BackTail wagging the dog
The Indian economy is heading into a state of financial friction that can cause real economic activity to collapse
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The Indian economy has seen many a recession. Increasingly, the concern is not going to be slow growth but instability in financial markets. The crisis is slowly engulfing all of them: currency, debt, equity, money and credit.
With the way these markets are integrated now—spillovers from one to the other are swift, sharp and sudden—instability in any of them has the potential to disrupt economic processes and performance.
These conditions in conjunction with turmoil in the financial markets have made the Indian economy vulnerable. Such vulnerability can alter the causality between the economy and markets in India: from the economy driving markets to markets driving the economy a la the US in 2008-09. The tail shall now wag the dog.
The Indian economy is now heading into a state of financial friction, a situation where the cost to one side of a transaction does not benefit the other side. For example, in debt markets, where the intermediary is a bank, friction drives up the borrower’s cost of funds without raising the payoff that the supplier of funds receives.
While macroeconomics lacks the tools for fully understanding what connects financial turmoil to economic collapse, it is now more or less established that a financial crisis causes real economic activity to collapse by raising frictions.
Given the underdeveloped nature of Indian financial markets, they are inadequately prepared to handle the stress on them from domestic developments and global factors. The dimensions of vulnerability are now visible in almost every single market.
On Friday, the rupee ended at an all-time closing low of 61.10 to a dollar. The rupee has depreciated rapidly since 22 May, when the US Federal Reserve first hinted at a possible tapering of its quantitative easing programme, triggering what was then a generalized sell-off in emerging market currencies and financial assets.
The Reserve Bank of India (RBI) fought the currency shock with an interest rate shock. While this textbook response may work when financial markets are efficient it is not the case in India today.
As such there is a risk that the negative effect of RBI’s measures on financial market stability and economic growth may far outweigh the beneficial effects, if any, on currency stabilization. Indeed, the debt and money markets have already been thrust into the whirlpool.
With repo borrowings now restricted to just 0.5% of banks’ net demand and time liabilities, the marginal cost of short-term borrowings for banks has shot up to the marginal standing facility rate of 10.25%. This has led to mayhem in money markets.
The one-year dollar-rupee forward premium is up by 146 basis points, the Mumbai inter-bank offer rate is up by 151 basis points while the one-year overnight index swap rate is up by a whopping 241 basis points.
This has worsened the already precarious liquidity situation which Indian firms and banks have been struggling with.
The risk of non-performing assets and defaults has risen significantly as companies and financial institutions will find it hard to raise short-term funds to manage their leverage. Additionally, bond investments are now facing huge mark-to-market pressures.
Debt markets aren’t faring any better. The benchmark 10-year government security yield has surged by around 75 basis points since the start of July and is now close to the levels last seen in December.
This rise in government yields will increase borrowing costs for the government, raising doubts whether the fiscal deficit target of 4.8% will be adhered to. This number becomes even more doubtful when one sees a reorientation in public expenditure policy from capital expenditure to transfer payments, particularly in an election year. The threat of a sovereign debt downgrade, thus, increases considerably.
The rise in rates will also feed into equity markets, as corporate profitability gets eroded further and growth prospects become dimmer. Foreign institutional investor (FII) inflows tend to have a high marginal impact on India’s equity markets and the FII equity portfolio at $250 billion dwarfs the debt portfolio of $30 billion.
With the rupee not being fully convertible, foreign exchange flows have a larger effect on the rupee than interest rate differentials. Thus there is a risk that the benefits, to the rupee, of a tightening in interest rates may be outweighed by the costs. This is a classic example of financial frictions across sectors or segments.
A partial patchwork liberalization of markets has meant that the linkage of Indian markets with global markets is incomplete.
This has tended to link Indian markets with the more volatile parts of global financial flows. These are not counterbalanced by the more stable components because of imperfections and rigidities. Indian markets are facing a crisis and are making the economy vulnerable like never before.
Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice.
To read Haseeb A. Drabu’s earlier columns,go to
www.livemint.com/methodandmanner
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