Posted by: Pradeep | October 9, 2008

India and Liquidity crunch

India must respond proactively to the global financial crisis, with domestic policy measures and workable suggestions in coordination with other major economies, including China. These are extraordinary times, calling for extraordinary steps, even if these steps seem to take you into territory where well-behaved angels tread not at all. 

The most visible impact of the global crisis in India so far has been the plunging sensex. While this looks alarming, in reality, it is a buying opportunity for investors — for the Employees’ Provident Fund, the fund managers under the new pension scheme, insurance companies, etc, whose time horizon is at least three years. But the impact that will affect the real sectors most severely is the credit crunch arising from the global financial crisis. And this calls for active intervention by the government and the central bank. 

When asset prices fall, those who have invested in these assets sell. Those who have borrowed in order to invest in these assets sell even faster. The result is a self-reinforcing downward spiral for asset prices. Credit freezes up in two ways. All financial intermediaries that have borrowed heavily want to get rid of these borrowings — deleverage, in the jargon — rather than lend. And all of them find one another unworthy borrowers, given the pile of bad debt on everyone’s books. So they are reluctant to lend amongst themselves. The London inter-bank offered rate (Libor) has shot up, in consequence, even as the yield on government bonds has fallen. 

For the bigger Indian companies that have got used to raising cheap loans abroad, this comes as a double whammy. The interest rate on these loans is fixed as Libor plus a premium. Now, Libor and premia have gone up sharply. The rupee is depreciating like mad, on top of all this, adding to the cost of servicing a foreign loan. So, even while Indian regulators have kindly permitted greater foreign borrowings, the external loan window is effectively shut for Indian companies. Foreign convertible bonds are equally risky when share prices are in free fall. 

So, what this means is that these big Indian companies that have so far preferred to borrow abroad will now turn to the domestic market for loans. Since these are prime customers, banks will happily accommodate them, but won’t then be able to continue servicing their existing, relatively less premium customers. This would hurt their businesses and impact growth — unless there is a big surge in domestic liquidity. If $20 billion worth of foreign loans get substituted with domestic ones, the additional demand for credit would be upwards of Rs 90,000 crore. 

The government would also need to borrow an additional Rs 10,000 crore or so, just to add to the public sector banks’ capital, to enable them to maintain a healthy capital-to-assets ratio while expanding their lending on such a scale. In short, we need to increase liquidity drastically. 

Opening up FII investment in the debt market would be one solid step to increase liquidity. But that is not enough. The possibility of sharp depreciation of the rupee makes India a shaky investment destination. The RBI must be more proactive in managing both liquidity and the exchange rate. 

It should sell a larger portion of its dollar hoard. Why have these reserves, if not to use in an emergency? This would stop the rupee’s continuing fall, but it would also suck out rupees from circulation (those who want dollars would hand over the rupee equivalent to the RBI). This would worsen the liquidity crunch. So, the RBI must lose no time in buying back from the public a good part of the Rs 174,000 crore worth of market stabilisation bonds it has sold so far. The RBI would inject liquidity when it buys back the bonds. The Statutory Liquidity Ratio could be cut to permit banks to decumulate these bonds. 

In addition, the RBI must bring down the cash reserve ratio further, and follow other central banks in slashing policy rates. Inflation is yesterday’s battle — the global drivers of inflation, commodity prices, including crude prices, are down. The task now is to salvage growth, even as the rest of the world slows down in the wake of the global credit crisis. 

What can India suggest by way of global action? Many of the world’s leading banks with huge leverage desperately need additional capital, to maintain confidence in an increasingly distrustful world. Many of these banks operate globally, and have assets larger than the gross output of their home country (in contrast, the combined bank lending in India is less than 50% of GDP). Their home governments cannot capitalise them on their own. They need external capital. Capital is available with countries that have built up huge current account surpluses — oil exporters Saudi Arabia and Russia, China, Japan, etc. Such available capital is yet not getting readily deployed where it is badly needed. India could take the lead in facilitating such deployment in a multilateral framework. 

India will be impacted by the global crisis, but to no crippling effect. The severity of the impact will depend on how well the credit crunch is handled. The time to act is now.

Reproduced from TOI.


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