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UNITED NATIONS ECONOMIC AND SOCIAL COMMISSION FOR ASIA AND THE PACIFIC Regional High-Level Workshop on Strengthening the Response to the Global Financial Crisis in Asia-Pacific: The Role of Monetary, Fiscal and External Debt Policies 27-30 July 2009 Dhaka, Bangladesh

Breakout Session on Monetary Policy

Global Financial Crisis and Monetary Policy Response: Experience of India

By B.M.Misra Adviser Department of Economic Analysis and Policy Reserve Bank of India, Mumbai.
July 2009

The views expressed in the paper are those of the author(s) and should not necessarily be considered as reflecting the views or carrying the endorsement of the United Nations. This paper has been issued without formal editing.

Global Financial Crisis and Monetary Policy Response: Experience of India

The global financial crisis has called into question several fundamental assumptions and beliefs governing economic resilience and financial stability. What started off as turmoil in the financial sector of the advanced economies has snowballed into the deepest and most widespread financial and economic crisis of the last 60 years. With all the advanced economies in a synchronised recession, global GDP is projected to contract for the first time since the World War II, anywhere between 0.5 and 1.0 per cent, according to the March 2009 forecast of the International Monetary Fund (IMF). The emerging market economies are faced with decelerating growth rates. The World Trade Organisation (WTO) has forecast that global trade volume will contract by 9.0 per cent in 2009. Governments and central banks around the world have responded to the crisis through both conventional and unconventional fiscal and monetary measures. Indian authorities have also responded with fiscal and monetary policy measures. This paper gives a brief account of the Monetary Policy response in Indian context. Impact of Global Financial Crisis on India, Why? There is, at least in some quarters, dismay that India has been hit by the crisis. This dismay stems from two arguments. The first argument goes as follows. The Indian banking system has had no direct exposure to the sub-prime mortgage assets or to the failed institutions. It has very limited off-balance sheet activities or securitised assets. In fact, our banks continue to remain safe and healthy. So, the enigma is how can India be caught up in a crisis when it has nothing much to do with any of the maladies that are at the core of the crisis. The second reason for dismay is that Indias recent growth has been driven predominantly by domestic consumption and domestic investment. External demand, as measured by merchandise exports, accounts for less than 15 per cent of our GDP. The question then is, even if there is a global downturn, why should India be affected when its dependence on external demand is so limited? The answer to both the above frequently-asked questions lies in globalisation. 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 globalisation, Indias two-way trade (merchandise exports plus imports), as a proportion of GDP, grew from 21.2 per cent in 1997-98, the year of the Asian crisis, to 40.6 per cent in 2008-09. Second, Indias financial integration with the world has been as deep as Indias trade globalisation, if not deeper. If we take an expanded measure of globalisation, that is the ratio of total external transactions (gross current account flows plus gross capital flows) to GDP, this ratio has more than doubled from 46.8 per cent in 1997-98 to 112.4 per cent in 2008-09. Impact of Global Financial Crisis on India, How? The contagion of the crisis has spread to India through three major channels the financial channel, the real channel, and importantly, as happens in all financial crises, the confidence channel.

Indias financial markets equity markets, money markets, forex markets and credit markets had all come under pressure from a number of directions. First, as a consequence of the global liquidity squeeze, Indian banks and corporates found their overseas financing drying up, forcing corporates to shift their credit demand to the domestic banking sector. Also, in their frantic search for substitute financing, corporates withdrew their investments from domestic money market mutual funds putting redemption pressure on the mutual funds and down the line on non-banking financial companies (NBFCs) where the MFs had invested a significant portion of their funds. This substitution of overseas financing by domestic financing brought both money markets and credit markets under pressure. Second, the forex market came under pressure because of reversal of capital flows as part of the global deleveraging process. Simultaneously, corporates were converting the funds raised locally into foreign currency to meet their external obligations. Both these factors put downward pressure on the rupee. Third, the Reserve Banks intervention in the forex market to manage the volatility in the rupee further added to liquidity tightening. Rupee-US$ rate moved up from 40.25 during 2007-08 to 45.92 during 2008-09 and 48.65 during April 01-July 21, 2009. So far the real sector is concerned, 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. Exports from India started experiencing negative growth from October 2008, a trend which has continued till May 2009, latest month for which data is available. During 2008-09, exports from India rose by 3.6 per cent in US$ terms compared to 28.9 per cent growth in the previous year. 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. Net capital inflows, which increased sharply to 9.2 per cent of GDP (US$ 108 bn) in 2007-08 from 1.9 per cent of GDP in 2000-01, witnessed a sharp decline to 0.8 per cent of GDP (US$ 9.2 bn) during 2008-09. FDI and NRI deposits witnessed a surge over their previous year's level. Portfolio investment declined to outflow of US$ 15.0 billion in 2008-09 from net inflow of US$ 29.6 billion inflow during 2007-08. The current account deficit stood at US$ 29.8 billion (2.6 per cent of GDP) in 2008-09 as against US$ 17.0 billion (1.5 per cent of GDP) during 2007-08. The CAD was driven mainly by a sharp slowdown in exports and imports growth outpacing the growth in exports led to a widening of trade deficit to US$ 119.4 billion (or 10.3 per cent of GDP) in 2008-09 from US$ 91.6 billion (or 7.8 per cent of GDP) in 2007-08. 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 credit growth during 2008-09 decelerated to 17.3 per cent from 22.3 per cent in the previous year.

