Impact on the Indian Banking System

In India, the adverse effects have been mainly in the equity markets because of reversal of portfolio equity flows, and the concomitant effects on the domestic forex market and liquidity conditions. But real estate, retail, IT/ITES, banking and export have also been affected. The macro effects have so far been muted due to the overall strength of domestic demand, the healthy balance sheets of the Indian corporate sector, and the predominant domestic financing of investment. As might be expected, the main impact of the global financial turmoil in India has emanated from the significant change experienced in the capital account in 2008-09.

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Total net capital flows fell from US$17. 3 billion in April-June 2007 to US$13. 2 billion in April-June 2008. Nonetheless, capital flows are expected to be more than sufficient to cover the current account deficit this year as well. While Foreign Direct Investment (FDI) inflows have continued to exhibit accelerated growth (US$ 16. 7 billion during April-August 2008 as compared with US$ 8. 5 billion in the corresponding period of 2007), portfolio investments by foreign institutional investors (FIIs) witnessed a net outflow of about US$ 6. 4 billion in April-September 2008 as compared with a net inflow of US$ 15.5 billion in the corresponding period last year. Similarly, external commercial borrowings of the corporate sector declined from US$ 7. 0 billion in April-June 2007 to US$ 1. 6 billion in April-June 2008, partially in response to policy measures in the face of excess flows in 2007-08, but also due to the current turmoil in advanced economies. With the existence of a merchandise trade deficit of 7. 7 per cent of GDP in 2007-08, and a current account deficit of 1. 5 per cent, and change in perceptions with respect to capital flows, there has been significant pressure on the Indian exchange rate in recent months.

Whereas the nominal exchange rate appreciated from US$1 = Rs. 46. 12 in September 2006 to US$ 1 = Rs. 40. 34 in September 2007, it has depreciated to a level of US $ 1 = Rs. 47. 42 as on December 18, 2008. With the volatility in portfolio flows having been large during 2007 and 2008, the impact of global financial turmoil has been felt particularly in the equity market. The BSE Sensex (1978-79=100) increased significantly from a level of 13,072 as at end-March 2007 to its peak of 20,873 on January 8, 2008 in the presence of heavy portfolio flows responding to the high growth performance of the Indian corporate sector.

With portfolio flows reversing in 2008, partly because of the international market turmoil, the Sensex has now dropped to a level of 10076 on December 18, 2008, in line with similar large declines in other major stock markets. The domestic investment is largely financed by domestic savings. However, the corporate sector has, in recent years, mobilized significant resources from global financial markets for funding, both debt and non-debt, their ambitious investment plans. The current risk aversion in the international financial markets to EMEs could,

therefore, have some impact on the Indian corporate sector’s ability to raise funds from international sources and thereby impede some investment growth. Such corporate would, therefore, have to rely relatively more on domestic sources of financing, including bank credit. This could, in turn, put some upward pressure on domestic interest rates. Moreover, domestic primary capital market issuances have suffered in the current fiscal year so far in view of the sluggish stock market conditions.

Thus, one can expect more demand for bank credit, and non-food credit growth has indeed accelerated in the current year (26. 2 per cent on a year-on-year basis as on September 12, 2008 as compared with 23. 3 per cent a year ago). A detailed study undertaken by the RBI in September 2007 on the impact of the subprime episode on the Indian banks had revealed that none of the Indian banks or the foreign banks, with whom the discussions had been held, had any direct exposure to the sub-prime markets in the USA or other markets. However, a few Indian banks had invested in the collateralised debt obligations (CDOs) / bonds which had a few underlying entities with sub-prime exposures.

Thus, no direct impact on account of direct exposure to the sub-prime market was in evidence. However, a few of these banks did suffer some losses on account of the mark-to-market losses caused by the widening of the credit spreads arising from the sub-prime episode on term liquidity in the market, even though the overnight markets remained stable. Consequent upon filling of bankruptcy by Lehman Brothers, all banks were advised to report the details of their exposures to Lehman Brothers and related entities both in India and abroad.

Out of 77 reporting banks, 14 reported exposures to Lehman Brothers and its related entities either in India or abroad. An analysis of the information reported by these banks revealed that majority of the exposures reported by the banks pertained to subsidiaries of Lehman Bros Holdings Inc. which are not covered by the bankruptcy proceedings. Overall, these banks’ exposure especially to Lehman Brothers Holding Inc. which has filed for bankruptcy is not significant and banks are reported to have made adequate provisions.

In the aftermath of the turmoil caused by bankruptcy, the Reserve Bank has announced a series of measures to facilitate orderly operation of financial markets and to ensure financial stability which predominantly includes extension of additional liquidity support to banks. Although foreign trade does help an economy, it also becomes vulnerable to external shocks as has happened with the US financial crisis which has now affected India’s key sectors including information technology, banking and commodities.

As foreign trade rises, more and more products are imported. Much of our value-added spices exported are based on raw spices imported into the country in large quantities. It is true that the government has always provides sops to boost the agricultures and allied businesses, but the major focus was sometimes on imports. Exports fell by 12 percent in October and the government has cut its export target for the year to 175 billion US dollars from 200 billion.