How to ring-fence India from a global financial crisis: lessons from 2008

Dousing a fire.
Dousing a fire.
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The collapse of Lehman Brothers on Sept. 15, 2008 marked the beginning of the worst phase of the global crisis. But within hours of Lehman Brothers filing for bankruptcy, the Indian authorities had swung into crisis management.

The two key crisis managers in those early days were finance minister P Chidambaram and planning commission deputy chairman Montek Singh Ahluwalia. The worry for India was that the credit squeeze around the world meant credit would dry up, irrespective of the underlying credit worthiness of Indian companies and financial institutions.

Chidambaram’s instructions to the crisis managers at the Reserve Bank of India (RBI) and the government were precise. He wanted measures that could ensure three objectives: enough liquidity in the market; no run on banks; and no bank collapses resulting from asset-liability mismatch.

The day Lehman collapsed, the RBI and the other Indian regulators ring-fenced its Indian subsidiaries. Restrictions were placed on their operations, and they were prohibited from remitting funds out of the country.

Lehman’s operations were ring-fenced, and none of the toxicity could spill into the Indian financial system.

Indian authorities moved with alacrity in addressing liquidity issues as and when they arose, and there were no insolvency-type situations. But there was fearful apprehension of the possibility that there might be some.

The country’s second largest bank, ICICI, said it might have to set aside an additional $28 million (Rs 131 crore) to cover losses on investments in Lehman securities in the UK.

There were fears now of a run on ICICI Bank deposits. The bank made use of a massive communication campaign to send out messages and emails to its 27 million customers, saying,

“Dear customer, your deposits with ICICI Bank are safe. Your bank is well capitalised with good liquidity. Please do not listen to baseless rumours.”

CEO KV Kamath said the rumours were “baseless and malicious,” but they refused to die down. The governor consulted his senior advisers on how the RBI should respond to the reports about ICICI.

A statement was issued, saying that ICICI had enough liquidity, and RBI was ready to make more cash available to the bank, should it run short. A bland statement like this might seem banal from this distance of time, but in real time, it proved remarkably effective in calming the anxiety around ICICI. “ICICI’s leadership was, if I may say, a little nervous, and rather closed. That itself was feeding rumours about ICICI,” recalls Chidambaram.

He insisted that Kamath go on television and say that the bank was sound and that there was no need for any apprehensions about it. “It took a little persuasion. But I told him, ‘I’m very clear in my mind, you have to go on television and make this statement. Once you make this statement, I will come and support you,'” recalls Chidambaram.

Finally, after about a day or so, Kamath went live on television and said, “Hand on my heart, the deposits are safe.”

The Mumbai terror attacks

On Nov. 26, 2008, dastardly terrorist attacks struck Mumbai. The city shut down, but the terrorist attack was not allowed to impact the financial system.

Chidambaram was on the phone several times with (the then RBI governor Duvvuri) Subbarao, asking when the markets would reopen. He was particular that the regulators demonstrate to the world that India would not be cowed by terrorists and that our financial markets were too resilient to be hit by anything, even something of the magnitude of the 26/11 terror attacks.

The payment and settlement systems for financial transactions, the real-time gross settlement (RTGS) and national electronic funds transfer (NEFT), recommenced on Nov. 27, the day after the attack.

A breakdown could have brought commercial activity to a standstill, which would have sapped the confidence of an already shaken public.

On Nov. 30, Chidambaram, who’d had a stint as minister for internal security in prime minister Rajiv Gandhi’s government in the late 1980s, was appointed the union home minister after the incumbent, Shivraj V Patil, resigned, owning moral responsibility for the terror attacks.

Prime minister Manmohan Singh, a distinguished economist, decided to keep the finance portfolio with himself. Montek Singh Ahluwalia and the chairman of the economic advisory council, C Rangarajan, would assist him.

The rescue plan

Emergency fiscal measures were needed to stave off a GDP growth collapse. Ahluwalia and the team of economists entrusted with the job of crafting a rescue plan for the economy settled on a two-part fiscal response, supplementing the monetary measures being taken by the RBI.

In the beginning of 2008, before the Lehman collapse, Chidambaram had already announced loan waivers for farmers. At the time of the announcement, the move was motivated by political considerations ahead of the impending 2009 Lok Sabha elections, rather than sound economics.

But, with the financial crisis striking the economy unexpectedly, having a farm loans package in the pipeline proved felicitous—a case of getting a policy response right by fluke due to changed circumstances; not well-grounded policymaking.

Quickly pushing out the farm loan waivers became the first element of the response plan the government’s economists devised. The finance ministry processed the scheme with urgency.

Natural stabilisers formed the second set of responses. An economic collapse naturally reduces tax collections, but expenditures adjust slowly. It was decided to maintain the expenditures, which implied that the fiscal deficit could be expected to automatically expand.

Expenditure heads, technically called automatic stabilisers, were left untouched. The government’s detractors, and eventually urban voters even, were critical of this focus on rural spending, in particular the MGNREGA (Mahatma Gandhi National Rural Employment Guarantee Act). But to arrest the dampening effects of the global financial crisis, an immediate pickup in consumption was needed, without which, projections showed, a drastic fall in GDP would be near certain. Among the choices available, MGNREGA was the fastest and easiest way of putting money in people’s pockets.

Ahluwalia announced a ten-point fiscal stimulus package, a mini-budget of sorts, on Dec. 7. It included an across-the-board tax cut to bring down the prices of cars, cement, textiles and other products. An additional Rs20,000 crore was proposed to be spent on infrastructure that year.

In Mumbai, the RBI, to arrest moderation in GDP growth, provided monetary stimulus. It slashed its repo rate to 5.5% from 6.5%. It reduced the reverse repo rate from 5% to 4%. And it reduced the cash reserve ratio (CRR) of scheduled commercial banks from 5.5% to 5% to pour an additional Rs20,000 crore into the system to facilitate the flow of funds from the financial system to meet the needs of productive sectors.

This was over and above the over Rs3 lakh crore the RBI had pumped into the monetary system since mid-November 2008. Simultaneously, in Delhi, the government directed public sector banks (PSBs) to step up their lending with the additional liquidity that had been made available to them at cheaper rates.

“The measures that were put in place in those two and a half months (the period from Sept. 15 to Nov. 30 after which Chidambaram was moved to the home ministry) ensured that all three objectives were met: there was sufficient liquidity in the market; there was no run on any bank, which was my worst fear; and, no bank collapsed,” recalls Chidambaram. “Indian markets didn’t collapse. All over the world, markets collapsed.”

Excerpted from Puja Mehra’s book The Lost Decade with permission from Penguin Random House India. We welcome your comments at