1. Global Financial Crisis: Causes, Consequences and India’s Prospects By RAKESH MOHAN Deputy Governor Reserve Bank of India At Annual General Meeting of Indian Banks’ Association May 11, 2009

2. Scheme of Presentation  Global Financial Crisis  Impact on India  Difference between US/Europe and India  Lessons from the Crisis  Medium-term Issues and Challenges

3. Scheme of Presentation Global Financial Crisis  Impact on India  Difference between US/Europe and India  Lessons from the Crisis  Medium-term Issues and Challenges

4. Global Financial Crisis (1)  Proximate causes Sub-prime lending Originate and distribute model Financial engineering, derivatives Credit rating agencies Lax regulation Large global imbalances  Fundamental cause Excessively accommodative monetary policy in the US and other advanced economies (2002-04)

5. Global Financial Crisis (2) Current Account Balance (per cent to GDP) Country 1990-941995-992000-04 2005200620072008 China1.41.92.47.29.511.010.0 India-1.3 0.5-1.3-1.1-2.8 Russia0.93.511.211.09.55.96.1 Saudi Arabia-11.7-2.410.628.727.925.128.9 United Arab Emirates8.34.69.918.022.616.115.8 United States-2.1-4.5-5.9-6.0-5.3-4.7 Memo: Euro arean.a.0.90.4 0.30.2-0.7 Middle East-5.11.08.419.721.018.218.8 Source: World Economic Outlook Database, April 2009, International Monetary Fund. Note: (-) indicates deficit.

6. Global Financial Crisis (4) US Monetary Policy (1) Volatility in monetary policy in advanced economies Large volatility in capital flows to EMEs Again very loose MP in US – likely surge in capital flows to EMEs?

7. Global Financial Crisis (5) US Monetary Policy (2) US Monetary policy too loose during 2002-04; aggregate demand exceeded output; large current a/c deficit; mirrored in large surpluses in China and elsewhere.

8. Global Financial Crisis (6) US Monetary Policy (3)  Large Fed cuts in 2007: strong boost to oil, other commodity and asset prices

9. Global Financial Crisis (3) Capital Flows to Emerging Market Economies Very large capital flows to EMEs –– now outflows in 2009 - large volatility - implications for monetary management and financial stability

10. Global Financial Crisis (7) Worsening Global Economic Outlook Growth Forecast of IMF (per cent) Region April 2008July 2008October 2008April 2009 20082009200820092008200920082009 Advanced countries1.3 1.71.41.50.50.9(-)3.8 EMEs6.76.66.96.76.96.1 1.6 World3.73.84.13.9 3.03.2(-)1.3 Global Trade Volume (Goods and Services) World3.73.84.13.9 3.03.3-11.0

11. Scheme of Presentation  Global Financial Crisis Impact on India  Difference between US/Europe and India  Lessons from the Crisis  Medium-term Issues and Challenges

12. Impact on India (1) Trends in Capital Flows ComponentPeriod2007-08 2008-09 Foreign Direct Investment to India April-March34.433.6 FIIs (net) April-March20.3-15.0 External Commercial Borrowings (net) April- December17.56.0 Short-term Trade Credits (net) April- December10.70.5 Total capital flows (net) April- December 82.015.3 Memo: Current Account Balance April- December-15.5-36.5 Valuation Gains (+)/Losses (-) on Foreign Exchange Reserves April- December9.0-33.4 Foreign Exchange Reserves (variation) April-December76.1-53.8 April-March110.5 -57.7

13. Impact on India (2) Key Macro Indicators IndicatorPeriod2007-082008-09 Growth, per cent Real GDP GrowthApril-December9.06.9 Industrial productionApril-March8.52.4 ServicesApril-December10.59.7 ExportsApril-March28.46.4 ImportsApril-March40.217.9 GFD/GDPApril-March2.76.0 Stock Market (BSE Sensex) April-March16,56912,366 Rs.per US$April-March40.2445.92

14. Scheme of Presentation  Global Financial Crisis  Impact on India Difference between US/Europe and India  Lessons from the Crisis  Medium-term Issues and Challenges

15. Differences Between Financial Crisis in US/Europe and India (1)  What has not happened here No subprime No toxic derivatives No bank losses threatening capital No bank credit crunch No mistrust between banks

16. Differences Between Financial Crisis in US/Europe and India (2)  Our Problems Reduction in capital flows Pressure on BoP Stock markets Monetary and liquidity impact Temporary impact on MFs/NBFCs (Sept-Oct) Reduction in flow from non-banks Perceptions of credit crunch

17. Differences Between Financial Crisis in US/Europe and India (3)  Our Problems Fiscal stress Oil, Fertiliser, Food subsidies Pay Commission, Debt waiver, NRE Stimulus packages GFD/GDP ratio: 5.5-6.0% Large increase in market borrowings Rs. crore 2008-09 BE2008-09 RE2009-10 BE Gross1,76,4533,42,7693,98,552 Net1,13,0003,29,6493,08,647

18. Differences Between Financial Crisis in US/Europe and India (4)  India’s Approach to Managing Financial Stability (1) Current account: Full, but gradual opening up Capital account and financial sector: More calibrated approach towards opening up. Equity flows encouraged; debt flows subject to ceilings and some end-use restrictions. Capital outflows: progressively liberalized.

