India - The financial crisis & the Indian response

Arjun.K.Sengupta

After the international financial crisis even the most ardent market fundamentalists now recognise that markets often fail, and the governments have to correct the markets equitably and efficiently. But for that, the government actions have to be carefully designed, which policymakers often do not, because of their reluctance to give up orthodox market solutions.

During the current financial crisis the government seems to be following a similar conventional approach of market management, without directly addressing the source of the problem. Traditionally during a financial crisis, the Central Banks act as lenders of last resort, lending liquidity to the banks. In India, RBI is returning some of the liquidities of the banking system that it held as reserves. As a lender of last resort, RBI would provide such liquidity only to those banks who needed them.

No doubt our banks are suffering from liquidity crunch for some time, caused by our earlier policy of liquidity withdrawal to manage inflation. The RBI’s attempts to contain the fall in the exchange rate of rupee by selling dollar is also withdrawing rupees. Most important however is in a falling stock markets, FII investors take away dollars by surrendering rupees.

But injection of rupee by the RBI into the system will not necessarily increase bank lending unless borrowers have the confidence in the sustainability of our economy to induce them to increase their investment and the banks have the confidence that these borrowers will be able to pay back.

Missing element


The main element that is missing in the system is enough confidence of our economic actors in our ability to get over the crisis within a short period. In its absence, there is hardly any way that either the demand for credit and finance for investment or the bankers’ willingness to meet that demand can increase. This is a classic case similar to the Keynesian liquidly trap when a substantial increase in liquidity supply is only accumulated as cash or near cash instruments with little effect on investment expenditure.

In such situations, the government has to take steps to increase confidence in the system, and provide a stimulus to increase the rate of investment and expectations of revival of growth. Relaxation of liquidity shortage will be good, especially when it was the result of government’s policies. But, it may not be able to reduce the interest rates very much, even if the Repo-rate is brought down, because market expectations of non-sustainability of return may more than swamp the effects of a fall in cost of finance.

Only a policy to increase the rate of investment will be seen as promoting growth and revive confidence. When private investors are reluctant, we have to depend upon public investment to stimulate investment. We have a large public sector functioning with efficiency, as has been demonstrated by a sustained increase in its profitability. The government may mobilise some of our public sector corporations engaged in the sectors of power, transport, construction and communication to expand investment in our infrastructure. Many of these enterprises have long experience of successful execution of such projects, and if the programmes can be properly designed to share the risk and incentivise the success, these enterprises may again prove their worth and perform.

They also have substantial reserves to be able to finance some of these investments. But when they do not, the government may provide them with funds through deficit financing. We should try to increase in such investment compensated by reducing government expenditures in other areas. But if in spite of all that an increase in deficit is necessary, they should be financed openly by money creation, that is by the government borrowing directly from the Reserve Bank. The effect of that will be an increase in liquidity, exactly in the same way liquidity is increased through the reduction of CRR. In one case the RBIs liability will increase, in other case its assets will decline, with similar effect on money creation and inflation. But while the liquidity provided to the banks may not be translated into increased lending or investment expenditure, promoting investment of the PSUs in infrastructure will directly impact on our growth potential. Private investors will eventually regain their confidence in our prospects of growth and increase investment.

This policy of expanding real expenditure through a monetized budget deficit to finance infrastructure investment, can be compensated by a policy of expanding credit to the SMEs. This sector with only 10 per cent import content and with a proven ability to expand production through small amount of investment can very rapidly increase output and employment in our system. This sector has suffered most when the banks are in no mood to support SMEs with limited profitability and with practically no collateral. Only a directed public policy of providing financial support can galvanize them.

Stock markets


But the government also must attack directly the problem of loss of confidence in the stock markets. If this market continues to fall, not only the FIIs but also the domestic investors will move away. With a mark-to-market requirement of Basel -2, most of our corporate entities have severely suffered in their market capitalization, making it increasingly difficult for them to borrow not only for investment but also for working capital. This is exactly the situation when the financial crisis can quickly lead to a real economic crisis, with the corporate entities selling their assets for their borrowing requirements or just going bankrupt.

This calls for active government intervention in the stock markets to raise their values, through some kind of sovereign funds for purchasing stocks. Without buying designated assets, as some others are trying, we may use our mutual funds. They can do the job quite effectively with the minimum involvement of the government. A simple mechanism would be opening a window of lending to the mutual funds against their purchase of stocks or retaining them even when there is a high demand for redemption. To make this window attractive, this lending can be at variable interest rates, such as at a zero rate for the first six months, raising it steadily for every succeeding six months. If the mutual funds can invest in stocks whose prices go up quickly, they can retain the profits or pass them on to the investors, paying only a relatively small rate of interest. This is a simple mechanism which can have an immediate impact on our stock market.

The response of public intervention in a situation of market failure must be designed in such a way that attacks the problem at its roots. The government should use all its instruments with a clear objective. In the current situation the primary objective is to increase the confidence of all market participants in our potential for growth. Our fundamentals may be alright but the confidence in them has been grossly eroded. If a government programme can stimulate that confidence by investing in infrastructure, by allowing the small and micro enterprises to expand their output and employment and by increasing the private sector confidence in our stock market, it is highly likely that we shall get our the crisis.

(Dr. Sengupta is a Member of Parliament and former Executive Director of the International Monetary Fund and was a Member of the senior management team of the IMF, during the Debt Crisis of the late 1980s, as a Special Adviser of the Managing Director.)