Y V Reddy: Implications of global financial imbalances for the emerging market
economies
Remarks by Dr Y V Reddy, Governor of the Reserve Bank of India, at the round table discussion at
the International Symposium organised by the Bank of France, Paris, 4 November 2005.
Please also refer to the website of the Reserve Bank of India for annex that accompanies this speech.
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I am thankful to the Banque de France for inviting me to the international symposium on Productivity,
Competitiveness and Globalisation to enable me to share my thoughts on financial stability. I intend
speaking on the possible implications of global imbalances for the emerging market economies
(EMEs) with special focus on India.
Although fast growing economies are generally grouped together as EMEs , some of their major
macroeconomic indicators present a wide spectrum. While some of the EMEs are running large
current account surpluses (such as China, the Russian Federation, South Korea, Venezuela,
Malaysia, Taiwan and Brazil), some others are running current account deficits (such as Turkey,
Hungary, South Africa, Mexico, India and the Czech Republic) and their current account balances
range from a deficit of US$ 20 billion to a surplus of US $ 69 billion. While savings rates for select
EMEs1 range from nine per cent to 43 per cent of the GDP, in most of the EMEs the rates have
increased and overtaken those of the industrial countries, with particularly high savings rates in China,
Malaysia and Russia. Likewise, while some of the EMEs have fiscal surplus (Russia), several others
have fiscal deficit (Turkey, India, the Philippines, Argentina and several other EMEs). Also, while
some of the EMEs such as India are largely domestic-demand driven, some other EMEs, particularly
in the East Asia (Malaysia and the Philippines) are largely dependent on exports to sustain their
growth and their exports of goods and services range from 15 per cent to over 120 per cent of GDP.
It is useful to note that while some of the EMEs are net oil exporters, some others are net oil importers.
Thus, given the diverse nature, macroeconomic conditions and policy regimes of the EMEs, it may be
difficult to treat all of them as contributing to global financial imbalances, in the same manner, nor
would all the EMEs be identically affected by the adjustment of global financial imbalances. It may,
therefore, be somewhat difficult to speak about the implications of global financial imbalances for the
EMEs as a group. I would, therefore, focus primarily on India, but the analytic framework could
perhaps be of some help in appreciating the implications for different EMEs.
It is worthwhile to mention that there are some factors which could adversely impact the EMEs as a
group, though with varying intensity. Global developments, particularly those in the world financial
markets, have the most direct and serious impact on the financing conditions in the emerging markets.
An abrupt and sharp adjustment of the currencies may potentially lead to a significant portfolio
rebalancing by the foreign investors, which could cause sharp changes in the long-term yields. This,
in turn, could result in volatility in the level and cost of capital flows with direct implications for the
EMEs.
Volatility in financial markets could adversely affect the EMEs in many ways, and also in a complex
and interrelated fashion. For convenience of analysis, the impact may be classified broadly into: (i) the
impact on the financing conditions in which EMEs operate; (ii) impairment of the balance sheets of the
banking sector, and (iii) hampering of the growth prospects in the real sector. Even within the same
EMEs, the impact could vary across different entities such as the Government, the corporate sector,
the households and the financial sector, depending upon the country-specific and institution-specific
operating environment, the stage of development and the degree of integration with and exposure to
the international financial markets. In view of the diversity of the EMEs and the complexity of impact of
any unpredictable unwinding of global imbalances, it is proposed to analyse the possible implications,
illustratively, with reference to India
Recent macroeconomic developments in India
There are several noteworthy features of India's recent macroeconomic performance. First, the
investment climate has improved and industrial and service sector activity has picked up. Second,
buoyant exports have emerged as the driver of demand for a broad spectrum of industries. Third,
there has been a modest attempt at and a commitment to achieve fiscal consolidation. Fourth, the
trend inflation has declined over the years and inflation expectations stabilised. Fifth, India has been
successful in managing liquidity against the backdrop of continuing capital flows. Sixth, India has
emerged as a preferred destination for foreign investors and received about a quarter of the global
portfolio flows to the EMEs in 2004. Seventh, India's foreign exchange reserves are in excess of the
total outstanding external debt of the country. Eighth, the performance of the corporate sector has
improved and some corporates are now listed on the international stock exchanges. Ninth, India's
financial markets have deepened, widened and become vibrant over the years with a robust
institutional framework and market infrastructure in place. Tenth, the profitability and soundness
indicators of the banking sector have improved. Finally, India has been adopting international
benchmarks for financial standards and best practices with suitable adaptations for Indian conditions.
