Global Financial Crisis : Causes, Impact, Policy Responses and Lessons - ஆர்பிஐ - Reserve Bank of India
Global Financial Crisis : Causes, Impact, Policy Responses and Lessons 1
Dr. Rakesh Mohan, Deputy Governor, Reserve Bank of India
delivered-on ஏப். 23, 2009
The intensification of the global financial crisis, following the bankruptcy of Lehman Brothers in September 2008, has made the current economic and financial environment a very difficult time for the world economy, the global financial system and for central banks. The fall out of the current global financial crisis could be an epoch changing one for central banks and financial regulatory systems. It is, therefore, very important that we identify the causes of the current crisis accurately so that we can then find, first, appropriate immediate crisis resolution measures and mechanisms; second, understand the differences among countries on how they are being impacted; and, finally, think of the longer term implications for monetary policy and financial regulatory mechanisms. These are all large subjects and I cannot hope to do justice to in the limited space available in one speech. A legion of both policymakers and scholars are at work analysing the causes of the crisis and findings both immediate and longer term solutions (For example, the de Larosiere Report (2009), the Turner Review (2009), the Geneva Report (2009), the Group of Thirty Report (2008) and the IMF Lessons paper (2009b)). I can only attempt some conjectures, raise issues and identify some possible directions in which we should move. I. Global Financial Crisis Genesis of Global Financial Crisis The proximate cause of the current financial turbulence is attributed to the sub-prime mortgage sector in the USA. At a fundamental level, however, the crisis could be ascribed to the persistence of large global imbalances, which, in turn, were the outcome of long periods of excessively loose monetary policy in the major advanced economies during the early part of this decade (Mohan, 2007, Taylor, 2008).
Excessively loose monetary policy in the post dot com period boosted consumption and investment in the US and, as Taylor argues, it was made with purposeful and careful consideration by monetary policy makers. As might be expected, with such low nominal and real interest rates, asset prices also recorded strong gains, particularly in housing and real estate, providing further impetus to consumption and investment through wealth effects. Thus, aggregate demand consistently exceeded domestic output in the US and, given the macroeconomic identity, this was mirrored in large and growing current account deficits in the US over the period (Table 1). The large domestic demand of the US was met by the rest of the world, especially China and other East Asian economies, which provided goods and services at relatively low costs leading to growing surpluses in these countries. Sustained current account surpluses in some of these EMEs also reflected the lessons learnt from the Asian financial crisis. Furthermore, the availability of relatively cheaper goods and services from China and other EMEs also helped to maintain price stability in the US and elsewhere, which might have not been possible otherwise. Thus measured inflation in the advanced economies remained low, contributing to the persistence of accommodative monetary policy.
The emergence of dysfunctional global imbalances is essentially a post 2000 phenomenon and which got accentuated from 2004 onwards. The surpluses of East Asian exporters, particularly China, rose significantly from 2004 onwards, as did those of the oil exporters (Table 1). In fact, Taylor (op. cit.) argues that the sharp hike in oil and other commodity prices in early 2008 was indeed related to the very sharp policy rate cut in late 2007 after the sub-prime crisis emerged. The deep and lingering crisis in global financial markets, the extreme level of risk aversion, the mounting losses of banks and financial institutions, the elevated level of commodity prices (until the third quarter of 2008) and their subsequent collapse, and the sharp correction in a range of asset prices, all combined, have suddenly led to a sharp slowdown in growth momentum in the major advanced economies, especially since the Lehman failure. Global growth for 2009, which was seen at a healthy 3.8 per cent in April 2008, is now projected to contract by 1.3 per cent (IMF, 2009c) (Table 2). Major advanced economies are in recession and the EMEs - which in the earlier part of 2008 were widely viewed as being decoupled from the major advanced economies – have also been engulfed by the financial crisis-led slowdown. Global trade volume (goods and services) is also expected to contract by 11 per cent during 2009 as against the robust growth of 8.2 per cent during 2006-2007. Private capital inflows (net) to the EMEs fell from the peak of US $ 617 billion in 2007 to US $ 109 billion in 2008 and are projected to record net outflows of US $ 190 billion in 2009. The sharp decline in capital flows in 2009 will be mainly on account of outflows under bank lending and portfolio flows. Thus, both the slowdown in external demand and the lack of external financing have dampened growth prospects for the EMEs much more than that was anticipated a year ago.
