Rakesh Mohan: Global financial crisis - causes, impact, policy
responses and lessons
Speech by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at the 7th
Annual India Business Forum Conference, London Business School, London, 23 April 2009.
Based on remarks delivered by Dr Rakesh Mohan, Deputy Governor at the RBI-BIS Seminar on "Mitigating
Spillovers and Contagion - Lessons from the Global Financial Crisis" at Hyderabad on 4 December 2008, at the
International Chambers of Commerce at New Delhi on 16 January 2009, at the Yale School of Management, Yale
University on 3 April 2009 and at the 7th Annual India Business Forum Conference at London Business School,
London on 23 April 2009. Assistance of Muneesh Kapur in preparing the speech is gratefully acknowledged.
* * *
The intensification of the global financial crisis, following the bankruptcy of Lehman Brothers
in September 2008, has made the current economic and financial environment a very difficult
time for the world economy, the global financial system and for central banks. The fall out of
the current global financial crisis could be an epoch changing one for central banks and
financial regulatory systems. It is, therefore, very important that we identify the causes of the
current crisis accurately so that we can then find, first, appropriate immediate crisis resolution
measures and mechanisms; second, understand the differences among countries on how
they are being impacted; and, finally, think of the longer term implications for monetary policy
and financial regulatory mechanisms.
These are all large subjects and I cannot hope to do justice to in the limited space available
in one speech. A legion of both policymakers and scholars are at work analysing the causes
of the crisis and findings both immediate and longer term solutions (For example, the de
Larosiere Report (2009), the Turner Review (2009), the Geneva Report (2009), the Group of
Thirty Report (2008) and the IMF Lessons paper (2009b)). I can only attempt some
conjectures, raise issues and identify some possible directions in which we should move.
What I will attempt to do is to provide my interpretation of the unfolding of the present global
financial crisis; how it is affecting us; why the Indian financial sector has been able to
weather the crisis relatively well; the analytics of our policy response; and, finally, some
implications of its longer lasting effects.
I. Global financial crisis
Genesis of global financial crisis
The proximate cause of the current financial turbulence is attributed to the sub-prime
mortgage sector in the USA. At a fundamental level, however, the crisis could be ascribed to
the persistence of large global imbalances, which, in turn, were the outcome of long periods
of excessively loose monetary policy in the major advanced economies during the early part
of this decade (Mohan, 2007, Taylor, 2008).
Global imbalances have been manifested through a substantial increase in the current
account deficit of the US mirrored by the substantial surplus in Asia, particularly in China,
and in oil exporting countries in the Middle East and Russia (Lane, 2009). These imbalances
in the current account are often seen as the consequence of the relative inflexibility of the
currency regimes in China and some other EMEs. According to Portes (2009), global
macroeconomic imbalances were the major underlying cause of the crisis. These
savinginvestment imbalances and consequent huge cross-border financial flows put great stress on
the financial intermediation process. The global imbalances interacted with the flaws in
financial markets and instruments to generate the specific features of the crisis. Such a view,
however, offers only a partial analysis of the recent global economic environment. The role of
monetary policy in the major advanced economies, particularly that in the United States, over
the same time period needs to be analysed for a more balanced analysis.
Following the dot com bubble burst in the US around the turn of the decade, monetary policy
in the US and other advanced economies was eased aggressively. Policy rates in the US
reached one per cent in June 2003 and were held around these levels for an extended
period (up to June 2004) (Chart 1). In the subsequent period, the withdrawal of monetary
accommodation was quite gradual. An empirical assessment of the US monetary policy also
indicates that the actual policy during the period 2002-06, especially during 2002-04, was
substantially looser than what a simple Taylor rule would have required (Chart 2). "This was
an unusually big deviation from the Taylor Rule. There was no greater or more persistent
deviation of actual Fed policy since the turbulent days of the 1970s. So there is clearly
evidence that there were monetary excesses during the period leading up to the housing
boom" (Taylor, op.cit.). Taylor also finds some evidence (though not conclusive) that rate
decisions of the European Central Bank (ECB) were also affected by the US Fed monetary
policy decisions, though they did not go as far down the policy rate curve as the US Fed did.
Excessively loose monetary policy in the post dot com period boosted consumption and
investment in the US and, as Taylor argues, it was made with purposeful and careful
consideration by monetary policy makers. As might be expected, with such low nominal and
real interest rates, asset prices also recorded strong gains, particularly in housing and real
estate, providing further impetus to consumption and investment through wealth effects.
