Though India has largely remained unaffected by the ongoing financial crisis, the country is experiencing the knock-on effects, through monetary, financial and real channels – all of which are now slowing down the earlier higher growth of 8-9%.

The Indian financial markets? equity market, money market, forex market and credit market?have all come under pressure mainly because of what experts term ?the substitution effect? of: (i) drying up of overseas financing for Indian banks and Indian corporates; (ii) constraints in raising funds in a bearish domestic capital market and (iii) decline in the internal accruals of corporates. These factors added to the pressure on the domestic credit market.

The reversal of capital flows, caused by the global de-leveraging process, has also put pressure on our forex market. The sharp fluctuation in the overnight money market rates in October 2008 and the depreciation of the rupee reflected the combined impact of the global credit crunch and the de-leveraging process underway.

However, experts say one of the key features of the current financial turmoil has been the lack of perceived contagion being felt by banking systems in EMEs, particularly in Asia. The Indian banking system also has not experienced any contagion, similar to its peers in the rest of Asia.

A study undertaken by RBI on the impact of the subprime episode on Indian banks had revealed that no Indian or foreign bank, with whom the discussions had been held, had any direct exposure to the subprime markets in the US or other markets.

However, a few Indian banks had invested in collateralised debt obligations (CDOs)/bonds, which had a few underlying entities with subprime exposures. Thus, no direct impact on account of direct exposure to the subprime 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 credit spreads arising from the subprime episode on term liquidity in the market, even though overnight markets remained stable.

Consequent to the filling of bankruptcy under Chapter 11 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 a 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, is not significant and banks are reported to have made adequate provisions.

?We must note another vital difference between the crisis in advanced countries and the developments in India. While in advanced countries, the contagion spread from the financial to the real sector, in India, the slowdown in the real sector is affecting the financial sector, which in turn, has a second-order impact on the real sector,? says D Subbarao, governor, RBI.

India too has to weather the negative impact of the crisis. According to Subbarao, as the impact on India unfolds, there are two frequently asked questions: First, how is it that India has been affected when it came out of the Asian crisis relatively unscathed?

Second, why is India affected even when its exports account for only 15% of its GDP? The answer to both the questions lies in globalisation.

?We are certainly more integrated into the world economy today than ten years ago at the time of the Asian crisis. Integration into the world implies more than just exports,? he says.

India has also by-and-large been spared of global financial contagion due to the subprime turmoil for a variety of reasons. India?s growth process has been largely domestic demand-driven and its reliance on foreign savings has remained around 1.5% in the recent period. It also has a very comfortable level of forex reserves. The credit derivatives market is in an embryonic stage; the originate-to-distribute model in India is not comparable to the ones prevailing in advanced markets; there are restrictions on investments by residents in such products issued abroad; and regulatory guidelines on securitisation do not permit immediate profit recognition.

Financial stability in India has been achieved through perseverance of prudential policies, which prevent institutions from excessive risk taking, and financial markets from becoming extremely volatile and turbulent, says Rakesh Mohan, deputy governor, RBI Public sector banks continue to be a dominant part of the banking system. As on March 31, 2008, PSBs accounted for 69.9% of the aggregate assets and 72.7% of the aggregate advances of the scheduled commercial banking system. The average capital adequacy ratio for scheduled commercial banks, which was around 2% in 1997, had increased to 13.08% as on March 31, 2008. The improvement in the capital adequacy ratio has come about despite significant growth in the aggregate asset of the banking system.

In regard to the asset quality as well, gross NPAs of scheduled commercial banks, which were as high as 15.7% at end-March 1997, declined significantly to 2.4% as at end-March 2008. The net NPAs of these banks during the same period declined from 8.1% to 1.08%.

To check asset bubbles during the time of large credit expansion, in addition to the exercise of normal prudential requirements on banks, RBI successively imposed additional prudential measures in respect of exposures to particular sectors, akin to a policy of dynamic provisioning.

For example, in view of the accelerated exposure observed in the real estate sector, banks were advised to put in place a proper risk management system to contain the risks involved. Banks were advised to formulate specific policies covering exposure limits, collaterals to be considered, margins to be kept, sanctioning authority/level and sector to be financed. In view of the rapid increase in loans to the real estate sector raising concerns about asset quality and the potential systemic risks posed by such exposure, the risk weight on banks? exposure to commercial real estate was increased from 100% to 125% in July 2005 and further to 150% in April 2006.

In light of the strong growth of consumer credit and the volatility in the capital markets, it was felt that the quality of lending could suffer during the phase of rapid expansion. Hence, as a counter cyclical measure, RBI increased the risk weight for consumer credit and capital market exposures from 100% to 125%. However, after September 2008, the central bank, also as a part of counter-cyclical measures, has relaxed its earlier tight monetary policies from all fronts.

Says Mohan, ?There has been sustained demand from various quarters for exercising regulatory forbearance in regard to extant prudential regulations applicable to the banking sector. As a part of the counter-cyclical package, we have already made several changes to the current prudential norms. ??These include: (a) reduction in the risk weights for claims on unrated corporates and commercial real estate to 100%; (b) reduction in the provisioning requirement for all standard assets to 0.40%; (c) permitting housing loans to be restructured even if the revised payment period exceeds 10 years; (d) making the restructured commercial real estate exposures eligible for special treatment if restructured before June 30, 2009.

However, Mohan says the prudential regulatory norms ought not to be changed lightly, especially when markets are on edge. If the impression gains ground that the modified norms understate the extent of impairment and overstate asset quality in the banking sector, the markets could suspect the worst and needlessly penalise the banks through market discipline.

The Indian financial system may be under developed in many respects, but never lacks wisdom, which, as the global financial crisis shows, has been missing in developed countries.