Volatility in Capital Flows: Implications for Emerging Market Economies Monetary policy developments in the leading economies not only affect them domestically, but also have a profound impact on the rest of the world through changes in risk premia and search for yield leading to significant switches in capital flows. While the large volatility in the monetary policy in the US, especially since the beginning of this decade, could have been dictated by internal compulsions to maintain employment and price stability, the consequent volatility in capital flows impinges on exchange rate movements and more generally, on the spectrum of asset and commodity prices. The monetary policy dynamics of the advanced economies thus involve sharp adjustment for the EMEs.Private capital flows to EMEs have grown rapidly since the 1980s, but with increased volatility over time. Large capital flows to the EMEs can be attributed to a variety of push and pull factors. The pull factors that have led to higher capital flows include strong growth in the EMEs over the past decade, reduction in inflation, macroeconomic stability, opening up of capital accounts and buoyant growth prospects. The major push factor is the stance of monetary policy in the advanced economies. Periods of loose monetary policy and search for yield in the advanced economies encourages large capital inflows to the EMEs and vice versa in periods of tighter monetary policy. Thus, swings in monetary policy in the advanced economies lead to cycles and volatility in capital flows to the EMEs. Innovations in information technology have also contributed to the two-way movement in capital flows to the EMEs. Overall, in response to these factors, capital flows to the EMEs since the early 1980s have grown over time, but with large volatility (Committee on Global Financial System, 2009). After remaining nearly flat in the second half of the 1980s, private capital flows jumped to an annual average of US $ 124 billion during 1990-962. With the onset of the Asian financial crisis, total private capital flows fell to an annual average of US $ 86 billion during 1997-2002. Beginning 2003, a period coinciding with the low interest rate regime in the US and major advanced economies and the concomitant search for yield, such flows rose manifold to an annual average of US $ 285 billion during 2003-2007 reaching a peak of US $ 617 billion in 2007 (Chart 3). As noted earlier, the EMEs, as a group, are now likely to witness outflows of US $ 190 billion in 2009 – the first contraction since 1988. Amongst the major components, while direct investment flows have generally seen a steady increase over the period, portfolio flows as well as other private flows (bank loans etc) have exhibited substantial volatility. While direct investment flows largely reflect the pull factors, portfolio and bank flows reflect both the push and the pull factors. It is also evident that capital account transactions have grown much faster relative to current account transactions, and gross capital flows are a multiple of both net capital flows and current account transactions. Also, large private capital flows have taken place in an environment when major EMEs have been witnessing current account surpluses leading to substantial accumulation of foreign exchange reserves in many of these economies.
