India's post-Lehman Policy: Success or Failure?
From L to R: Former PM Dr. Manmohan Singh, Dr. P. Chidambaram (former Finance Minister of India), and Dr. Montek Singh Ahluwalia (fmr Dep. Chairman of the Planning Commission). The three are considered to be the architects of India's post-Lehman economic policy.
When we think of the Lehman crisis from a regular person’s perspective, the idea is, more or less, that some rich people in the West wrecked the entire world economy. However, two outliers of the trend were India and China – India being more successful than China at insulating itself from the crisis. Whereas the usual Indian notion is “if the world has it bad, India has it worse”, the 2008 crisis presents a very different picture. Despite the slowdown in the Indian economy since 2013, India’s crisis survival story stands out as exceptional. But how did a relatively small economy (compared with giants such as US, Europe, Japan, and China), heavily dependent on services exports, manage to keep its head above the water and outperform the world? That makes for an interesting tale.
An impressive growth rates, a healthy and regulated banking system, and adequate fiscal stimulus in times of need are what largely constitute this ‘India-played-well’ story. Along with this, the fact that India had to deal with 2008 terror attacks on Bombay, goes to show how India survived the storm with commendable resilience. To see how it pulled off with minimal damage, it is useful to look at the measures it adopted in order to locate and understand its performance during the crisis.
The Banking Sector
Banking and lending were crucial aspects of the 2008 crisis. “Toxic assets”, common phrase thrown around in reference to Lehman’s downfall includes any asset which was expected to bring in profit for its owner, but has now turned loss making – such as home loans to individuals who can no longer payback. As the owner of assets also possess liabilities (they may have taken loans from somewhere else) and have obligations to pay off, a toxic asset can reduce their ability to payback, so every owner aims to pass it on to someone else who would be willing to risk the recovery process. In this sale, while the owner loses a considerable amount over the initial expected return, a complete loss is averted. However, in an economy wide crisis, the availability of buyers of such toxic assets reduces – a situation known as “freezing”. In such a scenario, the original owner has to bear all the losses. Toxic assets, mainly subprime mortgages, were the bane of the Western financial system and were crucial to the 2008 downfall (read more). The Indian banking system, on the other hand, was relatively unexposed to such toxic assets. As Rakesh Mohan, Deputy Governor of the Reserve Bank of India in 2009 explains,
“Indian banks and financial system had only negligible direct exposure to the type of toxic assets that have contaminated the Western countries’ banking system. Bank’s credit quality remains of high quality. Although bank credit growth was quite high at around 30 per cent per annum during 2004-07, it would appear that there was no significant relaxation of lending standards. Bank’s loans to individuals for housing have been backed by prudent loan-to value ratios. However, in view of the rapid credit growth to certain sectors, the Reserve Bank had pre-emptively tightened prudential norms (provisioning requirements and risk weights) for these sectors in order to safeguard financial stability; provisioning norms for standard assets were also raised across the board except for agriculture and SMEs. These tightened provisioning norms and risk weights have now been rolled back in the wake of slowdown in order to ensure flow of credit to the productive sectors of the economy”
This “roll-back” of weights is a good way to describe the Reserve Bank’s policy response to the crisis. By carefully tightening the process of who borrows from whom and at what interest, and for what purpose, the RBI was able to ensure toxic assets did not flow into the banking sector easily. After the crisis, when the market was in panic mode and credit expansion was required for the economy, these norms were relaxed to compensate for the slowdown and spur lending, with the aim of re-tightening once things came back to normal. This is called “counter-cyclical” policy making. As Duvvuri Subbarao, the then Governor of the Reserve Bank elaborates,
“Our policy packages included, like in the case of other central banks, both conventional and unconventional measures. On the conventional side, we reduced the policy interest rates aggressively and rapidly, reduced the quantum of bank reserves impounded by the central bank and expanded and liberalized the refinance facilities for export credit. Measures aimed at managing forex liquidity included an upward adjustment of the interest rate ceiling on the foreign currency deposits by non-resident Indians, substantially relaxing the external commercial borrowings (ECB) regime for corporates, and allowing non-banking financial companies and housing finance companies access to foreign borrowing … The important among the many unconventional measures taken by the Reserve Bank of India are a rupee-dollar swap facility for Indian banks to give them comfort in managing their short-term foreign funding requirements, an exclusive refinance window as also a special purpose vehicle for supporting nonbanking financial companies, and expanding the lendable resources available to 9 apex finance institutions for refinancing credit extended to small industries, housing and exports.”
As is evident, what safeguarded the banking system was a series of checks and balances. While the Indian banking system is often described as conservative, to the point where even Governors like Raghuram Rajan have expressed the need for slight relaxation in certain conservative lending attitudes, it must be acknowledged that measures like these created the background conditions which allowed India to deal with the crisis rather skillfully.
