Deepak Mohanty: Global financial crisis and monetary policy response in
India
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
3rd Indian Council for Research on International Economic Relations-Internationale
Weiterbildung und Entwicklung (ICRIER-InWEnt) Annual Conference, New Delhi,
12 November 2009.
* * *
The assistance provided by Shri Bhupal Singh is gratefully acknowledged.
I thank ICRIER and InWEnt for giving me this opportunity to speak with you this morning. In
my talk, I will try to address the following set of questions: How and why was India impacted
by the global financial crisis? How did monetary policy respond to the crisis? What was the
impact of the policy on the Reserve Bank's balance sheet? How did monetary transmission
work? I will conclude by highlighting the challenges of exit from monetary easing.
2. The subprime crisis that emerged in the US housing mortgage market in 2007
snowballed into a global financial crisis, and a global economic recession followed. The
financial landscape has changed significantly after the collapse of Lehman Brothers in
September 2008. An important lesson, post-September 2008, is that irrespective of the
degree of globalisation of a country and the soundness of its domestic policies, a financial
crisis could spread to every economy.
3. The international transmission of liquidity shocks was fast and unprecedented. While
falling asset prices and uncertainty about valuation of the traded instruments affected market
liquidity, failure of leading global financial institutions and the deleveraging process tightened
the market for funding liquidity. Given the growing risk of illiquidity cascading into solvency
problems, credit and quantitative easing acquired priority in most central banks. While the
global financial markets have since started showing signs of stabilisation, credit flow in
advanced markets is yet to recover. The contagion from the global financial crisis warranted
swift monetary and fiscal policy responses with a view to ensuring orderly functioning of
markets, preserving financial stability, and moderating its adverse effects on growth.
How was India impacted by the global financial crisis?
Transmission of shocks to India
4. There were two distinct phases in 2008-09 during which the transmission of global
shocks - through trade, finance and expectations channels - posed different but significant
challenges for the Reserve Bank. In the first half of the year, the world experienced
simultaneous increase in both food and commodity prices, and there was a return of inflation
after a phase of "great moderation". Dealing with supply side sources of inflation posed
challenges for the conduct of Reserve Bank's monetary policy, particularly in the face of
signs of cyclical slowdown on the one hand and the risk of spiralling headline inflation on the
other. In the second half of the year, the global financial crisis and the subsequent global
recession dramatically changed the nature of the challenge emanating from globalisation.
Impact on the financial markets
5. Post-Lehman, the impact of the global financial crisis unfolded in the Indian financial
markets, though reversal of capital inflows and significant correction in the domestic stock
markets on the back of sell-off in the equity market by the foreign institutional investors (FIIs).
The withdrawal of funds from the Indian equity markets and reduced access of the Indian
entities to raise funds from the international markets put significant pressure on the dollar
liquidity in the domestic foreign exchange market. These developments created adverse
expectations on the balance of payments (BoP) outlook and led to depreciation pressures on
the Indian rupee and increased volatility in the foreign exchange market.
6. The banking sector was not affected as it had hardly any direct exposure to
subprime assets. Moreover, banks were well capitalised and inherently sound. The reduced
foreign funding and the subdued domestic capital market, however, put pressure on some
segments of the financial system, such as non-bank financial companies (NBFCs) and
mutual funds. Mutual funds were dependent on corporates for bulk funds. As liquidity needs
of the corporates increased, redemption pressures on mutual funds rose. This translated into
liquidity problems for NBFCs as mutual funds were important supplier of funds to NBFCs.
Further, the demand for bank credit also increased as external sources of credit dried up for
corporates. Against this background of increase in demand for liquidity, the Reserve Bank
had to step in with liquidity augmenting measures such as cuts in cash reserve ratio (CRR)
and increase in refinance facilities. Consequently, the pressure for funding liquidity came to
rest on the banks. In this scenario, the banks continued to expand credit and meet the funds
requirements of mutual funds and NBFCs aided by liquidity easing measures by the Reserve
Bank. Initially, though bank credit could not fully offset the shortfall in credit from other
sources. Subsequently, demand for bank credit came down as the contagion transmitted to
the real economy and eroded private consumption and investment demand.
Impact on the real economy
7. Under the impact of external demand shocks, the Indian economy witnessed
moderation in growth in the second half of 2008-09 in comparison with the robust growth
performance in the preceding five years (8.8 per cent per annum). The deceleration in growth
was particularly noticeable in negative growth in industrial output in Q4 of 2008-09; a decline
for the first time since the mid-1990s (Table 1). This was on account of erosion of external
demand which affected industrial performance; a reflection of increasing globalisation of the
Indian industry.