As noted earlier, the policy interest rates in the US reached extremely low levels during 2002 – one per cent - and remained at these levels for an extended period of time, through mid 2004. Low nominal interest rates were also witnessed in other major advanced economies over the same period. The extremely accommodative monetary policy in the advanced economies was mirrored in the strong base money expansion during the period 2001-02 – shortly before the beginning of the current episode of strong capital flows to EMEs. As the monetary accommodation was withdrawn in a phased manner, base money growth witnessed correction beginning 2004. However, contrary to the previous episodes, capital flows to the EMEs continued to be strong. The expected reversal of capital flows from the EMEs was somewhat delayed and finally took place in 2008. Similarly, the previous episode (1993-96) of heavy capital inflows was also preceded by a significant expansion of base money during 1990-94, and sharp contraction thereafter. This brief discussion highlights the correlation between monetary policy cycles in the advanced economies on the one hand and pricing/mispricing of risk and volatility in capital flows on the other hand. At present, monetary policies across the advanced economies have again been aggressively eased and policy interest rates have reached levels even lower than those which were witnessed in 2002. Base money in the US more than doubled over a period of just six months between June and December 2008. Given such a large monetary expansion and given the past experiences, large capital inflows to the EMEs could resume in the foreseeable future, if the unwinding of the current monetary expansion is not made in a timely fashion. II. Impact on India Initial Impact of the Sub-prime Crisis The initial impact of the sub-prime crisis on the Indian economy was rather muted. Indeed, following the cuts in the US Fed Funds rate in August 2007, there was a massive jump in net capital inflows into the country. The Reserve Bank had to sterilise the liquidity impact of large foreign exchange purchases through a series of increases in the cash reserve ratio and issuances under the Market Stabilisation Scheme (MSS)3. With persistent inflationary pressures emanating both from strong domestic demand and elevated global commodity prices, policy rates were also raised. Monetary policy continued with pre-emptive tightening measures up to August 2008. Impact of Lehman Failure Balance of Payments: Capital Outflows There was also no direct impact of the Lehman failure on the domestic financial sector in view of the limited exposure of the Indian banks. However, following the Lehman failure, there was a sudden change in the external environment. As in the case of other major EMEs, there was a sell-off in domestic equity markets by portfolio investors reflecting deleveraging. Consequently, there were large capital outflows by portfolio investors during September-October 2008, with concomitant pressures in the foreign exchange market. While foreign direct investment flows exhibited resilience, access to external commercial borrowings and trade credits was rendered somewhat difficult. On the whole, net capital inflows during 2008-09 were substantially lower than in 2007-08 and there was a depletion of reserves (Table 4). However, a large part of the reserve loss (US $ 33 billion out of US $ 54 billion) during April-December 2008 reflected valuation losses.
The contraction of capital flows and the sell-off in the domestic market adversely affected both external and domestic financing for the corporate sector. The sharp slowdown in demand in the major advanced economies is also having an adverse impact on our exports and industrial performance. On the positive side, the significant correction in international oil and other commodity prices has alleviated inflationary pressures as measured by wholesale price index. However, various measures of consumer prices remain at elevated levels on the back of continuing high inflation in food prices. Fiscal Impact Government finances, which had exhibited a noteworthy correction starting 2002-03, came under renewed pressure in 2008-09 on account of higher expenditure outgoes due to (i) higher international crude oil prices (up to September 2008) and the incomplete pass-through to domestic prices (ii) higher fertiliser prices and associated increase in fertiliser prices (iii) the Sixth Pay Commission award and (iv) debt waiver scheme. The fiscal stimulus packages involving additional expenditures and tax cuts have put further stress on the fisc. Reflecting these factors, the Central Government’s fiscal deficit more than doubled from 2.7 per cent of GDP in 2007-08 to 6.0 per cent in 2008-09, reaching again the levels seen around the end of the 1990s. The revenue deficit at 4.4 per cent of GDP will be at its previous peak touched during 2001-02 and 2002-03. Primary balance again turned into deficit in 2008-09, after recording surpluses during the preceding two years (Table 5). Net market borrowings during 2008-09 almost trebled from the budgeted Rs.1,13,000 crore to Rs.3,29,649 in the revised estimates (actual borrowings were Rs.2,98,536 crore as per Reserve Bank records) and are budgeted at Rs.3,08,647 crore (gross borrowings at Rs. 3,98,552 crore) in 2009-10. In view of the renewed fiscal deterioration, the credit rating agency Standard and Poor’s has changed its outlook on long-term sovereign credit rating from stable to negative, while reaffirming the ‘BBB-‘ rating. If bonds issued to oil and fertiliser companies are taken into account, the various deficit indicators will be even higher. Moreover, in order to boost domestic demand, the Government has announced additional tax sops subsequent to the interim vote-on-account budget putting further pressure on fiscal position. Thus, while the slowdown in the domestic economy may call for fiscal stimulus, fiscal manoeuvrability is limited.
