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Article 1
Article 1
T
Though the Indian financial sector had very he Indian financial sector had very limited ex-
limited exposure to the toxic assets at the posure to subprime securities and other toxic
assets at the heart of the global financial cri-
heart of the global financial crisis, it suffered
sis. However, the Indian financial sector was impacted
a severe liquidity crisis after the Lehman
by the global crisis in several important ways.
bankruptcy. This liquidity crisis could have
been averted with timely injection of liquid- • Before the crisis, India’s current account deficit was
ity into the system by the Reserve Bank of being financed largely by portfolio (mainly equity)
flows. A reversal of these flows during the crisis
India, claims Jayanth Varma. Apart from the
led to a sharp depreciation of the rupee. Capital
liquidity crisis, India also had to deal with outflows meant that liquidity was sucked out of
the collapse of global trade finance; deflation the markets, and also that risk capital more or less
of an asset market bubble; demand contrac- disappeared.
tion for exports; and corporate losses on • After the bankruptcy of the US investment bank,
currency derivatives. Looking ahead, the Lehman, global credit markets dried up and the
paper argues that the crisis is a wake-up call Indian corporate sector and banks were unable to
roll over their short-term dollar liabilities. This cre-
for the Indian banks and financial system for
ated a severe liquidity crisis in the rupee market
better managing their liquidity and credit which was exacerbated by the failure on the part
risks, re-examining the international expan- of the central bank to respond to the problem
sion policies of banks, and reviewing risk quickly enough.
management models and stress test method- • The global reduction in liquidity and risk appetite
ologies. Rejecting the widely held notion that triggered the deflation of a domestic asset market
financial innovation caused the global crisis, bubble (in equities and real estate) and this placed
strains on the domestic financial system.
the author offers examples from bond mar-
• The collapse of global demand impacted export-
kets and securitization to establish the neces- oriented sectors of the economy very badly and
sity of continuing with the financial reforms. the resulting economic slowdown was another
While India has high growth potential, negative shock for the financial sector.
growth is not inevitable. Only the right • The sharp appreciation of the Swiss franc and Japa-
economic and financial policies and a favour- nese yen against the US dollar as well as the steep
able global environment can make rapid depreciation of rupee created severe stress for
mishedged corporate borrowers and their bank-
growth a sustainable phenomenon.
ers.
large part of it was in the form of trade finance (nor- The Reserve Bank of India could have nipped this
mal trade credit as well as suppliers’ credit and other crisis in the bud by lending dollars to Indian banks
deferred finance arrangements). After the bankruptcy out of its ample foreign exchange reserves. In the ab-
of Lehman on September 15, 2008, trade finance col- sence of dollar liquidity from the RBI, Indian banks
lapsed globally as international banks became wary and companies were forced to raise dollar resources
of accepting even letters of credit issued by other large by borrowing in rupees and converting the rupees
into dollars. This process created a dramatic liquid-
1 The data for this chart as well as the data on interest rates, forward ity squeeze in the rupee money market and inter-bank
premia, and stock prices later in this paper are from the Business Bea- interest rates shot up well outside the rate band set
con and Prowess databases published by the Centre for Monitoring
the Indian Economy (CMIE). by the RBI.
REFERENCES
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Jayanth R Varma is currently a Professor in the Finance and pects of financial markets. Prof. Varma has carried out exten-
Accounting Area at the Indian Institute of Management, sive research in the field of Indian financial markets and fi-
Ahmedabad where he teaches courses in capital markets, in- nance theory and has authored books on portfolio management
ternational financial management and corporate finance. He and on derivatives and risk management.
has been a full-time Member of the Securities and Exchange
Board of India (SEBI) for a year and has chaired several regu- e-mail: jrvarma@iimahd.ernet.in
latory committees relating to risk management and other as-