8. The transmission of external demand shocks was swift and severe on export
growth, which declined from a peak of about 40 per cent in Q2 of 2008-09 to (-) 15 per cent
in Q3 and further to (-) 22 per cent in Q4; a contraction for the first time since 2001-02.
Concurrently, domestic aggregate demand also moderated resulting from sharp deceleration
in the growth of private consumption demand. In order to respond to the slowing demand,
fiscal stimulus measures were undertaken by the government which included both tax cuts
and increase in expenditure. This raised the fiscal deficit of the Central Government by
3.5 per cent of GDP in 2008-09. Consequently, the growth in government final consumption
expenditure registered a sharp increase in Q3 and Q4 of 2008-09 (Table 2). It is, however,
important to note that unlike many countries the entire fiscal stimulus in India was aimed at
addressing the deficiency in aggregate demand rather than extending support to the financial
sector. While this meant a deviation from the planned fiscal consolidation path as committed
under the Fiscal Responsibility and Budget Management (FRBM) Act, without the stimulus
the deceleration in GDP growth during 2008-09 would have been much sharper.
Table 1: Key macroeconomic indicators - India
Indicators 2008-09: 2009-10:
Q1-Q4 Q1-Q2
Q1 Q2 Q3 Q4 Q1 Q2
Real GDP Growth (Y-o-Y) (%) 7.8 7.7 5.8 5.8 6.1 -
Industry 5.1 4.8 1.6 -0.5 4.2 -
Services 10.0 9.8 9.5 8.4 7.7 -
Inflation (Y-o-Y) (%)
WPI 12.0 12.1 5.9 0.8 -1.1 -0.2
CPI-Industrial Workers 7.7 9.8 9.7 8.0 9.3 11.8
Money and Credit Growth
(Y-o-Y) (%)
Broad Money (M3) 21.5 19.5 19.9 18.6 20.2 19.7
Banks Credit 24.5 23.5 22.7 16.4 15.1 14.1
Interest Rates (%)
Overnight (call) money 6.8 9.5 7.8 4.2 3.2 3.2
10-year g-sec 8.4 8.5 5.9 6.6 6.8 7.1
Foreign Trade
Export Growth (%) 37.6 39.5 -15.0 -22.3 -30.0 -21.0
Import Growth (%) 31.6 60.5 2.1 -29.1 -35.0 -33.6
Balance of Payments
(US $ billion)
Trade Deficit (-) -31.4 -38.7 -34.7 -14.6 -26.0 -
Current Account Deficit (-) -9.0 -12.5 -13.0 4.7 -5.8 -
Net Capital Flows 11.1 7.6 -4.3 -5.3 6.7 -
Reserve Outstanding 312.1 286.3 256.0 252.0 265.1 281.3
Table 2: Components of aggregate demand in India
(Per cent)
Item 2008-09 2009-10
Q1 Q2 Q3 Q4 Q1
Growth Rates (Year-on-Year)
Private Final Consumption Expenditure 4.5 2.1 2.3 2.7 1.6
Government Final Consumption Expenditure -0.2 2.2 56.6 21.5 10.2
Gross Fixed Capital Formation 9.2 12.5 5.1 6.4 4.2
Change in Stocks 6.0 5.6 1.4 -0.9 3.2
Exports 25.6 24.3 7.1 -0.8 -10.9
Less Imports 27.4 35.3 21.7 -5.7 -21.2
Relative shares
Private Final Consumption Expenditure 58.0 55.5 57.4 51.4 55.6
Government Final Consumption Expenditure 9.6 8.3 12.5 13.4 9.9
Gross Fixed Capital Formation 32.2 34.5 30.9 31.6 31.6
Change in Stocks 3.2 3.2 2.9 2.9 3.1
Net Exports -1.3 -10.5 -8.5 -2.9 1.6
Source: Central Statistical Organisation.
Why was India impacted by the global financial crisis?
9. During the initial phases of the global crisis, the Indian financial markets remained
unaffected as the direct exposure of banks to global subprime assets was negligible. The
growth process being largely domestic demand driven remained broadly intact. It was then
perceived that India and other EMEs were "decoupled" from the advanced economies. As
indicated by Governor Dr. Subbarao "the 'decoupling theory' was never totally persuasive".1
As the crisis intensified, particularly after the Lehman collapse, the global shocks first
impacted the domestic financial markets and then transmitted to the real economy through
the trade and finance and confidence channels.
