August 20, 2009

CENTRAL BANK OF ARGENTINA

CONFERENCE
AUGUST 31 – SEPTEMBER 1, 2009

Global Financial Crisis:

Causes, Consequences and India’s Prospects

SLIDE 1

BACKGROUND

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 can’t 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 (2009)). I
can only attempt some conjectures, raise issues and identify some possible directions in
which we should move.

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SLIDE 2

- So I first want to talk about the key causes of the global financial crisis and then
about the impact on India and the way forward.

GENESIS OF THE GLOBAL FINANCIAL CRISIS

- Proximate cause

o sub Prime mortgage sector in the US

o Originate and distribute

o Securitisation, credit derivatives, credit ratings, lax regulation

- Fundamental level, however

SLIDE 3

o Persistence of large global imbalances

SLIDE 4

o outcome of

long period of excessively loose monetary policy in the US

coupled with some rigidities in exchange rate policies of East Asian

countries/oil supplies

- Large US CAD mirrored by

China ] current account +

Russia ] capital surplus
oil producers ]

- These Saving-Investment imbalances

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 o Huge cross border financial flows

o Huge stress on cross border financial flows

- After dot com bust

o Very rapid cut in policy

interest rate
1 per cent

o Large monetary accommodation

o Followed by ECB

SLIDE 5

o Fed kept interest rates low for too long (Taylor)

Boosted consumption and investment in US

SLIDE 6

o Boom in asset and oil and other commodity prices

o aggregate demand exceeded domestic aggregate supply

large CAD

China supplied goods/at low cost

China + others supplied capital flows

- Some argue that problem was caused by saving glut + exchange rate policy

- Counter factual would be

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 o if Chinese exchange rate was more flexible, Chinese surplus would have
been smaller, but difficult to argue that US CAD would have been lower.

- Note that Europe had surplus or low CAD

Net Result

(1) Low short term interest rates

(2) Low long term interest rates/mortgages [Reverse capital flow from central banks]

(3) Search for yields

* financial innovation/irregularities

SLIDE 7

* large and volatile capital flows to EMEs

1990-96 US$137 bn

1997-02 US$ 97 bn

2003-07 US$ 301 bn

2007 US$633 bn peak

2009 Expected to be negative (- US$ 190 bn)

Withdrawal of monetary accommodation 2004 Q3 to Q2 2007

Hardening of interest rates

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SLIDE 8

- housing price reverse

- Asset re-pricing

- Emergence of sub prime

- Deleveraging, bank losses, financial market turbulence, loss of confidence,

- credit markets and trade financing clogged

- global trade slumps – industrial production decline

- output and employment losses

- Global growth for 2009: |Now -1.3 per cent

- merchandise export volume: (- ) 9 per cent in 2009 (WTO).

IMF (-3 per cent) earlier

Now -11%

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SLIDE 9 Important to understand

IMPACT ON INDIA Impact in India

SLIDE 10

Capital Flows to India

- heavy 2004 onwards

- 2007 peak > $ 100 billion 9 per cent of GDP but CAD 1.5 per cent

- Little absorption

- Large intervention

o money supply

o sterilisaiton

o large portfolio

o ECB (low interest rates) External Commercial Borrowings

- Oil/Commodities Price increase 2007-08

o Inflation

- Monetary Tightening 2005-08:

o Much more in 2008

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Impact of the Crisis on India

• With the increasing integration of the Indian economy with the rest of the world,
the country does face some downside risks from global economic developments.
The risks arise mainly from the slowdown in exports, potential reversal of capital
flows on account of slowdown in advanced economies and difficulty in raising
resources by corporates in overseas markets.

• The knock-on effects of the global financial crisis and the subsequent economic
slowdown are affecting the Indian economy in several ways. First, capital flow
reversals intensified in September and October 2008 though they have stabilised
since then. Second, international credit channels continue to be constrained.
Third, export growth has turned negative during October-January 2008. Fourth,
industrial production growth has slackened, partly due to negative export growth.
Fifth, reversal of portfolio flows has affected the equity market, which has made it
difficult for the corporates to raise equity from the domestic capital market. Sixth,
overall business sentiment has deteriorated.

• As might be expected, the main impact of the global financial turmoil in India has
emanated from the significant change experienced in the capital account in 2008-
09. While Foreign Direct Investment (FDI) inflows have continued to exhibit
accelerated growth, portfolio investments by foreign institutional investors (FIIs)
witnessed a net outflow. Similarly, external commercial borrowings of the
corporate sector declined, partially in response to policy measures in the face of
excess flows in 2007-08, but also due to the current turmoil in advanced
economies. With the emergence of a large merchandise trade deficit and change
in perceptions with respect to capital flows, there has been significant pressure
on the exchange rate in recent months.

• With the volatility in portfolio flows having been large during 2007 and 2008, the
impact of global financial turmoil has been felt particularly on the equity market.
The BSE Sensex (1978-79=100) increased significantly from a level of 13,072 as
at end-March 2007 to its peak of 20,873 on January 8, 2008 on account of heavy
portfolio flows responding to the high growth performance of the Indian corporate
sector. With portfolio flows reversing in 2008, partly because of the international
market turmoil, the Sensex has now dropped to a level of around 11,000 at
present in line with similar large declines in other major stock markets.