According to the IMF, based on measures already taken and current plans, it is estimated that government debt ratios and fiscal deficits, particularly in advanced economies, will increase significantly. For the G-20 as a whole, the general government balance is expected to deteriorate by 3½ percent of GDP, on average, in 2009. While the fiscal cost for some countries will be large in the short-run, the alternative of providing no fiscal stimulus or financial sector support would be extremely costly in terms of the lost output (IMF, 2009b). Impact on the Real Economy Reflecting the slowdown in external demand, and the consequences of reversal of capital flows, growth in industrial production decelerated to 2.8 per cent in 2008-09 (April-February) from 8.8 per cent in the corresponding period of 2007-08. On the other hand, services sector activity has held up relatively well in 2008-09 so far (April-December) with growth of 9.7 per cent (10.5 per cent in the corresponding period of 2007-08). Services sector activity was buoyed up by acceleration in “community, social and personal services” on the back of higher government expenditure. Overall, real GDP growth has slowed to 6.9 per cent in the first three quarters of 2008-09 from 9.0 per cent in the corresponding period of 2007-08. On the expenditure side, growth of private final consumption expenditure decelerated to 6.6 per cent from 8.3 per cent. On the other hand, reflecting the fiscal stimuli and other expenditure measures, growth in government final consumption expenditure accelerated to 13.3 per cent from 2.7 per cent. III. Financial Regulatory Policies to Manage Financial Stability: Why the Indian Financial Sector has Weathered the Storm? As the preceding discussion shows, it is apparent that the Indian banks and financial system had only negligible direct exposure to the type of toxic assets that have contaminated the Western countries’ banking system. Bank’s credit quality remains of high quality. Although bank credit growth was quite high at around 30 per cent per annum during 2004-07, it would appear that there was no significant relaxation of lending standards. Bank’s loans to individuals for housing have been backed by prudent loan-to-value ratios. However, in view of the rapid credit growth to certain sectors, the Reserve Bank had pre-emptively tightened prudential norms (provisioning requirements and risk weights) for these sectors in order to safeguard financial stability; provisioning norms for standard assets were also raised across the board except for agriculture and SMEs. These tightened provisioning norms and risk weights have now been rolled back in the wake of slowdown in order to ensure flow of credit to the productive sectors of the economy. This “dynamic provisioning” approach has facilitated adequate buffers within the banking system. Such “dynamic provisioning” is now being advocated as general practice internationally. Therefore, unlike the banking system in the Western world, domestic banks have not recorded losses so far and there has been no need for any government bailout. Bank balance sheets remain healthy and adequately capitalised. The CRAR of all scheduled commercial banks (SCBs) taken together was 13.0 per cent at end-March 2008, well-above the regulatory requirement of 9 per cent. No SCB has CRAR below 9 per cent. Of the 79 SCBs, 77 banks had CRAR above 10 per cent, while 2 banks had CRAR between 9 and 10 per cent. Asset quality of the domestic banks also remains satisfactory with net NPAs being only 1.0 per cent of net advances and 0.6 per cent of assets at end-March 2008 (Table 6). A more rigorous assessment of the health of commercial banks, recently undertaken by the Committee on Financial Sector Assessment (CFSA) (Chairman: Dr. Rakesh Mohan) (RBI, 2009), also shows that the commercial banks are robust and resilient. The single-factor stress tests undertaken by the CFSA reveal that the banking system can withstand significant shocks arising from large potential changes in credit quality, interest rate and liquidity conditions. These stress tests for credit, market and liquidity risk show that Indian banks are generally resilient. Given the ongoing financial crisis and its likely impact on the Indian economy, the CFSA conducted stress tests for the end of September 2008. Under the worst-case scenario (150 per cent increase in gross NPAs), the overall capital adequacy position of the banking sector would have declined to 10.6 percent in September 2008 – still well-above the regulatory requirement of 9 per cent. Thus, even under the worst case scenario, CRAR remains comfortably above the regulatory minimum.
