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The global financial system (GFS) is a financial system consisting of institutions and regulators that
act on the international level, as opposed to those that act on a national or regional level. The main
players are the global institutions, such as International Monetary Fund and Bank for International
Settlements, national agencies and government departments, e.g., central banks and finance ministries,
and private institutions acting on the global scale, e.g., banks and hedge funds.Deficiencies and
reform of the GFS have been hotly discussed in recent years.

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The history of financial institutions must be differentiated from economic history and history
of money. In Europe, it may have started with the first commodity exchange, the Bruges
Bourse in 1309 and the first financiers and banks in the 1400±1600s in central and western
Europe. The first global financiers the Fuggers (1487) in Germany; the first stock company in
England (Russia Company 1553); the first foreign exchange market (The Royal Exchange
1566, England); the first stock exchange (the Amsterdam Stock Exchange 1602).

Milestones in the history of financial institutions are the Gold Standard (1871±1932), the
founding of International Monetary Fund (IMF), World Bank at Bretton Woods, and the
abolishment of fixed exchange rates in 1973.

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The most prominent international institutions are the IMF, the World Bank and the WTO:

c The International Monetary Fund (http://www.imf.org/) keeps account of international
balance of payments accounts of member states. The IMF acts as a lender of last
resort for members in financial distress, e.g., currency crisis, problems meeting
balance of payment when in deficit and debt default. Membership is based on quotas,
or the amount of money a country provides to the fund relative to the size of its role in
the international trading system.

c The World Bank (http://www.worldbank.org/) aims to provide funding, take up credit
risk or offer favourable terms to development projects mostly in developing countries
that couldn't be obtained by the private sector. The other multilateral development
banks and other international financial institutions also play specific regional or
functional roles.

c The World Trade Organization (http://www.wto.org/) settles trade disputes and
negotiates international trade agreements in its rounds of talks (currently the Doha
Round)

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Governments act in various ways as actors in the GFS: they pass the laws and regulations for
financial markets and set the tax burden for private players, e.g., banks, funds and exchanges.
They also participate actively through discretionary spending. They are closely tied (though
in most countries independent of) to central banks that issue government debt, set interest
rates and deposit requirements, and intervene in the foreign exchange market.

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Players acting in the stock-, bond-, foreign exchange-, derivatives- and commodities-markets
and investment banking are

c Commercial banks

c ßedge funds and Private Equity

c Pension funds

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c Commonwealth of Independent States (CIS)

c Eurozone

c Mercosur

c „orth American Free Trade Agreement („AFTA)

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There are three primary approaches to viewing and understanding the global financial system.

The liberal view holds that the exchange of currencies should be determined not by state
institutions but instead individual players at a market level. This view has been labelled as the
Washington Consensus. This view is challenged by a social democratic front which
advocates the tempering of market mechanisms, and instituting economic safeguards in an
attempt to ensure financial stability and redistribution. Examples include slowing down the
rate of financial transactions, or enforcing regulations on the behaviour of private firms.
Outside of this contention of authority and the individual, neoMarxists are highly critical of
the modern financial system in that it promotes inequality between state players, particularly
holding the view that the political „orth abuse the financial system to exercise control of
developing countries' economies

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Global financial reforms

The cataclysmic developments in the financial and banking sectors in the US and other industrial
countries would not have sprung an ugly surprise on the world had the countries woken up
sufficiently early to the plenty of alarm signals that showed that a devastating crisis was in the
making.
The collapse, and in many cases disappearance without trace, of many companies, beginning from
Enron, which were household names, should have alerted the governments, economists and financial
analysts round the world that boundless greed, unscrupulous top brass, pliant boards and reckless
abandon in handling public funds on the corporate side and lack of any control, regulation and
supervision on the side of governments were taking a heavy toll. And still, governments turned the
other way.

It is to the credit of Finance Minister, Mr P. Chidambaram, and the Chancellor of the British
Exchequer, Mr Alistair Darling, that, on August 12, at „ew Delhi, well before the onset of the
turbulence, they were the first to urge international financial institutions such as the International
Monetary Fund (IMF) to work towards developing µan early warning system of the threats from the
international financial system to financial and economic stability.¶ They were also prescient in
stressing the importance of reforming the international financial institutions and supporting an
effective multilateral response to global challenges and opportunities.

