Deepak Mohanty: The global financial crisis - genesis, impact and
lessons
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
international conference on "Frontiers of interface between statistics and science", organised
in honour of Prof C R Rao on the occasion of his 90th birthday by the C R Rao Advanced
Institute of Mathematics, Statistics and Computer Science and the University of Hyderabad
Hyderabad, 30 December 2009.
The assistance provided by Dr Rajiv Ranjan and Shri Binod B Bhoi is acknowledged.
* * *
Respected Dr. Reddy, Prof. T. N. Srinivasan, Prof. S. D. Tendulkar, Prof. T. Krishnakumar,
distinguished invitees and friends. I thank the C. R. Rao Advanced Institute of Mathematics,
Statistics and Computer Sciences and the University of Hyderabad for giving this opportunity
to share my thoughts on the global financial crisis. I am humbled speaking on this subject in
the presence of Dr. Reddy, the distinguished former Governor of the Reserve Bank of India,
who is widely credited for having put in place prudential policies which shielded India from
the worst effects of the global financial crisis.
The world economy today seems to be recovering from the most severe crisis since the
Great Depression of the 1930s. As you know, it surfaced in the subprime mortgage sector in
the US in August 2007 and took the character of a global crisis in September 2008 following
the collapse of Lehman Brothers. It is also dubbed as the greatest crisis in the history of
financial capitalism because of the way it simultaneously propagated to other countries.
The impact of the crisis can be gauged from the sharp upward revisions to the estimates of
possible write-downs by banks and other financial institutions from about US$ 500 billion in
March 2008 to about US$ 3.5 trillion in October 2009. More than the financial cost, the
adverse impact on the real economy has been severe: in 2009, the world GDP is estimated
by the IMF to have contracted by 0.8 per cent and the world trade volume is estimated to
have declined by 12 per cent.
The expanse of the crisis has tested all the limits of conventional and unconventional policy
options available to policymakers around the world. In fact, the speed and intensity with
which the US subprime crisis turned into a global financial crisis and then into a global
economic crisis has led to a whole new debate on dominant tenets in macroeconomics. It
has challenged the conventional views on the self-correcting nature of financial markets. The
debate on the role of finance in economic growth has again come to the centre stage.
Against this backdrop, I will reflect on the following set of questions. How similar or different
is the recent crisis from the past crises in terms of its cause and manifestation? How did
policies in different countries respond to the crisis? How and why was India impacted and
how did we respond? What are the key lessons from the crisis? I will conclude with a focus
on India.
I. Genesis of the crisis
The crisis was an outcome of the interplay between both macroeconomic and
microeconomic factors. From a macroeconomic perspective, the crisis has been attributed to
the persistence of global imbalances, excessively accommodative monetary policy pursued
in major advanced economies and lack of recognition of asset prices in policy formulation.
From a microeconomic perspective, the crisis has been attributed to the rapid financial
innovations without adequate regulation, credit boom and the lowering of credit standards,
inadequate corporate governance and inappropriate incentive system in the financial sector
and overall lax oversight of the financial system.
Global imbalances
It is argued that while the subprime problem was the trigger, the root cause of the crisis lies
in the persistence of the global imbalances since the start of the current decade (BIS, 2009).
Large current account deficits in the advanced countries mirrored by large current account
surpluses in the emerging market economies (EMEs) implied that excess saving flowed
uphill from developing countries to developed countries (Chart 1 and Table 1). Bernanke
(2005) considered this "saving glut" as one of the factors leading to the crisis. Among the
advanced countries, it is the US which has a large saving-investment gap. Among the EMEs,
it is China, which has the largest saving surplus. The causation, however, is not very clear:
whether it is excess saving in China or excess consumption in the US that contributed to the
crisis.
