Subprime Crisis and its impact on the Indian Economy

Submitted in partial fulfilment of the requirements of the course

MACROECONOMIC ENVIRONMENT
Faculty: Prof. Chandan Sharma

Group -7 || Section - A

IPMX13016 – Jayamohan CS

IPMX13034 – Sadasivuni Amarnadh

IPMX13036 – Satyananda Palui

IPMX13052 – Yatin Bansal

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Contents
Introduction........................................................................................................................ Error! Bookmark not defined.
Causes of Subprime Crisis............................................................................................................................................................ 4
Impact of the Global Financial Crisis....................................................................................................................................... 7
Impact of the Subprime Financial Crisis on India............................................................................................................... 8
Policy Responses........................................................................................................................................................................... 16
Why was the impact on India muted ?................................................................................................................................. 19
Takeaways from the Crisis........................................................................................................................................................ 19
Conclusion....................................................................................................................................................................................... 21
References....................................................................................................................................................................................... 22

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Introduction

The recent adverse impact of COVID19 on the world economy and the travails being
faced by all the economies, be it a developed, developing or a Third World Nation is a
matter of prime concern. However, the non-availability of a reliable vaccine along with
ill-conceived strategies and knee jerk reactions to control the spread of the virus has put
a dampener on the recovery process. The recent RBI bulletin has pointed towards a
technical recession for the very first time in the history of our country. And as a part of
the exercise, the RBI has also started “nowcasting” or “the prediction of the present or
very near future of the economy”. Though, there are also speculations that our current
economic situation is due to initiatives like implementation of GST and Demonetization,
the impact of COVID is more substantial and was the straw that broke the camel’s back.
Our group would have ideally wanted to study the current economic crisis and its impact
on the Indian economy, however due to non-availability of enough data and the
repercussions it is going to have in the future, we have decided to study and assess the
impact of the Subprime Crisis in 2008 which affected the world economy and India on
similar lines.

Subprime crisis was a financial crisis that occurred between 2007 and 2010. This was
initiated by decline in housing prices after the collapse of the housing bubble. This
triggered a chain reaction in which loan repayments reduced whilst the banks increased
interest rates amid a rapidly falling investor confidence in financial institutions which led
to the collapse of behemoths like Lehman Brothers and bankruptcy of many, affecting
the US economy adversely. The tremors were felt worldwide with the ensuing European
debt crisis, and the 2008 – 2011 Icelandic financial crisis due to their deep connections
and substantial exposure to the US Housing and Subprime market. Since the Indian
economy was more dependent on domestic market and the Indian Financial Institutions
had less/limited exposure to US Housing market, we were relatively shielded but still the
aftershocks were felt by us too with the crash of the stock market, during which a few of
our group members burnt their fingers too, low investor confidence, the rise of the NPAs
in Public Sector Banks and the recent IL & FS crisis, which mostly have its origins from
this crisis.

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The origin of the crisis goes back to the year 2004 when Wall Street experimented with
varied loan products and mortgages. Banks and Housing finance corporations targeted
extraordinary profits through unsavory means like predatory loans and as they were not
subject to Government regulations, rules were bent and banking standards lowered,
assuming rising home prices for perpetuity. But then home prices began to collapse,
creating ripples in the system. A recession normally begins just after an economy has
reached its peak and ends as the economy approaches a trough. A recession is defined
as an event in which the economy experiences decline in real GDP for two consecutive
quarters along with a slowdown in the economic activity.

As per IMF, losses due to the real estate crisis amounted to $945 billion in the USA
alone, but finally ran into trillions of dollars worldwide. First and foremost, the crisis
caused mass foreclosure and default in subprime loans and then the crisis accelerated
during September 2008, and finally developed into a global financial crisis. Subprime
loan/lending is the practice of providing loans to borrowers who do not qualify at the
market rate of interest due to various risk factors such as low-income level, poor credit
worthiness/credit history, employment status etc. The subprime loans are provided to
those who do not qualify at the market rate of interest. A baffling fact about these
subprime loans was that the delinquency rate was as high as 25 per cent till March
2008 and rose even higher subsequently. The impact was so severe that top investment
firms like Lehman Brothers and Bears Stearns collapsed. Others behemoths such as
Merrill Lynch, Citi Group, JP Morgan were rescued by the government. The U.S.
Government intervened in the free-market economy and came out with a $700 billion
bailout package to revive the banking system and reinstate the investor’s faith in the
stock market. Since January 2008, the U.S. stock market has suffered about $12 trillion
dollar in losses and this had a domino effect on the bourses throughout the world.

