Extraordinary times bring forth extraordinary solutions. Western governments and central banks have already gone to astonishing lengths to prevent an economic meltdown; the US Federal Reserve now buys dodgy mortgage derivatives and lends directly to non-financial companies through the commercial paper market.

The liquidity problem in India comes from the tumbling stock market rather than from a banking system that is frozen in fear. Foreign investors are dumping Indian shares and heading for the exits. They have sold rupees and bought dollars on the way out. The rupee has dropped to record lows.

The Reserve Bank of India (RBI) has tried to stabilize the currency by selling billions of dollars from its reserves in exchange for rupees. This has led to a domestic liquidity squeeze. Short-term borrowing costs for banks and companies are at multi-year highs.

Illustration: Jayachandran / Mint

Should interest rates be cut?

There are growing demands for lower rates, now that inflation has peaked and the signs of a sharp slowdown in growth are evident in the latest industrial growth numbers. The overnight index swaps market seems to be pricing in a rate cut in the new monetary policy that will be announced later this month.

We have two sets of concerns. One, inflation is still in double digits and we are not sure if it will drop below 5% because of the drop in global commodity and fuel prices. The disappointing first estimates of food production could lead to another spike in food prices. The steep fall in the rupee will push up the landed cost of various imports, including oil. That will not help inflation control.

Two, the rupee is under immense pressure. The government is now trying to attract foreign capital and pull in deposits from overseas Indians. Lower interest rates will not help either cause. Countries with an open capital account that are trying to defend their currencies usually raise interest rates; it is not clear to us how India can get away by doing the opposite.

We continue to stick to our view that policy interest rates should be maintained at current levels for now.

But what if the situation deteriorates further? Let’s not discount the possibility. This has already been termed the worst financial crisis since the Great Depression of the 1930s. During the 1997 Asian crisis, the US could be the liquidity provider of last resort; there is nobody like that right now. India has a structural defect—a large current account deficit that is financed by unstable equity and debt inflows. We are particularly at threat if global liquidity shrinks further in the coming months.

That’s when more unconventional cannons may be rolled out. Malaysia has closed its capital account during the worst months of the Asian crisis to prevent outflows. Hong Kong had intervened directly in the stock market to prop up share prices and hence the currency. We hope India does not go down these paths because they may end up as semi-permanent arrangements: renationalizations and a closed capital account. More than 15 years of reforms will be rolled back.

The real challenge will then be to attract foreign capital at a time of rampant risk aversion. There are several options that will have to be weighed. Floating a global sovereign bond issue? Allowing foreign investors into the domestic bond market? Special schemes for offshore Indians? Seeking money from sovereign wealth funds? Or maybe a few big-bang privatizations?

The textbook Plan A may work. If not, Plan B may have to be unconventional.

Given India’s structural problems, what will work: textbook solutions or out-of-the-box thinking? Write to us at views@livemint.com