Unfortunately, their Economic and Financial Dialogue, and the launching of the International Centre
for Financial Regulation in London with the active participation of business and industry, went
unnoticed at the time. If only the world community had paid heed to the fervent call by India and the
UK to evolve guidelines for observance by private equity, hedge funds and investment banks so as to
ensure that they exercise their µexponentially rising¶ clout along healthy lines much of the chaos could
have been averted.

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There is now a rising crescendo of worldwide demand for a thorough and comprehensive overhauling
of the international monetary and financial system. The conclave of heads of 40 European and Asian
countries has pledged collectively to draw up a blueprint in what has been termed a second Bretton
Woods.The blueprint has not taken concrete shape. It is merely a declaration of the determination not
to let the unprecedented chaos occur again, and a promise to put in place a system that will maintain
stability and promote growth. Only the German Chancellor, Ms Angela Merkel, has come anywhere
near listing specific goals of absolute transparency and firm safeguards. In this background, it is a
good augury that the United „ations has constituted a Task Force chaired by Dr Joseph Stiglitz, „obel
Laureate in Economics, to make recommendations on the structural reforms of international financial
institutions, and to identify longer-term measures that go beyond protection of banks, stabilisation of
credit markets and reassurances for big investors.

The effort is best undertaken under the auspices of a forum like the U„, in view of the need to
harmonise the approaches and proposals of the various governments, particularly those of developing
countries which bear the brunt of financial disasters. The reform process should be genuinely
participative and multilateral, instead of being the preserve of a privileged few among industrial
countries. This was the mistake made by the Bretton Woods Conference soon after the War, resulting
in a dispensation under the domination of the rich imposing their judgment on the rest of the world.
The new system must guarantee that the poor have better access to financial services, so that the new
financial architecture helps reduce poverty as well.

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The key question confronting the economy now is the backwash effect of the American (or
global) financial crisis. Central banks in several countries, including India [ Images ], have
moved quickly to improve liquidity, and the finance minister has warned that there could be
some impact on credit availability. That implies more expensive credit (even public sector
banks are said to be raising money at 11.5 per cent, so that lending rates have to head for 16
per cent and higher -- which, when one thinks about it, is not unreasonable when inflation is
running at 12 per cent).

For those looking to raise capital, the alternative of funding through fresh equity is not cheap
either, since stock valuations have suffered in the wake of the FII pull-out. In short, capital
has suddenly become more expensive than a few months ago and, in many cases, it may not
be available at all.

The big risk is a possible repeat of what happened in 1996: Projects that are halfway to
completion, or companies that are stuck with cash flow issues on businesses that are yet to
reach break even, will run out of cash. If the big casualty then was steel projects (recall
Mesco, Usha and all the others), one of the casualties this time could be real estate, where
building projects are half-done all over the country and some developers who touted their
'land banks' find now that these may not be bankable.

The only way out of the mess is for builders to drop prices, which had reached unrealistic
levels and assumed the characteristics of a property bubble, so as to bring buyers back into
the market, but there is not enough evidence of that happening.

The question meanwhile is: Who else is frozen in the sudden glare of the headlights? The
answer could be consumers, many of whom are already quite leveraged. More expensive
money means that floating rate loans begin to bite even more; even those not caught in such a
pincer will decide that purchases of durables and cars are not desperately urgent.And it is not
just the impact of those caught on the margin who must be considered. The drop in real estate
and stock prices robs a much larger body of consumers of the wealth effect, which could
affect spending on a broader front. In short, the second round effects of the financial crisis
will be felt straightaway in the credit-driven activities and sectors, but will spread beyond that
in a perhaps slow wave that could take a year or more to die down.

One danger meanwhile is of a dip in the employment market. There is already anecdotal
evidence of this in the IT and financial sectors, and reports of quiet downsizing in many other
fields as companies cut costs. More than the downsizing itself, which may not involve large
numbers, what this implies is a significant drop in new hiring -- and that will change the
complexion of the job market.