Causes of Subprime Crisis

The subprime crisis has its origin in reasons which were varied and complex. It can be
attributed to a number of factors consisting of both the credit and housing markets,
which developed over a period of time and inclusive of: (1) inability of homeowners to

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make their mortgage payments (2) poor judgment by the borrowers (3) information
asymmetries, i.e., lending to borrowers with poor credit histories at higher interest rates
(4) inability of the lenders to precisely determine their subprime exposures (5)
speculation and overbuilding during the boom period (6) risky mortgage products (7)
high personal and corporate debt levels (8) breakdown of the market discipline (9)
failure of credit-rating agencies to properly assess the credit worthiness and risk,
financial innovations that distributed and perhaps concealed not only the default risks
but also the regulation.

Even after a root cause analysis, it was difficult to point out the exact cause of this crisis
but the majority of the financial experts and economists are of the view that subprime
loans were one of the main culprits. The different causes of the crisis are explained
below:

Boom, Bubble and the burst in the housing market: The housing bubble happened
due to rapid increase in the valuation of real estate property until the prices reached
unsustainable levels. One of the main factors that led to the burgeoning increase in the
demand for house prices is the low interest rate i.e. the Fed cut the short-term interest
rates and huge influx of foreign capital from countries such as U.K., Japan and China.
Also, subprime loans fastened the process by further increasing the demand for houses
due to easy credit availability in the market. Because of the aforementioned facts, the
homeownership rate increased and this rise in demand pushed the prices of houses
through the roof. Also, U.S. home owners, lured by the increasing value of their homes
went on a borrowing spree. They started borrowing money for personal needs by
mortgaging their property and further re-mortgaging too. Excessive building during the
boom eventually led to a surplus of houses, causing home prices to decline. As a result,
default rate and foreclosure increased, leading to the mortgage value far exceeding that
of the houses’.

Speculation: Another important cause of the housing crisis is speculation in real estate.
It was observed that investment in the housing sector yields high return compared to
other traditional investment avenues. Investment in the housing sector increased as a

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result of this. Nearly 40% of home purchases were not for primary residences. All this
extravagance and greed was taking the shape of a bubble waiting to burst.
High risk lending practices: The subprime loans were offered to the high-risk
borrowers i.e. illegal immigrants, unemployed, and persons without any assets and
income. The repayment from these borrowers was a big question mark. Another
example of high-risk loans is the Adjustable Rate Mortgages (ARM). Under ARMs,
borrowers had to pay only the interest amount and not principal during the initial period
and that too with a minimal interest rate making them sell like hot cakes.

Securitization of Assets: Securitization is a structured finance process in which

assets, receivables and financial instruments are acquired and pooled together as
collateral for the third party investments (Investment banks). Due to securitization,
Mortgage Backed Securities (MBS) were created and distributed by the investment
banks. Initially, only Freddie Mae and Fannie Mac (federally-backed home mortgage
companies created by the U.S. Congress) used to issue MBS but later private agencies
also started issuing MBS on subprime loans. During 2003 to 2006, Freddie Mae and
Fannie Mac’s share of MBS fell to 43% from a high of 76% while Wall Street’s share
climbed up from 24% to 57% during the same period.

Inaccurate credit rating: Under the new system of securitization, investment banks
repackaged Mortgage Backed Securities - MBS into innovative financial products called
Collateral Debt Obligation - CDOs, that promised to boost the return for investors. The
Collateral Debt Obligations were further divided into small financial units called
tranches, which were rated on the basis of risk involved. The safest portion received the
highest rating of AAA, while riskier tranches received the medium quality BBB rating,
just above the junk bonds. MBS and CDOs originating from subprime mortgages were
distributed by the investment firms. Later, credit rating agencies too came under the
scanner for giving investment-grade rating to securitized transactions based on
subprime loans.

