Global Financial Crisis:

Causes, Consequences and India’s Prospects

RAKESH MOHAN
Distinguished Consulting Professor
Stanford University
Former Deputy Governor, Reserve Bank of India
at
Central Bank of Argentina
August 31 – September 1, 2009
0
Scheme of Presentation

Global Financial Crisis

Impact on India/Asia

Difference between US/Europe and India/Asia

RBI’s Policy Response and Impact

Lessons from the Crisis and Emerging Challenges

1
Global Financial Crisis (1)

Proximate causes
• Sub-prime lending
• Originate and distribute model
• Financial engineering, derivatives
• Credit rating agencies
• Lax regulation
• Large global imbalances

Fundamental cause
• Excessively accommodative monetary policy in
the US and other advanced economies (2002-04)
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Global Financial Crisis (2)
Current Account Balance (per cent to GDP)
Country 1990-94 1995-99 2000-04 2005 2006 2007 2008
China 1.4 1.9 2.4 7.2 9.5 11.0 10.0
India -1.3 -1.3 0.5 -1.3 -1.1 -1.0 -2.8
Russia 0.9 3.5 11.2 11.0 9.5 5.9 6.1
Saudi Arabia -11.7 -2.4 10.6 28.7 27.9 25.1 28.9
United Arab
8.3 4.6 9.9 18.0 22.6 16.1 15.8
Emirates
United States -1.0 -2.1 -4.5 -5.9 -6.0 -5.3 -4.7

Memo:
Euro area n.a. 0.9 0.4 0.4 0.3 0.2 -0.7
Middle East -5.1 1.0 8.4 19.7 21.0 18.2 18.8
Source: World Economic Outlook Database, April 2009, International Monetary Fund.
Note: (-) indicates deficit.
3
Global Financial Crisis (3)
US Monetary Policy (1)
Effective Federal Fund Rate in the US

Volatility in monetary policy in advanced economies

Again very loose MP in US – likely surge in capital flows to EMEs?
4
Global Financial Crisis (4)
US Monetary Policy (2)

Aggregate demand exceeded output; large current a/c

deficit; mirrored in large surpluses in China and elsewhere
5
Global Financial Crisis (5)
US Monetary Policy (3)

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

and asset prices
6
Global Financial Crisis (6)
Capital Flows to EMEs

Very large capital flows to EMEs - now outflows in 2009 - large

volatility - implications for monetary management and financial stability
7
Global Financial Crisis (7)
Worsening Global Economic Outlook

Growth Forecast of IMF (per cent)

Apr-08 Jul-08 Oct-08 Jul-09

Region 2008 2009 2008 2009 2008 2009 2008 2009
Advanced
1.3 1.3 1.7 1.4 1.5 0.5 0.8 -3.8
Countries

EMEs 6.7 6.6 6.9 6.7 6.9 6.1 6.0 1.5

World 3.7 3.8 4.1 3.9 3.9 3.0 3.1 -1.4

Global Trade Volume (Goods and Services)

World 3.7 3.8 4.1 3.9 3.9 3.0 2.9 -12.2

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Scheme of Presentation

Global Financial Crisis

Impact on India/Asia

Difference between US/Europe and India/Asia

RBI’s Policy Response and Impact

Lessons from the Crisis and Emerging Challenges

9
Impact on India/Asia (1)
Trends in Capital Flows - India
US $ Billion
Component 2007-08 2008-09
Foreign Direct Investment to India 34.2 35.0

Portfolio Investment (net) 29.6 -14.0

External Commercial Borrowings (net) 22.6 8.2

Short-term Trade Credits (net) 17.2 -5.8

Total capital flows (net) 108.0 9.1

Memo:
Current Account Balance -17.0 -29.8

Valuation Gains (+)/Losses (-) on

18.4 -37.7
Foreign Exchange Reserves

Foreign Exchange Reserves (variation) 110.5 -57.7

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Impact on India/Asia (2)
Key Macro Indicators - India
Growth, per cent
Indicator 2007-08 2008-09
Real GDP Growth 9.0 6.7

Industry 7.4 2.6

Services 10.8 9.4

Government 6.8 13.1

Exports (US $B) 28.9 5.4

Imports (US $B) 35.2 14.3

Gross Fiscal Deficit /GDP 2.7 6.0

Stock Market Average (BSE Sensex) 16,569 12,366

Rs.per US$ 40.24 45.92

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Impact on India/Asia (3)

Per cent Real GDP Growth

Country 2007 2008 2009 (IMF Proj.)

