Global economic slowdown and its impact on the financial services industry in India

April 2009

The global slowdown was an outcome of two events - absence of a sound regulatory framework & mismatch between financial innovation and the ability of the regulators to monitor them immediate aim should be to fix the financial system and to maintain the aggregate demand at a high enough level to stimulate the real sector

Contents

Executive summary 1. Global financial markets: A perspective 2. Indian financial services industry 3. Impact of the recession on the financial sector of the Indian economy 4. Future outlook 5. Conclusion Contacts

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Executive summary

The global economy is reeling with the impact of the ongoing recession which started with the sub-prime crisis in the United States and found its way to other developed and emerging economies of the world. This recession has its roots in the initial collapse of the financial sector. However, in a world that is more integrated within each country as well as across nations, the events in the financial sector have eventually trickled down to the real sector of the economies as well. Finance and financial markets play a dominant role in growth and development of modern economies hence, any recovery from the current recession must be couched in an overall recovery of the health and performance of the financial sector. In the absence of mature financial markets in their own economies, several emerging economies (including India) have heavily depended on credit and other financial services from the western financial markets.

Therefore, any form of failure in these markets has a direct effect on the markets in emerging economies. The concerns relating to the US slowdown and its intensity have mounted in view of the potential spill over on to the global economy. With tightening in lending standards, deterioration in asset quality and deceleration in consumer loan demand, events in the financial markets are beginning to have a persisting impact on the real economy as well, with direct slowdown in employment and growth in several economies across the world. Terms-of-trade losses due to soaring commodity prices have not only reduced the capacity of a re-balancing of the world economy but have also adversely impacted several countries. Although the Emerging Market Economies (EMEs) are exhibiting resilience until now, the eventual depth and width of the impact on these economies have kept many economists guessing.

This report focuses on the impact of the global slowdown on the banking and financial services sector in India. The impact of the slowdown on the banking and financial services sector in India has so far been moderate. Ironically, the slow pace of financial reforms in India, an overly cautious approach towards permitting foreign investments in the Indian business sectors, numerous bureaucratic hurdles and regulatory constraints have turned out to be a blessing in disguise in India. The Indian financial system has very little exposure to foreign assets and their derivative products and it is this very feature that is likely to prove an antidote to the financial sector ills that have plagued many other emerging economies.

The revival of the world economy will take a long time. During this time, India is likely to be affected due to the low investments by foreign companies into India, heavy selling by the FIIs (Foreign Institutional Investors) in their holdings in numerous Indian companies, and depressed global demand for the various services that have added to Indias GDP growth. However, the overall impact on the Indian economy will be lesser as compared to other emerging economies. Indias cautious approach towards integrating with the world economy has paid off and it is very likely that speed of integration and de-regularization of the financial sector will be even slower in the aftermath of the recession. More regulations are expected to come into force to prevent India from experiencing a situation that characterized the economies of the ASEAN countries during the 1997-98 crisis as well as the current recession.

1. Global financial markets: A perspective

While the current recession was triggered by the rising default rates on sub-prime mortgages in the US, the source of the problem was significant mispricing of risks in the US financial system. Easy monetary policy in major financial centres, globalisation of liquidity flows, wide-spread use of highly complex structured debt instruments and the inadequacy of banking supervision in coping with financial innovations contributed to the severity of the current crisis. The persistent under pricing of risks was suspected by several central banks for quite some time, but it was felt by many that these risks were widely dispersed through financial innovation and that they would not pose any serious problems to the banking system. When the sub-prime crisis did occur, however, it triggered a wide contagion affecting many of the large global financial institutions. Banks, in particular, appear to have ceased to trust each others creditworthiness leading to difficulties in the money markets in the US, Europe and the UK resulting in drying up of liquidity. In an attempt to meet their liquidity support obligations to the SIVs or to fund the assets of the SIVs that were taken on to their balance sheets, several banks leveraged excessively without recognizing the corresponding risks and / or underpriced them thus warranting large capital infusion. Uncertainty about the possible losses yet to be disclosed by several of them has not yet ceased. These developments brought forward several new realities that pose severe challenges to macroeconomic management, in particular to monetary and regulatory policies globally. First, concerns relating to the US slowdown and its intensity have mounted in light of the spill over of these troubles on to the global economy. Second, threats to the global economy are emanating from advanced economies in sharp contrast to earlier crises which stemmed from the emerging world. Third, there are indications that protectionist tendencies have increased around the world in anticipation of the growing possibilities of slower growth in advanced economies. Fourth, linkages between financial sector developments and the real sector have become more apparent and worrisome than before, with growing evidence of the effects of the financial turmoil on the real sector. With tightening in lending standards, deterioration in asset quality and deceleration in consumer loan demand, events in the financial markets are beginning to have a persisting impact on the real economy. Fifth, new global economic imbalances are emerging on account of large movements in commodity prices, especially oil. Sixth, Emerging Market Economies (EMEs) are exhibiting resilience until now in the face of the global financial turmoil reflecting relatively stronger macroeconomic framework and sustainable macroeconomic balances. However, until how long and to what extent such resilience will persist is uncertain. The central banks in major countries have had to take recourse, in appropriate mix, to three instruments to avoid serious spill-over of these issues in money or credit markets into the wider economy: (i) Adjustment of interest rates for borrowing and lending (ii) Money market operations designed to inject special liquidity in order to avoid a break-down in payment systems among banks; and

