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The Impact of the Crisis on the Indian Economy

The effects of the global financial crisis have been more severe than initially forecast. The turning point was the decision in September 2008 to let Lehman Brothers fail, an event that had a series of ruinous cascading effects. Given the depth of the crisis in the United States and Europe, it was only to be expected that India too would be affected. But India's well-regulated banking system and adequate policy responses should ensure that the fallout, at least on the banking sector, will be contained.


The Impact of the Crisis on the Indian Economy

T T Ram Mohan

The effects of the global financial crisis have been more severe than initially forecast. The turning point was the decision in September 2008 to let Lehman Brothers fail, an event that had a series of ruinous cascading effects. Given the depth of the crisis in the United States and Europe, it was only to be expected that India too would be affected. But India’s well-regulated banking system and adequate policy responses should ensure that the fallout, at least on the banking sector, will be contained.

T T Ram Mohan ( is with the Indian Institute of Management, Ahmedabad.

Economic & Political Weekly

march 28, 2009 vol xliv no 13

he global financial crisis is into its third year now. Many have termed it the “worst financial crisis of the last c entury”. The crisis began in the US and Europe and it has since affected the rest of the world, including Asia, in a bigger way than was thought at the beginning. This article explores some facets of the crisis, including its impact on the Indian e conomy and Indian banking.

1 Introduction

In Section 2, we touch on the nature of financial crises and the severity of the present one. In Section 3, we examine the impact of financial crises, including the present, on emerging markets. Section 4 looks at the impact of the crisis on the Indian economy and the Indian policy response. In Section 5, we dwell on the implications for the Indian banking sector. Section 6 concludes.

2 Severity of the Present Crisis

Financial crises can have a severe effect on economies. This is well known. What is not so well recognised is that the severity of the impact can vary widely. Somehow, in the popular perception, financial crises are identified with the mother of them all, the Great Depression, that followed the stock market crash of 1929. The general sense is that financial crises are crippling in their impact.

A recent study on the impact of financial crises by Reinhart and Rogoff (2008b) seems to bear out this gloomy view. The a uthors note, “Broadly speaking, financial crises are protracted affairs”. However, they quickly make it clear that they are talking of “severe” financial crises.

Can we tell whether a crisis is going to be “severe” without waiting to see how long it lasts and what havoc it inflicts? In an earlier paper, Reinhart and Rogoff (2008a) claim this is possible using a variety of indicators – asset price inflation, level of leverage, size of the current account deficit and the slowing down of economic growth. Going by these indicators, the authors suggest that the present US financial crisis qualifies as “severe”.

So what can we expect of a severe financial crisis? In their later paper Reinhart and Rogoff (2008b) focus on 18 major post-war banking crises in the developed world and three in emerging markets. They arrive at the following conclusions: y Real housing prices decline by an average of 36% over five years and equity prices by 56% over three and a half years.

  • The unemployment rate rises by 7 percentage points on the average over a period of four years while output falls from peakto-trough by 9% over a shorter period, two years.
  • The real value of government debt tends to explode, rising by an average of 86% in the major post-second world war episodes.
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    The encouraging thing, as the authors point out in their paper, is that such crises do end and that output declines last only two years on the average. The implication seems to be that when hit by a financial crisis, we must chin up and bear it. Two caveats are, however, in order.

    One, “financial crisis” is a very broad term that covers a whole range of events, including crashes in the housing market, stock market, foreign exchange market, current accounts of nations and, of course, problems afflicting the banking sector. There is evidence that the really severe financial crises are those in which the banking sector is affected. The episodes covered by the a uthors are all banking-related episodes.

    The International Monetary Fund (IMF) in 2008 surveyed 113 episodes of financial stress in 17 countries. Of these, 43 episodes were driven mainly by stress in the banking sector. In 17 episodes, stresses arising elsewhere in the financial system had a significant impact on the banking sector. Thus, a total of 60 episodes – or a little over half of all the episodes of financial stress – were banking-related.

    Of the 113 episodes studied, 29 were followed by slowdowns and 29 by recessions. The remaining 55 episodes – or nearly half the episodes of financial stress – were not followed by an economic downturn. There is no reason, therefore, why every financial crisis should inspire pessimism.

    How do we square this finding with Reinhart and Rogoff’s gloomy assertion about the impact of financial crises? Well, by their own admission, they focused only on the most severe crises. Second, and equally important, they focused on crises where the banking sector was severely affected.

