Mon, 27 Oct 2008

Policy Choices for India

Most of my posts in recent days have focused on the risks that I see for the Indian economy and the financial system rather than on the policy responses. Jahangir Aziz, Ila Patnaik and Ajay Shah (APS) address the question of policy responses in a paper that I mentioned in an earlier post. They recommend among other things that the policy makers should undertake the following measures:

• Increase rupee liquidity substantially with the CRR being cut to 5% and the SLR to 20% with a further de facto reduction in SLR by allowing oil bonds to be counted as SLR.
• Provide substantial dollar liquidity to the market in the form of currency swaps.
• Let go of the currency and allow it to fall.

I agree with the broad thrust of most of these recommendations. Unlike APS, I do not worry that these proposals would amount to over reaction, rather I fear that they would not be enough. I look at what Korea has done and believe that India’s responses can be only mildly milder than theirs. Neither India nor Korea needs to go to the IMF for dollar funds, but the good news really stops there.

Our reserves are sufficient to finance the current account deficit for a couple of years and to take care of the dollar needs of the banking system and a few systemically important entities. As in the case of Korea, the reserves are not enough for anything more ambitious, and we will have to take harsh decisions beyond that. Meeting the dollar needs of the entire corporate sector as APS appear to suggest would risk depleting the reserves to alarming levels. Defending the currency as the RBI has been doing is of course plainly unsustainable.

My main complaint with the APS paper is its title which makes it appear as if we are faced with only a liquidity crunch. No, I think we are faced with a much bigger threat to our economy than during the Asian crisis of 1997. As I have written in earlier posts, in terms of the evolution of the current crisis, we are only where the US was in September 2007. The big shocks are yet to come.

We have not yet had our Bear Stearns moment, but that moment will surely come. We have not yet had a collapse of the real estate market. The big real estate companies have been borrowing at 35-40% interest rates in the hope that the festive season (Diwali) will bring much needed home sales. This has clearly not happened, and November will perhaps see the first distress sales of property. Non performing assets in the financial system will probably start climb rapidly from then on. At least some banks, mutual funds and systemically important non bank finance companies will need some kind of bail out.

For the corporate sector, the real distress is still in the future as the large capacity expansion of recent years encounters a slowing economy. We are also yet to see the flood of cheap imports from countries like Korea that have let their currencies fall sharply. I fear that some East European currencies could collapse to the point where they become competitive with Indian IT and BPO companies unless the rupee itself goes into free fall. It is likely that aggregate Indian corporate earnings will decline significantly. A wave of corporate defaults will of course put further strains on the financial system.

As in the US and Europe, our government too cannot stop the carnage. The government can only try to mitigate its worst ill effects. Moreover the Indian government will have to be even more selective than other governments because it enters the battle with a rather weak fiscal position. If it tries to save everybody, then it will be in need of succour itself. Moreover, the government will face intense pressure for fiscal measures to boost the economy if necessary by monetizing the deficit.

Posted at 15:47 on Mon, 27 Oct 2008     View/Post Comments (8)     permanent link

Will Asia go on a fiscal binge?

In my last post, I argued that Asian currencies are likely to witness a round of competitive devaluations. The purpose of this post is to consider whether this could be accompanied by a fiscal binge as well.

But first some elaboration of my two fold argument for Asian devaluations. The first part of the argument is that reserves are large but not infinite – reserves may be drained rather quickly if the country tries to defend the currency. The Koreans found this out quickly. (My definition of Asia does not include Russia, but the Russians may also be in the same boat right now. Their half trillion dollar reserves are the third largest in the world, but they have already lost a tenth of it and clearly, this rate of reserve loss can not last forever).

Faced with this reality many countries will let the currency find its level and let the rest of the world deal with its consequences. Korea is today telling the rest of Asia what US Treasury Secretary, Jim Connally told his European counterparts back in the 1970s: “The dollar may be our currency, but it is your problem.” The added twist is that Korea is also telling its own corporate sector that the won is their problem, not that of the government. Many Asian companies will hear the same message. Any emerging market company with lots of foreign currency debt will lilkely find itself staring into the abyss.

The second part of the argument was that faced with a global recession that threatens to be a global deflation, currency depreciation becomes a desparate attempt to maintain exports. Commentators on my earlier post asked whether this can succeed. Of course, beggar thy neighbour cannot succeed if everybody tries it as the world found in the great depression, but that does not prevent everybody from trying it.

There will therefore be two kinds of currencies – those that are taken down by the markets and those that are taken down by their own governments. Some currencies will be somewhere in between – the markets will begin the job and the governments will finish it.

Now back to the fiscal implications. During the 1997 crisis, the discipline of currency markets was a strong factor in favour of fiscal restraint. This time around, that restraint will be lacking. In fact, the governments will be tempted to use fiscal boosts to lift the economy out of recession. Two statements from the just concluded Seventh Asia-Europe Meeting were interesting in this regard:

• Indian Prime Minister Manmohan Singh stated quite bluntly: “As a counter cyclical device, increased infrastructure investments in developing countries, if backed by increased resources flows from multilateral financial institutions such as the IBRD and Regional Development Banks, can act as a powerful stabilizer.” India has still not let go of its currency and so the call for support from the world bank makes sense. But the day the government decides that the rupee is somebody else’s problem, this support will be less important. Elsewhere in his speech, Dr Singh also quoted Keynes with approval.
• The statement of the Seventh Asia-Europe Meeting on the International Financial Situation contains this line: “Leaders called on all countries to pursue responsible and sound monetary, fiscal and financial regulatory policies, enhance transparency, inclusiveness, strengthen oversight, and improve crisis management mechanisms so as to maintain their own economic development and the stability of the financial markets.” This was remarkable for not talking about price stability or orderly exchange rates. One could argue that financial markets include currency markets, but in today’s context, the terms refers more to credit markets.

The fiscal binge (particularly when financed by the printing press) is just the currency debasement strategy applied internally rather than externally. It is a very powerful weapon against “debt deflation”, but the remedy can sometimes be worse than the disease.

Can the fisc substitute for the lost foreign demand? The fisc is ill suited to buying the stuff that Asia is used to selling to the now retrenching American consumer. The fisc is best suited to building roads to nowhere providing some support to the steel and cement industries which are now gasping for breath.

Posted at 04:11 on Mon, 27 Oct 2008     View/Post Comments (2)     permanent link