(iii) To put in mechanisms for financial transactions among the largest of the financial intermediaries which automatically impact the second and third rung intermediaries. Central banks in major industrialised economies, by and large, responded with injection of liquidity for a longer period than is usually done; they also resorted to dilution in the quality of collateral required for liquidity support. Most of these operations have not been conducted at the penal rates expected in such situations. This is an unprecedented package which, some observers believe, is indicative of the seriousness of the underlying problems. In addition, there were some specific-institution oriented operations, namely, in the United States, Germany and the United Kingdom There are also calls for fundamental rethink on macroeconomic, monetary and financial sector policies to meet the new challenges and realities, which, represent a structural shift in the international financial architecture demanding potentially enhanced degree of coordination among monetary authorities and regulators. A review of the policies relating to financial regulation, in a way, needs to address both the acute policy dilemmas in the short run and a fundamental re-think on broader frameworks of financial and economic policies over the medium-term. Market failures1 There have been numerous systemic failures in the performance and conduct of the large financial sector institutions that have been a key reason for the current crisis. First, the prolonged benign macroeconomic conditions gave rise to complacency among many market participants and led to an erosion of sound practices, resulting in adoption of poor credit risk appraisal standards.

Second, some of the standard risk management tools and models used by market participants were not equipped to estimate the potential impact of adverse events for structured credit products and high uncertainty around model estimates that largely missed the underlying combination of risks. Further, these risk models, generally tended to induce the market participants to adopt a unidirectional approach. Third, many investors, including institutional ones, with the capacity to undertake their own credit analysis, did not undertake sufficient in-house examination of the risks in the assets underlying structured investments. Fourth, the role of Credit Rating Agencies (CRAs) in the recent market developments has attracted attention. Fifth, the distortions in incentive structures can be seen from various perspectives namely incentives for originators, arrangers, distributors and managers in the originate-to-distribute model; the compensation schemes in financial institutions not distinguishing between realised and unrealised profits; encouraging financial structures tailored to obtaining high ratings etc. Sixth, weaknesses in public disclosures by financial institutions on the type and magnitude of risks associated with their on-and off-balance sheet exposures are noticeable. Seventh, large commercial banks and investment banks have assumed increasingly similar risk profiles, use similar models to assess and are subject to the same risk management challenges under the given circumstances. Eighth, there is a new dimension to bank liquidity, with the shifting emphasis to a market based wholesale or purchased liabilities. This makes banks increasingly dependent on the market for raising liquidity, while markets may have a tendency to shy away from providing liquidity when they are most needed.

Regulatory shortcomings1 While the foregoing brings out the failures of the markets and of the market participants, some of the regulatory shortcomings identified are as follows: First, the regulators recognised some of the underlying vulnerabilities in the financial sector but failed to take effective action, partly because they may have overestimated the strength and resilience of the financial system or they assumed that the risks were well distributed among entities outside the banking system. Many analysts and policymakers had raised concerns about excessive risk taking, loose underwriting standards, and asset overvaluations, all of which have in the absence of timely effective actions laid the seeds for crises. Second, the limitations in regulatory arrangements, including the capital adequacy framework, contributed to the growth of unregulated exposures, excessive risktaking and weak liquidity risk management. Third, weaknesses in the application of accounting standards and the shortcomings associated with the valuation and financial reporting of structured products played a significant role in the current turbulence through pro-cyclical valuations and lack of full disclosure of banks true risk profile through the cycle. Fourth, the crisis revealed the need to adapt some of the tools and practices of central banks to manage system liquidity in the light of banks cross-border operations. The recent experiences have highlighted the differences in emergency liquidity frameworks of central banks, on aspects such as range of collateral, range of eligible counterparties; and the differences in central bank practices.

Fifth, supervisors did not adequately address deterioration in risk management standards in the regulated entities, which did not fully reckon the risks associated with new financial instruments, and there were shortcomings in consolidated supervision. Sixth, deficiencies in crisis management and bank resolution frameworks, including deposit insurance, have been observed, especially where central banks do not have a central supervisory role. Seventh, the complex inter-relationship between regulation, the inappropriate accounting practices, and regulators excessive dependence on external ratings may have exacerbated the market turbulence.