At the heart of the problem lie questions of liquidity and confidence. What the RBI needs to
do, as events unfold, is to neutralise the outflow of FII money by unwinding the market
stabilisation securities that it had used to sterilise the inflows when they happened. This will
mean drawing down the dollar reserves, but that is the logical thing to do at such a time. If
done sensibly, it would prevent a sudden tightening of liquidity, and also not allow the credit
market to overshoot by taking interest rates up too high.

Meanwhile, there is an upside to be considered as well. The falling rupee (against the dollar,
more than against other currencies) will mean that exporters who felt squeezed by the earlier
rise of the currency can breathe easy again, though buyers overseas may now become more
scarce. Overheated markets in general (stocks, real estate, employment-among others) will all
have an element of sanity restored. And for importers, the oil price fall (and the general fall in
commodity prices) will neutralise the impact of the dollar's decline against the rupee.

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When the financial crisis erupted in a comprehensive manner on Wall Street, there was some
premature triumphalism among Indian policymakers and media persons. It was argued that
India would be relatively immune to this crisis, because of the ³strong fundamentals´ of the
economy and the supposedly well-regulated banking system.

This argument was emphasised by the Finance Minister and others even when other
developing countries in Asia clearly experienced significant negative impact, through
transmission of stock market turbulence and domestic credit stringency.

These effects have been most marked among those developing countries where the foreign
ownership of banks is already well advanced, and when US-style financial sectors with the
merging of banking and investment functions have been created.

If India is not in the same position, it is not to the credit of our policymakers, who had in fact
wanted to go along the same route. Indeed, for some time now there have been complaints
that these ³necessary´ reforms which would ³modernise´ the financial sector have been held
up because of opposition from the Left parties.

But even though we are slightly better protected from financial meltdown, largely because of
the still large role of the nationalised banks and other controls on domestic finance, there is
certainly little room for complacency.

The recent crash in the Sensex is not simply an indicator of the impact of international
contagion. There have been warning signals and signs of fragility in Indian finance for some
time now, and these are likely to be compounded by trends in the real economy.

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After a long spell of growth, the Indian economy is experiencing a downturn. Industrial
growth is faltering, inflation remains at double-digit levels, the current account deficit is
widening, foreign exchange reserves are depleting and the rupee is depreciating.

The last two features can also be directly related to the current international crisis. The most
immediate effect of that crisis on India has been an outflow of foreign institutional
investment from the equity market. Foreign institutional investors, who need to retrench
assets in order to cover losses in their home countries and are seeking havens of safety in an
uncertain environment, have become major sellers in Indian markets.
In 2007-08, net FII inflows into India amounted to $20.3 billion. As compared with this, they
pulled out $11.1 billion during the first nine-and-a-half months of calendar year 2008, of
which $8.3 billion occurred over the first six-and-a-half months of financial year 2008-09
(April 1 to October 16). This has had two effects: in the stock market and in the currency
market.

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1.The global economic outlook deteriorated sharply over the last quarter. In a sign of the
ferocity of the down turn, the IMF made a marked downward revision of its estimate for
global growth in 2009 in purchasing power parity terms ± from its forecast of 3.0 per cent
made in October 2008 to 0.5 per cent in January 2009. In market exchange rate terms, the
downturn is sharper ± global GDP is projected to actually shrink by 0.6 per cent. With all the
advanced economies ± the United States, Europe and Japan - having firmly gone into
recession, the contagion of the crisis from the financial sector to the real sector has been
unforgiving and total. Recent evidence suggests that contractionary forces are strong:
demand has slumped, production is plunging, job losses are rising and credit markets remain
in seizure. Most worryingly, world trade ± the main channel through which the downturn will
get transmitted on the way forward ± is projected to contract by 2.8 per cent in 2009.

2. Policy making around the world is in clearly uncharted territory. Governments and central
banks across countries have responded to the crisis through big, aggressive and
unconventional measures. There is a contentious debate on whether these measures are
adequate and appropriate, and when, if at all, they will start to show results. There has also
been a separate debate on how abandoning the rule book driven by the tyranny of the short-
term, is compromising medium-term sustainability. What is clearly beyond debate though is
that this Great Recession of 2008/09 is going to be deeper and the recovery longer than
earlier thought.

