The Reserve Bank of India has released today its Report on Currency and Finance, 2008-09 on “Global Financial Crisis and the Indian Economy.  From 1998-99, the Report has focused on select themes (see table).  The theme of this report is both timely and relevant, as it reflects upon the global financial crisis of 2008 and its widespread impact--including in India--and draws an objective assessment of its global impact, with particular emphasis on the Indian economy. The Report highlights many policy lessons from the crisis and future challenges.

Highlights from the Report:

• The recent crisis has been the worst since the Great Depression in terms of geographical spread and intensity. A comparison with other episodes of crisis reveals similarities: systemic fragilities and imbalances in the functioning of the global economy. However, the recent crisis has been more global due to the enhanced financial linkages that prevail today.

• High global inter-linkages led to the adverse impact of the crisis on real economic activity being felt in every part of the world.

• The volatilities in the financial markets, along with the slowdown in economic activities in the advanced economies, were transmitted to the emerging market economies (EMEs) through both trade and financial (especially through capital flows) channels.

• Despite a modest decline, remittance inflows have remained more resilient  than private debt and equity flows and have become important as a source of external financing in many developing countries.

• The crisis saw the unprecedented use of both conventional and unconventional policy measures. Governments and central banks across the countries also responded to the crisis through large-scale fiscal and monetary support of the financial system, and through increased coordination of both monetary and fiscal policy.

• Sustained economic recovery will require re-orienting the supervisory approach and strengthening regulatory and legal framework.

Impact of Crisis and Policy Responses in India

• In India, the crisis was transmitted through four channels--trade, financial, commodity prices and expectations channels.

• The financial channel was more pronounced due to increased globalisation in the recent period. The banking sector in India, however, displayed resilience during the current global financial meltdown. The strength and resilience in the balance sheets of Indian banks was derived from being well-capitalised and having greater exposure to domestic conventional assets.

• The measures put in place by the Reserve Bank and the Government of India since mid-September 2008 ensured that the Indian financial sector continued to function in an orderly manner.

Lessons and Future Challenges

• The Report points to the widely perceived need to revisit and redefine the role of central banks, particularly in the context of (i) their role in asset markets, (ii) as a lender of last resort and (iii) clear communication with the market.

• The crisis highlighted some keylessons: market discipline and supervision should complement each other; greater market transparency is crucial; countries need to contain their fiscal deficits so as to meet debt service obligations; and the need for global economic co-ordination.

• Specific lessons for EMEs, including India, include

  1. recognising the invalidation of de-coupling hypothesis,
  2. the importance of domestic demand  as a durable source of growth,
  3. financial sector reforms that emphasize the balance between efficiency and innovation on the one hand and stability and safety on the other,
  4. acautious approach to the pace and scope of capital account liberalization,
  5. need for development of local bond market,
  6. creation of fiscal policy space on a sustainable basis as a central feature of their reform agenda,
  7. need for social security system, and
  8. a reasonable amount of self-insurance against crisis.

• Future challenges for policymakers include: what role should central banks play in financial regulation and supervision; dealing with existing information asymmetries, striking a balance between regulation and market innovation; managing the challenges of globalization for macroeconomic policymaking; managing an exit strategy that balances growth and inflation; and avoiding protectionist measures.

Details

Chapter Scheme

The Report has seven chapters. After setting forth the rationale for the theme of the Report in Chapter 1, Chapter 2 “Genesis and the Nature of the Crisis” traces the origin and nature of the crises. This chapter also covers the crisis in a historical perspective by comparing the present crises with the earlier episodes of a similar nature. Chapter 3 “Manifestation of the Crisis” attempts to analyze the impact of the crisis on the various sectors of the global economy, such as financial markets, financial institutions, international trade, international capital flows, remittances and the real economy. Chapter 4, “International Responses to the Crisis” elaborates on the measures taken by the international community and evaluates them against the backdrop of the conventional crisis management strategies. Chapter 5 “Impact and Policy Responses in India: Financial Sector” and chapter 6 “Impact and Policy Responses in India: Real Sector” outlines the impact of the global financial crisis on the Indian economy and the policy responses of the authorities. The final Chapter 7 “Lessons from the Crisis and Future Challenges” draws lessons from the crisis in an effort to identify future challenges.