    The IMF (2008) study found that “episodes of financial turmoil characterised by banking distress are more often associated with severe and protracted downturns than episodes of stress centred mainly in securities or foreign exchange markets”. Of the 58 episodes that were followed either by a slowdown or a recession, 35 (or 60%) were banking-related.

    In the present crisis, the banking sector is clearly affected. Reinhart and Rogoff contend that, going by several indicators, the crisis is severe. This means that output decline should stretch over about two years. Since the crisis started in August 2007, a positive spin would imply that we should be nearing its end around August 2009. Even if we were to take a pessimistic view, December 2009 should mark the beginning of the end. This view is shared by several commentators.

    It is worth mentioning that the IMF had a different view on the severity of the present crisis until a few months ago. The IMF (2008) notes that “financial stress episodes are more likely to be followed by severe economic downturns when they occur in the context of a rapid build-up in credit and house prices and a heavier reliance on credit by firms and households”. In other words, the greater the imbalances and excesses, the greater the fall.

    The IMF compares data for the current crisis against data for six major episodes in the past. It notes, “The current imbalances and adjustments appear generally much smaller than those for the six episodes examined here, except for US residential real e state investment and the US current account.” The IMF report came out in October 2008 and presumably the conclusions were arrived

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    at a month or two before that – or before the collapse of Lehman Brothers in September 2008. The point is that the IMF at that time did not believe that financial crisis in the US was of the same severity as some of the bigger crises in the past – contrary to the conclusion that Reinhart and Rogoff have drawn in their later paper, the draft of which was published in December 2008.

    The second caveat to the proposition that financial crises tend to inflict huge costs on economies is that it is not as if the policy response is immaterial, that is, the severity of the crisis is not independent of the policy response. The Great Depression itself was the result of policy blunders that are well recognised now – such as fiscal and monetary tightening, the failure of several banks, and protectionist trade policies.

    There is a conceptual flaw, therefore, in looking at past episodes of the crisis and arriving at averages for the intensity of the impact – much depends on how prompt and how correct the policy responses were. Reinhart and Rogoff (2008b) do not appear to set much store by the quality of policy response nor are they inclined to believe that the impact of the present crisis can be seriously mitigated by the policy response.

    How relevant are historical benchmarks for assessing the trajectory of the current global financial crisis? On the one hand, the authorities today have arguably more flexible monetary policy frameworks, thanks particularly to a less rigid global exchange rate regime. Some central banks have already shown an aggressiveness to act that was notably absent in the 1930s, or in the latter-day Japanese experience. On the other hand, one would be wise not to push too far the conceit that we are smarter than our predecessors. A few years back many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of financial contagion. Since the onset of the current crisis, asset prices have tumbled in the United States and elsewhere along the tracks laid down by historical precedent. The analysis of the post-crisis outcomes in this paper for unemployment, output and government debt provide sobering benchmark numbers for how the crisis will continue to unfold. Indeed, these historical comparisons were based on episodes that, with the notable exception of the Great Depression in the United States, were indi vidual or regional in nature. The global nature of the crisis will make it far more difficult for many countries to grow their way out through higher exports, or to smooth the consumption effects through foreign borrowing.

    Is there a fatal inevitability, then, to the unwinding of imbalances built up in the global economy? If so, then most c ommentators appear, in retrospect, to have been astonishingly sanguine about the prospects for the global economy August/ September 2008. Indeed, it is fair to say that until the collapse of Lehman Brothers in September 2008, there was a general sense that the financial crisis was coming under control.

    Let us take, for in-

    Table 1: IMF Growth Forecasts for the World Economy

    stance, the successive (%)

    2008 2009

    growth forecasts of

    April 2007 4.9

    the IMF’s World Eco-

    September 2007 4.8

    nomic Outlook (WEO;

    April 2008 3.7 3.8

    Table 1). The crisis is

    October 2008 3.9 3.0

    r eckoned to have be-

    January 2009 (update) 3.4 0.5

    gun in August 2007. Note that through the unfolding of the crisis over nearly 14 months up to October 2008, the growth forecast for 2008 goes down only by about 1 percentage point relative to the forecast in April 2007. The forecast of 3.9% for global economic growth is

    109 impressive going by the growth record since the second world war. Even in January 2009, the forecast for 2008 remains a respectable 3.4%. It is the forecast for 2009 that changes drastically.

