Global Financial Crisis: Causes, Consequences and India’s Prospects By RAKESH MOHAN

1. Global Financial Crisis: Causes, Consequences and India’s Prospects By RAKESH MOHAN Deputy Governor Reserve Bank of India

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

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

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

5. Global Financial Crisis (2)Current Account Balance (per cent to GDP)

6. Global Financial Crisis (4)US Monetary Policy (1) • Volatility in monetary policy in advanced economies • Large volatility in capital flows to EMEs • Again very loose MP in US – likely surge in capital flows to EMEs?

7. Global Financial Crisis (5)US Monetary Policy (2) • US Monetary policy too loose during 2002-04; aggregate demand exceeded output; large current a/c deficit; mirrored in large surpluses in China and elsewhere.

8. Global Financial Crisis (6)US Monetary Policy (3) • Large Fed cuts in 2007: strong boost to oil, other commodity and asset prices

9. Global Financial Crisis (3)Capital Flows to Emerging Market Economies • Very large capital flows to EMEs –– now outflows in 2009 - large volatility - implications for monetary management and financial stability

10. Global Financial Crisis (7) Worsening Global Economic Outlook

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

12. Impact on India (1)Trends in Capital Flows

13. Impact on India (2)Key Macro Indicators

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

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

16. Differences Between Financial Crisis in US/Europe and India (2) • Our Problems • Reduction in capital flows • Pressure on BoP • Stock markets • Monetary and liquidity impact Temporary impact on MFs/NBFCs (Sept-Oct) Reduction in flow from non-banks Perceptions of credit crunch

17. Differences Between Financial Crisis in US/Europe and India (3) • Our Problems • Fiscal stress • Oil, Fertiliser, Food subsidies • Pay Commission, Debt waiver, NRE • Stimulus packages • GFD/GDP ratio: 5.5-6.0% Large increase in market borrowings

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

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

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

21. Measures since Mid-September, 2008 (1) • Expanding rupee liquidity • Reduction in CRR (400 bps) & SLR (100 bps) • Special Repo window under LAF for banks on-lending to NBFCs, HFCs & MFS • Special Refinance to banks without collateral • Unwinding of MSS – buyback/desequestering • OMOs – pre-announced calendar • Cut in repo (425 bps) and reverse repo (275 bps) rates. • Existing instruments – enough flexibility • MSS and CRR – good, effective buffers of liquidity – both absorption and injection

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

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

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

25. Measures since Mid-September, 2008 (5)Impact of Measures (2)

26. Measures since Mid-September, 2008 (6)Total Resource Flow from Banks and Non-banks

27. Measures since Mid-September, 2008 (7)Inflation in India

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

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

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

31. Medium-term Issues and Challenges (1)Macroeconomic Indicators at a Glance • Continuing increase in real GDP growth - Interregnum during the 1970s • Secular uptrend in domestic saving and investment -investment largely financed by domestic savings • Continuation of growth in domestic savings necessary; fiscal prudence

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

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

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

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

36. Medium-term Issues and Challenges (6)External Sector (1) • Optimal response to the large and volatile capital flows is a combination of (CGFS, 2009) • sound macroeconomic policies • prudent debt management • exchange rate flexibility • effective management of the capital account • accumulation of appropriate levels of reserves as self-insurance and • development of resilient domestic financial markets • combination is country-specific; no “one size fits all”.

37. Medium-term Issues and Challenges (7)External Sector (2) Indian policy approach to CAL Distinction between debt and equity flows Higher inflation and interest rates in India vis-a-vis advanced economies Liberalisation of debt flows can lead to arbitrage flows Ceilings on debt flows appropriate

38. Medium-term Issues and Challenges (8)Financial Sector • Commercial banks robust • Committee on Financial Sector Assessment (CFSA) • Stability Assessment and Stress Testing • Concerns about credit risk remain muted at present • Note: CRAR = credit to risk-weighted assets ratio

39. Medium-term Issues and Challenges (9)Conclusion India’s fundamentals remain strong Financial sector robust Monetary policy – sufficient instruments, flexible Corporate sector not too leveraged – second round of restructuring going on – productivity gains Foreign direct investment buoyant Agriculture improving Growth domestically financed Indian economy should be able to recover fast and return to 9%+ growth path

40. Thank You