Global Financial Crisis:

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Global Financial Crisis Causes, Consequences
and Indias Prospects By RAKESH MOHAN Deputy
Governor Reserve Bank of India At Annual General
Meeting of Indian Banks Association May 11, 2009
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Scheme of Presentation

• Global Financial Crisis
• Impact on India
• Difference between US/Europe and India
• Lessons from the Crisis
• Medium-term Issues and Challenges

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Scheme of Presentation

• Global Financial Crisis
• Impact on India
• Difference between US/Europe and India
• Lessons from the Crisis
• Medium-term Issues and Challenges

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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)

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

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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.

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

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

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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

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Global Financial Crisis (7) Worsening Global
Economic Outlook
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Scheme of Presentation

• Global Financial Crisis
• Impact on India
• Difference between US/Europe and India
• Lessons from the Crisis
• Medium-term Issues and Challenges

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Impact on India (1)Trends in Capital Flows
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Impact on India (2)Key Macro Indicators
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Scheme of Presentation

• Global Financial Crisis
• Impact on India
• Difference between US/Europe
• and India
• Lessons from the Crisis
• Medium-term Issues and Challenges

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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

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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

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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

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Differences Between Financial Crisis in US/Europe
and India (4)

• Indias 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.

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Differences Between Financial Crisis in US/Europe
and India (5)

• Indias 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.

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Scheme of Presentation

• Global Financial Crisis
• Impact on India
• Difference between US/Europe and India
• Lessons from the Crisis
• Medium-term Issues and Challenges

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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

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Scheme of Presentation

• Global Financial Crisis
• Impact on India
• Difference between US/Europe and India
• Lessons from the Crisis
• Medium-term Issues and Challenges

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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

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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.

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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.

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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.

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Medium-term Issues and Challenges (5)Monetary
Policy (2)

• Further development of financial markets
• Large capital inflows in recent years
• Reserve Banks 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?

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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.

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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

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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

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Medium-term Issues and Challenges (9)Conclusion

• Indias 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

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• Thank You