    This does suggest that until the October 2008 WEO report (whose numbers must have been firmed up before the Lehman collapse in September), the impact of the financial crisis on the world economy was expected to be modest. It was the Lehman collapse that changed the situation dramatically. This accords with the widespread perception that the decision to allow Lehman to go into bankruptcy was a policy blunder. To put it differently, the impact of the financial crisis may not have been as severe as it is turning out to be but for the decision to let Lehman fail.

    It is understood that letting a large bank fail has major externalities. In the Long-Term Capital Management (LTCM) crisis of 1998, a decision was taken not to allow the hedge fund to go under and it was salvaged through an initiative of the Federal Reserve. The principle derived from that experience was that the failure of even nonbank institutions that are systemically important should not be easily permitted. However, the same logic was not applied to Lehman, by any standard a systemically important player. The reasons for this decision are not clear and need not detain us here.

    What is material is that the Lehman collapse had important implications for the impact of the financial crisis on the global economy. The Bank for International Settlements (BIS) deals at some length with the implications of the Lehman bankruptcy in its review for the last quarter of 2008. Lehman was, among other things, a prime broker, that is, it provided two-way quotes and funds to its broking clients. The BIS paper argues that its b ankruptcy had implications for the market in three ways: one, the impact on the credit default swaps (CDS) market; two, the liquidation of money market funds due to losses suffered on L ehman debt; and three, the consequences for the firm’s prime brokerage clients.

    Lehman was a counterparty to many CDS contracts and it was referenced in others (meaning, people had taken bets on L ehman). It was not immediately apparent what the net impact of the bankruptcy on various institutions would be. Following the adoption of a series of procedures, the net settlement was estimated at $6 billion, out of which payments of $5.2 billion were made. The BIS notes that these modest amounts would not have had a noticeable impact on liquidity. But the uncertainty created by the earlier announcement of bankruptcy created volatile conditions in the market and raised the possibility of the failure of insurer American International Group (AIG), which was eventually prevented by a government rescue.

    An even bigger fallout of the Lehman failure was on the money markets. A principal source of funding for Lehman had been commercial paper and short-term debt, which were highly rated and whose yields were attractive to money market funds. The BIS notes, “Money market fund investors also felt protected against principal loss because of regulatory restrictions imposed on fund managers and because fund managers had avoided losses in the past”. So there was a lot of market sentiment riding on paper issued by investment banks such as Lehman.

    In the aftermath of the Lehman bankruptcy, the net asset value of a public money market fund, Reserve Primary, fell below $1 and it had to be liquidated. This led to massive redemptions by i nvestors in other money market funds. To stop the run on these funds, the US Treasury had to initiate various measures, including a temporary programme of insurance for investors in money market funds. The undermining of confidence of money market funds in investment banks was undoubtedly a factor in the disappearance of large investment banks as a class as these banks relied substantially on wholesale funds for their high levels of leverage.

    Third, Lehman, as a prime brokerage, provided finance to hedge funds against assets posted by them as collateral. These assets were available to Lehman for meeting its own obligations through a process called “re-hypothecation”. When Lehman became insolvent, its clients lost access to their collateral until such time as the bankruptcy process was completed. This meant they were locked into positions of changing value. It also meant that hedge funds had to resort to asset sales to meet funding pressures. The fall in values of assets had an adverse impact on the financial condition of many institutions, including banks, all of which were holding similar assets.

    Financier George Soros (2009) calls the decision to let Lehman fail “the game changer” – it changed the complexion of the crisis and possibly changed it from a modest one to a severe one. The Lehman bankruptcy, Soros observes, “had had the same shock effect on the behaviour of consumers and businesses as the bank failures of the 1930s”.

    Taylor (2009) contends that it was not so much the Lehman collapse as the uncertainty it created about when and under what circumstances the US authorities would support financial institutions that led to a worsening of conditions post-September 2008. He also believes that lack of clarity about the Trouble Assets R elief Programme was a contributory factor. One might add that, in recent months, uncertainty as to whether the US government will nationalise leading banks is yet another contributory factor.

    It would be incorrect, therefore, to see the present crisis of the global economy as something that flows inexorably from the imbalances created in the past several years. Two points are worth emphasising. First, while a correction was overdue, it need not have been as severe as it is turning out to be if the financial system had been better regulated. I have argued elsewhere (Ram Mohan 2008) that even if we were to put together all the adverse factors in the economic environment – current account imbalances, greedy bankers, excess reserves of Asian economies, low interest rates, housing bubbles and sub-prime loans – it does not follow that these must translate into a global financial crisis. Inadequate regulation is what caused a tidal wave to turn into a tsunami.