Chapter 2: Genesis and Nature of the Crisis

A comparison with the Great Depression of the 1930s indicates that the recent crisis is the worst since the Great Depression in terms of geographical spread and intensity.  A number of micro and macroeconomic factors have been listed in the literature as the proximate causes of the crisis – role of easy money, financial innovations and global imbalances on the one hand and regulatory loopholes both at the national and global level on the other. The present crisis has also rekindled interest in the history of financial crises. A comparison of the several other episodes of crisis reveals similarities in the underlying causes, viz., systemic fragilities and imbalances in the functioning of the global economy. Though the US has been at the centre of both crises (Great Depression and the recent one) and both have been essentially financial and banking crises, the recent crisis has been more global due to the enhanced financial linkages that prevail today. The recent crisis seems to be less adverse than the previous episodes of crises in terms of duration, although the extent of output loss is estimated to be much larger.

Chapter 3: Manifestation of the Crisis

All segments of the global financial markets experienced tremors of the financial crisis in varying degrees. The financial institutions, the principal players behind the crisis, were the worst affected. Commercial banks suffered a decline in profitability and large mark-to-market losses, giving rise to bank failures in the US and other mature economies in Europe. Financial performance of monoline insurers was also severely affected.

The volatilities in the financial markets, along with the slowdown in economic activities in the advanced economies, were transmitted to the emerging market economies (EMEs) through both trade and financial channels. The declines in trade flows since October 2008 were larger than in the past due to the sharp reductions in prices along with volumes. Despite a modest decline, remittance inflows have remained more resilient compared to private debt and equity flows and have become important as a source of external financing in many developing countries. Apart from trade, the crisis spread through the financial channel, especially through capital flows. During the pre-crisis years 2002-2007, capital flows to developing and emerging market economies were very large, creating new exposures and new risks. On an average, the levels of net private inflows to EMEs during crisis years 2008 and 2009, were just about half of those during 2007. The countries that had built up their international reserves from capital flows in the past years experienced a decline in their reserve levels. Nevertheless, reserves acted as buffer against volatile capital flows and provided confidence to the market in the inherent strength of the macroeconomic fundamentals of several economies including India. An important development during 2009 was the marginal contraction in the global imbalances.

With regard to the impact on the real economy, every region has been affected by the global crisis, irrespective of the differences in their economic structures or policy frameworks. The crisis highlighted the vulnerability of a growth strategy that is based on over-dependence on export demand. Consumption and investment witnessed sharp contractions in line with the fall in output and productivity.  Industrial production collapsed in response to contraction in global trade while unemployment rates touched all-time highs.

Chapter 4: International Response to the Crisis

The crisis saw the unprecedented use of both conventional and unconventional policy measures. The monetary policy response to the crisis began with the conventional measure of easing policy rates in advanced countries. This was increasingly carried out in a co-ordinated manner among the major central banks as the crisis deepened. But the persistence of financial strains even after the policy rate was brought down to zero or near-zero levels led to unleashing of a number of unconventional measures on a scale hitherto unseen. These unconventional measures included: central bank foreign exchange swap and collateralised lending; domestic liquidity easing; and credit and quantitative easing. In the EMEs, the unconventional measures-- provision of foreign exchange by the central banks-- preceded the conventional policy rate cuts, as the liquidity constraints first surfaced in the foreign exchange market. Countries across the globe activated counter-cyclical fiscal policy simultaneously to overcome the economic slowdown. However, the size, composition and duration of the stimulus measures have varied among the countries.

Governments across the countries responded through large-scale fiscal support of the financial system. The severity of the financial crisis called for responses which included varying combinations of deposit guarantees, debt guarantees, capital injections, asset purchases, and monetary and fiscal measures to stimulate the economy. These measures, too, were co-ordinated globally.

The crisis has highlighted the need for an increased coordination of both monetary and fiscal policy, as well as the need for international coordination. The large-scale economic downturn and impairment of the monetary transmission mechanism have warranted monetary policy to be accommodative to fiscal policy. The massive expansion of central bank balance sheets through some of the quasi-fiscal functions of credit/quantitative easing undertaken has also increased the need for closer co-operation between the two authorities. Furthermore, as a large fiscal deficit can potentially conflict with the objectives of monetary policy and financial stability in the near future, the need for co-ordination continues to remain. Besides, the crisis has amply demonstrated the need for international co-ordination.