10. Despite the dominance of domestic demand, the role of trade in conditioning the
growth process in India is becoming important over time. A significant boost to global
integration came through rapid growth in India's international trade in services in the 2000s
enabled by expansion in information technology which facilitated cross-border delivery of
services. Progressive liberalisation of capital account initiated in the 1990s and continued
through the 2000s gave further fillip to the process of financial integration. Thus the financial
channel emerged as dominant factor with gross capital flows (inflows plus outflows) rising to
over 50 per cent of GDP in 2008-09 from an average of about 5 per cent in the 1980s
(Table 3). Given the significant degree of openness achieved since the 1990s, it is natural
that the global shocks - real as well as financial - have greater impact.
Table 3: Key indicators of openness of the Indian economy
(Per cent of GDP)
Year Goods Services Gross Gross Gross
Trade Trade Current Capital Current
Account Account and Capital
Account
1 2 3 4 5 6
1970s 10.0 1.3 12.7 4.2 16.9
1980s 12.7 2.5 17.2 5.4 22.6
1990s 18.8 4.1 26.7 15.1 41.8
2000s
(2000-09) 29.3 9.7 45.0 32.7 77.7
2008-09 40.2 13.2 60.5 51.0 111.5
11. With increased global integration, the Indian economy now is subject to greater
influence of global business cycles. The correlation between the cyclical component of the
index of industrial product (IIP) of the advanced economies and India has risen to 0.50 during
the period 1991-2009 from 0.20 in during the period 1971-1990 (Chart 1).
Chart 1:
Business cycle of advanced economies and India: 1991 to 2009
0.06
Cyclical industrial production of India
Cyclical industrial production of advanced economies
0.04
0.02
0
-0.02
-0.04
-0.06
1991M01 1991M10 1992M07 1993M04 1994M01 1994M10 1995M07 1996M04 1997M01 1997M10 1998M07 1999M04 2000M01 2000M10 2001M07 2002M04 2003M01 2003M10 2004M07 2005M04 2006M01 2006M10 2007M07 2008M04 2009M01
12. The traditional conduit of transmission of global shocks is trade cycles. The cyclical
movement in India's exports and world imports during the earlier period 1970-91 was not
significantly synchronised with a relatively low correlation of 0.38. However, with rising
exports along with a transition from primary article exports to manufacturing exports, the
correlation between India's exports and world imports has increased significantly to 0.80
during the recent period 1992-2009 (Chart 2).
Chart 2:
Trade cycle of advanced economies and India: 1992 to 2009
0.25
0.2
IMPWORLDCY
0.15
EXPINCY
0.1
0.05
0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
1992M01 1992M08 1993M03 1993M10 1994M05 1994M12 1995M07 1996M02 1996M09 1997M04 1997M11 1998M06 1999M01 1999M08 2000M03 2000M10 2001M05 2001M12 2002M07 2003M02 2003M09 2004M04 2004M11 2005M06 2006M01 2006M08 2007M03 2007M10 2008M05 2008M12
13. Besides the synchronisation of the trade cycles, the financial channel of integration
has also become prominent during the recent period. A causal analysis between the cyclical
component of the Indian stock prices (BSE Sensex) and the US stock prices (S&P 500
Index) reveals that during the earlier period (1970-1991), when foreign investors could not
participate in the Indian stock market, there was no causal effect of the global stock prices on
the Indian markets. However, in the recent period (1992-2009), there has been greater
impact from the global stock prices on domestic stock prices with the US stock prices having
significant causal impact on the Indian stock prices (Table 4).
Table 4: Causality between the cyclical components of the Indian
and the US stock prices
Null Hypothesis F-Statistic Result.
Sample: 1970M01 1991M12
BSE Index does not Granger Cause S&P500 1.89 Accept
S&P500 does not Granger Cause BSE Index 0.48 Accept
Sample: 1992M01 2009M06
BSE Index does not Granger Cause S&P500 0.36 Accept
S&P500 does not Granger Cause BSE Index 4.80 Reject
14. These shifts in the degree of synchronisation of the Indian trade and business
cycles with the global cycles and increased financial integration in the recent period indicate
that India cannot remain immune to global trends. Thus, global economic developments now
have a greater influence on the domestic economy.
How did monetary policy in India respond to the global financial crisis?
15. As the crisis intensified, the Reserve Bank, like most central banks, took a number
of conventional and unconventional measures to augment domestic and foreign exchange
liquidity, and sharply reduced the policy rates. In a span of seven months between October
2008 and April 2009, there was unprecedented policy activism. For example: (i) the repo rate
was reduced by 425 basis points to 4.75 per cent, (ii) the reverse repo rate was reduced by
275 basis points to 3.25, (iii) the cash reserve ratio (CRR) was reduced by a cumulative
400 basis points to 5.0 per cent, and (iv) the actual/potential provision of primary liquidity was
of the order of Rs. 5.6 trillion (10.5 per cent of GDP).
