Deepak Mohanty: Global financial crisis and monetary policy response in India Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the 3rd Indian Council for Research on International Economic Relations-Internationale Weiterbildung und Entwicklung (ICRIER-InWEnt) Annual Conference, New Delhi, 12 November 2009. * * * The assistance provided by Shri Bhupal Singh is gratefully acknowledged. I thank ICRIER and InWEnt for giving me this opportunity to speak with you this morning. In my talk, I will try to address the following set of questions: How and why was India impacted by the global financial crisis? How did monetary policy respond to the crisis? What was the impact of the policy on the Reserve Bank’s balance sheet? How did monetary transmission work? I will conclude by highlighting the challenges of exit from monetary easing. 2. The subprime crisis that emerged in the US housing mortgage market in 2007 snowballed into a global financial crisis, and a global economic recession followed. The financial landscape has changed significantly after the collapse of Lehman Brothers in September 2008. An important lesson, post-September 2008, is that irrespective of the degree of globalisation of a country and the soundness of its domestic policies, a financial crisis could spread to every economy. 3. The international transmission of liquidity shocks was fast and unprecedented. While falling asset prices and uncertainty about valuation of the traded instruments affected market liquidity, failure of leading global financial institutions and the deleveraging process tightened the market for funding liquidity. Given the growing risk of illiquidity cascading into solvency problems, credit and quantitative easing acquired priority in most central banks. While the global financial markets have since started showing signs of stabilisation, credit flow in advanced markets is yet to recover. The contagion from the global financial crisis warranted swift monetary and fiscal policy responses with a view to ensuring orderly functioning of markets, preserving financial stability, and moderating its adverse effects on growth. How was India impacted by the global financial crisis? Transmission of shocks to India 4. There were two distinct phases in 2008–09 during which the transmission of global shocks – through trade, finance and expectations channels – posed different but significant challenges for the Reserve Bank. In the first half of the year, the world experienced simultaneous increase in both food and commodity prices, and there was a return of inflation after a phase of “great moderation”. Dealing with supply side sources of inflation posed challenges for the conduct of Reserve Bank’s monetary policy, particularly in the face of signs of cyclical slowdown on the one hand and the risk of spiralling headline inflation on the other. In the second half of the year, the global financial crisis and the subsequent global recession dramatically changed the nature of the challenge emanating from globalisation. Impact on the financial markets 5. Post-Lehman, the impact of the global financial crisis unfolded in the Indian financial markets, though reversal of capital inflows and significant correction in the domestic stock markets on the back of sell-off in the equity market by the foreign institutional investors (FIIs). The withdrawal of funds from the Indian equity markets and reduced access of the Indian entities to raise funds from the international markets put significant pressure on the dollar liquidity in the domestic foreign exchange market. These developments created adverse expectations on the balance of payments (BoP) outlook and led to depreciation pressures on the Indian rupee and increased volatility in the foreign exchange market. 