The Indian economy today is characterised by an environment of confidence, positive business
expectations, a renewal of rule-based fiscal consolidation, stable and orderly financial markets and
institutions and progressive integration with the global economy. Real GDP growth for 2005-06
(April-March) has been conservatively projected at around 7.0 per cent, and more recently, revised
upwards to a range of 7.0 to 7.5 per cent. Despite the sustained strength of export performance, the
merchandise trade deficit is expected to be somewhat higher in 2005-06 than in the previous year,
mainly on account of substantially higher oil prices and non-oil import demand for investment. For the
year as a whole, while invisibles may finance a large part of the enlarged trade deficit, the current
account deficit is expected to widen during 2005-06 but to remain within acceptable limits that can be
financed by normal capital flows. The headline inflation is expected to lie in the range of 5.0-5.5 per
cent. Consolidation of Central Government finances is the goal of fiscal policy at the Centre - the
targets are: the gross fiscal deficit (GFD) of 3.0 per cent of GDP and the elimination of the revenue
deficit by 2008-09. The fiscal position of State Governments also continues to undergo slight
correction in terms of key deficit indicators.
Against this background, it may be useful to analyse the implications of global financial imbalances for
India in terms of the likely impact on four separate balance sheets - of the government, of the Reserve
Bank of India, of the corporate sector and of the banking sector.
Impact on the government
The Government of India does not raise resources from the international capital markets to finance the
fiscal deficit, though the bilateral and multilateral sources do provide moderate amount of foreign
currency funds. The Government could, therefore, be affected indirectly through the spill-over impact
of external developments on domestic interest rates. What is of relevance, inter alia, is the nominal
international interest rates and domestic interest rates, adjusted for inflation differential. To the extent
there is a rise in domestic interest rates, there could be an increase in the cost of government
borrowings of the Government. Since most of the outstanding debt is at fixed rates and not on floating
rates, the rise in the borrowing cost will be incremental. This situation also provides greater headroom
for a flexible monetary policy to adjust policy rates, as and when warranted, without any excessive
impact on the fiscal deficit.
Impact on the Reserve Bank's balance sheet
The fiscal position of the Government could also be indirectly impacted through the nature of
management of foreign exchange reserves held by the Reserve Bank. Volatility in the foreign
exchange market exposes foreign exchange reserves to both operational and market risks.
Depreciation in the value of any reserve currency vis-à-vis the domestic currency would result in an
equivalent decline in the value of the reserves held, though the impact may be mitigated to some
extent through appreciation of other currencies in which foreign exchange reserves are held. Also,
increase in global interest rates would entail capital losses on the corresponding assets, including
fixed income securities. Valuation and capital losses could impact the income of the Reserve Bank of
India and thus, its surplus transferable to the Government which, in turn, would have fiscal
implications. It is pertinent to mention that the Reserve Bank of India, as a matter of prudent practice,
follows conservative accounting norms whereby the valuation gains/losses on foreign exchange
reserves and gold are not taken to the profit and loss account, but instead, booked under a separate
reserve head.
Impact on the Indian corporates
As a result of deterioration in global financial market conditions, spreads on corporate debt might
widen suddenly due to shift in investor confidence in the global financial markets. Increase in the
global interest rates may also have impact on other benchmarks such as LIBOR. A sharp rise in yields
may entail an increase in cost of variable-rate debt contracted by the corporates. This, to some extent,
could be offset if there is a depreciation of the relevant currency and consequent decline in the value
of the existing debt contracted by corporates in that currency.
