REPORT ONCURRENCY AND FINANCE

2008-09

GLOBAL FINANCIAL CRISIS ANDTHE INDIAN ECONOMY

RESERVE BANK OF INDIA

The findings, views, and conclusions expressed in this Report are entirely thoseof the contributing staff of the Department of Economic Analysis and Policy(DEAP) and should not necessarily be interpreted as the official views of theReserve Bank of India.

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Reserve Bank of India 2010All rights reserved. Reproduction is permitted provided an acknowledgement of the source is made.

ISSN 0972-8759

FOREWORD

The Global Financial Crisis, which has been compared with the Great Depression of the 1930s,in intensity and impact, has shown signs of moderation, lately. The crisis, which surfaced within thenarrow confines of the subprime mortgage sector in the US in August 2007, metamorphosed into aglobal financial crisis in September 2008 following the collapse of Lehman Brothers. Recentdevelopments in Europe suggest that there are still some remaining weak spots in the global economy.

With the benefit of hindsight, a number of macro - and micro-economic factors have been identifiedin the literature as the proximate causes of the crisis role of easy money, global imbalances andfinancial innovations on the one hand to regulatory and supervisory loopholes both at the national andglobal level on the other. A comparison of the current crisis with the various episodes of crises in thepast reveals that some semblance can be found amongst them with regard to the underlying causes.

In terms of impact, however, the recent crisis seems to have been more widespread thanmany other previous episodes. Almost all segments of the global financial markets experienced tremorsof the financial crisis, though at varying degrees. Interbank markets in advanced economies were thefirst one to be affected with severe liquidity pressures as banks became reluctant to lend to eachother on fear of counterparty risks. EMEs were also adversely affected by the spillover effects of themacroeconomic turbulence emanating from global financial meltdown. The crisis evokedunprecedented policy responses, both domestically and internationally. Monetary authorities all overthe world went far beyond their customary roles and resorted to aggressive monetary easing, somuch so that policy rates reached record lows. The forceful and coordinated policy actions appear tohave been successful in preventing a catastrophe. India could not remain unscathed and the globaldevelopments affected the financial and real activities in the second half of 2008-09.

Every crisis provides us powerful lessons. What we carry forward from this crisis is the needfor some new regulatory and supervisory institutions with emphasis on a system-wide approach,some new objectives for the central banks, importance of communication, transparency andcoordination in central bank functioning, a new design of the international financial architecture andrenewed faith in some of the safeguards adopted by the emerging market economies. This crisis hasraised questions about the adequacy and efficacy of the current international financial architecture toprevent and manage global crises. In fact, the speed and intensity with which the US subprime crisisexploded into a global financial crisis and then into a global economic crisis has led to a whole newdebate on dominant tenets of macroeconomics and has challenged established views on self correctingmarket mechanisms and the role of public policy. The depth and breadth of the crisis tested the limitsof conventional and unconventional policy options available to policymakers around the world.

Against this backdrop, it was felt that it will be timely to reflect upon the global crisis to make anobjective assessment of its impact on the global economy and the Indian economy, in particular, andto draw some policy lessons. Accordingly, the theme of this Report for 2008-09 was selected asGlobal Financial Crisis and the Indian Economy. The Report undertakes an in-depth analysisof causes of the crisis, the policy measures undertaken and the impact on the global as well as theIndian economy.

It may be recalled that from 1998-99, the Report on Currency and Finance has become themebased. So far nine Reports have been published as follows;

Year Theme

1. 1998-99 The Structural Transformation of the Indian Economy2. 1999-2000 Financial Sector and Market Integration3. 2000-01 Revitalising Growth4. 2001-02 Stock taking of the Reform Process and its Outcomes5. 2002-03 Management of the External Sector in an Open Economy Framework6. 2003-04 The Evolution of Monetary Policy7. 2004-05 The Evolution of Central Banking in India8. 2005-06 Development of Financial Markets and Role of the Central Bank9. 2006-07 and 2007-08 The Banking Sector in India : Emerging Issues and Challenges10. 2008-09 (Current) Global Financial Crisis and the Indian Economy

This Report has been prepared in the Department of Economic Analysis and Policy by a teamof officers led by Shri S.V.S. Dixit, Adviser and Dr. Rajiv Ranjan, Director under the overall supervisionand guidance of Shri Deepak Mohanty, Executive Director. The core team comprised Jeevan K.Khundrakpam, Rekha Misra, Bhupal Singh, Sunil Kumar, Abhiman Das, S.C. Dhal, Anupam Prakash,Rajeev Jain, Atri Mukherjee, Saurabh Ghosh, Sangita Misra, S.M. Lokare, Pankaj Kumar, RakeshKumar, Subrat Seet, N.Arun Vishnukumar, Indrajit Roy and S.Suraj. Valuable inputs from officers ofother Departments are highly appreciated.

Many of the issues raised in the Report are still evolving and it will take some time for them tosettle down. This group of young economists, who undertook the challenge of drawing a fine balance,did so, with courage, determination and forthrightness. I place on record my deep appreciation oftheir efforts.

Subir GokarnDeputy Governor

July 1, 2010

ICONTENTS

FOREWORDPage No.

1. THE THEME OF THE REPORT .............................................................................. 1-6

2. GENESIS AND THE NATURE OF THE CRISIS .................................................... 7-58Causes of the Crisis .................................................................................................. 8Financial Crises in a Historical Perspective ............................................................ 27How the Recent Crisis Differs from Earlier Crises ................................................. 47Concluding Observations ......................................................................................... 57

3. MANIFESTATION OF THE CRISIS ........................................................................ 59-125Impact on Financial Markets .................................................................................... 60Impact on Financial System ..................................................................................... 78Impact on the External Sector .................................................................................. 87Impact on Real Economy ......................................................................................... 106Concluding Observations ......................................................................................... 123

4. INTERNATIONAL RESPONSES TO THE CRISIS ................................................. 126-190Policy Responses During Financial Crises: Historical Perspective ....................... 127Monetary Policy Responses ..................................................................................... 132Fiscal Support to the Financial Sector .................................................................... 143Counter-Cyclical Fiscal Policy: Keynesian Measures ........................................... 149Fiscal and Monetary Policy Co-ordination .............................................................. 160Response of Multilateral Institutions ....................................................................... 163Financial Sector Policies .......................................................................................... 166Concluding Observations ......................................................................................... 188

5. IMPACT AND POLICY RESPONSES IN INDIA: FINANCIAL SECTOR ............. 191-241Channels of Global Integration ................................................................................ 192Impact of Global Crisis on Financial Markets ......................................................... 197Banking Sector, Mutual Funds and Non-Banking Financial Companies .............. 218Policy Responses ...................................................................................................... 233Concluding Observations ......................................................................................... 239

6. IMPACT AND POLICY RESPONSES IN INDIA: REAL SECTOR........................ 242-292Transmission of Global Shock to the Real Sector .................................................. 242Impact on India Through Trade Channel ................................................................. 248Impact on India Through Financial Channel ........................................................... 270Impact on Saving, Investment and Growth ............................................................. 276Concluding Observations ......................................................................................... 289

(Contd...)

II

7. LESSONS FROM THE CRISIS AND FUTURE CHALLENGES ........................... 293-336Lessons for Central Banks ....................................................................................... 296Lessons for Financial Regulation and Supervision ................................................ 302International Policy Co-ordination ............................................................................ 311Role of International Financial Institutions .............................................................. 312Global Imbalances and Macroeconomic Management .......................................... 314Lessons for Fiscal Policy .......................................................................................... 315Role of Credit Rating Agencies ................................................................................ 316Balancing the Size of Financial and Real Sectors ................................................. 317Lessons for Emerging Market Economies Including India ..................................... 317Major Challenges for Policymakers ......................................................................... 327Concluding Observations ......................................................................................... 333

SELECT REFERENCES .......................................................................................... I-XXIV

(Contd...)

Page No.

III

Box No. Title Page No.