The resilience of the Indian financial sector in the face of the worst global financial crisis since the 1930s can also be attributed to our approach to financial globalization. The key features of our approach have been reflected in a full, but gradual opening up of the current account but a more calibrated approach towards the opening up of the capital account and the financial sector. As far as the capital account is concerned, whereas foreign investment flows, especially direct investment inflows are encouraged, debt flows in the form of external commercial borrowings are generally subject to ceilings and some end-use restrictions. Macro ceilings have also been stipulated for portfolio investment in government securities and corporate bonds. Capital outflows have also been progressively liberalized. Along with the calibrated approach to opening of the capital account, we have also practised prudential regulation, particularly of banks to manage financial instability. Thus, a number of prudential measures were put in place incrementally over the past five years in order to maintain stability in the Indian financial system and these measures in conjunction with the overall cautious approach to financial and external sector liberalisation have contributed to domestic macroeconomic and financial stability. IV. Our Response to the Unfolding Impact of the Crisis As noted earlier, the main impact over the past few months, especially following the collapse of Lehman Brothers in September 2008, has been the outcome of the reduction in net capital inflows and the significant correction in the domestic stock markets on the back of sell-off in the equity market by FIIs. The reduced foreign funding and the lacklustre domestic capital market had put pressures on some segments of the financial system, such as NBFCs and mutual funds. A substantial proportion of collections of mutual funds reflected bulk funds from the corporate sector under the money market schemes, partly reflecting tax and other regulatory arbitrage. As alternative sources of funding dried up and also due to the substantial correction in stock prices, there were large redemption pressures on mutual funds. While the mutual funds promised immediate redemption, there assets were relatively illiquid. Maturity mismatches between assets and liabilities of mutual funds further aggravated the problems. Drying up of funds with mutual funds, which in turn were provider of funds to other sectors, further accentuated the flow of funds. Consequently, all the pressure for fund availability came to rest on banks: from the corporate sector unable to get external funds or equity, from NBFCs and from mutual funds; and the perception of a credit crunch emerged. Reserve Bank’s Policy Response: Analytics In view of the lower level of capital inflows, there were some pressures in the foreign exchange market. Consistent with its policy objective of maintaining orderly conditions in the foreign exchange market, the Reserve Bank sold foreign exchange in the market. While foreign exchange sales attenuated the mismatch in the foreign exchange market, these operations drained liquidity from the rupee market and accentuated pressures on the rupee liquidity. Accordingly, the Reserve Bank has been pro-actively managing liquidity since mid-September 2008 to assuage the liquidity pressures through a variety of measures. The cash reserve ratio (CRR) was reduced from 9 per cent (September 2008) to 5 per cent by early January 2009 injecting nearly Rs.1,60,000 crore of primary liquidity in the system. Fresh issuances under MSS were stopped and buyback of existing MSS securities was also resorted to to inject liquidity into the system. Buybacks were timed with government market borrowing programme. Following the amendment to the Memorandum of Agreement on the MSS, Rs.12,000 crore was transferred to the Government cash account from the MSS cash account. Reflecting the various operations, MSS balances declined from Rs.1,75,362 crore at end-May 2008 to around Rs.88,000 crore by end-March 2009. Other measures taken by the Reserve Bank in response to the global financial crisis include cut in the statutory liquidity ratio (SLR), opening of new refinancing windows, refinance to SIDBI and EXIM Banks, and clawing back of prudential norms in regard to provisioning and risk weights. The measures to improve forex liquidity included increase in interest rate ceilings on non-resident deposits, and easing of restrictions on external commercial borrowings and on short-term trade credits.
Monetary Aggregates in Major Advanced Economies: Recent Trends In this regard, the recent behaviour of US monetary aggregates is interesting. With interest rates approaching near zero levels, the US Federal Reserve has resorted to aggressive quantitative easing as reflected in its expansion of balance sheet. In view of the continuing strains in the US financial markets, the Fed’s major policy tools - lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities - represent a use of the asset side of the Fed's balance sheet, that is, they all involve lending or the purchase of securities. According to the Federal Reserve, these policies provide it the flexibility to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound. The Fed prefers to dub this approach as “credit easing” - rather than terming it as “quantitative easing”, the policy approach used by the Bank of Japan from 2001 to 2006. While both approaches involve an expansion of the central bank's balance sheet, in a pure quantitative easing regime, the focus of policy is the quantity of bank reserves (liabilities of the central bank); the composition of loans and securities on the asset side of the central bank's balance sheet is incidental. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses (Bernanke, 2009). The Bank of England is also now doing similar quantitative easing.
