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Response of the Reserve Bank of India (RBI) to the Financial and Economic Crisis

Response of the Reserve Bank of India (RBI) to the Financial and Economic Crisis. Aleksandar Zaklan. While the Advanced Economies were in Crisis Already…. India enjoyed GDP growth around 9% going into 2008

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Response of the Reserve Bank of India (RBI) to the Financial and Economic Crisis

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  1. Response of the Reserve Bank of India (RBI) to the Financial and Economic Crisis Aleksandar Zaklan

  2. While the Advanced Economies were in Crisis Already… • India enjoyed GDP growth around 9% going into 2008 • Main drivers: domestic investment, resulting from savings rate of about 35% of GDP, and domestic consumption. • However, foreign investment and trade also contributed to the expansion of the economy • India was integrating into the world economy • Trade share of GDP (exports + imports/GDP) went from 21.2% in 1997 to 34.7% by 2008 • Foreign capital had been available and cheap and capital inflows amounted to 9% of GDP by 2008 • So in 2007 and going into 2008 the RBI was fighting overheating rather than crisis

  3. Ex Ante Measures by the RBI: Interest Rate Policy • Starting in early 2008 consumer inflation started rising towards 10% per year • In addition, a boom was under way in real estate, in particular in commercial real estate • To maintain price stability the RBI pursued a relatively tight monetary policy, and the main policy rate, the repo rate, was raised to 9% by the summer of 2008

  4. Ex Ante Measures by the RBI: Micro and Macro Prudential Policy • The RBI is also in charge of banking supervision, and 70% of India’s banking system is state-owned, so the RBI has a lot of control over the system • The RBI’s governor, Y.V. Reddy, took strong anti-expansionary regulatory measures: • Banks were not allowed to speculate with land • Banks were forced to maintain conservative lending standards for mortgages and consumer loans • The RBI required fairly high capital reserves (12-14%)

  5. Y. V. Reddy, the anti Greenspan

  6. With the Lehman Brothers Default the Crisis Reached India • The second-round effects of the crisis were transmitted both through the financial and the real channel • Financial channel: • Liquidity dried up as foreign investors divested and put pressure on the Rupee exchange rate • Domestic companies were cut off from foreign capital and turned to a tightening domestic credit market • Real channel: • Demand for Indian exports dropped because of the recession in advanced economies • Remittances from the Gulf region dropped because falling energy prices diminished construction activity there

  7. Ex Post Measures: Interest rate policy • Starting in the fall of 2008 the actions of the RBI bacame highly expansionary • The repo rate (the rate which RBI charges banks when they borrow from it) fell from 9% in October 2008 to 4.75% currently • The reverse repo rate (the rate the RBI offers banks for taking in the banks’ money) was cut from 6% in December 2008 to 3.25% currently

  8. Ex Post Measures: Aggregate Liquidity Supply Operations • Ensuring Liquidity supply both in the foreign exchange and the domestic markets was the overarching goal of the RBI’s response to the crisis • However, no particular emergency measures for specific banks were needed, since no banks were threatened by failure.

  9. Ex Post Measures: Aggregate Liquidity Supply Operations • Domestic liquidity: • The cash reserve ratio (CRR) was decreased from 9% at the end of 2008 to 5% currently • The statutory lending requirement (SLR) was lowered from 25% to 24% of deposits • A number of special financing programs were set up, e.g. guaranteeing credit to non-banking financial companies (NBFCs) and to micro, small and medium sized companies (MSMEs) • Foreign exchange liquidity: • The RBI intervened massively in the foreign exchange market by selling US dollar reserves to support the Rupee exchange rate • A rupee-dollar swap facility provided liquidity to commercial banks • External borrowing restrictions on corporations were relaxed • Repatriation of remittances was made easier for Indians living abroad

  10. Conclusion • While the crisis is certainly having an impact, the impact on India is muted compared to what is going on in advanced economies and other emerging economies, e.g. Eastern Europe • The RBI has taken pretty swift and decisive action against the liquidity crunch, and is coordinating its actions with the fiscal stimulus provided by the government • Overall, the fundamentals of the economy seem to be sound, and given that the drivers of growth in India are predominantly domestic, there should not be significant damage to the country’s medium to long term economic prospects

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