Duvvuri Subbarao: Impact of the global financial crisis on India -
collateral damage and response
Speech by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the Symposium
on "The Global Economic Crisis and Challenges for the Asian Economy in a Changing
World" organized by the Institute for International Monetary Affairs, Tokyo, 18 February 2009.
* * *
Global outlook
The global economic outlook deteriorated sharply over the last quarter. In a sign of the
ferocity of the down turn, the IMF made a marked downward revision of its estimate for
global growth in 2009 in purchasing power parity terms - from its forecast of 3.0 per cent
made in October 2008 to 0.5 per cent in January 2009. In market exchange rate terms, the
downturn is sharper - global GDP is projected to actually shrink by 0.6 per cent. With all the
advanced economies - the United States, Europe and Japan - having firmly gone into
recession, the contagion of the crisis from the financial sector to the real sector has been
unforgiving and total. Recent evidence suggests that contractionary forces are strong:
demand has slumped, production is plunging, job losses are rising and credit markets remain
in seizure. Most worryingly, world trade - the main channel through which the downturn will
get transmitted on the way forward - is projected to contract by 2.8 per cent in 2009.
Policy making around the world is in clearly uncharted territory. Governments and central
banks across countries have responded to the crisis through big, aggressive and
unconventional measures. There is a contentious debate on whether these measures are
adequate and appropriate, and when, if at all, they will start to show results. There has also
been a separate debate on how abandoning the rule book driven by the tyranny of the
shortterm, is compromising medium-term sustainability. What is clearly beyond debate though is
that this Great Recession of 2008/09 is going to be deeper and the recovery longer than
earlier thought.
Emerging economies
Contrary to the "decoupling theory", emerging economies too have been hit by the crisis. The
decoupling theory, which was intellectually fashionable even as late as a year ago, held that
even if advanced economies went into a downturn, emerging economies will remain
unscathed because of their substantial foreign exchange reserves, improved policy
framework, robust corporate balance sheets and relatively healthy banking sector. In a
rapidly globalizing world, the "decoupling theory" was never totally persuasive. Given the
evidence of the last few months - capital flow reversals, sharp widening of spreads on
sovereign and corporate debt and abrupt currency depreciations - the "decoupling theory"
stands totally invalidated. Reinforcing the notion that in a globalized world no country can be
an island, growth prospects of emerging economies have been undermined by the cascading
financial crisis with, of course, considerable variation across countries.
Questions that will be addressed
India too has been impacted by the crisis - and by much more than it was suspected earlier.
What I propose to do in the rest of my speech is to address the following four questions:
(i) Why has India been hit by the crisis?
(ii) How has India been hit by the crisis?
(iii) How have we responded to the challenge?
(iv) What is the outlook for India?
Why has India been hit by the crisis?
There is, at least in some quarters, dismay that India has been hit by the crisis. This dismay
stems from two arguments.
The first argument goes as follows. The Indian banking system has had no direct exposure to
the sub-prime mortgage assets or to the failed institutions. It has very limited off-balance
sheet activities or securitized assets. In fact, our banks continue to remain safe and healthy.
So, the enigma is how can India be caught up in a crisis when it has nothing much to do with
any of the maladies that are at the core of the crisis.
The second reason for dismay is that India's recent growth has been driven predominantly by
domestic consumption and domestic investment. External demand, as measured by
merchandize exports, accounts for less than 15 per cent of our GDP. The question then is,
even if there is a global downturn, why should India be affected when its dependence on
external demand is so limited?
The answer to both the above frequently-asked questions lies in globalization. Let me
explain. First, India's integration into the world economy over the last decade has been
remarkably rapid. Integration into the world implies more than just exports. Going by the
common measure of globalization, India's two-way trade (merchandize exports plus imports),
as a proportion of GDP, grew from 21.2 per cent in 1997-98, the year of the Asian crisis, to
34.7 per cent in 2007-08.