Indian corporates as also some of the public sector enterprises raise resources from the international
capital markets. While a part of their external commercial borrowings is at variable interest rate, a part
is at fixed interest rates. In order to avoid any serious impact of changes in the exchange rate on the
balance sheet of the corporate sector, Reserve Bank has been advising banks to regularly monitor the
unhedged position of the corporates and has also been exhorting corporates to hedge their foreign
exchange exposures. Thus, India's corporates could be affected by the deterioration in the financing
conditions only to the extent they are not hedged either by foreign-currency cash flows in the normal
course of business or through recourse to appropriate hedging products. Corporates would, however,
be affected to the extent interest rates firm up in the domestic market, depending on their exposure to
debt relative to other liabilities.
Impact on the banking sector
Banks in India are dependent mainly on domestic deposits, predominantly at fixed rates, for their
resource requirements. They would, therefore, be impacted significantly only if the adverse
developments in the international capital markets are particularly severe. Banks, in general, also do
not hold stock of securities in foreign currency. Banks in India have, thus, relatively small exposure to
the foreign exchange market. Their foreign currency borrowings are subject to the prudential limit of
25 per cent of their Tier-I capital and they are also required to maintain capital against the net open
position. Foreign currency borrowings by the banks are permitted beyond this ceiling, which is linked
to the net worth, exclusively for the purpose of export finance.
Like many other emerging market economies, credit extended by banks in India has increased sharply
in recent times. Credit growth, which was earlier seen largely in housing and retail loans, has now
turned quite broad-based with agriculture and industry also joining to drive up the credit demand. The
credit growth in some sectors, specially those related to assets which are experiencing price
volatilities, is being monitored closely.
Banks are allowed to lend to resident exporters in foreign currency at internationally competitive rates
of interest from their foreign currency lines of credit as well as out of funds available in exchange
earners' foreign currency accounts, resident foreign currency accounts and foreign currency
non-resident (banks) accounts. These loans are intended to finance domestic and imported inputs for
export production. Foreign currency loans to exporters are generally hedged against credit risk since
they are extended for bona fide underlying activity viz., export production. They are also usually
covered for exchange risk since they are denominated in foreign currency. Banks are also allowed to
extend loans in foreign currency to non-resident Indians against their FCNRB deposits. Funds in
foreign currency deposits can also be utilized for lending to domestic corporates for working capital
requirements in India, import financing, purchase of indigenous machinery, repayment of rupee term
loans and external commercial borrowings.
Banks have also been extending credit for investment in the asset market. Like many other EMEs,
asset prices in India have also risen sharply in the last couple of years. Should there be reversal of
capital flows, asset prices may decline sharply exposing the banks' balance sheets to credit risk.
There is a risk that rise in interest rates in general could impact housing prices and expose the
balance sheet of the households to interest rate risk, leading to some loan losses for banks. The
overall banking sector's exposure to housing loans is relatively small and may not have serious
systemic implications. Likewise, the equity market has also seen a sustained uptrend. Reversal of
capital flows could impact the equity market and some of the advances extended for investments in
the equity market might turn non-performing. Again, Indian banks do not have large exposure in the
asset market though, in the recent past, it has been increasing. Decline in asset prices could cause
loan losses and capital losses, if the decline is significant, though the impact on banks' balance sheets
might be muted, given their small exposure to the asset market.
The most significant impact on banks' balance sheet, however, could be felt through their investment
portfolio. Banks in India hold substantial investments in Government and other fixed income securities.
Such investments amounted to US $ 173 billion, constituting 35.1 per cent of their total assets as on
September 16, 2005. To the extent a rise in international interest rates impacts the domestic interest
rates, it would entail marked-to-market losses on the investment portfolios.
The banking sector, however, has acquired some added strength to absorb such probable shocks,
largely aided by regulatory actions. Apart from having built up a significant capital base reflected in the
capital to risk-weighted assets ratio (CRAR) for the sector of 12%, specific steps have been taken to
meet the interest rate risk. First, separate provision for capital against market risk has been
introduced. Second, a gradual building up of Investment Fluctuation Reserve up to 5% of the
markedto-market portfolio (out of tax-free profits) by March 2006 has been mandated, and several banks have
already achieved the target. Third, an enabling risk management environment has been provided to
banks to hedge their risks through vanilla derivative instruments. Fourth, Conservative accounting
norms followed did not allow banks to book unrealized gains. Fifth, as a one time measure, banks
were allowed to transfer securities to HTM, after booking the MTM losses against these. Thus, banks
in India, in general, have the resilience to withstand some rise in interest rates.