China 13.0 9.0 7.5
India 9.3 7.3 5.4
Indonesia 6.3 6.1 3.5
Korea 5.1 2.2 -1.8
Malaysia 6.3 4.6 -4.5
Philippines 7.2 4.6 0.0
Taiwan 5.7 0.1 -7.5
Thailand 4.9 2.6 -3.0
Source: IMF

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Impact on India/Asia (4)
Openness and Real GDP Slowdown in Asian
EMEs

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 Impact on India/Asia (5)
Per cent Select Bank Ratios (end-2008)
Loans to Loans to Foreign Liabilities to
Country Domestic Deposits Total Liabilities Domestic Deposits
China 0.69 0.68 0.01
Hong Kong 0.50 0.28 0.78
India 0.82 0.79 0.07
Indonesia 0.80 0.75 0.07
Korea 1.36 1.05 0.30
Malaysia 0.96 0.86 0.11
Philippines 0.78 0.69 0.14
Singapore 0.85 0.51 0.66
Taiwan 0.77 0.71 0.08
Thailand 0.98 0.94 0.04
Vietnam 0.98 0.91 0.07
Sources: Asian Development Outlook 2009, Asian Development Bank; Reserve Bank of India 14
 Impact on India/Asia (6)
Banking Sector Indicators in EMEs
Capital to Non-Performing Loans to
Per cent
Risk-weighted Assets Ratio Total Loans
Country 1998 2000 2005 2008 1998 2000 2005 2008

China 12.8 a 13.5 2.5 8.2 n.a. 29.8 b 9.8 2.5

India 11.6 11.1 12.8 13.0 14.4 12.7 5.2 2.3

Indonesia -13.0 21.6 19.3 16.8 48.6 18.8 7.6 3.5

Korea 8.2 10.5 13 10.9 7.4 6.6 1.2 1.1

Malaysia 11.8 12.5 13.7 12.6 18.6 15.4 9.6 5.1

Philippines 17.7 16.2 17.6 15.5 19.5 19.5 `10.3 5.2

Thailand 10.9 11.9 13.2 15.3 42.9 17.7 9.1 6.5

Source: Global Financial Stability Report, IMF (various issues).
Note: a: Data pertain to 1999;. b: Data pertain to 2001; n.a.: not available.
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Scheme of Presentation

Global Financial Crisis

Impact on India/Asia

Difference between US/Europe and India/Asia

RBI’s Policy Response and Impact

Lessons from the Crisis and Emerging Challenges

16
Differences Between Financial Crisis
in US/Europe and India/Asia (1)

What has not happened in India/Asia:

• No subprime

• No toxic derivatives

• No bank losses threatening capital

• No bank credit crunch

• No mistrust between banks

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

Our Problems (India)
• 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
18
Differences Between Financial Crisis
in US/Europe and India/Asia (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. Billion
• 2008-09 2008-09 2009-10
Gross BE
1,765 Actual
3,186 BE
4,910
Net 1,130 2,985 3,979 19
Differences Between Financial
Crisis in US/Europe and India/Asia (4)

India’s 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

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

India’s Approach to Managing Financial Stability (2)
• Financial sector, esp. 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
• 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
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Scheme of Presentation

Global Financial Crisis

Impact on India/Asia

Difference between US/Europe and India/Asia

RBI’s Policy Response and Impact

Lessons from the Crisis and Emerging Challenges

22
RBI’s Policy Response and Impact (1)
Measures since Mid-September, 2008 (1)
Actual/Potential Release of Primary Liquidity
Rs. Additionally:
Measure/Facility
Billion
Monetary Policy Ratio
1. Cash Reserve Operations (1 to 3) of
(CRR) Reduction
Cut in repo (425 bps)
400bps 1,600 and reverse repo (275
2. Open Market Operations 801 bps) rates
3. MSS Unwinding/De-sequestering 1,556
Existing instruments –
Extension of Liquidity Facilities (4 to 8) enough flexibility
4. Term Repo Facility 600 • MSS and CRR –
5.
6. Increase in Export Facility
Special Refinance Credit Refinance
for SCBs (Non- 266 good, effective
RRB)
7. Refinance Facility for SIDBI/ NHB/EXIM 385 buffers of
Bank 160 liquidity – both
8. Liquidty Facility for NBFCs through SPV 250 absorption and
Total (1 to 8) 5,617
injection
Memo:
Statutory Liquidty Ratio (SLR) Reduction of
100bps 400 23
RBI’s Policy Response and Impact (2)
Measures since Mid-September, 2008 (2)

