Journal of International Business and Law

Volume 9 | Issue 1 Article 2

2010

The Global Financial Crisis and its Impact on India

K. G. Viswanathan

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Viswanathan, K. G. (2010) "The Global Financial Crisis and its Impact on India," Journal of International Business and Law: Vol. 9: Iss.
1, Article 2.
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 Viswanathan: The Global Financial Crisis and its Impact on India

THE GLOBAL FINANCIAL CRISIS AND ITS IMPACT ON

INDIA

K G. Viswanathan*

I. INTRODUCTION

The world has witnessed several financial crises in the past few
decades, such as the OPEC oil crises of the 1970s, the United States Savings
and Loan crisis of the 1980s, the prolonged economic downturn in the Japanese
economy in the 1990s, the Asian financial crisis in the latter part of the 1990s,
and the problems following the crash of the dot com bubble in the early part of
the last decade. Each of these events had been accompanied by shocks to the
economies of one or more markets or regions and it took several years of
concerted economic and regulatory policy adjustments for the affected markets
to return to stability. While it is normal for financial crises to occur frequently
and the affected economies to recover subsequently, it nevertheless results in
economic losses for the countries involved and for the people, businesses and
institutions in those countries.
The Global Financial Crisis, which started in 2008, is the latest in the
series of economic crises to adversely impact world economies. Unlike the past
few crises, the current crisis has not spared any of the countries or market
sectors, and has devastated economies that were traditionally strong. While the
world is slowly seeing an end to the crisis, it is widely acknowledged that
among the financial crisis of the past hundred years, only the Great Depression
of the 1930s had a more severe and protracted effect on the world economy
compared to the current economic upheaval. What started as an excessively
loose monetary policy in the 1990s in major developed economies transformed
into global imbalances and a full-blown financial and economic crisis for all the
economies of the world. 1 The problems that were first noticed in the US sub-
prime mortgage market quickly spilled over into the real estate and banking

* K. G. Viswanathan, Ph.D., CFA, is an Associate Professor of Finance at Frank G. Zarb School of

Business at Hofstra University.
1 Mohan, Rakesh (2009), "Global Financial Crisis: Causes, Impact, Policy Responses and Lessons",
Working Paper 407, Stanford University, Stanford, CA, USA. Taylor, John (2008), "The Financial
Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong," Working Paper
14631, National Bureau ofEconomic Research, Washington D.C., USA.

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sectors. From the financial sector, it moved on to the real sector in the US
market and then into the international markets. The contagion effect impacted
both the advanced economies and the emerging market economies (EME).

II. CAUSES AND MAGNITUDE OF THE CRISIS

Beginning in the 1990s, countries had been following relatively loose

monetary policies which continued in the period following the dot corn bubble.
During this period, the United States faced a growing current account deficit
which was financed by capital flows from exporting countries. This global
imbalance contributed to the low interest rates in the United States and the
resulting real estate asset bubble. In addition, lenders relaxed their standards for
mortgage loans and financial innovations allowed them to mask the risk of their
portfolios. Beginning in 2004, the United States Federal Reserve Bank started
tightening the credit markets by raising interest rates in response to rising
inflation, which caused the crisis in the sub-prime mortgage market. This
quickly spread to the entire banking sector in the United States and other
advanced economies, resulting in the liquidation of several major banks. The
banking sector in the advanced economies is estimated to have lost up to $2.8
trillion between 2007 and 2010. The contagion in the banking sector caused a
near shutdown of the credit markets and the United States economy went into a
severe recession which was reflected in the securities markets. The crisis was
not limited to the United States market - it quickly spread to all other markets,
including emerging markets, through both financial channels (i.e., flow of
funds) and real channels (i.e., foreign trade).
Table 1 shows the economic indicators for selected markets during
2005-2010. The deterioration in the economic conditions is evident in all the
indicators and in all markets. The world economy, represented by the change in
Gross Domestic Product (GDP), was growing at a healthy rate of about 5%
from 2005 to 2007. In 2008, the year when the financial crisis started, the GDP
grew at a rate of only 3%. In 2009, when the crisis was at its peak, the world
economy contracted by 0.8%. For 2010, the growth rate is projected to be
3.10%, well below the average growth rate that existed prior to the crisis.
Similar trends are evident in all the markets shown in the table. The advanced
economies, including United States, United Kingdom and Germany, were
growing steadily prior to the crisis, but deteriorated significantly in 2008 and
2009. These economies are projected to grow in 2010, but at a very small rate.
The emerging economies as a group and developing Asian countries were
growing at impressive rates in the years leading up to the financial crisis, but the
growth rates were curtailed in the subsequent periods. Although they are
projected to grow faster than the advanced economies in the next few years, it
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 Viswanathan: The Global Financial Crisis and its Impact on India

THE GLOBAL FINANCIAL CRISIS AND ITS IMPACT ON INDIA

will be some time before they can match the growth rates they had prior to the
crisis.
Table 1. Economic Indicators for Selected Markets: 2005-2010

2005 2006 2007 2008 2009' 2010e

GDP (annual % change)
World 4.48 5.09 5.17 3.00 -0.80 3.10
Advanced economies 2.63 2.99 2.72 0.56 -3.20 1.32
Emerging and developing 7.09 7.94 8.31 5.99 2.10 5.08
economies
Developing Asia 9.03 9.83 10.59 7.50 6.50 7.35
Germany 0.73 3.18 2.52 1.25 -4.80 0.34
United Kingdom 2.17 2.85 2.56 0.74 -4.80 0.91
United States 3.05 2.67 2.14 0.44 -2.50 1.52

Current Account Balance (% of GDP)

Advanced economies -1.18 -1.26 -0.92 -1.26 -0.66 -0.40
Emerging and developing 4.18 5.20 4.30 3.88 2.02 2.84
economies
Developing Asia 4.16 6.09 7.03 5.90 4.99 5.24
Germany 5.15 6.13 7.52 6.41 2.91 3.61
United Kingdom -2.62 -3.31 -2.70 -1.73 -2.04 -1.95
United States -5.92 -6.00 -5.16 -4.89 -2.59 -2.21

