Global Financial Crisis and Indian Policy Response

Introduction

The financial crisis of 2008 or the Global Financial Crisis was considered by many economists at the time to be one of the biggest recessions in the global economy since the Great Depression of 1929. It was a hefty and unexpected jolt to the world’s financial system which almost caused the collapse of the international banking system. Despite the fact that it has recently been overshadowed by the Great Lockdown of 2020, it is still an undeniably devastating global event which led to the collapse of several economies in a very short period of time. In this article, I aim to analyse the Great Financial Crisis of 2008 in terms of the causes and events leading up to it and also take a critical look into the impact on India as well as its policy response.

The Nature of Financial Market Leading up to the Crisis

The U.S. faced a short lived recession in 2001. Therefore, to keep the recession away, the Federal Reserve (the Central Bank of the U.S), dramatically lowered the Federal Funds rate from 6.5% in May 2000 to 1.75% in December 2001. The Federal Funds rate is essentially the target interest rate fixed by the Federal Open Market Committee, at which commercial banks lend and borrow their excess reserves from each other overnight on an uncollateralised basis.

Consequently, lowering this rate, made borrowing cheaper. The combination of cheap rates and easy credit made the aspect of taking loans to fulfil needs, such as that of buying a house, seem quite attractive. With this, more home loans were taken, more houses were bought and the value of houses kept increasing.

The Federal Reserve kept slashing the interest rates until it went as low as 1% in June 2003. The bankers were making good money due to the high demand for credit. And on the supply side, banks and other credit institutions were equally eager to lend. The logic was that if banks gave money to the borrowers who want to buy a house, and the borrower defaulted, the banks could seize the house and sell it for a higher amount. Hence, lending money started to seem like a safe and relatively risk free investment.

However, banks did not stop there, they went on to combine and pool their collective loans. This was done mainly due to the fact that individual loans of a few thousand dollars in itself was not a very valuable asset. However, when the banks pooled the loans they became valuable assets, that became attractive investment opportunities due to their high value and relatively risk free nature, or so was thought. The banks went on to pass the debt to other investors and financial institution in the form of CDOs or Collateralised Debt Obligation. The way CDOs work is that they use the promise of repayment of loans and bonds and sell the authority to collect these loans to investors. Hence the value of CDOs came directly from the asset they held.

So the financial landscape of the time seems to be focusing greatly on the credit market and credit based assets.

The Beginning

As most good things do not last, this environment of cheap loans and financial prosperity didn’t last either. In 2004, the Federal Reserve started increasing interest rates at such a fast pace, that by June 2006, the Federal Funds rate had reached 5.25% and the problems began. People were not interested in taking more housing loans due to the high interest rates and the prices of houses fell. More and more people started finding it difficult to pay off their loans with the higher interest rates, and the number of defaulters kept increasing.

But the lenders were prepared for defaulters and could sell the mortgaged house which will make up for the loan not repaid, as mentioned above. This was the original plan, however, with such a large number of defaulters, more houses were being sold in the housing market, in which the value of houses was already declining due to the lack of demand. The value of the houses became so low that it could hardly make up for the money lost. With this, banks started losing a lot of money when the time to cash their assets came.

This clearly meant bad news for the credit market and many big banks started declaring bankruptcy in 2007. Although, the crisis officially began in 2007, it only developed into a global banking crisis with the bankruptcy and the eventual collapse of investment bank Lehman Brothers on 15 September 2008. The financial crisis has long roots, however, it was not until September 2008, that its effects became evident.

Causes of the Crisis

The question of what caused the Great Financial Crisis of 2008, is a disputed topic among many economists. Although, it is difficult to pin point the exact cause, there are definitely a few factors which can be identified which eventually led to the financial meltdown.

First factor, was the fact that to avoid a mild recession, the Federal Reserve reduced the interest rate so low that it created an environment of cheap money and loans. The environment of cheap money urged the banks to lend more housing loans to borrowers wanting to buy a house

This brings us to the issue of the U.S. housing bubble. With the availability of cheap loans, people started to buy houses and the value of houses kept rising like a bubble until it eventually popped with the increase in the interest rates and the demand fell.

Predatory lending was another factor. With the increase in investors investing in CDOs, banks started to find more loans to sell. In order to meet this demand, the bankers started to relax the credit lending standards. This means that banks stated to give loans to people without verifying their income. These loans seemed affordable at first, but later became a huge burden on the people with lower incomes, making it predatory in nature. This became a problem when people started defaulting on loans because they were given loans without the bank verifying if they would be able to pay back the loan. This is essentially what made the CDOs, which were marketed as safe investments, risky.

Finally we come to inability of the Federal Reserve to regulate bank action. The Federal Reserve did not prevent banks from taking such high risks nor did it make an effort to weed out toxic credit that eventually led to such an economic catastrophe.