Thus, aggregate demand consistently exceeded domestic output in the US and, given the
macroeconomic identity, this was mirrored in large and growing current account deficits in
the US over the period (Table 1). The large domestic demand of the US was met by the rest
of the world, especially China and other East Asian economies, which provided goods and
services at relatively low costs leading to growing surpluses in these countries. Sustained
current account surpluses in some of these EMEs also reflected the lessons learnt from the
Asian financial crisis. Furthermore, the availability of relatively cheaper goods and services
from China and other EMEs also helped to maintain price stability in the US and elsewhere,
which might have not been possible otherwise. Thus measured inflation in the advanced
economies remained low, contributing to the persistence of accommodative monetary policy.
The emergence of dysfunctional global imbalances is essentially a post 2000 phenomenon
and which got accentuated from 2004 onwards. The surpluses of East Asian exporters,
particularly China, rose significantly from 2004 onwards, as did those of the oil exporters
(Table 1). In fact, Taylor (op. cit.) argues that the sharp hike in oil and other commodity
prices in early 2008 was indeed related to the very sharp policy rate cut in late 2007 after the
sub-prime crisis emerged.
It would be interesting to explore the outcome had the exchange rate policies in China and
other EMEs been more flexible. The availability of low priced consumer goods and services
from EMEs was worldwide. Yet, it can be observed that the Euro area as a whole did not
exhibit large current account deficits throughout the current decade. In fact, it exhibited a
surplus except for a minor deficit in 2008. Thus it is difficult to argue that the US large current
account deficit was caused by China's exchange rate policy. The existence of excess
demand for an extended period in the U.S. was more influenced by its own macroeconomic
and monetary policies, and may have continued even with more flexible exchange rate
policies in China. In the event of a more flexible exchange rate policy in China, the sources of
imports for the US would have been some countries other than China. Thus, it is most likely
that the US current account deficit would have been as large as it was - only the surplus
counterpart countries might have been somewhat different. The perceived lack of exchange
rate flexibility in the Asian EMEs cannot, therefore, fully explain the large and growing current
account deficits in the US. The fact that many continental European countries continue to
exhibit surpluses or modest deficits reinforces this point.
Apart from creating large global imbalances, accommodative monetary policy and the
existence of very low interest rates for an extended period encouraged the search for yield,
and relaxation of lending standards. Even as financial imbalances were building up,
macroeconomic stability was maintained. Relatively stable growth and low inflation have
been witnessed in the major advanced economies since the early 1990s and the period has
been dubbed as the Great Moderation. The stable macroeconomic environment encouraged
underpricing of risks. Financial innovations, regulatory arbitrage, lending malpractices,
excessive use of the originate and distribute model, securitisation of sub-prime loans and
their bundling into AAA tranches on the back of ratings, all combined to result in the
observed excessive leverage of financial market entities.
Components of the crisis
Most of the crises over the past few decades have had their roots in developing and
emerging countries, often resulting from abrupt reversals in capital flows, and from loose
domestic monetary and fiscal policies. In contrast, the current ongoing global financial crisis
has had its roots in the US. The sustained rise in asset prices, particularly house prices, on
the back of excessively accommodative monetary policy and lax lending standards during
2002-2006 coupled with financial innovations resulted in a large rise in mortgage credit to
households, particularly low credit quality households. Most of these loans were with low
margin money and with initial low teaser payments. Due to the "originate and distribute"
model, most of these mortgages had been securitized. In combination with strong growth in
complex credit derivatives and the use of credit ratings, the mortgages, inherently sub-prime,
were bundled into a variety of tranches, including AAA tranches, and sold to a range of
financial investors.
As inflation started creeping up beginning 2004, the US Federal Reserve started to withdraw
monetary accommodation. With interest rates beginning to edge up, mortgage payments
also started rising. Tight monetary policy contained aggregate demand and output,
depressing housing prices. With low/negligible margin financing, there were greater
incentives to default by the sub-prime borrowers. Defaults by such borrowers led to losses by
financial institutions and investors alike. Although the loans were supposedly securitized and
sold to the off balance sheet special institutional vehicles (SIVs), the losses were ultimately
borne by the banks and the financial institutions wiping off a significant fraction of their
capital. The theory and expectation behind the practice of securitisation and use of
derivatives was the associated dispersal of risk to those who can best bear them. What
happened in practice was that risk was parcelled out increasingly among banks and financial
institutions, and got effectively even more concentrated. It is interesting to note that the
various stress tests conducted by the major banks and financial institutions prior to the crisis
period had revealed that banks were well-capitalised to deal with any shocks. Such stress
tests, as it appears, were based on the very benign data of the period of the Great
Moderation and did not properly capture and reflect the reality (Haldane, 2009).