As a result, economic growth decelerated to 6.7 per cent in 2008-09 from high growth of 9.5 per cent, 9.7 per cent and 9.0 per cent in 2005-06, 2006-07 and 2007-08, respectively. The manufacturing sectors decelerated to 2.4 per cent during 2008-09 from 8.2 per cent respectively in 2007-08. The slowdown in manufacturing could be attributed to the combined impact of a fall in exports and a decline in domestic demand, especially in the second half of the year.

Monetary Policy Response The policy responses in India since September 2008 have been designed largely to mitigate the adverse impact of the global financial crisis on the Indian economy. The conduct of monetary policy had to contend with the high speed and magnitude of the external shock and its spill-over effects through the real, financial and confidence channels. The evolving stance of policy has been increasingly conditioned by the need to preserve financial stability while arresting the moderation in the growth momentum. The Reserve Bank has multiple instruments at its command such as repo and reverse repo rates; cash reserve ratio (CRR), statutory liquidity ratio (SLR), open market operations, including the market stabilisation scheme (MSS) and the LAF, special market operations, and sector specific liquidity facilities. In addition, the Reserve Bank also uses prudential tools to modulate flow of credit to certain sectors consistent with financial stability. The availability of multiple instruments and flexible use of these instruments in the implementation of monetary policy has enabled the Reserve Bank to modulate the liquidity and interest rate conditions amidst uncertain global macroeconomic conditions. The thrust of the various policy initiatives by the Reserve Bank has been on providing ample rupee liquidity, ensuring comfortable dollar liquidity and maintaining a market environment conducive for the continued flow of credit to productive sectors. The key policy initiatives taken by the Reserve Bank since September 2008 are set out below: Policy Rates The policy repo rate under the liquidity adjustment facility (LAF) was reduced by 400 basis points from 9.0 per cent to 4.75 per cent. The policy reverse repo rate under the LAF was reduced by 250 basis points from 6.0 per cent to 3.25 per cent. Rupee Liquidity The cash reserve ratio (CRR) was reduced by 400 basis points from 9.0 per cent of net demand and time liabilities (NDTL) of banks to 5.0 per cent. The statutory liquidity ratio (SLR) was reduced from 25.0 per cent of NDTL to 24.0 per cent. The export credit refinance limit for commercial banks was enhanced to 50.0 per cent from 15.0 per cent of outstanding export credit. A special 14-day term repo facility was instituted for commercial banks up to 1.5 per cent of NDTL.
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A special refinance facility was instituted for scheduled commercial banks (excluding RRBs) up to 1.0 per cent of each banks NDTL as on October 24, 2008. Special refinance facilities were instituted for financial institutions (SIDBI, NHB and Exim Bank).

Forex Liquidity The Reserve Bank sold foreign exchange (US dollars) and made available a forex swap facility to banks. The interest rate ceilings on nonresident Indian (NRI) deposits were raised. The all-in-cost ceiling for the external commercial borrowings (ECBs) was raised. The all-in-cost ceiling for ECBs through the approval route has been dispensed with up to June 30, 2009. The systemically important non-deposit taking non-banking financial companies (NBFCs-ND-SI) were permitted to raise short-term foreign currency borrowings. Regulatory Forbearance The risk-weights and provisioning requirements were relaxed and restructuring of stressed assets was initiated.