• In India, domestic investment is largely financed by domestic savings. However,

the corporate sector has, in recent years, mobilized significant resources from
global financial markets for funding, both debt and non-debt, their ambitious
investment plans. The current risk aversion in the international financial markets
to EMEs has, therefore, impacted the ability of the Indian corporate sector to
raise funds from international sources and thereby impede some investment
growth. Such corporates would, therefore, have to rely relatively more on
domestic sources of financing, including bank credit. However, domestic primary
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 capital market issuances have suffered in the current fiscal year so far in view of
the sluggish stock market conditions.

• The financial crisis in the advanced economies and the likely slowdown in these
economies could have some impact on the IT sector. According to the latest
assessment by the NASSCOM, the software trade association, the current
developments with respect to the US financial markets are very eventful, and
may have a direct impact on the IT industry and likely to create a downstream
impact on other sectors of the US economy and worldwide markets. About 15 per
cent to 18 per cent of the business coming to Indian outsourcers includes
projects from banking, insurance, and the financial services sector which is now
uncertain.

• Summing up, the combined impact of the reversal of portfolio equity flows, the
reduced availability of international capital both debt and equity, the perceived
increase in the price of equity with lower equity valuations, and pressure on the
exchange rate, growth of the Indian corporate sector is has been impacted due
to global financial turmoil. However, on a macro basis, with external savings
utilisation having been low traditionally, between one to two per cent of GDP, and
the sustained high domestic savings rate, this impact can be expected to be at
the margin. Moreover, the continued buoyancy of foreign direct investment
suggests that confidence in Indian growth prospects remains healthy.

Slide 11

Key Macro Indicators

• Real GDP Growth slowed from 9% (2007-08) to 6.7% (2008-09)

• Industry 7.4% to 2.6%

• SERVICES 10.8% to 9.4%

• But government 6.8% to 13.1%

Slide 12

Openness and Real GDP Slowdown in Asian EMEs

Slide 13

Select Bank Ratios (end-2008)

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 • Loans to domestic deposits

• Loans to total liabilities

• Foreign liabilities to domestic deposits

Slide 14

Banking Sector Indicators in EMEs

• Capital to risk weighted assets

• Non-performing loans to total loans

SLIDE 15

Difference between US/Europe and India

SLIDE 16

- Indian banks had negligible direct exposure to toxic assets

- High growth in bank credit 2004-07

o But little relaxation in lending standards

o Prudent LTV

- No banking problems

o Banks are strong and well capitalised

CRAR ~ 13 per cent

o NPAs low

o Profitable

o Robust to stress testing (FSAP)

- Money market has been functioning normally throughout the period

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 - (About US$ 10 billion/day) - No inter-institutional trust problem

- forex market functioning normally

o But some volatility and pressure on exchange rate

SLIDE 17

- But main impact is from

o Reduction in capital flows

stock market

ECB

o Trade reduction

NBFC/Mutual Fund in September-October (Redemption and maturity

mismatches)

o Much higher pressure on banking system

Overall credit growth ~ 17 per cent

Public sector banks ~ 22 per cent

Private and foreign banks < 10 per cent

Perception of credit crunch

SLIDE 18

o Fiscal stress

Oil, fertiliser subsidies

Debt waiver

Pay commission

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Fiscal stimulus

o Widening of deficits

o Market borrowings: More than doubling

Pro-active management by RBI

• MSS buyback, desequestering

• OMOs – calendar

SLIDE 19 Why have we weathered the storm?

- India’s Approach to Managing Financial Stability

o Current account convertibility:

Full, but gradual opening up

o Capital account and financial sector liberalisation

calibrated opening.

• Equity flows encouraged;

• debt flows subject to ceilings and some end-use restrictions.

SLIDE 20

o 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;

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Dynamic provisioning

o NBFCs: regulation and supervision tightened - to reduce regulatory

arbitrage.

SLIDE 21

WHAT HAVE WE DONE

SLIDE 22

Monetary Policy

Liquidity

• Interest rate reduction:

9 per cent Repo → 3.25 per cent reverse repo Now

• Both the Government and the Reserve Bank have acted to protect the economy
from the adverse impact of the crisis since mid-September 2008. While the
Government has announced three major fiscal stimulus packages, the endeavour
of the Reserve Bank has been to provide ample rupee liquidity, ensure
comfortable dollar liquidity and maintain a monetary policy environment
conducive for the continued flow of credit to productive sectors. Towards this
endeavour, the Reserve Bank has adopted both conventional as well as
unconventional measures.