The excessive leverage on the part of banks and the financial institutions (among
themselves), the opacity of these transactions, the mounting losses and the dwindling net
worth of major banks and financial institutions led to a breakdown of trust among banks.
Given the growing financial globalization, banks and financial institutions in other major
advanced economies, especially Europe, have also been adversely affected by losses and
capital write-offs. Inter-bank money markets nearly froze and this was reflected in very high
spreads in money markets. There was aggressive search for safety, which has been
mirrored in very low yields on Treasury bills and bonds. These developments were
significantly accentuated following the failure of Lehman Brothers in September 2008 and
there was a complete loss of confidence.
The deep and lingering crisis in global financial markets, the extreme level of risk aversion,
the mounting losses of banks and financial institutions, the elevated level of commodity
prices (until the third quarter of 2008) and their subsequent collapse, and the sharp
correction in a range of asset prices, all combined, have suddenly led to a sharp slowdown in
growth momentum in the major advanced economies, especially since the Lehman failure.
Global growth for 2009, which was seen at a healthy 3.8 per cent in April 2008, is now
projected to contract by 1.3 per cent (IMF, 2009c) (Table 2). Major advanced economies are
in recession and the EMEs - which in the earlier part of 2008 were widely viewed as being
decoupled from the major advanced economies - have also been engulfed by the financial
crisis-led slowdown. Global trade volume (goods and services) is also expected to contract
by 11 per cent during 2009 as against the robust growth of 8.2 per cent during 2006-2007.
Private capital inflows (net) to the EMEs fell from the peak of US $ 617 billion in 2007 to US $
109 billion in 2008 and are projected to record net outflows of US $ 190 billion in 2009. The
sharp decline in capital flows in 2009 will be mainly on account of outflows under bank
lending and portfolio flows. Thus, both the slowdown in external demand and the lack of
external financing have dampened growth prospects for the EMEs much more than that was
anticipated a year ago.
Volatility in capital flows: implications for emerging market economies
Monetary policy developments in the leading economies not only affect them domestically,
but also have a profound impact on the rest of the world through changes in risk premia and
search for yield leading to significant switches in capital flows. While the large volatility in the
monetary policy in the US, especially since the beginning of this decade, could have been
dictated by internal compulsions to maintain employment and price stability, the consequent
volatility in capital flows impinges on exchange rate movements and more generally, on the
spectrum of asset and commodity prices. The monetary policy dynamics of the advanced
economies thus involve sharp adjustment for the EMEs.
Private capital flows to EMEs have grown rapidly since the 1980s, but with increased
volatility over time. Large capital flows to the EMEs can be attributed to a variety of push and
pull factors. The pull factors that have led to higher capital flows include strong growth in the
EMEs over the past decade, reduction in inflation, macroeconomic stability, opening up of
capital accounts and buoyant growth prospects. The major push factor is the stance of
monetary policy in the advanced economies. Periods of loose monetary policy and search for
yield in the advanced economies encourages large capital inflows to the EMEs and vice
versa in periods of tighter monetary policy. Thus, swings in monetary policy in the advanced
economies lead to cycles and volatility in capital flows to the EMEs. Innovations in
information technology have also contributed to the two-way movement in capital flows to the
EMEs. Overall, in response to these factors, capital flows to the EMEs since the early 1980s
have grown over time, but with large volatility (Committee on Global Financial System, 2009).
After remaining nearly flat in the second half of the 1980s, private capital flows jumped to an
annual average of US $ 124 billion during 1990-96.1 With the onset of the Asian financial
crisis, total private capital flows fell to an annual average of US $ 86 billion during 1997-2002.
Beginning 2003, a period coinciding with the low interest rate regime in the US and major
advanced economies and the concomitant search for yield, such flows rose manifold to an
annual average of US $ 285 billion during 2003-2007 reaching a peak of US $ 617 billion in
2007 (Chart 3). As noted earlier, the EMEs, as a group, are now likely to witness outflows of
US $ 190 billion in 2009 - the first contraction since 1988. Amongst the major components,
while direct investment flows have generally seen a steady increase over the period, portfolio
flows as well as other private flows (bank loans etc) have exhibited substantial volatility.
