These are tough times. The monetary policy announced on 30 October paints a happy picture for India, with strong growth momentum and contained inflation. But all is not well with the world, and the policy statement deals extensively with global issues and their likely impact on the economy.
So, apart from the usual list of goals in the stance of the monetary policy, there is substantial emphasis in the report towards an added new objective which is, “to be in readiness to take recourse to all possible options for maintaining stability and the growth momentum in the economy in view of the unusual heightened global uncertainties, and the unconventional policy responses to the developments in financial markets”.
What are these unusual heightened uncertainties and unconventional policy responses? There is, of course, the subprime crisis in the US markets where big names such as Merill Lynch, Citigroup, Bank of America, Bear Stearns etc., are all in the process of what is politely called “restructuring”, but which essentially means cleaning up the mess in their portfolios.
Other fissures have erupted. With little trust between the banks, they withdrew into themselves, leading to a sharp drawing down of liquidity. The European Central Bank had to pour in funds to ease the situation, even as it acknowledged the presence of inflationary pressures. Credit card debt is becoming another potential breaking point; what Fortune magazine calls the $915 billion bomb in consumer wallets. Living off borrowed money can stretch only just so much and it looks like the time of reckoning is not too far off now. Naturally, a collapse in the housing market and consumer spending can spell disaster for the economy, and the probability of the US going into a recession next year has by some estimates increased to 60%. The Federal Reserve responded with a higher than expected rate cut in September and another one in October.
The reason why all this is of concern to us is that the solutions to problems abroad are complicating life for India. The US rate cuts put pressure to reduce domestic rates, but with the consumer price index running at above 7%, elevated prices of crude, metals and food, it is difficult for the Reserve Bank of India (RBI) to signal lower rates at the present moment. With funds poured in to ease liquidity abroad and more attractive rates here, money finds its way into Indian capital markets. And then there is the issue of currency speculation with the rupee.
Worse, the dollar has been declining globally, causing new problems. When the largest reserves of dollars are held outside the US, it is actually in the interests of countries such as China and India to keep the dollar up, and by fighting to do so, they are complicating their own domestic monetary management. There can only be a slow transition away from the standard of using the dollar as the world’s reserve currency.
Unfortunately, central banks can’t afford to be like the beach salesman in the Maldives who recently told Bloomberg columnist William Pesek, “You can keep your dollars!”
RBI’s concern about “unconventional policy responses” refers to the fact that central banks have not imposed any penalties on financial institutions for the tangle they have got themselves into. This could be that they see themselves as sharing the blame for lack of effective regulation, but as of now they seem to be led by the market, rather than leading it. In fact, there has been a lot of controversy about the rescue packages given to the banks. The US treasury is facilitating a special fund set up by banks to acquire the bad assets in the market and resell them to investors. Even though it is put forth as a “market solution” to the problem of bad debt as it does not involve public money, the government is actively involved in its organization; it is in effect a bailout for the banks. The episode of Northern Rock in England, where supervision and regulation broke down, is another story altogether.
For the average person who understands little of market complexities, it is bewildering to see the confusion, to see that those we trust with our financial security are themselves unsure of the future.
Trying to answer the question as to why regulators in Britain failed to check the crisis, Martin Weale of the National Institute of Social and Economic Research, UK, writes: “One senses that they were in the same position as Strabo, the geographer of Ancient Rome, who could see that the rocks on Vesuvius looked like those on Mount Etna, which he knew to be a volcano. But he did not reach the conclusion that there was a risk of Vesuvius erupting, let alone wiping out Pompeii and Herculaneum.”
In this monetary policy, RBI governor Y.V. Reddy has clearly outlined the shape of the volcano, stating that there may be little risk for India since our economy is resilient and diversified, but placed extreme caution ahead to avoid getting burnt or, worse, buried alive.
So, watch out for tough measures, such as curbs on inflows, if the crisis comes closer to our shores.
Sumita Kale is chief economist at Indicus Analytics. Comment at firstname.lastname@example.org