Unemployment (% of total labor force)

Advanced economies 6.20 5.79 5.40 5.80 8.20 9.29
Germany 10.62 9.83 8.38 7.40 8.02 10.69
United Kingdom 4.79 5.39 5.40 5.55 7.65 9.33
United States 5.08 4.62 4.63 5.81 9.26 10.15

Trade Volume of Goods and Services (annual % change)

World 7.80 9.10 7.33 2.95 -12.30 2.47

Source: International Monetary Fund. World - World Economic Outlook Database,

October 2009, January 2010.
' GDP and Trade Volume are actual values; Current Account Balance and
Unemployment are IMF estimates as of October 2009.
IMF estimates.
The volume of trade in goods and services across the world was
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significantly affected by the crisis. It was growing at a rate of 9.1% in 2006. It

fell to 2.95% in 2008, and shrank by 12.30% in 2009. Contraction in trade
volume across countries can exacerbate global imbalances and cause financial
distress in firms that depend on international trade for selling their output and
for sourcing their resources. This is also reflected in the unemployment
numbers reported for the different markets. The unemployment rate for the
advanced economies was projected to rise to 8.20% in 2009, and 9.29% in 2010.
Such high unemployment rates for protracted periods in the US and the UK are
unprecedented in the post-world war period. The unemployment rates among
EMEs (not shown in Table 1) also deteriorated, but to a lesser extent. For
example, the unemployment rate for India increased from 10.4% to 10.7%
between 2008 and 2009. In China and Russia, the corresponding increases were
from 4.2% to 4.3% and 6.5% to 8.9%, respectively. 2 The current account
balance expressed as a percentage of the GDP shows that while EMEs,
developing Asian countries and some advanced economies, such as Germany,
continue to be positive, it remains negative for United States, United Kingdom
and other advanced economies.

III. IMPACT OF THE CRISIS ON EMERGING MARKETS

Several emerging market economies were severely impacted by the

financial crisis that originated in the advanced economies. Nanto claims that the
impact of the crisis on EMEs was more severe than that of the Asian financial
crisis of 1997-98 and the Latin American crisis of 2001-02.3 EMEs had been
growing at very high rates prior to the crisis. They were able to finance their
growth by borrowing in global capital markets, and by exporting a growing part
of their output to the advanced economies. This made them very vulnerable to
the availability of credit and the demand for their output. When the crisis
started and a severe credit crunch ensued in the advanced economies, it became
difficult for the EMEs to continue to finance their foreign debt. Eventually, the
liquidity crisis transferred from the advanced economies to the domestic sector
of the EMEs and many of them had problems borrowing in the domestic capital
markets. In addition to causing a liquidity crisis in the EMEs, the financial
crisis had adverse effects in the real sectors in all of them. As the advanced
economies contracted, the EMEs experienced a decline in the growth of their
exports. Export revenues are a significant component of the GDP of EMEs and

2 The computation procedures of unemployment rates differ across countries and levels cannot be
meaningfully compared to one another.
3 Nanto, Dick (2009), "The Global Financial Crisis: Analysis and Policy Implications",
CongressionalResearch Service 7-5700.
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 Viswanathan: The Global Financial Crisis and its Impact on India

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a slowing down of the exports led to socio-economic problems in the affected

countries.
Previously, it was assumed that EMEs had sufficiently decoupled from
the rest of the world and that they could withstand downturns in the advanced
economies. But the events of the last two years have shown that EMEs and
developing countries are still linked to the advanced economies of the world,
albeit to a lesser extent compared to the economic interdependence among the
more advanced economies. Dooley and Hutchinson find that while the
emerging markets were decoupled from the US at the beginning of the crisis and
were sufficiently insulated, the economic and financial linkages reappeared
subsequently and adversely affected them in both the real and financial sectors.
Following the Asian financial crisis of 1997-98, many EMEs had accumulated
foreign reserves to withstand any pressure on their currencies.6 In the second
half of 2008, many of them drew down their reserves to protect their currencies
and to dampen the contagion effects of the crisis.7 But, this did not prevent the
financial crisis from spreading from the advanced economies to the EMEs.

IV. GLOBAL RESPONSE TO THE CRISIS

In response to the shocks caused by the crisis, world economies have

been adopting reforms to their economic policies and have implemented several
fiscal and monetary stimulus initiatives to recover from the crisis. Some of
these initiatives include tax rebates and tax cuts at both the corporate level to
spur investment, and at the personal level to increase consumption and to bail
out households with diminished wealth and income. Other initiatives provide
incentives to invest in infrastructure and public works projects. Though
difficult to measure accurately, Saha and Weizsacker estimate the size of the
stimulus package for the European Union for 2009 at 0.9% of the GDP, while
the corresponding figures for the United States and China are 2% and 7.1%,
respectively.8 Nanto estimates the size of the stimulus package in Japan at

4 Ghosh, Jayati (2009), "Global Crisis and the Indian Economy", in 'Global Financial Crisis:

Impact on India's Poor, United Nations Development Programme (India).

' Dooley, Michael and Michael Hutchinson (2009), "Transmission of the U.S. Subprime Crisis to
Emerging Markets: Evidence on the Decoupling-Recoupling Hypothesis", Journal of International
Money and Finance, Volume 28, pp. 1331-1349.
6 For example, the foreign reserves holding of India in June of 2008 was over $312 billion. The

corresponding amount for China in September of 2008 was $585 billion.

