Global Financial Crisis: Causes, Consequences and

India’s ProspectsBy

RAKESH MOHANDeputy Governor

Reserve Bank of India At

Annual General Meeting of Indian Banks’ Association

May 11, 2009

Scheme of Presentation

Global Financial CrisisImpact on IndiaDifference between US/Europe and

IndiaLessons from the CrisisMedium-term Issues and Challenges

Scheme of Presentation

Global Financial Crisis

Impact on IndiaDifference between US/Europe and

IndiaLessons from the CrisisMedium-term Issues and Challenges

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)

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

Country 1990-94 1995-99 2000-04 2005 2006 2007 2008China 1.4 1.9 2.4 7.2 9.5 11.0 10.0India -1.3 -1.3 0.5 -1.3 -1.1 -1.0 -2.8Russia 0.9 3.5 11.2 11.0 9.5 5.9 6.1Saudi Arabia -11.7 -2.4 10.6 28.7 27.9 25.1 28.9United Arab Emirates 8.3 4.6 9.9 18.0 22.6 16.1 15.8United States -1.0 -2.1 -4.5 -5.9 -6.0 -5.3 -4.7Memo:Euro area n.a. 0.9 0.4 0.4 0.3 0.2 -0.7Middle East -5.1 1.0 8.4 19.7 21.0 18.2 18.8Source: World Economic Outlook Database, April 2009, International Monetary Fund.

Note: (-) indicates deficit.

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?

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.

Global Financial Crisis (6)US Monetary Policy (3)

Large Fed cuts in 2007: strong boost to oil, other commodity and asset prices

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

Global Financial Crisis (7) Worsening Global Economic Outlook

Growth Forecast of IMF (per cent)

Region April 2008 July 2008 October 2008 April 2009

 2008 2009 2008 2009 2008 2009 2008 2009

Advanced countries 1.3 1.3 1.7 1.4 1.5 0.5 0.9 (-)3.8

EMEs 6.7 6.6 6.9 6.7 6.9 6.1 6.1 1.6

World 3.7 3.8 4.1 3.9 3.9 3.0 3.2 (-)1.3

Global Trade Volume (Goods and Services)

World 3.7 3.8 4.1 3.9 3.9 3.0 3.3 -11.0

Scheme of Presentation

Global Financial Crisis

Impact on IndiaDifference between US/Europe and

IndiaLessons from the CrisisMedium-term Issues and Challenges

Impact on India (1)Trends in Capital Flows

Component Period 2007-08   2008-09

Foreign Direct Investment to India April-March 34.4 33.6

FIIs (net) April-March 20.3 -15.0

External Commercial Borrowings (net) April- December 17.5 6.0

Short-term Trade Credits (net) April- December 10.7 0.5

Total capital flows (net) April- December 82.0 15.3

Memo:

Current Account Balance April- December -15.5 -36.5

Valuation Gains (+)/Losses (-) on Foreign Exchange Reserves April- December 9.0 -33.4

Foreign Exchange Reserves (variation)

April-December 76.1 -53.8

April-March 110.5  -57.7

Impact on India (2)Key Macro Indicators

Indicator Period 2007-08 2008-09

Growth, per cent

Real GDP Growth April-December 9.0 6.9

Industrial production April-March 8.5 2.4

Services April-December 10.5 9.7

Exports April-March 28.4 6.4

Imports April-March 40.2 17.9

GFD/GDP April-March 2.7 6.0

Stock Market (BSE Sensex)

April-March 16,569 12,366

Rs.per US$ April-March 40.24 45.92

Scheme of Presentation

Global Financial CrisisImpact on India

Difference between US/Europe

and IndiaLessons from the CrisisMedium-term Issues and Challenges

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

Differences Between Financial Crisis in US/Europe and India (2)

Our Problems Reduction in capital flows

Pressure on BoPStock marketsMonetary and liquidity impact

Temporary impact on MFs/NBFCs (Sept-Oct)

Reduction in flow from non-banks

Perceptions of credit crunch

Differences Between Financial Crisis in US/Europe and India (3)

Our Problems Fiscal stress

Oil, Fertiliser, Food subsidiesPay Commission, Debt waiver, NREStimulus packagesGFD/GDP ratio: 5.5-6.0%

Large increase in market borrowings

Rs. crore

2008-09 BE 2008-09 RE 2009-10 BE

Gross 1,76,453 3,42,769 3,98,552

Net 1,13,000 3,29,649 3,08,647

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.

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 regulationboth 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 itemsBasel II framework: guidelines issued. Dynamic provisioningNBFCs: regulation and supervision tightened - to

reduce regulatory arbitrage.

Scheme of Presentation

Global Financial CrisisImpact on IndiaDifference between US/Europe and

IndiaLessons from the Crisis

Medium-term Issues and Challenges

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

Scheme of Presentation

Global Financial CrisisImpact on IndiaDifference between US/Europe and

IndiaLessons from the Crisis

Medium-term Issues and Challenges

Medium-term Issues and Challenges (1)Macroeconomic Indicators at a Glance

(Per cent)

1950-51 to

1964-651965-66 to

1980-81 1980s 1990-91

1991/92 to

1996-97

1997/98 to

2002/03

2003/04To

2007/08

1 2 3 4 5 6 7 8

1. Real GDP Growth 4.1 3.2 5.6 5.3 5.7 5.2 8.7

Agriculture 2.9 2.1 4.4 4.0 3.7 0.9 4.4

Industry 6.7 4.2 6.4 5.7 7.0 4.1 8.4

Manufacturing 6.6 3.9 5.8 4.8 7.5 3.9 9.1

Services 4.9 4.2 6.3 5.9 6.4 7.8 10.3

2. Real GDCF/GDP 13.5 19.2 20.2 24.4 22.5 24.1 31.4

3. ICOR 3.3 6.0 3.6 4.6 4.0 4.6 3.6

4. Nominal GDCF/GDP 11.8 16.7 20.8 26.0 23.9 24.5 33.0

5. GDS/GDP 10.3 15.9 19.0 22.8 22.7 24.1 32.7

6. Saving-Investment Gap -1.5 -0.7 -1.8 -3.2 -1.2 -0.4 -0.3 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

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.

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.

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.

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?

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”.

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

Medium-term Issues and Challenges (8)Financial Sector

  Without Stress

Scenario - increase in NPA by:

100 per cent 150 per cent

  CRAR (%) CRAR (%) CRAR (%)

Mar-08 13.0 11.6 11.0Sept–08 12.5 11.1 10.6

•Note: CRAR = credit to risk-weighted assets ratio

Commercial banks robustCommittee on Financial Sector Assessment

(CFSA)

• Stability Assessment and Stress Testing

• Concerns about credit risk remain muted at present

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

Thank You