II.1 Originate-to-Distribute Model ............................................................................ 17II.2 Credit Rating Agencies (CRAs): Boon or Bane? ............................................. 20II.3 The Concept of Shadow Banking ..................................................................... 23II.4 The Great Depression ....................................................................................... 31II.5 East Asian Crisis ................................................................................................ 34II.6 The Great Depression and India ...................................................................... 48II.7 Genesis of Crisis in Greece .............................................................................. 55

III.1 Impact of Declining Asset Prices on Household Wealth ................................. 77III.2 Why Asian Exports Were Worst Affected ......................................................... 91III.3 Impact on Aggregate Demand .......................................................................... 108III.4 Transmission Channels of Financial Crisis:

Financial and Real Linkages ............................................................................. 117III.5 Impact of the Global Crisis on Asia .................................................................. 120III.6 Labour Productivity Analysis during Boom and Bust Period .......................... 121IV.1 Lender of Last Resort ........................................................................................ 128IV.2 Policy Response during the Great Depression and

the Recent Crisis ............................................................................................... 131IV.3 Quantitative Easing and Central Bank Balance Sheets ................................. 138IV.4 Measures Relating to Deposit Guarantee ........................................................ 145IV.5 Discretionary Fiscal Policy as Counter-Cyclical Measures ............................ 150IV.6 Relevance of Fiscal Policy in the Current Downturn ....................................... 151IV.7 Some Requirements for Fiscal Policy Effectiveness ....................................... 152IV.8 Determinates of Fiscal Multiplier ...................................................................... 157IV.9 G-20 Working Group 3: Reform of the IMF ...................................................... 164

IV.10 G-30 Report on Financial Reform: A Framework for Financial Stability ........ 167IV.11 Report of G-20 Working Group 1 on Enhancing Sound Regulation

and Strengthening Transparency: Major Recommendations .......................... 169IV.12 Turner Review: Major Recommendations ........................................................ 171IV.13 Recommendations of the High-Level Group on Financial

Supervision in the European Union .................................................................. 172IV.14 Report of the Commission of Experts of the President of the United Nations

General Assembly on Reforms of the International Monetary and FinancialSystem (Chairman: Joseph E. Stiglitz) ............................................................. 175

IV.15 G-20 Working Group 2: Reinforcing International Cooperation andPromoting Integrity in Financial Markets ......................................................... 176

(Contd...)

LIST OF BOX ITEMS

IV

Box No. Title Page No.

(Contd...)

IV.16 US Administrations Financial Sector Plan ...................................................... 178IV.17 Enhancements to the Basel II Framework ....................................................... 180IV.18 FASB and IASB Approaches ............................................................................. 181IV.19 Expanding the Scope of Financial Regulation ................................................. 184

V.1 Financial Openness and Economic Growth ..................................................... 194V.2 Policy Measures to Augment Forex Liquidity ................................................... 201V.3 Major Global Events and Response of Indian Stock Markets ........................ 214V.4 Regulatory Measures ........................................................................................ 223V.5 Balance Sheet Effect of Monetary Policy ......................................................... 224V.6 Policy Measures to Address Financial Stress Faced

by NBFCs............................................................................................................ 229V.7 Fiscal Policy Responses against the Backdrop of the

Global Financial Crisis ....................................................................................... 235V.8 Monetary Policy Response................................................................................ 238

VI.1 Loss of Potential Growth in India vis--vis EmergingMarket Economies (EMEs)................................................................................ 247

VI.2 Exports and Domestic Growth Relationship: The GrowthAccounting Approach......................................................................................... 250

VI.3 The Gravity Model of Foreign Trade ................................................................. 255VI.4 Indias Exports of Engineering Goods .............................................................. 256VI.5 Affect of Commodity Prices on Asset Prices, Investment,

Trade and Economic Activity ............................................................................. 262VI.6 Global Crisis and Impact on Software Exports ............................................... 269VI.7 Foreign Savings and Investment in India ......................................................... 271VI.8 Global Crisis and Performance of Corporates in India ................................... 286

VLIST OF CHARTSChart No. Title Page No.

II.1 Global Imbalances: 1990-2009 ......................................................................... 11II.2 US Real Interest Rate and Effective Fed Funds Rate .................................... 14II.3 Structured Finance Products: Matryoshka Russian Doll Structure .............. 19II.4 Capital Flows to Developing Countries during Crisis Episodes

(as % to GDP) .................................................................................................... 53II.5 Trends in EME Trade Volume during Crisis Episodes

(percentage change) .......................................................................................... 53II.6 US GDP Growth since 1930s (annual percentage change) ........................... 54

III.1 Funding Liquidity and Inter-bank Spreads ....................................................... 62III.2 Impact on the Credit Market .............................................................................. 63III.3 Movements in Equity Markets ........................................................................... 67III.4 Impact on Corporate Bond Market ................................................................... 69III.5 Volatility in Government Bond Yields ................................................................ 71III.6 Movement in Exchange Rates .......................................................................... 73III.7 Movement in Commodity Prices ....................................................................... 75III.8 Movement in House Prices ............................................................................... 78III.9 Realised and Expected Writedowns of Loss Provision for Banks.................. 79

III.10 Bank Failures in the United States ................................................................... 80III.11 Insurance Sector Credit Default Swap Spread ................................................ 86III.12 International Trade Trends and Significance ................................................. 87III.13 Monthly Trade Performances ............................................................................ 89III.14 Region-wise Trade Performance ....................................................................... 90III.15 Remittances Outflows ........................................................................................ 93III.16 Net Capital Flows to Emerging and Developing Countries ............................ 98III.17 Impact of Crisis on Economic Growth .............................................................. 109III.18 Synchronised Fall in GDP Growth .................................................................... 109III.19 Consumer Price Inflation Select Countries ................................................... 111III.20 Real GDP in the Euro Area ............................................................................... 113III.21 Growth of Industrial Production (SA) ................................................................ 115

IV.1 Monetary Policy Rates: Deviation from the Taylor Rule .................................. 135IV.2 Policy Rates Cuts in EMEs during Sept. 2008 to June 2009 ......................... 140IV.3 Size of Fiscal Packages (revenue and spending measures) in

OECD Countries during 2008-10 (as % of 2008 GDP) .................................. 153

(Contd...)

VI

Chart No. Title Page No.

(Contd...)

IV.4 Discretionary Fiscal Stimulus and Automatic Stabilisers inOECD Countries ................................................................................................ 154

IV.5 Discretionary Fiscal Stimulus and Output Gap in G-20 Countries ................ 154IV.6 Discretionary Fiscal Stimulus and Initial Debt Position

in G-20 Countries ............................................................................................... 154V.1 Key Transmission Channels of Global Shocks on

the Domestic Economy ...................................................................................... 192V.2 External Openness of Indian Economy ............................................................ 196V.3 Cyclical synchronisation of GDP with Exports, Bank Credit and

Capital Flows (Correlation coefficient) ............................................................. 196V.4 Trends in Exchange Rates (USD-INR) ............................................................. 198V.5 Volatility and Rate in Indias Forex Market ....................................................... 200V.6 Movement in Indian Rupee ............................................................................... 200V.7 Forex Swap Facility and USD-INR Volatility ..................................................... 202V.8 Liquidity Adjustment Facility and Call rate ....................................................... 203V.9 Call Rate Volatility .............................................................................................. 204

V.10 Liquidity Position and Money Market Rate....................................................... 205V.11 CP and CD Issuances ....................................................................................... 206V.12 Money Market Spreads...................................................................................... 207V.13 Developments in Government Securities Market ............................................ 208V.14 Movements in Benchmark Yieds (1y, 5y and 10y) during 2007-09 ................ 209V.15 Volatility in Stock Markets ................................................................................. 215V.16 Growth Trend in Sectoral Bank Credit .............................................................. 222V.17 Trends in Credit Growth and Economic Activity .............................................. 222V.18 Interest Rates Movements ................................................................................ 226V.19 BSE Sensex and Net Investments by Mutual Funds....................................... 227V.20 Financial Stress Indicators ................................................................................ 232V.21 Relative Contribution of Government Consumption to GDP Growth ............. 237VI.1 Trends in GDP Growth ....................................................................................... 244VI.2 Indias Business Cycle Synchronisation (2005Q1-2009Q2) ........................... 245VI.3 Synchronisation of the Industrial Sector .......................................................... 246VI.4 Exports and External Demand .......................................................................... 249VI.5 Imports and Industrial Activity .......................................................................... 260VI.6 Indias Imports of Commodities and Global Prices ......................................... 261

VII

VI.7 Global Commodity Price Cycles ....................................................................... 261VI.8 Oil and Food Prices ........................................................................................... 264VI.9 Trade-Related Services ..................................................................................... 266

VI.10 Remittances: Trends and Relationship with International Oil Prices ............. 268VI.11 Capital Flows and Domestic Capital Formation .............................................. 271VI.12 ECB Disbursements and Capital Goods Imports ............................................ 273VI.13 Indicators of Finance Channel .......................................................................... 274VI.14 Trends in Quarterly Growth in Demand-Side Components ............................ 280VI.15 Trends in Cyclical IIP, Exports and FDI ............................................................ 283VI.16 Relative Contribution of Services ..................................................................... 288

(Contd...)

Chart No. Title Page No.

VIII

LIST OF TABLESTable No. Title Page No.