7 The Wall Street Journal reported that Brazil, Russia, India and Mexico used $75 billion of their

foreign reserves in October of 2008 to support their currencies. Wall Street Journal (2008),
"Currency-Price Swings Disrupt Global Markets", October 25, 2008.
8 Saha, David and Jakob von Weizsacker (2009), "Estimating the Size of the European Stimulus
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about 5% of its GDP in 2009.9 In addition to the fiscal stimulus initiatives,

many countries adopted a more accommodative monetary policy to ease the
liquidity tightening in the credit markets.10
While most of the economic indicators portended a bleak outlook for
the world economy and for individual markets, the severity of the crisis in the
affected countries and their responses to tackle the problems were not uniform.
While the advanced economies either contracted or had no growth during the
crisis, the emerging market economies continued to grow, although at a lower
rate. The impacts of the crisis on the financial and real sectors of the economy
were also not uniform across the countries. While some economies that were
structurally strong were able to better withstand the crisis, others had to be
bailed out with extensive and multiple stimulus packages to overcome the
adverse effects on the domestic economies. The consensus opinion is that
countries that curtailed the use of risky assets and encouraged domestic
investment and savings were less affected by the crisis. The countries that did
not adequately penalize risky behavior and those that had high rates of
consumption were more severely affected.
One of the EMEs that performed relatively well during the financial
crisis and recovered quickly from its effects was India. The strength of the
economy, the structure of regulation in the financial markets, and the timely and
appropriate responses to the financial crisis by the monetary authorities in India
allowed the country to contain the adverse effects of the crisis and continue on
the expansionary path it was on prior to the crisis. In the following sections, the
impact of the financial crisis on the Indian economy and some of the strategies
adopted by it to manage the crisis are detailed.

V. IMPACT OF THE CRISIS ON INDIA

A. Indian Economy prior to the Crisis

In 1991, India started implementing a policy of economic

liberalization, which has been opening up the Indian market to the outside world
in different areas. Over the last nineteen years, the country has witnessed

Packages for 2009: An Update", Bruegel Policy Contribution,Issue 2009/02, April.

9 Nanto, Dick (2009), "The Global Financial Crisis: Analysis and Policy Implications",
CongressionalResearch Service 7-5700.
10 For example, OECD estimates that the net effect of the fiscal and monetary policy initiatives in

the US amounts to about 5.6% of the 2008 US GDP, and the corresponding number for OECD
countries is 3 .3%.
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dramatic changes in economic policy and market regulation which has made it
one of the fastest growing economies among emerging markets. The bilateral
trade with the rest of the world has grown significantly during this period and is
now a significant component of the GDP. A major part of the export revenues
is in the Information Technology and Textiles sectors. The liberalization policy
has attracted growing foreign direct investments (FDI) in the various industry
sectors and portfolio investments in the Indian capital markets." Regulatory
reforms introduced in the capital markets have increased transparency which
helped attract portfolio investments from foreign investors. Meanwhile, in the
domestic market, the market reforms allowed the private sector to successfully
challenge the dominance of the state-owned and state-sponsored business
organizations. In a recent study using various operating and financial
performance measures, Viswanathan finds that the private sector firms in India,
which include family-owned and non-family-owned firms, have outperformed
state-owned firms since the implementation of the economic liberalization
policies. 12 Banking reforms have ensured continued access to credit and capital
for household consumption and for businesses.
The macroeconomic and financial indicators predominantly pointed to
a strong and vibrant Indian economy prior to the financial crisis. Table 2
presents selected macroeconomic and financial indicators for India for 2004 to
2009.13 The GDP was growing at the rate of 7.5%, 9.5%, 9.7% and 9%,
respectively, for the four years leading up to the crisis. The original consensus
estimate for 2008-09 was also around 9%. The impressive growth in the Indian
economy is further validated by the growth rates in industrial production which
ranged from 8.2% to 11.5% over the four years. The optimism in the economy
was reflected in the stock markets. The Bombay Stock Exchange (BSE) Index
representing 30 large companies in India increased by 16.1%, 73.7%, 15.9%
and 19.7%, respectively, during the same period. The average inflation
(computed using the Wholesale Price Index) during this period was a
manageable 5.2%. 14

" Foreign portfolio investment in India is primarily conducted by Foreign Institutional Investors
(FII); the foreign individual investor market is practically non-existent.
12 Viswanathan (2009), "Financial and Operating Performance of State-Owned,
Family-Owned and
Publicly-Owned Firms in India", Paper presented at Seventh Annual AIMS Conference, Bangalore,
India, December 2009.
13 The fiscal year for India starts in April and ends in the following March. The first four columns

in Table 2 cover the period leading up to the global financial crisis. The last column shows the
values for the indicators during the crisis.
14 Although high by the standards of industrialized countries, this range of inflation is normal for

emerging markets.
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Table 2. Selected Macroeconomic and Financial Indicators for

India: 2004-2009
Item 2004-05 2005-06 2006-07 2007-08 2008-
09
GDP (Annual % change) 7.5 9.5 9.7 9.0 6.7
Industrial Production 8.4 8.2 11.5 8.5 2.7
(Annual % change)

BSE Index (Annual% change) 16.1 73.7 15.9 19.7 -37.9

Inflation (% change) 6.4 4.4 5.4 4.7 8.3
Export Growth (Annual % change) 28.5 23.4 22.6 28.9 5.4
Export/GDP (%) 12.1 13.0 14.1 14.2 15.1
Foreign Reserves (US $ Billions) 141.5 151.6 199.1 309.7 252.0
Current Account (% of GDP) -0.4 -1.2 -1.1 -1.5 -2.6
External Debt (US $ Billions) 133.0 138.1 171.3 224.6 229.9
Foreign Debt-GDP Ratio 0( ) 18.5 17.2 18.1 19.0 22.0
Source: Compiled from various tables in Reserve Bank of India 2009 Annual Report and
Central Statistical Organization database
Note: The fiscal calendar year for India starts in April and ends in March of the
following year.

