 2008

July 2008 October 2008 April 2009 2008 2009 2008 2009

2008 2009 2008 2009 Advanced countries EMEs World World

1.3 1.3 1.7 1.4 1.5 0.5 6.7 6.6 6.9 6.7 6.9 6.1 3.7 3.8 4.1 3.9 3.9 3.0 Global Trade Volume (Goods and Services) 3.7 3.8 4.1 3.9 3.9 3.0

0.9 (-)3.8 6.1 1.6 3.2 (-)1.3 3.3 -11.0

Scheme of Presentation

Global Financial Crisis

Impact on India
Difference between US/Europe and India RBIs Policy Response and Impact Lessons from the Crisis Medium-term Issues and Challenges

Impact on India (1) Trends in Capital Flows

Component
Foreign Direct Investment to India FIIs (net)

Period April-February April-March

2007-08 27.6 20.3 17.5 10.7 82.0

2008-09 31.7 -15.0 6.0 0.5 15.3

External Commercial Borrowings (net) April- December Short-term Trade Credits (net) Total capital flows (net) Memo:

April- December
April- December

Current Account Balance

Valuation Gains (+)/Losses (-) on Foreign Exchange Reserves Foreign Exchange Reserves (variation)

April- December
April- December April-December April-March

-15.5
9.0 76.1 110.5

-36.5
-33.4 -53.8 -57.7

Impact on India (2) Key Macro Indicators

Indicator Real GDP Growth Period April-December 2007-08 9.0 2008-09 Growth, per cent 6.9

Industrial production April-February Services

Exports Imports GFD/GDP Stock Market (BSE Sensex) Rs.per US$

8.8 10.5
28.4 40.2 2.7 16,569 40.24

2.8 9.7
6.4 17.9 6.0 12,366 45.92

April-December
April-March April-March April-March April-March April-March

Scheme of Presentation

Global Financial Crisis Impact on India Difference between US/Europe and India RBIs Policy Response and Impact Lessons from the Crisis Medium-term Issues and Challenges

Differences Between Financial Crisis in US/Europe and India (1)

What has not happened here

No subprime No toxic derivatives No bank losses threatening capital No bank credit crunch No mistrust between banks

Differences Between Financial Crisis in US/Europe and India (2)

Our Problems

Reduction in capital flows

Pressure on BoP Stock markets Monetary and liquidity impact

Temporary impact on MFs/NBFCs (Sept-Oct) Reduction in flow from non-banks Perceptions of credit crunch

Differences Between Financial Crisis in US/Europe and India (3)

Our Problems

Fiscal stress
Oil, Fertiliser, Food subsidies Pay Commission, Debt waiver, NRE Stimulus packages GFD/GDP ratio: 5.5-6.0% Large increase in market borrowings

Rs. crore 2008-09 BE Gross Net 1,76,453 1,13,000 2008-09 RE 3,42,769 3,29,649 2009-10 BE 3,98,552 3,08,647

Differences Between Financial Crisis in US/Europe and India (4) Indias Approach to Managing Financial Stability (1)

Current account: Full, but gradual opening up Capital account and financial sector: More calibrated approach towards opening up.
Equity flows encouraged; debt flows subject to ceilings and some end-use restrictions.

Capital outflows: progressively liberalized.

Differences Between Financial Crisis in US/Europe and India (5)

Indias Approach to Managing Financial Stability (2)

Financial sector, especially banks, subject to prudential regulation both liquidity and capital. prudential limits on banks inter-bank liabilities in relation to their net worth; asset-liability management guidelines take cognizance of both on and off balance sheet items Basel II framework: guidelines issued. Dynamic provisioning NBFCs: regulation and supervision tightened - to reduce regulatory arbitrage.

Scheme of Presentation

Global Financial Crisis Impact on India Difference between US/Europe and India
RBIs Policy Response and Impact

Lessons from the Crisis Medium-term Issues and Challenges

Measures since Mid-September, 2008 (1) Expanding rupee liquidity

Reduction in CRR (400 bps) & SLR (100 bps) Special Repo window under LAF for banks onlending to NBFCs, HFCs & MFS Special Refinance to banks without collateral Unwinding of MSS buyback/desequestering OMOs pre-announced calendar

Cut in repo (425 bps) and reverse repo (275 bps) rates.