2.1 Macro Parameters of the United States ........................................................... 10

2.2 Current Account Balance .................................................................................. 10

2.3 Current Account Balance (per cent to GDP) ................................................... 112.4 Savings and Investment .................................................................................... 12

2.5 Exports of Goods and Services ........................................................................ 13

2.6 Mortgage Originations ....................................................................................... 16

2.7 Global Issuance of Credit Debt Obligations (CDOs)....................................... 192.8 U.S. Sub-prime Exposures and Losses ........................................................... 22

2.9 Incidence of Financial Crisis ............................................................................. 35

2.10 Frequency of Financial Crisis :1973-2007 ....................................................... 36

2.11 Major Financial Crises: 1873-2007 ................................................................... 362.12 Global Crises Originating in the USA ............................................................... 47

2.13 Duration and Depth of Financial Crises ........................................................... 49

2.14 Previous Episodes of Global Imbalances ........................................................ 49

2.15 Systemic Crises: Broad Indicators ................................................................... 50

2.16 Cross-Country Crises: Initial Conditions .......................................................... 51

2.17 United States: Great Depression vs. Recent Crisis ........................................ 54

3.1 Movement in Interbank Spreads ....................................................................... 61

3.2 Growth of Private Domestic Credit in Select Asian Economies ..................... 64

3.3 Credit Market Spreads....................................................................................... 64

3.4 Emerging Market Equity Issuance .................................................................... 66

3.5 Stock Market Changes - Select Countries ....................................................... 66

3.6 Performance of Emerging Equity Prices .......................................................... 66

3.7 Cross-Country Stock Market Capitalisation ..................................................... 67

3.8 Emerging Market Bond Issuance-Select Countries ........................................ 69

3.9 Emerging Market Bond Spreads Select Countries ...................................... 70

3.10 Sovereign External Borrowings in Emerging Europe ...................................... 71

3.11 Exchange Rates: Appreciation (+)/Depreciation (-) of Currenciesagainst the US dollar ......................................................................................... 73

(Contd...)

IX

(Contd...)

Table No. Title Page No.

3.12 Movement of Real Effective Exchange Rates of Select EmergingCountries ............................................................................................................ 74

3.13 Movement in Global Commodity Prices ........................................................... 76

3.14 Profitability of Major Banks as a Percentage of Total Average Assets .......... 803.15 Banking Indicators Select Countries ............................................................. 81

3.16 Select Asian Banks with Exposure to Lehman Brothers ................................ 82

3.17 Bank Ratios ........................................................................................................ 83

3.18 Banking Indicators Select Countries ............................................................. 83

3.19 Emerging Market Hedge Funds ........................................................................ 86

3.20 Trade Openness Select Countries ................................................................. 88

3.21 Developments in World Trade Volumes ............................................................ 88

3.22 Trade Performance of Select Asian Countries ................................................. 92

3.23 World Exports of Merchandise and Commercial Services ............................. 92

3.24 Remittance Flows to Developing Countries, 2002-09 ..................................... 94

3.25 Major Remittance-receiving Developing andTransition Economies in 2009 ........................................................................... 94

3.26 Cross-country Movement of Trade Balance andCurrent Account Balance .................................................................................. 95

3.27 Capital Flows in EMEs: Various Episodes Compared ..................................... 96

3.28 Net Capital Inflows to EMEs by Region ........................................................... 97

3.29 Net External Capital Flows to Developing Countries ...................................... 99

3.30 Outflows from Major Advanced Economies ..................................................... 1003.31 Cross-country Movement of FDI Flows ............................................................ 101

3.32 Cross-country Movement of Portfolio Flows .................................................... 102

3.33 Cross-country Comparison of Short-term Trade Credit .................................. 103

3.34 International Short-term Liabilities up to One Year Remaining Maturity ....... 105

3.35 International Reserve Movement ...................................................................... 106

3.36 Growth in Real GDP .......................................................................................... 107

3.37 Quarterly GDP Growth ...................................................................................... 1073.38 Comparison of GDP Growth Estimates for 2009............................................. 109

3.39 Gross Saving and Investment ........................................................................... 110

X(Contd...)

3.40 Trends in Consumer Price Inflation .................................................................. 111

3.41 Composition of Real Domestic Demand (seasonally adjusted) ..................... 1123.42 Residential Property Prices in the Euro Area .................................................. 114

3.43 Government Fiscal Balance .............................................................................. 116

3.44 Real GDP Growth, Investment and Exports Select Asian Economies .................................................................................... 118

3.45 Unemployment Rates ........................................................................................ 123

4.1 Typology of Conventional and Unconventional Measures ofCentral Banks ..................................................................................................... 133

4.2 Policy Rate Cuts in Advanced Countries ......................................................... 134

4.3 Select Recent Central Bank Measures ............................................................ 135

4.4 Major Crisis Interventions Introduced by Central Banks ................................ 1374.5 Select Unconventional Measures by EME Central Banks .............................. 139

4.6 Measures Implemented in Select EMEs (September 2008-May 2009) ......... 1404.7 Effectiveness of Crisis Interventions ................................................................ 141

4.8 3-Month LIBOR-Overnight Index Swap Spread: Declines from Peak............ 142

4.9 Support to Financial Sector as on June 2009 (as % of 2008 GDP) .............. 1474.10 Fiscal Costs of Selected Crises in the Past (as per cent of GDP) ................ 1484.11 Financial Sector Support Utilised Relative to Announcement

(as % of 2008 GDP) ........................................................................................... 1484.12 Size of Discretionary Measures in G-20 Countries, 2008-10 ......................... 153

4.13 Composition of Fiscal Packages in OECD Countries during 2008-10(as % of GDP) .................................................................................................... 155

4.14 G-20 Stimulus Measures, 2008-10 ................................................................... 156

4.15 Multipliers in OECD Countries .......................................................................... 158

4.16 G-20 Countries- Impact of Fiscal Expansion on Growth ................................ 159

4.17 Debt Dynamics and Debt Stabilising Primary Balances ................................. 160

5.1 Openness Indicators of Indian Economy ......................................................... 195

5.2 Transactions in Foreign Exchange Rate Market ............................................. 199

5.3 Movement of Indian Rupee ............................................................................... 199

5.4 Activity in Money Market Segments ................................................................. 205

Table No. Title Page No.

XI

(Contd...)

5.5 Transactions in Government Securities Market ............................................... 209

5.6 New Capital Issues by Non-Government Public Ltd. Companies .................. 211

5.7 Market Capitalisation of Stock Exchanges: Region-wise ............................... 212

5.8 Market Capitalisation of Stock Markets in Emerging Market Economies ...... 212

5.9 Cyclical Synchronisation of Indian Stock Market with Select Countries ....... 213

5.10 Integration of Indias Stock Market with Regional and GlobalMarkets Long-run Co-integrating Relation (April 1993 to July 2009,weekly stock prices in US dollars) .................................................................... 213

5.11 Trends in BSE and Nifty Indexes ...................................................................... 215

5.12 Stock Market Indicators ..................................................................................... 216

5.13 FII Flows and Indias Stock Market: Causal Relationship ............................... 217

5.14 Real Stock Return and Industrial Production Growth Pair-wiseGranger Causality Tests .................................................................................... 218

5.15 Bank Size and Average Operating Performance ............................................. 219

5.16 Growth of Balance Sheet of Scheduled Commercial Banks-Bank Group-wise................................................................................................ 220

5.17 Credit Growth and Financial Performance: 2008-09 ....................................... 221

5.18 Growth in Sectoral Bank Credit ........................................................................ 222

5.19 Resource Mobilisation by Mutual Funds .......................................................... 227

5.20 Sector-wise Net Resources Mobilised by Mutual Funds ................................ 227

5.21 Consolidated Balance Sheet of NBFCs-D ....................................................... 228

5.22 NPA Ratios of NBFCs-D .................................................................................... 229

5.23 Financial Performance of NBFCs-D ................................................................. 230

5.24 Monthly Financial Stress Indicators ................................................................. 231

5.25 Liquidity Injection/ Availability Since September 2008 ................................... 2376.1 Shift in the Composition of Aggregate Demand in India ................................. 242

6.2 Correlation between Growth of India and the World Economy ...................... 244

6.3 Indias Business Cycle Synchronisation (GDP Growth) with Advancedand Emerging Market Economies (EMEs) ....................................................... 245

6.4 Indias Business Cycle Synchronisation (Household Consumption) withAdvanced and Emerging Market Economies (EMEs) ..................................... 245

6.5 World Trade Performance .................................................................................. 249

Table No. Title Page No.

