Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Policy Choices for India

Most of my posts in recent days have focused on the risks that I
see for the Indian economy and the financial system rather than on the
policy responses. Jahangir Aziz, Ila Patnaik and Ajay Shah (APS)
address the question of policy responses in a paper
that I mentioned in an earlier post. They recommend among other things
that the policy makers should undertake the following measures:

  • Increase rupee liquidity substantially with the CRR being cut
    to 5% and the SLR to 20% with a further de facto reduction in SLR by
    allowing oil bonds to be counted as SLR.
  • Provide substantial dollar liquidity to the market in the form of
    currency swaps.
  • Let go of the currency and allow it to fall.

I agree with the broad thrust of most of these
recommendations. Unlike APS, I do not worry that these proposals would
amount to over reaction, rather I fear that they would not be
enough. I look at what Korea has done and believe that India’s
responses can be only mildly milder than theirs. Neither India nor
Korea needs to go to the IMF for dollar funds, but the good news really
stops there.

Our reserves are sufficient to finance the current account deficit
for a couple of years and to take care of the dollar needs of the
banking system and a few systemically important entities. As in the
case of Korea, the reserves are not enough for anything more
ambitious, and we will have to take harsh decisions beyond
that. Meeting the dollar needs of the entire corporate sector as APS
appear to suggest would risk depleting the reserves to alarming
levels. Defending the currency as the RBI has been doing is of course
plainly unsustainable.

My main complaint with the APS paper is its title which makes it
appear as if we are faced with only a liquidity crunch. No, I think we
are faced with a much bigger threat to our economy than during the
Asian crisis of 1997. As I have written in earlier posts, in terms of
the evolution of the current crisis, we are only where the US was in
September 2007. The big shocks are yet to come.

We have not yet had our Bear Stearns moment, but that moment will
surely come. We have not yet had a collapse of the real estate
market. The big real estate companies have been borrowing at 35-40%
interest rates in the hope that the festive season (Diwali) will bring
much needed home sales. This has clearly not happened, and November
will perhaps see the first distress sales of property. Non performing
assets in the financial system will probably start climb rapidly from
then on. At least some banks, mutual funds and systemically important
non bank finance companies will need some kind of bail out.

For the corporate sector, the real distress is still in the future
as the large capacity expansion of recent years encounters a slowing
economy. We are also yet to see the flood of cheap imports from
countries like Korea that have let their currencies fall sharply. I
fear that some East European currencies could collapse to the point
where they become competitive with Indian IT and BPO companies unless
the rupee itself goes into free fall. It is likely that aggregate
Indian corporate earnings will decline significantly. A wave of
corporate defaults will of course put further strains on the financial

As in the US and Europe, our government too cannot stop the
carnage. The government can only try to mitigate its worst ill
effects. Moreover the Indian government will have to be even more
selective than other governments because it enters the battle with a
rather weak fiscal position. If it tries to save everybody, then it
will be in need of succour itself. Moreover, the government will face
intense pressure for fiscal measures to boost the economy if necessary
by monetizing the deficit.


One response to “Policy Choices for India

  1. Pingback: An Explanation of Whole Life Insurance — Life Insurance Basics

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