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lc Contrary to the 'decoupling theory', emerging economies too have been hit by the
crisis. The decoupling theory, which was intellectually fashionable even as late as a
year ago, held that even if advanced economies went into a downturn, emerging
economies will remain unscathed because of their substantial foreign exchange
reserves, improved policy framework, robust corporate balance sheets and relatively
healthy banking sector. In a rapidly globalizing world, the 'decoupling theory' was
never totally persuasive. Given the evidence of the last few months ± capital flow
reversals, sharp widening of spreads on sovereign and corporate debt and abrupt
currency depreciations - the 'decoupling theory' stands totally invalidated.
Reinforcing the notion that in a globalized world no country can be an island, growth
prospects of emerging economies have been undermined by the cascading financial
crisis with, of course, considerable variation across countries.

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 lc India too has been impacted by the crisis ± and by much more than it was suspected
earlier. What I propose to do in the rest of my speech is to address the following four
questions:

i.c Why has India been hit by the crisis?

ii.c ßow has India been hit by the crisis?
iii.c ßow have we responded to the challenge?
iv.c What is the outlook for India?

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lc There is, at least in some quarters, dismay that India has been hit by the crisis. This
dismay stems from two arguments.
lc The first argument goes as follows. The Indian banking system has had no direct
exposure to the sub-prime mortgage assets or to the failed institutions. It has very
limited off-balance sheet activities or securitized assets. In fact, our banks continue to
remain safe and healthy. So, the enigma is how can India be caught up in a crisis
when it has nothing much to do with any of the maladies that are at the core of the
crisis.
lc The second reason for dismay is that India's recent growth has been driven
predominantly by domestic consumption and domestic investment. External demand,
as measured by merchandize exports, accounts for less than 15 per cent of our GDP.
The question then is, even if there is a global downturn, why should India be affected
when its dependence on external demand is so limited?
lc The answer to both the above frequently-asked questions lies in globalization. Let me
explain. First, India's integration into the world economy over the last decade has
been remarkably rapid. Integration into the world implies more than just exports.
Going by the common measure of globalization, India's two-way trade (merchandize
exports plus imports), as a proportion of GDP, grew from 21.2 per cent in 1997-98,
the year of the Asian crisis, to 34.7 per cent in 2007-08.
lc Second, India's financial integration with the world has been as deep as India's trade
globalization, if not deeper. If we take an expanded measure of globalization, that is
the ratio of total external transactions (gross current account flows plus gross capital
flows) to GDP, this ratio has more than doubled from 46.8 per cent in 1997-98 to
117.4 per cent in 2007-08.
lc Importantly, the Indian corporate sector's access to external funding has markedly
increased in the last five years. Some numbers will help illustrate the point. In the
five-year period 2003-08, the share of investment in India's GDP rose by 11
percentage points. Corporate savings financed roughly half of this, but a significant
portion of the balance financing came from external sources. While funds were
available domestically, they were expensive relative to foreign funding. On the other
hand, in a global market awash with liquidity and on the promise of India's growth
potential, foreign investors were willing to take risks and provide funds at a lower
cost. Last year (2007/08), for example, India received capital inflows amounting to
over 9 per cent of GDP as against a current account deficit in the balance of payments
of just 1.5 per cent of GDP. These capital flows, in excess of the current account
deficit, evidence the importance of external financing and the depth of India's
financial integration.

So, the reason India has been hit by the crisis, despite mitigating factors, is clearly
 India's rapid and growing integration into the global economy.