While direct investment flows largely reflect the pull factors, portfolio and bank flows reflect
both the push and the pull factors. It is also evident that capital account transactions have
grown much faster relative to current account transactions, and gross capital flows are a
multiple of both net capital flows and current account transactions. Also, large private capital
flows have taken place in an environment when major EMEs have been witnessing current
account surpluses leading to substantial accumulation of foreign exchange reserves in many
of these economies.
As noted earlier, the policy interest rates in the US reached extremely low levels during 2002
- one per cent - and remained at these levels for an extended period of time, through mid
2004. Low nominal interest rates were also witnessed in other major advanced economies
over the same period. The extremely accommodative monetary policy in the advanced
economies was mirrored in the strong base money expansion during the period 2001-02 -
shortly before the beginning of the current episode of strong capital flows to EMEs. As the
monetary accommodation was withdrawn in a phased manner, base money growth
witnessed correction beginning 2004. However, contrary to the previous episodes, capital
flows to the EMEs continued to be strong. The expected reversal of capital flows from the
EMEs was somewhat delayed and finally took place in 2008. Similarly, the previous episode
(1993-96) of heavy capital inflows was also preceded by a significant expansion of base
money during 1990-94, and sharp contraction thereafter. This brief discussion highlights the
correlation between monetary policy cycles in the advanced economies on the one hand and
pricing/mispricing of risk and volatility in capital flows on the other hand. At present, monetary
policies across the advanced economies have again been aggressively eased and policy
interest rates have reached levels even lower than those which were witnessed in 2002.
Base money in the US more than doubled over a period of just six months between June and
December 2008. Given such a large monetary expansion and given the past experiences,
large capital inflows to the EMEs could resume in the foreseeable future, if the unwinding of
the current monetary expansion is not made in a timely fashion.
In rapidly growing economies such as India, high real GDP growth needs concomitant growth
in monetary aggregates, which also needs expansion of base money. To this extent, the
accretion of unsterilised foreign exchange reserves to the central bank's balance sheet is
helpful in expanding base money at the required rate. However, net capital flows and
accretion to foreign exchange reserves in excess of such requirements necessitate
sterilisation and more active monetary and macroeconomic management. Thus, large inflows
of capital, well in excess of the current financing needs, can lead to high domestic credit and
monetary growth, boom in stock market and other asset prices, and general excess domestic
demand leading to macroeconomic and financial instability. Abrupt reversals in capital flows
also lead to significant difficulties in monetary and macroeconomic management.
While, in principle, capital account liberalisation is expected to benefit the host economy and
raise its growth rate, this theoretical conjecture is not supported by the accumulated
empirical evidence. Despite an abundance of cross-section, panel, and event studies, there
is strikingly little convincing documentation of direct positive impacts of financial opening on
the economic welfare levels or growth rates of developing countries. There is also little
systematic evidence that financial opening raises welfare indirectly by promoting collateral
reforms of economic institutions or policies. At the same time, opening the financial account
does appear to raise the frequency and severity of economic crises (Obstfeld, 2009). The
evidence appears to favour a hierarchy of capital flows. While the liberalisation of equity
flows seems to enhance growth prospects, the evidence that the liberalisation of debt flows is
beneficial to the EMEs is ambiguous (Henry, 2007; Committee on Global Financial System
(2009)).
Reversals of capital flows from the EMEs, as again shown by the current financial crisis, are
quick, necessitating a painful adjustment in bank credit, and collapse of stock prices. Such
reversals also result in the contraction of the central bank's balance sheet, which may be
difficult to compensate with accretion of domestic assets as fast as the reserves depletion.
These developments can then lead to banking and currency crises, large employment and
output losses and huge fiscal costs. Thus, the boom and bust pattern of capital inflows can,
unless managed proactively, result in macroeconomic and financial instability. Hence, the
authorities in the EMEs need to watch closely and continuously financial and economic
developments in the advanced economies on the one hand and actively manage their capital
account.
