The International Financial Crisis and its Impact

CONVOCATION ADDRESS
by
Dr. C. Rangarajan
(Ex Governor RBI & Andhra Pradesh)
Member of Parliament, Rajya Sabha

I am extremely thankful to the Chairman and the Director for inviting me to deliver the
rd
43 Convocation Address of this Institute. The Indian Institute of Foreign Trade has emerged
as a leading management institution with a focus on the external sector. It has been ranked
among the top ten Business Schools of the country. The external sector is increasing in
importance. Exports and imports of goods and services taken together constitute more than
35 per cent of the GDP. The capital account is also emerging as a dominant segment of the
balance of payments. It becomes, therefore, necessary to pay special attention to the external
sector in terms of research and training. It is this gap which has been filled admirably by
IIFT.
Let me at the outset congratulate all those who are graduating today. Let me add a word
of special appreciation to those who are receiving awards. Youth is full of idealism and
ambition. Idealism without ambition may not achieve much. On the other hand, ambition
without idealism may be dangerous. May you combine the two in the right proportion. May I
wish you all the very best in the years to come.
The New Year has opened on a sombre mood. The world is passing through a difficult
time. More so, the developed world. The industrially advanced countries are now officially
in recession, having had two consecutive quarters of negative growth. It is not known at this
stage how long will this recession last and how deep will it be. This will be perhaps the
deepest recession in the post-second world war period.
The impact of the financial crisis is felt by the developing economies as well. Growth is
slowing down in all these countries. India’s growth rate in 2008-09 will be below 7 per cent
as compared to 9 per cent in the previous year. Prospects for 2009-10 do not appear to be
better. While in 2008-09 the first half escaped the impact of global recession, in the current
year the impact will be felt throughout the year. Globalisation spreads both prosperity and
distress. The contagion works both ways.

Evolution of the Crisis

The international financial crisis originated in the sub-prime mortgage crisis which
surfaced nearly two years ago in the US. With interest rates rising and home prices falling,
there was a sharp jump in defaults and foreclosures. However, this would have remained as a
purely mortgage market crisis but for the fact that these sub-prime mortgages were
securitized and packaged into products that were rated as investment grade. Once doubts
about these assets arose they turned illiquid; it also became very hard to price them. As a
result, it started affecting a host of institutions which had invested in these products. These
institutions were not confined to US alone. Financial institutions in Europe and to a much
lesser extent in East Asia had such assets on their books. With the failure of a few leading
institutions and most notably Lehman Brothers, the entire financial system was enveloped
into an acute crisis. There was mutual distrust among the financial institutions which led to
freezing up of several markets including the overnight inter-bank market. Many think today
that letting the Lehman Brothers to fail was a great mistake. The crisis in the financial system
has now moved to affect the real sector in a significant way.

Regulatory Failure
What stands out glaringly in the current episode is the regulatory failure. The regulatory
failure was two-fold. First, some parts of the financial system were either loosely regulated
or were not regulated at all, a factor which led to “regulatory arbitrage” with funds moving
more towards the unregulated segments.
The second failure lies in the imperfect understanding of the implications of various
derivative products. In one sense, derivative products are a natural corollary of financial
development. They meet a felt need. However, if the derivative products become too
complex to discern where the risk lies, they become a major source of concern. Rating
agencies in the present episode were irresponsible in creating a booming market in suspect
derivative products. Quite clearly, there was a mismatch between financial innovation and the
ability of the regulators to monitor them. It is ironic that such a regulatory failure should have
occurred at a time when intense discussions were being held in Basle and elsewhere to put in
place a sound regulatory framework.