XII

6.6 Elasticity Response of Indias Commodity Exports to World Income ............ 250

6.7 Contribution of Consumption, Investment andExports to Economic Growth ............................................................................ 251

6.8 Some Determinants of Private Consumption in India ..................................... 251

6.9 Indias Trade Performance ................................................................................. 252

6.10 Composition of Indias Commodity Exports ..................................................... 253

6.11 Global Crisis and Indias Exports ..................................................................... 254

6.12 Geographical Diversification of Indias Exports ............................................... 254

6.13 Relative Price and Real Demand Effects on Indias BroadDirection of Exports (Long-run Co-integration Coefficients) .......................... 255

6.14 Principal Characteristics of Leading Export Industries ................................... 257

6.15 Firm-level Export Orientation ............................................................................ 257

6.16 Global Crisis and Indias Imports .................................................................... 258

6.17 Commodity Composition of Indias Imports ..................................................... 258

6.18 Geographical Diversification of Indias Imports ............................................... 259

6.19 Import Intensity of Production: Firm-Level Evidence ...................................... 260

6.20 Pass-through of International Oil Prices to Export Prices of Developedand Emerging Market Economies: Granger Causal Analysis ........................ 263

6.21 Correlation of Indias Import Prices with Global andRegional Export Prices ...................................................................................... 263

6.22 Correlation of Indias Import Price Index with Domestic Prices (WPI) .......... 2636.23 Oil Imports Volume Growth ............................................................................... 264

6.24 Indias Imports and Exports of Food ................................................................ 265

6.25 Indias Dependence on Imports for Consumption Requirements .................. 265

6.26 Comparative Position of India among Top Service Exporters, 2008 ............. 267

6.27 Growth in Services Exports and Imports (US$) .............................................. 2676.28 Indias Foreign Exchange Earnings from Tourism Sector ............................... 267

6.29 Software Services Export .................................................................................. 268

6.30 Software Services Exports of India .................................................................. 268

6.31 India: Net Capital Flows .................................................................................... 272

6.32 Foreign Investment in India ............................................................................... 272

Table No. Title Page No.

(Contd...)

XIII

Table No. Title Page No.

6.33 Change in Reserves .......................................................................................... 276

6.34 Contribution to Gross Domestic Savings ......................................................... 277

6.35 Gross Domestic Capital Formation at Current Prices..................................... 278

6.36 Quarterly Growth in GDP at Factor Cost ......................................................... 2796.37 Cyclical Co-movements of GDP with Components of Aggregate

Demand (Correlation Coefficient) ..................................................................... 2806.38 Growth in Demand Components of GDP (At 2004-05 prises) ....................... 2816.39 Sectoral Growth in GDP (At 2004-05 prises) .................................................. 2826.40 Industrial Growth in Advanced and Emerging Market Economies ................. 283

6.41 Performance of Broad-Based Sectors in Industry ........................................... 284

6.42 Growth Performance of 17 two-digit Manufacturing Industries ...................... 285

6.43 Average Growth in Export-Oriented Manufacturing Industries ...................... 285(based on IIP)

6.44 Monthly Growth of Use-based Industries ......................................................... 286

6.45 Gap Between Targets and Achievements of Infrastructure Industries .......... 287

6.46 Growth of Services Sector at Disaggregated Level ........................................ 289

XIV

ABCP Asset Backed Commercial PaperABS Asset-Backed SecuritiesACMA Automobile Components

Manufacturing Association of IndiaAD Authorised DealerADF Augmented Dicky FullerARM Adjustable Rate MortgagesBCBS Basel Committee on Banking Su-

pervisionBIS Bank for International SettlementsBoP Balance of PaymentsBPO Business Process OutsourcingCAD Current Account DeficitCBRG Cross-Border Bank Resolution

GroupCBO Congressional Budget OfficeCDOs Collateralised Debt ObligationsCDS Credit Default SwapsCESR Committee of European Securities

RegulatorsCFPA Consumer Financial Protection

AgencyCMBS Commercial Mortgage-Backed

SecuritiesCP Commercial PaperCPI Consumer Price IndexCPFF Commercial Paper Funding Facil-

ityCPSS Committee on Payment and

Settlement SystemsCRAs Credit Rating AgenciesCRAR Capital to Risk-Weighted Assets

RatioCRR Cash Reserve RatioCVD Countervailing DutyEC European CommissionECB European Central Bank

Ecofin Economic and Financial AffairsCouncil

EMEs Emerging Market EconomiesEMPI Exchange Market Pressure IndexESF Exogenous Shock FacilityERM Exchange Rate MechanismESFS European System of Financial

SupervisorsESRC European Systemic Risk CouncilFASB Financial Accounting Standards

BoardFBT Fringe Benefit TaxFCL Flexible Credit LineFDI Foreign Direct InvestmentFDIC Federal Deposit Insurance Corpo-

ration

FHCs Financial Holding CompaniesFHLMC Federal Home Loan Mortgage

CorporationFIIs Foreign Institutional InvestorsFIPB Foreign Investment Promotion

BoardFSI Financial Stress IndicatorFNMA Federal National Mortgage Asso-

ciation

FSA Financial Services AuthorityFSCS Financial Services Compensation

SchemeFTC Federal Trade CommissionGAAP Generally Accepted Accounting

PrinciplesGDP Gross Domestic ProductGECC Global Economic Co-ordination

CouncilGFD Gross Fiscal DeficitGFSR Global Financial Stability Report

ABBREVIATIONS

XV

GIMF Global Integrated Monetary andFiscal

GPRF Global Food Crisis Response Pro-gramme

GSDP Gross State Domestic ProductDTA Domestic Tariff AreasHFCs Housing Finance CompaniesHP Hodrick-PrescottHKMA Hong Kong Monetary AuthorityIASB International Accounting Stand-

ards BoardIFC International Finance CorporationIFRS International Financial Reporting

StandardsIIFCL India Infrastructure Finance Com-

pany LimitedINFRA Infrastructure Recovery and

AssetsIMF International Monetary FundIMFC International Monetary and Finan-

cial CommitteeIOSCO International Organization of

Securities CommissionsIPAs Issuing and Paying AgentsIPOs Initial Public OfferingsIRB Internal Rating BasedIT Information TechnologyITEs Intra-Group Transactions and Ex-

posures (ITEs)ITES Information Technology-enabled

ServicesLAF Liquidity Adjustment FacilityLCBGs Large and Complex Banking

GroupsLCD Liquid Crystal DisplayLIBOR London Inter-Bank Offer RateLOLR Lender of Last ResortMAS Monetary Authority of SingaporeMBS Mortgage Backed Securities

MFIs Micro-Finance Institutions

MIBOR Mumbai Inter-Bank Offer RateMIGA Multilateral Investment Guarantee

AgencyMSMEs Micro, Small and Medium Enter-

prisesMSS Market Stabilisation SchemeMTM Mark-to-Market

M&As Mergers and AcquisitionsNAB New Arrangements to BorrowNBFCs Non-Banking Financial Compa-

nies

NBS National Bank SupervisorNCBP Non-Concessional Borrowing

Policy

NDA Net Domestic Asset

NDTL Net Demand and Time Liability

NFA Net Foreign AssetsNFC Non-Food CreditNMF Investment by Mutual FundsNPLs Non-Performing LoansNRSROs Nationally Recognised Securities

Rating OrganisationsOBSVs Off-Balance Sheet VehiclesOCR Ordinary Capital ResourcesOECD Organisation for Economic Coop-

eration and DevelopmentOIS Overnight Indexed SwapOLS Ordinary Least SquaresOMO Open Market OperationONI Office of National InsuranceOTC Over-the-CounterOTD Originate-to-DistributeOTH Originate-to-HoldOTS Office of Thrift SupervisionOBSEs Off-Balance Sheet Entities

XVI

PDIC Philippine Deposit Insurance Cor-poration

PDs Primary Dealers

PPAC Petroleum Planning Analysis CellPPP Public Private PartnershipPRGF Poverty Reduction and Growth

Facility

PVAR Panel Vector Auto-RegressionREER Real Effective Exchange RateRMBS Residential Mortgage-Backed

SecuritiesRWA Risk-Weighted AssetsSEBI Securities and Exchange Board of

India

SEC Securities and ExchangeCommission

SEP Supervisory EnhancementProgramme

SEZs Special Economic ZonesSHGs Self-Help GroupsSIDBI Small Industries Development

Bank of India

SDL State Development LoanSIVs Structured Investment VehiclesSLR Statutory Liquidity RatioSMEs Small and Medium EnterprisesSMO Special Market OperationSSMB Standard Setting and Monitoring

Body

SSIs Small-Scale IndustriesStAR Stolen Asset RecoveryS&L Savings and Loan AssociationsTAF Term Auction Facility

TARP Troubled Asset Relief ProgramTFFP Trade Facilitation ProgrammeTUF Technology Upgradation FundUNWTO United Nations World Tourism

OrganizationVAR Vector AutoregressionWADR Weighted Average Discount RateWEO World Economic OutlookWTO World Trade Organisation

This Report can also be accessed on InternetURL : www.rbi.org.in

Genesis and the Nature of the Crisis1.1 The world economy experienced asustained period of growth with only moderatefluctuations coupled with low inf lat ion, aphenomenon popularly termed as the GreatModeration till the precipitation of the recent globalcrisis. This prolonged period of macro-economicstability was essentially attributed to efficientlyfunctioning markets and the benefits ofglobalisation. However, what remained hiddenwithin these overall signs of prosperity were theimmensely complex financial systems and thesystemic risks they entailed due to the policy ofbenign neglect followed by authorities. In addition,some structural imbalances had also developed inthe world economy in terms of mismatches betweensavings and investments and production andconsumption across nations that manifested in thewidening current account imbalances in some partmirrored with surpluses in others, misalignmentin exchange rates and booming asset prices.These developments had to unwind at some pointof time and when the unwinding began, theymanifested themselves in the form of the worstever global financial crisis since the GreatDepression of the 1930s.