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lc The contagion of the crisis has spread to India through all the channels ± the financial
channel, the real channel, and importantly, as happens in all financial crises, the
confidence channel.
lc Let us first look at the financial channel. India's financial markets - equity markets,
money markets, forex markets and credit markets - had all come under pressure from
a number of directions. First, as a consequence of the global liquidity squeeze, Indian
banks and corporates found their overseas financing drying up, forcing corporates to
shift their credit demand to the domestic banking sector. Also, in their frantic search
for substitute financing, corporates withdrew their investments from domestic money
market mutual funds putting redemption pressure on the mutual funds and down the
line on non-banking financial companies („BFCs) where the MFs had invested a
significant portion of their funds. This substitution of overseas financing by domestic
financing brought both money markets and credit markets under pressure. Second,
the forex market came under pressure because of reversal of capital flows as part of
the global deleveraging process. Simultaneously, corporates were converting the
funds raised locally into foreign currency to meet their external obligations. Both
these factors put downward pressure on the rupee. Third, the Reserve Bank's
intervention in the forex market to manage the volatility in the rupee further added to
liquidity tightening.
lc „ow let me turn to the real channel. ßere, the transmission of the global cues to the
domestic economy has been quite straight forward ± through the slump in demand for
exports. The United States, European Union and the Middle East, which account for
three quarters of India's goods and services trade are in a synchronized down turn.
Service export growth is also likely to slow in the near term as the recession deepens
and financial services firms ± traditionally large users of outsourcing services ± are
restructured. Remittances from migrant workers too are likely to slow as the Middle
East adjusts to lower crude prices and advanced economies go into a recession.
lc Beyond the financial and real channels of transmission as above, the crisis also spread
through the confidence channel. In sharp contrast to global financial markets, which
went into a seizure on account of a crisis of confidence, Indian financial markets
continued to function in an orderly manner. „evertheless, the tightened global
liquidity situation in the period immediately following the Lehman failure in mid-
September 2008, coming as it did on top of a turn in the credit cycle, increased the
risk aversion of the financial system and made banks cautious about lending.
lc The purport of the above explanation is to show how, despite not being part of the
financial sector problem, India has been affected by the crisis through the pernicious
feedback loops between external shocks and domestic vulnerabilities by way of the
financial, real and confidence channels.

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lc Let me now turn to how we responded to the crisis. The failure of Lehman Brothers
in mid-September was followed in quick succession by several other large financial
institutions coming under severe stress. This made financial markets around the
world uncertain and unsettled. This contagion, as I explained above, spread to
emerging economies, and to India too. Both the government and the Reserve Bank of
India responded to the challenge in close coordination and consultation. The main
 plank of the government response was fiscal stimulus while the Reserve Bank's
action comprised monetary accommodation and counter cyclical regulatory
forbearance.

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lc The Reserve Bank's policy response was aimed at containing the contagion from the
outside - to keep the domestic money and credit markets functioning normally and
see that the liquidity stress did not trigger solvency cascades. In particular, we
targeted three objectives: first, to maintain a comfortable rupee liquidity position;
second, to augment foreign exchange liquidity; and third, to maintain a policy
framework that would keep credit delivery on track so as to arrest the moderation in
growth. This marked a reversal of Reserve Bank's policy stance from monetary
tightening in response to heightened inflationary pressures of the previous period to
monetary easing in response to easing inflationary pressures and moderation in
growth in the current cycle. Our measures to meet the above objectives came in
several policy packages starting mid-September 2008, on occasion in response to
unanticipated global developments and at other times in anticipation of the impact of
potential global developments on the Indian markets.
lc Our policy packages included, like in the case of other central banks, both
conventional and unconventional measures. On the conventional side, we reduced the
policy interest rates aggressively and rapidly, reduced the quantum of bank reserves
impounded by the central bank and expanded and liberalized the refinance facilities
for export credit. Measures aimed at managing forex liquidity included an upward
adjustment of the interest rate ceiling on the foreign currency deposits by non-
resident Indians, substantially relaxing the external commercial borrowings (ECB)
regime for corporates, and allowing non-banking financial companies and housing
finance companies access to foreign borrowing.
lc The important among the many unconventional measures taken by the Reserve Bank
of India are a rupee-dollar swap facility for Indian banks to give them comfort in
managing their short-term foreign funding requirements, an exclusive refinance
window as also a special purpose vehicle for supporting non-banking financial
companies, and expanding the lendable resources available to apex finance
institutions for refinancing credit extended to small industries, housing and exports.