Existing instruments enough flexibility

MSS and CRR good, effective buffers of liquidity both absorption and injection

Measures since Mid-September, 2008 (2)

Managing Forex liquidity NRE and FCNR(B) deposits: interest rate ceilings raised ECB norms relaxed Allowing corporates to buy back FCCBs Rupee-dollar swap facility for banks with overseas branches

Measures since Mid-September, 2008 (3)

Encouraging Flow of credit Exporters:
extension of period for export credit. Expansion in refinance

Dynamic provisioning

Contracyclical adjustment of prudential norms

SIDBI and NHB: lendable resources expanded

Loan restructuring

 Measures ensuring orderly functioning of Indian financial markets Cumulative potential primary liquidity impact over Rs. 4,90,000 crore (9 % of GDP) Comfortable liquidity position since mid-November, 2008 LAF window in absorption mode. Call rate within LAF corridor since November 3, 2008 bottom of the corridor. Gradual reduction in deposit and lending rates of banks . Government yields: upward pressure from large market borrowing programme Proactive management by RBI MSS unwinding Enhanced and pre-announced calendar for OMOs

Measures since Mid-September, 2008 (4) Impact of Measures (1)

Measures since Mid-September, 2008 (5) Impact of Measures (2)

Item March 2008 11,182 63,395 7.37 6.55 15946 September 2008 11,690 42,891 10.52 9.26 13943 October 2008 14,497 40,906 9.90 8.66 10550 March 2009 11,909 81,821 4.17 3.76 8995 Turnover (Rupees crore, average daily) 1 2
3 4 5

Call market All money markets @ Call market All money markets @ BSE Sensex

Key Interest Rates (per cent)

6 7
8 9 10 11

Rs. Per US $ 10-year G-sec yield

Certificate of Deposits Commercial Paper Deposit rate (1-3 yrs)# BPLR#

40.36 7.69
10.0 10.4 8.25-9.25 12.25-13.50

45.56 8.45
11.6 12.3 8.75-10.25 13.75-14.75

48.64 7.85
10.0 14.7 8.75-10.25 13.75-14.75

51.23 6.56
7.0 8.9 8.00-9.25 11.50-14.00

@: Call money, CBLO and market repo;

#: Data pertain to PSBs.

Measures since Mid-September, 2008 (6)

Total Resource Flow from Banks and Non-banks

2 3

Item Non-food Bank credit Non-banks Total flow of resources (1+2)

Rupees crore 2007-08 2008-09 4,44,807 4,14,902 3,35,698 7,80,505 2,64,138 6,79,040

Measures since Mid-September, 2008 (7)

Inflation in India
Item March 2008 7.8 9.7 6.8 7.3 June 2008 September December 2008 2008 (per cent) March 2009 0.3 3.5 -6.1 1.4

Wholesale price inflation

All commodities Of which: Primary articles Fuel Manufactured products Agricultural labourers Rural labourers
Urban non-manual employees

12.0 11.0 16.3 10.9

12.1 12.0 16.5 10.5

5.9 11.6 -0.7 6.2

Consumer price inflation

7.9 8.8 11.0 11.4 10.8 (Feb)

7.6 6.0
7.9

8.7 7.3
7.7

11.0 9.5
9.8

11.4 10.8 (Feb) 9.8 9.9 (Feb)

9.7 9.6 (Feb)

Industrial workers

Scheme of Presentation

Global Financial Crisis Impact on India Difference between US/Europe and India RBIs Policy Response and Impact
Lessons from the Crisis

Medium-term Issues and Challenges

Lessons from the Crisis

Avoid high volatility in monetary policy Appropriate response of monetary policy to asset prices Manage capital flow volatility Look for signs of over leveraging Active dynamic financial regulation

Capital buffers, dynamic provisioning Look for regulatory arbitrage incentives/ possibilities

Scheme of Presentation

Global Financial Crisis Impact on India Difference between US/Europe and India RBIs Policy Response and Impact Lessons from the Crisis
Medium-term Issues and Challenges