Impact of Poilcy Response Liquidity Impact The actions of the Reserve Bank since mid-September 2008 have resulted in augmentation of actual/potential liquidity of over Rs.4,22,000 crore. In addition, the permanent reduction in the SLR by 1.0 per cent of NDTL has made available liquid funds of the order of Rs.40,000 crore for the purpose of credit expansion (Table 1) Table 1: Actual/Potential Release of Primary Liquidity since Mid-September 2008 Measure/Facility Amount (Rs. crore) 1 CRR Reduction 1,60,000 2 Unwinding/Buyback/De-sequestering of MSS Securities 97,781 3 Term Repo Facility 60,000 4 Increase in Export Credit Refinance 25,512 5 Special Refinance Facility for SCBs (Non-RRBs) 38,500 6 Refinance Facility for SIDBI/NHB/EXIM Bank 16,000 7 Liquidity Facility for NBFCs through SPV 25,000* Total (1 to 7) 4,22,793 Memo: Statutory Liquidity Ratio (SLR) Reduction 40,000 * Includes an option of Rs.5,000 crore.
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The liquidity situation has improved significantly following the measures taken by the Reserve Bank. The overnight money market rates, which generally hovered above the repo rate during September-October 2008, have softened considerably and have generally been close to or near the lower bound of the LAF corridor since early November 2008. Other money market rates such as discount rates of CDs and CPs softened in tandem with the overnight money market rates. The LAF window has been in a net absorption mode since mid-November 2008. The liquidity problem faced by mutual funds has eased considerably. Most commercial banks have reduced their benchmark prime lending rates. The total utilisation under the recent finance/liquidity facilities introduced by the Reserve Bank has been low as the overall liquidity conditions remain comfortable. However, their availability has provided comfort to the banks/FIs, which can fall back on them in case of need (Table 2). Table 2: Interest Rates - Monthly Average (Per cent) Segment/Instrument Call Money Commercial Paper Certificates of Deposit 91-day Treasury Bills 10-year Government Security *relates to May 2009 March October January March 2008 7.37 10.38 10.00 7.33 7.69 2008 9.90 14.17 10.00 7.44 7.80 2009 4.18 9.48 7.33 4.69 5.82 2009 4.17 9.79 8.61 4.77 6.57 June 2009 3.25 6.06* 3.70 3.22 6.83

Taken together, the measures put in place since mid-September 2008 have ensured that the Indian financial markets continue to function in an orderly manner. The cumulative amount of primary liquidity potentially available to the financial system through these measures is over US$ 75 bln or 7 per cent of GDP. This sizeable easing has ensured a comfortable liquidity position starting mid-November 2008 as evidenced by a number of indicators including the weighted-average call money rate, the overnight money market rate and the yield on the 10-year benchmark government security. 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.
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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, response has been predominantly driven by the need to arrest moderation in economic growth. Policy Response and Medium-term Prospects Both the Government and the Reserve Bank responded to the challenge of minimizing the impact of crisis on India in co-ordination and consultation. The Reserve Bank shifted its policy stance from monetary tightening in response to the elevated inflationary pressures in the first half of 2008-09 to monetary easing in response to easing inflationary pressures and moderation of growth engendered by the crisis. The Reserve Bank's policy response was aimed at containing the contagion from the global financial crisis while maintaining comfortable domestic and forex liquidity. Taking a cue from the Reserve Bank's monetary easing, most banks have reduced their deposit and lending rates. Notwithstanding the Global Financial turmoil, the Indian banking sector continues to be strong and robust. The Indian banking system was not affected by the global crisis and all financial parameters have remained strong with capital adequacy ratio for the system at 13.65 per cent (tier I ratio at 8.95 per cent), return on assets over 1 per cent, nonperforming loans around 2 per cent as of March 2009. Indian banking has by-and-large been spared of global financial contagion due to the subprime turmoil for a variety of reasons. The credit derivatives market is in an embryonic state. The originate-to-distribute model in India is not comparable to the ones prevailing in advanced markets. There are restrictions on investments by residents in such products issued abroad and regulatory guidelines on securitisation do not permit immediate profit recognition. 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, financial markets remained orderly, and financial institutions, especially banks, remained financially sound. 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 admirableresilience. This is in large part because Indias banking system remains sound, healthy, well capitalised 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 27. Going forward, the Reserve Banks policy stance will continue to be to maintain comfortable rupee and forex liquidity positions. The Annual Policy Statement, 2009-10 announced on April 21, 2009 stated the following policy stance: Ensure a policy regime that will enable credit expansion at viable rates while preserving credit quality so as to support the return of the economy to a high growth path. Continuously monitor the global and domestic conditions and respond swiftly and effectively through policy adjustments as warranted so as to minimise the impact of adverse developments and reinforce the impact of positive developments. Maintain a monetary and interest rate regime supportive of price stability and financial stability taking into account the emerging lessons of the global financial crisis. The Reserve Bank of India has been actively engaged in policy action to minimise the impact of the global crisis on India. The policy response of the Reserve Bank has helped in keeping Indias financial markets functioning in a normal manner and in arresting the growth moderation. The Reserve Bank will continue to maintain vigil, monitor domestic and global developments, and take swift and effective action to minimise the impact of the crisis and restore the economy to a high growth path consistent with price and financial stability.

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