The world is what it is

Indian Express, 21 October 2008

RBI's interest rate cut is among the many steps Indian policy makers need to take to reduce the impact of the global crisis on India. The global crisis has hit India at lightening speed. Governments across the world are trying to minimize the dislocation the financial crisis is causing to their economies. The Indian goverment has been reponding fast. It must now look forward and take steps to minimise the potential damage to the economy.

The global liquidity crunch became a full blown financial crisis on 14th September 2008 when world money markets froze in response to the Lehman Brothers bankruptcy filing. The response in India was instant. Call money rates in India on Monday, Setptember 15th rose to 9.8 percent, up from 6.15 percent on the previous working day. Two days later, on September 17th call rates were up to 13 percent and India was witnessing a sharp liquidity crunch. The speed with with the global crisis hit India is unprecedented. This event put an end to all notions of the Indian capital account being only partly open.

How might this have happened? In terms of numbers, the FII withdrawals in equity markets is not enough to explain the tightness in money markets even if the RBI sold dollars back to back to prevent rupee depreciation. there seems to be much more going on. A large number of Indian corporations are now operating overseas. As money markets dried up abroad, they are likely to have turned towards rupee markets to meet their dollar liabilities abroad. This might be a significant factor in the liquidity shortage that has arisen in India.

While this liquidity shortage has been addressed by the RBI through CRR cuts, and now the interest rate cut, there is concern that some sectors and activites will continue to face acute liquidity shortage. A recent paper with Jahangir Aziz and Ajay Shah examines the potential impact of the current liquidity crunch and offer some policy responses. One concern is that the downturn in the global economy will impinge on Indian firms. FIrms betting on the expansion of sales abroad, those with exposure to commodities, those with large leverage for their overseas expansions may suffer in the months to come. Their problems will get exacerbated unless there is adequate liquidity. A strong financial sector can help firms adjust during a crisis. If a firm is unable to get credit and is thus unable to do business, it will rapidly become insolvent.

In addition to the CRR and repo rate cuts, a number of additional steps are necessary. The RBI must reduce the SLR to 20 percent. This will allow banks to use the repo facility to a larger extent. To prevent bond prices from falling precipitously as a consequence quantitative restrictions on foreign holding of government bonds should be removed. Second, the RBI must make oil and fertiliser bonds both SLR and repo eligible. In addition to these bonds, the RBI must explore other avenues for enhancing the range of assets that are repo eligible. Third, at present most repo transactions are 1-3 days. On 14th October RBI has announced a 14 day repo window. To provide stability to the financial system the maturity needs to be extended to 1-3 months repos as well. Fourth, RBI should provide counterparty risk for interbank borrowing (at a price) to make sure that no rumours or glitches in the payment system lead to a loss of confidence in the interbank money market in the days to come.

To ease dollar liquidity in the market various avenues for easing capital controls must be immediately implemented. While the interest rate ceiling on external commercial borrowings have been raised, at the prescribed rates there are hardly a handful of Indian companies who can borrow at those rates. The policy framework should allow roughly 2 percent of GDP to come in through ECBs without interest rate controls. Rupee denominated corporate bonds should have no caps.

India must be the only country that follows a policy of positive discrimination against people of Indian origin. A foreign institutional investor has to give an undertaking saying that the funds being invested by it do not have NRI clients even in the second or third layer. In bank deposits there are interest rate ceilings imposed for foreign currency deposits that NRIs can invest in. At a time of crisis, when we need dollar inflows we should remove all these restrictions. NRI should be given access to Indian capital markets the way any Indian resident is. India's strong growth story and the relatively stable condition of the banking sector in contrast to the options NRIs have in other parts of the world may attract them to bring dollars to India, helping us ease the dollar liquidity shortage.

The redemption of equities in the stock market by FIIs as pressure from their clients rises could be more a function of the loss in confidence in them by their clients rather than a loss in confidence in the Indian stock market. This is a time to permit foreigners to invest in Indian markets without them having to take the risk of going through an investment bank who they no longer trust. While this may have limited impact in the midst of the crisis, as confidence returns to global equity markets Indian stock markets could gain from it.

In addition to these steps, RBI should take steps to help banks and corporates meet their dollar obligations and reduce currency mismatches that may be building up in the system. At the same time, it is important for the RBI not to try to prop up the spot rupee as that would only increase speculative outflows.

With a decline in global commodity prices and the decline in liquidity growth, inflationary concerns have eased. As confidence returns to global markets and the flight to US treasury bills goes down, the US dollar is likely to weaken. This will reduce the pressure on the rupee to weaken. Along with slower GDP growth in India and abroad, these factors will reduce inflationary pressure further. Already seasonally adjusted data is showing a decline in inflation rates. The RBI should now focus on increasing liquidity and protecting growth.

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