Credit Growth in India: Perceptions and Reality In view of the changed environment due to capital outflows and risk aversion, there was a substantial shrinking of non-bank sources of funding in India – such as domestic capital markets, funding from NBFCS and mutual funds and external funding in the form of commercial borrowings and ADRs/GDRs (Table 10). Accordingly, there was a sudden rush for bank credit from the various sectors of the economy and there were perceptions of credit crunch. Moreover, in view of incomplete pass-through to domestic petroleum prices in the first half of 2008-09 (before the sharp correction in international crude oil prices), there was a large demand from petroleum companies for bank credit. For almost similar reasons, fertilizer companies also had a large resort to bank credit. Reflecting these factors, growth in non-food bank credit (y-o-y) accelerated to around 30 per cent by October 2008. Nonetheless, there was a perception that there was credit crunch during this period, which could be attributed to a large decline in non-bank sources of funding. The slowdown of the manufacturing sector and a temporary build-up in inventories as well as liquidity problems faced by mutual funds and NBFCs during this period added to an increased demand for bank credit. At the same time, there might have been an increase in precautionary demand for bank credit in the last quarter of 2008 in view of the heightened uncertainties. The cumulative impact of all these demand pressures was reflected in acceleration of non-food bank credit from around 25-26 per cent in the quarter July-September 2008 to around 30 per cent in October 2008. Accordingly, a number of steps were taken by the Reserve Bank to make available adequate rupee and forex liquidity and to ensure adequate flow of credit.
Non-food bank credit growth has, however, moderated from the peak of around 30 per cent in October 2008 to around 18 per cent by end-March 2009. This could be attributed to both demand and supply factors. The demand-side factors include the significant moderation in industrial activity over the past few months, the substantial correction in international commodity and raw material prices and the still elevated bank lending rates. On the supply side, some risk-aversion on the part of the banks could have reduced the availability of bank credit. The cumulative impact of deceleration in bank credit, relatively strong deposit growth and various measures by the Reserve Bank to increase liquidity is mirrored in the Reserve Bank’s LAF operations – switch from an average net repo (injection) of around Rs. 45,600 crore in September 2008 to an average net reverse repo (absorption) of around Rs.43,000 crore during January-March 2008. Stickiness in Bank Deposit and Lending Rates While the policy rates have been substantially eased since early October 2008, some rigidity has been observed in banks’ deposit and lending rates. Banks deposit and lending rates continue to be high, albeit some easing has been witnessed in the past few months. This rigidity could be attributed to a variety of factors. First, while headline inflation in terms of wholesale price index has seen a significant easing over the past few months (from around 12 per cent in September 2008 to 0.3 per cent by end-March 2009), it is largely due to the substantial decline in international crude oil prices and some reduction in domestic prices of administered oil products. Food articles inflation in the WPI continues to remain at high levels (6 per cent). Reflecting high food inflation, various measures of consumer price inflation – which have a relatively higher weight for food items vis-a-vis WPI – also remain at elevated levels (around 10-11 per cent). Second, the interest rate on small savings continues to be administered and any reduction in interest rates on bank deposits can make bank deposits relatively unattractive, which could lead to some deceleration of growth in bank deposits. Third, the bulk of banks’ time deposits continue to be at fixed interest rates. While interest rates on incremental time deposits are coming down, the average cost of deposits will remain high till the maturing deposits get renewed. This, in turn, constrains an immediate substantial reduction in lending rates. Thus, for a variety of factors, bank lending rates are expected to exhibit only a gradual softening, which impedes monetary transmission.
