By Shyamala Gopinath
Economic and financial conditions have improved following the unprecedented and coordinated response to the crisis. There has been discernible improvement in the financial sector and financial markets in particular, though some concerns in regard to the real sector and the high levels of unemployment persist in many countries. There is greater appreciation of the divergent situations and pace of recovery in different countries and that the process of withdrawal from the accommodative policies will need to be nuanced by the specifics of each country albeit in a coordinated manner. This spirit was captured in the final communiqué issued after the meeting of the G-20 Finance Minister and Governors which reflected the countries’ commitment to “to implement our plans flexibly, taking full account of variations in the pace of economic recovery and market conditions across countries and regions, and the complex interactions between different policy areas”

Indian Banking Sector Overview
The modern economic system depends on a reliable flow of financing through intermediaries such as banks, insurance companies securities companies and mutual funds. Although India has a well diversified financial system it is still dominated by bank intermediation. Important components of the financial sector in India broadly fall into categories viz banks, non-banking financial institutions and insurance sector. Commercial banks together with cooperative banks account for nearly 70 percent of the total assets of the Indian financial institutions.

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Significant financial deepening has been taking place in Indian economy over the years as seen from the credit-GDP ratios. A noteworthy feature discernible in the Indian context is that the rise in indicators of financial deepening takes place along with a noticeable rise in the domestic savings rate. This has to be seen in the backdrop of financial sector reforms, rise in total factor productivity and investment boom which has led to acceleration in the growth performance.

There are around 80 Scheduled Commercial Banks (SCBs) operating in India, including public sector banks, private banks and foreign banks. The banks have remained largely robust against the backdrop of global financial crisis, though there has been some slowdown in the growth of assets. The Capital to Risk-weighted Assets Ratio (CRAR) of banks in India has improved further to 13.2 per cent at end-March 2009 from 13.0 per cent at end-March 2008. The asset quality of banks has been improving over the past few years as reflected in the declining NPA to advances ratio.

It is especially noteworthy that notwithstanding the pressures of a slowdown in the economy and an atmosphere of uncertainty, the net NPA to net advances ratio increased only marginally to 1.1 per cent as at end March 2009 from 1.0 per cent as at end March 2008. Significantly, gross NPA to gross advances ratio remained constant at 2.3 per cent. Thus, in terms of the two crucial soundness indicators, viz., capital and asset quality, the Indian banking sector has exhibited resilience amidst testing times. It is noteworthy that contrary to the trend in some advanced countries, the leverage ratio (Tier I capital to total assets ratio) in India has remained high reflecting the strength of the Indian banking system. The growth rate of consolidated balance sheet of banks decelerated to 21.2 per cent in 2008-09 from 25.0 per cent in 2007-08. The growth rate was, however, higher than the nominal gross domestic product (GDP) (at current market prices) resulting in a higher ratio of assets of banks to GDP.

The growth rate of advances, which was as high as 33.2 per cent as at end-March 2005 has been witnessing a slowdown since then. During the year 2008-09, the growth rate decelerated to 21.2 per cent from 25.0 per cent in the previous year. During the current financial year, the growth has further declined to 4.3 per cent, which is significantly lower than the growth of 10.5 per cent in the corresponding period of last year. Several factors have contributed to the slowdown in non-food bank credit. One, overall credit demand from the manufacturing sector slowed down reflecting a decline in commodity prices and drawdown of inventories. Two, corporates were able to access non-bank domestic sources of funds and external financing – which had almost dried up during the crisis – at lower costs.

Three, unlike in the previous year, oil marketing companies reduced their borrowings from the banking sector as oil prices moderated. Four, a significant amount of bank finance has gone to the corporate sector through banks’ investment in units of mutual funds. Five, banks have also reined in credit to the retail sector due to the perceived increased risk on account of the general slowdown. This credit retrenchment was more pronounced in the case of foreign banks and private banks.

India has already committed to fully move to a Basel-II environment from April 1, 2010. The enhancements issued by the Basel Committee in response to the crisis will also be made applicable to Indian banks, as applicable to standardized/basic approaches.

The Way Forward
The immediate task of repairing the global financial system in the aftermath of the crisis has seen considerable progress with a broad agreement on the general principles for strengthening the prudential and regulatory framework for banks and the need to develop macroprudential frameworks and tools to monitor and assess the build up of macroprudential risks in the financial system and take action to limit such risks. The challenge, going forward, would be for the respective national authorities to take appropriate actions within the broad contours of the international approaches. There would indeed be certain issues requiring a more nuanced approach depending on individual countries circumstances. I would like to touch upon the key policy challenges for countries.

Policy challenges – Short-term
A. Exit from supportive policies:
In line with the discernible improvement in the economic outlook globally as also in India, attention has shifted from managing the crisis to managing the recovery. But the issue here is that given differences in prospects, monetary policies may begin to diverge considerably between the advanced and emerging economies. While the design of exit strategy, especially its timing in each country will largely depend on the respective macroeconomic and financial market conditions, factors like strong aggregate demand conditions and a well-functioning domestic banking system may pave the way for early, yet gradual, exit from the expansionary policy. There is, however, no doubt that given the level of integration among the economies, each country will also have to take into account the external factors.

It is, however, important to recognise though that the exit debate in India is qualitatively different from that in other advanced and emerging economies because of the unique features of its macroeconomic context, for the following reasons:

Most of these countries do not face an immediate risk of inflation, whereas India is actively confronted with an upturn in inflation. As per the latest information available, wholesale price index (WPI) inflation, on a y-o-y basis for the week ended October 17, 2009 was at 1.51 per cent largely on account of the base effect of sharp increases in prices recorded a year ago. However, there are emerging signs of underlying inflationary pressures. The inflation based on different CPIs continue to remain stubborn at double digits and the prices of food articles and essential commodities in WPI increased substantially on year-on-year basis. The momentum of WPI since end-March 2009 indicates that the WPI has increased by 5.9 per cent indicating emerging inflationary pressures.

India has the challenge of reviving domestic consumption and investment demand - the traditional dominant drivers of our growth. Households, firms and financial institutions in India are not struggling with impaired balance sheets unlike those in advanced economies.

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