Former President, Mr. Pranab Mukherjee served Finance Minister of India in 2009. (The Hindu)
India’s relationship with the globalized world is also noteworthy. On this aspect Rakesh Mohan notes,
“The Indian approach to financial globalization has been reflected in a full, but gradual opening up of the current account but a more calibrated approach towards the opening up of the capital account and the financial sector … debt flows in the form of external commercial borrowings are generally subject to ceilings and some end-use restrictions. Macro ceilings have also been stipulated for portfolio investment in government securities and corporate bonds.”
Another important aspect of policy response were fiscal stimulus. To simplify, fiscal stimulus measures expenditure policies undertaken by the government to encourage economic activity. This is usually done to counter global slowdowns and encourage spending. Stimulus packages usually involve reduction in taxes and duties, state sponsored building projects (roads, bridges, buildings), subsidies to manufacturers etc. The idea is to provide incentives and safeguards to encourage economic activity among the people, so that production can be ramped up and the fear of a slowdown that is often responsible for reduction in production (a self-fulfilling prophecy of sorts) is avoided. In this regard, Indian Government’s response was sharp and incisive as Dr. Subbarao explains,
“The central government invoked the emergency provisions of the FRBM (Fiscal Responsibility and Budget Management) Act to seek relaxation from the fiscal targets and launched two fiscal stimulus packages in December 2008 and January 2009. These fiscal stimulus packages, together amounting to about 3 per cent of GDP, included additional public spending, particularly capital expenditure, government guaranteed funds for infrastructure spending, cuts in indirect taxes, expanded guarantee cover for credit to micro and small enterprises, and additional support to exporters. These stimulus packages came on top of an already announced expanded safety-net for rural poor, a farm loan waiver package and salary increases for government staff, all of which too should stimulate demand.”
Hence, India’s policy response to the crisis can largely be characterized as a strategic loosening up of its standards and weights. And, as of then, it worked out great. However, it would be wrong to say that India did not suffer at all during the crisis. India’s economy was impacted since, even if relatively well regulated, it was connected to the global economy after all. As Subbarao points out,
“India's financial markets - equity markets, money markets, forex markets and credit markets - had all come under pressure from a number of directions. First, as a consequence of the global liquidity squeeze, Indian banks and corporates found their overseas financing drying up, forcing corporates to shift their credit demand to the domestic banking sector. Also, in their frantic search for substitute financing, corporates withdrew their investments from domestic money market mutual funds putting redemption pressure on the mutual funds and down the line on non-banking financial companies (NBFCs) where the MFs had invested a significant portion of their funds. This substitution of overseas financing by domestic financing brought both money markets and credit markets under pressure.”
The governor goes on to describe how developments in the foreign exchange market along with slumping Indian exports were also major contributors to the damage faces by India during the crisis. However, in totality, India bounced back rather swiftly as is evident from the graph below, on the back of strong domestic consumption and a robust domestic credit market that aided private investment. As the economy struggles with growth since 2012, it is no wonder that weak private capital investment and tepid domestic consumption have been the major causes of the slowdown.
Reminiscing the Story
Looking beyond 2008, many experts and observers have not hesitated to point out how the policy response during the crisis may have sowed the seeds of India’s current banking crisis. The time period of 2008-2012 is of importance in this discussion. As The Economic Times reports, RBI’s relaxation of the repo rate (the rate at which banks borrow from the RBI) in order to encourage lending, along with the fall in duties as part of the government’s stimulus packages, were all acts of pumping money into an economy which was slowing down during 2008. However, as a result of increased government spending, the government deficit rose as well. This led to inflation over the next 4 years, and a drop in savings was witnessed in the 2008-2012 period, ultimately causing a fall in GDP growth. Livemint, another reputed business daily in India, argues that governments all over the world, and in India, are facing a “fiscal” karma. The deficits (due to increased spending) following the crisis, turned out to be larger than predicted.
As India currently deals with a large stock of NPAs (Non Performing Asserts), it is worth nothing that it may have brought this on itself when it dealt with the crisis the way it did. As Tamal Bandhopadhyay of Livemint writes,
“(the) Indian financial system is still reeling under the Lehman impact. Banks were allowed to restructure repeatedly those loans that had gone bad. It helped borrowers—affected by demand recession globally and the collapse of the exports markets—who were not in a position to pay back to the banks. Indeed, India could stage a sharp, V-shaped recovery but the ultra-loose monetary policy and massive loan restructuring had sown the seeds of inflation and creation of bad assets. The inflation genie was bottled only after Subbarao’s successor, Raghuram Rajan, launched a war against it, but the bad assets pile has still been growing, leading to banks’ reluctance to lend. Among others, this has played a role in crimping the economic growth.”
In conclusion, it will be apt to say that while India managed to swim through the 2008 crisis, it incurred a significant cost. The usual optimism surrounding the “sharp, V-shaped recovery” in 2008 tipped off the NPA crisis, giving India figures like Nirav Modi (an infamous businessman who defaulted on loans). The banking system, already an obscure mess to a common observer, was further damaged by the crisis of credibility. The story is not as rosy as it seemed.
Comments and suggestions are welcome.