Second, India's financial integration with the world has been as deep as India's trade
globalization, if not deeper. If we take an expanded measure of globalization, that is the ratio
of total external transactions (gross current account flows plus gross capital flows) to GDP,
this ratio has more than doubled from 46.8 per cent in 1997-98 to 117.4 per cent in 2007-08.
Importantly, the Indian corporate sector's access to external funding has markedly increased
in the last five years. Some numbers will help illustrate the point. In the five-year period
200308, the share of investment in India's GDP rose by 11 percentage points. Corporate savings
financed roughly half of this, but a significant portion of the balance financing came from
external sources. While funds were available domestically, they were expensive relative to
foreign funding. On the other hand, in a global market awash with liquidity and on the
promise of India's growth potential, foreign investors were willing to take risks and provide
funds at a lower cost. Last year (2007/08), for example, India received capital inflows
amounting to over 9 per cent of GDP as against a current account deficit in the balance of
payments of just 1.5 per cent of GDP. These capital flows, in excess of the current account
deficit, evidence the importance of external financing and the depth of India's financial
integration.
So, the reason India has been hit by the crisis, despite mitigating factors, is clearly India's
rapid and growing integration into the global economy.
How has India been hit by the crisis?
The contagion of the crisis has spread to India through all the channels - the financial
channel, the real channel, and importantly, as happens in all financial crises, the confidence
channel.
Let us first look at the financial channel. India's financial markets - equity markets, money
markets, forex markets and credit markets - had all come under pressure from a number of
directions. First, as a consequence of the global liquidity squeeze, Indian banks and
corporates found their overseas financing drying up, forcing corporates to shift their credit
demand to the domestic banking sector. Also, in their frantic search for substitute financing,
corporates withdrew their investments from domestic money market mutual funds putting
redemption pressure on the mutual funds and down the line on non-banking financial
companies (NBFCs) where the MFs had invested a significant portion of their funds. This
substitution of overseas financing by domestic financing brought both money markets and
credit markets under pressure. Second, the forex market came under pressure because of
reversal of capital flows as part of the global deleveraging process. Simultaneously,
corporates were converting the funds raised locally into foreign currency to meet their
external obligations. Both these factors put downward pressure on the rupee. Third, the
Reserve Bank's intervention in the forex market to manage the volatility in the rupee further
added to liquidity tightening.
Now let me turn to the real channel. Here, the transmission of the global cues to the
domestic economy has been quite straight forward - through the slump in demand for
exports. The United States, European Union and the Middle East, which account for three
quarters of India's goods and services trade are in a synchronized down turn. Service export
growth is also likely to slow in the near term as the recession deepens and financial services
firms - traditionally large users of outsourcing services - are restructured. Remittances from
migrant workers too are likely to slow as the Middle East adjusts to lower crude prices and
advanced economies go into a recession.
Beyond the financial and real channels of transmission as above, the crisis also spread
through the confidence channel. In sharp contrast to global financial markets, which went into
a seizure on account of a crisis of confidence, Indian financial markets continued to function
in an orderly manner. Nevertheless, the tightened global liquidity situation in the period
immediately following the Lehman failure in mid-September 2008, coming as it did on top of
a turn in the credit cycle, increased the risk aversion of the financial system and made banks
cautious about lending.
The purport of the above explanation is to show how, despite not being part of the financial
sector problem, India has been affected by the crisis through the pernicious feedback loops
between external shocks and domestic vulnerabilities by way of the financial, real and
confidence channels.
How have we responded to the challenge?
Let me now turn to how we responded to the crisis. The failure of Lehman Brothers in
midSeptember was followed in quick succession by several other large financial institutions
coming under severe stress. This made financial markets around the world uncertain and
unsettled. This contagion, as I explained above, spread to emerging economies, and to India
too. Both the government and the Reserve Bank of India responded to the challenge in close
coordination and consultation. The main plank of the government response was fiscal
stimulus while the Reserve Bank's action comprised monetary accommodation and counter
cyclical regulatory forbearance.