Effect on India

India at the time of the Great Financial Crisis did not face any immediate effects due to the fact that Indian banks did not partake in such investments. Although, foreign branches of Indian banks were affected, the impact on India was not felt until a little later. India during this time, could not be insulated from the adverse conditions of the international market and faced indirect effects of the crisis.

With the introduction of the New Economic Policy in 1990, the integration of the Indian economy into the world economy had soon taken place. India had become an attractive investment destination. Thus Foreign Direct Investment increased which helped the economy grow. With the integration of Indian economy into the world economy, it was only a matter of time before India started to feel the effects of the financial crisis that had brought the world’s credit market to its knees.

The crisis began affecting India when there was an enormous withdrawal of capital from India’s financial market. As the indirect effects of the crisis started to affect India, the equity market, the foreign exchange market, money market and credit market started to feel the pressure. The net capital inflows dramatically declined from US$ 51.4 billion in 2007-08 to US$ 19 billion in 2008-09. The effects of the crisis also slowed down the GDP growth which was steadily rising in the last five years.

Due to the liquidity squeeze in the international financial markets after the collapse of Lehman Brothers, Indian banks and companies were forced to shift their credit demand from external sources to the Indian banking sector. This led to a liquidity crunch in the economy. Along with the grim condition of the global economy, exports were adversely affected as well.

Indian Policy Response
The Indian policy response during the Global Financial Crisis included both fiscal and monetary policy measures. The Reserve Bank of India (RBI) took several measures to prevent the depreciation of the value of the Indian Rupee due to the large capital outflows.

Under the monetary measures, since the biggest problem in the economy was credit and liquidity crunch, the RBI reduced the reserve ratios (Statutory Liquidity Ratio to 24%, Repo Rate to 4.75%, Reverse Repo Rate to 3.25%, and Cash Reserve Ratio to 5%). This enabled the banks to lend more money and bring more cash into circulation, thereby easing the liquidity squeeze. This was done mainly to ensure that the liquidity pressure did not create bigger problems.

Along with this, the RBI also encouraged banks to lend to mutual funds, Non-Banking Financial Companies (NBFCs) and other financial institution for a certain period of time

Under the fiscal policy measures, the government announced three consecutive fiscal stimulus packages. This included additional capital spending (in both capital expenditure and infrastructure spending), reduction in indirect tax (Central Value Added Tax reduced by 4% and Central Excise and Service tax by 2% each), additional support to encourage exporters and provide them with incentives and finally providing credit to small business as well as enterprises.

Results and Effectiveness of Policies

In the following year, the economy did show slow signs of recovery. The liquidity slowly eased up and credit was not extremely scarce. However, there were some consequences. The inflation kept increasing and even went above 9%. Along with this, the government was running on a large and increasing fiscal deficit. Because of this, there still existed instability in the economy. Seeing the rising inflation, the RBI began exiting from the crisis triggered expansionary policy and started increasing the reserve ratios. When we assess the fiscal policy result, they were successful in increasing the aggregate demand, however, this rise in aggregate demand also resulted in enormous government debt.

If these policy measures were to be analysed through the IS-LM framework, the initial expansionary fiscal and monetary policy would have led to a rightward shift of the IS and LM curve respectively and would have increased the money supply and output of the economy. However, since the inflation was not kept constant, the monetary authorities started exiting from the crisis driven expansionary monetary policy and the LM curve would shift to the left. Since, the fiscal authorities could not exit from their expansionary policy with the same speed, the IS curve would remain unchanged after the initial shift.

Conclusion

A country must be extremely careful while formulating policies in order to come out of recession or any other economic hardships. They must not end up creating long term problems for the economy while trying to solve a short term issue. In the case of fiscal authorities, the large fiscal deficit made it difficult go back to normal after the crisis had passed. In contrast to this, the monetary authorities were quick to raise the reserve ratios when the threat was averted and inflation stated to rise due to which the inflation was contained in time.
The Great Financial Crisis was an unexpected adversity from which there is a lot to learn. By looking into this issue, we not only learn how governments must react during a recession, but also how economic agents must make decisions during economic prosperity. It is common knowledge that every boom is followed by a recession, however, during the boom, a recession seems like a surreal possibility. All those banks and financial institutions invested in the credit pools thinking the boom would last, however, it did not. And there will not come a time when it will, because every boom is inevitably followed by a recession. Economic agents must act while keeping this in mind. Investing large sums of money in credit pools without looking into how the banks were creating so much debt in the first place was like keeping all your eggs in the same basket. When the eggs break, you are eventually left with nothing but a big mess which you need to clean up.

AUTHOR

Ruhi