Genesis and the Nature of the Crisis
1.1 The world economy experienced a
sustained period of growth with only moderate
fluctuations coupled with low inflation, a
phenomenon popularly termed as the ‘Great
Moderation’ till the precipitation of the recent global
crisis. This prolonged period of macro-economic
stability was essentially attributed to efficiently
functioning markets and the benefits of
globalisation. However, what remained hidden
within these overall signs of prosperity were the
immensely complex financial systems and the
systemic risks they entailed due to the policy of
‘benign neglect’ followed by authorities. In addition,
some structural imbalances had also developed in
the world economy in terms of mismatches between
savings and investments and production and
consumption across nations that manifested in the
widening current account imbalances in some part
mirrored with surpluses in others, misalignment
in exchange rates and booming asset prices.
These developments had to unwind at some point
of time and when the unwinding began, they
manifested themselves in the form of the worst
ever global financial crisis since the ‘Great
Depression’ of the 1930s.
1.2 The speed and intensity with which the US
sub-prime crisis that appeared in mid-2007
transformed itself into a global financial crisis and
then into a global economic crisis has attracted the
attention of all. In the postmortem analysis, a
number of micro and macroeconomic factors have
been listed in the literature as the proximate causes
of the crisis – role of easy money, financial
innovations and global imbalances on the one hand
to regulatory loopholes both at the national and
global level on the other. At the fulcrum of the crisis
was too much of leverage. Easy credit combined
with under-pricing of risks both by the households
as well as financial intermediaries created bubbles in real estate, energy and other sectors that had to
face a disorderly unwinding. The recent crisis has
necessitated the need to revisit the global
regulatory and supervisory structures and
perimeters against the backdrop of rapid financial
innovations. The analysis of the various causes of
the crisis has evolved a whole new debate on the
relevance of various economic tenets and has
challenged the economic doctrine that assumed the
self correcting mechanism of the markets. There is
also a view which holds responsible the policy
frameworks and growth strategies pursued by
economies in the various regions.
1.3 A comparison of the recent crisis with the
various episodes of crises in the past reveals that
some semblance can be found amongst them with
regard to the underlying causes. As in the past,
the main causes of the recent crisis are linked to
systemic fragilities and imbalances that contributed
to the inadequate functioning of the global
economy. Leading up to the crisis, these factors
became more pronounced due to major
weaknesses in financial regulation, supervision and
monitoring of the financial sector and inadequate
surveillance and early warning. These, together with
over-reliance on market self-regulation, overall lack
of transparency with distorted incentive structure
led to excessive risk-taking, unsustainable high
asset prices, irresponsible leveraging and high
levels of consumption which were fuelled by easy
credit and inflated asset prices. In terms of impact,
however, the recent crisis seems to be more
widespread than many other previous episodes and
is considered to be closest to the Great Depression
of the 1930s. The estimates of output loss place
this crisis above most of the episodes in the past
with majority of the advanced and emerging market
economies facing the downturn as a result of the
rapid transmission of the crisis from the epicenter
to the periphery. In fact, the same forces of globalisation and international finance that had led
to developments in poorer countries over the past
decades also carried with them the seeds of
contagion, which resulted in the international
transmission of shocks.
1.4 As a result, the so-called ‘decoupling theory’
which was in full force just before the recent crisis,
came under question in an increasingly
interdependent world. The crisis that emerged in
the US spread to other advanced economies
quickly and at a later stage spread to emerging and
developing economies through various channels -
financial, trade and confidence - despite their
relatively sound macroeconomic fundamentals and
policy frameworks. Thus, the established views on
the efficiency of markets and the role of public policy
both came under severe criticism, which posed new
challenges for the discipline of economics. More
fundamentally, the old debate on the ‘role of finance
in economic growth’ has again come to the centre
stage, while the potential costs and benefits of
financial globalisation have become the focus of
policy discussions in international fora. At the same
time, the adequacy and efficacy of the current
international financial architecture to prevent and
manage global crises has resurfaced again.
Manifestation of the Crisis
1.5 Almost all segments of the global financial
markets experienced tremors of the financial crisis,
though at variant degrees. Interbank markets in
advanced economies were the first to be affected
with severe liquidity crisis as banks became
reluctant to lend to each other on fear of
counterparty risks. Subsequently, the crisis spread
to the money markets as manifested in abnormal
level of spreads, shortening of maturities, and
contraction, or even closure, of some market
segments. In the wake of credit and money markets
witnessing a squeeze and equity prices
plummeting, banks and other financial institutions
experienced erosion in their access to funding and
capital base, owing to accumulating mark to market
losses. 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, and
suffered sharp decline in prices and turnover.