6. The banking sector was not affected as it had hardly any direct exposure to subprime assets. Moreover, banks were well capitalised and inherently sound. The reduced foreign funding and the subdued domestic capital market, however, put pressure on some segments of the financial system, such as non-bank financial companies (NBFCs) and mutual funds. Mutual funds were dependent on corporates for bulk funds. As liquidity needs of the corporates increased, redemption pressures on mutual funds rose. This translated into liquidity problems for NBFCs as mutual funds were important supplier of funds to NBFCs. Further, the demand for bank credit also increased as external sources of credit dried up for corporates. Against this background of increase in demand for liquidity, the Reserve Bank had to step in with liquidity augmenting measures such as cuts in cash reserve ratio (CRR) and increase in refinance facilities. Consequently, the pressure for funding liquidity came to rest on the banks. In this scenario, the banks continued to expand credit and meet the funds requirements of mutual funds and NBFCs aided by liquidity easing measures by the Reserve Bank. Initially, though bank credit could not fully offset the shortfall in credit from other sources. Subsequently, demand for bank credit came down as the contagion transmitted to the real economy and eroded private consumption and investment demand. Impact on the real economy 7. Under the impact of external demand shocks, the Indian economy witnessed moderation in growth in the second half of 2008–09 in comparison with the robust growth performance in the preceding five years (8.8 per cent per annum). The deceleration in growth was particularly noticeable in negative growth in industrial output in Q4 of 2008–09; a decline for the first time since the mid-1990s (Table 1). This was on account of erosion of external demand which affected industrial performance; a reflection of increasing globalisation of the Indian industry. 8. The transmission of external demand shocks was swift and severe on export growth, which declined from a peak of about 40 per cent in Q2 of 2008–09 to (–) 15 per cent in Q3 and further to (–) 22 per cent in Q4; a contraction for the first time since 2001–02. Concurrently, domestic aggregate demand also moderated resulting from sharp deceleration in the growth of private consumption demand. In order to respond to the slowing demand, fiscal stimulus measures were undertaken by the government which included both tax cuts and increase in expenditure. This raised the fiscal deficit of the Central Government by 3.5 per cent of GDP in 2008–09. Consequently, the growth in government final consumption expenditure registered a sharp increase in Q3 and Q4 of 2008–09 (Table 2). It is, however, important to note that unlike many countries the entire fiscal stimulus in India was aimed at addressing the deficiency in aggregate demand rather than extending support to the financial sector. While this meant a deviation from the planned fiscal consolidation path as committed under the Fiscal Responsibility and Budget Management (FRBM) Act, without the stimulus the deceleration in GDP growth during 2008–09 would have been much sharper. Table 1: Key macroeconomic indicators – India Indicators 2008–09: Q1–Q4 2009–10: Q1–Q2 Real GDP Growth (Y-o-Y) (%) Industry Services Q1 7.8 5.1 10.0 Q2 7.7 4.8 9.8 Q3 5.8 1.6 9.5 Q4 5.8 –0.5 8.4 Q1 6.1 4.2 7.7 Q2 – – – Inflation (Y-o-Y) (%) WPI CPI-Industrial Workers 12.0 7.7 12.1 9.8 5.9 9.7 0.8 8.0 –1.1 9.3 –0.2 11.8 Money and Credit Growth (Y-o-Y) (%) Broad Money (M3) Banks Credit 21.5 24.5 19.5 23.5 19.9 22.7 18.6 16.4 20.2 15.1 19.7 14.1 Interest Rates (%) Overnight (call) money 10-year g-sec 6.8 8.4 9.5 8.5 7.8 5.9 4.2 6.6 3.2 6.8 3.2 7.1 37.6 31.6 39.5 60.5 –15.0 2.1 –22.3 –29.1 –30.0 –35.0 –21.0 –33.6 –31.4 –9.0 11.1 312.1 –38.7 –12.5 7.6 286.3 –34.7 –13.0 –4.3 256.0 –14.6 4.7 –5.3 252.0 –26.0 –5.8 6.7 265.1 – – – 281.3 Foreign Trade Export Growth (%) Import Growth (%) Balance of Payments (US $ billion) Trade Deficit (–) Current Account Deficit (–) Net Capital Flows Reserve Outstanding Table 2: Components of aggregate demand in India (Per cent) Item 2008–09 2009–10 Q1 Q2 Q3 Q4 Q1 Growth Rates (Year-on-Year) Private Final Consumption Expenditure Government Final Consumption Expenditure Gross Fixed Capital Formation Change in Stocks Exports Less Imports 4.5 –0.2 9.2 6.0 25.6 27.4 2.1 2.2 12.5 5.6 24.3 35.3 2.3 56.6 5.1 1.4 7.1 21.7 2.7 21.5 6.4 –0.9 –0.8 –5.7 1.6 10.2 4.2 3.2 –10.9 –21.2 Relative shares Private Final Consumption Expenditure Government Final Consumption Expenditure Gross Fixed Capital Formation Change in Stocks 58.0 9.6 32.2 3.2 55.5 8.3 34.5 3.2 57.4 12.5 30.9 2.9 51.4 13.4 31.6 2.9 55.6 9.9 31.6 3.1 Net Exports –1.3 –10.5 –8.5 –2.9 1.6 Source: Central Statistical Organisation. Why was India impacted by the global financial crisis? 