Capital ideas

Indian Express, 5 January 2009

The second stimulus package announced by the government and another round of rate cuts by the RBI are steps in the right direction and will help to ease the pain India will face in 2009. Since the crisis arose out of a crisis in finance, the focus is, quite appropriately, on opening up channels for access to finance. Fiscal space is limited, as seen in the Rs 20,000 crore package that amounts to less than half a percent of GDP. Removing interest rate ceilings for ECBs, increasing caps on FII investment in bonds, easing of restrictions on borrowing for real estate, reducing the repo, reverse repo and the CRR will increase the availability and lower the cost of credit for companies. However, while these measures will certainly help they may not be sufficient to contain the slowdown. While there is little scope for further fiscal action in the current fiscal year, there is need for action on at least three fronts. These include further cutting interest rates, immediate steps to develop the BCD nexus and further removal of capital controls. Though the government has said that it does not envisage any further measures in the current fiscal year, measures such as these which do not impact the fisc can and should be immediately implemented.

First, there is a case for RBI to cut rates even further. RBI can go all the way to a zero short-term interest rate, as some other central banks have done. To understand the case for cutting rates let us focus on the real rate, i.e. the short-term policy rate minus the expected inflation rate. What do current trends show? WPI inflation, based on point-on-point calculations using seasonally adjusted data, was above 8% (annualised) for each month from November 2007 till July 2008 which was a high inflation environment. But in September, WPI inflation was at roughly 0, and in October, it was -7.4% on an annualised basis.

Suppose we think that in the coming three months, annualised inflation will be -5%. In this case, a short-term interest rate of +5% implies a real interest rate of 10%. This is a highly restrictive stance of monetary policy which is not appropriate in a downturn. A scenario of -5% inflation with even a 0% policy rate giving a high value of the real rate at 5% is tight monetary policy. The RBI needs to continue aggresively cutting interest rates.

However, unfortunately while high interest rates can do damage, a sharp easing of interest rates is not going to have a large or immediate impact on the economy. The way monetary policy works is that the central bank makes changes to the short-term price of money. Through the `monetary policy transmission' these decisions reach out and influence the entire economy. This process requires the Bond-Currency-Derivatives (BCD) Nexus, the intricate system of markets through which small changes in the policy rate propagate out to influence rates across the economy. Unfortunately in India, the BCD Nexus is basically malfunctioning. The Patil, Mistry and Rajan reports have recommended actions for creating a BCD Nexus. But as of today, not many of these recommendations have been implemented.

As a consequence, monetary policy is largely ineffective. So while the RBI should cut rates further, we should not be particularly optimistic about its effectiveness.

In general, banks are a poor source of financing in a downturn. Banks have very little ability to absorb shocks of companies going bankrupt. Further, banks in India genearally lend to companies that are doing well. They do not have the expertise for examining companies which are presently facing difficulties but have the genuine strengths to thrive in the long term. This is usually the domain of private equity (PE) firms.

If banking is a not a good channel through which Indian firms can get credit in these difficult times, what are the good options? There are three possibilities.

The first is the removal of capital controls on NRIs. NRIs are Indian citizens, holding Indian passports. They are the vanguard of India's globalisation. It is in India's interest to give them a welcoming environment where they are able to bring money into the country. Today many NRI actually think of India as a safe harbour. Putting controls on NRI's bringing money into India is bad policy in general, but at a time like this, it is absurd policy. The RBI's response of tinkering with NRI deposit rates is woefully inadequate in terms of the large number of restrictions NRIs face in bringing money into India.

The second area of urgent action are the capital controls imposed on private equity and venture capital funds. These are investors, who can take a close look at firms, and inject risk capital into good businesses while monitoring the outcome. In a downturn their role is particularly important. While banks will not take the risk of lending to poorly performing businesses, such companies offer good investment opportunities to PE funds and those who believe in India's long term growth story. Of course, the role of bank finance for working capital will stay, but PE funding can be crucial for saving many a firm that may see distress in the coming year.

The third area for rapid action is the corporate bond market. Even when banks may not be willing to lend to companies due to their own constraints, there is a case for disintermediating banking and allowing individuals to buy corporate bonds. The regulatory framework must encourage this. Along with that, to help individuals, mutual funds and others lending to companies hedge their credit risk, a credit default swap market should be developed. At a sum a customer should be able to buy insurance against a company going bankrupt. To prevent making the mistakes that other countries made in this, such a market should be a well regulated exchange traded market with high transparency.

RBI's move on raising the limit for FIIs investing in Indian corporate bonds is on the right track. But much more needs to be done to get a corporate bond market going. Every day of delay in this hurts.

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