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Government Policies: It was a priority for the earlier governments to provide affordable
housing to all the people. It was made mandatory for all the banks and saving
institutions to provide home loans to the lower income people. In their eagerness to
achieve these targets, the underwriting lending standards eroded. Fannie Mae
aggressively bought loans which require little or no documentation of a borrower’s
finances, also called as Alt-A loans. Till November 2007, a total of $55.9 billion of
subprime securities and $324.7 billion of Alt-A securities were held by Fannie Mae in
their portfolios

Central Bank’s policies: The Fed’s primary concern was to manage monetary policy
and was least bothered about the housing bubble. Once the markets fell, the Central
Bank tried to control the spread of the crisis in other sectors. A main factor contributing
to the rise in home prices was the lowering of the interest rate by the Federal Reserve.
The crisis began in the US high-risk subprime home loan market and then spread into a
global credit squeeze, bringing down economies worldwide. While U.S. remained the
focal point, financial institutions worldwide were also affected.

The International Monetary Fund and the Organization for Economic Cooperation and
Development had warned about the crisis and the looming stagflation in the financial
system and the required measures to be taken to shore up investor’s confidence. The
IMF forecasted and warned about the looming crisis and indicated that the total losses
related to US risky loans could reach $1 trillion. It was a misfortune that the financial
crisis coincided with the decline of the dollar, rising inflation and booming commodity
prices. The Federal Reserve ignored this and paid more attention to the rate cuts to
minimize financial meltdown. Soon the global financial crisis has gradually taken the
form of recession.

Impact Of The Global Financial Crisis

The global financial turbulence had its impact on almost all the economies and impacted
the corporates, banks and investor sentiments. Any crisis of such magnitude is bound to
affect the working of the economy, be it a developed country or a developing country.

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The renowned Nobel economist, Amartya Sen, regarded this crisis as a “crisis of
confidence”. Meanwhile, the impact of the present global financial crisis has been
different for different countries. With an increasingly interconnected world, things like a
credit crunch can spill over through the entire economy. Many sectors felt the credit
crunch and the higher costs of borrowing led to job cuts. Consumers cutback on their
spending to try and weather this economic storm, yet other businesses struggled to
survive leading to further job losses. Many industrialized nations were sliding into
recession if they were not already there. A number of major financial institutions failed in
Europe and others needed rescuing. The crisis affected markets of several developing
countries as well. India and China also saw a decline in housing prices after a period of
steady increases. Also, in the developing world, the rise in food prices as well as the
spill-over effects from the financial instability and uncertainty in the industrialized nations
started to have a compounding effect. Soaring fuel costs and commodity prices together
with the fear of global recession were a cause of major concern for many developing
countries. The most common problem for any developing economy is to contain inflation
and have a decent growth rate. With respect to Asia and the financial crisis, many
believed that Asia was sufficiently decoupled from the western financial systems and
also never had a subprime mortgage crisis like many nations in the west had. Also,
many Asian countries were also major global players and a slowdown in the wealthier
ones meant increased chances of a slowdown in Asia, the risk of losses and associated
problems like social unrest. The African countries were not affected by the crisis, at
least not initially but later faced increasing pressure for debt repayment. The Latin
American countries also had a slower growth rate due to the crisis and gave rise to a
crisis of poverty. The poorest were the most affected due to the global food crisis and
the development process of the poor nations also due to lack of finance for their
development projects. The countries which were less dependent on foreign credit,
investment and trade were much safer.