    Second, it is also arguable that the economic impact could have been better contained had the policy response been better. In particular, the decision to let Lehman fail appears to have been a blunder of colossal proportions. It would explain why forecasts for global economic growth consequent to the Lehman episode have been far gloomier than the ones until then.

    The broader point is that we cannot afford to take a mechanistic view of financial crises and their economic impact going by averages estimated from the past. The quality of policy response can make a world of difference.

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    3 Impact on Emerging Markets

    Views on how far the convulsions in the US economy will affect emerging markets, including India, have evolved with the unfolding of the crisis. In the initial stages, there was a fairly high degree of optimism about the capacity of at least some of the emerging markets, particularly leading lights such as China and India, to insulate themselves substantially from the crisis. Such optimism has since worn thin and, of late, one finds more doomsayers.

    Successive issues of the IMF’s WEO report over the crisis period reflect this evolution. In the initial stages of the crisis, several reasons were put forward as to why the emerging markets might hope to get “decoupled” from the US and other advanced e conomies: y the US slowdown was related to factors specific to the US economy, especially corrections in the housing sector, rather than to more generalised factors such as an oil shock or adverse equity market developments; y trade linkages of the emerging economies with the US had d iminished and trade among emerging markets had become more important than in the past; y growth in some of the leading emerging markets was driven overwhelmingly by domestic demand; y the emerging markets were net savers in the world economy, not borrowers; and y over the past decade, the emerging markets had effected several economic reforms, as a result of which they had become more stable and efficient.

    The IMF (2007) noted favourable factors such as the above and observed: … the potential size of spillovers from the United States has increased with greater trade and financial integration, but that the importance of these links should not be overestimated… past episodes of highly synchronised growth declines across the globe were not primarily the result of developments specific to the United States, but rather were caused by factors that affected many countries at the same time. Examples of such episodes include the first oil price shock in 1974-75 and the bursting of the information technology (IT) bubble in 2000.

    Nevertheless, the IMF did distinguish between the effects of a moderate slowdown in the US and a sharp slowdown or recession in the US:

    Overall, these factors suggest that most countries should be in a position to “decouple” from the US economy and sustain strong growth if the US slowdown remains as moderate as expected, although countries with strong trade linkages with the United States in specific sectors may experience some drag on their growth. However, if the US economy experienced a sharper slowdown because of a broader-than-expected impact of the housing sector difficulties, the spillover effects into other economies would be larger, and decoupling would be more difficult.

    Why should this be so? Why should the severity of a slowdown in the US determine whether emerging markets economies “d ecouple” from the US or not? Either they “decouple” or they do not. The IMF provides an explanation that appears plausible. In a modest US slowdown, emerging markets (and also other economies) are affected mainly through the trade channel. However, when the US economy runs into serious problems, the asset price channel gets activated. Finan cial flows to emerging markets are severely affected during a serious US recession and equity prices also tend to become highly correlated with those in the US market. Besides, there is a broader impact through undermining of confidence among consumers and investors.

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    A better way of judging the impact on an emerging market of a slowdown in the US economy, therefore, would be to take into a ccount trade flows as well as financial flows. As the IMF (2007) puts it:

    While export exposure to the United States appears to be an important determinant of the severity of the response to US recessions, “openness” in general seems to be more of a factor for emerging market economies. More open emerging market economies, in terms of both trade and financial openness … consistently show larger declines in output gaps during US recessions.

    This would explain why emerging markets, particularly India and China, remained “decoupled” from the US almost through 2008. The indications were that the US slowdown would not be very severe. In that event, the impact would be mainly through the trade channel. For India, this impact would be modest. The Lehman episode in September 2008 dramatically changed the outlook for the US economy and, in consequence, for emerging markets, including India and China. Both economies have a high degree of “openness” as measured by trade and financial flows put together. Once it became clear that the US economy was in deep trouble, the financial channels gained in importance, going by the logic articulated by the IMF.

    This should put the entire debate on “decoupling” in perspective. The thesis was all the rage in the early stages of the crisis. Now, its proponents are being laughed at. They were both right and wrong. They were right in that emerging markets are substantially “decoupled” from the US economy when the latter suffers a mild slowdown; they were wrong in that emerging markets are not “decoupled” once the slowdown becomes severe.

    4 Impact on the Indian Economy and the Policy Response

    India, like other emerging markets, has suffered a more severe impact than supposed earlier. The impact has been pronounced after the Lehman crisis and, as Reserve Bank of India (RBI) Governor D Subbarao (2009) has pointed out, it arises from three channels: the trade channel, the financial channel and the confidence channel.

