Our story marking the tenth anniversary of the 2008 financial crisis following the collapse of the Lehman Brothers bank:
MUMBAI: One fine spring morning in 2006, Alan Greenspan, chairman, US Federal Reserve, broke bread with 10 central bankers, including our very own Dr YV Reddy. They all hunkered down in Washington DC for a breakfast meeting to discuss global imbalances and, in particular, dollar’s future.
Reddy shared his anxiety about economic vulnerabilities, seconded by Jean-Claude Trichet, chairman, European Central Bank, who was visibly worried. But Greenspan wasn’t concerned and the culinary diplomacy to devise corrective action ended inconclusively. Months later in 2007, select governors and riband investment bankers like Goldman Sachs, Citibank and HSBC met again to identify the extent of central banks’ support if the US housing bubble bursts.
Investment bankers batted forever friendlier accounting standards to show profits that were non-existent in some and fast-thinning in others. This, a furious Trichet asserted, was like changing the thermometer to declare a patient healthy, instead of treating him for fever, but the other side maintained that it could aid recovery.
The meeting ended inconclusively yet again, but it was after this moment that Reddy’s worst fears were confirmed: A global crisis was coming and it was time to buckle up. He came back and put in place contingency plans, not for one, but three anticipated scenarios: sudden massive capital outflows, sustained large outflows, and slow continuing outflows. The extent of his preparedness was exhaustive, to even include draft press releases to be issued following the aftermath.
All done, Reddy shot his final salvo. Delivering a speech, he offered an invaluable advice to strategically manage the capital account should a crisis erupt. But this warning went unnoticed, Reddy recalled in his autobiography Advice and Dissent: My Years in Public Service. That was January 2008, just when the world was basking in the New Year revelry. The crisis eventually broke out eight months later.
Our policymakers realised early on that India could be vulnerable and a framework for external sector was spearheaded by none other than Dr Manmohan Singh, when he was RBI Governor and further strengthened by Dr C Rangarajan. Besides a calibrated approach towards external and financial sectors, one of the first things Reddy did was to sock away forex reserves. Consequently, the daily average forex market turnover jumped fivefold from $7 billion to $34 billion between April 2004 and 2007 — the highest among 54 countries covered by the Bank of International Settlements.
In the run-up to the crisis, Reddy sewed up sectoral limits tight that averted damage. For instance, amid asset quality concerns and potential systemic risks to real estate, the risk weight on banks’ exposure to commercial real estate was increased from 100 to 150 per cent in April 2006. Similarly, risk weight for consumer credit and capital market exposure too rose from 100 to 125 per cent.
While encouraging foreign investment, especially FDI, a cautious, nuanced approach was adopted for debt flows, including ECBs, which were subjected to ceilings and end-use restrictions. Portfolio investment in government securities and corporate bonds too were modulated on a need-basis. These prudential policies prevented excessive recourse to foreign borrowings and dollarisation of the economy. The policy framework was progressively liberalised enabling non-financial corporates to invest and acquire companies abroad, while resident individuals were permitted outflows subject to reasonable limits. Eventually, when the crisis hit, India took the blow, but didn’t drown itself in financial misery like others.
Banks, the lifeblood of Indian economy, remained unscathed, thanks to measures like restrictions of overnight unsecured market for funds, as well as imposing prudential limits on banks’ inter-bank liabilities. Less than a fortnight after Reddy stepped down and Dr D Subbarao took over as RBI Governor, Lehman filed for bankruptcy. The financial contagion was set on fire and hell broke loose, but Rao kept calm and carried on. Though a few Indian banks had indirect sub-prime exposures, the impact was minimal with a few suffering mark-to-market losses caused by widening credit spreads.
Capital flows fell from $17.3 billion in April-June 2007 to $13.2 billion in 2008. FDI grew from $16.7 billion in 2008 as against 2007, while FIIs net outflow stood at $6.4 billion in April-September 2008 compared to net inflows of $15.5 in 2007. Sensex rallied significantly from 13,000 points in March 2007 to peak to 20,800 by January 2008 on heavy portfolio inflows, but fell with a giant thud to 11,300 by October 2008 due to reversing portfolio flows.
Rao’s immediate task was to maintain liquidity, ensure supply of dollars and contain market volatility, which he managed making use of monetary policy tools like Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio. To provide short-term liquidity, CRR, which was increased from 4.5 per cent in 2004 to 9 per cent by August 2008, was sliced to the bone by 50 bps in October 2008 — the first cut in five years. Another 100 bps cut followed later. Benchmark repo rate too was cut by 250 bps. Besides, rates on foreign currency deposits were raised, while banks were allowed to dip into the mandated SLR to avail liquidity.
Rao put to rest rumours of a bank run on ICICI, even issuing a rare clarification about liquidity availability and support. Government too weighed in, dismissing fears of the private lender’s collapse. On its part, the government pumped fiscal stimulus via reduction of VAT, and additional government spending in infrastructure and export sectors, which some believe was over boarded, leading to a jobless growth in subsequent years.
WHAT WAS DONE
■ One of the first things the RBI did was to sock away forex reserves. The daily average forex market turnover jumped fivefold from $7bn to $34bn between April 2004 and 2007
■ The risk weight on banks’ exposure to commercial real estate was increased from 100 to 150 per cent in April 2006; that for consumer credit and capital market exposure was raised from 100 to 125 per cent.