An agenda for difficult times
Indian Express, 30 September 2008
The financial crisis in the US has created ripple effects all around the world. As a result of our globalisation, in India too, we have seen the impact of this crisis at various levels. Stock prices have declined, foreign investors have pulled money out of India, the rupee has depreciated, and business confidence has slipped. Capital flows into India are today being affected by credit market conditions and stock market volatility in the US and global business cycle conditions.
There are two fronts on which policy makers in India need to repond immediately. First, lower capital inflows pose a problem at the moment as they would push down the rupee, something India can ill afford when inflation is high and oil imports form a huge part of our import bill. A lower rupee will worsen inflation.
But we know that India has a number of restrictions on capital inflows. There are ceilings on foreign borrowing of corporate and government bonds, external commercial borrowings, and in equity markets through restrictions on instruments like participatory notes. These self-imposed restrictions can be eased so that for the foreign capital that wants to come into India, it is not the Indian government that is coming in the way. Saumitra Choudhuri, member of the Prime Minister's economic advisory council has remarked recently that we should not persist with flood control measures during a drought. Easing of capital controls will help, even though marginally, to pull in inflows. The impact will admittedly not be large at this time because the main constraint we face is the drying up of liquidity in global financial markets.
The second front on which policy makers must respond immediately is to reduce the impact of the global liquidity crunch on Indian firms and investment in the country. Over the last few years, though Indian industry and its needs have expanded rapidly, there have been few improvements in the functioning of the domestic financial system. There has been little improvement, for example, in the domestic corporate bond market. This has pushed Indian firms to look outwards. As foreign finance becomes scare, Indian firms will have to rely more on domestic resources. The government, along with regulators like SEBI and RBI must put this issue on top priority. They should try to do whatever possible so that the lack of liquidity does not pull down investment and growth in India.
The US Treasury and the Fed are today trying to figure out how to reduce the impact of the global crisis on the real economy. Indian policy makers need to play their own war games and find ways to reduce the impact of the US financial crisis on India. This means easing capital controls against ECBs, PNs, foreign participation in the bond market, and barriers which have been placed to prevent bond market development.
It is imperative that at a time like this we must be prepared for the worst. Policy makers in India must acknowledge that GDP growth in India is likely to get adversely affected if the US economy witnesses a recession due to the financial crisis. Take, for example, the case of the IT sector. Today, the Indian IT sector employs more than a million workers and earns 7 percent of GDP. This sector, we may find, in the event of a downturn in the US economy, is vulnerable. It may witness job losses as financial firms shut down. Further, US imports are likely to shrink with a decline in US incomes and the unwinding of global imbalances. All these factors could lead to a slowdown in the Indian economy.
Monetary policy needs to recognise that the outlook for GDP growth has changed, and that global inflation has subsided considerably. Difficulties of the operating procedures of monetary policy have been showing up, with the call rate shooting above the corridor all the way to 16 per cent. RBI needs to now respond to these tight liquidity conditions in the money market and to the prospect of a slowdown. The steps taken to tighten liquidity in the market over the last few months need to be reversed. To prevent a drying up of liquidity to firms, the RBI should ease the Cash Reserve Ratio (CRR) which was hiked sharply over the last one year to suck liquidity out of the banking system. In addition, as the RBI intervened in foreign exchange markets and build up reserves, it had sterilised its intervention through sale of MSS, the monetary stabilisation scheme bonds. Now that RBI is selling dollars to prevent the rupee from sliding further, it should simultaneously buy back MSS bonds. This will help put liquidity back into the system.
For the last one year, there has been a huge sale of oil bonds to banks as the goverment borrowed for meeting the shortfall in revenues of oil companies thanks to price controls on the domestic price of oil. These bonds were, however, not eligible for meeting the SLR (Statutory Liquidity Ratio) requirements of banks. This meant that banks purchased oil bonds over and above their purchases of government bonds worth 25 percent of their assets. Both put together pre-empt a large amount of bank assets and reduce the availablility of funds to the private sector. To increase the availability of credit to firms, the RBI must make oil bonds SLR eligible.
In summary, India needs to mount a strong response to the changed conditions. The response involves two things. FIrst, this is an opportune time to press forward on capital account liberalisation, and the development of the bond market. Second, the outlook on GDP growth has darkened, and global inflation has eased. It is now time for RBI to shift into easing. This involves buying back MSS bonds, cutting CRR, making oil bonds SLR eligible and reforming the operating procedures of monetary policy.
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