Impact of the Subprime Financial Crisis on India

India was impacted significantly by the crisis, notwithstanding its sound banking system,
negligible exposure of Indian banks to sub-prime assets and relatively well functioning

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financial markets. The main reason was on account of India’s growing trade and
financial integration with the global economy. India’s two-way trade (merchandize
exports plus imports), as a proportion of GDP, was 40.7% in 2008, the crisis year, up
from 19.6% in 1998. The immediate impact of the crisis was experienced through
outflows of huge capital and the consequent fall in domestic stock markets on account
of sell-off by FIIs and steep depreciation of the Rupee against US Dollar. The BSE
Sensex, which had touched a peak of 20873 points on January 8, 2008, declined to a
low of 8160 points on March 9, 2009. And the ensuing capital outflows led to a decline
in the domestic forex liquidity, RBI’s intervention in the forex market resulted in
tightening of Rupee liquidity. The inter-bank call money (overnight) rates firmed up
during the period from second half of September ’08 to end October ’08 (high of 19.70%
on October 10). However, the series of liquidity augmenting measures undertaken by
RBI resulted in call rates coming back to the normal levels from first week of November
’08. Global recession adversely affected the Indian exports, resulting in widening of
current account deficit. Exports which grew at 25% during 2005/08 decelerated to
13.6% in the crisis year and registered a degrowth of 3.5% in the ensuing year. In the
pre-crisis years, capital inflows were far in excess of the current account deficit and the
RBI had to absorb these flows in its balance sheet. During the crisis period, as global
investors tried to rebalance their portfolios, there were large capital outflows
immediately after the collapse of Lehman Brothers leading to a downward pressure on
the rupee. There was a depreciation in the rupee from Rs. 39.37 per $ in January 2008
to Rs. 51.23 per $ in March 2009.

Though in the beginning, India officially denied the impact of US Subprime crisis on the
Indian economy, later, the government had to acknowledge the impact whatever be the
magnitude of it. The impact on major industries is elucidated as given below:

1. Impact on Indian Banking:

There was no immediate and direct impact on India’s banking sector given the stringent
regulations and consequent limited integration with the global financial system.
According to the Banking Regulation Act, 1949 (as amended by The Banking

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Regulation (Amendment) Act, 2017), banks have to maintain – in addition to cash
reserve requirements – assets in India amounting to 40% of their total liabilities in India.
Banks are not permitted to borrow externally i.e. outside of the country for lending
purposes, and the permissible limit of foreign borrowing for capital is linked to their
capital adequacy ratio . The presence of foreign banks is low due to restriction on entry.
The share of banking assets held by foreign banks with majority ownership was very
low, and these banks do not have wide reach in the domestic economy. Also, unlike
advanced economies such as Japan, there was not much exposure to sophisticated
investment products and subprime mortgages that were the main cause of the crisis in
the US. These factors insulated the banking sector from the spill-over effects of the
crash. ICICI Bank, India’s largest private sector lender at that time, had some exposure
to the US subprime mortgage market, but due to its strong capitalization, it was able to
tide over the losses.

According to economist Kaushik Basu, along with precautionary norms of the RBI, the
pervasive use of black money in the economy created a bulwark against a crisis in the
banking sector. The basic argument is as follows: A large part of the payment in almost
all property purchases in India is made in cash so as to avoid taxes. Thus, making the
declared value of property lower than the actual value and since mortgage loans can
only be raised on the declared value, and the proportion is, in any case, much lower
than that in advanced economies.

2. Impact on Real Economy, Trade and Exports:

The real economy, on the other hand, was indeed connected with the global economy
and the impact on the banking sector came largely through this channel. External
commercial borrowing of firms, which grew year-on-year in the years preceding the
crisis remained almost the same between 2008 and 2009. The financial sector collapse
in the US spread to its real sector in the form of a credit crunch, resulting in lowering of
aggregate demand, causing a recession. The slowdown had a significant dampening
effect on trade: India’s total trade (excluding oil) experienced an average annual growth
rate of 23.53% during 2005-2009 and this figure fell to -4.34% between 2008-09 and

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2009-10. Lower export demand and a burgeoning import bill due to rising commodity
prices led to widening of the current account deficit. This adversely impacted the real
economy, likely weakening the ability to repay bank loans, as well as exerted pressure
on domestic credit. There was an increase in demand for bank credit as external
sources of credit were unavailable. Thus, there arose some pressure on banks for
funding liquidity.

