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This paper aims at exploring the recent global financial crises that occurred in the years 2007- 08, and the monetary policy responses that were developed by different financial institutions around the word such as the Indian reserve bank, the European central banks and the Federal Reserve's of United States. According to Tropeano, This crisis was precedent by an increase in the volume of transactions in financial markets and all the most significant central banks seemed ignorant of the inherent dangers, and the intricate web of mutual relationships among fiscal institutions (Subbarao 2008).

The contagion from the global financial crises necessitated fast monetary and fiscal strategies aimed at ensuring logical operation of the markets, preserving financial stability, and moderating its unpleasant effects on growth (Topeano 4). Although the global markets have shown signs of stability, credit flow in superior markets has not yet recovered. According to Misra p2, what started off as turmoil in the financial sector of superior economies eventually snowballed into the deepest and most rife financial and economic crises in the last sixty years. The financial crisis that occurred in the year 2007- 08 caused a meltdown of financial markets around the globe. Globalization has caused an increase in mutual inter connectivity among financial institutions in different countries, a reason why real freezing of many financial transactions were felt in financial markets far away from the epicenter of the crisis (Misra, p4). The financial crisis that occurred recently was therefore felt globally unlike other crises that have had regional impacts such as the Asian crises.

The policy responses directed toward the crises has been similar in Europe and U.S with variations arising from their relevant governmental backgrounds (Tropeano 3). Central banking institutions in these two robust economies remained ignorant of the inherent dangers that could arise as a result of increased volume of transactions in financial markets and they continually reduced their lending rates without caution. (Khan 2010), argues that owing to the complicated web of mutual relationship among financial markets around the globe, the adverse effects caused by this turmoil spilled over to the developing economies and this has brought a struggle with balanced sheets in this lesser economies, and has seen precedent growth reduce significantly and high inflation rates resulting in almost every part of the world.

Literature review

The worldwide fiscal crisis has questioned several elemental assumptions and beliefs governing economic flexibility and financial stability. What began as disorder in the financial segment of the superior economies has led to the most pronounced and widespread financial and economic crisis of the last 60 years. (Misra 2), argues that with all the advanced economies in a harmonized decline, global GDP is expected to deflate for the first time since the World War II, values between 0.5 and 1.0 per cent, according to the March 2009 forecast of the International Monetary Fund (IMF). The developing market economies are experiencing reducing growth rates:

The World Trade Organization (WTO) had projected that worldwide trade volume would decline by a whole by 9.0 per cent in 2009. Governments and central banks around the world have responded to the crisis through both conventional and unconventional fiscal and monetary measures. Indian authorities have also responded with fiscal and monetary policy measures. (Misra 2). This paper outlines a summary account of monetary response India.

Spread of the Crises from Major Economies

The crises began in august 2007 in America, with original signs of slight rise in rate of aberrant mortgages and apparently this small turmoil led to disruption of infinitely greater value markets (Dodd 2007). Through the linkages among financial intermediaries balance sheet, the crises spread to all markets, what came to be known as the global financial crises. Apparently, safe markets for assets such as commercial papers issued by firms for their supplementary financial needs were affected (Khan 2010). Khan explained that this was attributed to fact that the intermediaries in the commercial paper markets were having on their balance sheet, assets linked to the mortgage market.

According to Tropeano (4), the failure of the mortgage buyers to pay their dept would have affected the worth of their property ensuing from securitization of their mortgages. Poorly capitalized and under- regulated intermediaries, were the dealers in this very important segment of the market. Due to the counterpancy risk involved, this meant that mortgage buyers could not sell their assets, and since was the only way they would finance their depts. Then, they were compelled to give up their role as market makers. They also lacked the right to central bank refinancing.

Following this first episode, the Federal Reserve continually reduced interests' rates on lending but remained ignorant that this act did not solve liquidity problems of financial institutions which financed themselves on the market before the crisis. Instead, the liquidity offered flowed to banks, who in turn kept in their balance sheets as excess reserve, instead of lending it to other financial institutions. Tropeano (4) further explains that later the financial powers that be, realized that they had to allow many financial institutions that were not entitled to refinancing to access credit services and that they could assemble surplus reserves by common banks offering an interest on reserves held at central banks.  

To get the money the financial institutions where it was required, the authorities changed rules that allowed non financial institutions to be refinanced by the central bank. Also they introduced a new form of remuneration held by banks at central banks and they were collecting excess reserves idle in banks balance sheets and through various facilities they lending to non bank financial institutions.

The disorder in the commercial paper market went down for close to a year and recurrent strains in the same market was only felt after the collapse of Lehman brothers in September 2008 which triggered a wave of disruptions, falling asset price etc (Tropeano 4). This had not been experienced the year before the collapse of Lehman brother which was characterized by freezing in the inter-bank market. In that whole year the Federal Reserve together with other private financial institutions took place in the so called bailout.

Effect of the Crises on India's Economy

(Khan 2010) elaborates that this shocks were transmitted to other countries such as India where it resulted In reversal of capital inflows, correction in the domestic markets, reduced access to Indian identities to raise funds from international markets, downward expectations on the balance of payments and downward pressure as well as affecting the banking sector. In the view of khan (2010), the transmission of external demand shocks was swift and severe on export growth, which deteriorated from a peak rate of 40% in second quarter of 2008-09 to (-) 15% in the third quarter to a further (-) 22% in the fourth quarter, a contraction for the first time since 2001-02.