2. Indian financial services industry2

Financial stability in India has been achieved through perseverance of prudential policies which prevent institutions from excessive risk taking, and financial markets from becoming extremely volatile and turbulent. As a result, while there are orderly conditions in financial markets, the financial institutions, especially banks, reflect strength and resilience. While supervision is exercised by a quasi-independent Board carved out of the Reserve Bank of India (RBI) Board, the interface between regulation and supervision is close in respect of banks and financial institutions, and on market regulation, a close coordination with other regulators exists. In contrast to the global scenario, India has by-and-large been spared of global financial contagion for a variety of reasons. The credit derivatives market is in an embryonic stage in India; the originate-to-distribute model in India is not comparable to the ones prevailing in advanced markets; there are restrictions on investments by Indian investors in such products issued abroad; and regulatory guidelines on securitisation do not permit immediate profit recognition. Investment portfolio In the year 2000 the Reserve Bank of India (RBI) conducted a stress test of the banks investment portfolio in an increasing interest rate scenario, when the general trend then was decreasing interest rates. At that time, banks in India were maintaining a surrogate capital charge for market risk, which was at a variance from the Basel norms. On the basis of the findings, in order to equip the banking system to be better positioned to meet the adverse impact of interest rate risk, banks were advised in January 2002 to build up an Investment Fluctuation Reserve (IFR) within a period of five years. The prudential target for the IFR was 5% of their investments in Held for Trading (HFT) and Available for Sale (AFS) categories. Banks were encouraged to build up a higher percentage of IFR up to 10% of their AFS and HFT investments. This countercyclical prudential requirement enabled banks to absorb some of the adverse impact when interest rates began moving in the opposite direction in late 2004. Banks have been maintaining capital charge for market risk as envisaged under the Basel norms since end-March 2006. The regulatory guidelines in India require banks to classify their investments in three categories, similar to the international standards. The investments included in the Held to Maturity (HTM) category was capped at 25% of the total investments and banks are allowed to carry the investments in the HTM category at cost. With the change in the direction of the movement of interest rates in 2004, the cap on the HTM category was reviewed in the light of the statutory prescriptions (referred to as Statutory Liquidity Ratio (SLR) in India) requiring banks to mandatorily invest up to 25% of their Demand and Time Liabilities (DTL) in eligible government securities. In view of the statutory pre-emption and the long duration of the government securities, banks were permitted to exceed the limit of 25% of total investments under Held to Maturity (HTM) category provided the excess comprised only of the SLR securities, and the total SLR securities held in the HTM category was not more than 25% of their DTL. Such shifting was allowed at acquisition cost or book value or market value on the date of transfer, whichever is the least, and the depreciation, if any, on such transfer was required to be fully provided for. The above transition is consistent with international standards that do not place any cap on HTM category, and was considered advisable taking into account the statutory nature of the SLR while ensuring prudence and transparency in valuation on transfer to HTM category. While the earlier prescription for this category was relatively more conservative, the changes in September 2004 recognised the dynamic interface with the interest rate cycles and were countercyclical.

Note: Originate-to-distribute model is a model of lending, where the originator of a loan sells it to various third parties. This method of lending was very popular in the mortgageloans market until a disruption in this market began in the middle of 2007. It is basically an agency problem in which agents (the originator of the loans) do not have the incentives to act fully in the interest of the principal (the ultimate holder of the loan). Originators had every incentive to maintain origination volume, because that would allow them to earn substantial fees, but they had weak incentives to maintain loan quality. When loans went bad during the subprime crisis, originators lost money, mainly because of the warranties they provided on loans; however, those warranties often expired as quickly as ninety days after origination. Furthermore, unlike traditional players in mortgage markets, originators often saw little value in their charters, because they often had little capital tied up in their firm. When hit with a wave of early payment defaults and the associated warranty claims, they simply went out of business. While the lending boom lasted, however, originators earned large profits. Many securitizers of mortgage-backed securities and resecuritizers, such as CDO managers, also, in retrospect, appear to have been motivated more by issuance and arrangement fees and less by concern for the longer-run performance of these securities. These agency problems combined to lower underwriting standards, so that borrowers with weaker financial histories had access to larger loans. When the housing market cooled and house prices no longer rose at a rapid pace, these subprime borrowers found themselves unable to either repay their loans or refinance out of them. India has historically followed a cautious policy of financial de-regulation and supervision as described in the following subsections. 9

Capital adequacy risk weights In view of the increase in growth of advances to the real estate sector, banks were advised to put in place a proper risk management system to contain the risks involved. In June 2005, the RBI advised banks to have a board mandated policy in respect of their real estate exposure covering exposure limits, collaterals to be considered, margins to be kept, sanctioning authority / level and sector to be financed. In view of the rapid increase in loans to the real estate sector raising concerns about asset quality and the potential systemic risks posed by such exposure, the risk weight on banks exposure to commercial real estate was increased from 100% to 125% in July 2005 and further to 150% in April 2006. The risk weights on housing loans extended by banks to individuals against mortgage of housing properties and investments in Mortgage Backed Securities (MBS) of Housing Finance Companies (HFCs), recognised and supervised by National Housing Bank (NHB) were increased from 50% to 75% in December 2004. However, on a review, banks were advised to reduce the risk weight in respect of exposures arising out of housing loans up to Rs.30 lakh (USD 75,000 approx) to individuals against the mortgage of residential housing properties from 75% to 50%, in view of the lower perception of risks in these exposures. Provisions against standard assets The prudential norms relating to income recognition, asset classification and provisioning, introduced during 1992-93 are being continuously monitored and refined to bring them on par with international best practices. In keeping with this, several measures were initiated in 2005-06. The provisions for standard assets were revised progressively in November 2005, May 2006 and January 2007, in stages in view of the continued high credit growth in the real estate sector, personal loans, credit card receivables, and loans and advances qualifying as capital market exposure and a higher default rate with regard to personal loans and credit card receivables, which emerged as a matter of concern. The standard assets in the following categories of loans and advances attract a 2% provisioning requirement (i) personal loans (including credit card receivables); (ii) loans and advances qualifying as capital market exposure; (iii) real estate loans (excluding residential housing loans), and (iv) loans and advances to systemically important