Immediate Tasks
The immediate tasks before the authorities in the developed world are two-fold. One is to
fix the financial system and the other is to maintain the aggregate demand at a high enough
level to stimulate the real sector. Since it is the tail of the financial system that is wagging the
dog of the economy, the first priority is to take care of the financial system and this is being
done in a number of ways. Liquidity is being provided to key institutions which are locked
into assets that cannot be easily realized. In the US, the Federal Reserve has lowered the
policy rate to near zero. It has also injected liquidity in an abundant measure. Consequently,
the balance sheet of the Federal Reserve has expanded from $900 billion to $2.2 trillion. The
Troubled Assets Relief Programme of $700 billion approved by the US Congress is being
utilized to inject more capital into banks and other institutions. There was some doubt
whether the package will be used to buy distressed assets. The recent Gaithner proposal has
chalked out a programme to buy “toxic” assets. Some think that buying the assets is
important because this will lead to revival of markets such as housing. To stimulate the
economy, a massive revival package is being thought of in the US. This is a straight forward
application of the Keynesian prescription. The US Congress at the initiative of President
Obama has passed a stimulus package of nearly $800 billion.
Medium Term Concerns
Even as these immediate tasks are addressed, there are medium term concerns. Many of
the weaknesses of the financial system developed in an environment of very low interest
rates. Pushing interest rates below a level that is not sustainable can also have its
consequences. The US has been incurring heavy current account deficits year after year for a
decade or so. While analysts have been pointing out to the danger of such a situation, the
authorities have been brushing aside these concerns by saying that the US was the desired
destination for the investors. But the danger of such a situation is that once there is loss of
confidence, it can have serious consequences. The US must address this issue. A closely
related to this is the issue is of leveraging. Almost every segment of the US society including
households is a net borrower. Many of the institutions that have fallen into trouble in the
current episode are those which were highly leveraged. The net savings rate of the household
sector stands negative. It is true that in a globalised system a country’s investment rate is not
solely determined by its savings rate. Nevertheless, the extent of leverage is an issue which
regulators and policy-makers must pay attention, if financial stability is to be achieved.

International Co-ordination
The present crisis calls for co-ordinated efforts of all affected countries. First, a
simultaneous effort at stimulating the economy will have a profound effect on aggregate
demand. Second, the various countries must avoid protectionist policies. This is a lesson that
we have learnt from the depression of 1930s. Third, the international financial institutions
need to strengthened in order to enable them to meet the financial needs of poor developing
countries badly affected by the crisis. There are of course, some fundamental issues which
need to be addressed with respect to the international financial institutions, such as
ownership, voting power and management control.

Impact on India
The Indian financial system is not directly exposed to the “toxic” or “distressed” assets of
the developed world. This is not surprising since Indian banks have very few branches
abroad. However, the indirect impact on the economy because of the recession abroad is very
much there. The “decoupling” theory does not hold good.
The indirect impact is felt both through trade and capital flows. The fall in international
commodity prices and more particularly crude oil is reducing sharply the import bill from
previous estimates. The recession abroad is having an adverse effect on our exports of goods
and services. There is a sharp deceleration in the rate of growth of exports in 2008-09. The
decline in growth rate in exports will affect strongly some sectors where exports constitute a
significant proportion of the total production. Some examples are textiles, automobile
components and gem & jewellery.
In contrast, to the strong inflow of over $100 billion last year, this year may not see any
net increase in capital flows. Portfolio capital has already turned negative, with a significant
impact on the stock market. Indian firms may also experience difficulties in raising money
abroad. All this will impact the exchange rate.