Managing Forex liquidity

• Interest rate ceilings raised on non-resident Indian deposits

• Norms relaxed on external commercial borrowings

• Allowing corporates to buy back foreign currency

convertible bonds

• Rupee-dollar swap facility for banks with overseas

branches

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RBI’s Policy Response and Impact (3)
Measures since Mid-September, 2008 (3)

Huge supply of liquidity

No liquidity constraints

Flexible liquidity modulation

Host of instruments

No dilution of collateral

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RBI’s Policy Response and Impact (4)
Impact of Measures

Orderly functioning of Indian financial markets ensured

Cumulative potential primary liquidity impact: 10.6 % 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 26
RBI’s Policy Response and Impact (5)
Inflation in India
(per cent)
Wholesale Price Inflation Mar 08 Jun 08 Sep 08 Dec 08 Jul 09
All commodities 7.8 12 12.1 5.9 -1.2
Of which:
Primary articles 9.7 11 12 11.6 4.96
Fuel 6.8 16.3 16.5 -0.7 -10.1
Manufactured products 7.3 10.9 10.5 6.2 -0.1

Consumer Price Inflation Mar 08 Jun 08 Sep 08 Dec 08 Jun 09

Agricultural labourers 7.9 8.8 11 11.4 11.5
Rural labourers 7.6 8.7 11 11.4 11.3
Urban non-manual
6 7.3 9.5 9.8 9.7
employees
Industrial workers 7.9 7.7 9.8 9.7 8.6
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Scheme of Presentation

Global Financial Crisis

Impact on India/Asia

Difference between US/Europe and India/Asia

RBI’s Policy Response and Impact

Lessons from the Crisis and Emerging Challenges

28
Lessons and Emerging Challenges (1)

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

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Lessons and Emerging Challenges (2)
Monetary Policy and Asset Prices

Need to revisit conventional wisdom on relationship between
monetary policy and asset prices

Important to take monetary and regulatory actions in tandem
• Functions should rest with central banks

“Central banks should adopt a broader macro-prudential
view, taking into account in their decisions asset price
movements, credit booms, leverage, and the build up of
systemic risk. The timing and nature of pre-emptive
policy responses to large imbalances and large capital
flows needs to be re-examined” (IMF, 2009b)
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Lessons and Emerging Challenges (3)
Management of Capital Flows by EMEs

Volatile capital flows due in part by push factors from
monetary policy of advanced economies
• Necessitates management of capital accounts by EMEs

Optimal response is a combination of (CGFS, 2009)
• Sound macroeconomic policies
• Prudent debt management
• Exchange rate flexibility
• Effective management of the capital account
• Appropriate levels of reserves as self-insurance
• Development of resilient domestic financial markets
• Combination is country-specific; no “one size fits all”
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Lessons and Emerging Challenges (4)
Financial Regulation

Liquidity issues are equally important as capital adequacy

Need to fix regulatory loopholes to avoid regulatory

arbitrage

Need strong regulation but also flexibility for financial sector

to expand and meet financing needs of growing economies

Regulatory authorities approach would have to be dynamic

and adjust in response to changing economic environment
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Lessons and Emerging Challenges (5)
Monetary Policy in EMEs (1)

Continuous need to adapt monetary management to the needs
of fast growing and increasingly open economies

Financial deepening and increasing monetization
• 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

Further development of financial markets

Large capital inflows in recent years
• Need to manage the impossible trinity
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Lessons and Emerging Challenges (6)
Monetary Policy in EMEs (2)

Sustained interest rate differential 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

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?
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Lessons and Emerging Challenges (7)
India (1)

Combined fiscal deficit in India
• Very high by international standards
• Contributes to the persistence of an interest rate
differential with the rest of the world
• Constrains progress to full capital account convertibility
• Self-imposed rule-based fiscal correction needs to be
consolidated and carried forward

Indian policy approach to current account liberalization
• Distinction between debt and equity flows
• Liberalization of debt flows can lead to arbitrage flows
• Ceilings on debt flows appropriate
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Lessons and Emerging Challenges (9)
India (2)

India’s 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
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Thank You

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