IMPACT OF GLOBAL FINANCIAL

CRISIS ON INDIAN FINANCIAL

SYSTEM

Deepti N
PES1UG22BL013

October 2024

Prof. Viraja Kanawally

INDIAN FINANCIAL SYSTEM
ABSTRACT
When did India first feel the ripple effects of a global financial crisis, and how did the
country respond? Historically, India’s financial system was somewhat insulated from global
market turmoil. However, the 2007-2008 global financial crisis (GFC) marked the first time
India experienced significant repercussions from a crisis originating in another country. By
late 2008, as the crisis deepened worldwide, India's capital markets faced sharp declines, with
the Bombay Stock Exchange (BSE) Index falling nearly 38% during the fiscal year 2008-09.
This was compounded by a net withdrawal of approximately USD 15 billion by Foreign
Institutional Investors (FIIs) and a slowdown in Foreign Direct Investment (FDI) inflows.
This paper discusses the long-term impacts of the GFC on India's capital markets and foreign
investment flows. It explores how the Indian government, in coordination with the Reserve
Bank of India (RBI), implemented timely policy interventions to stabilize the economy. Key
measures included injecting liquidity into the banking system, reducing interest rates, and
modifying capital adequacy requirements to sustain lending. Fiscal stimulus packages
focusing on public infrastructure were also introduced to stimulate economic activity.
By 2009-10, these policies contributed to a strong recovery in India’s capital markets, with
the BSE Index rebounding by almost 80%. FIIs and FDI inflows also recovered, highlighting
the resilience of India’s financial system. This paper provides a detailed analysis of how
India’s policy responses mitigated the worst effects of the crisis and restored investor
confidence, ensuring long-term financial stability.
INTRODUCTION
India’s current economic prosperity can be traced back to the pivotal reforms initiated during
the 1991 balance of payments crisis. Faced with near bankruptcy, India’s foreign exchange
reverses were only sufficient to cover three weeks’ worth of imports. This crisis, largely
caused by large fiscal deficits in the 1980s, pushed India towards a New Economic Policy
(NEP). The NEP introduced sweeping reforms aimed at liberalizing trade, reducing
government control, attracting foreign investment, and encouraging private sector growth.
These reforms transformed India into one of the fastest-growing economies, with a
significant shift towards globalization and trade. By 2007, India’s share in global exports
increased substantially, and trade became a key driver of economic growth. However, India
now faces new challenges due to the global financial crisis, emphasizing the need for further
reforms to strengthen trade and capitalize on the country's unrealized potential.
Financial crises can have a severe effect on economies. This is well known. What is not so
well recognised is that the severity of the impact can vary widely. Somehow, in the popular
perception, financial crises are identified with the market crash of 1929. The general sense is
that financial crises are crippling in their impact.
Can we tell whether a crisis is going to be severe without waiting to see how long it lasts and
what havoc it inflicts? This is possible using a variety of indicators that is asset price
inflation, level of leverage, size of the current account deficit and the slowing down of
economic growth.
So, what can we expect of a severe financial crisis?
 Real housing prices decline by an average of 36% over five years and equity prices by
56% over three and a half years
 The unemployment rate rises by 7% points on the average over a period of four years
while output falls from peak to trough by 9% over a shorter period, 2 years
 The real value of government debt tends to explode, rising by an average of 86% in
the major post second world war episodes1.
The encouraging thing, is that such crisis do end and that output declines last only two years
on the average. The implications seem to be that when hit by a financial crisis, we must chin
up and bear it.
Financial crisis is very broad term that covers a whole range of events, which includes
crashes in the housing market, stock market, foreign market, current accounts of nations.

LITRATURE REVIEW

1
Mohan, T. T. Ram. “The Impact of the Crisis on the Indian Economy.” Economic and Political Weekly, vol.
44, no. 13, 2009, pp. 107–14. JSTOR, http://www.jstor.org/stable/40278668.
 1. Mohan, T. T. Ram. “The Impact of the Crisis on the Indian Economy.” Economic and
Political Weekly, vol. 44, no. 13, 2009, pp. 107–14. JSTOR,
http://www.jstor.org/stable/40278668.
This research paper talks about the global financial crisis (GFC) of 2008, which is often
regarded as the "worst financial crisis since the Great Depression." Initially underestimated,
the crisis soon spread from the U.S. and Europe to the rest of the world, including emerging
economies like India. A key moment in the crisis was the decision to let Lehman Brothers
fail, triggering severe cascading effects globally. Reinhart and Rogoff (2008) highlight that
financial crisis, particularly those involving banking, are often prolonged and severe, leading
to declines in housing and equity prices, rising unemployment, and soaring government debt.
Despite these global challenges, India's well-regulated banking system and timely policy
responses helped mitigate the crisis's impact on its economy. The paper explores various
facets of the GFC, including its broader economic implications and the resilience shown by
the Indian banking sector.