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lc Over the last five years, both the central and state governments in India have made a
serizus effort to reverse the fiscal excesses of the past. At the heart of these efforts
was the Fiscal Responsibility and Budget Management (FRBM) Act which mandated
a calibrated road map to fiscal sustainability. ßowever, recognizing the depth and
extraordinary impact of this crisis, the central government invoked the emergency
provisions of the FRBM Act to seek relaxation from the fiscal targets and launched
two fiscal stimulus packages in December 2008 and January 2009. These fiscal
stimulus packages, together amounting to about 3 per cent of GDP, included
additional public spending, particularly capital expenditure, government guaranteed
funds for infrastructure spending, cuts in indirect taxes, expanded guarantee cover for
credit to micro and small enterprises, and additional support to exporters. These
stimulus packages came on top of an already announced expanded safety-net for rural
 poor, a farm loan waiver package and salary increases for government staff, all of
which too should stimulate demand.

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lc Taken together, the measures put in place since mid-September 2008 have ensured
that the Indian financial markets continue to function in an orderly manner. The
cumulative amount of primary liquidity potentially available to the financial system
through these measures is over US$ 75 bln or 7 per cent of GDP. This sizeable easing
has ensured a comfortable liquidity position starting mid-„ovember 2008 as
evidenced by a number of indicators including the weighted-average call money rate,
the overnight money market rate and the yield on the 10-year benchmark government
security. Taking the signal from the policy rate cut, many of the big banks have
reduced their benchmark prime lending rates. Bank credit has expanded too, faster
than it did last year. ßowever, Reserve Bank¶s rough calculations show that the
overall flow of resources to the commercial sector is less than what it was last year.
This is because, even though bank credit has expanded, it has not fully offset the
decline in non-bank flow of resources to the commercial sector.

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lc In evaluating the response to the crisis, it is important to remember that although the
origins of the crisis are common around the world, the crisis has impacted different
economies differently. Importantly, in advanced economies where it originated, the
crisis spread from the financial sector to the real sector. In emerging economies, the
transmission of external shocks to domestic vulnerabilities has typically been from the
real sector to the financial sector. Countries have accordingly responded to the crisis
depending on their specific country circumstances. Thus, even as policy responses
across countries are broadly similar, their precise design, quantum, sequencing and
timing have varied. In particular, while policy responses in advanced economies have
had to contend with both the unfolding financial crisis and deepening recession, in
India, our response has been predominantly driven by the need to arrest moderation in
economic growth.

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lc The outlook for India going forward is mixed. There is evidence of economic activity
slowing down. Real GDP growth has moderated in the first half of 2008/09. The
services sector too, which has been our prime growth engine for the last five years, is
slowing, mainly in construction, transport and communication, trade, hotels and
restaurants sub-sectors. For the first time in seven years, exports have declined in
absolute terms for three months in a row during October-December 2008. Recent data
indicate that the demand for bank credit is slackening despite comfortable liquidity in
the system. ßigher input costs and dampened demand have dented corporate margins
while the uncertainty surrounding the crisis has affected business confidence. The
index of industrial production has shown negative growth for two recent months and
investment demand is decelerating. All these factors suggest that growth moderation
may be steeper and more extended than earlier projected.
lc In addressing the fall out of the crisis, India has several advantages. Some of these are
recent developments. Most notably, headline inflation, as measured by the wholesale
 price index, has fallen sharply, and recent trends suggest a faster-than-expected
reduction in inflation. Clearly, falling commodity prices have been the key drivers
behind the disinflation; however, some contribution has also come from slowing
domestic demand. The decline in inflation should support consumption demand and
reduce input costs for corporates. Furthermore, the decline in global crude prices and
naphtha prices will reduce the size of subsidies to oil and fertilizer companies,
opening up fiscal space for infrastructure spending. From the external sector
perspective, it is projected that imports will shrink more than exports keeping the
current account deficit modest.
lc There are also several structural factors that have come to India's aid. First,
notwithstanding the severity and multiplicity of the adverse shocks, India's financial
markets have shown admirable resilience. This is in large part because India's banking
system remains sound, healthy, well capitalized and prudently regulated. Second, our
comfortable reserve position provides confidence to overseas investors. Third, since a
large majority of Indians do not participate in equity and asset markets, the negative
impact of the wealth loss effect that is plaguing the advanced economies should be
quite muted. Consequently, consumption demand should hold up well. Fourth,
because of India's mandated priority sector lending, institutional credit for agriculture
will be unaffected by the credit squeeze. The farm loan waiver package implemented
by the Government should further insulate the agriculture sector from the crisis.
Finally, over the years, India has built an extensive network of social safety-net
programmes, including the flagship rural employment guarantee programme, which
should protect the poor and the returning migrant workers from the extreme impact of
the global crisis.