Apart from the saving-investment imbalances, there has been concurrent accumulation of
large foreign exchange reserves by the EMEs, particularly China, also as self insurance
against sudden reversal of capital flows (Table 2). It is argued that accumulation of reserves,
particularly from trade surplus, resulted in misalignment of exchange rates. This prevented
the global imbalances to adjust. Moreover, the burden of adjustment was borne
disproportionately by countries with flexible currencies. While there is merit in this argument,
it is not clear whether movement in exchange rates by itself could have prevented global
imbalances without an adjustment in aggregate demand - lower consumption in the US and
higher consumption in China.
Monetary policy
In a number of advanced countries, policy rates remained below what could be considered
as neutral rates. Monetary policies in the US and Japan were too easy for too long (Truman,
2009). The US federal funds rate was lowered to 1 per cent by June 2003 while the Bank of
Japan's discount rate reached 0.1 per cent by September 2001. Subsequently, though policy
rates were raised, they have been brought down again to their lowest levels following the
crisis (Chart 2).
Many critics argue that the current low levels of policy rates may well be sowing the seeds for
the next crisis. Notwithstanding the arguments on both the sides, one aspect is clear that
monetary policy in advanced countries has spillover effect on the EMEs. Monetary Policy is
generally conducted with the domestic objectives in view but the international spillover
effects are not inconsequential. For example, increase in interest rate differential could
engender excessive capital flows from developed countries to developing countries with an
increasing risk of reversal unrelated to the fundamentals of the capital recipient countries.
This can accentuate asset prices, put upward pressure on exchange rate, and could have
destabilizing effects.
Excess leverage
A comparison of the current crisis with various episodes of past crises reveals considerable
similarity with regard to the underlying causes - excessive use of credit, lowering of credit
standards, and heavy reliance on leverage. Reinhart and Rogoff (2009) find that the global
dimension of the current crisis is neither new nor unique to this episode.
Apart from perpetuating global imbalances, the easy monetary policy pursued in advanced
economies encouraged excessive leveraging on the part of investors as well as banks and
financial institutions. The sharp rise in the leverage of financial institutions in the first decade
of this century has been particularly striking (Chart 3).
Source: Global Financial Stability Report, April 2009, IMF.
Search for yields
The low levels of interest rates led to the search for yields. This encouraged rapid financial
innovations in terms of complex derivative instruments and structured finance products
created through the process of securitization. Easy credit combined with under pricing of
risks created speculative asset bubbles, especially in real estate. However, domestic
macroeconomic policies in many cases could not take into account the build-up of systemic
risks in the financial system arising from leverage and asset price bubbles, thereby
contributing to the crisis.
The financial system also was enlarged with the growth in off-balance sheet activities of
banks through the process of "originate-to-distribute" model. This shadow banking sector,
however, remained beyond the pale of regulation. Consequently, both the investors and
regulators increasingly relied on the assessment of rating agencies and independent
auditors, who are supposed to provide a third-party evaluation of the risks embedded in
various financial transactions. However, due to the existing flaws in the financial system and
distorted incentive structures, the rating agencies issued unrealistically high ratings to new
issuances, thereby contributing to the build-up of systemic risks.
The crisis shows that the systemic risks posed by the immensely complex financial system
were masked by the benign macroeconomic outcomes characterized as the "great
moderation". This prolonged period of high output growth and low inflation was essentially
attributed to free markets and successful globalisation. During the golden years, financial
economists believed that free-market economies could never go astray which is belied by the
crisis (Krugman, 2009). The financial system, however, remained vulnerable to the risks of
reversal in easy monetary policy on the one hand and disorderly unwinding of global
imbalances on the other. It is argued that the "great moderation" carried the seeds of its own
destruction. This stability bred complacency, excessive risk taking and, ultimately, instability
(Minsky, 2008). Furthermore, multilateral institutions like the IMF which were charged with
the responsibility of surveillance, failed in diagnosing the vulnerabilities both at the global
level and at the level of systemically important advanced economies (Reddy, 2009).