In response to the slow growth the government adopted a fiscal stimulus measures such as tax cuts and increased expenditure, which raised the fiscal deficit of the central government by 3.5% of GDP in 2008-09. Subbarao further points that the stimulus measures in India were aimed at addressing the deficiency in aggregate demand rather than extending support to the financial sector as was the case in America and Europe (2008). This prevented even more severe deceleration of GDP growth in India in that particular year. While there no direct exposure of Indian banks to subprime assets and the growth in this country is largely dependent on domestic demand, the increased global interlink of world economies caused. (Khan 2010).

Fig. 1. Key Macroeconomic Indicators in India, 2010

indicators

2008-09:Q1-Q4

2009-10: Q1-Q2

 

Q1

Q2

Q3

Q4

Q1

Q2

Real GDP Growth (Y-o-Y)%

7.8

7.7

5.8

5.8

6.1

-

Industry

5.1

4.8

1.6

-0.5

4.2

-

Services

10.0

9.8

9.5

8.4

7.7

-

Inflation (Y-o-Y) %

 

 

 

 

 

 

WPI

12.0

12.1

5.9

0.8

-1.1

-0.2

CPI- industrial workers

7.7

9.8

9.7

8.0

9.3

11.8

Money and credit growth

 

 

 

 

 

 

Broad money

21.5

19.5

19.9

18.6

20.2

19.7

Banks credit

24.5

23.5

22.7

16.4

15.1

14.1

Interest rates

 

 

 

 

 

 

Overnight call money

6.8

9.5

7.8

4.2

3.2

3.2

10 year g-sec

8.4

8.5

5.9

6.6

6.8

7.1

Foreign trade

 

 

 

 

 

 

Export growth (%)

37.6

39.5

-15.0

-22.3

-30.0

-21.0

Import growth (%)

31.6

60.5

2.1

-29.1

-35.0

-33.6

Balance of payments (US $ billions)

 

 

 

 

 

 

Trade deficit(-)

-31.4

-38.7

-34.7

-14.6

-26.0

 

Current account deficit(-)

-9.0

-12.5

-13.0

4.7

-5.8

-

Net capital flows

11.1

7.6

-4.3

-5.3

6.7

-

Reserve outstanding

312.1

286.3

256.0

252.0

265.1

281.3

 

Source: Khan, S. Global Financial Crises and Monetary Response in India. New Delhi: PDGM finance, 2010.

In essence the contagion of the crises spread to India through three major channels - the financial channel, real channel and confidence channel.

Monetary response

In India the policy responses were aimed at mitigating the adverse effects of the crises on its economy. The conduct of monetary policy had to contend with rapid and magnitude of external shock as its spill-over effects through the real, financial and confidence channels. The need to preserve financial stability and moderate growth momentum has conditioned the evolving stance of policy.  Moreover, the Reserve Bank also uses prudential tools to alter flow of credit to certain sectors consistent with financial stability.

The availability of multiple instruments and flexible use of these instruments in the implementation of monetary policy has enabled the Reserve Bank to modulate the liquidity and interest rate conditions amidst vague global macroeconomic situation. Key policy initiative taken by the reserve bank as outlined by Misra includes,

1) Policy rates- the policy rate under the liquidity adjustment facility (LAF) was reduced by 400 basis points from 9% to 4.5%. Similarly the reverse repo under LAF was reduced 250 basis points from 6% to 3.5%.

2) Rupee liquidity- the CRR was reduced 400 basis points from 9% of net demand and time liabilities (NDTL) of banks to 5%. SLR was reduced from 25% of NDTL to 24%. The export credit refinance limit for commercial banks was enhanced to 50% from 15% of outstanding export credit. Also a special fortnight repo facility was instituted for commercial banks up to 1.5% of NDTL.

3) Forex liquidity- foreign exchange was sold and a forex swap facility was made available to banks. Interests on deposits made by non resident Indians were raised. Also the all-in-cost ceilings for the external commercial borrowing (ECBs) was raised. The systematically important non- deposit taking non baking financial companies were permitted to raise short term foreign currency borrowing.

4) Regulatory forbearance

Impacts of policy response

In India, according to Khan the changes that were undertaken by the reserve bank of India such as policy rates were rapidly transmitted to the money and debt markets and the money market rates moves in tandem with the policy reverse repo rate. In contrast the transmission to the credit market was slow to several structural rigidities in the system, especially the dominance of fixed term deposit liabilities in banks balance sheets at fixed interests' rates.

In conclusion, though India was not directly exposed to the subprime assets and sound fundamentals, financial crises still penetrated reflecting increasing globalization of Indian economy. In his speech on this subject on 12th November 2007, Mohatany pointed that the fiscal stimulus cushioned the deficit in demand and the monetary policy improved the domestic and foreign exchange liquidity. Expansionary policy stance of reserve bank was manifested in CRR and also policy rates.

The contraction of reserve bank's balance sheet caused by the reduction in foreign assets required active liquidity administration so as to inflate domestic asset. This was achieved through OMO including regular operations under LAF, unwinding of MSS securities, and introduction of new and regular scale up of existing refinance facilities. Moreover drastic reductions in CRR and availing of primary liquidity raised money multiplier and ensured steady increase in money supply.

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