1.2 The speed and intensity with which the USsub-prime crisis that appeared in mid-2007transformed itself into a global financial crisis andthen into a global economic crisis has attracted theattention of all. In the postmortem analysis, anumber of micro and macroeconomic factors havebeen listed in the literature as the proximate causesof the crisis role of easy money, financialinnovations and global imbalances on the one handto regulatory loopholes both at the national andglobal level on the other. At the fulcrum of the crisiswas too much of leverage. Easy credit combinedwith under-pricing of risks both by the householdsas well as financial intermediaries created bubbles

in real estate, energy and other sectors that had toface a disorderly unwinding. The recent crisis hasnecessitated the need to revisit the globalregulatory and supervisory structures andperimeters against the backdrop of rapid financialinnovations. The analysis of the various causes ofthe crisis has evolved a whole new debate on therelevance of various economic tenets and haschallenged the economic doctrine that assumed theself correcting mechanism of the markets. There isalso a view which holds responsible the policyframeworks and growth strategies pursued byeconomies in the various regions.1.3 A comparison of the recent crisis with thevarious episodes of crises in the past reveals thatsome semblance can be found amongst them withregard to the underlying causes. As in the past,the main causes of the recent crisis are linked tosystemic fragilities and imbalances that contributedto the inadequate functioning of the globaleconomy. Leading up to the crisis, these factorsbecame more pronounced due to majorweaknesses in financial regulation, supervision andmonitoring of the financial sector and inadequatesurveillance and early warning. These, together withover-reliance on market self-regulation, overall lackof transparency with distorted incentive structureled to excessive risk-taking, unsustainable highasset prices, irresponsible leveraging and highlevels of consumption which were fuelled by easycredit and inflated asset prices. In terms of impact,however, the recent crisis seems to be morewidespread than many other previous episodes andis considered to be closest to the Great Depressionof the 1930s. The estimates of output loss placethis crisis above most of the episodes in the pastwith majority of the advanced and emerging marketeconomies facing the downturn as a result of therapid transmission of the crisis from the epicenterto the periphery. In fact, the same forces of

THE THEME OF THE REPORT1

2REPORT ON CURRENCY AND FINANCE

globalisation and international finance that had ledto developments in poorer countries over the pastdecades also carried with them the seeds ofcontagion, which resulted in the internationaltransmission of shocks.

1.4 As a result, the so-called decoupling theorywhich was in full force just before the recent crisis,came under question in an increasinglyinterdependent world. The crisis that emerged inthe US spread to other advanced economiesquickly and at a later stage spread to emerging anddeveloping economies through various channels -financial, trade and confidence - despite theirrelatively sound macroeconomic fundamentals andpolicy frameworks. Thus, the established views onthe efficiency of markets and the role of public policyboth came under severe criticism, which posed newchallenges for the discipline of economics. Morefundamentally, the old debate on the role of financein economic growth has again come to the centrestage, while the potential costs and benefits offinancial globalisation have become the focus ofpolicy discussions in international fora. At the sametime, the adequacy and efficacy of the currentinternational financial architecture to prevent andmanage global crises has resurfaced again.

Manifestation of the Crisis1.5 Almost all segments of the global financialmarkets experienced tremors of the financial crisis,though at variant degrees. Interbank markets inadvanced economies were the first to be affectedwith severe liquidity crisis as banks becamereluctant to lend to each other on fear ofcounterparty risks. Subsequently, the crisis spreadto the money markets as manifested in abnormallevel of spreads, shortening of maturities, andcontraction, or even closure, of some marketsegments. In the wake of credit and money marketswitnessing a squeeze and equity pricesplummeting, banks and other financial institutionsexperienced erosion in their access to funding andcapital base, owing to accumulating mark to marketlosses. Stock markets in EMEs, on the other hand,bore much of the heat of the crisis as equity markets

all over the world witnessed high volatility, andsuffered sharp decline in prices and turnover.Commodity prices, which reached record highsduring the initial stages of the crisis witnessed asharp reversal in trend since the collapse ofLehman Brothers in September 2008. The depthand spread of the crisis can be gauged from thesuccessive revisions in the estimates of write-downs, decline in trade and finally the contractionin economic activity.

1.6 In the backdrop of large scale disruptionsin international financial markets and deterioratingmacroeconomic conditions, financial institutionsalso suffered significantly. Commercial bankssuffered from decline in profitability and large markto market losses. The crisis almost sidelined theinvestment banking industry, while the financialperformance of the monoline insurers and hedgefunds were impacted severely. The bankingsystems of emerging market economies, on thecontrary, showed relative resilience during the crisison account of their limited exposure to the toxicassets and the regulatory and supervisorymeasures taken to strengthen their balance sheetsin the aftermath of the East Asian crisis.

1.7 The increasing globalisation and tradeintegration have brought enormous economic andfinancial benefits to the EMEs, but have alsowidened channels through which a slowdown ineconomic activity in advanced economies couldspread to the EMEs. Initially, it appeared that EMEswere better positioned to weather the storm createdby the global financial meltdown on the back ofsubstantial foreign exchange reserve cushion,improved policy frameworks and generally robustbanking sector and corporate balance sheets.However, any hope about EMEs escapingunscathed could not sustain much after the failureof Lehman Brother in September 2008 and ensuingrise in the global risk aversion; EMEs were alsoadversely affected by the spillover effects of themacroeconomic turbulences created by globalfinancial meltdown. The EMEs were affectedthrough contraction in world trade especially duringthe second half of 2008. Net private capital flows

3THE THEME OF THE REPORT

to EMEs also reversed reflecting globaldeleveraging and risk aversion on the part ofinvestors, which led to tightening of externalfinancing conditions. Finally, their growth was alsoimpacted.

International Responses to the Crisis1.8 The crisis evoked unprecedented policyresponses, both domestically and internationally.Amidst the deteriorating global f inancialenvironment, the authorities, particularly in theadvanced countries recognised at an early stagethat they needed to respond bravely and act swiftly.The national Governments and central banks inseveral countries resorted concomitantly with avariety of both conventional and unconventionalpolicy actions to contain systemic risk to shore upthe confidence in the financial system and arrestthe economic slowdown. The policy responses-regulatory, supervisory, monetary and fiscal duringthe crisis have been unparalleled in terms of theirscale, magnitude and exceptional coordinationacross various jurisdictions. The responsesincluded varying combinations of monetary andfiscal measures, deposit guarantees, debtguarantees, capital injections and asset purchases,which were coordinated globally.1.9 Monetary authorities in the industrial worldwere the first to take a plunge by resorting to anaggressive monetary easing; so much so that policyrates reached to record lows. To contain the crisisof confidence and ease financial conditions, centralbanks ventured even further by using their balancesheets in unconventional ways. The governmentsacross the countries responded by way of massivebail outs and capital injections to resolve theproblem of insolvency and stabilise the financialsystem. The unprecedented scale of economicslowdown accompanying the financial crisis alsoled to activation of counter-cyclical fiscal policy ofmagnitudes, least seen in the past.1.10 As the crisis unfolded, the resolutionmechanisms that came to the fore had to contendwith new and complex web of financial worldinvolving credit default swaps, special investment

vehicles and hence differed radically from theresponses undertaken in the previous suchepisodes. Supervisors and standard setting bodiesaround the world increasingly got engaged instrengthening the standards governing bankcapital, liquidity, risk management, incentivecompensation, and consumer protection, and soon. The emphasis on scaling up the supervisionwith greater macro prudential focus, throughenhanced consolidated supervision and thedevelopment of new supervisory tools begangathering momentum.1.11 Although advanced countries turned theirpolicy attention on restoring normalcy andstrengthening financial regulation/ supervision andEMEs began dealing with the collapse of trade andthe capital outflows, restoring growth emerged asthe common thread of policy response among boththe categories. It was for the first time that EMEsturned out to be active partners in f indingmeaningful resolution mechanisms to a globalproblem. A distinguishing feature of the currentfinancial crisis is that despite being global in nature,there appears to be a clear divide between theadvanced countries and the emerging marketeconomies (EMEs) in terms of impact and policyresponses. For advanced countries, the policypriority has been to strengthen financial regulationand supervision. In the EMEs, dealing with thecollapse of trade and the outflow of capitaloccupied the policy attention.1.12 The forceful and coordinated policy actionshave been successful in extinguishing the initialdamages and averting a global financial collapse.Although the policy responses could avoid the worstfinancial and economic outcomes, the policymakersand academia are still grappling with the designand conduct of appropriate policies to arrest thepossibility of such events in the future. Moreover,the unconventional measures, while helping instabilising the financial system, have posed severalchallenges and risks.1.13 More recently, in the wake of the financialstress triggered by Greece, comprehensive supportmeasures have been announced focusing on

4REPORT ON CURRENCY AND FINANCE

preserving economic and financial stability withinthe Euro Area. The belief that sovereign states canborrow without any limits has been once againcalled into question after the problem in Greece.This is a reminder that fiscal space is finite andcannot be extended indefinitely. It is being nowrealised that the Euro Area has to supplement itsstrict entry norms regarding fiscal discipline withcontinuous fiscal surveillance so as to detectvulnerabilities well in time.