non-deposit accepting non-banking finance companies (NBFC-ND-SI). In order to ensure continued and adequate availability of credit to the highly productive sectors of the economy, the provisioning requirement for all other loans and advances, classified as standard assets was kept unchanged, viz., (i) direct advances to the agricultural and SME sectors at 0.25%; and (ii) all other loans and advances at 0.4%. Exposure to inter-bank liability In order to reduce the extent of concentration of banks liabilities the RBI had issued guidelines to banks in March 2007 placing prudential limits on the extent of their Inter-Bank Liability (IBL) as a proportion of their net worth (200%). Those banks which had a higher capital adequacy ratio of 125% of the regulatory minimum were allowed a higher limit of 300% of net worth. In addition, prudential limits have also been placed on the extent to which banks may access the inter-bank call money market both as a lender and as a borrower. Financial regulation of systemically important NBFCs and banks relationship with them The RBI has been strengthening the regulatory and supervisory framework for Non-Banking Finance Companies (NBFCs) since 1997 with the objective of making the NBFC sector vibrant and healthy. The focus was initially on deposit-taking NBFCs. These efforts were pursued further during 2006-07, when a major thrust was on strengthening the regulatory framework with regard to systemically important non-banking financial companies so as to reduce the regulatory gaps. At that time, the regulatory focus was also widened to include systemically important non-deposit taking NBFCs and prudential norms were specified for these entities. The application of different levels of regulations to the activities of banks and NBFCs, and even among different categories of NBFCs, had given rise to some issues relating to uneven coverage of regulations. Based on the recommendations of an Internal Group and taking into consideration the feedback received thereon, a revised framework to address the issues pertaining to the overall regulation of systemically important NBFCs and the relationship between banks and NBFCs was put in place in December 2006.

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Securitisation guidelines The RBI has issued guidelines on securitisation of standard assets in February 2006. The guidelines are applicable to banks and financial institutions, including Non-Banking Financial Companies (NBFCs). These guidelines provide for a conservative treatment of securitisation exposures for capital adequacy purposes, especially in regard to the credit enhancement and liquidity facilities. The regulatory framework encourages greater participation by third parties with a view to ensure better governance in the structuring of Special Purpose Vehicles (SPVs), the products, and the provision of support facilities. A unique feature of these guidelines, which may be at a variance with the accounting standards, is that any profits on sale of assets to the SPV are not allowed to be recognised immediately on sale but over the life of the pass through certificates issued by the SPV. We believe that these guidelines, as a package, have ensured an appropriate incentive mechanism for securitisation transactions. Banks investment in non-SLR Securities RBI had emphasised that banks should observe prudence in order to contain the risk arising out of their non-SLR (i.e., non government) investment portfolio, in particular through the private placement route. Detailed prudential guidelines on the subject were issued in June 2001, which were reviewed and revised in November 2003. These guidelines, inter alia, address aspects of coverage, regulatory requirements, listing and rating requirements, fixing of prudential limits, internal assessments, role of boards, disclosures, and trading and settlement in debt securities. Banks were specifically advised that they should not be solely guided by the ratings assigned to these securities by the external rating agencies but that they should do a detailed appraisal as in the case of direct lending.

Marking-to-market The Indian accounting standards are generally aligned to the International Financial Reporting Standards, though there are some differences. In India, we are yet to fully adopt the marking-to-market requirements as available in the international standards. The Indian standards are relatively conservative and do not permit recognition of unrealised gains in the profit and loss account or equity, though unrealised losses are required to be accounted. Banks are required to mark-to-market the investments in the Held for Trading (HFT) and Available for Sale (AFS) categories at periodical intervals, on a portfolio basis, and provide for the net losses and ignore the net gains. This has proved to be a stabilising factor, inasmuch as it has not induced an imbalance in the incentive structures and has also proved to be less pro-cyclical.

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Moral suasion and supervisory review Moral suasion and public articulation of concerns has helped in achieving a desired re-balancing of suspected excesses in risk taking among banks. Some of the areas where moral suasion has been used are the need for banks to monitor unhedged foreign currency exposures of their corporate clients, adoption of appropriate incentive mechanisms by banks for encouraging disclosures of derivative exposures by their corporate clients, banks reliance on non-deposit resources to finance assets, their excessive reliance on wholesale deposits and uncomfortable Loan-to-Value (LTV) ratios in respect of housing loans etc. A Supervisory Review Process (SRP) was initiated with select banks having significant exposure to sensitive sectors, including reliance on call money market, in order to ensure that effective risk mitigants and sound internal control systems are in place. In the first round, a framework was developed for monitoring the systemically important individual banks. The second round of SRP was directed to analyse banks exposure to sensitive sectors and identify outliers. Based on the analyses of these outlier banks, guidelines were issued to all banks indicating the need for better risk management systems in banks at operating levels. In brief, in India the focus is on regulatory comfort, going beyond regulatory compliance. In a choice between emphasis of regulations on saving capital and protecting depositors interests or reinforcing financial system stability, the latter have always prevailed.

Financial sector liberalisation and development It is necessary to clarify that while the measures mentioned above were aimed at fostering financial stability, several other initiatives have been taken to liberalise the macro-policy environment in which banks operate through a re-orientation of regulatory prescriptions by replacing micro regulations with macro-prudential regulations. These changes have been instrumental in providing an enabling environment for universal banking, improved corporate governance in private sector banks, and enabling consolidation of banks in the private sector. Some of these measures include: A reduction in pre-emption through reserve requirements Shift to market determined pricing for government securities Disbanding of some of the administered interest rates Auction-based repos-reverse repos for short-term liquidity management Facilitation of improved payments and settlement mechanism Setting up of the Clearing Corporation of India Limited (CCIL) to act as central counter party for facilitating payments and settlement system relating to fixed income securities, money market instruments and foreign exchange transactions Setting up of INFINET as the communication backbone for the financial sector Introduction of Negotiated Dealing System (NDS) for screen-based trading in government securities

The prudential target for the IFR was 5% of their investments in Held for Trading (HFT) and Available for Sale (AFS) categories