2. Blankenburg, Stephanie, and José Gabriel Palma. “Introduction: The Global Financial
Crisis.” Cambridge Journal of Economics, vol. 33, no. 4, 2009, pp. 531–38. JSTOR,
http://www.jstor.org/stable/23601986.
This literature on the global financial crisis (GFC) extensively explores its causes,
consequences, and policy responses. Blankenburg and Palma (2009) emphasize that the
crisis's global reach and systemic nature were unprecedented, underpinned by financial
deregulation and a “New Financial Architecture” (Crotty, 2009). Morgan (2009) critiques
central banks’ policies, while Perez (2009) and Tregenna (2009) analyze the pre-crisis boom
and bust cycles. Wray (2009) and Palma (2009) take a broader political economy view,
linking the crisis to neoliberal ideologies that encouraged rent-seeking behavior and
undermined competitive pressures. D’Arista (2009) and Kregel (2009) focus on reform,
advocating for a more sustainable international monetary system, revisiting Keynesian ideas
from Bretton Woods. These analyses collectively highlight the interplay of financial
innovations, regulatory failure, and structural economic imbalances as root causes of the
GFC, and underline the need for deep structural reforms to prevent future crises.

3. Dhal, Sarat. “Global Crisis and the Integration of India’s Stock Market.” Journal of
Economic Integration, vol. 24, no. 4, 2009, pp. 778–805. JSTOR,
http://www.jstor.org/stable/23001249.
The literature on international financial integration highlights its significant role in financial
development, particularly in emerging market economies (EMEs). Studies such as Agenor
(2001), Levine (2001), and Prasad et al. (2003) underscore the benefits of financial
integration, including enhanced liquidity, price discovery, and diversification of investment
risks. Emerging markets, like India, have liberalized their trade and capital accounts to
integrate into the global financial system, resulting in structural shifts from bank-based to
market-based financial intermediation. However, crises like the 2007-08 global financial
crisis prompted a re-evaluation of the effects of such integration. While some argue that
financial integration exacerbates volatility (e.g., Obsfeld, 1998), others, such as Mohan
(2009), suggest that improper risk pricing led to the crisis. The use of econometric models,
like the Vector Error Correction Model (VECM), has become standard in assessing long-run
and short-run integration between global and regional markets, as demonstrated by Dhal's
study on India's stock market.

4. De, Prabir. “Global Economic and Financial Crisis: India’s Trade Potential and Prospects,
and Implications for Asian Regional Integration.” Journal of Economic Integration, vol.
25, no. 1, 2010, pp. 32–68. JSTOR, http://www.jstor.org/stable/23000965.
The literature on India’s trade potential highlights the country's transformation following the
1991 economic crisis, driven by liberalization and globalization reforms. Studies emphasize
how India's share in global trade, particularly in exports, significantly expanded post-1991,
with trade now constituting a substantial portion of its GDP2. The gravity model approach has
been widely applied in trade literature to estimate trade potential, revealing that India's
greatest trade opportunities lie in the Asia-Pacific region, followed by Africa and Latin
America. However, several studies also point to unrealized trade potential globally,
underscoring the need for India to further liberalize tariffs and enhance trade facilitation to
capitalize on these opportunities. The global financial crisis of 2008 impacted India’s trade
patterns, but research indicates that additional reforms, particularly in trade policies, can help
India maintain its export momentum and enhance its trade integration within Asia .