Commodity prices, which reached record highs
during the initial stages of the crisis witnessed a
sharp reversal in trend since the collapse of
Lehman Brothers in September 2008. The depth
and spread of the crisis can be gauged from the
successive revisions in the estimates of writedowns,
decline in trade and finally the contraction
in economic activity.
1.6 In the backdrop of large scale disruptions
in international financial markets and deteriorating
macroeconomic conditions, financial institutions
also suffered significantly. Commercial banks
suffered from decline in profitability and large mark
to market losses. The crisis almost sidelined the
investment banking industry, while the financial
performance of the monoline insurers and hedge
funds were impacted severely. The banking
systems of emerging market economies, on the
contrary, showed relative resilience during the crisis
on account of their limited exposure to the toxic
assets and the regulatory and supervisory
measures taken to strengthen their balance sheets
in the aftermath of the East Asian crisis.
1.7 The increasing globalisation and trade
integration have brought enormous economic and
financial benefits to the EMEs, but have also
widened channels through which a slowdown in
economic activity in advanced economies could
spread to the EMEs. Initially, it appeared that EMEs
were better positioned to weather the storm created
by the global financial meltdown on the back of
substantial foreign exchange reserve cushion,
improved policy frameworks and generally robust
banking sector and corporate balance sheets.
However, any hope about EMEs escaping
unscathed could not sustain much after the failure
of Lehman Brother in September 2008 and ensuing
rise in the global risk aversion; EMEs were also
adversely affected by the spillover effects of the
macroeconomic turbulences created by global
financial meltdown. The EMEs were affected
through contraction in world trade especially during
the second half of 2008. Net private capital flows to EMEs also reversed reflecting global
deleveraging and risk aversion on the part of
investors, which led to tightening of external
financing conditions. Finally, their growth was also
impacted.
International Responses to the Crisis
1.8 The crisis evoked unprecedented policy
responses, both domestically and internationally.
Amidst the deteriorating global financial
environment, the authorities, particularly in the
advanced countries recognised at an early stage
that they needed to respond bravely and act swiftly.
The national Governments and central banks in
several countries resorted concomitantly with a
variety of both conventional and unconventional
policy actions to contain systemic risk to shore up
the confidence in the financial system and arrest
the economic slowdown. The policy responsesregulatory,
supervisory, monetary and fiscal during
the crisis have been unparalleled in terms of their
scale, magnitude and exceptional coordination
across various jurisdictions. The responses
included varying combinations of monetary and
fiscal measures, deposit guarantees, debt
guarantees, capital injections and asset purchases,
which were coordinated globally.
1.9 Monetary authorities in the industrial world
were the first to take a plunge by resorting to an
aggressive monetary easing; so much so that policy
rates reached to record lows. To contain the crisis
of confidence and ease financial conditions, central
banks ventured even further by using their balance
sheets in unconventional ways. The governments
across the countries responded by way of massive
bail outs and capital injections to resolve the
problem of insolvency and stabilise the financial
system. The unprecedented scale of economic
slowdown accompanying the financial crisis also
led to activation of counter-cyclical fiscal policy of
magnitudes, least seen in the past.
1.10 As the crisis unfolded, the resolution
mechanisms that came to the fore had to contend
with new and complex web of financial world
involving credit default swaps, special investment vehicles and hence differed radically from the
responses undertaken in the previous such
episodes. Supervisors and standard setting bodies
around the world increasingly got engaged in
strengthening the standards governing bank
capital, liquidity, risk management, incentive
compensation, and consumer protection, and so
on. The emphasis on scaling up the supervision
with greater macro prudential focus, through
enhanced consolidated supervision and the
development of new supervisory tools began
gathering momentum.
1.11 Although advanced countries turned their
policy attention on restoring normalcy and
strengthening financial regulation/ supervision and
EMEs began dealing with the collapse of trade and
the capital outflows, restoring growth emerged as
the common thread of policy response among both
the categories. It was for the first time that EMEs
turned out to be active partners in finding
meaningful resolution mechanisms to a global
problem. A distinguishing feature of the current
financial crisis is that despite being global in nature,
there appears to be a clear divide between the
advanced countries and the emerging market
economies (EMEs) in terms of impact and policy
responses. For advanced countries, the policy
priority has been to strengthen financial regulation
and supervision. In the EMEs, dealing with the
collapse of trade and the outflow of capital
occupied the policy attention.
