“Inflation pressures will remain and private credit demand will be stronger with the threat of crowding out becoming quite real,” the Reserve Bank of India report said.
The RBI research report on Currency and Finance stated, “The crisis has taught the important lesson that forex market intervention to contain sharp and disruptive depreciation is no longer a sin and reserves are a new virtue,” the report stated. “Thus, central banks need to adopt a more flexible approach and strengthen their capacity to provide liquidity and respond to systemic shocks,” the report said.
The theme of this report is both timely and relevant, as it reflects upon the global financial crisis of 2008 and its widespread impact--including in India--and draws an objective assessment of its global impact, with particular emphasis on the Indian economy. The Report highlights many policy lessons from the crisis and future challenges.
Highlights from the Report:
The recent crisis has been the worst since the Great Depression in terms of geographical spread and intensity. A comparison with other episodes of crisis reveals similarities: systemic fragilities and imbalances in the functioning of the global economy. However, the recent crisis has been more global due to the enhanced financial linkages that prevail today.
High global inter-linkages led to the adverse impact of the crisis on real economic activity being felt in every part of the world.
The volatilities in the financial markets, along with the slowdown in economic activities in the advanced economies, were transmitted to the emerging market economies (EMEs) through both trade and financial (especially through capital flows) channels.
Despite a modest decline, remittance inflows have remained more resilient than private debt and equity flows and have become important as a source of external financing in many developing countries.
The crisis saw the unprecedented use of both conventional and unconventional policy measures. Governments and central banks across the countries also responded to the crisis through large-scale fiscal and monetary support of the financial system, and through increased coordination of both monetary and fiscal policy.
Sustained economic recovery will require re-orienting the supervisory approach and strengthening regulatory and legal framework.
Impact of Crisis and Policy Responses in India
In India, the crisis was transmitted through four channels--trade, financial, commodity prices and expectations channels.
The financial channel was more pronounced due to increased globalisation in the recent period. The banking sector in India, however, displayed resilience during the current global financial meltdown. The strength and resilience in the balance sheets of Indian banks was derived from being well-capitalised and having greater exposure to domestic conventional assets.
The measures put in place by the Reserve Bank and the Government of India since mid-September 2008 ensured that the Indian financial sector continued to function in an orderly manner.
Lessons and Future Challenges
The Report points to the widely perceived need to revisit and redefine the role of central banks, particularly in the context of (i) their role in asset markets, (ii) as a lender of last resort and (iii) clear communication with the market.
The crisis highlighted some keylessons: market discipline and supervision should complement each other; greater market transparency is crucial; countries need to contain their fiscal deficits so as to meet debt service obligations; and the need for global economic co-ordination.
Specific lessons for EMEs, including India, include
recognising the invalidation of de-coupling hypothesis,
the importance of domestic demand as a durable source of growth,
financial sector reforms that emphasize the balance between efficiency and innovation on the one hand and stability and safety on the other,
acautious approach to the pace and scope of capital account liberalization,
need for development of local bond market,
creation of fiscal policy space on a sustainable basis as a central feature of their reform agenda,
need for social security system, and
a reasonable amount of self-insurance against crisis.
Future challenges for policymakers include: what role should central banks play in financial regulation and supervision; dealing with existing information asymmetries, striking a balance between regulation and market innovation; managing the challenges of globalization for macroeconomic policymaking; managing an exit strategy that balances growth and inflation; and avoiding protectionist measures.