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lc Going forward, the Reserve Bank's policy stance will continue to be to maintain
comfortable rupee and forex liquidity positions. There are indications that pressures
on mutual funds have eased and that „BFCs too are making the necessary
adjustments to balance their assets and liabilities. Despite the contraction in export
demand, we will be able to manage our balance of payments. It is the Reserve Bank's
expectation that commercial banks will take the signal from the policy rates reduction
to adjust their deposit and lending rates in order to keep credit flowing to productive
sectors. In particular, the special refinance windows opened by the Reserve Bank for
the MSME (micro, small and medium enterprises) sector, housing sector and export
sector should see credit flowing to these sectors. Also the SPV set up for extending
assistance to „BFCs should enable „BFC lending to pick up steam once again. The
government's fiscal stimulus should be able to supplement these efforts from both
supply and demand sides.

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lc Over the last five years, India clocked an unprecedented nine per cent growth, driven
largely by domestic consumption and investment even as the share of net exports has
been rising. This was no accident or happenstance. True, the benign global
environment, easy liquidity and low interest rates helped, but at the heart of India's
 growth were a growing entrepreneurial spirit, rise in productivity and increasing
savings. These fundamental strengths continue to be in place. „evertheless, the global
crisis will dent India's growth trajectory as investments and exports slow. Clearly,
there is a period of painful adjustment ahead of us. ßowever, once the global
economy begins to recover, India's turn around will be sharper and swifter, backed by
our strong fundamentals and the untapped growth potential. Meanwhile, the challenge
for the government and the RBI is to manage the adjustment with as little pain as
possible.

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Ensuring financial stability is a prime concern for monetary policy in India while maintaining
growth momentum at reasonable levels and giving a high priority to price stability. Financial
stability in India has been sought to be achieved through perseverance of prudential policies
which prevent institutions from excessive risk taking, and financial markets from becoming
extremely volatile and turbulent. As a result, while there are orderly conditions in financial
markets, the financial institutions, especially banks, reflect strength and resilience. Certain
policy measures, as described below, were adopted to ensure financial stability.

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The Reserve Bank used both monetary and regulatory measures to maintain financial
stability. This synergistic approach has been possible because the Reserve Bank is both the
monetary authority and the regulator of banks, non-banks and a large segment of the financial
markets. On the way forward, Indian financial markets will deepen and broaden further and
will also be increasingly exposed to the forces of globalisation. All this will have implications
for the financial stability. The Reserve Bank is conscious of the need to pay increasing
attention to financial stability and to improve the required skills in this area. As a beginning
in this direction, the Reserve Bank has set up a multi- disciplinary Financial Stability Unit to
put out a regular Financial Stability Report. The first report is planned in the next few
months. These reports will present an overall unified assessment of the health of the financial
system with a focus on identification and analysis of potential risks to systemic stability.

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In meeting its responsibility for financial stability, the Reserve Bank focuses on the
prevention of financial disturbances with potentially systemic consequences. The Reserve
Bank has policies in place that help prevent these types of disturbances or to respond in the
event that a financial system disturbance does occur.
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There are several ways in which the Reserve Bank attempts to reduce the likelihood of
financial instability. One is by laying the foundation for low and stable inflation and
sustainable economic growth. Crises often have their origin in periods of rapid and prolonged
credit growth, particularly when coupled with speculative activity and high asset price
inflation.Associated with this is the role that the Reserve Bank plays in monitoring the health
of the financial system. On an ongoing basis, the Bank assesses a range of aggregate financial
and economic data which help gauge the soundness of the financial system and potential
vulnerabilities. The results of such analysis are published half-yearly in the Reserve Bank¶s

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The Bank also works to ensure that the payments system is safe and robust, so as to minimise
the scope for difficulties at an individual institution to be spread to others. The Payments
System Board within the Bank has explicit authority for payments system safety and stability,
and has the backing of strong regulatory powers.