9. During the initial phases of the global crisis, the Indian financial markets remained unaffected as the direct exposure of banks to global subprime assets was negligible. The growth process being largely domestic demand driven remained broadly intact. It was then perceived that India and other EMEs were “decoupled” from the advanced economies. As indicated by Governor Dr. Subbarao “the ‘decoupling theory’ was never totally persuasive”. 1 As the crisis intensified, particularly after the Lehman collapse, the global shocks first impacted the domestic financial markets and then transmitted to the real economy through the trade and finance and confidence channels. 10. Despite the dominance of domestic demand, the role of trade in conditioning the growth process in India is becoming important over time. A significant boost to global integration came through rapid growth in India’s international trade in services in the 2000s enabled by expansion in information technology which facilitated cross-border delivery of services. Progressive liberalisation of capital account initiated in the 1990s and continued through the 2000s gave further fillip to the process of financial integration. Thus the financial channel emerged as dominant factor with gross capital flows (inflows plus outflows) rising to over 50 per cent of GDP in 2008–09 from an average of about 5 per cent in the 1980s (Table 3). Given the significant degree of openness achieved since the 1990s, it is natural that the global shocks – real as well as financial – have greater impact. Table 3: Key indicators of openness of the Indian economy (Per cent of GDP) Year Goods Trade Services Trade Gross Current Account Gross Capital Account 1970s 1980s 1990s 2000s (2000–09) 10.0 12.7 18.8 1.3 2.5 4.1 12.7 17.2 26.7 4.2 5.4 15.1 Gross Current and Capital Account 16.9 22.6 41.8 29.3 9.7 45.0 32.7 77.7 2008–09 40.2 13.2 60.5 51.0 111.5 11. With increased global integration, the Indian economy now is subject to greater influence of global business cycles. The correlation between the cyclical component of the index of industrial product (IIP) of the advanced economies and India has risen to 0.50 during the period 1991–2009 from 0.20 in during the period 1971–1990 (Chart 1). See Dr. D. Subbarao (2008), “Mitigating Spillovers and Contagion – Lessons from the Global Financial Crisis”, Speech delivered at the RBI-BIS Seminar at Hyderabad on December 4, 2008. Chart 1: Business cycle of advanced economies and India: 1991 to 2009 0.06 Cyclical industrial production of India Cyclical industrial production of advanced economies 0.04 0.02 -0.02 -0.04 2009M01 2008M04 2007M07 2006M10 2006M01 2005M04 2004M07 2003M10 2003M01 2002M04 2001M07 2000M10 2000M01 1999M04 1998M07 1997M10 1997M01 1996M04 1995M07 1994M10 1994M01 1993M04 1992M07 1991M10 1991M01 -0.06 12. The traditional conduit of transmission of global shocks is trade cycles. The cyclical movement in India’s exports and world imports during the earlier period 1970–91 was not significantly synchronised with a relatively low correlation of 0.38. However, with rising exports along with a transition from primary article exports to manufacturing exports, the correlation between India’s exports and world imports has increased significantly to 0.80 during the recent period 1992–2009 (Chart 2). Chart 2: Trade cycle of advanced economies and India: 1992 to 2009 0.25 0.2 0.15 IMPWORLDCY EXPINCY 0.1 0.05 -0.05 -0.1 -0.15 -0.2 -0.25 1992M01 1992M08 1993M03 1993M10 1994M05 1994M12 1995M07 1996M02 1996M09 1997M04 1997M11 1998M06 1999M01 1999M08 2000M03 2000M10 2001M05 2001M12 2002M07 2003M02 2003M09 2004M04 2004M11 2005M06 2006M01 2006M08 2007M03 2007M10 2008M05 2008M12 -0.3 13. Besides the synchronisation of the trade cycles, the financial channel of integration has also become prominent during the recent period. A causal analysis between the cyclical component of the Indian stock prices (BSE Sensex) and the US stock prices (S&P 500 Index) reveals that during