    For the reasons mentioned above, right up to the Lehman episode, it was assumed that the impact on India would be primarily through the trade channel. Since merchandise exports account for less than 15% of gross domestic product (GDP), the trade c hannel impact was assumed to be bearable – it would set back growth only by more than 1-1.5%.

    Once we factor in the financial channel, the picture changes quite a bit. One measure of financial integration, Subbarao points out, would be the ratio of total external transactions (gross current account flows plus gross capital flows) to GDP. This ratio has more than doubled from 46.8% in 1997-98 to 117.4% in 2007-08.

    In a time of global economic crisis, a higher level of financial integration impacts on the economy in three related ways: reducing Indian companies’ access to overseas finance, lowering domestic liquidity and causing stock prices to fall.

    Adverse global conditions have limited Indian firms’ access to global finance in various forms: fresh international borrowings external commercial borrowings (ECBs) have become difficult and existing ones are not easily being rolled over; long-term finance for international acquisitions made earlier through bridge finance is not available; buyers’ credit has become scarce for international transactions; Indian banks’ overseas branches and subsidiaries find they are unable to access funds in the wholesale market and have had to be p rovided with dollar funds by their parents from out of India; and so on.

    There is a much broader impact on the Indian economy arising from foreign inflows in forms such as foreign direct investment (FDI) and foreign institutional investment (FII). These inflows had contributed to accretion of foreign exchange reserves. Any accretion to reserves enhances domestic liqui dity; any decline in reserves constitutes a reduction in l iquidity.

    The gap between domestic investment and savings or the current account deficit – of around 1.5% of GDP – in recent years understates the potential impact on the Indian economy of foreign inflows. As Subbarao (2009) points out, capital inflows in 2007-08 amounted to 9% of GDP, vastly in excess of the current account deficit. In the period 2003-08, the share of investment in India’s GDP rose by 11 percentage points. Of this, roughly half was financed by corporate savings but a significant portion of the balance came from external sources.

    It is fair to say that when liquidity becomes scarce, the impact on investment and economic growth is greater than is suggested by the current account deficit gap of 1.5% of GDP. If the impact was only of this order, then economic growth should not decline by more than 0.5-1%. Most projections place economic growth for 2008-09 at around 7% and even lower for 2009-10, which indicates that financial integration exacts a much higher price in adverse conditions. (The prime minister’s Economic Advisory Council is among the few exceptions: it estimates a growth of 7-7.5% in 2009-10.)

    Going by RBI (2009), the balance of payments position swung from an increase in reserves of $40.4 billion in April-September 2008 to a decrease in reserves of $2.5 billion in April-September 2009. This order of change in the accretion of reserves was bound to make itself felt in the domestic liquidity situation since accretion to reserves has been the biggest driver of domestic liquidity in recent years.

    The fall in domestic stock prices is another aspect of financial integration, reflecting as much the impact of net sales by FIIs as sentiment about prospects for global and domestic economic growth. (FII inflows were – $6.6 billion in April-September 2008-09 compared to $15.5 billion in the same period in 2007-08.) At a time of low share prices, firms are reluctant to tap the capital market. Unless bank finance can substitute adequately for the capital markets, firms’ investment plans are bound to be hit.

    We may round off this discussion about the impact on the Indian economy by mentioning the confidence channel as well. In a time of global crisis, consumers and investors are both bound to cut back on spending because of the general setback to confidence or “animal spirits”. Job losses accentuate the impact on consumer spending. Not least, there is pronounced risk aversion among banks. Banks are either averse to lending altogether (especially to risky areas such as real estate) and would like to hoard capital or will lend only at a steep price. All these effects have been in evidence in recent months in the Indian economy.

    Turning now to the policy response, both fiscal and monetary policy have responded to the worsening environment although there is much debate about the adequacy of efforts on the two fronts, especially the monetary front. As mentioned earlier, India did not appear significantly affected until after the Lehman episode, hence the fiscal and monetary responses have come primarily after September 2008 although some fiscal measures taken earlier but implemented post-September are part of the menu of responses.

    The focus of fiscal policy has changed from fiscal stabilisation to providing a growth stimulus. In consequence, there is no longer any talk of meeting the targets under the Fiscal Responsibility and Budget Management (FRBM) Act. The fiscal stimulus has come primarily through two Supplementary Demand for Grants in October and December 2008. The major components of the two supplementary demands were pay and pension revision consequent to the Sixth Pay Commission’s award; oil and fertiliser subsidies (bonds); food subsidy; additional allocations for the National R ural Employment Guarantee Act; and farmers’ debt relief.