A significant component of the growth in the Indian economy was the

export sector. In the four years leading up to the crisis, India's exports grew by
more than 22% each year, averaging 25.8% during that period. The significance
of the external trade to the economy is further evidenced by the increasing
contribution of exports to the GDP each year. The exports, as a percentage of
GDP, increased each year, from 12.1% in 2004-05 to 14.2% in 2007-08. At the
same time, India was building its foreign reserves, which increased from $141.5
billion in 2004-05 to $309.7 billion in 2007-08. However, the current account,
as a percentage of GDP, was negative and growing in size - from -0.4% in
2004-05 to -1.5% in 2007-08. Finally, Table 2 also shows that India was
increasingly financing its growth by borrowing in the external markets.
External debt increased from $133 billion to $224.6 billion, a 69% change over
the four year period. As a percentage of GDP, foreign debt was close to 20%.

B. Indian Economy during the Crisis

Dooley and Hutchinson has identified that prior to May 2008, the
EMEs were insulated from the financial crisis that had been severely affecting

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the industrialized countries for more than sixteen months." The decoupling of
the EMEs from the advanced economies broke down in May 2008 as the crisis
spread to the rest of the global economy. This is apparent in the case of India,
as evidenced by the deterioration of all the macroeconomic and financial
indicators in 2008-09. Industrial production increased by 2.7%, a significant
drop from the 9.2% average growth in the previous four years. This contributed
to the economy growing at only 6.7%. The BSE Index, which had been rising
over a protracted period, lost 37.9% of its value, adversely affecting household
wealth and the ability of businesses raising money in the capital market. At the
same time, rising commodity prices in world markets contributed to a sharp
increase in inflation rates. As the advanced economies started growing at
slower rates and in some cases contracted, India's bilateral trade stagnated in
2008-09, with exports growing at only 5.4% and current account deficit
increasing to 2.6%. The tightening in the credit markets in advanced economies
made it more difficult for Indian businesses to continue borrowing in external
markets. The size of the external debt did not change much from 2007-08 to
2008-09. In fact, the Indian Rupee had depreciated against many of the major
foreign currencies and the debt service cost was rising. To rectify the problem,
India intervened in the foreign exchange market to support its currency using its
foreign reserves, which declined from US$ 309.7 billion in 2007-08 to US$ 252
billion in 2008-09.

C. Transmission of the Crisis to the Indian Economy

The global financial crisis which originated in the advanced

economies, spread to India and other EMEs through financial and real channels.
Given the strength of its economy, India should have been able to withstand the
adverse effects of the financial crisis and avoid any serious and long-term
consequences to its economic growth. However, its increasing dependence on
bilateral trade with other countries and on financing from external markets
makes it vulnerable to economic shocks in the global economy. Although India
was not immune to the contagion effects of the global financial crisis, it was one
of the few countries to recover quickly from the slowdown in the economy and
appears to be back on the growth trajectory it was on prior to the crisis. In its
latest report, IMF estimates that India's GDP will grow by 7.7% in 2010 and by
7.8% in 2011.16 This compares very favorably with IMF's estimates for the

15 Dooley, Michael and Michael Hutchinson (2009), "Transmission of the U.S. Subprime Crisis to
Emerging Markets: Evidence on the Decoupling-Recoupling Hypothesis", Journal of International
Money and Finance, Volume 28, pp. 1331-1349.
16 International Monetary Fund, World Economic Outlook Update, January 26, 2010.

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world output to grow by 3.9% in 2010 and 4.3% in 2011. To understand India's
response to the crisis and the resiliency of the Indian economy, it is helpful to
analyze the channels through which the real and financial shocks are transmitted
from the advanced economies to India.
The contagion effects of the financial crisis spread from the advanced
economies to the Indian market in three distinct channels - the financial
channel, the real or trade channel, and the confidence channel.1 7

1. Financial Channel

The losses in the subprime mortgage markets in the US and the

consequent exposure on the part of the banking sector in the advanced
economies resulted in a liquidity crisis. The heightened risk aversion on the
part of investors resulted in a credit crunch which directly impacted the
financial markets in India in three ways. First, the ability of Indian businesses
to use the external markets to finance their operations was severely curtailed by
the credit crunch in global markets. As shown in Table 2, the size of the
external debt, which had increased by 69% over the previous four years,
remained stagnant in 2008-09. Funds raised through American Depositary
Receipts and Global Depositary Receipts in 2008-09 had dropped by 63% from
the previous year.18 This was exacerbated by the fact that the cost of borrowing
funds in the domestic markets had also spiked. Gupta reports that the call
money rates in October of 2008 was above 20%, and that credit default spreads
for some Indian banks increased suddenly, indicating a greater degree of risk
aversion on the part of the investors. 19 Second, businesses with existing foreign
debt started borrowing in the domestic market to meet debt service payments in
foreign currencies. This caused a sharp depreciation in the value of the Indian
Rupee, which made the debt service burden even larger. To support its
currency, India intervened in the foreign exchange markets, which resulted in a
decline of foreign reserves from US$ 309.7 billion in 2007-08 to US$ 252
billion in 2008-09. The third way in which the financial markets were affected
by the global liquidity crisis was through the reduction in capital flows in the
equity markets. Table 3 shows the flow of external funds in India for 2000 to

17Subbarao, Duvvuri (2009), "Impact of the Global Financial Crisis on India - Collateral Damage
and Response," Speech delivered at the Symposium on 'The Global Economic Crisis and
Challenges for the Asian Economy in a Changing World', Institute for International Monetary
Affairs, 18 February 2009.
18 As reported in the Reserve Bank of India Annual Report, 2009.

19 Gupta, Abhijit (2009), "India's Tryst with the Global Financial Crisis", Review of Market

Integration,Volume 1, Number 2, pp. 171-197.