Monetary and Fiscal Actions

The Indian financial system has not been affected in the same way the financial system
abroad has been affected for reasons already explained. However, there is the impact of the
drying up of liquidity because of the fall in reserves. The inability of Indian firms to raise
funds abroad, including trade credit, puts pressure on the domestic banking system for more
credit. It is, in this context, one must view the actions of the Reserve Bank in expanding
liquidity. Reduction of the CRR and repo and reverse repo rates are steps in the right
direction. It is necessary for the RBI to watch the liquidity situation and take such actions as
are necessary from time to time. It is being pointed out that the actions of the RBI have not
percolated to the ground level. People point to the slow growth in credit. Is this a case of
“taking the horse to the pond but cannot compel it to drink?”. The role of the Reserve Bank
of India is to create an environment in which additional credit can be made available.
Our fiscal actions to stimulate the economy have taken two forms. One is to cut excise
duty and the second is to enlarge government expenditure. Both should lead to stimulating
aggregate demand. It depends finally on whether the additional expenditures planned are
actually incurred. Also we need to look at the composition of expenditure and effectiveness
of expenditures. “Digging holes and filling them up” is not a right prescription. Expenditures
should be biased towards investment so that capacities can be created which can facilitate
growth later. That public spending should remain at a high level in a situation like the present
one is not a matter for dispute. The revised estimates of total expenditure for 2008-09 are 20
per cent higher than the budget estimates. With this increase in expenditure, the fiscal deficit
in the current year is estimated at 6 per cent of GDP, 3 percentage points above the FRBM
target. While it is correct to argue that the fiscal deficit target should be an average over the
cycle, we need to remember that even in boom years we have not been able to hold the deficit
at the target level. Keeping the target as a cyclical average is a good guidance in the medium
term. We should revert to the FRBM targets, as the economy begins to recover.
As far as India is concerned, we will see signs of recovery in the second half of 2009.
Fiscal 2010-11 will see a distinct improvement in growth.
It is contended by some that India “escaped” from a serious impact of the financial crisis
because financial sector reforms were not pushed forward. This is a false assertion. The
financial sector reforms in India are intended to improve the efficiency of the financial
system. Had we pushed hard in this direction, it would not have had any adverse effect. The
shock waves produced by the financial crisis will have their own effect on the structure of
capitalism. Acceptable capitalism would require more regulation. Future discussions must
centre around the nature and scope of such regulation. Run-a-way financial innovations that
are dysfunctional do more harm than good. There are the lessons that we can draw from the
current financial crisis.
*****
 Press Release

INDIAN INSTITUTE OF FOREIGN TRADE

43RD ANNUAL CONVOCATION

The 43rd convocation of the IIFT was held on 13th April 2009 at the Delhi campus, where students
from IIFT Delhi and Kolkata received their degrees in the presence of Dr. C. Rangarajan, Ex
Governor RBI and Andhra Pradesh and Member of Parliament, Rajya Sabha, Dr. G. K. Pillai,
Chairman IIFT, Shri K.T. Chako, Director IIFT Delhi, Dr. S. Bhatia, Chairperson (GSD), IIFT
Dehli, Dr. K. Rangarajan (H) Kolkata and many other dignitaries including the Professors and the
family members of the students.

During his convocation address, Dr. C. Rangarajan appreciated the students and advised them to
move further with appropriate combination of idealism and ambition. He emphasized the
importance of the external sector and admired the role of IIFT in filling the gap by its research
and training programs in facilitating the external sector. Focusing the convocation address on “the
international financial crisis and its impact”, the ex-governor spoke about the evolution of the
crisis and told that failure of the regulatory system in financial sector played major role in the
current financial crisis. He also suggested some immediate tasks like fixing the financial system
and stimulating the real sector by maintaining the aggregate demand at the high level.
Highlighting some of the medium term concerns of the developed countries, he pointed out that
these countries have to overcome the weaknesses of the financial system that developed in the
environment of very low interest rates. He mentioned that present crisis needs co-ordinated
efforts of all the affected countries. Discussing the impact of financial crisis on India, he said that
Indian financial system is not directly exposed to the “toxic” or “distressed” assets of the
developed world. Concluding his address, Dr. C. Rangarajan talked about the monetary and fiscal
actions and advocated that future discussions must focus around the nature and scope of financial
regulation.

Dr. G. K. Pillai, Chairman IIFT also addressed the convocation and praised IIFT for conducting
high quality research and executive training on the issues valuable to domestic as well as world
trade and business. Focusing his address around the financial crisis and its impact on India, Dr.
Pillai mentioned that the times when countries are suffering from financial crisis, the investment
in knowledge and skills needs to be safeguarded, as it will ultimately pave the way towards
recovery and prepare us to seize new opportunities. He also told about different programmes and
courses offered by IIFT that covers different areas of international business and are widely
accepted in the different industries. Addressing the meeting Dr. Pillai said that downturn in the
world economy will have its impact on India as well but the measures that the government has
been taking will prevent many of the downside risks of growth and ensure that we still have good
growth in the country.

He also informed that IIFT has strengthened its relationship with international organizations and
now it is member of the several International organizations and a large number of b-schools in
Europe and USA. Finally he appealed the graduating students to follow the ideals and education
which they have imbibed at IIFT for contributing to the ethics & value based management
practices and to the welfare of the people.