ABSTRACT
While most of the world’s attention has been focused on the growth and dynamism of China and the East Asian region, South Asia has quietly been growing at 6.8 per cent per year over the past decade. While people are becoming more aware of the Indian growth story, its South Asian neighbours, Bangladesh in particular, but also Pakistan and Sri Lanka, have also experienced growth spurts. Increased openness to trade particularly in the past decade has no doubt been an important factor behind the region’s robust growth.1 Greater private capital inflows have also played a role in promoting growth, particularly in India.2 However, this increased openness also implies that, like its East Asian neighbours, India and some of the other South Asian countries were not immune to the financial crisis, particularly following the collapse of Lehman Brothers in September 2008. This was in sharp contrast to 1997-8 when India and its South Asian neighbours were by and large unaffected by the severe financial crisis that started in Thailand and engulfed most of the rest of East Asia. The 2008 global financial crisis and the ensuing global economic slowdown hit the South
Asia region at a bad time. The region was recovering from the impact of high global fuel and food prices. Before the crisis, while growth in the region was robust, demand management policies in most countries were somewhat problematic, with high fiscal deficits, high inflation, and unsustainable current account deficits (Figure 11.1). Most of these problems were related to the fact that, since 2000, the South Asia region has experienced one of the fastest rates of credit growth in the world, outpacing growth rates in neighbouring East Asia (Figure 11.2). This in turn was due to the fact that South Asian economies, and India in particular, were beneficiaries of a ‘virtuous cycle’ of large capital inflows, low interest rates and high investments. With the unfolding global financial crisis, domestic credit markets tightened considerably and the ‘virtuous cycle’ was broken. The cost of funds for banks spiked and they became increasingly risk averse in their credit decisions. As a result, throughout the region, even established corporate sector players were finding it hard to access financing on either domestic or international markets. As the credit crunch hit the region it constrained private sector investment activities,
consequently halting the region’s economic growth. Asset prices deflated quite sharply (Figure 11.3). There was a marked rise in the perceived risk as measured by credit default swaps (CDS) (Figure 11.4).3 Balance sheets of the private sector, particularly from the financial sector,
deteriorated as non-performing loans (NPLs) rose.4 The South Asian policy makers tried to counter the impact of the crisis using a combination of fiscal and monetary policy responses. From the monetary policy side, the drop in global commodity prices and reduced inflationary pressure created room for accommodative monetary policies to thaw the tight credit markets and try and revive bank lending to firms and households. From the fiscal side, the only South Asian government that provided an economy-wide
fiscal stimulus was India, which amounted to 0.5 per cent of its GDP (i.e. average per cent of GDP in 2009/10). Bangladesh also provided a fiscal stimulus, though its fiscal stimulus was more targeted to help the non-apparel export industry in the amount of a modest US$500 million.5 As apparent from Figure 11.1, the fiscal balance and public debt in India increased in 2009 vis-à-vis 2008. Pakistan and Sri Lanka, on the other hand, were constrained somewhat — at least in principle — as they had both approached the International Monetary Fund (IMF)
for assistance and their fiscal stances were more limited by the IMF conditionalities they had agreed to. To be sure, Sri Lanka missed its fiscal target (attempting to stimulate the economy following the economic and political crisis/civil war) but the IMF still approved the loan disbursements under the Stand-by agreement in late 2009.6 Pakistan has faced a much harder budget constraint. Thus, as Figure 11.1 shows, while Pakistan’s fiscal balance was curbed in 2009, that for Sri Lanka rose sharply from 2008. It is fair to say that, given the limited fiscal space that was available for policy makers in
South Asia, monetary policy was the most aggressive line of defence in South Asia to combat the negative fallout from the global financial crisis. Given this fact, the rest of this chapter concentrates on the monetary policy responses of the major South Asian countries, India, Pakistan, Sri Lanka and Bangladesh, and revisits the monetary policy transmission mechanism and, in particular, the role of the banking system in this process.