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 Introduction of Real Time Gross Settlement (RTGS) system Debt recovery tribunals, asset reconstruction companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for quicker recovery / restructuring of stressed assets Promulgation of Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act, 2002 and its subsequent amendment to ensure creditor rights; setting up of Credit Information Bureau of India Limited (CIBIL) for information sharing on defaulters as also other borrowers These growth oriented initiatives have appropriately complemented the stability oriented initiatives. Development orientation In the context of the rapidly evolving financial landscape, the RBI has also been suitably reorienting its regulatory and supervisory framework to meet the needs of the common man by simultaneously focusing on financial inclusion and extension of banking services to the unbanked areas of the economy. The RBI has taken several measures in recent years aimed at providing customer service at reasonable cost. These measures include enhancing customer protection and disclosures, code of ethics and grievance redressal, among others. The RBIs broad approach to financial inclusion aims at connecting people with the banking system and not just credit dispensation; giving people access to the payments system; and portraying financial inclusion as a viable business model and opportunity.

Monetary policy As a part of the conduct of monetary policy, the RBI monitors, inter alia, monetary and credit aggregates. It uses both liquidity and interest rate instruments to achieve the monitory policy objectives. Pre-emptive actions have been taken since 2004 to withdraw monetary accommodation which was reinforced with measures aimed at moderating early signs of over-heating. Further, appreciation of the possible permanent and temporary components with regard to oil prices has been articulated in the policies. While undertaking a nuanced approach to managing aggregate demand recognising the elements of shock and consequent impact on inflation expectations, the underlying demand conditions warranted several interest rate and liquidity measures in recent weeks. While monetary policy influences aggregates, reality is often dis-aggregated. Hence, the RBI uses prudential regulatory policies to complement the monetary policy measures and objectives. It is pertinent that the lender of last resort function is not separate either from monetary and liquidity management or from financial regulation. Thus both monetary policy and prudential regulations are used as complementary tools to achieve the central bank objectives and they both support and reinforce each other.

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3. Impact of the recession on the fin

Contrary to the decoupling theory, whereby several emerging economies were claimed to be decoupled from the developed economies, most emerging economies have been hit by the crisis. The decoupling theory held that even if advanced economies went into a downturn, emerging economies will remain unscathed because of their substantial foreign exchange reserves, improved policy framework, robust corporate balance sheets and relatively healthy banking sector. Given the evidence of the last few months capital flow reversals, sharp widening of spreads on sovereign and corporate debt and abrupt currency depreciations the decoupling theory stands totally invalidated reinforcing the notion that in a globalized world no country can be an island with growth prospects of emerging economies being undermined by the cascading financial crisis with, of course, considerable variation across countries. How has India been hit by the crisis? The contagion of the crisis has spread to India through all the channels the financial channel, the real channel, and importantly, the confidence channel. Let us first look at the financial channel. Indias financial markets equity markets, money markets, forex markets and credit markets had all come under pressure from a number of directions. Indian equity market will continue to track global developments in 2009. First, the Indian stock markets, both BSE as well as NSE, fell dramatically over 2008 Indias main index sensex plunged nearly 50% during the year from a high of 19,080 in January 2008 to 8,674 in January 2009. The NSE also fell by a similar percentage. Foreign institutional investors pulled out close to Rs 50,000 crore (Rs 500 billion) from the

domestic stock market in 2008-09, almost equalling the inflow in the previous fiscal. As per the latest information on the Securities and Exchange Board of India website, FIIs net outflows have been Rs 47,706 crore (Rs 477.06 billion) till March 30 in the financial year 2008-09 as against huge inflows of Rs 53,000 crore (Rs 530 billion) in the previous fiscal. However, it is believed that FIIs may resume investments in Indian equities later in FY 2009-10, as the country still remains an attractive investment destination with sound fundamentals. As a consequence of the global liquidity squeeze, Indian banks and corporates found their overseas financing drying up, forcing corporates to shift their credit demand to the domestic banking sector. Also, in their frantic search for substitute financing, corporates withdrew their investments from domestic money market mutual funds putting redemption pressure on the mutual funds and down the line on Non-Banking Financial Companies (NBFCs) where the MFs had invested a significant portion of their funds. This substitution of overseas financing by domestic financing brought both money markets and credit markets under pressure. In the foreign exchange market, although there has been some flight of foreign capital from the Indian capital markets, the current level of reserves is reasonably healthy. In fact, the extent of inward remittances during 2008 was a record $40 billion. The forex market came under pressure because of reversal of capital flows as part of the global deleveraging process. Simultaneously, corporates were converting the funds raised locally into foreign currency to meet their external obligations. Both these factors put downward pressure on the rupee. Third, the Reserve Banks intervention in the forex market to manage the volatility in the rupee further added to liquidity tightening.

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ancial sector of the Indian economy

On the real channel, the transmission of the global cues to the domestic economy has been quite straight forward through the slump in demand for exports. The United States, European Union and the Middle East, which account for three quarters of Indias goods and services trade are in a synchronized down turn. Service export growth is also likely to slow in the near term as the recession deepens and financial services firms traditionally large users of outsourcing services are restructured. Remittances from migrant workers too are likely to slow as the Middle East adjusts to lower crude prices and advanced economies go into a recession. Beyond the financial and real channels of transmission as above, the crisis also spread through the confidence channel. In sharp contrast to global financial markets, which went into a seizure on account of a crisis of confidence, Indian financial markets continued to function in an orderly manner. Nevertheless, the tightened global liquidity situation in the period immediately following the Lehman failure in mid-September 2008, coming as it did on top of a turn in the credit cycle, increased the risk aversion of the financial system and made banks cautious about lending. The purport of the above explanation is to show how, despite not being part of the global financial sector problem, India has been affected by the crisis through the pernicious feedback loops between external shocks and domestic vulnerabilities by way of the financial, real and confidence channels. Why has India been hit by the crisis? There is, at least in some quarters, surprise that India has been affected by the crisis in global financial markets. This surprise stems from two arguments: The first argument states that the Indian banking system has had no direct exposure to the sub-prime mortgage assets or to the failed institutions. It has very limited off-balance sheet activities or securitized assets. Hence, the enigma is - how can India be caught up in a crisis when it is not exposed to any of the maladies that are at the core of the crisis? The second reason for surprise is that Indias recent growth has been driven predominantly by domestic consumption and domestic investment. External