1.12 The forceful and coordinated policy actions
have been successful in extinguishing the initial
damages and averting a global financial collapse.
Although the policy responses could avoid the worst
financial and economic outcomes, the policymakers
and academia are still grappling with the design
and conduct of appropriate policies to arrest the
possibility of such events in the future. Moreover,
the unconventional measures, while helping in
stabilising the financial system, have posed several
challenges and risks.
1.13 More recently, in the wake of the financial
stress triggered by Greece, comprehensive support
measures have been announced focusing on preserving economic and financial stability within
the Euro Area. The belief that sovereign states can
borrow without any limits has been once again
called into question after the problem in Greece.
This is a reminder that fiscal space is finite and
cannot be extended indefinitely. It is being now
realised that the Euro Area has to supplement its
strict entry norms regarding fiscal discipline with
continuous fiscal surveillance so as to detect
vulnerabilities well in time.
Impact and Policy Responses in India
1.14 Until the emergence of global crisis, the
Indian economy also passed through a phase of
high growth driven by domestic demand - growing
domestic investment financed mostly by domestic
savings and sustained consumption demand. In fact,
consumption and saving are well balanced. Services
sector, led by domestic demand, contributed to the
stability in growth. Concomitantly, inflation was also
generally low and stable. This overall improvement
in macroeconomic performance in India was
attributed to the sequential financial sector reforms
that resulted in an efficient system of financial
intermediation, albeit bank-based; the rule-based
fiscal policy that reduced the public sector’s drag on
private savings; and forward looking monetary policy
that balanced the short-term trade-off between
growth and inflation on a continuous basis, while also
pursuing the objective of financial stability.
Additionally, the phased liberalisation of the economy
to trade and capital flows along with a broadly
market driven exchange rate regime enhanced the
role of external demand in supporting the growth
process, simultaneously exposing the economy to
the forces of globalisation. In the process, India
became increasingly integrated with the world
economy and maintaining financial stability
assumed importance in the hierarchy of public
policy; in fact, it emerged as an important objective
of monetary policy in India even before the current
crisis. This is evident from the counter-cyclical
monetary policy and macro-prudential financial
regulations that were in force during the boom
phase just before the crisis.
1.15 In these circumstances, the Indian
economy benefited from global integration and had
also exhibited remarkable resilience to various
adverse external developments – the east-Asian
crisis (1997-98), the dot.com crisis (2000-01), etc.
However, during the current global crisis, India was
impacted like most other emerging markets,
despite hardly any direct exposure to the troubled
assets in the epicenter of the financial crisis. In
fact, the contagion spread through all the channels
– trade, finance and confidence.
1.16 During the initial phase of the crisis, the
impact on the Indian financial markets was rather
muted. In fact, banks dominated the financial
system and their negligible engagement in the offbalance-
sheet activities and illiquid securitised
assets, which remained at the heart of current
global financial crisis in advanced economies,
protected India from early turmoil in international
financial markets. Nonetheless, India could not
remain unscathed and the global developments
affected the financial and real activities in the
second half of 2008-09. India’s financial markets -
equity market, money market, forex market and
credit market - all came under pressure from a
number of directions.
Lessons from the Crisis and Future Challenges
1.17 Several lessons could be drawn from the
crisis to identify the future challenges in the global
financial system. A number of important issues have
emerged relating to the prevention and management
of crises which allows us to draw relevant lessons
for both market participants and policy makers. The
analysis of underlying factors – whether
macroeconomic or microeconomic in nature -
responsible for evolving and intensifying the crisis -
raises issues about the role of public authorities, viz.,
central banks, supervisor/regulators and
governments in safeguarding financial stability. The
crisis has certainly doubted the efficacy of the
existing institutional framework and available policy
instruments at the national as well as international
levels in ensuring global financial stability.