II. Manifestation of the crisis
Interbank markets in advanced economies were the first to be affected by severe liquidity
crisis as banks became reluctant to lend to each other on fear of counterparty risks. This was
manifested in abnormal level of spreads, shortening of maturities, and contraction, or even
closure, of some market segments (Table 3).
Transmission to the real sector
With money markets witnessing a squeeze, equity prices plummeting and credit spreads
rising, banks and other financial institutions experienced erosion in their access to funding
and capital. The tightening of credit conditions combined with deleveraging and risk aversion
by banks and financial institutions led to a sharp slowdown in private sector credit growth,
particularly in the advanced economies, which worked as a channel for transmitting the crisis
from financial institutions to the real economy (Chart 4). At the same time, the deteriorating
macroeconomic conditions affected profitability. Consequently, the liquidity problem
transformed into a solvency problem leading to bank failures in the US and other advanced
economies in Europe. The attendant wealth loss on account of collapsing asset prices further
accentuated the problem in the real sector.
Transmission to EMEs
The crisis spread to the EMEs through all the three broad channels - confidence, finance
and trade - reflecting increased global integration. The confidence channel worked in two
ways. First, although the epicenter of crisis was in advanced markets, exposures to emerging
markets were reduced sharply with the return of risk aversion. Second, with increase in
deleveraging, there was a widespread shortage of US dollar. Consequently, reversal of
capital flows led to equity market losses and currency depreciations (Table 4). The slump in
export demand and tighter trade credit caused deceleration in aggregate demand. The
banking system in the EMEs, however, showed relative resilience during the crisis because
of their limited exposure to the toxic assets as also improved regulation and supervision in
the aftermath of the East Asian crisis.
Policy response
The crisis evoked unprecedented policy response, both nationally and internationally. The
resolution mechanisms that came to the fore had to contend with new and complex web of
the financial world involving credit default swaps (CDS), special investment vehicles (SIVs)
and credit ratings. Monetary authorities in the advanced economies were the first to resort to
an aggressive monetary easing first by reducing policy rates and then by using their balance
sheets in unconventional ways to augment liquidity.
The large scale economic downturn accompanying the financial crisis also led to activation of
counter-cyclical fiscal policy of unprecedented magnitudes. The fiscal measures focused on
improving the balance sheet of the financial and corporate sectors as reflected in large scale
bailouts in the US and other advanced economies.
The EMEs also undertook various policy measures to limit the adverse impact of contagion
and their policy responses became more coordinated with global efforts. A distinguishing
feature, however, is that while for the advanced countries the policy priorities were to restore
normalcy and strengthen financial regulation and supervision, dealing with the reversal of
capital flows and collapse of trade occupied the policy attention in the EMEs.
Notwithstanding such differences, restoring growth emerged as the overriding objective
among both the set of countries. It was for the first time that EMEs turned out to be active
partners in finding meaningful resolution mechanisms to a global problem.
III. Impact and policy responses in India
Why was India impacted?
In the initial phase of the crisis, the impact on the Indian financial markets was rather muted
as the direct exposure of banks to subprime assets was negligible. Nonetheless, India could
not remain unscathed for long. As the crisis intensified in the aftermath of collapse of
Lehman Brothers, the global shocks first impacted the domestic financial markets and then
transmitted to the real economy through the finance, trade and confidence channels. This
could be attributed to the global nature of the current crisis on the one hand and accelerated
trade and financial integration of the Indian economy with the world since the 1990s.
Consequently, there has been a shift in the degree of synchronisation of the Indian trade and
business cycles with the global cycles, which along with 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 (Mohanty,
2009).
How was India impacted?
Post-Lehman, the impact of the global financial crisis was first felt through reversal of capital
flows and fall in equity prices in the domestic stock markets on the back of large scale sell-off
by the foreign institutional investors (FIIs) as a part of the global deleveraging process.