Impact on the real sector
Readjustment of the currencies would also have implications for the real sector. Significant
readjustment of the currencies and rise in interest rates could slow down the global growth. This would
entail a reduction in export opportunities and reduction in investment demand for EMEs, in general,
many of which depend on export demand to sustain their growth. Rise in interest rates, by slowing
down spending, may have a negative impact on the global economic growth. Thus, readjustment of
the currencies may affect several EMEs in a significant way.
The impact of any slowdown on India may be assessed with reference to two factors. First, India's
economy is largely domestic-demand driven. While India's exports constituted 11.5 per cent of GDP,
its share in the world trade is only 0.8 per cent. Second, India's exports basket is fairly diversified.
Some concerns arise with regard to the implications for employment in case of a slowdown in the
exports sector, especially with regard to the significant specialisation in BPO/IT Enable Services.
Rapid job growth that absorbs the huge supply of agricultural labour into its industrial work force is
necessary for socio-economic stability in India. Any negative impact on employment resulting in
substantial decrease of real earnings and widening income inequality is likely to reduce overall welfare
and increase the cost of structural adjustments required, especially in the absence of meaningful
social safety nets.
Monetary and prudential measures as responses
The outlook for output growth in India has improved in the recent months, particularly with the
momentum gained in manufacturing sector. However, persistence of global imbalances and high oil
prices with a significant permanent component do pose some risks. Furthermore, the credit growth
has recently been extremely strong possibly impacting credit quality, while money-supply is
overshooting the anticipated trajectory and strong investment demand coupled with high oil-prices is
turning the current account surplus into a deficit, though modest and manageable through normal
capital flows. These developments pose new challenges to maintaining price and financial stability
while ensuring momentum in growth. Consequently, in the Mid-Term Review of Annual Policy
Statement for the year 2005-06, released on October 25, 2005, several measures have been
announced to contain and manage the downside risks.
First, the reverse-repo rate (overnight liquidity absorption by Reserve Bank) has been increased by 25
basis points to 5.25 per cent, keeping the spread between reverse repo and repo at 100 basis points.
The Bank Rate, being the signalling rate for medium term, is retained at 6.00 per cent.
Second, rationalization of limits on banks' exposure to capital market has been announced, restricting
it to 40 per cent of a bank's net worth while simplifying the exemptions and coverage.
Third, the general provisioning requirement for standard advances has been enhanced from the
present level of 0.25 per cent to 0.40 per cent except in regard to Banks' exposures to laggards in
credit-growth, namely, Agriculture and Small and Medium Industries.
Fourth, a decision had been taken to treat the entire balance under Investment Fluctuation Reserve as
Tier I capital, thus providing some head-room to banks to raise Tier II capital in future.
Fifth, revised guidelines are being issued on corporate restructuring mechanisms to be followed by
banks in the light of experience gained.
Sixth, having regard to the recent trends in the credit markets, RBI is initiating a supervisory review
process with select banks having significant exposure to some sectors, namely, real estate, highly
leveraged non-banking financial companies, venture capital funds and capital markets. The purpose
of such a review is to ensure that effective risk mitigants and sound internal controls are in place for
managing such exposures.
Some reflections
From the above discussion, it is clear that the Impact on India would depend on the pace and extent of
currency and current account readjustments, and changes in global interest rates. While India by itself
hardly contributes to global financial imbalances, any large and rapid adjustments in major currencies
and related interest rates or current accounts of trading partners could indirectly impact the Indian
economy.
From the case of India, it is also clear that readjustment of the currencies and rise in interest rates
would impact different EMEs differently. Despite rise in short-term interest rates, long-term interest
rates, instead of rising, have moderated, leading to a further flattening of the global yield curve and
narrowing down of credit spreads. EMEs have taken advantage of favourable financial conditions.