demand, as measured by merchandize exports, accounts for less than 15% of our GDP. The question then is, even if there is a global downturn, why should India be affected when its dependence on external demand is so limited? The explanation lies in the story of Indias globalization. First, Indias integration into the world economy over the last decade has been remarkably rapid. Integration into the world implies more than just exports. Going by the common measure of globalization, Indias two-way trade (merchandize exports plus imports), as a proportion of GDP, grew from 21.2% in 1997-98, the year of the Asian crisis, to 34.7% in 2007-08. Second, Indias financial integration with the world has been as deep as Indias trade globalization, if not deeper. If we take an expanded measure of globalization, that is the ratio of total external transactions (gross current account flows plus gross capital flows) to GDP, this ratio has more than doubled from 46.8% in 1997-98 to 117.4% in 2007-08. Importantly, the Indian corporate sectors access (and dependence) to external funding has markedly increased in the last five years. In the five year period 2003-08, the share of investment in Indias GDP rose by 11% points. Corporate savings financed roughly half of this, but a significant portion of the balance financing came from external sources. While funds were available domestically, they were expensive relative to foreign funding. On the other hand, in a global market awash with liquidity and on the promise of Indias growth potential, foreign investors were willing to take risks and provide funds at a lower cost. For example, last year (2007 / 08) India received capital inflows amounting to over 9% of GDP as against a current account deficit in the balance of payments of just 1.5% of GDP. These capital flows, in excess of the current account deficit, evidence the importance of external financing and the depth of Indias financial integration. Hence, the reason why India has been impacted by the crisis, despite mitigating factors, is clearly Indias rapid and growing integration into the global economy.

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How have we responded to the challenge? The failure of Lehman Brothers in mid-September was followed in quick succession by several other large financial institutions coming under severe stress. This made financial markets around the world uncertain and unsettled. This contagion spread to emerging economies, including India. Both the government and the Reserve Bank of India responded to the challenge in close coordination and consultation. The main plank of the government response was fiscal stimulus while the Reserve Banks action comprised monetary accommodation and counter cyclical regulatory forbearance. Monetary policy response The Reserve Banks policy response was aimed at containing the contagion from the outside to keep the domestic money and credit markets functioning normally and see that the liquidity stress did not trigger solvency cascades. In particular, we targeted three objectives: first, to maintain a comfortable rupee liquidity position; second, to augment foreign exchange liquidity; and third, to maintain a policy framework that would keep credit delivery on track so as to arrest the moderation in growth. This marked a reversal of Reserve Banks policy stance from monetary tightening in response to heightened inflationary pressures of the previous period to monetary easing in response to easing inflationary pressures and moderation in growth in the current cycle. The measures to meet the above objectives came in several policy packages starting mid-September 2008, on occasion in response to unanticipated global developments and at other times in anticipation of the impact of potential global developments on the Indian markets. Our policy packages included both conventional and unconventional measures. On the conventional side, the RBI reduced the policy interest rates aggressively and rapidly, reduced the quantum of bank reserves impounded by the central bank and expanded and liberalized the refinance facilities for export credit.

Measures aimed at managing forex liquidity included an upward adjustment of the interest rate ceiling on the foreign currency deposits by non-resident Indians, substantially relaxing the External Commercial Borrowings (ECB) regime for corporates, and allowing non-banking financial companies and housing finance companies access to foreign borrowing. The important unconventional measures taken by the Reserve Bank of India are a rupee-dollar swap facility for Indian banks to give them comfort in managing their short-term foreign funding requirements, an exclusive refinance window as also a special purpose vehicle for supporting non-banking financial companies, and expanding the lendable resources available to apex finance institutions for refinancing credit extended to small industries, housing and exports. Governments fiscal stimulus Over the last five years, both the central and state governments in India have made a serious effort to reverse the fiscal excesses of the past. At the heart of these efforts was the Fiscal Responsibility and Budget Management (FRBM) Act which mandated a calibrated road map to fiscal sustainability. However, recognizing the depth and extraordinary impact of this crisis, the central government invoked the emergency provisions of the FRBM Act to seek relaxation from the fiscal targets and launched two fiscal stimulus packages in December 2008 and January 2009. These fiscal stimulus packages, together amounting to about 3% of GDP, included additional public spending, particularly capital expenditure, government guaranteed funds for infrastructure spending, cuts in indirect taxes, expanded guarantee cover for credit to micro and small enterprises, and additional support to exporters. These stimulus packages came on top of an already announced expanded safety-net for rural poor, a farm loan waiver package and salary increases for government staff, all of which too should stimulate demand.