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2010. During this ten year period, the foreign direct investment into India had
been increasing and remained strong even during the crisis. The size of the FDI
was US$ 4 billion in 2000-01. By 2008-09, it had grown into US$35 billion.
This segment of the capital flows was not affected by the liquidity crisis.
However, the net Foreign Institutional Investment, which had been growing
from US$ 1.847 billion in 2000-01 to US$ 20.328 billion in 2007-08, suddenly
became a deficit in 2008-09. In that year, foreign investors withdrew a net
amount of US$ 15.017 billion from the equity markets in India. This was a
reflection of the heightened risk aversion on the part of the investors, and the
liquidity crunch in the credit markets. The result was a decline in the equity
prices in India - the BSE Index lost 37.94% in 2008-09, after posting gains in
each of the previous six years.
Table 3. Flow of External Funds in India: 2000 - 2010
Fiscal Year
2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007- 2008- 2009-
01 02 03 04 05 06 07 08 09 10*

Foreign 4029 6130 5035 4322 6051 8961 22826 34835 35180 26506
Direct
Investment
(US$
millions)
Growth in +87 +52 -18 -14 +40 +48 +146 +53 +1 OP
FDJ (%
change
from year
to year)

Net Foreign 1847 1505 377 10918 8686 9926 3225 20328 15017 20518
Institutional
Investment
(in US$
millions)

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Change in -27.9 -3.7 -12.1 +83.37 +16.13 +73.73 +15.89 +19.68 37.94 +79.88
BSE
Sensex
Index(%
change
from year
to year)

Source: Securities and Exchange Board of India (SEBI) Annual Reports, SEBI
Handbook of Statistics, and Reserve Bank of India Annual Report
Note: The fiscal calendar year in India starts in April and ends in March of the following
year
* 2009-2010 fiscal year data is for the period ending in December 2009.

P Computed using prorated FDI based on the first nine months of the fiscal year.

Despite the negative impact of the liquidity crisis on its financial

markets, India was able to contain the effects and implement a quick recovery,
as shown in the Table 3. The net Foreign Institutional Investment for the first
three quarters of 2009-10 has exceeded that of any of the prior fiscal years. As
noted previously, IMF estimates the growth rates in GDP and industrial
production to rebound in the near future to levels that existed prior to the crisis.
The optimism in the Indian economy is also reflected in the BSE Index, which
rose by 79.88% in the first three quarters of the last fiscal year.
Several factors contributed to the quick recovery of the financial
markets in India. Although the economic liberalization policies were initiated
in 1991, the transformations in the markets have been implemented cautiously,
and the markets are still highly regulated relative to the standards of advanced
economies. Stringent regulation of banks has limited their exposure to complex
derivatives and off-balance sheet activities. The exposure of the banks in India
to the United States subprime mortgage and credit default swaps markets was
negligible and indirect. 20 Further, the share of bank assets held by foreign
banks in India is only 5%, one of the lowest among all EMEs, which limits the
transmission of the crisis through the banking sector. This contrasts with the
high foreign ownership of bank assets in East European and Latin American
EMEs, which made them more vulnerable to contagion effects. The banks in
India were also prudent in their lending practices in the real estate sector.

20Although Lehman Brothers had 14 offices in India, its operations did not materially affect the
banking sector. Only ICICI Bank had some exposure to the US subprime mortgage market, but it
was able to absorb the losses due to its strong capitalization.
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Unlike in the United States, subprime mortgages are non-existent in India and
the mortgage loans generally have shorter maturities. In response to the crisis,
the Reserve Bank of India had raised the capital adequacy ratio from 8% to 9%
for existing banks, and to 10% for new private sector banks and banks
undertaking insurance business. This exceeds the 8% requirement imposed by
Basel II on commercial banks. Table 4 shows selected monetary policy
measures in India for 2000-10.

Table 4. Selected Monetary Policy Measures in India: 2000 - 2010

Fiscal Year
2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007- 2008- 2009-
01 02 03 04 05 06 07 08 09 10*
Gross 23.5 23.4 26.1 28.1 31.7 34.2 35.7 37.7 na na
Domestic
Savings (% of
GDP)
Capital 11.4 12.0 12.7 12.9 12.8 12.3 12.4 13.1 na na
Adequacy
Ratio (%
capital to
assets)
Net 2.5 2.3 1.8 1.2 0.9 0.7 0.6 0.6 na na
Nonperforming
Assets Of
Commercial
Banks (% of
assets)
Net 2.7 2.4 1.9 1.3 1.0 0.7 0.6 0.6 na na
Nonperforming
Assets Of
Public Sector
Banks (% of
assets)
Gross Fiscal 5.65 6.19 5.91 4.48 3.99 4.08 3.45 2.69 6.14 6.85
Deficit (% of
GDP)
Call Money 9.15 7.16 5.89 4.62 4.65 5.60 7.22 6.07 7.06 3.22
Rate (%/)

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Cash Reserve 8.0 5.5 4.75 4.5 5.0 5.0 6.5 7.5 5.0 5.0
Ratio (CRR)
(0/6)

Source: Securities and Exchange Board of India (SEBI) Annual Reports, SEBI
Handbook of Statistics, and Reserve Bank of India Annual Report.
Note: The fiscal calendar year in India starts in April and ends in March of the following
year.
* 2009-2010 fiscal year data is for the period ending in December 2009.

The capital adequacy ratio (that is, the capital as a percentage of the
risk-weighted assets of the bank) had been rising steadily from 11.4% in 2000-
01 to 13.1% in 2007-08. Further, all 79 commercial banks in 2007-08 surpassed
the 9% requirement, and 56 of them had capital adequacy ratios that exceeded
12%. The net nonperforming assets as a percentage of all assets, which is an
indication of problem loans in the asset portfolio, of both commercial banks and
public sector (or government sponsored) banks have been declining in each year
from 2000-01 to 2007-08. For both groups of banks, this ratio had dropped to
0.6% in 2007-08, which is less than one-fourth of that in 2000-01. The gross
domestic savings rate as a percentage of the GDP has also been rising from
23.5% in 2000-01 to 37.7% in 2007-08, which again, contributed to the
investment component of the India's economic output. Lastly, the direct
participation of households and retirement portfolios in the equity markets was
relatively small. Most of the household wealth and pension funds were invested
in fixed income and secured investments. Consequently, the sharp decline in
the equity markets in 2008-09 did not result in significant losses in household
wealth. Although the real estate market did stagnate for some time, it has since
recovered and has been growing.

