Global Financial Crisis Causes Consequences and Indias Prospects

Global Financial Crisis: Causes, Consequences and India’s Prospects By RAKESH MOHAN Deputy Governor Reserve Bank of India At London Business School April 23, 2009

Scheme of Presentation w Global Financial Crisis w Impact on India w Difference between US/Europe and India w RBI’s Policy Response and Impact w Lessons from the Crisis w Medium-term Issues and Challenges

Scheme of Presentation Global Financial Crisis w Impact on India w Difference between US/Europe and India w RBI’s Policy Response and Impact w Lessons from the Crisis w Medium-term Issues and Challenges

Global Financial Crisis (1) w Proximate causes n n n Sub-prime lending Originate and distribute model Financial engineering, derivatives Credit rating agencies Lax regulation Large global imbalances w Fundamental cause n Excessively accommodative monetary policy in the US and other advanced economies (2002 -04)

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 0. 5 Russia 0. 9 3. 5 11. 2 Saudi Arabia -11. 7 -2. 4 10. 6 United Arab 8. 3 4. 6 9. 9 Emirates 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 2006 9. 5 -1. 1 9. 5 27. 9 2007 11. 0 -1. 0 5. 9 25. 1 2008 10. 0 -2. 8 6. 1 28. 9 18. 0 -5. 9 22. 6 -6. 0 16. 1 -5. 3 15. 8 -4. 7 0. 4 19. 7 0. 3 21. 0 0. 2 18. 2 -0. 7 18. 8

Global Financial Crisis (4) • 9 • 8 • 7 • 6 • 5 • 4 • 3 • 2 • 1 • 0 -0 8 an • J -0 6 an • J -0 4 an • J -0 2 an • J -0 0 an • J -9 8 an • J -9 6 an • J 4 an -9 • J an -9 2 • Effective Federal Fund Rate in the US • J an -9 0 • Per cent US Monetary Policy (1) • 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?

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) w 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 • Direct investment, net • Other private capital flows, net • -600 • 2008 • 2006 • 2004 • 2002 • 2000 • 1998 • 1996 • 1994 • 1992 • 1990 • 1988 • 1986 • -200 • 1984 • 0 • 1982 • 200 • 1980 • US $ billion • 400 • 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

Global Financial Crisis (7) Worsening Global Economic Outlook Growth Forecast of IMF (per cent) Region Advanced countries EMEs World April 2008 July 2008 October 2008 April 2009 2008 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. 0 Global Trade Volume (Goods and Services) 3. 7 3. 8 4. 1 3. 9 3. 0 2009 0. 9 (-)3. 8 6. 1 1. 6 3. 2 (-)1. 3 3. 3 -11. 0

Scheme of Presentation w Global Financial Crisis Impact on India w Difference between US/Europe and India w RBI’s Policy Response and Impact w Lessons from the Crisis w Medium-term Issues and Challenges

Impact on India (1) Trends in Capital Flows Component Period 2007 -08 2008 -09 Foreign Direct Investment to India April-February 27. 6 31. 7 FIIs (net) April-March 20. 3 -15. 0 External Commercial Borrowings (net) April- December 17. 5 6. 0 Short-term Trade Credits (net) April- December 10. 7 0. 5 Total capital flows (net) April- December 82. 0 15. 3 Current Account Balance April- December -15. 5 -36. 5 Valuation Gains (+)/Losses (-) on Foreign Exchange Reserves April- December 9. 0 -33. 4 April-December 76. 1 -53. 8 110. 5 -57. 7 Memo: Foreign Exchange Reserves (variation) April-March

Impact on India (2) Key Macro Indicators Indicator Period 2007 -08 2008 -09 Growth, per cent Real GDP Growth April-December Industrial production April-February 9. 0 6. 9 8. 8 2. 8 Services April-December 10. 5 9. 7 Exports April-March 28. 4 6. 4 Imports April-March 40. 2 17. 9 GFD/GDP April-March 2. 7 6. 0 Stock Market (BSE Sensex) April-March 16, 569 12, 366 Rs. per US$ April-March 40. 24 45. 92

Scheme of Presentation w Global Financial Crisis w Impact on India Difference between US/Europe and India w RBI’s Policy Response and Impact w Lessons from the Crisis w Medium-term Issues and Challenges

Differences Between Financial Crisis in US/Europe and India (1) w What has not happened here No subprime n No toxic derivatives n No bank losses threatening capital n No bank credit crunch n No mistrust between banks n