Impact and Policy Responses in India1.14 Until the emergence of global crisis, theIndian economy also passed through a phase ofhigh growth driven by domestic demand - growingdomestic investment financed mostly by domesticsavings and sustained consumption demand. In fact,consumption and saving are well balanced. Servicessector, led by domestic demand, contributed to thestability in growth. Concomitantly, inflation was alsogenerally low and stable. This overall improvementin macroeconomic performance in India wasattributed to the sequential financial sector reformsthat resulted in an efficient system of financialintermediation, albeit bank-based; the rule-basedfiscal policy that reduced the public sectors drag onprivate savings; and forward looking monetary policythat balanced the short-term trade-off betweengrowth and inflation on a continuous basis, while alsopursuing the objective of financial stabil ity.Additionally, the phased liberalisation of the economyto trade and capital flows along with a broadlymarket driven exchange rate regime enhanced therole of external demand in supporting the growthprocess, simultaneously exposing the economy tothe forces of globalisation. In the process, Indiabecame increasingly integrated with the worldeconomy and maintaining financial stabil i tyassumed importance in the hierarchy of publicpolicy; in fact, it emerged as an important objectiveof monetary policy in India even before the currentcrisis. This is evident from the counter-cyclicalmonetary policy and macro-prudential financialregulations that were in force during the boomphase just before the crisis.

1.15 In these circumstances, the Indianeconomy benefited from global integration and hadalso exhibited remarkable resilience to variousadverse external developments the east-Asiancrisis (1997-98), the dot.com crisis (2000-01), etc.However, during the current global crisis, India wasimpacted like most other emerging markets,despite hardly any direct exposure to the troubledassets in the epicenter of the financial crisis. Infact, the contagion spread through all the channels trade, finance and confidence.

1.16 During the initial phase of the crisis, theimpact on the Indian financial markets was rathermuted. In fact, banks dominated the financialsystem and their negligible engagement in the off-balance-sheet activities and illiquid securitisedassets, which remained at the heart of currentglobal financial crisis in advanced economies,protected India from early turmoil in internationalfinancial markets. Nonetheless, India could notremain unscathed and the global developmentsaffected the financial and real activities in thesecond half of 2008-09. Indias financial markets -equity market, money market, forex market andcredit market - all came under pressure from anumber of directions.

Lessons from the Crisis and Future Challenges

1.17 Several lessons could be drawn from thecrisis to identify the future challenges in the globalfinancial system. A number of important issues haveemerged relating to the prevention and managementof crises which allows us to draw relevant lessonsfor both market participants and policy makers. Theanalysis of underlying factors whethermacroeconomic or microeconomic in nature -responsible for evolving and intensifying the crisis -raises issues about the role of public authorities, viz.,central banks, supervisor/regulators andgovernments in safeguarding financial stability. Thecrisis has certainly doubted the efficacy of theexisting institutional framework and available policyinstruments at the national as well as internationallevels in ensuring global financial stability.

5THE THEME OF THE REPORT

1.18 It also raised questions on the functioningof financial markets and institutions, in particulartheir capacity to price, allocate and manage riskefficiently. Thus, the lessons to be drawn from therecent crisis are not only manifold but also for adiverse set of authorities entrusted with the task ofmaintaining financial stability being most applicablefor the advanced economies besides a broaderrelevance for EMEs. Looking ahead, devising acalibrated exit from the unprecedented monetaryaccommodation globally, which has already startedin some countries, is one of the most importantchallenges. In this context, the timing and theamount of reversing become very important.1.19 It is not yet known whether the businesscycle synchronization that was evident just beforethe crisis and monetary policy synchronization thatemerged in response to the crisis, will give way tosimilar synchronization in the exit strategies. It istherefore timely to reflect upon the global crisis -the past, present and future to make an objectiveassessment of its impact on the Indian economyand to draw policy lessons to ward-off anyrecurrence of crisis like situation in future, and inthe event of a crisis to deal with it more effectively.Accordingly, the theme of this Report for 2008-09has been titled as Global Financial Crisis and theIndian Economy. The Report undertakes an in-depth analysis of causes and consequences of thecrisis, compares and contrasts the present crisiswith past crises, analyse the effectiveness of theconventional and unconventional policy responsesto the crisis at the global level. From the Indianperspective, the Report covers in detail themanifestation of the crisis in India, the nature ofpolicy responses undertaken and their impact inlimiting the adverse impact and the broad lessonsthat emerge from the crisis at the domestic as wellas international level.

Chapter Scheme of the Report

1.20 The Report includes seven chaptersincluding this one. Chapter 2 titled Genesis andthe Nature of the Crisis traces the genesis andnature of the crises which has affected both the

developed, emerging and developing world over thelast century and a half, when they have often arrivedwith fierce force and departed with importantlessons for the policy makers. This chapterdiscusses the causes of the current financial crisiswhile simultaneously highlighting the debate as ithas evolved on the various contributing factors ofthe crisis, besides covering the crisis in a historicalperspective by giving a comparison between thepresent crisis with the earlier episodes of crisis ofsimilar nature. The Chapter also covers the genesisof the recent crisis in Greece.1.21 The chapter 3 on Manifestation of theCrisis attempts at analysing the impact of the crisison the various sectors of the global economy, suchas f inancial markets, f inancial insti tut ions,international trade, international capital flows,remittances and the real economy.1.22 The chapter 4 on International Responsesto the Crisis discussed the measures taken by theinternational community during the present financialcrisis against the backdrop of the conventional crisismanagement strategies. The chapter also providesthe policy responses to financial crisis in a historicalperspective. The monetary policy and the fiscalpolicy responses along with the issues on fiscalmonetary coordination are covered. The responsesfrom the multilateral institutions are also presented.The actions taken relating to financial sectorpolicies to reduce the chance of recurrence offinancial crisis of such a magnitude are elucidatedin the chapter.1.23 After discussing the genesis, manifestationand policy responses of the crisis in the globalcontext in Chapters 2,3, and 4 respectively, the nexttwo Chapters 5 and 6 cover impact of the globalfinancial crisis on the Indian economy and thepolicy responses of the authorities. In Chapter 5on Impact and Policy Responses in India:Financial Sector, the impact on the Indiasfinancial sector is analysed in detail. In thefol lowing Chapter 6 on Impact and Pol icyResponses in India: Real Sector, the impact onthe real sector of the Indian economy through trade,services, capital flows are analysed.

6REPORT ON CURRENCY AND FINANCE

1.24 In examining the impact of the financialcrisis on the financial sector, the Chapter 5analyses the evolving global integration of theIndian economy through trade and financialchannels over the years. The impact of the crisison various financial markets and respective policymeasures has been delineated. The spillovereffects travelling to the banking sector, mutualfunds and non-banking finance companies andpolicy measures to counter their impact have beenexamined in detail. The policy responses to thecrisis by the Government of India and the ReserveBank are also discussed in the chapter.

1.25 Chapter 6 covers the impact through tradeand capital flows channel, which finally penetratedinto the real sector of the economy. In this chapter,a perspective is given on various channels of

transmission of global shocks to the real sector. Theanalysis of the impact emanating from trade andfinancial channels are discussed elaborately andultimately the impact on the saving, investment andgrowth are covered in the chapter.1.26 The Chapter 7 on Lessons from the Crisisand Future Challenges draws lessons from thecrisis to identify some of the future challenges.The chapter covers lessons for the central banks,for the financial regulation and supervision, forfiscal policy and for the international policycoordination followed by the role of internationalfinancial institutions. Issues coming out of globalimbalances and macroeconomic management arealso covered in this chapter. Finally, this chapterbrings out the lessons and challenges for EMEsand India.