16. There are, however, some key differences between the actions taken by the
Reserve Bank of India and the central banks in many advanced countries:
•
First, in the process of liquidity injection the counter-parties were banks; even
liquidity measures for mutual funds, NBFCs and housing finance companies were
largely channeled through the 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 large liquidity injection the Reserve Bank's balance sheet did not
show unusual increase because of release of earlier sterilised liquidity.
•
Fourth, availability and deployment of multiple instruments facilitated better
sequencing of monetary and liquidity measures.
•
Finally, the experience in the use of procyclical provisioning norms and
countercyclical regulations ahead of the global crisis helped enhance financial stability.
17. By synchronising the liquidity management operations with those of exchange rate
management and non-disruptive internal debt management operations, the Reserve Bank
ensured that appropriate liquidity was maintained in the system, consistent with the objective
of price and financial stability. The policy stance clearly reflected the forward looking
undertone, particularly the expectations of more prolonged adverse external conditions in the
face of no visible risks to inflation. While the magnitude of the crisis was global in nature, the
policy responses were adapted to domestic growth, inflationary and financial sector
conditions.
How did crisis management change the reserve bank's balance sheet?
18. As the balance of payments came under pressure in Q3 of 2008-09 due to capital
outflows, it became necessary to draw down reserves to finance the shortfall and maintain
orderly conditions in the foreign exchange market. This led to corresponding contraction in
the base (reserve) money. The Reserve Bank, therefore, ensured the necessary expansion
in net domestic assets (NDA) through conventional open market operations (OMO) involving
outright purchase of government securities in the secondary market as well as provision of
liquidity through repos under in its daily liquidity adjustment facility (LAF) (Chart 3). Another
instrument which allowed the Reserve Bank to expand liquidity was the unwinding of the
market stabilisation scheme (MSS) securities.2 The unwinding of MSS balances not only
created the scope for adequate liquidity expansion by the Reserve Bank without expanding
its balance sheet (Chart 4) in any significant measure, but the timing of the unwinding could
also be modulated in such a way that the large borrowing programme of the government was
managed smoothly without exerting undue market stress. In addition, the reduction in CRR of
banks from 9 per cent to 5 per cent released Rs.1.6 trillion of primary liquidity to the banking
system.
Chart 3:
Impact of liquidity management
1000
500
Billion
0
Rs.
-500
Variation in NDA
-1000
Variation in NFA
Q1 Q2 Q3 Q4 Q1 Q2
2008: 2008: 2008: 2008: 2009: 2009:
Note: Net Domestic Assets (NDA) here excludes non-monetary
liabilities and the impact of LAF; Net Foreign Assets (NFA) excludes
valuation changes
19. While the Reserve Bank's balance sheet did not show unusual expansion, sharp
reductions in CRR raised the money multiplier, leading to higher increase in broad money.3
The average money multiplier rose from 4.3 in March 2008 to 4.8 in March 2009, reflecting
lowering of CRR (Chart 5). The increase in money multiplier ensured steady increase in
money supply consistent with the liquidity requirements of the economy.
The balance sheet of the Reserve Bank of India
16.0
15.0
14.0
Trillion
Rs.
13.0
12.0
04,08 29,09
04,08 03,08 03,08 02,08 01,08 01,08 31,08 30,08 30,08 29,09 28,09 30,09 29,09 28,09 28,09 27,09 26,09 26,09
Jul Jul
Jun Jan Jun
Apr Sep Oct Oct Feb Apr Sep Oct
Aug Nov Dec Mar Aug
May May
Chart 5:
Changes in money multiplier
5.5
5.0
4.5
4.0
Jul-08
Jan-08 Jun-08 Jan-09
Oct-08
Feb-08 Apr-08 Sep-08 Dec-08 Feb-09 Apr-09
Mar-08 Aug-08 Nov-08 Mar-09
May-08
20. The liquidity injection efforts of the Reserve Bank, despite being large, could be
achieved without compromising either on the eligible counterparties or on the asset quality in
the Reserve Bank's balance sheet. The liquidity requirements of non-bank financial entities
were met indirectly by extending liquidity support to the designated counterparties like
scheduled commercial banks and primary dealers. Liquidity expansion achieved through
unwinding of MSS and reduction in reserve requirement ensured that the Reserve Bank's
balance sheet did not expand significantly, unlike in several other central banks.
How did monetary transmission work?