Sustained economic recovery will require re-orienting the supervisory approach and strengthening regulatory and legal framework. The financial sector reforms under progress in various countries are being worked on a very wide canvas encompassing a revamp of the prudential standards, accounting practices and transparency norms.

Chapter 5: Impact and Policy Responses in India: Financial Sector

Since mid-September 2008, due to the knock-on effects of the global financial crisis, the India's financial markets – equity markets, money markets, forex markets and credit markets – came under pressure from a number of directions. The crisis was transmitted through four channels--trade, financial, commodity prices and expectations channels. The financial channel was more pronounced due to increased globalisation in the recent period. The banking sector in India, however, displayed resilience during the current global financial meltdown. The strength and resilience in the balance sheets of Indian banks was derived from being well-capitalised and having greater exposure to domestic conventional assets, unlike advanced countries where the banking sector had extensive exposure to sub-prime mortgage markets (particularly, in the US) and other exotic structured products. Furthermore, the banking sector in India, unlike in advanced countries, is dominated by commercial banking and not investment banking.

The measures put in place by the Reserve Bank and the Government of India since mid-September 2008 ensured that the Indian financial sector continued to function in an orderly manner.  Actions taken by the Reserve Bank of India differed from the central banks of many advanced countries.

• First, in the process of liquidity injection the counterparties involved were banks.

• Second, there was no dilution of collateral standards which were largely government securities, unlike the mortgage securities and commercial papers in the advanced economies.

• Third, despite a large liquidity injection, the Reserve Bank’s balance sheet did not show an unusual increase, unlike global trends, because of the earlier release of sterilised liquidity.

• Fourth, the availability and deployment of multiple instruments facilitated better sequencing of monetary and liquidity measures.

• Finally, the experience in the use of pro-cyclical provisioning norms and counter-cyclical regulations ahead of the global crisis helped enhance financial stability.

Chapter 6: Impact and Policy Responses in India: Real Sector

Empirical evidence confirms that the current global crisis accentuated the cyclical downturn in the Indian economy, adversely affecting private consumption and investment and thereby affecting saving. The early impact of the sub-prime crisis on the real sector of the Indian economy was muted as the crisis was restricted to turmoil in international financial markets. However, due to compositional shift in aggregate demand, the Indian economy became more vulnerable to external shocks compared to the earlier period. This is clearly visible in the decline in the growth rate of the Indian economy as the current global crisis gathered momentum with widespread impact across sectors. With increased global integration, the Indian economy’s growth movements have been more correlated with growth movements in the world economy. During previous episodes of crises, viz., the balance of payments (BOP) crisis in India (1990-91), the East Asian Crisis (1997-1998) and the dot-com crisis in the US (2001-2002), India experienced a slowdown in its growth momentum and a concurrent deceleration in the growth of gross domestic savings. A similar phenomenon has been observed during the current global financial crisis.

The Indian economy is vulnerable to external demand shocks, with a large impact on output and employment. Empirical evidence suggests that with high global growth, the pull factor operating on India’s exports could be sizeable. Research suggests that 42 per cent of the manufacturing exports is accounted for by employment intensive sectors like leather and manufactures, textile and textile products, gems and jewellery and handicrafts. Thus, an external demand shock has a larger impact on output and employment in such industries, with implications for domestic consumption demand. Further, the most direct impact of the global commodity cycle on the economy comes through the prices of primary commodities.

The impact of the financial channel was more distinct with sharp decline in portfolio inflows, external commercial borrowings, trade credit, and overseas borrowings of banks. Inflows under foreign direct investment and non-resident deposits, however, showed resilience.

Chapter 7: Lessons from the Crisis and Future Challenges

The Report points to the widely perceived need to revisit and redefine the role of central banks, particularly in the context of (i) their role in asset markets, (ii) as a lender of last resort and (iii) communication with the market. The recent crisis has led to a debate as to whether central banks’ monetary policy has any role to rein in asset booms. Some hold the view that forward looking monetary policy should provide the lead indicator for the stance of macroprudential policies. The recent crisis has brought to the fore the issue of the efficacy of central banks as a lender of last resort (LOLR). As the crisis unfolded, a radically changed concept of the LOLR had to be put into practice by the central banks. Central banks needed to adopt a more flexible approach and strengthen their capacity to provide liquidity and respond to systemic shocks. It was felt that not only central bank policy measures need to be clearly communicated, the dissemination of timely information on economic outlook by central banks is extremely crucial.