2. Trade Channel

The effects of the crisis in the real sector of the Indian economy were
transmitted through the external trade channels, that is, exports and imports.
Although India's exports are a relatively small fraction of the GDP (15.1% in
2008-09), it had been growing steadily since 2004-05 (Table 2). The two-way
trade (sum of exports and imports) as a fraction of the GDP was about 34% in
2008-09. As shown in Table 1, in Section II, the global volume of trade in
goods and services declined by 12.30% in 2009. The advanced economies'
imports did not grow in 2008 and declined sharply in 2009. Gupta reports that
India's exports in the second half of 2008-09 shrunk by 15% mainly due to the
economic contraction in its trading partners and partly due to the threats of

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protectionism. 2 1 Specifically, export oriented sectors, such as textiles, gems and

jewelry, leather, chemicals and information technology, experienced declines in
export growth. Software and IT enabled services, whose exports to the United
States accounted for 60% of its total exports, witnessed revenue declines as
United States firms cut back on their purchases from India. At the same time
when its exports were declining, India's imports were rising, primarily due to
higher prices for oil, fertilizers and other commodities. Inflation (measured by
wholesale price index) had been falling from 6.4% in 2004-05 to 4.7% in 2007-
08 (Table 2). In 2008-09, due to higher commodity prices, it climbed steeply to
8.3%, affecting sales and profit margins of businesses. The declining exports
and rising imports resulted in a larger current account deficit in 2008-09. In the
domestic market, the liquidity crisis in the financial sector, along with rising
inflation rates, resulted in lowering the demand for goods and services. The
rising current account deficit and the declining demand in the domestic market
contributed to labor retrenchment in the affected industries.
Another consequence of the declining demand for India's output was a
fall in direct and indirect tax revenues for the government. Political exigencies
limited the government's ability to completely pass-through the higher
commodity import costs to the consumers. Along with the reduced tax
revenues, this put pressure on India's fiscal deficit. Table 4 shows the gross
fiscal deficit as a percentage of GDP for the last ten years. Prudent policies on
the part of the government helped reduce the fiscal deficits from 5.65% in 2000-
01 to 3.45% in 2006-07 and 2.69% in 2007-08. As a direct consequence of the
global financial crisis, the fiscal deficit more than doubled to 6.14% in 2008-09.
It is projected to rise to 6.85% for 2009-10. In view of the problems in the real
sector and the high fiscal deficit faced by the government, Standard and Poor's
lowered its long-term sovereign credit rating of India from 'stable' to 'negative'
in February 2009. The downgrade of the sovereign ratings raises the cost of
borrowing for firms in the external markets.
The effects of the global financial crisis transmitted through both the
financial and trade channels impacted the real estate market in India in 2008-09,
which did not post any growth for the first time in many years. According to
Gupta, private investment in India, which accounted for 28.5% of GDP in 2007-
08, declined from a growth rate 29.9% in 2004-05 to 5.9% in 2007-08. 22
Although India's export to GDP ratios has been steadily rising in the
past five years, it is still lower than that of many of the East Asian countries.

21 Gupta, Abhijit (2009), "India's Tryst with the Global Financial Crisis",
Review of Market
Integration,Volume 1, Number 2, pp. 171-197.
22 Gupta, Abhijit (2009), "India's Tryst with the Global Financial
Crisis", Review of Market
Integration,Volume 1, Number 2, pp. 171-197.
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Consequently, the adverse effects of shrinking imports by advanced economies

were not as severe on India as that of other EMEs with higher exports to GDP
ratios. As soon as the financial markets around the world recovered, India's
exports, employment and real estate market rebounded. Service exports are
generally more resilient than merchandise exports as they are less reliant on
external finance and are necessities for the buyers even during economic
downturns.23 Currently, exports and employment in the software and
information technology industries are on the rise again. Several fiscal and
monetary policy initiatives (listed in the next section) were successfully
implemented by the government to tackle the problems posed by the financial
crisis.

3. Confidence Channel

The third channel through which the financial crisis spread from the
advanced economies to the Indian economy is through the confidence channel,
that is, the impact of the crisis on the sentiment of investors and consumers in
India. Regardless of whether the financial crisis in the United States and
Europe had any direct or indirect bearing on the Indian market, and the size of
the effect, if any, consumers, investors and businesses became more risk averse
and cut back on their consumption and investment. Mishra reports that banks
became more cautious about lending to borrowers in 2008-09 and credit growth
declined to 17.3% from 22.3% in the previous year. 24 Similarly, consumers in
India cut back on their demand for goods and services after being spooked by
the sharp decline in the equity markets. Unsure about the demand for their
output in both domestic and external markets, businesses cut back on their
investments and labor resources. Gupta documents decline in employment in
several industries and in wage earnings of the labor force. 25 The pessimistic
sentiment of businesses, consumers and investors were reflected by the 41%
decline in the National Council of Applied and Economic Research (NCAER)
Business Confidence Index in January 2009, compared to the previous year.
Several other indicators, such as ABN Amro's Purchasing Managers' Index,
Dun and Bradstreet Business Optimism Index and UBS Lead Economic

23 Ghosh, Jayati (2009), "Global Crisis and the Indian Economy", in 'Global
Financial Crisis:
Impact on India's Poor, United Nations Development Programme (India).
24 Misra, B. M. (2009), "Global Financial Crisis and Monetary Policy
Response: Experience of
India", Paper presented at the workshop on 'Strengtheningthe Response to the Global Financial
Crisis in Asia-Pacific: The Role of Monetary, Fiscal and External Debt Policies, United Nations
Economic and Social Commission for Asia and the Pacific, Dhaka, Bangladesh, July 2009.
25 Gupta, Abhijit (2009), "India's Tryst with the Global Financial Crisis", Review of Market

Integration,Volume 1, Number 2, pp. 171-197.

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Indicator exhibited similar declines in sentiment in the manufacturing sector.