Differences Between Financial Crisis in US/Europe and India (2) w Our Problems n Reduction in capital flows Pressure on Bo. P l Stock markets l Monetary and liquidity impact l 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) w Our Problems n Fiscal stress Oil, Fertiliser, Food subsidies l Pay Commission, Debt waiver, NRE l Stimulus packages l GFD/GDP ratio: 5. 5 -6. 0% Large increase in market borrowings l Rs. crore 2008 -09 BE 2008 -09 RE 2009 -10 BE Gross 1, 76, 453 3, 42, 769 3, 98, 552 Net 1, 13, 000 3, 29, 649 3, 08, 647

Differences Between Financial Crisis in US/Europe and India (4) w India’s Approach to Managing Financial Stability (1) n n Current account: Full, but gradual opening up Capital account and financial sector: More calibrated approach towards opening up. Equity flows encouraged; l debt flows subject to ceilings and some end-use restrictions. l Capital outflows: progressively liberalized. l

Differences Between Financial Crisis in US/Europe and India (5) w India’s Approach to Managing Financial Stability (2) n Financial sector, especially banks, subject to prudential regulation l both liquidity and capital. l prudential limits on banks’ inter-bank liabilities in relation to their net worth; l asset-liability management guidelines take cognizance of both on and off balance sheet items l Basel II framework: guidelines issued. l Dynamic provisioning l NBFCs: regulation and supervision tightened - to reduce regulatory arbitrage.

Scheme of Presentation w Global Financial Crisis w Impact on India w Difference between US/Europe and India RBI’s Policy Response and Impact w Lessons from the Crisis w Medium-term Issues and Challenges

Measures since Mid-September, 2008 (1) w Expanding rupee liquidity n n n 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 w Cut in repo (425 bps) and reverse repo (275 bps) rates. w Existing instruments – enough flexibility n MSS and CRR – good, effective buffers of liquidity – both absorption and injection

Measures since Mid-September, 2008 (2) w Managing Forex liquidity n NRE and FCNR(B) deposits: interest rate ceilings raised n ECB norms relaxed n Allowing corporates to buy back FCCBs n Rupee-dollar swap facility for banks with overseas branches

Measures since Mid-September, 2008 (3) w Encouraging Flow of credit n Exporters: extension of period for export credit. l Expansion in refinance l n Dynamic provisioning l Contracyclical adjustment of prudential norms n SIDBI and NHB: lendable resources expanded n Loan restructuring

Measures since Mid-September, 2008 (4) Impact of Measures (1) w Measures ensuring orderly functioning of Indian financial markets w Cumulative potential primary liquidity impact – over Rs. 4, 90, 000 crore (9 % of GDP) w Comfortable liquidity position since mid-November, 2008 n LAF window in absorption mode. n Call rate within LAF corridor since November 3, 2008 – bottom of the corridor. n Gradual reduction in deposit and lending rates of banks. w Government yields: n upward pressure from large market borrowing programme n Proactive management by RBI l MSS unwinding l Enhanced and pre-announced calendar for OMOs

Measures since Mid-September, 2008 (5) Impact of Measures (2) Item March 2008 September 2008 October 2008 March 2009 Turnover (Rupees crore, average daily) 1 Call market 11, 182 11, 690 14, 497 11, 909 2 All money markets @ 63, 395 42, 891 40, 906 81, 821 Key Interest Rates (per cent) 3 Call market 7. 37 10. 52 9. 90 4. 17 4 All money markets @ 6. 55 9. 26 8. 66 3. 76 5 BSE Sensex 15946 13943 10550 8995 6 Rs. Per US $ 40. 36 45. 56 48. 64 51. 23 7 10 -year G-sec yield 7. 69 8. 45 7. 85 6. 56 8 Certificate of Deposits 10. 0 11. 6 10. 0 7. 0 9 Commercial Paper 10. 4 12. 3 14. 7 8. 9 10 Deposit rate (1 -3 yrs)# 8. 25 -9. 25 8. 75 -10. 25 8. 00 -9. 25 11 BPLR# 12. 25 -13. 50 13. 75 -14. 75 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 1 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 (per cent) June 2008 September December March 2008 2009 March 2008 Wholesale price inflation All commodities Of which: Primary articles Fuel Manufactured products 7. 8 12. 0 12. 1 5. 9 0. 3 9. 7 6. 8 7. 3 11. 0 16. 3 10. 9 12. 0 16. 5 10. 5 11. 6 -0. 7 6. 2 3. 5 -6. 1 1. 4 Consumer price inflation Agricultural labourers Rural labourers Urban non-manual employees Industrial workers 7. 9 8. 8 11. 0 11. 4 10. 8 (Feb) 7. 6 6. 0 8. 7 7. 3 11. 0 9. 5 11. 4 10. 8 (Feb) 9. 8 9. 9 (Feb) 7. 9 7. 7 9. 8 9. 7 9. 6 (Feb)