With several European countries and the US slipping under a full-blown recession,
Indian exports ran into difficult times, since October 2008. Manufacturing sectors were
hit hard because of the slump in demand in the US and Europe. Further, India enjoys
trade surplus with the USA and about 15% of its total export in 2006-07 was directed
toward the US. Due to the impact of declining consumer demand in the US and other
major global markets, Indian exports fell by 9.9% in November 2008. Official statistics
showed that exports had dropped from $12.7 billion to $1.5 billion in November 2008,
while imports grew to $21.5 billion.

Fig 1: Growth in External Commercial Borrowings, 2005-2017 (y-o-y in %)

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Fig 2: Growth in total trade (non-oil), 2004-05 to 2017-18 (y-o-y in %)
Source: RBI Data

3. Impact on Real GDP Growth Rate:

Strong GDP growth was maintained throughout this period. In the pre-crisis year, India
was growing faster than the group of EMEs (Emerging Market and developing
Economies) and advanced economies (Figure 3). Post-crisis, growth fell most sharply in
India from 9.8% in 2007 to 3.9% in 2008. In the severely affected advanced economies,
the rate fell from 2.7% to 0.1%; the corresponding fall in other EMEs was 8.5% to 5.7%.
In 2009, while growth in India jumped up to 8.5%, it continued to fall in advanced
economies and other EMEs.

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Fig 3: Real GDP growth, 2005-17 (annual in %), Source: IMF Data

The above Table 1 represents the annual growth rates of real gross domestic product
over the years starting from 2000 to 2012. The GDP was rising continuously from 2003-
2004 and this continued till 2007-2008, but it decreased during 2008-09 due to the
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impact of crisis. It recovered later due to the efforts of the Reserve Bank and the
Government but again had a dip due to the poor performance of the manufacturing
sector.

4. Impact on stock market:

The stock market did crash immediately after the crisis and before the upturn began. On
10 October 2008, Rs. 2,50,000 crores was wiped out on a single day. But, due to the
low participation in equity investment among Indian households, the stock market does
not have any significant wealth and consumption effects. This huge withdrawal from
India's stock market was mainly by Foreign Institutional Investors (FIIs), and
participatory-notes. But later, due to the sharp increase in FIIs in the post-crisis years
led to a spectacular performance of the stock market, which has gone up in value by
nearly 90% in the past decade.

Fig 4: Stock Mark Index, 2006-18, Source: RBI Data

5. Impact on India’s handloom sector, jewellery, tourism and exports:

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Reduction in demand in the advanced economies affected the Indian gems and
jewellery industry, handloom and tourism sectors. Thousands of artisans employed in
the jewellery industry had lost their jobs. The crisis also affected the Rs. 3000 crore
handloom industry and the volume of handloom exports dropped by 4.6%, creating
widespread unemployment in this sector. Indian tourism too was badly affected as the
number of tourists flowing in from Europe and the USA decreased sharply during this
period.

6. IT-BPO sector:

During the concerned period, the overall Indian IT-BPO revenue aggregate was
expected to grow by over 33% and reach $64 billion. IT sectors derive about 75 per cent
of their revenues from US and IT-ITES sector (Information Technology Enabled
Services) contributes about 5.5% towards India’s total export. So, the IT sector was
impacted by the meltdown in the US.

7. FII and FDI:

US and other advanced economies adopted expansionary monetary policies to

stimulate aggregate demand and revive growth thus lowering interest rates to near-zero
levels, and undertaking large-scale asset purchase programs (quantitative easing). As a
result, there was an outflow of capital to emerging economies like India, where interest
rates were higher. Given India’s widening current account deficit post-crisis, this inflow
of foreign capital helped the overall Balance of Payments (BoP). The financial meltdown
eroded a large chunk of money from the Indian stock market, impacting the Indian
corporate sector. FIIs made withdrawal of $5.5 billion, whereas the inflow of foreign
direct investment (FDI) more than doubled from $7.5 billion in 2007 to $19.3 billion in
2008.