5. Arestis, Philip, and Ajit Singh. “Financial Globalisation and Crisis, Institutional
Transformation and Equity.” Cambridge Journal of Economics, vol. 34, no. 2, 2010, pp.
225–38. JSTOR, http://www.jstor.org/stable/24231916.
This literature on financial globalization explores its profound impact on crises, institutional
transformation, and equity. Arestis and Singh highlight that financial liberalization,
particularly the repeal of the Glass-Steagall Act, contributed to the 2007–2008 financial
crisis. Dymski uses Minsky's financial instability hypothesis to explain the depth of the crisis,
focusing on institutional changes that altered the role of banks, the rise of subprime loans,
and the effects of US current account deficits. Stein examines the role of the World Bank,
arguing that its strategies of financial liberalization and foreign bank ownership have often
undermined local Small and Medium Enterprises (SMEs), limiting access to credit and
impeding poverty reduction efforts in developing countries. The literature collectively
emphasizes the need for reconsidering global financial policies to protect vulnerable sectors
and ensure equity.

2
Ghosh, Jayati (2009), "Global Crisis and the Indian Economy", in 'Global Financial Crisis: Impact on India's
Poor, United Nations Development Programme (India).
RESEARCH QUESTIONS
1. How did the 2007- 2008 global financial crisis affect the stability and performance of
India’s banking sector, particularly in terms of liquidity, credit availability, and non
performing assets?
2. What were the long-term impacts of the global financial crisis on India’s capital
markets and foreign investments flows, and how did the Indian government’s policy
responses mitigate these effects?

RESEARCH OBJECTIVE
The objective of this research is to analyse the long-term impacts of the 2007-2008 global
financial crisis on India's financial system, particularly focusing on capital markets and
foreign investment flows. Additionally, it aims to evaluate the effectiveness of the Indian
government’s policy responses in mitigating the adverse effects and restoring financial
stability.

RESEARCH METHODOLOGY
This research employs a qualitative analysis of secondary data from financial reports,
government publications, and relevant literature on the 2007-2008 global financial crisis. It
focuses on evaluating the impact on India’s financial system and the effectiveness of policy
measures through case studies and historical data comparisons.

ANALYSIS
The 2007-2008 global financial crisis, often described as one of the most severe economic
downturns since the Great Depression, had far-reaching implications for financial systems
across the globe. Originating in the United States with the collapse of the housing bubble and
subsequent defaults on subprime mortgages, the crisis led to the failure of major financial
institutions and a significant tightening of credit markets. As the contagion spread, it
adversely affected economies worldwide, including India, which, despite being less exposed
to toxic assets than Western financial systems, experienced significant challenges in its
banking sector. This paper explores how the crisis impacted the stability and performance of
India's banking system, particularly concerning liquidity, credit availability, and the rise in
non-performing assets (NPAs).
The 2007-2008 Global Financial Crisis
The crisis began with the collapse of the subprime mortgage market in the United States in
2007. Financial institutions had engaged in risky lending practices, offering high-risk
mortgage loans to borrowers with poor credit histories. When housing prices began to
decline, defaults on these mortgages surged, leading to substantial losses for banks and
financial institutions that had invested heavily in mortgage-backed securities. The ensuing
panic triggered a credit freeze as financial institutions became wary of lending, causing a
domino effect on global markets. Major players, including Lehman Brothers, declared
bankruptcy, while others, like Bear Stearns and AIG, required government bailouts to
survive.
As global liquidity evaporated, the crisis quickly spread to other economies, including India,
which had been enjoying robust economic growth and stability prior to 2007. The
interconnectedness of global financial markets meant that no country was immune from the
shockwaves, and India faced its own set of challenges despite its relatively insulated banking
sector.

Impact on India's Banking Sector

 Liquidity Constraints:
The immediate aftermath of the crisis saw a dramatic tightening of liquidity in India. As
international markets froze, Indian banks faced difficulties in obtaining foreign funds, which
were crucial for their operations and lending activities. The Reserve Bank of India (RBI)
responded by injecting liquidity into the banking system through various measures, including
the reduction of the cash reserve ratio (CRR) and repo rate. However, in the short term, many
banks struggled with rising call money rates, which spiked to over 20% in October 2008,
indicating severe liquidity stress. This environment forced banks to become more cautious,
limiting their lending capacities.