Economies can adopt measures to insulate themselves from the
contagion effects of financial crises in foreign markets through the financial and
trade channels. However, the crisis can still spread through the confidence
channel. In the stated opinion of the monetary policy makers (that is, the
Reserve Bank of India), financial markets in India continued to function in an
orderly manner even when most of the world economies were experiencing a
severe liquidity crisis. Although India was well positioned to manage the
spread of the global financial crisis from the advanced economies, it could not
deflect the effects on the confidence level of the investors, consumers and
businesses. In the domestic economy, the primary impact was a sharp reduction
in consumption by both households and businesses. As a consequence, business
investment slowed down during the crisis, and it was reflected in the domestic
component of the growth in GDP. It was also reflected in the higher rates of
unemployment in some of the sectors of the market. This translated into an
increased aversion and higher premium for risk among private and institutional
investors. The lack of confidence in the financial markets was reflected by the
37.9% decline in the BSE Index.

D. India's Policy Response to the Crisis

Subbarao, Misra and Thorat present the various monetary and fiscal
policy initiatives implemented by the Indian government and its agencies in
response to the global financial crisis and its effects on the domestic economy.26
In its role as the principal regulator of the financial markets in India, the primary
responsibility of the Reserve Bank of India (RBI) is to ensure the orderly
functioning of the credit and foreign exchange markets in India. The monetary
policy response of the RBI was aimed at containing the contagion effects of the
financial crisis from the advanced economies by ensuring sufficient liquidity in

26 Dr. Duvvuri Subbarao, Ms. Usha Thorat and Mr. B.M. Misra are, respectively, the Governor, the
Deputy Governor and Economic Adviser of the Reserve Bank of India. Subbarao, Duvvuri (2009),
"Impact of the Global Financial Crisis on India - Collateral Damage and Response", Speech
delivered at the Symposium on 'The Global Economic Crisis and Challenges for the Asian
Economy in a Changing World', Institute for International Monetary Affairs, 18 February 2009.
Misra, B. M. (2009), "Global Financial Crisis and Monetary Policy Response: Experience of India",
Paper presented at the workshop on 'Strengtheningthe Response to the Global FinancialCrisis in
Asia-Pacific: The Role of Monetary, Fiscal and External Debt Policies, United Nations Economic
and Social Commission for Asia and the Pacific, Dhaka, Bangladesh, July 2009. Thorat, Usha
(2009), "Impact of Global Crisis on Reserve Bank of India (RBI) as a National Regulator", Paper
presented at the 56h EXCOM Meeting and FinPower CEO Forum, APRACA, Seoul, Korea, June
2009.
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the credit markets. On the fiscal side, the government's policy responses were
aimed at protecting businesses and groups that were directly affected by the
crisis. This was accomplished through relaxation of some onerous restrictions,
tax subsidies and strengthening of social safety-nets.

1. Monetary Policy Responses

The goals of the monetary policy initiatives were three-fold: to provide

sufficient liquidity in the domestic market, to provide dollar liquidity for
businesses financing in the external markets, and to ensure flow of credit to
those industry sectors that were productive.
Following the rapid expansion in the first half of the decade, the
monetary policy was tightened in the second half. This policy had been in place
till August 2008 when the initial effects of the crisis started impacting India in
the form of reduced credit availability. Banks became cautious and started
cutting back on their new loan offerings. To provide more liquidity to the credit
markets, the RBI gradually reduced the repo rate from 9% (in August 2008) to
4.75%, and the reverse repo rate from 6% to 3.25%.27 Table 4 shows the call
money rates (an indicator of the borrowing rates) in India for the last ten years.
From 2000-01 to 2004-05, the rates were declining during the expansionary
phase. To moderate the expansion, monetary tightening was put into effect
between 2005-06 and August of 2008, when the rates increased. In 2009-10,
the call rate was reduced sharply to 3.22%, reflecting the RBI's injection of
liquidity into the market. In effect, this expanded the money supply in India by
providing incentives to banks to increase their loan portfolios. The cash reserve
ratio (or reserve requirement), which had been at 7.5% in 2007-08, was also
reduced to 5%, allowing the multiplier effect to expand the money supply.
Along with this, the Statutory Liquidity Rate, a liquidity requirement for
commercial banks, was also relaxed to allow them to provide more credit.
To facilitate availability of sufficient dollar liquidity, the RBI
intervened in the foreign exchange markets to support the Indian Rupee. In the
process, the foreign reserves held by India declined from US$ 309.7 billion in
2007-08 to US$ 252 billion in 2008-09. The rising dollar had been increasing
the debt service costs for businesses that had been using external financing. By
stabilizing the value of the Indian Rupee, RBI was attempting to manage the
exchange rate risks by the borrowers. Further, it initiated currency swaps with
businesses that were exposed to United States dollar payables, and extended

27The repo rate is the discount rate at which the RBI buys government securities from commercial
banks, and the reverse repo rate is the interest rate at which RBI borrows money from commercial
banks.
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export credit finance to them. With the limited availability of United States
dollar funding in external markets and increased risk aversion on the part of
lenders, ceilings on rates at which businesses could borrow in external markets
were relaxed. Finally, the rates on Eurodollar deposits in India were raised to
attract more funds from foreign individual investors.
The RBI, in conjunction with the government, implemented policies
that provided additional credit facilities specifically for Small and Medium
Enterprises (SMEs) that were particularly affected by the non-availability of
credit. Banks were allowed to reclassify certain nonperforming assets in a way
that allowed them to refinance borrowers who were behind in their debt service
payments. A bailout package was implemented in the agriculture sector in the
form of a farm-loan waiver that allowed farmers to continue operations facing a
mounting debt burden.