Monetary policy response
The Reserve Bank's policy response was aimed at containing the contagion from the outside
- to keep the domestic money and credit markets functioning normally and see that the
liquidity stress did not trigger solvency cascades. In particular, we targeted three objectives:
first, to maintain a comfortable rupee liquidity position; second, to augment foreign exchange
liquidity; and third, to maintain a policy framework that would keep credit delivery on track so
as to arrest the moderation in growth. This marked a reversal of Reserve Bank's policy
stance from monetary tightening in response to heightened inflationary pressures of the
previous period to monetary easing in response to easing inflationary pressures and
moderation in growth in the current cycle. Our measures to meet the above objectives came
in several policy packages starting mid-September 2008, on occasion in response to
unanticipated global developments and at other times in anticipation of the impact of
potential global developments on the Indian markets.
Our policy packages included, like in the case of other central banks, both conventional and
unconventional measures. On the conventional side, we reduced the policy interest rates
aggressively and rapidly, reduced the quantum of bank reserves impounded by the central
bank and expanded and liberalized the refinance facilities for export credit. Measures aimed
at managing forex liquidity included an upward adjustment of the interest rate ceiling on the
foreign currency deposits by non-resident Indians, substantially relaxing the external
commercial borrowings (ECB) regime for corporates, and allowing non-banking financial
companies and housing finance companies access to foreign borrowing.
The important among the many unconventional measures taken by the Reserve Bank of
India are a rupee-dollar swap facility for Indian banks to give them comfort in managing their
short-term foreign funding requirements, an exclusive refinance window as also a special
purpose vehicle for supporting non-banking financial companies, and expanding the lendable
resources available to apex finance institutions for refinancing credit extended to small
industries, housing and exports.
Government's fiscal stimulus
Over the last five years, both the central and state governments in India have made a serious
effort to reverse the fiscal excesses of the past. At the heart of these efforts was the Fiscal
Responsibility and Budget Management (FRBM) Act which mandated a calibrated road map
to fiscal sustainability. However, recognizing the depth and extraordinary impact of this crisis,
the central government invoked the emergency provisions of the FRBM Act to seek
relaxation from the fiscal targets and launched two fiscal stimulus packages in December
2008 and January 2009. These fiscal stimulus packages, together amounting to about 3 per
cent of GDP, included additional public spending, particularly capital expenditure,
government guaranteed funds for infrastructure spending, cuts in indirect taxes, expanded
guarantee cover for credit to micro and small enterprises, and additional support to
exporters. These stimulus packages came on top of an already announced expanded
safetynet for rural poor, a farm loan waiver package and salary increases for government staff, all
of which too should stimulate demand.
Impact of monetary measures
Taken together, the measures put in place since mid-September 2008 have ensured that the
Indian financial markets continue to function in an orderly manner. The cumulative amount of
primary liquidity potentially available to the financial system through these measures is over
US$ 75 bln or 7 per cent of GDP. This sizeable easing has ensured a comfortable liquidity
position starting mid-November 2008 as evidenced by a number of indicators including the
weighted-average call money rate, the overnight money market rate and the yield on the
10year benchmark government security. Taking the signal from the policy rate cut, many of the
big banks have reduced their benchmark prime lending rates. Bank credit has expanded too,
faster than it did last year. However, Reserve Bank's rough calculations show that the overall
flow of resources to the commercial sector is less than what it was last year. This is because,
even though bank credit has expanded, it has not fully offset the decline in non-bank flow of
resources to the commercial sector.
Evaluating the response
In evaluating the response to the crisis, it is important to remember that although the origins
of the crisis are common around the world, the crisis has impacted different economies
differently. Importantly, in advanced economies where it originated, the crisis spread from the
financial sector to the real sector. In emerging economies, the transmission of external
shocks to domestic vulnerabilities has typically been from the real sector to the financial
sector. Countries have accordingly responded to the crisis depending on their specific
country circumstances. Thus, even as policy responses across countries are broadly similar,
their precise design, quantum, sequencing and timing have varied. In particular, while policy
responses in advanced economies have had to contend with both the unfolding financial
crisis and deepening recession, in India, our response has been predominantly driven by the
need to arrest moderation in economic growth.