• Infusing liquidity CRR

OMO

MSS

• Liquidity Facilities - 17 (3B)

- SIDBI/NHB/Exim

- Special Repo

MFs/HFC/NBFC - SPV - NBFC

SLIDE 23

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Forex

• NRI Deposits

• ECB Liberalisation

• Rupee $ swaps

SLIDE 24

• Huge supply of liquidity

• No liquidity constraints

• Flexible liquidity modulation

• Host of instruments

• No dilution of collateral

SLIDE 25

• Impact of measures

o Indian financial markets continue to function in an orderly manner.

o comfortable liquidity position starting mid-November 2008 as evidenced by

a number of indicators

weighted average call money rate,

overnight money market rate

yield on the 10-year benchmark government security,

• Bank credit

o peak of 29.4 per cent growth in October 2008

o since decelerated to 18 per cent.

• overall flow of resources to the commercial sector less than what it was last year

o decline in non-bank flow of resources to the commercial sector.

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 • The transmission of the policy interest rate signal has been effective in the
money and government securities markets; however, the transmission in the
credit market has so far been subdued. From the real economy perspective,
however, for monetary policy to have demand inducing effects, lending rates will
have to come down. Most banks have reduced lending and deposit rates to some
extent, but a few have yet to do so. In the Reserve Bank's view, the policy easing
done by it in the last few months allows for considerable room for banks to
respond more actively to the policy cues.

SLIDE 26

BUT Bank Interest Rates Slow to Respond

Deposit rates > 8 per cent

Lending rates ~ 11-12 per cent

Rigidity

- small savings
- Inflation expectation

WPI Zero
CPI 10 per cent
- Slow reduction in Bank costs
- Credit growth ~ 20 per cent
But total flow
o Some reduction
- Economic growth has clearly slowed down, particularly industry
- Export growth is negative
- But overall GDP growth ~ 7 per cent (-)

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SLIDE 27

Lessons from the crisis

SLIDE 28

 Avoid high volatility in monetary policy

 Broader framework for monetary policy –

 beyond inflation targeting

 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

SLIDE 29

Monetary policy and asset prices

• Need to revisit conventional wisdom and relationship between monetary and

asset prices

• Monetary and regulatory actions need to be taken in tandem (both functions

should be with central banks)

• Central banks: “macro-prudential” view, pre-emptive policy responses

Slide 30

Management of Capital Flows by EMEs

• Volatile capital flows due to push factors

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 • Optimal response is combination of

o Sound macroeconomic policies

o Prudent debt management

o Exchange rate flexibility

o Effective management of the capital account

o Appropriate levels of reserves as self-insurance

o Development of resilient domestic financial markets

o Combination is country-specific; no “one size fits all”

Slide 31

Financial Regulation

• Liquidity issues as important as capital adequacy

• Regulatory loopholes / arbitrage

• Flexibility for innovation and growing economies

• Dynamic approach to regulation

Slide 32

Monetary Policy in EMEs (1)

• Adapt policy to growing and opening economies

• Financial deepening and increasing monetization: manage growth with stability

• Development of financial markets

• Managing impossible trinity

Slide 33

Monetary Policy in EMEs (2)

• Interest rate differential and inflation differential

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 • 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?

Slide 34

(1) Fiscal Policy

- Had been on path to consolidation

- Now again back to 2001-02 levels

- Will need to unwind

o world wide problem

(2) Monetary Policy/Capital Account Management

- Structural difference in inflation 2 per cent / 4-5 percent

- Hence interest rate difference

- Hence Active capital account management

- Management of volatile capital flows

o Distinction between debt and equity flows

SLIDE 35

CONCLUSIONS

India’s fundamentals remain sound

• Financial sector robust

• Flexible, pro-active monetary management

o Balance between Price stability, financial stability and growth

o Robust financial sector regulation

Banks + NBFCs
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Counter cyclical actions

Focus on liquidity management

Willing to act contra-cyclically on asset bubbles

Monetary policy and bank regulation unified

Multiple instruments

• Judicious use of interest rates, reserve requirements and

prudential instruments

• Corporate sector not too leveraged

o Another round of restructuring going on

o Large productivity gains likely

• Agriculture improving

o Rural demand buoyant

o NREGS etc.

• Growth largely

o domestic-demand driven

o domestically financed

• So should be able to recover fast and return to 9%+ trajectory.

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Deleted slides

SLIDE 31

Growth Acceleration over the Decades

- Widely believed that Indian growth stagnated 1950-1980

- In fact continuing slow acceleration except 1970s.

- Service growth

o Not a new phenomenon

Continuing acceleration over the decades.

- Scholars have looked for turning point from slow growth to high growth.

- Data suggest more of continuous except for the 1970s.

- Key feature is continuous growth in savings and investment

1950s 9.6 per cent

2007-08 35 per cent

- Investment has been close to savings

o Indian growth financed domestically

o Very little foreign savings

≈ 1 - 1.5 per cent of GDP

o > 2 per cent ⇒ crisis, 1960s, 1980s

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CHALLENGES

SLIDE 34

SLIDE 35

(3) Financial Development and Deepening

- Financial development and financing for growth

SLIDE 38

• FINANCIAL SECTOR

o Commercial banks robust , resilient

o CFSA Report

banking system can withstand significant shocks arising from large

potential changes in credit quality, interest rate and liquidity
conditions.

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.

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