Medium-term Issues and Challenges (1) Macroeconomic Indicators at a Glance (Per cent)
1 1950-51 to 1964-65 2 1965-66 to 1980-81 3 1980s 4 1990-91 5 1991/92 to 1996-97 6 1997/98 to 2002/03 7 2003/04 To 2007/08 8

1. Real GDP Growth Agriculture Industry Manufacturing Services 2. Real GDCF/GDP 3. ICOR 4. Nominal GDCF/GDP

4.1 2.9 6.7

3.2 2.1 4.2

5.6 4.4 6.4

5.3 4.0 5.7

5.7 3.7 7.0

5.2 0.9 4.1

8.7 4.4 8.4

6.6 4.9 13.5 3.3

11.8 10.3

3.9 4.2 19.2 6.0

16.7 15.9

5.8 6.3 20.2 3.6

20.8 19.0

4.8 5.9 24.4 4.6

26.0 22.8

7.5 6.4 22.5 4.0

23.9 22.7

3.9 7.8 24.1 4.6

24.5 24.1

9.1 10.3 31.4 3.6

33.0 32.7

5. GDS/GDP
6. Saving-Investment Gap

-1.5 -0.7 -1.8 -3.2 -1.2 -0.4 -0.3 Continuing increase in real GDP growth - Interregnum during the 1970s Secular uptrend in domestic saving and investment -investment largely financed by domestic savings Continuation of growth in domestic savings necessary; fiscal prudence

Medium-term Issues and Challenges (2) Fiscal Policy (1)

Combined fiscal deficit in India Even before the recent setback: very high by international standards contribute to the persistence of an interest rate differential with the rest of the world, constrains progress towards full capital account convertibility. self imposed rule based fiscal correction needs to be consolidated and carried forward.

Medium-term Issues and Challenges (3) Fiscal Policy (2) Sustained interest rate differential also connected with the existence of a persistent inflation differential with the rest of the world. A key challenge is to further reduce inflation expectations toward international levels.

Medium-term Issues and Challenges (4) Monetary Policy (1)

A continuous need to adapt monetary management to the emerging needs of a fast growing and increasingly open economy. Financial deepening and increasing monetisation. expansion of monetary aggregates departs from their traditional relationship with real GDP growth. task of monetary management: manage such growth without endangering price or financial stability.

Medium-term Issues and Challenges (5) Monetary Policy (2)

Further development of financial markets Large capital inflows in recent years Reserve Banks ability to manage the impossible trinity Issues for monetary policy current account balance as a good guide to evaluation of the appropriate level of an exchange rate? to what extent should the capital account influence the exchange rate? implications of large current account deficits for the real economy?

Medium-term Issues and Challenges (6) External Sector (1) Optimal response to the large and volatile capital flows is a combination of (CGFS, 2009)

sound macroeconomic policies prudent debt management exchange rate flexibility effective management of the capital account accumulation of appropriate levels of reserves as self-insurance and development of resilient domestic financial markets combination is country-specific; no one size fits all.

Medium-term Issues and Challenges (7)

External Sector (2) Indian policy approach to CAL Distinction between debt and equity flows Higher inflation and interest rates in India vis-a-vis advanced economies Liberalisation of debt flows can lead to arbitrage flows Ceilings on debt flows appropriate

Medium-term Issues and Challenges (8) Financial Sector

Commercial banks robust Committee on Financial Sector Assessment (CFSA) Stability Assessment and Stress Testing Concerns about credit risk remain muted at present
Scenario - increase in NPA by:

Without Stress
CRAR (%) Mar-08 Sept08 13.0 12.5

100 per cent

CRAR (%) 11.6 11.1

150 per cent

CRAR (%) 11.0 10.6

Note: CRAR = credit to risk-weighted assets ratio

Medium-term Issues and Challenges (9)

Conclusion

Indias fundamentals remain strong

Financial sector robust Monetary policy sufficient instruments, flexible Corporate sector not too leveraged second round of restructuring going on productivity gains Foreign direct investment buoyant Agriculture improving Growth domestically financed Indian economy should be able to recover fast and return to 9%+ growth path

Thank You