Mumbai: There was not a single day in March this year when the Reserve Bank of India (RBI) had to infuse liquidity in the financial system, the first such month in the last few years.
It was quite a feat for a central bank that just months earlier was frenetically pouring money into a financial system shaken and stirred by the sudden outflow of foreign capital from the Indian stock market, following the September 2008 collapse of investment bank Lehman Brothers Holdings Inc. Credit became scarce and interest rates shot up before RBI stepped into calm the domestic money markets.
Liquidity was the overarching theme in the Indian financial markets in 2008-09. Too much of it had pumped air into an asset bubble and fanned inflation in the first half of the year, forcing RBI to push up interest rates. Then there was too little of it as the full impact of the global financial crisis hit India, forcing RBI to ease policy.
Fine balance: Reserve Bank of India governor D. Subbarao at a press conference in Mumbai in January. Since September, the bank released some Rs4.22 trillion into the system to help push the economy back on track. Abhijit Bhatlekar / Mint
While the Economic Survey 2008-09 commended the government and the central bank for the way they handled a year of extremes, it also cautiously called for further reforms in the financial system.
Thus, it called for a “phased increase” in foreign direct investment limits in banks and “greater entry” of foreign banks. It also talks of the need for “tighter regulation of investing banks and other foreign entities”. And even as the survey reiterated the need for more financial and commodity derivatives to help firms manage risks, it suggested that these products be traded on exchanges rather than through private deals. Deals done on exchanges are easier to police than those struck privately.
“The measures initiated on the monetary front were in the nature of an accommodative policy to ensure that there were no liquidity constraints in the economy,” the survey noted. “Coupled with the expansionary fiscal policy, the initiatives have had a favourable impact on domestic monetary, real and financial sectors.”
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“Last year was a year of contrast,” said Harihar Krishnamurthy, treasurer of the Indian unit of South Africa-based FirstRand Bank Holdings Ltd. “The story of the first six months got completely reversed in the last six months.”
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.
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.
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
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.”
The rupee was not spared either. By March 2009, the local currency had reached 52 to a dollar, a record low, as foreign investors continued to pull out. RBI had to sell dollars to prop up the rupee. India’s foreign reserves, $316 billion in May, subsequently came down to $250 billion by year-end.
As the situation worsened throughout October, banks soon had to start borrowing money from RBI though its so-called liquidity absorption facility window. On October 10, banks had to borrow a whopping Rs92,000 crore from RBI when the interest rate in the overnight interbank market jumped to 20%. On an average, banks borrowed Rs43,000-46,000 crore daily during September and October. An additional Rs40,000 crore was released by bringing down banks’ bond holding obligation to 24% of their deposit liabilities, from 25% earlier.
Since September, RBI reduced banks’ cash reserve requirement by 400 basis points, and brought down the repo and reverse repo rates, or the rates by which it injects and sucks out liquidity from the system, to 4.75% and 3.25% from 9% and 6%. These steps led to the release of some Rs4.22 trillion in the economy, RBI estimates. It also helped push the economy back on the growth track. Compared with recession-stricken developed nations, India merely saw growth moderate in 2008-09, the survey noted. “On a preliminary assessment, the economy evinces early signs of turnaround,” it summed up.