    A quick way to estimate the fiscal stimulus would be to simply take the difference in the fiscal deficit for the financial year (FY) 2007-08 and that for FY 2008-09 projected in the vote on account presented in February 2009, including off-budget items. The figures are 3.1% and 7.8%, respectively. The difference of 4.7% may be said to constitute the additional fiscal stimulus in FY 2008-09.

    However, of this, the increase on account of oil and fertiliser subsidies amounts to 2.6%. It is contended that this merely protects the Indian consumer from increases in the international oil price and is not going to stimulate consumption (although in the absence of the subsidy, consumption would decline). The “real” stimulus, in the sense of expenditure that would stimulate extra consumption, is thus only 2.1%. (At the time of writing, the government has announced a third stimulus of Rs 30,000 crore or 0.5% of GDP.)

    This accords with the minimum stimulus effort of 2% which the IMF has urged. Whether it is adequate for the present s ituation is doubtful, although with the consolidated deficit of the centre and the states (including off-budget items) in the r egion of 10-11% for 2008-09, there is some merit in the contention that the h eadroom for any further stimulus was limited. The best one can hope for is that the new government that comes to power after the general election will revisit the entire budgetary arithmetic in light of lower oil prices and the decline in wholesale price i nflation generally and explore the possibility for a higher fiscal stimulus.

    The monetary response to the financial crisis has been activated primarily since September 2008 following the Lehman collapse. Prior to that, the RBI had focused on fighting inflation and had adopted measures that contributed to tightening rather than relaxation. The flight of capital from India as well as the drying up of dollar credit abroad meant that both rupee and dollar liquidity were tightly squeezed. The sharp depreciation of the rupee with respect to the dollar required the RBI to intervene with dollar sales and this also impacted negatively on rupee liquidity.

    The principal monetary responses since October 2008 include: y reduction in the repo rate from 9% to 5.5% and in the reverse repo rate from 6% to 4%; y reduction in the cash reserve ratio from 9% to 5%; and y reduction in the statutory liquidity ratio from 25% to 24%.

    This was supplemented by a wide variety of measures to s upport liquidity, including to distressed segments of the financial system such as non-banking financial companies (NBFCs) and

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    mutual funds. The RBI estimates that its initiatives have helped augment liquidity to the extent of Rs 3,88,000 crore or nearly 75% of additional commercial credit growth over the year up to 2 J anuary 2009 (RBI 2009).

    5 Impact on the Banking System

    India’s banking system has been considerably less affected by the ongoing crisis than banking systems in the US and Europe. This is because the causes of the crisis in India are quite different from those elsewhere. In the advanced economies, the banking system suffered huge losses, this led to a collapse in the flow of credit and in confidence and dragged down the real economy. In India, it is the real economy that has been affected through various channels and banks are feeling the effects of a slowing down of

    the economy.

    There are three key issues with respect to the banking system: the volume of credit; the price of credit; and the performance of the banking system in today’s stressed conditions. We shall address each of these in turn.

    Table 2: Flow of Financial Resources to the Commercial Sector

    and does not contribute to productive

    Item 2007-08 2008-09 (Up to 4 January 2008) (Up to 2 January 2009)

    activity. If this element is large, it would

    From banks 2,24,921 2,93,243

    imply that credit growth for productive

    From other sources 2,74,563 1,91,470

    activity is not as large as is suggested

    Source: Macroeconomic Review, January 2009, RBI.

    by the figure of 24% growth in the year Table 3: Growth in Non-Food Credit (Rs crore) to date. It would explain industry’s

    It is clear that in one month, October 2008, which was the month consequent to the Lehman failure, there was a huge surge in non-food credit and also a decline in forex reserves. The question that arises is whether the two are correlated. The correlation could potentially arise as follows.

    Banks had sold derivative contracts to corporates. Corporates are known to have suffered mark-to-market losses on these contracts. If these contracts had been settled and not carried forward, the settlement would have been done by banks and would have to be recovered from corporates. These losses of corporates would thus appear on banks’ books as “loans recoverable” and show up as growth in credit. What portion of credit growth is attributable to this element?

