Economic Slow Down: Time to overreact

Friday, October 24, 2008

If there ever was a time when the government needed to overreact to a situation, it is now. The drying up of global liquidity after the bankruptcy of Lehman Brothers has hit financial markets across the board in India with astounding ferocity and speed. And with that, market uncertainty has spiked to unprecedented levels; rarely have we seen the stock market change direction by 500 points or more in a day, these many number of times, in this short a time. In this environment of hyper-uncertainty, traders, investors and businesses are likely to have overreacted and prices of equity, bonds, foreign exchange have probably overshot their fair valuations. Finely calibrating policy moves to meet the liquidity needs of businesses is an impossible task when there is this much uncertainty. Some businesses are looking for liquidity just to stay afloat, others may be pre-funding future needs, fearing the worst. How much of the future demand is being brought forward depends on how these businesses view the liquidity situation prevailing six months from now. And to assure businesses that adequate liquidity will be available not just today but also in the next six months and more, the government needs to overreact now. It isn’t as if the government has not reacted. Indeed, many have been pleasantly surprised at the speed at which the government has changed policy and that too in all the right areas. In the last month or so, the government has cut CRR by 250 basis points, the SLR by an effective 150 basis points, the repo rate by 100 basis points, increased foreign participation limits on corporate bonds, raised capitalisation of public sector banks, eased quantity and price limits on ECBs, reversed the restrictions on participatory notes and despite pressures has not banned short-sales. However, there is a sense that these measures are event-driven and reactive. What is needed is a set of standing liquidity-injecting facilities that will assure businesses that liquidity will be there if needed. In a paper co-authored with Ila Patnaik and Ajay Shah, we argued that given the underlying and proximate causes of the crisis there is a need to increase both rupee and dollar liquidity in a predictable manner. Last year, India received nearly 10 per cent of GDP in capital inflows. At that time we thought that this surge in capital inflows was a “problem”. This fiscal year, except for FDI, other sources of inflows have dried up. Today, we are being rudely reminded of how dependent our businesses, banks and mutual funds are on this inflow of liquidity. Why are foreign sources of liquidity this important? The reason lies in the funding models of Indian businesses, banks and mutual funds. For a while, Indian firms had been tapping global money markets for fund raising, often through the foreign branches of Indian banks. Many Indian banks have been relying on money markets, both domestic and foreign, to fund their loans. And before some of us start calling for a ban on such business models, let me stress that this is a well-accepted, safe and successful model, provided money markets work, which they did for the last 25 years and will do so once we get over the current liquidity crisis. So when global interest rates shot up after September 15, the rates at which the Indian firms could borrow rose, as did the cost of rolling over their maturing debt. These firms and banks turned to the Indian money market for funds, spiking the demand for domestic liquidity and for dollars as the funds raised needed to be converted into foreign exchange. The result was the upsurge in the call money rate and the sharp depreciation of the rupee. Domestic corporations typically place a significant amount of short-term funds with mutual funds to take advantage of the lower tax rate. When the domestic money market tightened, these corporations redeemed their investments to finance their own funding needs, setting off a wave of redemptions by mutual funds and plunging bond and stock prices. In the coming months and years, we will have time to gain distance from the current events, reflect on the crisis and debate reforms to the financial architecture to prevent a reoccurrence. But this is not the hour. Instead, the government needs to step up liquidity injection now; erring on the side of excess liquidity, not just enough. In our paper, to increase rupee liquidity we argued for cutting CRR to 5 per cent and SLR to 20 per cent, making oil and fertiliser bonds SLR-eligible, increasing the range of repo-eligible assets and even providing insurance against counterparty risk in interbank transactions. To raise dollar liquidity in a predictable manner, we argued for setting up a weekly dollar-swap facility against rupee-denominated assets and investing part of the foreign exchange reserves in one-year deposits in foreign branches of Indian banks. Some will argue that surely these measures will create too much liquidity and sow the seeds of the next asset price bubble and fan inflationary expectations. Perhaps. But if such signs emerge all these measures can be retracted. Indeed, all these measures can be made explicitly temporary. But they need to be done. The government not only needs to provide liquidity but also certainty. For the last, it needs to provide liquidity in spades.


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