There are two sets of impacts of the US financial crisis. Internally, though the threat of a total financial collapse has receded, the real economy is starting to show the impacts of the rapid financial deleveraging now taking place: A sharp, and possibly prolonged, recession is going to happen. Globally, other economies are starting to see the same processes at work in their financial sectors and in real economic activity. We have gone quite suddenly from a situation of an unusually low cost of capital and low risk perceptions to one where borrowing costs and risk perceptions are very high. Irrational (in hindsight) exuberance has changed to fear. Is the fear irrational? Not in those countries that are going to suffer badly as they are crunched by the sudden loss of liquidity and access to global capital.
India is one of the better-off emerging markets. It has limited foreign exposure, ample foreign exchange reserves, a robust domestic economy, relatively good institutions, and savvy policymakers. The official growth projections are still above 7% for fiscal 2008-09, which is half over. Policymakers are taking comfort from non-official estimates of industrial production, which are higher than government figures. The real concern should be the following two years, when a global recession will bite deeply. But short-term challenges remain. Here are some challenges and suggested policy responses—the theme being, fix only the actual problems and tackle them closest to the source.
Liquidity. It seems that this is still an issue within India. Global financial markets are still a long way from normal. Short-term credit in the financial markets, trade credit for importers and exporters, and working capital for domestic producers are all being squeezed. Rather than wait for specific crises to arise, the Reserve Bank of India (RBI) may be better off being more proactive in providing more liquidity and certainty to the economy upfront, including further reduction in the cash reserve ratio. Looking at the US Fed and treasury actions over the last year, one cannot help but think the current crisis could have been less severe if liquidity and assurance had been provided more aggressively.
Solvency. Providing ample liquidity avoids creating artificial insolvencies, but some institutions may genuinely have to go to the wall if their assets, properly valued, do not cover liabilities. One area of vulnerability is the real estate sector. Other sectors where investment has been aggressive may also see weaker firms face problems. India has no proper bankruptcy laws. A potential crisis may be an opportunity to create some streamlined procedures for restructuring. There will be secondary effects on the banking sector if real estate and other loans start going bad, and loosening monetary policy may provide a cushion. Essentially, RBI has to try to engineer as soft a landing as possible from the real estate bubble.
Inflation. Looser monetary policy may seem like a bad idea when WPI inflation is running at around 11%. The RBI governor raised the inflation concern recently, just after loosening the monetary stance. But the headline number is a year-on-year figure. It is backward-looking. Monetary policy works with a lag. It has to be based on predictions of future inflation. Recently, monthly inflation was in the 4-5% range. The latest monthly figure is essentially zero. The global demand slowdown really removes inflation as an immediate threat, so there should be no holding back on shoring up the financial sector.
The falling rupee. Remember when the problem was just the opposite, and the rupee was “too high”? It seems that RBI has engaged in an exercise in total futility, trying to manage the level of the rupee. India is unlikely to see a speculative attack on its currency, given its decent domestic economic fundamentals. In fact, the rupee’s weakness right now is really the dollar’s strength. That, in turn, is likely to be a temporary phenomenon, until financial markets begin to recover. Using up foreign exchange reserves to defend some arbitrary level of the rupee seems to be pointless. Fighting currency volatility right now also seems pointless. Far better to give domestic firms as much freedom as possible to hedge currency risk individually as they see fit, through liquid, deep and well-designed currency futures markets.
The stock market. Foreign leverage and foreign capital contributed to the stock market run-up. Now the excess leverage and capital are going away. The Indian stock market itself is quite efficient, and will right itself. Its impact on the overall economy is still relatively small, in any case.
Domestic demand. One proposal to shore up demand is Keynesian investment in public infrastructure. That might eventually be needed, but it seems that the government has already done a lot to put money in the hands of the rural poor, at the cost of its own fiscal health. Given the long lags and inefficiencies in public infrastructure projects, it would seem better to focus on monetary policy remedies, and keep control of public finances. (Note: This article was written just before RBI’s latest announcements)
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org