and the Global Financial Crisis
15th 2008, C.P. Chandrasekhar and Jayati Ghosh
the financial crisis erupted in a comprehensive manner
on Wall Street, there was some premature triumphalism
among Indian policy makers and media persons. It was
argued that India would be relatively immune to this
crisis, because of the “strong fundamentals” of the
economy and the supposedly well-regulated banking system.
This argument was emphasised by the Finance Minister
and others even when other developing countries in Asia
clearly experienced significant negative impact, through
transmission of stock market turbulence and domestic
credit stringency. These effects have been most marked
among those developing countries where the foreign ownership
of banks is already well advanced, and when US-style
financial sectors with the merging of banking and investment
functions have been created.
If India is not in the same position, it is not to the
credit of our policy makers, who had in fact wanted
to go along the same route. Indeed, for some time now
there have been complaints that these “necessary” reforms
which would “modernise” the financial sector have been
held up because of opposition from the Left parties.
But even though we are slightly better protected from
financial meltdown, largely because of the still large
role of the nationalised banks and other controls on
domestic finance, there is certainly little room for
complacency. The recent crash in the Sensex is not simply
an indicator of the impact of international contagion.
There have been warning signals and signs of fragility
in Indian finance for some time now, and these are likely
to be compounded by trends in the real economy.
After a long spell of growth, the Indian economy is
experiencing a downturn. Industrial growth is faltering,
inflation remains at double-digit levels, the current
account deficit is widening, foreign exchange reserves
are depleting and the rupee is depreciating.
The last two features can also be directly related to
the current international crisis. The most immediate
effect of that crisis on India has been an outflow of
foreign institutional investment from the equity market.
Foreign institutional investors, who need to retrench
assets in order to cover losses in their home countries
and are seeking havens of safety in an uncertain environment,
have become major sellers in Indian markets.
In 2007-08, net FII inflows into India amounted to $20.3
billion. As compared with this, they pulled out $11.1
billion during the first nine and half months of calendar
year 2008, of which $8.3 billion occurred over the first
six and a half months of financial year 2008-09 (April
1 to October 16). This has had two effects: in the stock
market and in the currency market.
Given the importance of FII investment in driving Indian
stock markets and the fact that cumulative investments
by FIIS stood at $66.5 billion at the beginning of this
calendar year, the pull-out triggered a collapse in
stock prices. As a result, the Sensex fell from its
closing peak of 20,873 on January 8, 2008 to less than
10,000 by 17 October 2008 (Chart 1).
In addition, this withdrawal by the FIIs led
to a sharp depreciation of the rupee. Between January
1 and October 16, 2008, the RBI reference rate for the
rupee fell by nearly 25 per cent, even relative to a
weak currency like the dollar, from Rs. 39.20 to the
dollar to Rs. 48.86 (Chart 2). This was despite the
sale of dollars by the RBI, which was reflected in a
decline of $25.8 billion in its foreign currency assets
between the end of March 2008 and October 3, 2008.
It could be argued that the $275
billion the RBI still has in its kitty is adequate to
stall and reverse any further depreciation if needed.
But, given the sudden exit by the FIIs, the RBI is clearly
not keen to deplete its reserves too fast and risk a
foreign exchange crisis. The result has been the observed
sharp depreciation of the rupee. While this depreciation
may be good for India’s exports that are adversely affected
by the slowdown in global markets, it is not so good
for those who have accumulated foreign exchange payment
commitments. Nor does it assist the government’s effort
to rein in inflation.
A second route through which the global financial crisis
could affect India is through the exposure of Indian
banks or banks operating in India to the impaired assets
resulting from the subprime crisis. Unfortunately, there
are no clear estimates of the extent of that exposure,
giving room for rumour in determining market trends.
Thus, ICICI Bank was the victim of a run for a short
period because of rumours that subprime exposure had
badly damaged its balance sheet, although these rumours
have been strongly denied by the bank.