    It should be understood that this element constitutes “involun

    tary” loan growth on the books of banks

    2007-08 2008-09 Difference claims about a credit squeeze at a time
    (i) Volume of Credit: Much has been April-26 Sept 115,802 179,777 63,975 when overall commercial credit
    said and written about the credit squeeze April-31 October 141,837 282,537 140,700 growth remains strong. The RBI needs
    faced by industry in recent months. Commercial credit had grown by 24% year on 31 October-26 Sept 26,035 April 1- Jan 30 284,456 Source: Weekly Statistical Supplement, RBI. 102,760 273,303 76,725 -11,153 to shed light on both the trends in nonfood credit and forex reserves

    year up to 2 January 2000. In the corresponding period last year, it grew by 22%. Even after adjusting for credit extended to cash-strapped oil and fertiliser companies, commercial credit growth has been 22%. This year’s credit growth has happened in the face of a deceleration in economic growth in the second half of FY 2008-09. Industry contends that bank credit growth has not been adequate in light of the drying up of credit from a variety of sources.

    The RBI has put out data on total flow of funds to the commercial sector (Table 2). This indicates that total resources have been lower than last year by Rs 15,000 crore or by about 3%. This is not a shortfall that should warrant an outcry about lack of funds of the sort we have been hearing.

    However, trends in non-food credit growth as well as in forex reserves during the year present something of a puzzle. Table 3 presents trends in growth of non-food credit in 2007-09 and 2008-09. In the period April-October 2009, credit grew by a staggering Rs 1,40,700 crore over growth in the previous year. In one month, October, growth in non-food credit was Rs 76,725 crore more than in the previous October.

    By January 2009, the trend mysteriously reverses – credit expansion in the year to date is Rs 11,153 crore lower than in the previous year. What does this mean? What happened to the greater amounts that industry had borrowed up to October 2008 relative to the previous year? Are we to believe that this excess amount was actually returned to the banks by January 2009?

    The trends in forex reserves (Table 4) are also a puzzle. In just one month, October 2008, forex reserves fell by $33 billion or nearly 12% of the total. Between March and September 2008, the decline had been just $24 billion.

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    highlighted above.

    (ii) Cost of Credit: There is also a clamour for a steep reduction in policy rates to facilitate a sharper decline in lending rates. Policy rates have been falling steeply since October 2008 as outlined above. But lending rates have not followed suit. While the repo rate has declined by 350 basis points, the prime lending rate at public sector banks (PSBs) has declined only by a maximum of 150 basis points and that at private banks by 50 basis points. P rivate banks are said to be market savvy while PSBs’ lending d ecisions are said to be subject to political direction. Are we Table 4: Forex Reserves ($ bn)

    to understand, then, that the September 2008

    actions of private banks are October 2008 253 more in consonance with

    Difference 33 Source: Macroeconomic Review, January 2009, RBI.

    market reality?

    There are sound reasons for lending rates not declining as much as expected and the RBI has spelt out these in its macroeconomic review of January 2009:

  • banks face competition for savings from small savings schemes whose rates are administered and relatively inflexible;
  • banks would have mobilised term deposits at higher rates and would face higher cost of funds until such time as the deposits come up for renewal;
  • banks have to raise wholesale deposits in order to meet high demand for credit and such deposits are more expensive than r etail deposits;
  • market borrowings of government are high and will be even higher in light of the fiscal stimuli announced; and
  • there is heightened risk aversion and banks will expect higher spreads over the risk-free rate in today’s conditions.
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    There is a more fundamental reason why lending rates will not decline when policy rates are cut. These rate reductions are quickly transmitted to the government securities market and result in capital gains on banks’ investment portfolios. The total return on government securities (interest plus capital gains) could be in excess of 8%, especially on older securities. Why would banks want to lend at under 10% in such conditions?

    We need a steeper reduction in the statutory liquidity ratio and more players in the government securities market to drive down yields on government securities and the overall return on such securities when interest rates are declining. Only then will i ncentives to lend become stronger in a context where policy rates are declining.

    (iii) Outlook for the Indian Banking Sector: India’s banking sector is in far better shape than its counterparts in the advanced economies. There is a heightened appreciation today – even among long-standing detractors of the RBI – that the bias towards caution in matters regulatory has stood India in good stead.

    Important features of regulation in recent years have been: a gradualist approach towards capital account convertibility; prudence in opening up the sector to private and foreign banks; stringent norms on exposure to sensitive sectors; pre-emptive action in respect of housing, real estate and consumer credit; stricter norms for securitisation; prudential limits on inter-bank borrowing; and tighter regulation of NBFCs. It is unlikely that there will any major departure from these in the near future and we can expect additional regulations based on the lessons drawn from the sub-prime crisis.