21. In the wake of the crisis, monetary transmission broke down in several countries as
risk aversion gave rise to credit crunch. As regards India, the changes in the Reserve Bank's
policy rates were quickly transmitted to the money and debt markets (Chart 6). The money
market rates moved in tandem with the policy reverse repo rate. However, transmission to
the credit market was slow due to several structural rigidities in the system, especially the
dominance of fixed term deposit liabilities in banks' balance sheets at fixed interest rates.
Transmission of policy rates to money and bond markets
12.0
10.0
8.0
cent
6.0
Per
4.0
Yield on AAA Corporate Bonds
Yield on 10-Year Government Securities
2.0
Call Rates
Policy Reverse Repo Rate
0.0
Jul-08
Jun-08 Jan-09 Jun-09
Apr-08 Oct-08 Apr-09 Oct-09
Aug-08 Sep-08 Nov-08 Dec-08 Feb-09 July-09 Aug-09 Sep-09
Mar-09
May-08 May-09
22. As bank deposits contracted in the past at high rates have started to mature and
banks have significantly reduced their term deposit rates, the transmission of lower policy
rates to the credit market has improved with a lag (Chart 7).
Chart 7:
Deposit and lending rates of public sector banks
What are the challenges of exit from monetary easing?
23. There is an active debate on the timing and sequencing of expansionary monetary
stance around the world. In this context, Governor Dr. Subbarao, in his J.R.D. Tata Memorial
Lecture had indicated that the current monetary and fiscal stance is not the steady state. The
exit from the current monetary policy accommodation could, however, be different across
countries depending on the balance of risk to growth and price stability, type of balance
sheet adjustment that have taken place during the crisis and the position of the economy in
the business cycle. In the case of advanced countries, where central bank balance sheets
have expanded substantially including the portfolio comprising of mortgage backed
securities, commercial papers and corporate bonds, the exit policies may be constrained by
the speed of revival and developments in the specific market segments. In contrast, the
central bank accommodation in India was mainly done through unwinding of MMS and
conduct of OMO including LAF and through special refinancing facilities in the banking
system. Thus, the withdrawal of monetary accommodation in India should be feasible without
adverse impact on specific market segments.
24. The October 2009 Review of Monetary Policy for the Year 2009-10 brought forward
the challenges. To quote:
"The precise challenge for the Reserve Bank is to support the recovery process
without compromising on price stability. This calls for a careful management of
trade-offs. Growth drivers warrant a delayed exit, while inflation concerns call for
an early exit. Premature exit will derail the fragile growth, but a delayed exit can
potentially engender inflation expectations.... The balance of judgment at the
current juncture is that it may be appropriate to sequence the "exit" in a calibrated
way so that while the recovery process is not hampered, inflation expectations
remain anchored. The "exit" process can begin with the closure of some special
liquidity support measures."
Accordingly, the Reserve Bank has begun the first phase of "exit", by withdrawal of most of
the unconventional measure taken during the crisis.
Conclusion
25. To sum up, despite sound fundamentals and no direct exposure to the sub-prime
assets, India was affected by global financial crisis reflecting increasing globalisation of the
Indian economy. The policy response has been swift. While fiscal stimulus cushioned the
deficiency in demand, monetary policy augmented both domestic and foreign exchange
liquidity. The expansionary policy stance of the Reserve Bank was manifested in significant
reduction in CRR as well as the policy rates. The contraction of the Reserve Bank's balance
sheet resulting from the decline in its foreign assets necessitated active liquidity
management aimed at expanding domestic assets, which was ensured through OMO
including regular operations under the LAF, unwinding of MSS securities, introduction of new
and scaling up of existing refinance facilities. In addition, sharp reductions in CRR besides
making available primary liquidity raised the money multiplier and ensured steady increase in
money supply. The liquidity injection efforts of the Reserve Bank could be achieved without
compromising either on the eligible counterparties or on the asset quality in the Reserve
Bank's balance sheet. Moreover, the Reserve Bank's balance sheet did not show unusual
increase, unlike that of several other central banks.
26. At present, the focus around the world and also in India has shifted from managing
the crisis to managing the recovery. The key challenge relates to the exit strategy that needs
to be designed considering that the recovery is as yet fragile but there is an uptick in inflation,
though largely from the supply side, which could engender inflationary expectations. Thus,
the Reserve Bank has initiated the first phase of exit in its October 2009 Review of monetary
policy in a calibrated manner mainly by withdrawal of unconventional measures taken during
the crisis. This should help anchor inflationary expectations by reducing the overhang of
liquidity without jeopardising the growth process as market liquidity remains comfortable.
Thank you.