 Credit Availability:
As liquidity constraints tightened, the availability of credit in India significantly decreased.
Corporates, especially those with exposure to foreign debt, faced challenges in refinancing
and securing new loans. The growth rate of credit disbursements slowed, impacting
investment and economic growth. Businesses, particularly in sectors reliant on external
financing, reported substantial reductions in credit availability. The slowdown in credit
growth led to a cautious stance among banks, which preferred to prioritize existing loans over
new ones to mitigate risks.
 Non-Performing Assets (NPAs):
One of the most critical impacts of the financial crisis on India's banking sector was the rise
in non-performing assets (NPAs). As economic growth began to falter and businesses
struggled to service their debts due to declining revenues, banks experienced an increase in
NPAs. According to RBI data, NPAs rose from 2.3% in 2007 to over 3.4% in 2009. The
increase in NPAs indicated that banks were grappling with higher default rates, which could
potentially threaten their stability. The crisis prompted a need for stringent asset quality
reviews and provisioning norms to address the rising NPAs.
The 2007-2008 global financial crisis profoundly affected the Indian banking sector,
revealing vulnerabilities that had previously been masked by years of growth. Liquidity
constraints, decreased credit availability, and an alarming rise in non-performing assets
highlighted the challenges faced by banks in a rapidly changing global landscape. The crisis
underscored the need for robust regulatory frameworks and proactive risk management
practices to safeguard the Indian banking system against future shocks. As India continues to
integrate into the global economy, lessons learned from this period will be vital for fostering
a resilient financial environment capable of withstanding global financial turbulence.
The global financial crisis (GFC) that erupted in 2007-2008 was marked by significant
disruptions in financial markets and an economic downturn that affected economies
worldwide. Initiated primarily in the United States due to the collapse of the housing market
and the proliferation of subprime mortgages, the crisis quickly spread through global
financial systems, impacting both advanced and emerging economies. In India, the GFC
posed unique challenges and risks, particularly in capital markets and foreign investment
flows, which had been gaining momentum due to the liberalization of the economy since
1991. The long-term impacts of the GFC on India's capital markets and foreign investment
flows, along with the policy responses of the Indian government that helped mitigate these
effects are also discussed.

Long-term Impacts on India's Capital Markets and Foreign Investment Flows

The GFC significantly influenced India's capital markets and foreign investment dynamics.
Prior to the crisis, India had experienced robust growth in foreign direct investment (FDI) and
foreign institutional investment (FII), which were instrumental in supporting economic
expansion. In 2007-08, FDI inflows reached approximately USD 35 billion, and net FII was
around USD 20 billion. However, the onset of the financial crisis triggered a sharp reversal in
these trends, leading to a net withdrawal of approximately USD 15 billion from Indian equity
markets in 2008-09 as foreign investors became increasingly risk-averse.
This withdrawal led to a decline in the Bombay Stock Exchange (BSE) Index, which fell by
approximately 38% during the fiscal year 2008-09, signalling a loss of confidence among
investors. The significant drop in capital market valuations adversely affected household
wealth and restricted corporate access to financing, contributing to a slowdown in economic
growth. Furthermore, as global economic conditions deteriorated, India's export sector was
impacted, leading to a reduction in trade volumes and heightened vulnerabilities in the
domestic economy.
In the aftermath of the GFC, the Indian government implemented several policy measures
aimed at stabilizing the capital markets and restoring investor confidence. The Reserve Bank
of India (RBI) took proactive steps to enhance liquidity in the banking system and ensure that
credit markets functioned efficiently. Key measures included reducing interest rates and
modifying the capital adequacy ratio to allow banks to lend more. Additionally, the
government announced fiscal stimulus packages that focused on public spending and
infrastructure development, aiming to spur economic activity and bolster confidence among
businesses and consumers.
The Indian government's policy responses were instrumental in mitigating the adverse effects
of the GFC. By enhancing liquidity and providing fiscal stimulus, the government managed
to restore confidence in capital markets, leading to a rebound in equity prices. The BSE Index
saw a remarkable recovery, rising by nearly 80% in the first three quarters of 2009-10.
Moreover, while net FII flows had turned negative during the crisis, they rebounded strongly
in subsequent years, reaching new heights as investors returned to capitalize on the growth
potential of the Indian economy.
In terms of foreign direct investment, India's regulatory environment and investment climate
remained relatively resilient during the GFC. While FDI inflows experienced a slowdown,
the long-term growth trajectory of FDI into India continued, with inflows increasing steadily
in the years following the crisis. By 2010-11, FDI inflows had rebounded to around USD 25
billion, underscoring India's attractiveness as an investment destination.
The long-term impacts of the global financial crisis on India's capital markets and foreign
investment flows were profound but managed effectively through timely and targeted policy
responses from the Indian government. The crisis highlighted vulnerabilities in the Indian
economy and financial systems, yet the proactive measures taken by the RBI and the
government helped to stabilize markets, restore investor confidence, and facilitate a recovery.
While challenges remain, India's capital markets and foreign investment flows have shown
resilience, demonstrating the potential for continued growth in the face of global economic
uncertainties.

