Global Financial Crisis and How India is Coping with it

N.A. Mujumdar

The global financial system is in a crisis of unprecedented dimensions. The situation described as the worst since the 1929 Great Depression continues to remain even today unsettled and uncertain. The problems that originated in large-scale defaults in the US sub-prime mortgage market and associated market for complex credit derivatives in August 2007, spread like conflaggeration to the financial sector as a whole in the U.S. and then to Europe, and then to the other parts of the world. There have been sharp declines in stock markets across the world, disruptions in international money markets and all this is fuelling investor panic. Will this global financial instability weaken global growth and portend the arrival of global recession? Governments and Central Banks have responded to the crisis with aggressive and unconventional measures to restore calm and confidence to the markets. Moreover, IMF has come to the rescue of some of the worst affected countries like Iceland, Ukraine and Hungary. In fact IMF would create a new short-term lending facility to channel funds quickly to emerging markets to tide over liquidity problems faced during the current crisis.

Though India is outside the epicenter of this crisis, it cannot be immune to these global developments. The Reserve Bank of India (RBI) is proactive and has taken several steps to minimise the adverse impact of the global financial crisis on the Indian economy. Dr. D. Subbarao, Governor, RBI devoted a considerable part of his “Mid-term Review of the Annual Policy Statement for the year 2008-09” made on October 24, 2008, to provide useful insights into this phenomenon and to indicate how India is coping with the crisis.

But first the global scenario. What happened in September 2008 in the U.S. is now history. In early September two large U.S. government – sponsored mortgage banks were put into conservator ship by the Government: in mid-September a major investment bank filed for bankruptcy and two investment banks were permitted by regulators to become commercial banks. On September 25, money markets ground to a halt and interbank and repo rates, rose to almost record levels. The U.S. financial system has virtually collapsed. The U.S. Treasury announced a rescue plan of $700 billion to clear the bad debt overhang. On October 14, 2008 the Board of Governors of the Federal Reserve System, the U.S. Department of Treasury and the Federal Deposit Insurance Corporation (FDIC) made a joint statement affirming their resolve to protect the U.S. economy, to strengthen public confidence in the financial institutions, and to foster robust functioning of credit markets.

This wave of banking contagion swept through Benelux, Germany, U.K., Spain Ireland and Iceland and this provoked Government intervention and in fact some banks were nationalised, ostensibly on a temporary basis. U.K. has taken steps to recapitalisation of the banking system. The Government of Australia and New Zealand have announced their decision to guarantee bank deposits.

The world has witnessed unprecedented co-operation among major Central Banks and joint actions to harmonise their policies. These actions focused on two objectives: to inject massive liquidity in the system and to reduce policy interest rates. On October 13, 2008, Bank of England, the European Central Bank, Federal Reserve Bank of Japan and Swiss National Bank jointly announced measures to improve liquidity. Similarly, the Bank of England, the European Central Bank, the Federal Reserve, the Sveriges Riks Bank and the Swiss National Bank reduced their policy rates by 50 basis points on October 8, 2008. This is concrete evidence, if proof indeed is needed, of the severity of the crisis facing the global financial system.

As a cumulative result of these disturbances, global economic prospects have been dampened by the weakening of the U.S. economy, the wider repercussions of the ongoing financial market crisis and volatility in the energy, food and commodity prices. According to the World Economic Outlook of the IMF, global GDP growth is expected to decelerate from 5 per cent in 2007, to 3.9 per cent in 2008, and further to 3 per cent in 2009.

How is India coping up with this global crisis? Dr. Subbarao, Governor of RBI makes the following reassuring statement: “India’s financial sector is stable and healthy. All indicators of financial strength such as capital adequacy, ratios of non-performing assets (NPA), and return on assets (ROA) for our commercial banks, which account for 88 per cent of banking assets, are robust. While many banks and quasi – banking financial institutions in advanced countries suffered large losses and needed substantial capital infusion and bail out packages, Indian banks have been affected only peripherally as they do not have direct financial exposure to the U.S. sub-prime assets ……… The overall capital adequacy ratio of commercial banks in India is 12.7 per cent, well above the regulatory minimum of 9 per cent and the Basel Accord requirement of 8 per cent …… Furthermore, the regulatory mandate of keeping 25 per cent of net demand and time liabilities as SLR and 6.5 per cent as CRR provides an inherent strength to Indian banks.

One of the major problems faced by Indian banks was the unusual tightening of liquidity in recent weeks caused in part by portfolio investment outflows by Foreign Institutional Investors (FIIs). For instance, portfolio investment outflows recorded net outflows of $7.3 billion during the current financial year upto October 10, 2008, in contrast to net inflows of $18.9 billion in the corresponding period of last year. RBI therefore took several measures since mid-September 2008 to assuage the liquidity stress: these included cumulative reduction of 250 basis point in CRR with effect from October 11; a special facility of RS. 20,000 crore to alleviate the liquidity pressures faced by mutual funds; and provision of Rs. 25,000 crore to banks as the first instalment of the Agricultural Debt Waiver and Debt Relief Scheme. The total liquidity support extended to banks thus worked out to a massive figure of Rs. 1,85,000 crore. The easing of the liquidity pressures is reflected in the fact that the call money rates which had touched a peak of 19.8 per cent on October 10, eased to normal levels subsequently.

The most obvious victim of the global melt down was the stock market. In India the bull market phase from 2003 till early 2008 was unprecendented, the Sensex reaching the peak of 20,873 on January 8, 2008. Subsequently, sensex started sliding but the fall was precipitous in October 2008, partly reflecting the contagion impact of what was happening in New York or London markets and partly as a result of massive outflows of funds through FIIs, discussed above. The Sensex reached 8701 on October 24 – the lowest level during the last 35 months. Although the index rose somewhat subsequently it has remained below the 10,000 level.

RBI acted again on November 1st, by reducing both CRR (Cash Reserve Ratio and SLRC statutory Liquidity Ratio) by 1 per cent each. In, effect this measure meant that banks’ usable resources were replenished by Rs. 80,000 crores. Dr. S.S.Tarapore, former Deputy Governor RBI, estimates that total liquidity pumped in by RBI through all these measures adds up to a staggering figure of Rs. 300,000 crore. Is there a surfeit of liquidity now? The underlying idea was to create an enabling environment for banks to reduce their lending rates. The private corporate sector was clamouring for a cheap landing rates structure and with a little nudging from Finance Minister, public sector banks, led by the State Bank of India decided to reduce their prime lending rates by 75 basis points with effect from November 10. One hopes that cheaper credit will spur corporate sector growth

India has thus coped with the global financial crisis reasonably well. For instance, RBI has revised its GDP forecast for 2008-09 only marginally down from 8 per cent to some 7.5 per cent. There are two other factors which would help India sustain such a high growth in a world threatened by recession. First externally, crude oil prices have shown a dramatic decline from $ 145 per barrel on July 3, 2008 to around $60 today. Secondly, domestically, inflation is decelerating: inflation which had reached 12:76 per cent in August, has now declined below 11 per cent. As Governor Dr. Subbarao has emphasized: “Quite evidently, the upward shift in our growth trajectory has been possible because of higher pace of investment. Investment as a share of GDP, increased from 25 per cent in 2002-03 to 38 per cent in 2007-08. Of this 13 percentage points increase, as much as 10 percentage points was financed domestically through higher household, public sector and corporate savings”. Interestingly enough inward foreign direct investment (FDI) has continued to remain buoyant during the current year. Thus India’s growth story is still intact and credible.

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