THE RESPONSE OF THE RBI TO THE LIQUIDITY CRISIS

Ruchika Damani (3 Year), Shruti Bhandari (3 Year), St. Xaviers College, Kolkata
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The recent financial crisis has been very severe in terms of both intensity and depth, as reflected in the speed of transmission of its impact across nations and the extent of the global recession. It was characterized by the failure of the financial system to perform its core tasks of allocating savings, financing investments, pricing assets and transferring risk. It posed difficult challenges to policy-making in terms of assessment and the calibration of responses. Furthermore, in the light of high inter-connectedness among economies, the management of the crisis was found to be difficult at the domestic level, but even more complex at the global level. Thus, after the emergence of the crisis, a well-sequenced policy response assumed utmost importance as that only could have restored normalcy at a faster pace. In the absence of a well-orchestrated policy response, the process of recovery could have been prolonged, causing widespread economic distress. The problems that surfaced in the US sub-prime market in August 2007 reached their peak during September 2008 when some of the prime Wall Street financial institutions collapsed, leading to a worldwide failure of confidence. Credit markets virtually froze with financial institutions almost unwilling to lend to each other. The loss of confidence set off a chain of deleveraging, declining asset and commodity prices, falling incomes, shrinking demand and trade and capital flows, and rising unemployment in the advanced economies in the early stages. Although advanced countries clearly remained the epicenter of the recent global crisis, emerging market economies (EMEs) have also been substantially affected by the crisis. The turmoil in the financial sector of the advanced countries traversed to the financial sector of the EMEs, including India, especially after the Lehman Brothers bankruptcy in midSeptember 2008. The contagion spread to these economies through financial, trade and confidence channels, despite their relatively sound fundamentals. This promoted many to revisit the so-called decoupling theory in an increasingly globalised world. Thus, what started off as a subprime crisis in the US housing market in August 2007 turned successively into a global banking crisis, a global financial crisis and then a global economic crisis. The financial crisis and the subsequent recession have re-opened two crucial debates on the efficacy of the markets and the role of public policy, the so-called Keynesianism and have posed new challenges for the discipline of economics. The recent crisis has again questioned the role of finance in leading to growth and brought into focus the role of non economic motives in explaining market rise and fall. It has also necessitated a revisit of the current global regulatory and supervisory structures and perimeters against the backdrop of rapid financial innovations.

The large global current account imbalances also got reflected in the savings investment behavior in both emerging and advanced nations. This is why global imbalances are now universally ascribed to the savings glut hypothesis, which states that the US current account deficit was driven by a savings glut in the rest of the world, especially in emerging market countries (Bernanke, 2005). While in the US the gap between savings and investment almost doubled from minus 2.7 per cent of GDP in 2001 to minus 5.6 per cent of GDP in 2008, the opposite was observed in the case of EMEs where excess savings led to significant current account surpluses. During the initial stages of the crisis, the impact was manifested in mounting losses on the exposures of banks and financial institutions to the sub-prime mortgages and structured finance products. These losses were exacerbated by illiquidity in the markets for those instruments, which led to substantial reductions in their mark-to-market valuations. Global trade and financial integration had given the US financial market crisis a global form as the increasingly integrated global trading and financial system magnified and accelerated the transmission process. There had been rapid transmission of shocks from the US and Europe to the rest of the world. The crisis spread to EMEs through all four channels trade, finance, commodity and confidence channels. In the EMEs, the slump in export demand and tighter trade credit caused deceleration in aggregate demand; reversal of capital flows led to equity market losses and currency depreciations; global liquidity tightening resulted in lower external credit flows; and market rigidities and erosion of confidence led to widening of credit spreads. It would be nave to imagine that a recession in the United States would have no impact on India. The United States accounts for one-fourth of the world GDP and any significant slowdown is bound to have reverberations elsewhere. On the other hand, interdependencies between the US economy and emerging economies like India and China has reduced considerably over the last two decades. Thus, the effect may not be as drastic as would have been the case in the 1980s. The developments in the global economy during the past three decades indicate that the process of financial development and globalization is, at times, susceptible to crisis. The contagion of the crisis has spread to India through three major channels the financial channel, the real channel, and the confidence channel. The crisis that emerged in the financial sector transmitted itself to the real sector also. The impact of the crisis was manifold. The substitution of overseas financing by domestic financing brought both the money market and credit market under pressure and led to global liquidity squeeze. Commercial credit, both for trade finance and medium-term advances from foreign banks has virtually dried-up. The credit growth during 2008-09 decelerated to 17.3 per cent from 22.3 per cent in the previous year. The deposit growth of commercial banks decelerated and the growth in borrowings by commercial banks declined sharply manifesting lower credit take off. The growth in the borrowing portfolio of NBFCs, which is their major source of financing, witnessed steep deceleration.