19. Differences Between Financial Crisis in US/Europe and India (5)  India’s Approach to Managing Financial Stability (2) Financial sector, especially banks, subject to prudential regulation both liquidity and capital. prudential limits on banks’ inter-bank liabilities in relation to their net worth; asset-liability management guidelines take cognizance of both on and off balance sheet items Basel II framework: guidelines issued. Dynamic provisioning NBFCs: regulation and supervision tightened - to reduce regulatory arbitrage.

20. Scheme of Presentation  Global Financial Crisis  Impact on India  Difference between US/Europe and India Lessons from the Crisis  Medium-term Issues and Challenges

21. Lessons from the Crisis  Avoid high volatility in monetary policy  Appropriate response of monetary policy to asset prices  Manage capital flow volatility  Look for signs of over leveraging  Active dynamic financial regulation Capital buffers, dynamic provisioning Look for regulatory arbitrage incentives/ possibilities

22. Scheme of Presentation  Global Financial Crisis  Impact on India  Difference between US/Europe and India  Lessons from the Crisis Medium-term Issues and Challenges

23. Medium-term Issues and Challenges (1) Macroeconomic Indicators at a Glance (Per cent) 1950-51 to 1964-65 1965-66 to 1980-811980s1990-91 1991/92 to 1996-97 1997/98 to 2002/03 2003/04 To 2007/08 1234567 8 1. Real GDP Growth 4.13.25.65.35.75.28.7 Agriculture 2.92.14.44.03.70.94.4 Industry 6.74.26.45.77.04.18.4 Manufacturing 6.63.95.84.87.53.99.1 Services 4.94.26.35.96.47.810.3 2. Real GDCF/GDP 13.519.220.224.422.524.131.4 3. ICOR 3.36.03.64.64.04.63.6 4. Nominal GDCF/GDP 11.816.720.826.023.924.533.0 5. GDS/GDP 10.315.919.022.822.724.132.7 6. Saving-Investment Gap -1.5-0.7-1.8-3.2-1.2-0.4-0.3  Continuing increase in real GDP growth - Interregnum during the 1970s  Secular uptrend in domestic saving and investment -investment largely financed by domestic savings  Continuation of growth in domestic savings necessary; fiscal prudence

24. Medium-term Issues and Challenges (2) Fiscal Policy (1)  Combined fiscal deficit in India Even before the recent setback: very high by international standards contribute to the persistence of an interest rate differential with the rest of the world, constrains progress towards full capital account convertibility. self imposed rule based fiscal correction needs to be consolidated and carried forward.

25. Medium-term Issues and Challenges (3) Fiscal Policy (2)  Sustained interest rate differential also connected with the existence of a persistent inflation differential with the rest of the world. A key challenge is to further reduce inflation expectations toward international levels.

26. Medium-term Issues and Challenges (4) Monetary Policy (1)  A continuous need to adapt monetary management to the emerging needs of a fast growing and increasingly open economy.  Financial deepening and increasing monetisation. expansion of monetary aggregates departs from their traditional relationship with real GDP growth. task of monetary management: manage such growth without endangering price or financial stability.

27. Medium-term Issues and Challenges (5) Monetary Policy (2)  Further development of financial markets  Large capital inflows in recent years Reserve Bank’s ability to manage the impossible trinity  Issues for monetary policy current account balance as a good guide to evaluation of the appropriate level of an exchange rate? to what extent should the capital account influence the exchange rate? implications of large current account deficits for the real economy?

28. Medium-term Issues and Challenges (6) External Sector (1)  Optimal response to the large and volatile capital flows is a combination of (CGFS, 2009) sound macroeconomic policies prudent debt management exchange rate flexibility effective management of the capital account accumulation of appropriate levels of reserves as self-insurance and development of resilient domestic financial markets combination is country-specific; no “one size fits all”.

29. Medium-term Issues and Challenges (7) External Sector (2)  Indian policy approach to CAL Distinction between debt and equity flows Higher inflation and interest rates in India vis-a-vis advanced economies Liberalisation of debt flows can lead to arbitrage flows Ceilings on debt flows appropriate

30. Medium-term Issues and Challenges (8) Financial Sector Without Stress Scenario - increase in NPA by: 100 per cent150 per cent CRAR (%) Mar-0813.011.611.0 Sept–0812.511.110.6 Note: CRAR = credit to risk-weighted assets ratio Commercial banks robust Committee on Financial Sector Assessment (CFSA) Stability Assessment and Stress Testing Concerns about credit risk remain muted at present

31. Medium-term Issues and Challenges (9) Conclusion  India’s fundamentals remain strong Financial sector robust Monetary policy – sufficient instruments, flexible Corporate sector not too leveraged – second round of restructuring going on – productivity gains Foreign direct investment buoyant Agriculture improving Growth domestically financed Indian economy should be able to recover fast and return to 9%+ growth path

32. Thank You