The Indian response to the global crisis

Financial Express, 21 October 2008

Many people in India feel that we are mostly cutoff from the world and that the dreadful events of London and New York do not affect us. This perception is based on an India which existed 10 years ago. Now cross-border flows of $1.3 trillion a year are 130% of the GDP of $1 trillion a year.

On Monday, 15 September, the money market in London froze up. On the same day, the money market in India froze up. Why? There are roughly 400 Indian multinationals. Many of them are users of the London money market. When they faced dollar obligations in London that they could not refinance in London, they borrowed in Bombay and sent money to London. Thus the money market shortage in London turned into a money market shortage in Bombay.

Jahangir Aziz, Ila Patnaik and I recently wrote a paper on these questions. Our first point is that the financial crisis that has afflicted the money market, banks and mutual funds needs to be resolved by public policy activism within days and not weeks. Finance needs to be put on its feet as soon as possible, for a second punch is coming: a global recession. India is now unprecedentedly integrated into the world economy, and the fall in growth in the US, UK, Europe and Japan will adversely affect India.

Indian firms will face lower prices and lower demand. In the short term, it is difficult to sack workers and adjust production contracts. In the short run, when shocks hit firms, financing is very important. When the second punch lands, what India needs most is a well functioning financial sector, which can engage in debt and equity financing, M&A, etc. in these troubled times. Some firms will undoubtedly go under - as they should in a well functioning capitalism. But if finance works well, the damage will be smaller; better firms (as judged by finance) will make it through the downturn.

The real shocks will come from October 2008 till October 2009. Our best tool for reducing the damage caused by these shocks is a well functioning financial system. Policy makers need to put finance back on its feet within days and not weeks, so that financial and non-financial firms can better navigate the difficulties of the coming year.

For both financial and non-financial firms, a key part of the story is how the private sector respects the capabilities of the government. Traditionally, governments in India have commanded very little respect. Politicians and bureaucrats are generally conceptually confused, are impeded from doing the obvious things by a minefield strewn with holy cows, and are simply unable to react to events rapidly enough. Such a government sector brings out the worst from the private sector. Financial and non-financial players make their plans assuming the worst in terms of the moves that the government will make.

In the last 35 days, the government has come out with a series of positive surprises. MOF, RBI and SEBI have worked smoothly together. Over this period, unprecedented policy activism has come about: a 250 bps cut in CRR, a 100 bps cut in the policy rate, a de facto 100 bps cut in SLR, the reversal of the mistakes on PNs of October 2007. All these moves are a break with the traditional functioning of RBI and SEBI. Mistakes have not been made: e.g. the political push for banning short selling has been successfully headed off.

It is a very impressive performance, and one that far exceeds what a wise cynic would have considered possible. Perhaps India is developing a mature economic policy capability after all. These positive surprises help GDP growth by bolstering the confidence of financial and non-financial players about the future. While we know we are in treacherous waters and more surprises will arise, perhaps the Indian government will perform its role more like a government of a mature market economy and thus reduce the damage caused by the surprises of the coming year. This trust in the policy process is a critical ingredient of becoming a mature market economy.

Much more now needs to be done to deal with the problems facing the economy. The problems of rupee liquidity and dollar liquidity of Indian firms (both financial and non-financial) have not yet been robustly solved. While the rupee money market seems stable, conditions could deteriorate sharply and suddenly unless deeper changes are made, such as cutting the SLR and bring oil/fertiliser bonds on par with government bonds for the purposes of repo and SLR. Capital controls need to be eased for NRIs, and FII purchases of rupee-denominated bonds need to be placed on par with FII purchases of equity. RBI needs to setup a program where it makes dollar liquidity available to Indian firms in predictable quantities at market prices. The idea should be to use reserves to bolster dollar liquidity and not to distort the rupee-dollar rate.

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