The Bank regularly shares its views on these matters with other relevant agencies.
Domestically, the main forum is the Council of Financial Regulators. The Council, which is
chaired by the Reserve Bank Governor, brings together the Bank, APRA, the Treasury, and
ASIC, with a mandate to contribute to the efficiency and effectiveness of regulation and the
stability of the financial system.Internationally, the Reserve Bank contributes to the debate on
the reform of the international financial system, primarily through its membership of the
Financial Stability Board (FSB). The FSB has a mandate to assess the vulnerabilities
affecting the financial system, identify and oversee action to address them, and promote co-
operation and information sharing among authorities responsible for financial stability.


 








The Reserve Bank¶s mandate to uphold financial stability does not equate to a guarantee of
solvency for financial institutions. The risk of loss or failure is a cornerstone of a competitive
and efficient financial system, and the Reserve Bank¶s mandate is not meant to be exercised
in a way which would compromise that principle.In exceptional circumstances, however, the
Reserve Bank may act to help minimise the costs of systemic financial disturbances. In
responding to such an event, the Reserve Bank may use its balance sheet to provide liquidity
to the financial system. It does so, wherever possible, by making funds available to the
market as a whole through its domestic market operations. The Bank would lend directly to
an illiquid deposit-taking institution authorised by APRA only if it was of the view that the
failure of the institution to make its payments could have serious implications for the rest of
the financial system. In principle, the Reserve Bank may also be willing to consider
applications for emergency liquidity support from non-APRA supervised institutions that
have been provided with an exchange settlement account by the Reserve Bank. The Reserve
Bank does not see its balance sheet as being available to support insolvent institutions.

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Like all other policy measures, maintenance of financial stability involves tradeoffs and
throws up a number of challenges. Important challenges that need to be addressed on the way
forward are the following:Some of the critical elements, as indicated below, of any financial
stability framework, need to be addressed:c

c Excessive volatility of macro-variables such as interest rates and exchange rates
which have direct impact on the real economy;

c uild-up of significant leverage in financial, corporate and household sector balance
sheets;

c The moral hazard risks posed by institutions that have become µtoo-big-to-fail¶ or too
interconnected or complex to resolve;

c Internal systemic buffers within the financial sector, both at the institution and
systemic levels, to counter potential shocks to the economy;

c Putting in place a strong policy and institutional mechanisms;

c Prevalence of unregulated nodes in the financial sector which, through their
interconnectedness with the formal regulated system, can breed systemic
vulnerabilities.

lc Second, the crisis has triggered an active discussion on an appropriate regulatory

structure that is best suited to safeguard financial stability. There are several
regulatory models around including those where the central bank is a pure monetary
authority with bank regulation and supervision vested with another agency. Post-
crisis, the emerging view is that the crisis was caused, at least in part, by the lack of
coordination and communication between the separate bodies and that it is optimal, in
the interest of financial stability, to entrust the function of regulation of banks and
non-banks also to i
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lc Third issue is managing the trade-offs between growth and financial stability. In order
to safeguard financial stability, the Reserve Bank has traditionally used a variety of
prudential measures such as specifying exposure norms and pre emptive tightening of
risk weights and provisioning requirements. But these measures are not always
costless. For instance, tightening of risk weights tempers the flow of credit to certain
sectors, but excessive, premature or unnecessary tightening could blunt growth. Thus,
 as in the case of price stability, central banks face the challenge of managing the
tradeoff between fá

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Fourth, reforming regulatory architecture is assuming significance as the central banks are
vigorously reinventing themselves and almost all countries are reviewing their regulatory
architectures. Two key lessons are driving this change: first that the responsibility for
financial stability cannot be fragmented across several regulators; it has to rest
unambiguously with a single regulator, and that single regulator optimally is the central bank.
Second, there is need for coordination across regulators on a regular basis and for developing
a protocol for responding to a crisis situation.

  

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