So far the RBI has claimed that the exposure of Indian
banks to assets impaired by the financial crisis is
small. According to reports, the RBI had estimated that
as a result of exposure to collateralised debt obligations
and credit default swaps, the combined mark-to-market
losses of Indian banks at the end of July was around
$450 million. Given the aggressive strategies adopted
by the private sector banks, the MTM losses incurred
by public sector banks were estimated at $90 million,
while that for private banks was around $360 million.
As yet these losses are on paper, but the RBI believes
that even if they are to be provided for, these banks
are well capitalised and can easily take the hit.
Such assurances have neither reduced fears of those
exposed to these banks or to investors holding shares
in these banks. These fears are compounded by those
of the minority in metropolitan areas dealing with foreign
banks that have expanded their presence in India, whose
global exposure to toxic assets must be substantial.
What is disconcerting is the limited information available
on the risks to which depositors and investors are subject.
Only time will tell how significant this factor will
be in making India vulnerable to the global crisis.
A third indirect fall-out of the global crisis and its
ripples in India is in the form of the losses sustained
by non-bank financial institutions (especially mutual
funds) and corporates, as a result of their exposure
to domestic stock and currency markets. Such losses
are expected to be large, as signalled by the decision
of the RBI to allow banks to provide loans to mutual
funds against certificates of deposit (CDs) or buy-back
their own CDs before maturity. These losses are bound
to render some institutions fragile, with implications
that would become clear only in the coming months.
A fourth effect is that, in this uncertain environment,
banks and financial institutions concerned about their
balance sheets, have been cutting back on credit, especially
the huge volume of housing, automobile and retail credit
provided to individuals. According to RBI figures (reported
by the Business Standard, 17 October 2008), the rate
of growth of auto loans fell from close to 30 per cent
over the year ending June 30, 2008 as low as 1.2 per
cent. Loans to finance consumer durables purchases fell
from around Rs 6,000 crore in the year to June 2007,
to a little over Rs 4,000 crore up to June this year.
Direct housing loans, which had increased by 25 per
cent during 2006-07, decelerated to 11 per cent growth
in 2007-08 and 12 per cent over the year ending June
It is only in an area like credit-card receivables,
where banks are unable to control the growth of credit,
that expansion was, at 43 per cent, quite high over
the year ending June 2008, even though it was lower
than the 50 per cent recorded over the previous year.
It is known that credit-financed housing investment
and credit-financed consumption have been important
drivers of growth in recent years, and underpin the
9 per cent growth trajectory India has been experiencing.
The reticence of lenders to increase their exposure
in markets to which they are already overexposed and
the fears of increasing payment commitments in an uncertain
economic environment on the part of potential borrowers
are bound to curtail debt-financed consumption and investment.
This could slow growth significantly.
the recession generated by the financial crisis in the
advanced economies as a group and the United States
in particular, will adversely affect India’s exports,
especially its exports of software and IT-enabled services,
more than 60 per cent of which are directed to the United
States. International banks and financial institutions
in the US and EU are important sources of demand for
such services, and the difficulties they face will result
in some curtailment of their demand. Further, the nationalisation
of many of these banks is likely to increase the pressure
to reduce outsourcing in order to keep jobs in the developed
countries. And the slowing of growth outside of the
financial sector too will have implications for both
merchandise and services exports. The net result would
be a smaller export stimulus and a widening trade deficit.
While these trends are still in process, their effects
are already being felt. They are not the only causes
for the downturn the economy is experiencing, but they
are important contributory factors. Yet, this does not
justify the argument that India’s difficulties are all
imported. They are induced by domestic policy as well.
The extent of imported difficulties would have been
far less if the government had not increased the vulnerability
of the country to external shocks by drastically opening
up the real and financial sectors. It is disconcerting,
therefore, that when faced with this crisis the government
is not rethinking its own liberalisation strategy, despite
the backlash against neoliberalism worldwide. By deciding
to relax conditions that apply to FII investments in
the vain hope of attracting them back and by focusing
on pumping liquidity into the system rather than using
public expenditure and investment to stall a recession,
it is indicating that it hopes that more of what created
the problem would help solve it. This is just to postpone
decisions that may prove critical-till it is too late.