2.1 The world economy witnessed a trulyglobal crisis since mid 2008. This crisis has testedthe contours of the functioning of the globalfinancial landscape, while the interl inkagesbetween the financial and the real economy weremagnified. The problems that surfaced in the USsub-prime market in August 2007 reached theirpeak during September 2008 when some of theprime Wall Street financial institutions collapsed,leading to a worldwide failure of confidence. Creditmarkets virtually froze with financial institutionsalmost unwilling to lend to each other. The loss ofconfidence set off a chain of deleveraging,declining asset and commodity prices, fallingincomes, shrinking demand and trade and capitalflows, and rising unemployment in the advancedeconomies in the early stages. Although advancedcountries clearly remained the epicentre of therecent global crisis, emerging market economies(EMEs) have also been substantially affected bythe crisis. The turmoil in the financial sector of theadvanced countries traversed to the financialsector of the EMEs, including India, especiallyafter the Lehman Brothers bankruptcy in mid-September 2008. The contagion spread to theseeconomies through financial, trade and confidencechannels, despite their relat ively soundfundamentals. This promoted many to revisit theso-called decoupling theory in an increasinglyglobalised world. Thus, what started off as a sub-prime crisis in the US housing market in August2007 turned successively into a global bankingcrisis, a global financial crisis and then a globaleconomic crisis.

2.2 The period prior to the unravelling of thecrisis was generally characterised by relativelysteady growth and low and stable inflation inadvanced economies and rapid growth anddevelopment in EMEs, popularly known as theperiod of Great Moderation (Bernanke, 2004). This

prolonged period of macroeconomic stability wasattr ibuted to free markets and successfulglobalisation. The Great Moderation in economicperformance, however, ignored the possibility ofcatastrophic failures in a market economy. Whatremained hidden within these overall signs ofprosperity were the immensely complex financialsystems that at times remained beyond theregulatory purview of policy authorities, and posedtremendous systemic risks. In addition, somestructural imbalances had also developed in theworld economy over the years in terms ofmismatches between savings and investments andproduction and consumption across nations thatwere manifested in widening current accountimbalances, misaligned exchange rates, and lowinterest rates and asset prices, which had to unwindat some point of time. All these factors manifestedthemselves in the form of the worst-ever globalfinancial crisis.

2.3 The rapid speed with which the financialcrisis spread from the United States to Europe andthen to the rest of the world shocked the entireworld. While crises have been part of the financiallandscape for ages, it is now widely accepted thatthe nearest precedent to the recent crisis is theGreat Depression of the 1930s in terms of its depth,geographical spread, intensity and duration. Nocountry has been spared from its wrath, althoughthe impact has varied across nations.

2.4 The recent f inancial cr is is and thesubsequent recession have re-opened two crucialdebates on the efficacy of the markets and therole of public policy, the so-called Keynesianism and have posed new challenges for the disciplineof economics. The recent cr isis has againquestioned the role of finance in leading to growthand brought into focus the role of non-economicmotives in explaining market rise and fall. Therecent crisis has also necessitated a revisit of the

GENESIS AND THE NATURE

OF THE CRISIS2

8REPORT ON CURRENCY AND FINANCE

current global regulatory and supervisorystructures and perimeters against the backdropof rapid financial innovations. Finally, it has re-invoked the debate on the adequacy and efficacyof the current international financial architectureto prevent and manage global crises of the kindrecently seen.

2.5 The depth and breadth of the crisis hastested the l imits of the conventional andunconventional pol icy options available topolicymakers around the world. The initial estimateof actual and potential global write-downs held bybanks and other financial institutions, which startedat about US$ 50 billion in mid-2007, increased toaround US$ 4.0 trillion by end-2008 and was scaleddown to US$ 2.3 trillion by the IMF in April 2010.As per IMF forecasts (April, 2010), world GDPgrowth after decelerating to 3.0 per cent in 2008from 5.2 per cent in 2007 declined by 0.6 per centin 2009. However, the global growth is projected torise to 4.2 per cent in 2010 and 4.3 per cent in2011. The advanced economies exhibited anegative growth of 3.2 per cent in 2009 (as againsta positive growth of 0.5 per cent in 2008), whileemerging and developing economies grew by 2.4per cent in 2009 (compared with 6.1 per cent in2008). The advanced economies and the emergingand developing economies are projected to growby 2.3 per cent and 6.3 per cent, respectively,during 2010.

2.6 Against the above backdrop, this chapterwill trace the genesis and nature of the crisesaffecting both the developed and developing worldover the past century and a half when they oftenarrived with fierce force and departed with importantlessons for policymakers. This will be covered underthree broad sections. Section I will discuss in detailthe causes of the recent financial crisis andsimultaneously trace the evolving debate on thevarious contributing factors. The crisis in a historicalperspective is covered in Section II. A comparisonbetween the recent crisis and similar earlierepisodes is presented in Section III. Section IV setsout the concluding observations.

I. CAUSES OF THE CRISIS

2.7 The causes of the crisis were many andintertwined as such a pervasive crisis cannot betriggered by a single or isolated cause. In trying tounderstand the various causes of the crisis,different viewpoints have emerged. One viewbelieves that the current disruption of financialmarkets is the long-run consequence of the easyglobal money and credit conditions that existed,particularly from the start of the decade. While theimmediate cause of the financial crisis is attributedto the problems persisting in the sub-primemortgage sector of the United States, the root liesin the persistence of global imbalances since thestart of the current decade (BIS, 2009; Mohan,2008; Portes, 2009; Taylor, 2009). The globalimbalances interacted with the flaws in financialmarkets and instruments to generate the specificfeatures of the crisis.

2.8 Another view argues that if imbalances at theglobal level were the root cause, then why did thecrisis originate in the United States and not in othercountries which were also partners of globalimbalances? The excesses in the US financialsystem are, in fact, at the core of the current crisisand all other factors contributed to further aggravatethe crisis. Finance has been the proximate factorbehind most crises of the past and the recent crisisis no different (Ferguson, 2009). Some are also ofthe opinion that one important cause of the crisis isthe US Feds very low interest rates that weremaintained for a very long time leading to a housingand asset price bubble (ECB, 2007; Taylor, 2009;Skidelsky, 2009) and an equally important cause hasbeen the lack of recognition of asset prices in policyformulation (Borio and Lowe, 2004; White 2008).According to some, the Basel Accord is also a causeof the recent banking crisis; banks efforts tocircumvent the capital adequacy requirements ofBasel Accord caused the financial crisis (Acharyaet al., 2009; Plender, 2007). Leaders at the G-20Summit in September 2009 blamed globalimbalances, seeing them as more responsible forthe crisis than the failure of global financial regulation.

9GENESIS AND THE NATURE OF THE CRISIS

2.9 The debate on the causes of the crisis hasalso revolved around whether the crisis was theresult of market failure or of governance failure.The Great Moderation in economic performanceover the previous decade and half ignored thepossibility of catastrophic failures in the marketeconomy. During the golden years, financialeconomists believed that free-market economiescould never go astray, which is belied by the crisis(Krugman, 2009). The IMF too supported themarket-oriented ideology.2.10 In contrast, the recent crisis has also beenconsidered to be a failure of governance. Centralbanks focused excessively on CPI inflation at theexpense of financial vulnerability (IMF, 2009a).Since there was no formal mandate to maintainfinancial stability, the latter was inadvertentlyignored in public policy. By accommodating laxcredit condit ions and rising debt, monetarypolicymakers in a way increased the risks of a bust.Besides, many central banks were persuaded tobe very transparent and provided forward guidanceto the financial markets on their policy stance,especially on the future course of monetary policy.Such forward guidance provided excessive comfortto the financial markets and aided the under-pricingof risks1. The roles of international financialinstitutions like the IMF with the responsibility ofsurveillance, have also been questioned. It islamented that the IMF failed in diagnosing andpointing out the vulnerabilities both at the globallevel and at the level of systemically importantadvanced economies.

2.11 A more balanced viewpoint is that the recentcrisis reflects a collapse of the market as well asthe State, since governance in both private andpublic sectors failed (Reddy, 2009c). This argumenthas been stretched further to interpret failure ofgovernance at all levels as indicative of moral failureof the whole economic system or what some havedescribed as a failure of capitalism (Krugman,

2009). Be that as it may, as the debate on thecauses of the crisis still continues, it is worthdistilling the variety of factors that contributed tothe crisis.