2. Fiscal Policy Responses

The focus of the fiscal policy responses of the Indian government to

the financial crisis was to stimulate demand for the country's output and to
bailout those industries and groups that were most vulnerable to the crisis.
Starting in December 2008, the government introduced three stimulus packages
in the span of four months that lowered tax rates and increased tax subsidies,
increased capital expenditures and government spending, and provided
incentives that encouraged growth in consumption and demand. Specifically,
the government announced plans for additional public spending in capital
expenditure projects, provided government guarantees for infrastructure
spending, and expanded credit for SMEs and exporters. The agriculture
industry, which supports a majority of the population, was particularly affected
due to rising oil and fertilizer prices, and due to failed monsoons. The loans that
were in default in the farming sector were waived by the government. The
stimulus packages also included tax rebates and subsidies for some of the
affected sectors of the market. Finally, a revised pay structure for all
government employees implemented salary increases that raised the disposable
income for a significant part of the labor force. Subbarao estimates the size of
the fiscal stimulus amounted to about 3% of the GDP.28

28Subbarao, Duvvuri (2009), "Impact of the Global Financial Crisis on India - Collateral Damage
and Response", Speech delivered at the Symposium on 'The Global Economic Crisis and
Challenges for the Asian Economy in a Changing World', Institute for International Monetary
Affairs, 18 February 2009.
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E. Evaluation of Policy Responses

Starting in 1991, India had been implementing economic reforms that

were aimed at moving from a centrally-planned economy to a market based
economy. In the process, it had been cautious in opening up its markets and
allowing risky innovations in the financial markets. While encouraging the
private sector to play a more dominant role in the economy, it was also in the
process of strengthening and streamlining the regulation of markets. The
banking sector, which plays a pivotal role in the savings and capital formation
functions in India, was heavily regulated to limit overly risky behavior by the
participants. Consequently, while the global financial crisis is having a
protracted and devastating effect on most of the economies of the world, its
impact on the Indian economy is not that severe. The strength of the Indian
economy along with the timely and appropriate monetary and fiscal policy
responses by the government helped manage the adverse effects of the crisis.
Mohan estimates the monetary policy responses to the crisis injected liquidity
that amounted to about INR 4,900 billion or 9% of GDP.29 On the fiscal side,
the spending initiatives amounted to INR 2,928 billion, and tax subsidies cost
INR 1,600 billion. These policy responses stabilized the financial markets and
facilitated a quick recovery of the economy. One negative consequence of the
various stimulus packages is that the fiscal deficit is at 11 percent of GDP and
will continue to be at this level for some time. This limits the policy options
available to the RBI to manage future shocks to the economy in the near term.

VI. CONCLUSION

Recent economic history has taught us that financial crises that

simultaneously affect several economies occur frequently, and that prudent
policies and appropriate responses by monetary authorities help in managing the
crises. However, the task of containing the adverse effects becomes more
challenging when all the economies of the world are affected by the crisis. The
current global financial crisis, which started in 2008, has been adversely
affecting all the world economies and the magnitude of its impact is exceeded
only by that of the Great Depression of 1930s. In response to the crisis, the
various national monetary authorities and international financial organizations
have implemented fiscal and monetary policy initiatives to alleviate the
problems and soften the impact on the affected sectors. While all economies
were adversely affected by the crisis, the impacts were not uniform across

29Mohan, Rakesh (2009), "Global Financial Crisis: Causes, Impact, Policy Responses and
Lessons", Working Paper 407, Stanford University, Stanford, CA, USA.
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countries. Consequently, the responses by the governments in individual

countries varied.
The global financial crisis has had a more severe impact on the
advanced economies compared to the rest of the world. The economic
indicators in the United States and the European Union countries point to a
severe contraction in these markets. At the same time, the slowdown in the
emerging markets has been smaller. Within the emerging markets, countries
such as India, China and Brazil have even managed to expand during the crisis,
albeit at a lower rate compared to their growth prior to the crisis. They have
also successfully avoided a protracted slowdown and are projected to achieve
higher growth rates. This paper detailed the impacts of the global financial
crisis on the Indian economy, and the responses of the Indian government in
managing the crisis.
The proactive policies of the RBI have ensured the availability of
adequate liquidity in the markets. In the credit and consumer markets, interest
rates and inflation rates have stabilized. In the foreign exchange market, the
Indian Rupee has rebounded against currencies of the major trading partners.
The fiscal stimulus provided by the government has helped cushion the decline
in private investment and consumption in the real sector. Although preliminary
estimates of the nonperforming assets of banks have been rising, they are still at
manageable levels. In the meantime, industries that were facing rising
unemployment in 2008-09 have been reversing the trend. The stock market,
which is an indicator of the strength of the economy, has risen by 80% in the
first three quarters of the current fiscal year (2009-10), after falling by 38% in
the previous year. The current figures for the Purchasing Managers' Index, the
RBI's Business Expectations Index and the Neilsen Global Consumer
Confidence Index for India indicate optimism about the economy on the part of
businesses and consumers in India. Finally, IMF's consensus estimate for the
GDP of 7.7% and 7.8% for 2010 and 2011, respectively, is evidence that India
has recovered from the global financial crisis and is back on the growth
trajectory.
Although India has been liberalizing its markets since 1991, it has
adopted a cautious approach by opening up its markets slowly and
implementing reforms after studying their effects on the domestic market.
Unlike many other emerging economies, the banking sector in India is still
highly regulated and continuously monitored. The Reserve Bank of India has at
its disposal a number of tools to control the money supply and to infuse
liquidity as needed. The size of its foreign reserves allows India to intervene
effectively in the foreign exchange market to support its currency.
Consequently, businesses can manage their exchange rate risk when trading
with foreign countries and when borrowing in the external markets. Although

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India has expanded its foreign trade sector, which is now a major component of
its GDP, the domestic sector is large enough to cushion any shocks in the real
sector of the global economy. This contrasts with several EMEs that have
implemented strategies to expand their external trade sector at the expense of
the domestic markets, making them vulnerable to external shocks. Finally, the
government in India has been expanding investments in social safety-nets to
soften the impact on the groups most vulnerable to economic shocks and
contagion in free markets.

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