Simultaneously, there was reduced access to external sources of funding by Indian entities
due to the tightening of credit conditions in international markets. This shortage of dollar
liquidity put significant pressures on the domestic foreign exchange market, which was
reflected in downward pressures on the Indian rupee along with its increased volatility.
Simultaneously, there was a substitution of overseas financing by domestic financing, which
brought both money market and credit market under pressure.
The transmission of this external demand shocks was swift and severe on India's export
growth, which turned negative in October 2008. Imports too started declining by December
2008 as domestic activity slowed. The overall impact was reflected in a fall in investment
demand and sharp deceleration in the growth of Indian economy in the second half of
2008-09 which persisted through the first quarter of 2009-10.
Policy response
In order to limit the adverse impact of the contagion on the Indian financial markets and the
broader economy, the Reserve Bank, like most other central banks, took a number of
conventional and unconventional measures. These included augmenting domestic and
foreign exchange liquidity and sharp reduction in the policy rates. The Reserve Bank used
multiple instruments such as the liquidity adjustment facility (LAF), open market operations
(OMO), cash reserve ratio (CRR) and securities under the market stabilization scheme
(MSS) to augment the liquidity in the system. 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 per cent, (iii) the 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). These measures were effective in ensuring speedy
restoration of orderly conditions in the financial markets over a short time span. These
measures were supported by fiscal stimulus packages during 2008-09 in the form of tax
cuts, investment in infrastructure and increased expenditure on government consumption.
The expansionary fiscal stance continues during 2009-10 to support aggregate demand.
While the magnitude of the crisis was global in nature, the policy responses were adapted to
domestic growth outlook, inflation conditions and financial stability considerations.
Until the emergence of global crisis, the Indian economy passed through a phase of high
growth driven by domestic demand: growing domestic investment financed mostly by
domestic savings and sustained consumption demand. This overall improvement in
macroeconomic performance in India could mainly be attributed to the sequential financial
albeit
sector reforms that resulted in an efficient system of financial intermediation,
bankbased; the rule-based fiscal policy that reduced the public sector's drag on private savings;
and forward looking monetary policy that balanced the short-term trade-off between growth
and inflation.
IV. Lessons from the crisis
The crisis has shown that irrespective of the degree of globalisation of a country and the
soundness of domestic policies, it can be impacted by a crisis in any other economy due to
the interlinkages in the global economy. With the benefit of hindsight, a number of important
issues have emerged which allows us to draw lessons. I will highlight four key lessons.
First, the policy objectives of central banks would have to be broader than price stability as
conventionally defined. The lesson for central banks that emerged from the crisis is that
financial stability can be jeopardised even if there is price stability and macroeconomic
stability (Subbarao, 2009). Moreover, the success in stabilising goods and services prices
may not preclude inflation in asset prices, causing unsustainable speculation leading to asset
booms. Thus, apart from price stability, the central banks would have to take into account
asset prices and focus on financial stability as an explicit objective of policy. While there is
more of an agreement to recognise financial stability as an objective, there is less of an
agreement about the instrumentalities for achieving this objective. There is a broader
acceptance of macroprudential tools for asset prices. It is, however, not apparent at this
stage as to what extent policy interest rates could be used to address asset price inflation.
Second, there is a need for fiscal consolidation to generate the fiscal space for macro
management. During the crisis, fiscal policy responses have been unprecedented, although
they were conditioned by country-specific factors. But the massive fiscal support, though
appropriate as a crisis response, has raised questions about debt sustainability. This is
reflected in increase in sovereign CDS spreads even for advanced countries which has
implications for macro-financial stability going forward. It is, therefore, important that fiscal
buffers are established in good times to provide the necessary fiscal space for
countercyclical fiscal measures in bad times.
