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.