Scheme of Presentation w Global Financial Crisis w Impact on India w Difference between US/Europe and India w RBI’s Policy Response and Impact Lessons from the Crisis w Medium-term Issues and Challenges

Lessons from the Crisis w Avoid high volatility in monetary policy w Appropriate response of monetary policy to asset prices w Manage capital flow volatility w Look for signs of over leveraging w Active dynamic financial regulation n n Capital buffers, dynamic provisioning Look for regulatory arbitrage incentives/ possibilities

Scheme of Presentation w Global Financial Crisis w Impact on India w Difference between US/Europe and India w RBI’s Policy Response and Impact w Lessons from the Crisis Medium-term Issues and Challenges

Medium-term Issues and Challenges (1) Macroeconomic Indicators at a Glance (Per cent) 1950 -51 to 1965 -66 to 1964 -65 1980 -81 2 3 1 1. Real GDP Growth Agriculture Industry Manufacturing Services 2. Real GDCF/GDP 3. ICOR 4. Nominal GDCF/GDP 5. GDS/GDP 1980 s 4 1990 -91 5 1991/92 to 1996 -97 6 1997/98 to 2002/03 7 2003/04 To 2007/08 8 4. 1 3. 2 5. 6 5. 3 5. 7 5. 2 8. 7 2. 9 6. 7 2. 1 4. 2 4. 4 6. 4 4. 0 5. 7 3. 7 7. 0 0. 9 4. 1 4. 4 8. 4 6. 6 4. 9 13. 5 3. 3 3. 9 4. 2 19. 2 6. 0 5. 8 6. 3 20. 2 3. 6 4. 8 5. 9 24. 4 4. 6 7. 5 6. 4 22. 5 4. 0 3. 9 7. 8 24. 1 4. 6 9. 1 10. 3 31. 4 3. 6 11. 8 10. 3 16. 7 15. 9 20. 8 19. 0 26. 0 22. 8 23. 9 22. 7 24. 5 24. 1 33. 0 32. 7 -1. 5 -0. 7 -1. 8 -3. 2 -1. 2 -0. 4 -0. 3 w Continuing increase in real GDP growth - Interregnum during the 1970 s w Secular uptrend in domestic saving and investment -investment largely financed by domestic savings w Continuation of growth in domestic savings necessary; fiscal prudence 6. Saving-Investment Gap

Medium-term Issues and Challenges (2) Fiscal Policy (1) w Combined fiscal deficit in India n Even before the recent setback: very high by international standards n contribute to the persistence of an interest rate differential with the rest of the world, l constrains progress towards full capital account convertibility. n self imposed rule based fiscal correction needs to be consolidated and carried forward.

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

Medium-term Issues and Challenges (4) Monetary Policy (1) w A continuous need to adapt monetary management to the emerging needs of a fast growing and increasingly open economy. w Financial deepening and increasing monetisation. n expansion of monetary aggregates departs from their traditional relationship with real GDP growth. n task of monetary management: manage such growth without endangering price or financial stability.

Medium-term Issues and Challenges (5) Monetary Policy (2) w Further development of financial markets w Large capital inflows in recent years n Reserve Bank’s ability to manage the impossible trinity w Issues for monetary policy n current account balance as a good guide to evaluation of the appropriate level of an exchange rate? n to what extent should the capital account influence the exchange rate? n implications of large current account deficits for the real economy?

Medium-term Issues and Challenges (6) External Sector (1) w Optimal response to the large and volatile capital flows is a combination of (CGFS, 2009) n n n n 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) w Indian policy approach to CAL n Distinction between debt and equity flows n Higher inflation and interest rates in India vis-a-vis advanced economies n Liberalisation of debt flows can lead to arbitrage flows n Ceilings on debt flows appropriate

Medium-term Issues and Challenges (8) Financial Sector n Commercial banks robust l 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 100 per cent 150 per cent CRAR (%) Mar-08 13. 0 11. 6 11. 0 Sept– 12. 5 11. 1 10. 6 • Note: CRAR = credit to risk-weighted assets ratio

Medium-term Issues and Challenges (9) Conclusion w India’s fundamentals remain strong n n n 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