the earlier period (1970–1991), when foreign investors could not participate in the Indian stock market, there was no causal effect of the global stock prices on the Indian markets. However, in the recent period (1992–2009), there has been greater impact from the global stock prices on domestic stock prices with the US stock prices having significant causal impact on the Indian stock prices (Table 4). Table 4: Causality between the cyclical components of the Indian and the US stock prices Null Hypothesis F-Statistic Result. Sample: 1970M01 1991M12 BSE Index does not Granger Cause S&P500 S&P500 does not Granger Cause BSE Index 1.89 0.48 Accept Accept Sample: 1992M01 2009M06 BSE Index does not Granger Cause S&P500 S&P500 does not Granger Cause BSE Index 0.36 4.80 Accept Reject 14. These shifts in the degree of synchronisation of the Indian trade and business cycles with the global cycles and increased financial integration in the recent period indicate that India cannot remain immune to global trends. Thus, global economic developments now have a greater influence on the domestic economy. How did monetary policy in India respond to the global financial crisis? 15. As the crisis intensified, the Reserve Bank, like most central banks, took a number of conventional and unconventional measures to augment domestic and foreign exchange liquidity, and sharply reduced the policy rates. In a span of seven months between October 2008 and April 2009, there was unprecedented policy activism. For example: (i) the repo rate was reduced by 425 basis points to 4.75 per cent, (ii) the reverse repo rate was reduced by 275 basis points to 3.25, (iii) the cash reserve ratio (CRR) was reduced by a cumulative 400 basis points to 5.0 per cent, and (iv) the actual/potential provision of primary liquidity was of the order of Rs. 5.6 trillion (10.5 per cent of GDP). 16. There are, however, some key differences between the actions taken by the Reserve Bank of India and the central banks in many advanced countries: • First, in the process of liquidity injection the counter-parties were banks; even liquidity measures for mutual funds, NBFCs and housing finance companies were largely channeled through the banks. • Second, there was no dilution of collateral standards which were largely government securities, unlike the mortgage securities and commercial papers in the advanced economies. • Third, despite large liquidity injection the Reserve Bank’s balance sheet did not show unusual increase because of release of earlier sterilised liquidity. • Fourth, availability and deployment of multiple instruments facilitated better sequencing of monetary and liquidity measures. • Finally, the experience in the use of procyclical provisioning norms and countercyclical regulations ahead of the global crisis helped enhance financial stability. 17. By synchronising the liquidity management operations with those of exchange rate management and non-disruptive internal debt management operations, the Reserve Bank ensured that appropriate liquidity was maintained in the system, consistent with the objective of price and financial stability. The policy stance clearly reflected the forward looking undertone, particularly the expectations of more prolonged adverse external conditions in the face of no visible risks to inflation. While the magnitude of the crisis was global in nature, the policy responses were adapted to domestic growth, inflationary and financial sector conditions. How did crisis management change the reserve bank’s balance sheet? 18. As the balance of payments came under pressure in Q3 of 2008–09 due to capital outflows, it became necessary to draw down reserves to finance the shortfall and maintain orderly conditions in the foreign exchange market. This led to corresponding contraction in the base (reserve) money. The Reserve Bank, therefore, ensured the necessary expansion in net domestic assets (NDA) through conventional open market operations (OMO) involving outright purchase of government securities in the secondary market as well as provision of liquidity through repos under in its daily liquidity adjustment facility (LAF) (Chart 3). Another instrument which allowed the Reserve Bank to expand liquidity was the unwinding of the market stabilisation scheme (MSS) securities. 