V. Conclusions and Lessons Monetary Policy and Asset Prices The conventional wisdom is that, even if the monetary authority can ex-ante identify an asset bubble, the typical monetary policy actions – changes of 25 or 50 basis points – would be insufficient to stop the bubble. It has been argued that only substantial hikes in policy rates could prick the bubble but this would be at a substantial cost to the real economy. The influence of interest rates on the speculative component of asset prices is unclear from both a theoretical and empirical perspective (Kohn, 2008). In the context of the current global financial crisis, with deleterious impact on growth and employment and significant fiscal costs, the issue of relationship between monetary policy and asset prices needs to be revisited. It can be argued that the output losses of a pre-emptive monetary action might have been lower than the costs that have materialised from a non-responsive monetary policy. At least, a tighter monetary policy could have thrown sand in the wheels and could have reduced the amplitude of asst price movements. As asset prices bubbles are typically associated with strong growth in bank credit to certain sectors such as real estate and stock markets, pre-emptive monetary actions could be reinforced by raising risk weights and provisioning norms for sectors witnessing very high credit growth. For both monetary and regulatory actions to be taken in tandem, it is important that both the functions rest with the central banks. In this context, the recent trend of bifurcation of monetary policy responsibility from regulatory responsibility appears to be unhelpful (Mohan, 2006b). On balance, it appears that pre-emptive and calibrated monetary and regulatory measures would be better than an inertial monetary policy response. Such an approach can help in mitigating the amplitude of the bubble in both the upswing and the downswing of the cycle and contribute to both macroeconomic and financial stability. This view seems to be gaining ground. As the IMF in its recent assessment notes: “Central banks should adopt a broader macro-prudential view, taking into account in their decisions asset price movements, credit booms, leverage, and the build up of systemic risk. The timing and nature of pre-emptive policy responses to large imbalances and large capital flows needs to be re-examined” (IMF, 2009b). Management of Capital Flows by EMEs Large volatility in capital flows to EMEs has been a recurrent feature of the global economic landscape since the early 1980s. Periods of large capital inflows, well above the financing need, have been followed by a sudden drying up of capital flows. Such large swings in capital flows over a very short period of time impose significant adjustment costs and large output and employment losses on the EMEs. As is well-known, capital flows reflect both push and pull factors. The push factors are critically dependent upon the stance of monetary policy in the advanced economies, a factor over which domestic authorities have no control. In view of these factors, it would be better for the EMEs to manage their capital account. Contrary to the theoretical expectation, empirical evidence does not find any support that free capital movement leads to higher economic growth. While benefits from external debt flows remain unproven, equity flows, especially FDI, are found to be beneficial. This suggests a relatively liberal regime for direct investment flows. Progress in the liberalisation of debt flows, especially short-term debt flows, by EMEs would depend upon greater macroeconomic stability, convergence of inflation levels and development of financial markets. Issues in Financial Regulation Finally, the current global financial crisis has again shown that markets can fail and such market failures have huge costs. The financial system is prone to excesses, given the high leverage of banks and other financial institutions. Within the financial system, banks are 'special', whether locally- or foreign-owned, because they effectively act as trustees of public funds through their deposit taking activities and are the lynch pins of the payments systems. The speed with which a bank under a run collapses is incomparable with any other organisation. A failure of one bank can have a strong contagion on the rest of the banks, even if they are healthy. In this age of globalisation, as the current crisis has revealed, the lack of confidence in banks in one country can also have a contagion on banks in the rest of the world. It is because of this that many governments in EMEs had to guarantee the deposits in their banking systems during the later part of 2008. Given the risks to financial stability, governments in advanced economies had to bail out their largest banks and financial institutions. The notion that markets will take care of weaknesses has once again been proven wrong. So far, the focus of banking regulation globally has been on capital adequacy. As this crisis has