During the first half of 2005, EMEs focused on operations aimed at meeting domestic and external
obligations and lengthening maturities. However, higher global interest rates could contribute to
widening of emerging market bond spreads, particularly those with high debt to GDP ratio. In view of
expected deceleration in financial conditions, some emerging markets have cushioned by advancing
their external financing, taking advantage of current benign financial market conditions. Emerging
market economies have, however, continued to improve their debt structures in an effort towards
reducing their vulnerability to external shocks. EMEs have carried out active liability management
operations aimed at meeting their financial requirements while minimising the cost of debt and its
risks. Some countries have taken steps to develop their local markets and have reduced the amount
of foreign currency-linked domestic debt, while gradually improving the maturity profile. Some of the
EMEs have also reduced the share of domestic debt indexed to the exchange rate.
Compared to the past crises, the EMEs, in general, are now resilient and in a better position to absorb
a financial shock. They have developed resilience to shocks by improving their macroeconomic
conditions and regulatory frameworks. EMEs have been achieving a healthy growth with more or less
stable inflation and have reduced their dependence on external demand. There has also been an
improvement in fiscal positions, supported by the development of domestic securities markets. The
external debt burden has declined and the composition of financial flows has changed with lower
reliance on borrowings from international banks. Several EMEs have addressed the weaknesses that
led to the earlier crisis by strengthening prudential regulation and supervision more in line with
international best practices. Banks' balance sheets have improved and capital ratios have risen.
Corporate governance practices have also improved. To the extent EMEs have introduced flexibility in
their exchange rates, their vulnerability to external shocks has declined. All these factors have
reduced the vulnerability of EMEs. Large reserves held by EMEs should also enable them to cope
with the volatility arising out of a sudden shift in market sentiment.
While macroeconomic fundamentals of several EMEs are strong, placing them in a relatively better
position to withstand deterioration in international financing conditions, economic performance of some
EMEs has been found to be less robust. The conditions in these economies may get accentuated by
adjustment of global financial imbalances and high and volatile oil prices. A possible volatility in the
global financial markets emanating from a rise in interest rates could magnify and propagate the
problems associated with less than satisfactory performance in some of the EMEs, making them
vulnerable to sudden reassessment of country risk. Such threats are real as the default rates of
subinvestment grade borrowers could increase. Credit derivatives, which have proliferated in recent years
and whose pricing has depended on relatively untested models and default correlation assumptions,
may in particular be vulnerable to corrections.
The main challenge for EMEs is to continue to take advantage of the current favourable external
financing conditions and at the same time pursue domestic macroeconomic and structural reforms
necessary for long-term stability. In fact, some EMEs have well-advanced external financing, in some
cases even including prefinancing for 2006 . EMEs have made significant gains in terms of healthy
growth, stable inflation, large trade surplus, greater exchange rate flexibility and lower debt burden.
While EMEs are preparing themselves to face sudden shocks, efforts need to be made by all
concerned for an orderly adjustment of global financial imbalances. While co-ordinated policy action
would minimise the cost of rebalancing, perhaps, a stress testing by all the concerned regulators in the
EMEs to assess the extent of the resilience could be helpful.
The EMEs, despite their diversity, seem to generate expectations of high growth and are generally
characterized by less-than-fully developed markets, specially financial markets. Consequently, there
are significant cross-border capital flows, with market perception of high risk and high reward in EMEs.
It is useful to note that implicit in the word "emerging" in the very title given to the EMEs as a group, is
the notion that they are undergoing a rapid change or transition. We must recognize that the transition
embraces demographics, political institutions, social dimensions and related attitudes. These
allencompassing changes have an in-built potential for uncertainties, possibly some volatility, but it gets
exacerbated by the international capital flows, particularly when the changes in such flows happen to
be unrelated to domestic fundamentals. In such a situation, managing the transition turns out to be a
critical challenge for policy making, and the management requires a more difficult and dynamic trade
off between commitment and flexibility in policy.
Overall, while added risks - both upside and downside - are inevitable with increasing global financial
and economic integration, the EMEs may consider strengthening their resilience through not only
sound macroeconomic management but also by adopting appropriate prudential measures. Over a
period, co-ordinated efforts, both at regional as well as global levels, could also help EMEs to cushion
themselves better against the risks of financial globalisation.
Thank you.