2 The unwinding of MSS balances not only created the scope for adequate liquidity expansion by the Reserve Bank without expanding its balance sheet (Chart 4) in any significant measure, but the timing of the unwinding could also be modulated in such a way that the large borrowing programme of the government was managed smoothly without exerting undue market stress. In addition, the reduction in CRR of banks from 9 per cent to 5 per cent released Rs.1.6 trillion of primary liquidity to the banking system. Chart 3: Impact of liquidity management Rs. Billion ‐500 Variation in NDA ‐1000 2009: Q2 2009: Q1 2008: Q4 2008: Q3 2008: Q2 2008: Q1 Variation in NFA Note: Net Domestic Assets (NDA) here excludes non-monetary liabilities and the impact of LAF; Net Foreign Assets (NFA) excludes valuation changes 19. While the Reserve Bank’s balance sheet did not show unusual expansion, sharp reductions in CRR raised the money multiplier, leading to higher increase in broad money. 3 The average money multiplier rose from 4.3 in March 2008 to 4.8 in March 2009, reflecting lowering of CRR (Chart 5). The increase in money multiplier ensured steady increase in money supply consistent with the liquidity requirements of the economy. MSS securities are essentially short-term government securities, introduced in April 2004, as an instrument of sterilisation to partly neutralise the expansionary effects of surges in capital inflows. The amount sterilised through MSS remained immobilised in the Central Government’s account with the Reserve Bank of India. As at end-September 2008, MSS amount stood over Rs. 1.7 trillion. Money Multiplier can be expressed as [1+c]/(c+r], where, c is currency-deposit ratio (a behavioural variable) and r is reserve requirement ratio (a policy variable). A reduction in r leads to an increase in the money multiplier. Chart 4: The balance sheet of the Reserve Bank of India 16.0 Rs. Trillion 15.0 14.0 13.0 Oct 26,09 Sep 26,09 Mar-09 Jul 28,09 Aug 27,09 Feb-09 Jun 28,09 Apr 29,09 May 29,09 Mar 30,09 Jan 29,09 Feb 28,09 Dec 30,08 Nov 30,08 Oct 01,08 Oct 31,08 Sep 01,08 Jul 03,08 Aug 02,08 Jun 03,08 Apr 04,08 May 04,08 12.0 Chart 5: Changes in money multiplier 5.5 5.0 4.5 Apr-09 Jan-09 Dec-08 Nov-08 Oct-08 Sep-08 Aug-08 Jul-08 Jun-08 May-08 Apr-08 Mar-08 Feb-08 Jan-08 4.0 20. The liquidity injection efforts of the Reserve Bank, despite being large, could be achieved without compromising either on the eligible counterparties or on the asset quality in the Reserve Bank’s balance sheet. The liquidity requirements of non-bank financial entities were met indirectly by extending liquidity support to the designated counterparties like scheduled commercial banks and primary dealers. Liquidity expansion achieved through unwinding of MSS and reduction in reserve requirement ensured that the Reserve Bank’s balance sheet did not expand significantly, unlike in several other central banks. How did monetary transmission work? 21. In the wake of the crisis, monetary transmission broke down in several countries as risk aversion gave rise to credit crunch. As regards India, the changes in the Reserve Bank’s policy rates were quickly transmitted to the money and debt markets (Chart 6). The money market rates moved in tandem with the policy reverse repo rate. However, transmission to the credit market was slow due to several structural rigidities in the system, especially the dominance of fixed term deposit liabilities in banks’ balance sheets at fixed interest rates. Chart 6: Transmission of policy rates to money and bond markets 12.0 10.0 6.0 4.0 Oct‐09 Sep‐09 Aug‐09 July‐09 Jun‐09 May‐09 Apr‐09 Mar‐09 Feb‐09 Jan‐09 Dec‐08 Nov‐08 Oct‐08 Sep‐08 Apr‐08 May‐08 0.0 Aug‐08 2.0 Jul‐08 Yield on AAA Corporate Bonds Yield on 10‐Year Government Securities Call Rates Policy Reverse Repo Rate Jun‐08 Per cent 8.0 22. As bank deposits contracted in the past at high rates have started to mature and banks have significantly reduced their term deposit rates, the transmission of lower policy rates to the credit market has improved with a lag (Chart 7). Chart 7: Deposit and lending rates of public sector banks What are the challenges of exit from monetary easing? 