The Global Financial Crisis, A New Governor And His Trial By Fire

It was about a decade ago, on Sept. 5, 2008, that D Subbarao took over as the governor of the Reserve Bank of India. An experienced administrator, Subbarao was new to the world of central banking. He was, as he wrote in his 2016 memoirs ‘Who Moved My Interest Rate’, looking forward to a series of meetings that would help induct him into the world of central banking.

On Sept. 15, Lehman Brothers filed for bankruptcy.

Subbarao’s meetings turned into fire-fighting sessions. The induction turned into a rite-of-passage of sorts for the new governor.

“It will be dishonest to say I had no fears, concerns or anxiety at the time,” said Subbarao, now a distinguished visiting fellow at the National University of Singapore.

With each day, the nature of the crisis was changing. Announcements were flowing in from developed market central banks. Emerging market central banks were reacting, while scanning their own markets for emerging vulnerabilities.

In the three months that followed, the RBI had to keep markets ticking, tackle rumours of a run on ICICI Bank Ltd., address a liquidity squeeze across the mutual fund and NBFC sectors and, eventually, cut interest rates sharply to dull the domestic growth impact of the global financial crisis.

The Immediate Aftermath

Ring-fencing the operation of Lehman Brothers in India was the first step. To do this, the top management of Lehman worked directly with RBI officials and ensured that it went smoothly.

There were three main parts to the Lehman business in India—a primary dealership, an NBFC and a back-office. The primary dealership was told not to undertake transactions in government securities in the primary market. The NBFC was asked not to take on any liabilities from any institution in India. But Lehman’s operations in India were small. As such, there was limited direct impact on the broader financial system.

Ensuring orderly conditions in the foreign exchange and inter-bank markets was the bigger challenge.

The initial steps from the RBI came in small doses. The central bank assured it would supply forex to the markets, interest rates on foreign currency deposits were raised marginally and banks were allowed to dip into the mandated-statutory liquidity ratio portfolio to avail the RBI’s liquidity facilities.

“Our actions in the days and weeks following Lehman brothers were guided by three objectives,” Subbarao explained. “First, we must maintain ample rupee liquidity. Second, we must douse the system with foreign exchange liquidity. Third, we must, at any cost, keep financial market going.”

It wasn’t until a fortnight later, on Oct. 6, that the first cut in cash reserve ratio was announced. It was a modest 50-basis-point reduction, which, four days later on Oct. 10, was revised to a 150-basis-points cut.

Decisions were taken separately and collectively. The Prime Minister’s office was monitoring events directly, then Finance Minister P Chidambaram was hands on, even as different regulators were monitoring their individual markets. There was no system in place but one evolved naturally, said Subbarao.

“It was seen and interpreted that the RBI is abandoning the leadership of government. But it was different story....We coordinated, discussed, argued and took actions, often separately but sometimes together,” he added.

The first cut in the benchmark repo rate—of 100 basis points—came on Oct. 20. “I recall that decision,” said Subbarao. The decision was announced just days before a scheduled monetary policy review. It was announced in the middle of the day at 11 a.m. Just before then Prime Minister Manmohan Singh was scheduled to make a statement in the Lok Sabha.

Saving ICICI And Then Mutual Funds

Trouble in those days was easy to spark.

Indian banks had limited exposure to the toxic securities that had led to a freezing-up of western markets. But there was some lingering concern that India’s relatively more global banks like ICICI may have an exposure.

Rumours started to swirl and the credit default swaps of ICICI spiked. One thing led to another and concerns of a possible run on the bank emerged. Those rumours needed to be stopped in their tracks.

Both the government and the RBI acted immediately. On Sept. 30, the following statement was released.

Government officials matched that assurance and the top management of ICICI Bank took to the media to say that the bank was in good financial health.

Attention slowly shifted away from the lender.

It moved to the health of the mutual fund sector, which was facing a genuine liquidity squeeze. On Oct. 15, the RBI put in place a special line of liquidity which would provide up to Rs 20,000 crore for mutual funds.

Later, special liquidity facilities were put in place for NBFCs, housing finance companies and the Small Industries Development Bank of India.

Saving The Economy

As the financial crisis stretched on, the task on hand went beyond just ensuring that financial markets remain orderly.

Over time, the focus shifted toward the real economy. India had hiked rates to 9 percent just before the financial crisis hit, with the view on curbing inflation. Macro-prudential measures had been introduced to prevent the build-up of risks in the financial system.

Some of that meant that the Indian economy was in a much better place to withstand the impact of the financial crisis.

“It is well known now that the RBI and Governor YV Reddy had instituted macro-prudential measures like risk weights, provisioning norms, loan to value ratios. All that the RBI did even before macro-prudential became fashionable in central banking,” said Subbarao.

Some of these measures were unwound partially in response to the crisis. That, together with the cut in interest rates and cash reserve ratio, helped shorten the length of the economic slowdown in India.

In fact, in retrospect, the RBI and the government have been chided for going overboard with the monetary and fiscal easing measures. It is felt that the policies of the time led to imbalances in the Indian economy, including high inflation.

In Retrospect

A decade later, what is Subbarao’s verdict on unconventional policies like Quantitative Easing adopted by the West back then?

According to Subbarao, while QE went a long way in repairing broken financial markets, the impact of those policies on stimulating demand has been mixed. “QE was more effective in America than in Europe or Japan because now, looking back, it is clear that QE acts through the bond market and America depends more on bond markets than Europe,” he explained.

He also points to the continuing debates about the impact of QE on asset prices and its implications down the line.

“We have learnt a lot from this experience of QE...but I don’t think there is decided consensus on the impact of QE,” Subbarao said.

What should India do to ensure it can handle any volatility that may emerge during the unwinding of these policies?

Take care of macros. Keep current account sustainable, fiscal deficit within target, inflation low and the financial sector well capitalised. “All this is easily said and difficult to do. But that should be the guiding mantra for protecting your own economy from global forces even as you remain globalised.”

Watch the interview with D Subbarao.