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Fig 5: Foreign Institutional Investment (FII), 2005-06 to 2017-18 (in Rs. crore)

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The annual growth rate of real GDP sector wise is presented in the Table - 2.
Agriculture and manufacturing sector’s contribution has been a dampener throughout
and further impact of the global financial crisis on these sectors is evident by their poor
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performance. The data clearly shows a steep fall for all the sectors during the year 2008
except in the Public Administration, Defence and other services as this was due to
enhanced government spending and stimulus package to offset the subprime crisis
effect on the economy. This clearly shows that the major sectors of the Indian economy
are not immune to the impact of global financial crisis.

Policy Responses

In line with efforts made by governments and central banks all over the world, the Indian
government and RBI took active steps to counter the slowdown, significantly relaxing
monetary policy through interest rate reduction and introducing fiscal stimulus to boost
domestic demand. While the round of stimulus helped spur economic growth, they led
to an increase in fiscal deficit. The Fiscal Responsibility and Budget Management
(FRBM) Act, 2003 mandates a fiscal deficit of up to 3%. The pre-crisis level was 2.54%,
which increased to 5.99% in 2008-09 and 6.46% in 2009-10. While it has more or less
shown a declining trend since then, it is still above the FRBM target. Another negative
effect of these macroeconomic policies was the increase in inflation from 6.2% to 9.1%
in 2008-09 and 13% in 2009-10.

Fig 6: Fiscal Deficit, 2005-06 to 2017-18 (% of GDP), Source: RBI data

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Given the degrowth and drying up of capital flows, both the RBI and the Government
undertook a plethora of measures to minimise the impact of the crisis on India. There
was, however, a notable difference between Indian response and those of many EMEs,
on the one hand, and the advanced economies, on the other hand. While policy
responses in advanced economies had to contend with both the unfolding financial
crisis and deepening recession, the Indian response was predominantly driven by the
need to arrest moderation in economic growth. The main agenda of the government
response was fiscal stimulus while the RBI’s action comprised counter-cyclical
regulatory measures and also measures to ensure easy liquidity and monetary
conditions. As in the case of other central banks, both conventional and unconventional
measures were undertaken. The conventional measures included, firstly, a sharp
reduction in the policy interest rates – the effective policy rate was cut from 9% (repo
rate) in September 2008 to 3.25% in April 2009. Secondly, the cash reserve ratio was
reduced from 9% in Sept 2008 to 5% in Jan 2009 with a view to inject liquidity into the
banking system. Thirdly, liquidity injection in bulk was made through purchase of
government securities under open market operations and unwinding of the balances
under Market Stabilization Scheme through buy-back, redemptions and de-
sequestering. Finally, refinance facilities for export credit were enhanced. Measures
were also taken for enhancing forex liquidity which included an upward adjustment of
the interest rate ceiling on the deposits by non-resident Indians under FCNR (B) and
NRE deposit accounts and relaxation in norms for external commercial borrowings. In
view of the slowing economy and decelerating credit flow, the counter-cyclical
regulatory measures introduced in 2006 were also reversed. The unconventional
measures taken by RBI included: (1) institution of a ₹-$ swap facility for Indian banks to
cushion their requirements in managing short-term foreign funding requirements of their
overseas branches (2) special liquidity support to banks for lending to mutual funds and
NBFCs (3) liquidity support to nonbanking financial companies through a special
purpose vehicle created for the purpose and expansion of the lendable resources
available to apex finance institutions for refinancing credit extended to small industries,
housing and exports.

The measures undertaken by the RBI during Sep 2008 – Jul 2009 have resulted in
augmentation of actual/potential liquidity of Rs. 5,61,700 cr. The fiscal stimulus

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measures undertaken included additional public spending as well as tax cuts. The
stimulus packages followed an already announced expanded safety net for the rural
poor, waiver package for farm loans and government staff’s salary increase, all of which
too stimulated demand. Thus, the fiscal and monetary measures were successful in
achieving their objectives. Financial markets and the banking sector began to function
normally. Real GDP growth which had a slump in 2008–09 as it reached 6.8%
recovered quickly to reach 8% in 2009–10 and 8.5% in 2010–11 under the impact of
stimulus measures as also the inherent strength of domestic demand.

Why was the impact on India muted?