23. There is an active debate on the timing and sequencing of expansionary monetary stance around the world. In this context, Governor Dr. Subbarao, in his J.R.D. Tata Memorial Lecture had indicated that the current monetary and fiscal stance is not the steady state. The exit from the current monetary policy accommodation could, however, be different across countries depending on the balance of risk to growth and price stability, type of balance sheet adjustment that have taken place during the crisis and the position of the economy in the business cycle. In the case of advanced countries, where central bank balance sheets have expanded substantially including the portfolio comprising of mortgage backed securities, commercial papers and corporate bonds, the exit policies may be constrained by the speed of revival and developments in the specific market segments. In contrast, the central bank accommodation in India was mainly done through unwinding of MMS and conduct of OMO including LAF and through special refinancing facilities in the banking system. Thus, the withdrawal of monetary accommodation in India should be feasible without adverse impact on specific market segments. 24. The October 2009 Review of Monetary Policy for the Year 2009–10 brought forward the challenges. To quote: “The precise challenge for the Reserve Bank is to support the recovery process without compromising on price stability. This calls for a careful management of trade-offs. Growth drivers warrant a delayed exit, while inflation concerns call for an early exit. Premature exit will derail the fragile growth, but a delayed exit can potentially engender inflation expectations…. The balance of judgment at the current juncture is that it may be appropriate to sequence the “exit” in a calibrated way so that while the recovery process is not hampered, inflation expectations remain anchored. The “exit” process can begin with the closure of some special liquidity support measures.” Accordingly, the Reserve Bank has begun the first phase of “exit”, by withdrawal of most of the unconventional measure taken during the crisis. Conclusion 25. To sum up, despite sound fundamentals and no direct exposure to the sub-prime assets, India was affected by global financial crisis reflecting increasing globalisation of the Indian economy. The policy response has been swift. While fiscal stimulus cushioned the deficiency in demand, monetary policy augmented both domestic and foreign exchange liquidity. The expansionary policy stance of the Reserve Bank was manifested in significant reduction in CRR as well as the policy rates. The contraction of the Reserve Bank’s balance sheet resulting from the decline in its foreign assets necessitated active liquidity management aimed at expanding domestic assets, which was ensured through OMO including regular operations under the LAF, unwinding of MSS securities, introduction of new and scaling up of existing refinance facilities. In addition, sharp reductions in CRR besides making available primary liquidity raised the money multiplier and ensured steady increase in money supply. The liquidity injection efforts of the Reserve Bank could be achieved without compromising either on the eligible counterparties or on the asset quality in the Reserve Bank’s balance sheet. Moreover, the Reserve Bank’s balance sheet did not show unusual increase, unlike that of several other central banks. 26. At present, the focus around the world and also in India has shifted from managing the crisis to managing the recovery. The key challenge relates to the exit strategy that needs to be designed considering that the recovery is as yet fragile but there is an uptick in inflation, though largely from the supply side, which could engender inflationary expectations. Thus, the Reserve Bank has initiated the first phase of exit in its October 2009 Review of monetary policy in a calibrated manner mainly by withdrawal of unconventional measures taken during the crisis. This should help anchor inflationary expectations by reducing the overhang of liquidity without jeopardising the growth process as market liquidity remains comfortable. Thank you.