But this was not before the economy and the financial sector suffered a lot of pain in the October-December quarter. The liquidity squeeze stymied credit flow to the industrial sector and together with other factors such as a slowdown in global economic growth and volatility in commodity prices, led to a sharp decline in the rate of economic growth in India. Stock markets crashed, banks wouldn’t lend to each other or to companies, and people rushed to redeem money from mutual funds, causing some to them to go out of the money or trade below par value.
Too much of liquidity had pumped air into an asset bubble and fanned inflation in the first half of the year, forcing RBI to push up interest rates. Sandeep Bhatnagar / Mint
By September 2008, liquidity was already tight in the system as the RBI fought inflation that had risen to a 16-year high of 12.91% in August. In the year leading up to this, the central bank had repeatedly raised interest rates and the amount of deposits that banks had to keep with it, known as the cash reserve ratio.
However, the tight money scenario worsened considerably following the collapse of Lehman Brothers. The world and its bankers started discovering the extent of leverage and toxic debt the financial system was mired in. Investors started to pull out money from shaky asset classes such as equity and corporate debt to squirrel it away in risk-free securities such as government bonds. Indeed, the spread between the yields on the five-year corporate bond and similar maturity government paper had moved in a range of 133-223 basis points between April-August 2008, the survey points out.
“There are a few nagging issues that need to be settled (in the corporate bond market),” said Alpana Dave, head of corporate bond trading at ICAP India Pvt. Ltd. “The interests are still with the AAA-rated (highest quality) papers and even AA papers are hardly traded. There is no liquidity in the market and there is absolutely no market maker, unlike the g-sec (government securities) market.”
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In India foreign institutional investors sold some Rs41,216 crore of equity in calendar year 2008, according to the survey. As a result, the markets went into a tailspin. The Bombay Stock Exchange’s Sensex, the benchmark index, lost about 52% during the year. Mutual funds saw their collective assets under management dip sharply to Rs4.13 trillion at the end of 2008 from Rs5.5 trillion a year earlier.
The crisis affected firms’ ability to raise funds abroad and locally, and constrained banks’ lending ability here. The number of firms that raised money in the equity markets in 2008 fell to 37, from 100 the previous year. Overall, Rs49,485 crore of fresh equity was issued, against Rs58,722 crore a year earlier, says the survey.
Though bank credit to the commercial sector witnessed strong growth in the first half of the year, it decelerated particularly in the second half of the year. For all of 2008-09, bank credit to the commercial sector expanded by 16.9%, against a 21% growth the previous year. In absolute terms, bank credit decelerated to Rs4.08 trillion in 2008-09, compared with Rs4.3 trillion in 2007-08.
“It started with the collapse of Lehman. Both the currency and liquidity pressure (made) banks refrain from lending,” said Mridul Saggar, associate director and chief economist at Kotak Securities Ltd. “Private and foreign banks have become risk averse. Fear of being hit by a non-performing loan cycle kept them away from the market.”