SUGGESTIONS
To bolster the resilience of India's financial system in the wake of the 2007-2008 global
financial crisis, several strategic suggestions can be implemented. Firstly, enhancing
regulatory frameworks is crucial; this involves updating risk management practices and
enforcing stricter lending regulations to mitigate the risk of non-performing assets (NPAs).
Secondly, fostering a diverse funding landscape will empower businesses by promoting the
development of corporate bond markets and alternative financing options, thereby reducing
reliance on traditional bank loans. Additionally, increasing financial literacy among investors
and businesses is essential, as it enables more informed decision-making in volatile markets.
Strengthening the capacity of financial institutions, including banks and non-banking
financial companies (NBFCs), through training and advanced data analytics will enhance
their ability to manage risks effectively. Furthermore, greater global cooperation on financial
regulations can facilitate knowledge sharing and best practices, ultimately leading to a more
robust financial ecosystem. Finally, prioritizing infrastructure development will stimulate
economic growth and attract foreign investment, reinforcing India’s position in the global
market. Implementing these recommendations can significantly improve the resilience and
stability of India's financial system against future economic shocks.

CONCLUSION

The 2007-2008 global financial crisis was a pivotal event that tested the resilience of
financial systems worldwide, including India. Although India’s financial system was
relatively insulated from the toxic assets that triggered the crisis in the West, the effects were
nonetheless significant. The sharp decline in the Bombay Stock Exchange (BSE) Index and
the withdrawal of foreign institutional investors underscored the vulnerability of India’s
capital markets to global economic shocks. Despite the initial turbulence, India’s timely
policy responses, spearheaded by the Reserve Bank of India (RBI) and the government,
played a crucial role in stabilizing the economy. Measures such as injecting liquidity into the
banking system, reducing interest rates, and fiscal stimulus packages helped restore
confidence and triggered a recovery in the capital markets.

By 2009-2010, India's capital markets had not only rebounded but also regained the
confidence of foreign investors, with both FDI and FII flows returning to positive trajectories.
The crisis highlighted the importance of maintaining a robust regulatory framework and
proactive economic policies to safeguard financial stability. It also reinforced the need for
continued reforms to strengthen the integration of India’s financial system with the global
economy. Overall, the experience of the GFC demonstrated India’s resilience and the
effectiveness of its policy responses in navigating the challenges posed by global financial
disruptions.

BIBLIOGRAPHY
1. Arestis, Philip, and Ajit Singh. “Financial Globalisation and Crisis, Institutional
Transformation and Equity.” Cambridge Journal of Economics, vol. 34, no. 2, 2010, pp.
225–38. JSTOR, http://www.jstor.org/stable/24231916.
2. De, Prabir. “Global Economic and Financial Crisis: India’s Trade Potential and Prospects,
and Implications for Asian Regional Integration.” Journal of Economic Integration, vol.
25, no. 1, 2010, pp. 32–68. JSTOR, http://www.jstor.org/stable/23000965.
3. Dhal, Sarat. “Global Crisis and the Integration of India’s Stock Market.” Journal of
Economic Integration, vol. 24, no. 4, 2009, pp. 778–805. JSTOR,
http://www.jstor.org/stable/23001249.
4. Blankenburg, Stephanie, and José Gabriel Palma. “Introduction: The Global Financial
Crisis.” Cambridge Journal of Economics, vol. 33, no. 4, 2009, pp. 531–38. JSTOR,
http://www.jstor.org/stable/23601986.
5. Mohan, T. T. Ram. “The Impact of the Crisis on the Indian Economy.” Economic and
Political Weekly, vol. 44, no. 13, 2009, pp. 107–14. JSTOR,
http://www.jstor.org/stable/40278668.
6. https://www.undp.org/india/publications/global-economic-crisis-impact-poor-india-
synthesis-sector-studies
7. https://timesofindia.indiatimes.com/blogs/voices/global-financial-crisis-and-its-
impact-on-the-indian-economy/