To summarise, excessively accommodative monetary policy for an extended period in the
major advanced economies in the post dot com crash period sowed the seeds of the current
global financial and economic crisis. Too low policy interest rates, especially the US, during
the period 2002-04 boosted consumption and asset prices, and resulted in aggregate
demand exceeding output, which was manifested in growing global imbalances. Too low
short-term rates also encouraged aggressive search for yield, both domestically and globally,
encouraged by financial engineering, heavy recourse to securitisation and lax regulation and
supervision. The global search for yield was reflected in record high volume of capital flows
to the EMEs; since such flows were well in excess of their financing requirements, the
excess was recycled back to the advanced economies, leading to depressed long-term
interest rates. The Great Moderation over the preceding two decades led to under-pricing of
risks and the new financial and economic regime was considered as sustainable. The
combined effect of these developments was excessive indebtedness of households, credit
booms, asset price booms and excessive leverage in the major advanced economies, but
also in emerging market economies. While forces of globalisation were able to keep goods
and services inflation contained for some time, the aggregate demand pressures of the
accommodative monetary started getting reflected initially in oil and other commodity prices
and finally onto headline inflation. The consequent tightening of monetary policy led to
correction in housing prices, encouraged defaults on sub-prime loans, large losses for banks
and financial institutions, sharp increase in risk aversion, complete lack of confidence and
trust amongst market participants, substantial deleveraging, and large capital outflows from
the EMEs. Financial excesses of the 2002-06 were, thus, reversed in a disruptive manner
and have now led to the severest post-war recession. In brief, the large volatility in monetary
policy in the major reserve currency countries contributed to the initial excesses and their
subsequent painful correction.
II. Impact on India
Initial impact of the sub-prime crisis
The initial impact of the sub-prime crisis on the Indian economy was rather muted. Indeed,
following the cuts in the US Fed Funds rate in August 2007, there was a massive jump in net
capital inflows into the country. The Reserve Bank had to sterilise the liquidity impact of large
foreign exchange purchases through a series of increases in the cash reserve ratio and
issuances under the Market Stabilisation Scheme (MSS).2 With persistent inflationary
pressures emanating both from strong domestic demand and elevated global commodity
prices, policy rates were also raised. Monetary policy continued with pre-emptive tightening
measures up to August 2008.
The direct effect of the sub-prime crisis on Indian banks/financial sector was almost
negligible because of limited exposure to complex derivatives and other prudential policies
put in place by the Reserve Bank. The relatively lower presence of foreign banks in the
Indian banking sector also minimized the direct impact on the domestic economy (Table 3).
The larger presence of foreign banks can increase the vulnerability of the domestic economy
to foreign shocks, as happened in Eastern European and Baltic countries. In view of
significant liquidity and capital shocks to the parent foreign bank, it can be forced to scale
down its operations in the domestic economy, even as the fundamentals of the domestic
2
In view of sustained large capital flows, the finite stock of government securities with the Reserve Bank, and
the absence of the option of issuing central bank securities under the RBI Act, a new scheme, Market
Stabilisation Scheme (MSS), was introduced in April 2004 to manage the large capital flows. Under this
scheme, the Reserve Bank has been empowered to issue government Treasury Bills and medium duration
dated securities exclusively for sterilization purposes, so as to manage liquidity appropriately. The proceeds
collected under MSS auctions are kept in a separate identifiable cash account with the RBI, and are used for
redemption and/or buy back of securities issued under the MSS. The payments for interest and discount on
MSS securities are not made from the MSS Account, but shown in the government budget transparently. The
MSS securities are indistinguishable from normal government Treasury Bills and dated securities in the hands
of the holders. The introduction of MSS has succeeded broadly in restoring LAF to its intended function of
daily liquidity management (see Mohan (2006)). MSS operates symmetrically as a store of liquidity: it helps to
absorb excess liquidity in times of large capital flows and to inject liquidity in periods of reversals in capital
flows. Thus, balances under MSS rose from around Rs.39,000 crore at end-January 2007 to around
Rs.1,75,000 crore by end-May 2008 in the face of large capital flows; in the subsequent period, with reversals
in capital flows, MSS balances came down to around Rs. 88,000 crore by end-March 2009 and helped
maintain adequate rupee liquidity in the system.
BIS Review 54/2009
economy remain robust. Thus, domestic bank credit supply can shrink during crisis episodes.
For instance, in response to the stock and real estate market collapse of early 1990s,
Japanese banks pulled back from foreign markets - including the United States - in order to
reduce liabilities on their balance sheets and thereby meet capital adequacy ratio
requirements. Econometric evidence shows a statistically significant relationship between
international bank lending to developing countries and changes in global liquidity conditions,
as measured by spreads of interbank interest rates over overnight index swap (OIS) rates
and U.S. Treasury bill rates. A 10 basis-point increase in the spread between the London
Interbank Offered Rate (LIBOR) and the OIS sustained for a quarter, for example, is
predicted to lead to a decline of up to 3 percent in international bank lending to developing
countries (World Bank, 2008).