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The important unconventional measures taken by the Reserve Bank of India are a rupee-dollar swap facility for Indian banks to give them comfort in managing their shortterm foreign funding requirements
Impact of monetary measures Taken together, the measures put in place since mid-September 2008 have ensured that the Indian financial markets continue to function in an orderly manner. The cumulative amount of primary liquidity potentially available to the financial system through these measures is over US$ 75 bn or 7% of GDP. This sizeable easing has ensured a comfortable liquidity position starting mid-November 2008 as evidenced by a number of indicators including the weighted-average call money rate, the overnight money market rate and the yield on the 10-year benchmark government security. Taking the signal from the policy rate cut, many of the big banks have reduced their benchmark prime lending rates. Bank credit has expanded too, faster than it did last year. However, Reserve Banks rough calculations show that the overall flow of resources to the commercial sector is less than what it was last year. This is because, even though bank credit has expanded, it has not fully offset the decline in non-bank flow of resources to the commercial sector. Evaluating the response In evaluating the response to the crisis, it is important to remember that although the origins of the crisis are common around the world, the crisis has impacted different economies differently. Importantly, in advanced economies where it originated, the crisis spread from the financial sector to the real sector. In emerging economies, the transmission of external shocks to domestic vulnerabilities has typically been from the real sector to the financial sector. Countries have accordingly responded to the crisis depending on their specific country circumstances. Thus, even as policy responses across countries are broadly similar, their precise design, quantum, sequencing and timing have varied. In particular, while policy responses in advanced economies have had to contend with both the unfolding financial crisis and deepening recession, in India, our response has been predominantly driven by the need to arrest moderation in economic growth.

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4. Future outlook

The global economic outlook deteriorated sharply over the last quarter. In a sign of the ferocity of the down turn, the IMF made a marked downward revision of its estimate for global growth in 2009 in purchasing power parity terms from its forecast of 3.0% made in October 2008 to 0.5% in January 2009. In market exchange rate terms, the downturn is sharper global GDP is projected to actually shrink by 0.6%. With all the advanced economies the United States, Europe and Japan having firmly gone into recession, the contagion of the crisis from the financial sector to the real sector has been unforgiving and total. Recent evidence suggests that contractionary forces are strong: demand has slumped, production is plunging, job losses are rising and credit markets remain in seizure. Most worryingly, world trade the main channel through which the downturn will get transmitted on the way forward is projected to contract by 2.8% in 2009. Policy making around the world is in clearly uncharted territory. Governments and central banks across countries have responded to the crisis through big, aggressive and unconventional measures. There is a contentious debate on whether these measures are adequate and appropriate, and when, if at all, they will start to show results. There has also been a separate debate on how abandoning the rule book driven by the tyranny of the short-term, is compromising mediumterm sustainability. What is clearly beyond debate though is that this Great Recession of 2008 / 09 is going to be deeper and the recovery longer than earlier thought. Solutions and prescriptions3 The factors mentioned earlier clearly demonstrate a need to enhance the resilience of the global system and consider some of the prescriptions that have been offered for the consideration of the policy makers. The recent developments in the global financial markets have been closely followed by many. These include market participants, central bankers, supervisors, multilateral institutions, political leaders, analysts, academicians, and also the layman. With so much attention being focused on the ongoing turbulence, by so many stakeholders,

we have a wide menu of solutions and prescriptions. Broadly, these prescriptions are as follows: 1. Improving risk management frameworks (including governance arrangements) in banks and financial institution 2. Empowering the supervisors to play a more active role in scrutinizing the risk management practices 3. Improving transparency by upgrading reporting requirements, reviewing the norms for dealing with off balance sheet items and delinking incentives from excessive risk taking behaviour 4. Improving the governance and rating methodologies used by the credit rating agencies 5. Constantly reviewing and resolving the element of pro-cyclicality in prudential regulations, accounting rules, and the attitude of the authorities that tend to apply these 6. Revisiting the relevant accounting standards and scope for applying fair value accounting to mitigate pro-cyclicality 7. Providing additional powers to the regulatory authorities to intervene at the first sign of weakness, preferably much before the institutions net worth turns negative 8. Evaluating the deposit insurance schemes adopted by the financial institutions and making appropriate modifications, when needed, to provide greater certainty and safeguards to the wealth of the depositors As far as India is concerned, the outlook going forward is mixed. There is evidence of economic activity slowing down. Real GDP growth has moderated in the first half of 2008 / 09. The services sector too, which has been our prime growth engine for the last five years, is slowing, mainly in construction, transport and communication, trade, hotels and restaurants sub-sectors. For the first time in seven years, exports have declined in absolute terms for three months in a row during October-December 2008. Recent data indicate that the demand for bank credit is slackening despite comfortable liquidity in the system. Higher input costs and dampened demand have dented corporate

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margins while the uncertainty surrounding the crisis has affected business confidence. The index of industrial production has shown negative growth for two recent months and investment demand is decelerating. All these factors suggest that growth moderation may be steeper and more extended than earlier projected. In addressing the fall out of the crisis, India has several advantages. Some of these are recent developments. Most notably, headline inflation, as measured by the wholesale price index, has fallen sharply, and recent trends suggest a faster-than-expected reduction in inflation. Clearly, falling commodity prices have been the key drivers behind the disinflation; however, some contribution has also come from slowing domestic demand. The decline in inflation should support consumption demand and reduce input costs for corporates. Furthermore, the decline in global crude prices and naphtha prices will reduce the size of subsidies to oil and fertilizer companies, opening up fiscal space for infrastructure spending. From the external sector perspective, it is projected that imports will shrink more than exports keeping the current account deficit modest. There are also several structural factors that have come to Indias aid. First, notwithstanding the severity and multiplicity of the adverse shocks, Indias financial markets have shown admirable resilience. This is in large part because Indias banking system remains sound, healthy, well capitalized and prudently regulated. Second, our comfortable reserve position provides confidence to overseas investors. Third, since a large majority of Indians do not participate in equity and asset markets, the negative impact of the wealth loss effect that is plaguing the advanced economies should be quite muted. Consequently, consumption demand should hold up well. Fourth, because of Indias mandated priority sector lending, institutional credit for agriculture will be unaffected by the credit squeeze. The farm loan waiver package implemented by the government should further insulate the agriculture sector from the crisis. Finally, over the years, India has built an extensive network of social safety-net programmes, including the flagship rural employment