Third, financial institutions would have to be less leveraged and better regulated. This
financial crisis brought into sharp focus the interlinkages among the financial institutions,
markets and the payment and settlement systems. It has shown that market self regulation
has limits. Hence, all systemically important financial institutions, markets and instruments
should be subject to an appropriate degree of regulation and oversight depending on their
relative importance for overall financial stability. At the same time, it needs to be recognised
that regulation in itself can act to magnify cycles. In order to address the issue of
procyclicality, regulators need to focus on: identifying factors that amplify cycles; improving and
diversifying market risk management models; undertaking more rigorous stress testing; and
adopt forward-looking procedures to capital calculations.
Fourth, the international financial architecture needs to be strengthened to address the
challenges of the global economy of the 21st century. The crisis has exposed fundamental
problems, not only in national regulatory systems affecting finance, competition and
corporate governance, but also in the international institutions and arrangements created to
ensure financial and economic stability. The IMF, the Financial Stability Board (FSB) and the
G-20 should provide the effective platform for addressing global issues in a more credible
manner. The IMF would have to play a more active role in crisis prevention, management
and resolution. It needs to strengthen its multilateral surveillance with a greater
macrofinancial focus. In this context, the G-20 emphasis on modernizing the IMF's governance
process is a welcome step which should improve its credibility, legitimacy and effectiveness.
The G-20 can provide the necessary political support for implementation of policies which
need a coordinated effort at the global level.
V. Conclusions
India was relatively less impacted by the crisis despite increased global integration of the
Indian economy in recent years. This could be attributed mainly to the structure of the
economy, cautious policies, prudent regulation and effective supervision.
First, India's economic growth is largely domestic driven - high investment financed by high
domestic saving.
Second, de-regulation and opening up of the economy was sequenced appropriately. Along
with the opening up of the economy, the financial markets were also developed to improve
efficiency in financial intermediation.
Third, the Reserve Bank also being the regulator and supervisor of the financial system,
information related to financial system always flowed to the central bank, which helped in fine
tuning the monetary policy. In fact, financial stability as a monetary policy objective in India
emerged much before the unraveling of the current crisis.
Fourth, the multiple indicator approach to the conduct of monetary policy in India helped in
identifying credit market excesses and undertaking counter-cyclical monetary policy
measures in a pre-emptive manner.
Fifth, monetary policy was well supported by macroprudential measures to ensure that it
does not impinge on financial stability. Pro-cyclical measures in respect of capital and
provisioning were tried in 2005, much before the crisis.
Sixth, in view of systemic implications of non-banks, they have been brought within the
regulatory framework in terms of prescriptions of capital adequacy and exposure norms.
Banks' exposures to these entities are subject to prudential regulations.
Seventh, the liquidity risks are contained by restricting the overnight unsecured market to
banks and primary dealers (PDs), with prudential limits. The requirement of statutory liquidity
ratio (SLR) for banks acts as a buffer for both liquidity and solvency of banks.
Although cautious macroeconomic policies coupled with macroprudential regulations helped
limit the adverse impact on the Indian economy, there is no room for complacency. As
highlighted by Governor Dr. Subbarao, there are lessons from the crisis for India too, which
include: (i) further strengthening regulation at the systemic and institutional levels; (ii) making
our supervision more effective and value adding; and (iii) improving our skills in risk
management. India has been an active participant at the global discussions, the task for us
will be to reflect our point of view in the global debate and adapt the global policies and
guidelines to the Indian situation on a dynamic basis. Furthermore, we need to actively
pursue the challenge of financial inclusion.
The functioning of global economy in the past three decades suggests that the process of
financial development and globalisation is susceptible to crisis. Nevertheless, the recurrence
of financial crisis has not changed the positive relation between financial development and
growth (Lipsky, 2009). As the current crisis shows, the problems in finance and financial
regulation need to be addressed at a national as well as global level to ensure that the
benefits of financial developments become more widespread and enduring in nature. Thus,
what is needed is not more regulation but sharper regulation of the financial system to
ensure sustained financial development with stability.
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