The forex market came under pressure because of reversal of capital flows as part of the global deleveraging process. In late 2008, foreign investors did withdraw $12 billion from Indias stock markets that even saw a 60% decline in the market index. The crisis had immense impact on the real sector especially through the slump in the demand for exports as its exports were highly elastic to world income. During the crisis,2008-09,exports from India rose by 3.6 per cent in US$ terms compared to 28.9 per cent growth in the previous year. Services exports across the board in India were adversely affected by the recent global crisis, miscellaneous services exports, primarily led by software exports. There were a host of problems like increase in stocks of finished goods; fall in the value of inventories, especially raw material which, in many cases, were acquired at higher prices such as metal and crude oil-based products; slowing of capacity expansion due to a fall in investment demand; and demand compression for employment-intensive industries, such as gems and jewelry, construction and allied activities, textiles, auto and auto components and other export-oriented industries. Hotels and airlines, apart from IT, also witnessed a fall in demand due to the global downturn. All this transmitted price shocks to the Indian economy mainly through oil and food prices. It also led to severe decline in the level of employment in the country.

Indias policy response to the crisis was aimed at containing the contagion from the outside to keep the domestic money and credit markets functioning normally and see that the liquidity stress did not trigger solvency cascades. Monetary policy was striving to dampen demandside pressures through monetary tightening. At the same time, fiscal policy was attempting to ease supply-side constraints with a slew of measures, such as slashing excise duties and custom duties and encouraging imports of necessary goods, among others. In particular, three objectives were pursued with respect to the financial sector: first, to maintain a comfortable rupee liquidity position; second, to augment foreign exchange liquidity; and third, to maintain a policy framework that would keep credit delivery on track so as to arrest the moderation in growth. As the banking system remained strong and well capitalized hence the fiscal policy was weighted towards containing the economic slowdown by raising aggregate demand through discretionary fiscal policy. The fiscal policy measures were taken in form of three stimulus packages which constituted tax cuts, encouraging investment on infrastructure and increased expenditure on both investment and consumption. In order to attain medium-term sustainability, the fiscal policy also recognized the importance of institutional reforms encompassing all aspects of the Budget such as subsidies, taxes, expenditure and disinvestment. During the crisis there was a sharp fall in private sector demand due to loss of confidence as well as decline in exports, the rise in government expenditure could provide the

required temporary fillip to the falling aggregate demand. These fiscal measures helped the Indian economy overcome the negative growth due to the crisis. The monetary policy response was in terms of easing liquidity into the system through conventional measures such as cutting policy rates [cash reserve ratio (CRR), reverse repo, and statutory liquidity ratio (SLR)] and open market operations, and unconventional measures, viz., opening refinance facilities to SIDBI and EXIM Banks and clawing back prudential norms in regard to provisioning and risk weights. The total amount of actual/potential liquidity injected was Rs.5,85,000 crore. There were differences between the actions taken by RBI and other countries central banks which help India remain by and large insulated against the crisis as compared to the advanced countries. There was no dilution of collateral standards which were largely government securities, unlike the mortgage securities and commercial papers in the advanced economies. Despite a large liquidity injection, the Reserve Banks balance sheet did not show an unusual increase, unlike global trends, because of release of the earlier sterilized liquidity. Policies were taken for employment generation in the rural and unorganized sectors, financial literacy and credit counseling, liberalization of the branch licensing policies of RRBs, simplification of the procedures and processes for lending to agriculture and micro, small and medium enterprises sectors. Despite an unprecedented global recession, India remained the second fastest growing economy in the world. Whereas most countries suffered negative growth in at least one quarter over the last two years, Indias GDP grew by more than 6% throughout this period and by 7.9% in the last quarter of 2009. Indias resilience in the face of adversity, and its mature restraint in the face of violent provocation, encouraged investors to return. Indias ability to stave off the economic gales was helped by the fact that it is much less dependent than most countries on global flows of trade and capital. However the crisis has certainly questioned the efficacy of the existing institutional framework and available policy instruments at the national as well as international levels in ensuring global financial stability .The synchronized nature of the crisis due to its potential contagion brought together governments and central banks across the globe for co-ordinate efforts in exploring ways to minimize the catastrophe in the world financial system. Therefore, the responses were manifold. To conclude, recent developments clearly raise an issue whether EMEs can protect themselves against the transmission of a large financial shock in advanced economies. It appears that reducing individual country vulnerabilities by improving current account and fiscal balances may not have fully insulated them from the transmission of financial stress but improvement on these parameters along with strong policy frameworks definitely provides greater headroom for implementation of an appropriate domestic policy response in such situations and facilitates faster recovery.