    In the year ahead, we can expect the following:

  • A deceleration in commercial credit growth to 15-20%, although the RBI has revised its target to 24%.
  • A decline in the net interest margin consequent to the decline in interest rates. But the margin in India of 2.4% is still on the higher side despite the decline we have seen since 2006-07.
  • An increase in the level of non-performing assets, thanks to stresses among corporates, especially small and medium enterprises, and also in retail credit.
  • However, the Indian banking system is well placed to withstand these adverse conditions because of a whole set of favourable f actors created over a decade and a half of reforms and five years of buoyant economic conditions.
  • Capital adequacy averages 13%.
  • The level of non-performing assets (NPAs) to net advances has been brought down to 1%; and
  • Return on assets is 1%, which constitutes a benchmark for p erformance for banks worldwide.
  • American and European banks have been undone by problems originating in the housing sector and compounded by investments backed by housing loans. There is as yet no sign of a serious collapse in housing prices in India. Even if it happened, the impact on the banking sector would be limited because housing loans constitute only around 10% of all advances. If we assume that 20% of these turn bad – a level seen in the sub-prime crisis – it would translate into an increase in NPAs of 2 percentage points. That would take the ratio of NPAs to advances to 3%, quite bearable given the present levels of capital adequacy.

    The decision to infuse capital into 18 PSBs over the next 24 months is well-timed as it removes uncertainty about these banks’ ability to sustain balance sheet growth at a time when the government’s shareholding is expected to drop to close to 51%.

    6 Conclusions

    The world is in the midst of a severe financial crisis, meaning a crisis that will exact a huge cost in terms of lost economic growth. It is not true, however, that all financial crises are severe. There is a high probability of a financial crisis having an impact on the real economy when there is disruption of the banking sector. S econd, the severity of the crisis is not independent of the policy response. An appropriate policy response does help contain the depth and period of an economic downturn.

    In the present crisis, we contend that the decision to let L ehman Brothers fail was an important landmark. Until then, it was reasonable to expect that the downturn in the US economy would not be very deep and prolonged and the impact on the global economy too would not be great. This is what most forecasts until the Lehman episode had us believe. The revision in forecasts thereafter was occasioned by the consequences of the Lehman failure, especially the loss of confidence among money market funds and the rise in premia on credit default swaps, both of which had serious repercussions for a whole range of financial institutions.

    There is some merit in the “decoupling” hypothesis. Emerging markets appear reasonably decoupled from the advanced e conomies as long as the downturn in the latter is moderate; a serious recession in the advanced economies, however, tends to drag down emerging markets as well. This is because emerging markets get affected initially mainly through the trade channel. When economic conditions in the advanced economies worsen, the financial channel also gets activated.

    India will not escape unscathed in the present crisis because its economy has become more integrated with the rest of the world over the past decade and a half. Overseas finance has become increasingly important for Indian corporates and the drying up of such finance is bound to tell on their fortunes. There is also a broader impact arising from tighter liquidity conditions and a decline in stock prices. India’s authorities have responded to the crisis with both fiscal and monetary stimuli although the scope for the former appears somewhat limited given India’s fiscal position.

    The Indian banking sector is well placed to weather the storm because it is not directly exposed to the financial crisis. It faces secondary effects arising from the slowdown of the economy.


    Bank for International Settlements (2008): BIS Quarterly Review, December. International Monetary Fund (2007): World Economic Outlook, April.

    – (2008): World Economic Outlook, October. Ram Mohan, T T (2008): “From the Sub-prime to the Ridiculous”, Economic &

    P olitical Weekly, 8 November. RBI (2009): “Third Quarter Review, January 2009”, Reserve Bank of India. Reinhart, Carmen and Kenneth Rogoff (2008a): “This Time Is Different: A Panoramic

    View of Eight Centuries of Financial Crises”, Harvard Working Paper, April.

    – (2008b): “The Aftermath of Financial Crises”, paper prepared for presentation

    at the American Economic Association, 3 January 2009. Soros, George (2009): “The Game Changer”, Financial Times, 28 January. Subbarao, D (2009): “Impact of the Global Financial Crisis on India: Collateral

    D amage and Response”, Speech delivered in Tokyo, 18 February. Taylor, John B (2009): “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong”, NBER Working Paper, January.

    march 28, 2009 vol xliv no 13

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