Despite the immediate impact on the financial markets and trade flows, the crisis did not
have any significant impact on the Indian financial system. The reasons for the muted
impact is attributed primarily to

(i) the macroprudential approach to regulation

(ii) multiple indicator based monetary policy
(iii) calibrated capital account management
(iv) management of systemic interconnectedness
(v) a conservative approach towards financial innovation.

The monetary policy formulation by the RBI has been guided by multiple objectives and
multiple instruments contrary to the approach followed by some countries of single
objective and single instruments. Monitoring of multiple macroeconomic indicators has
helped the Reserve Bank in interpreting developments in financial system and taking
prompt corrective action. Regulation of shadow banking institutions to address the
interconnectedness issues have helped in containing the impact of the crisis and helped
the economy keep afloat despite the huge global turbulences.

Takeaways from the crisis

While there are many regulatory and policy lessons that have come to the fore and are
under various stages of implementation, some takeaways which would be most relevant

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for preparing oneself for any such scenarios in the future as that was experienced
recently during the COVID pandemic are as follows:

Takeaway 1: Too much of anything is bad

You must have often heard your elders and well-wishers say this and it still remains
relevant even today, especially, post crisis. Too much of anything, be it – leverage,
liquidity or greed – they all have led to the crisis. Sometimes, too much of finance is also
not conducive to growth. Recent studies suggest that at low levels, a larger financial
system leads to higher productivity. Beyond a point, more banking and more credit
result in lower growth. It is also argued that fast growing financial sector can be
detrimental to the aggregate productivity growth. Moderation in approach, therefore, is
an important lesson.

Takeaway 2: Models are not absolute

There was always an excessive reliance and almost a blind faith that models convey
absolute truths. Entire risk management systems were built around this. Post crisis, the
world has woken up to the harsh reality that the realities of life can’t be replicated in
models and excessive reliance on them is laden with risk. Exact sciences like physics
are governed by nature’s laws that are immutable and lead to definite and predictable
results. Finance on the other hand, is governed by capricious human behaviour and
biases which cannot be easily modelled. Thus, knowing the shortcomings of the models
is, therefore, extremely important for their judicious usage.

Takeaway 3: Finance should be an abler to the real sector and not converse

A financial system should further the economic development by enabling efficient

allocation of capital and risk. In pre-crisis period, the financial activity grew so much that
the umbilical cord between financial and real sectors was severed and finance became
an entity in its own right and started to exist for its own sake.

Thus, it is widely believed that India’s stringent regulations and prudent policies enabled
it to survive the crisis without much damage. The Indian economy’s linkage to the global
financial system today is much more substantial and intricate than it was a decade ago.
The exposure to FIIs has increased and since these tend to be volatile, our vulnerability

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to external shocks has risen. With the rise of interest rates in advanced countries, India
began to experience outflows of foreign capital. Further, in the pre-crisis years, non-
performing assets (NPAs) of banks in India were on the decline, putting banks in a
strong position to deal with the adverse effects of the crisis. During 2008, annual gross
NPAs amounted to Rs. 500 billion, on average. The figure now is a whopping Rs. 7,903
billion and the recent exodus of bad boy billionaires like Vijay Mallya and Nirav Modi is a
testimony to this.

Conclusion

The proactive policies of the RBI have ensured the availability of adequate liquidity in
the markets. In the credit and consumer markets, interest rates and inflation rates have
stabilized and in the forex market, the Indian Rupee has rebounded against currencies
of the major trading partners. The stock market, an indicator of the strength of an
economy, has risen by 80% in the first three quarters of the fiscal 2009-10, after falling
by 38% in the previous year. The policy response from the RBI and government was
swift. While the fiscal policy cushioned the falling demand, the monetary policy
augmented both domestic and foreign exchange liquidity problems, thus ensuring that
the damage was minimal and we were able to bounce back.

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References:

https://rbidocs.rbi.org.in/rdocs/Content/PDFs/SSSI280509.pdf

https://www.ideasforindia.in/topics/macroeconomics/global-financial-crisis-and-india-a-look-
at- the-decade-gone-by.html

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