1.18 It also raised questions on the functioning
of financial markets and institutions, in particular
their capacity to price, allocate and manage risk
efficiently. Thus, the lessons to be drawn from the
recent crisis are not only manifold but also for a
diverse set of authorities entrusted with the task of
maintaining financial stability being most applicable
for the advanced economies besides a broader
relevance for EMEs. Looking ahead, devising a
calibrated exit from the unprecedented monetary
accommodation globally, which has already started
in some countries, is one of the most important
challenges. In this context, the timing and the
amount of reversing become very important.
1.19 It is not yet known whether the business
cycle synchronization that was evident just before
the crisis and monetary policy synchronization that
emerged in response to the crisis, will give way to
similar synchronization in the exit strategies. It is
therefore timely to reflect upon the global crisis -
the past, present and future – to make an objective
assessment of its impact on the Indian economy
and to draw policy lessons to ward-off any
recurrence of crisis like situation in future, and in
the event of a crisis to deal with it more effectively.
Accordingly, the theme of this Report for 2008-09
has been titled as “Global Financial Crisis and the
Indian Economy”. The Report undertakes an indepth
analysis of causes and consequences of the
crisis, compares and contrasts the present crisis
with past crises, analyse the effectiveness of the
conventional and unconventional policy responses
to the crisis at the global level. From the Indian
perspective, the Report covers in detail the
manifestation of the crisis in India, the nature of
policy responses undertaken and their impact in
limiting the adverse impact and the broad lessons
that emerge from the crisis at the domestic as well
as international level.
Chapter Scheme of the Report
1.20 The Report includes seven chapters
including this one. Chapter 2 titled “Genesis and
the Nature of the Crisis” traces the genesis and
nature of the crises which has affected both the developed, emerging and developing world over the
last century and a half, when they have often arrived
with fierce force and departed with important
lessons for the policy makers. This chapter
discusses the causes of the current financial crisis
while simultaneously highlighting the debate as it
has evolved on the various contributing factors of
the crisis, besides covering the crisis in a historical
perspective by giving a comparison between the
present crisis with the earlier episodes of crisis of
similar nature. The Chapter also covers the genesis
of the recent crisis in Greece.
1.21 The chapter 3 on “Manifestation of the
Crisis” attempts at analysing the impact of the crisis
on the various sectors of the global economy, such
as financial markets, financial institutions,
international trade, international capital flows,
remittances and the real economy.
1.22 The chapter 4 on “International Responses
to the Crisis” discussed the measures taken by the
international community during the present financial
crisis against the backdrop of the conventional crisis
management strategies. The chapter also provides
the policy responses to financial crisis in a historical
perspective. The monetary policy and the fiscal
policy responses along with the issues on fiscal
monetary coordination are covered. The responses
from the multilateral institutions are also presented.
The actions taken relating to financial sector
policies to reduce the chance of recurrence of
financial crisis of such a magnitude are elucidated
in the chapter.
1.23 After discussing the genesis, manifestation
and policy responses of the crisis in the global
context in Chapters 2,3, and 4 respectively, the next
two Chapters 5 and 6 cover impact of the global
financial crisis on the Indian economy and the
policy responses of the authorities. In Chapter 5
on “Impact and Policy Responses in India:
Financial Sector”, the impact on the India’s
financial sector is analysed in detail. In the
following Chapter 6 on “Impact and Policy
Responses in India: Real Sector”, the impact on
the real sector of the Indian economy through trade,
services, capital flows are analysed.
1.24 In examining the impact of the financial
crisis on the financial sector, the Chapter 5
analyses the evolving global integration of the
Indian economy through trade and financial
channels over the years. The impact of the crisis
on various financial markets and respective policy
measures has been delineated. The spillover
effects travelling to the banking sector, mutual
funds and non-banking finance companies and
policy measures to counter their impact have been
examined in detail. The policy responses to the
crisis by the Government of India and the Reserve
Bank are also discussed in the chapter.
1.25 Chapter 6 covers the impact through trade
and capital flows channel, which finally penetrated
into 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. The
analysis of the impact emanating from trade and
financial channels are discussed elaborately and
ultimately the impact on the saving, investment and
growth are covered in the chapter.
1.26 The Chapter 7 on “Lessons from the Crisis
and Future Challenges” draws lessons from the
crisis to identify some of the future challenges.
The chapter covers lessons for the central banks,
for the financial regulation and supervision, for
fiscal policy and for the international policy
coordination followed by the role of international
financial institutions. Issues coming out of global
imbalances and macroeconomic management are
also covered in this chapter. Finally, this chapter
brings out the lessons and challenges for EMEs
and India. |