Impact of Lehman failure
Balance of payments: capital outflows
There was also no direct impact of the Lehman failure on the domestic financial sector in
view of the limited exposure of the Indian banks. However, following the Lehman failure,
there was a sudden change in the external environment. As in the case of other major EMEs,
there was a sell-off in domestic equity markets by portfolio investors reflecting deleveraging.
Consequently, there were large capital outflows by portfolio investors during
SeptemberOctober 2008, with concomitant pressures in the foreign exchange market. While foreign
direct investment flows exhibited resilience, access to external commercial borrowings and
trade credits was rendered somewhat difficult. On the whole, net capital inflows during
200809 were substantially lower than in 2007-08 and there was a depletion of reserves (Table 4).
However, a large part of the reserve loss (US $ 33 billion out of US $ 54 billion) during
AprilDecember 2008 reflected valuation losses.
The contraction of capital flows and the sell-off in the domestic market adversely affected
both external and domestic financing for the corporate sector. The sharp slowdown in
demand in the major advanced economies is also having an adverse impact on our exports
and industrial performance. On the positive side, the significant correction in international oil
and other commodity prices has alleviated inflationary pressures as measured by wholesale
price index. However, various measures of consumer prices remain at elevated levels on the
back of continuing high inflation in food prices.
Fiscal impact
Government finances, which had exhibited a noteworthy correction starting 2002-03, came
under renewed pressure in 2008-09 on account of higher expenditure outgoes due to (i)
higher international crude oil prices (up to September 2008) and the incomplete pass-through
to domestic prices (ii) higher fertiliser prices and associated increase in fertiliser prices (iii)
the Sixth Pay Commission award and (iv) debt waiver scheme. The fiscal stimulus packages
involving additional expenditures and tax cuts have put further stress on the fisc. Reflecting
these factors, the Central Government's fiscal deficit more than doubled from 2.7 per cent of
GDP in 2007-08 to 6.0 per cent in 2008-09, reaching again the levels seen around the end of
the 1990s. The revenue deficit at 4.4 per cent of GDP will be at its previous peak touched
during 2001-02 and 2002-03. Primary balance again turned into deficit in 2008-09, after
recording surpluses during the preceding two years (Table 5). Net market borrowings during
2008-09 almost trebled from the budgeted Rs.1,13,000 crore to Rs.3,29,649 in the revised
estimates (actual borrowings were Rs.2,98,536 crore as per Reserve Bank records) and are
budgeted at Rs.3,08,647 crore (gross borrowings at Rs. 3,98,552 crore) in 2009-10.
In view of the renewed fiscal deterioration, the credit rating agency Standard and Poor's has
changed its outlook on long-term sovereign credit rating from stable to negative, while
reaffirming the "BBB-" rating. If bonds issued to oil and fertiliser companies are taken into
account, the various deficit indicators will be even higher. Moreover, in order to boost
domestic demand, the Government has announced additional tax sops subsequent to the
interim vote-on-account budget putting further pressure on fiscal position. Thus, while the
slowdown in the domestic economy may call for fiscal stimulus, fiscal manoeuvrability is
limited.
According to the IMF, based on measures already taken and current plans, it is estimated
that government debt ratios and fiscal deficits, particularly in advanced economies, will
increase significantly. For the G-20 as a whole, the general government balance is expected
to deteriorate by 31⁄2 percent of GDP, on average, in 2009. While the fiscal cost for some
countries will be large in the short-run, the alternative of providing no fiscal stimulus or
financial sector support would be extremely costly in terms of the lost output (IMF, 2009b).
Impact on the real economy
Reflecting the slowdown in external demand, and the consequences of reversal of capital
flows, growth in industrial production decelerated to 2.8 per cent in 2008-09 (April-February)
from 8.8 per cent in the corresponding period of 2007-08. On the other hand, services sector
activity has held up relatively well in 2008-09 so far (April-December) with growth of 9.7 per
cent (10.5 per cent in the corresponding period of 2007-08). Services sector activity was
buoyed up by acceleration in "community, social and personal services" on the back of
higher government expenditure. Overall, real GDP growth has slowed to 6.9 per cent in the
first three quarters of 2008-09 from 9.0 per cent in the corresponding period of 2007-08. On
the expe