Global Imbalances2.12 From a historical perspective, many nowargue that the US sub-prime mortgage crisis wasonly a proximate cause or simply a trigger for therecent crisis through the re-pricing of risks thatspil led over to other parts of the world viasecuritised mortgage derivatives. At a morefundamental level, i t can be traced to thepersistence of large global imbalances of varioussystemically important economies over a period oftime large current account deficits in the US alongwith some other advanced economies such as theUnited Kingdom, Greece, Italy, Portugal and Spainmirrored by substantial surplus in Asia, particularlyin China, oil-exporting countries in the Middle Eastand Russia that posed risks to the global financialsystem of a disorderly unwinding. Globalimbalances, in general, can be defined as externalpositions of systemically important economiesreflecting distortions or entailing risks for the globaleconomy (Bracke et al., 2008).2.13 The period following the bursting of the dot-com bubble in the US was marked by a highlyaccommodative monetary policy that boostedaggregate demand in the US as well as in otheradvanced countries. Lower interest rates along withfinancial innovations encouraged a housing boomand an increase in housing and other asset prices,providing further impetus to consumption andinvestment through wealth effects. While realactivity in the US did provide a stimulus to activityin the rest of the world, it was accompanied by largeand growing current account deficits (Table 2.1). Inabsolute terms, the current account deficit (CAD)of the US saw a seven-fold increase from US$114 billion in 1995 to US$ 804 billion in 2006

1 Even if some central banks perceived that there were excessive risks in the system, they concluded that such risks were dispersed widelydue to the emergence of new intermediaries, like hedge funds, and new instruments, like derivatives, with no impact on the financialsystem as a whole.

10

REPORT ON CURRENCY AND FINANCE

(Table 2.2). As a percentage of GDP, the CAD ofthe US almost doubled every 5 years from the early1990s (Table 2.3). During 2006, the CAD was closeto 6 per cent of GDP, the highest-ever CAD for theUS that amounted to about 1.5 per cent of globalGDP. Although it has declined since then, it remainshigh by historic standards. A large increase incurrent account deficits was not confined to the US;in fact; since 1996 a number of other key industrialcountries have also seen their current accountsturning to deficit, including France, Italy, Spain,Australia, and the United Kingdom. Most of these

have experienced substantial housing appreciationand increases in household wealth (Bernanke,2005). For example, since 1996 wealth-to-incomeratio has risen by 14 per cent in France, 12 percent in Italy, and 27 per cent in the United Kingdom.2.14 With large current account imbalances,capital flew from capital-poor emerging countriesto capital-rich industrial economies, especially the US.Also, in response to the series of financial crises theEMEs experienced during the 1990s, they eitherchose or were forced into new strategies formanaging international capital flows. In general, thesestrategies involved shifting from being net importersof financial capital to being net exporters, resultingin large current account surpluses (Chart II.1). Thiscontradictory phenomenon was attributed to asignificant rise in saving rates in emerging marketeconomies (EMEs), especially in China, a dearthof investment opportunities, and the accumulationof large foreign exchange reserves by EMEs tocheck their currency appreciation and as self-insurance against a sudden reversal of capitalflows. Many of these economies, particularly theEast Asian countries, began to build up largeamounts of foreign exchange reserves from the

Table 2.1: Macro Parameters of the United States(in per cent, annual average)

Period GDP CAD/ General Savings Investments Savings-growth GDP Government Investment

Fiscal gapBalance/

GDP

1 2 3 4 5 6 7

1981-85 3.3 -1.3 -4.5 18.7 20.8 -2.11986-90 3.2 -2.4 -4.1 16.6 19.8 -3.21991-95 2.5 -1.1 -4.5 15.4 17.8 -2.41996-2000 4.3 -2.6 -0.02 18.1 20.1 -1.92001-2005 2.4 -4.8 -3.3 14.9 19.3 -4.42005-2008 1.8 -5.3 -3.6 14.4 19.4 -5.0

Source : World Economic Outlook, October 2009, International MonetaryFund.

Table 2.2: Current Account Balance(US$ billion)

1990-94 1995-99 2000-04 2005 2006 2007 2008 2009

1 2 3 4 5 6 7 8 9

China 5.5 18.6 37.6 160.8 253.3 371.8 426.1 283.8France 0.9 32.3 18.2 -9.1 -11.6 -25.9 -64.8 38.8Germany -10.2 -19.4 36.5 142.8 188.4 253.8 245.7 160.6India -3.8 -5.0 2.7 -10.3 -9.3 -11.3 -26.6 -25.9Japan 97.4 101.5 125.7 165.7 170.4 211.0 157.1 141.7Korea -3.5 5.0 13.2 15.0 5.4 5.9 -5.8 42.7Malaysia -3.2 0.6 10.4 20.7 25.8 29.2 38.9 32.0Philippines -2.1 -2.3 -0.5 2.0 5.3 7.1 3.6 8.6Russia 3.1 8.5 41.0 84.4 94.3 77.0 102.4 47.5Saudi Arabia -15.4 -3.4 23.2 90.1 99.1 93.5 132.5 20.5South Africa 1.5 -1.9 -1.5 -8.6 -13.9 -20.1 -19.6 -11.4Switzerland 14.3 24.9 32.5 52.2 59.5 43.5 11.9 43.1Thailand -6.9 -0.8 5.3 -7.6 2.3 15.7 1.6 20.3Turkey -2.2 -1.9 -5.7 -22.1 -31.9 -37.7 -41.3 -13.6United Arab Emirates 2.9 2.3 8.0 22.6 36.2 19.5 22.2 -7.0United Kingdom -21.9 -13.3 -34.6 -59.8 -80.8 -75.5 -40.7 -28.8United States -66.5 -178.4 -485.5 -748.7 -803.5 -726.6 -706.1 -418.0Note: (-) indicates deficit.Source: World Economic Outlook database, International Monetary Fund.

11

GENESIS AND THE NATURE OF THE CRISIS

beginning of the current decade. Emerging marketcountries saw these reserve stockpiles as welcomewar-chests to defend them from sudden capitalflow reversals of the sort that had occurred duringthe Asian crisis.

Savings Glut Hypothesis2.15 The large global current accountimbalances also got reflected in the savings-investment behaviour in both emerging andadvanced nations. This is why global imbalancesare now universally ascribed to the savings gluthypothesis, which states that the US currentaccount deficit was driven by a savings glut in therest of the world, especially in emerging marketcountries (Bernanke, 2005). While in the US thegap between savings and investment almostdoubled from minus 2.7 per cent of GDP in 2001 tominus 5.6 per cent of GDP in 2008, the oppositewas observed in the case of EMEs where excesssavings led to significant current account surpluses.2.16 There was a significant rise in global grosssaving as a percentage of GDP, from about 21.4per cent in 2001 to almost 24.2 per cent in 2007.Most of the increase reflected the relatively highsaving rate of the EMEs in the post-Asian crisisperiod, where a more than three-fold rise inaggregate saving between 2001 and 2007 had lifted

Table 2.3: Current Account Balance (Per cent to GDP)

Country 1990-94 1995-99 2000-04 2005 2006 2007 2008 20091 2 3 4 5 6 7 8 9

China 1.4 1.9 2.4 7.2 9.5 11.0 9.4 5.8France 0.0 2.0 1.3 -0.4 -0.5 -1.0 -2.3 -1.5Germany -0.4 -0.8 1.4 5.1 6.5 7.6 6.7 4.8India -1.3 -1.3 0.5 -1.3 -1.1 -1.0 -2.2 -2.1Japan 2.4 2.3 2.9 3.6 3.9 4.8 3.2 2.8Korea -1.0 1.9 2.1 1.8 0.6 0.6 -0.6 5.1Malaysia -5.2 1.8 9.8 15.0 16.4 15.7 17.5 16.7Philippines -4.0 -2.8 -0.7 2.0 4.5 4.9 2.2 5.3Russia 0.9 3.5 11.2 11.0 9.5 6.0 6.2 3.9Saudi Arabia -11.7 -2.4 10.6 28.5 27.8 24.3 27.9 5.5South Africa 1.2 -1.3 -0.7 -3.5 -5.3 -7.0 -7.1 -4.0Switzerland 5.7 8.8 10.8 14.0 15.2 10.0 12.4 8.7Thailand -6.4 1.0 4.2 -4.3 1.1 6.3 -0.6 7.7Turkey -0.9 -0.8 -1.6 -4.6 -6.0 -5.8 -5.7 -2.3United Arab Emirates 8.3 4.6 9.9 16.9 22.1 9.4 8.5 -3.1United Kingdom -2.1 -1.0 -2.0 -2.6 -3.3 -2.7 -1.5 -1.3United States -1.0 -2.1 -4.5 -5.9 -6.0 -5.2 -4.9 -2.9Memo:Euro Area n.a. 0.9 0.4 0.4 0.4 0.4 -0.8 -0.4

Note: (-) indicates deficit.Source: World Economic Outlook Database, April 2010, International Monetary Fund.

12

REPORT ON CURRENCY AND FINANCE

the marginal propensity to save to 43 per cent (BIS,2009). In gross terms, the share of EMEs in globalsaving rose from 25 per cent in 199296 to 30 percent in 2003 and 37 per cent in 2007. Incomparison, the EME share of world GDP did notrise quite so rapidly, moving from 21 per cent in199296 to 31 per cent in 2007. Within emergingmarkets, the rise in average saving rates wassignificant for China and the Middle East. The US,in contrast, has observed a decline in savings since2001 (Table 2.4).2.17 The precautionary motive was the mainreason behind the high savings in these economies.The ab