What is the outlook for India?
The outlook for India going forward is mixed. There is evidence of economic activity slowing
down. Real GDP growth has moderated in the first half of 2008/09. The services sector too,
which has been our prime growth engine for the last five years, is slowing, mainly in
construction, transport and communication, trade, hotels and restaurants sub-sectors. For
the first time in seven years, exports have declined in absolute terms for three months in a
row during October-December 2008. Recent data indicate that the demand for bank credit is
slackening despite comfortable liquidity in the system. Higher input costs and dampened
demand have dented corporate margins while the uncertainty surrounding the crisis has
affected business confidence. The index of industrial production has shown negative growth
for two recent months and investment demand is decelerating. All these factors suggest that
growth moderation may be steeper and more extended than earlier projected.
In addressing the fall out of the crisis, India has several advantages. Some of these are
recent developments. Most notably, headline inflation, as measured by the wholesale price
index, has fallen sharply, and recent trends suggest a faster-than-expected reduction in
inflation. Clearly, falling commodity prices have been the key drivers behind the disinflation;
however, some contribution has also come from slowing domestic demand. The decline in
inflation should support consumption demand and reduce input costs for corporates.
Furthermore, the decline in global crude prices and naphtha prices will reduce the size of
subsidies to oil and fertilizer companies, opening up fiscal space for infrastructure spending.
From the external sector perspective, it is projected that imports will shrink more than exports
keeping the current account deficit modest.
There are also several structural factors that have come to India's aid. First, notwithstanding
the severity and multiplicity of the adverse shocks, India's financial markets have shown
admirable resilience. This is in large part because India's banking system remains sound,
healthy, well capitalized and prudently regulated. Second, our comfortable reserve position
provides confidence to overseas investors. Third, since a large majority of Indians do not
participate in equity and asset markets, the negative impact of the wealth loss effect that is
plaguing the advanced economies should be quite muted. Consequently, consumption
demand should hold up well. Fourth, because of India's mandated priority sector lending,
institutional credit for agriculture will be unaffected by the credit squeeze. The farm loan
waiver package implemented by the Government should further insulate the agriculture
sector from the crisis. Finally, over the years, India has built an extensive network of social
safety-net programmes, including the flagship rural employment guarantee programme,
which should protect the poor and the returning migrant workers from the extreme impact of
the global crisis.
RBI's policy stance
Going forward, the Reserve Bank's policy stance will continue to be to maintain comfortable
rupee and forex liquidity positions. There are indications that pressures on mutual funds have
eased and that NBFCs too are making the necessary adjustments to balance their assets
and liabilities. Despite the contraction in export demand, we will be able to manage our
balance of payments. It is the Reserve Bank's expectation that commercial banks will take
the signal from the policy rates reduction to adjust their deposit and lending rates in order to
keep credit flowing to productive sectors. In particular, the special refinance windows opened
by the Reserve Bank for the MSME (micro, small and medium enterprises) sector, housing
sector and export sector should see credit flowing to these sectors. Also the SPV set up for
extending assistance to NBFCs should enable NBFC lending to pick up steam once again.
The government's fiscal stimulus should be able to supplement these efforts from both
supply and demand sides.
When the turn around comes
Over the last five years, India clocked an unprecedented nine per cent growth, driven largely
by domestic consumption and investment even as the share of net exports has been rising.
This was no accident or happenstance. True, the benign global environment, easy liquidity
and low interest rates helped, but at the heart of India's growth were a growing
entrepreneurial spirit, rise in productivity and increasing savings. These fundamental
strengths continue to be in place. Nevertheless, the global crisis will dent India's growth
trajectory as investments and exports slow. Clearly, there is a period of painful adjustment
ahead of us. However, once the global economy begins to recover, India's turn around will be
sharper and swifter, backed by our strong fundamentals and the untapped growth potential.
Meanwhile, the challenge for the government and the RBI is to manage the adjustment with
as little pain as possible.