It was not supposed to happen this way; the decoupling theory was to kick in. Even as advanced countries went into a downturn, emerging economies – given their substantial foreign exchange reserves, improved policy framework, generally robust corporate balance sheets and relatively healthy banking sector – were to continue to steam ahead, with, at worst, only minor brushes. The reality turned out to be the opposite. All emerging economies have been impacted by the crisis, some quite significantly. Indeed, current indications are that the slowdown in growth of emerging economies will be sharper than earlier anticipated.
Impact on India
India, too, has been affected by the crisis – and much more than it was suspected earlier. The banking system was not directly exposed to subprime mortgage assets, and had only limited off-balance sheet activities or securitised assets, which were at the core of the crisis in advanced countries. India’s banks, both public and private, are financially sound, well capitalised and well regulated. The capital-to-risk weighted assets ratio of Indian banks, at 12.6%, is above the regulatory norm of 9% and well above the Basel Accord norm of 8%.
Even so, India is experiencing the knock-on effects of the global crisis, through the monetary, financial and real channels. Its financial markets have all come under pressure, mainly because of what we have begun to call ‘the substitution effect’. As credit lines and credit channels overseas dried as a result of liquidity tightening, some of the credit demand that had been met by overseas financing shifted to the domestic credit sector, putting pressure on domestic resources. The reversal of capital flows occurring as part of the global de-leveraging process put pressure on our foreign exchange markets. The global credit crunch and de-leveraging were reflected at home in the sharp fluctuation in the overnight money market rates in October 2008 and the depreciation of the rupee.
The RBI’s response
Contrary to hopes and expectations, the collapse of Lehman Brothers in mid-September was not a one-off event and was followed by several other big financial institutions needing to be rescued. It became quite clear that the global markets were unlikely to revive soon and central bank policy changes were warranted. The Reserve Bank of India (RBI) remained on constant vigil and devised a series of well-timed and calibrated policy packages. Our policy response had three objectives: to maintain a comfortable rupee liquidity position; to augment foreign exchange liquidity; and to maintain a policy framework that would keep credit delivery on track so as to arrest the moderation in growth.
Measures to expand rupee liquidity included a significant reduction in the cash reserve ratio – the amount of bank reserves impounded by the central bank – and a reduction in the statutory liquidity ratio – the portion of funds that banks need to keep invested in government bonds. The RBI also opened a special repo window under its liquidity adjustment facility (LAF), giving liquidity access to banks for on-lending to non-bank finance companies (NBFCs), housing finance companies (HFCs) and mutual funds. Defying orthodoxy, the reserve bank also opened a special refinance window, which banks can access without any collateral.
Measures aimed at managing foreign exchange liquidity include upward adjustment of the interest rate ceilings on foreign currency deposits by non-resident Indians, substantially relaxing the external commercial borrowings regime for corporates, and allowing NBFCs and HFCs access to foreign borrowing. The RBI also instituted a rupee-dollar swap facility for banks with overseas branches to give them comfort in managing their short-term funding requirements.
Measures to encourage flow of credit to targeted sectors include: extending the period of pre-shipment and post-shipment credit for exports; expanding the refinance facility for exports; counter-cyclical adjustment of provisioning norms for all types of standard assets and reduction in risk weights on banks’ exposure to certain sectors that had been increased earlier counter-cyclically; and expanding the lendable resources available to refinance institutions for refinancing credit extended for small industries, housing and exports.
The RBI, reflecting the declining inflationary pressures and growing concerns about growth moderation, adjusted its policy stance from tightening to easing. In an effort to improve the flow of credit to productive sectors, it signalled a lowering of the interest rates by reducing its key policy rates – both the repo rate at which the central bank injects liquidity and the reverse repo rate at which it absorbs liquidity.
The central government, recognising the depth and extraordinary impact of this crisis, invoked the emergency provisions of the Fiscal Responsibility and Budget Management Act to seek relaxation from the fiscal targets and in early December launched a fiscal stimulus package of 0.5% of gross domestic product (GDP) that includes additional public spending, cuts in indirect taxes and a government guarantee for infrastructure spending. This package comes on top of an already announced expanded safety-net for poor people in rural areas, a farm loan waiver package and salary increases for government staff, all of which are also fiscally expansionary.
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 made available to the financial system through these measures is more than $65bn. This sizeable easing has ensured a comfortable liquidity position starting in mid-November 2008, as evidenced by a number of indicators. Since November 18, the LAF window has largely been in absorption mode. The weighted-average call money rate has dropped substantially; the overnight money market rate has consistently remained within the LAF corridor; and the yield on the 10-year benchmark G-Sec has declined significantly. Taking their cue from the repo rate cut, many big banks have cut their benchmark prime lending rates.
The outlook for India is mixed. There is evidence of economic activity slowing down and real GDP growth has moderated in the first half of 2008/09. The services sector too, which has been India’s prime growth engine for the past five years, is slowing, mainly in the construction, transport and communication, trade, hotels and restaurants sub-sectors. For the first time in seven years, exports have declined in absolute terms for two months in a row, October and November 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. Industrial activity has slowed and, breaking a 15-year trend, posted negative growth in October 2008, suggesting that growth moderation may be steeper and more extended than projected earlier.
On the positive side, headline inflation – as measured by the wholesale price index – has fallen sharply, and this decline has been sustained since mid-November 2008, pointing to 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 reduction in the price of petrol and diesel and the cut in indirect taxes in early December 2008 should further ease inflationary pressures. Consumer price inflation did increase in September and October, possibly owing to the trend in food articles inflation and the higher weight of food articles in measures of consumer price inflation. Historically, there has been a correlation between wholesale and consumer price inflation, and given this, consumer price inflation too can be expected to soften in the months ahead.
Going forward, the RBI will continue to maintain a comfortable rupee and foreign exchange liquidity position. 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. The RBI expects that commercial banks will take the policy rates reduction as a signal to adjust their rates in order to keep credit flowing to productive sectors. In particular, the special refinance windows opened by the reserve bank for the micro, small and medium-sized enterprise, housing and export sectors should see credit flowing in their direction. The government's fiscal stimulus should be able to supplement these efforts from both supply and demand sides.
When the turnaround comes
Over the past five years, India clocked an unprecedented 9% growth, driven largely by domestic consumption and investment even as the share of net exports rose. This was no accident. True, the benign global environment, easy liquidity and low interest rates helped, but at the heart of India’s growth was a growing entrepreneurial spirit and rise in productivity. These fundamental strengths continue to be in place.
Yet the global crisis has dented India's growth trajectory as investments and exports have slowed. Clearly, there is a period of painful adjustment ahead of us. But, once the global economy begins to recover, India’s turnaround will be sharper and swifter, given the country’s strong fundamentals and untapped growth potential. Meanwhile, the challenge for the government and the RBI is to manage the adjustment with as little pain as possible.
Duvvuri Subbarao is governor of the Reserve Bank of India in Mumbai.