shown, liquidity issues are equally important and it is appropriate to note that, in India, we have focussed our attention on these issues as well. Given the complex inter-linkages between banks and non-banks and the move towards conglomerates, it is important that regulatory arbitrage loopholes are fixed to avoid regulatory arbitrage. It is in this context that we have tightened the regulatory regime in regard to NBFCs over the past few years in a phased manner. It is, therefore, important that banks and other financial sector players are well-regulated, while permitting them the necessary flexibility to grow and expand and meet the financing needs of a growing economy. A host of other issues such as accounting, auditing and compensation have also received attention in the aftermath of the global financial crisis. All these issues are engaging the active attention of policymakers and academia alike around the world (G-20, 2009). In view of the fast pace of technological and financial innovations, regulatory authorities would have to follow an approach that would have to be dynamic and adjust in response to changing economic environment. References Bernanke, Ben (2009), “The Crisis and the Policy Response”, Stamp Lecture at London School of Economics, January 13. 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Mohan, Rakesh (2006a), “Coping With Liquidity Management in India: A Practitioner's View”, Reserve Bank of India Bulletin, April. ---- (2006b), “Evolution of Central Banking in India”, Reserve Bank of India Bulletin, June ---- (2007), “India's Financial Sector Reforms: Fostering Growth While Containing Risk”, Reserve Bank of India Bulletin, December. Portes, Richard (2009), “Global Imbalances” in Mathias Dewatripont, Xavier Freixas and Richard Portes (Ed.), “Macroeconomic Stability and Financial Regulation: Key Issues for the G20”, Centre for Economic Policy Research, London. Obstfeld, Maurice (2009), “International Finance and Growth in Developing Countries: What Have We Learned?”, Working Paper 14691, National Bureau of Economic Research, Cambridge, MA. Reserve Bank of India (2009a), “India’s Financial Sector: An Assessment” Committee on Financial Sector Assessment (Chairman: Rakesh Mohan), March. ---- (2009b), “Macroeconomic and Monetary Developments during 2008-09”, April. Taylor, John (2009), “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong”, Working Paper 14631, January, National Bureau of Economic Research. Turner Review (2009), “The Turner Review: A Regulatory Response to the Global Banking Crisis” by Lord Turner, Chairman, Financial Services Authority, UK. World Bank (2008), Global Development Finance 2008: The Role of International Banking, World Bank. 1 Based on remarks delivered by Dr.Rakesh Mohan, Deputy Governor at the RBI-BIS Seminar on “Mitigating Spillovers and Contagion – Lessons from the Global Financial Crisis” at Hyderabad on December 4, 2008, at the International Chambers of Commerce at New Delhi on January 16, 2009, at the Yale School of Management, Yale University on April 3, 2009 and at the 7th Annual India Business Forum Conference at London Business School, London on April 23, 2009. Assistance of Muneesh Kapur in preparing the speech is gratefully acknowledged. 2 The data on capital flows are based on World Economic Outlook Database (April 2009) of the International Monetary Fund (IMF, 2009c). 3 In view of sustained large capital flows, the finite stock of government securities with the Reserve Bank, and the absence of the option of issuing central bank securities under the RBI Act, a new scheme, Market Stabilisation Scheme (MSS), was introduced in April 2004 to manage the large capital flows. Under this scheme, the Reserve Bank has been empowered to issue government Treasury Bills and medium duration dated securities exclusively for sterilization purposes, so as to manage liquidity appropriately. The proceeds collected under MSS auctions are kept in a separate identifiable cash account with the RBI, and are used for redemption and/or buy back of securities issued under the MSS. The payments for interest and discount on MSS securities are not made from the MSS Account, but shown in the government budget transparently. The MSS securities are indistinguishable from normal government Treasury Bills and dated securities in the hands of the holders. The introduction of MSS has succeeded broadly in restoring LAF to its intended function of daily liquidity management (see Mohan (2006)). MSS operates symmetrically as a store of liquidity: it helps to absorb excess liquidity in times of large capital flows and to inject liquidity in periods of reversals in capital flows. Thus, balances under MSS rose from around Rs.39,000 crore at end-January 2007 to around Rs.1,75,000 crore by end-May 2008 in the face of large capital flows; in the subsequent period, with reversals in capital flows, MSS balances came down to around Rs. 88,000 crore by end-March 2009 and helped maintain adequate rupee liquidity in the system. |