A key lesson that emerged from the crisis is that market discipline and supervision should complement each other. In this context, it is important that regulators look at system-wide risk and not just individual institution-specific risk. The supervisors and regulators need to evaluate the financial system in its entirety, given the experience that developments in one area can often have a damaging impact elsewhere. In addition, supervision needs to factor in the horizontal interconnectedness across banks, financial institutions, markets and geographies.

The recent crisis also underscored the importance of greater market transparency. This includes transparency about the techniques; caveats surrounding the valuation of complex financial instruments; improved information regarding OTC markets and clearing arrangements; and reporting of exposures (on- and off-balance sheet) in a format that permits regulators to aggregate and assess risks to the system as a whole. In addition, regulators need to ensure that (i) policies to mitigate pro-cyclicality in regulation and accounting are put in place, (ii) resolution mechanism for non-banking institutions is in place, (iii) capital rules are targeted efficiently (iv) effective mechanism for regulation of cross-border institutions exists, (v) credit and equity culture are not mixed and, (vi) reforms in compensation structure of financial firms is undertaken, (vii) financial innovations are welfare enhancing and cater to the needs of real economy (viii) proper coordination between monetary and regulatory authorities.

The crisis also pointed to the need for better coordination at the global level. As shocks can transmit across borders through non-traditional channels too, areas that need a better coordination at the global level include (i) co-ordination of resolution tools for financial entities, (ii) consistency and co-ordination in depositor and investor protection and (iii) clear legal obligations and powers to share information between home and host countries. Turning to multilateral institutions, the IMF’s surveillance mechanism needs to clearly indicate its perception on potential threats to national and global financial stability. While the resources of the IMF have been raised, the governance issues like quotas are still in pipeline.

The crisis underscores that countries should contain their fiscal deficits at a level that is consistent with their ability to meet debt service obligations. Financial crisis can suddenly burden fiscally imprudent countries with further high fiscal deficits and debt ratios, as has been seen in case of Greece and some other European countries. It is argued that rating agencies should be regulated and a certain element of social responsibility needs to be introduced into their functioning. Regulatory policy measures should be geared towards reducing conflicts of interest at the rating agencies and encouraging investor due diligence, especially of large institutions.

There are specific lessons for EMEs, including India, as they formulate their policies. These lessons include (i) recognising the invalidation of de-coupling hypothesis, (ii) allowing domestic demand to serve as a durable source of growth, (iii) financial sector reforms, (iv) a cautious approach to the pace and scope of capital account liberalization, (v) need for development of local bond market, (vi) creation of fiscal policy space on a sustainable basis as a central feature of their reform agenda, (vii) need for social security system and (viii) self insurance against crisis.

Post-crisis, policymakers face many challenges.

• First and important challenge is with regard to future of financial regulation. For instance, what should be the regulatory models, i.e. whether central banks should also be doing bank regulation and supervision.

• Second pertains to resistance that policymakers and international standards-setting bodies may face while convincing financial market players about the desired future agenda of reforms.

• Third, regulators need to deal with existing information asymmetries.

• Fourth, there is a need to strike a right balance between regulation and market innovation.

• Fifth, policymakers will need to manage the challenges from globalisation to their macroeconomic policies.

• Sixth, how to incorporate financial factors in the standard models of the transmission mechanism used by central banks.

• Seventh, policymakers will need to devise a calibrated exit balancing growth and inflation.

• Finally, policymakers need to face the challenge of resisting any direct and indirect protectionist measures to the extent possible to protect their domestic economies.

DISCLAIMER

The findings, views, and conclusions expressed in this Report are entirely those of the contributing staff of the Department of Economic Analysis and Policy (DEAP) and should not necessarily be interpreted as the official views of the Reserve Bank of India.

 Alpana Killawala
Chief General Manager

Press Release : 2010-2011/9