guarantee programme, which should protect the poor and the returning migrant workers from the extreme impact of the global crisis. RBIs policy stance Going forward, the Reserve Banks policy stance will continue to be to maintain comfortable rupee and forex liquidity positions. There are indications that pressures on mutual funds have eased and that NBFCs too are making the necessary adjustments to balance their assets and liabilities. Despite the contraction in export demand, we will be able to manage our balance of payments. It is the Reserve Banks expectation that commercial banks will take the signal from the policy rates reduction to adjust their deposit and lending rates in order to keep credit flowing to productive sectors. In particular, the special refinance windows opened by the Reserve Bank for the MSME (micro, small and medium enterprises) sector, housing sector and export sector should see credit flowing to these sectors. Also the SPV set up for extending assistance to NBFCs should enable NBFC lending to pick up steam once again. The governments fiscal stimulus should be able to supplement these efforts from both supply and demand sides. When the turnaround comes Over the last five years, India clocked an unprecedented 9% growth, driven largely by domestic consumption and investment even as the share of net exports has been rising. This was no accident or happenstance. True, the benign global environment, easy liquidity and low interest rates helped, but at the heart of Indias growth were a growing entrepreneurial spirit, rise in productivity and increasing savings. These fundamental strengths continue to be in place. Nevertheless, the global crisis will dent Indias growth trajectory as investments and exports slow. Clearly, there is a period of painful adjustment ahead of us. However, once the global economy begins to recover, Indias turn around will be sharper and swifter, backed by our strong fundamentals and the untapped growth potential. Meanwhile, the challenge for the government and the RBI is to manage the adjustment with as little pain as possible.

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5. Conclusion

The finance sector is currently undergoing a deep and thorough restructuring. The crisis has hit the sector unevenly, which may result in labour movement among financial sub-sectors. This will reinforce the impetus towards structural changes similar to those experienced until now. This restructuring of the finance sector cannot take place without substantial consequences for both employment and income of current employees in this industry. In fact, the sector is already experiencing a permanent decline in overall activity after years of expansion, which is triggering significant job losses. Moreover, evidence shows stagnation and even deceleration in income growth. The detailed account given above of the developments in the global and the Indian financial sector would be incomplete without devoting some attention to the broader issues. These issues need to be reckoned and debated widely lest the response to recent developments be construed as internal to the financial sector, warranting only such sector-specific solutions. First, should the benefits of financial liberalisation and financial globalisation be re-evaluated? It is possible to argue that liberalisation of trade in goods has contributed more to growth and price stability than financial sector initiatives. In particular, it may be argued that the incentive frameworks for financial intermediaries appear to be disproportionate to their conceivable contribution to the economy. The arguments in favour of persevering with financial innovation and urging regulators to continue to give priority to facilitate innovations should be viewed in this context. Second, should the regulators have placed greater emphasis on savings of capital in banks rather than on the interests of the depositors and on systemic stability? The recent compulsions for shoring up of capital by some of the global financial institutions in advanced economies seem to suggest this. What induced the regulators to permit such excesses in leverage and savings of capital? Does this also involve issues pertaining to governance and accountability of the regulators?

Third, it is relevant to ask whether there is a beginning of fiscalisation of the financial sector in view of the intensification of the links between the two? For example, the recent episodes of participation of the sovereign wealth funds in the re-capitalisation of banks tantamount to fiscal support. Further, large doses of liquidity support to financial markets by regulators against collateral may also involve quasi-fiscal costs, under some circumstances.

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Fourth, whether there is, what may be called, financialisation of the political economy? The attractiveness of financial intermediaries in terms of high profitability, significant growth especially cross-border, massive spread of investors, and the inadequate scope for application of principles of rules of origin in the financial sector could have resulted in enhanced clout for these intermediaries in the political economy. Fifth, whether there has been excessive financialisation of corporates, in the sense that large corporates take significant positions in the financial markets through their treasury operations? Increasingly, many of the

positions of the corporates in the financial markets may not be related to their underlying business. Do we have an issue when such activities of corporates in the financial markets, unrelated to their underlying business, are not regulated the way similar activities of financial market intermediaries are regulated? To conclude, on the way forward, to exit the current financial turbulence and fortify against future similar episodes, we may need to look beyond reforms within the financial sector and address broader related issues that impinge on the balance between the sovereign, the regulators, the financial institutions and the markets4.

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Endnote 1 Excerpts taken from a speech given by Y. V. Reddy on Global Financial Turbulence and Financial Sector in India: A Practitioners Perspective
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www.rbi.or.in Excerpts taken from a speech given by Y. V. Reddy on Global Financial Turbulence and Financial Sector in India: A Practitioners Perspective Excerpts taken from a speech given by Y. V. Reddy on Global Financial Turbulence and Financial Sector in India: A Practitioners Perspective

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