The global financial crisis, which had been simmering for over a year, came to a boil in September 2008 when major US and European financial institutions teetered on the brink of collapse and had to be bailed out by their respective governments and central banks. In a huge policy error, on September 15, the fourth largest American investment bank, Lehman Brothers, was allowed to go bust and filed for bankruptcy. Almost immediately, Western credit markets froze and massively amplified the recessionary forces at work in the US, Europe and Japan. Since then India and the rest of the world has been coping with the twin global shocks of a worldwide liquidity crunch and deepening global recession. The liquidity shock was immediate, with FII outflows surging, external trade credit vanishing, liabilities of Indian bank branches abroad drying up and needing to be substituted by credit lines from home base and external financing for ambitious foreign acquisitions by Indian corporates disappearing, thus forcing these companies to seek domestic credit. The recessionary shock has begun to hit Indian exports and investment and will likely intensify in the coming quarters.
How has Indian macroeconomic policy coped with these unprecedented challenges? What more needs to be done? Let us review briefly.
After a brief hesitation, the monetary policy response by RBI (and government) has been prompt and substantial. In the sharpest reduction ever, the CRR has been cut from 9 percent to 5.5 percent, thus injecting almost Rs 150,000 crores of primary liquidity in less than a month. In addition, the SLR has been reduced, effectively, to 21.5 percent (from 25 percent), with 1.5 percent points of the reduction earmarked for liquidity support by banks to mutual funds and NBFCs (since some of these entities had been experiencing substantial liquidity stress over the past month). The Repo policy rate has been reduced from 9 percent to 7.5 percent, effective early November. The RBI has also announced a plethora of other measures to enhance liquidity, liberalise terms for NRI deposits and external commercial borrowing (ECB), augment export credit refinance and (somewhat dubiously) reduce banks' provisioning norms (tightened during the earlier upswing in the credit cycle) for loans for housing, real estate, personal loans, credit card receivables and capital market exposure.
Despite this major loosening of monetary policy, there is a rising crescendo of demands from industry for more reductions in policy interest rates. In part this reflects the growing severity of the industrial downturn from global shocks; and in part it reflects increasing frustration with the continued high rates at which actual commercial lending and borrowing is taking place. There are at least four reasons why interest rates may not decline very much in the near term. First, even in normal times, the transmission of changes in policy rates to commercial rates is neither swift nor full. In the present environment of high financial stress, transmission is even weaker. Second, the RBI will find it hard to undertake further sharp cuts in both policy rates and the CRR without risking loss of control over an already sliding currency (looser monetary policy usually implies downward pressure on the currency value). Nor is inflation as dead as many assume. The annual rate of CPI (industrial workers) increase was still in uncomfortable double digits in October. Third, given the general (global) scarcity of capital and liquidity and rising stress among borrowers in a sharp slowdown, banks and other financial intermediaries in India will expect higher risk premia from most borrowers (yesterday's AAA client may only look single A today). Finally, the government's record increase in its true fiscal deficit, of over 4 per cent of GDP via the supplementary demand passed by Parliament last month, points to heavy borrowing requirements from the government sector in the remaining months of the fiscal year.
Additional fiscal stimulus is the global flavour of the season to compensate for declines in exports, investment and consumption demand. Sounds reasonable enough. The only problem is that we in India have already had our fiscal stimulus. Last month the government enacted the largest ever supplementary demand for grants of Rs 237,286 crores, reflecting a record 33 per cent increase over budget estimates. As Govinda Rao has lucidly detailed (BS, November 4, 2008), the bulk of this money has gone to pay for government pay increases, fertiliser subsidy, National Employment Guarantee Programme spending increases, oil bonds (or postponed oil subsidy), fertiliser bonds (postponed fertiliser subsidy) and the farm loan waiver. In his interaction with the press on the flight returning from the Washington G 20 summit last week, the Prime Minister pretty much implied that the fiscal stimulus for this year was mostly done, though his indication that it had all been anticipated by him and his finance minister at budget time remains a bit implausible. Adding this 4.5 per cent of GDP supplementary to the budgeted fiscal deficit yields a true central fiscal deficit (including off budget items) of 7 per cent of GDP for 2008/9. And this is assuming there are no further supplementaries and (even more heroically in a sharply slowing economy) that revenue targets are met. Even if an auction of 3G spectrum nets Rs 30,000 crores in 2008/9, this may only compensate for tax revenue shortfalls. In other words, a consolidated (Centre plus States) fiscal deficit of around 10 per cent of GDP still seems quite likely.
Put simply, we can ill afford further fiscal stimulus in the present year. Perhaps all the huffing and puffing about additional infrastructure spending is designed to boost spending next year, when subsidies for oil and fertilisers may be absent if the currently subdued international commodity prices persist.
Exchange Rate Policy
Since the downward pressure on the rupee started a few months ago, government and RBI have correctly permitted a controlled slide, backed by substantial RBI forex sales from time to time. (Contrary to popular perception, at least a third of the $60 billion drop in reserves is due to valuation changes, according to estimates of various investment banks). No better alternative policy is available. Defending a particular rupee/$ rate would invite swift and unwanted depletion of reserves. Allowing a "clean float" (no RBI intervention) sounds theoretically appealing until you recall the havoc wrought by such a policy in Indonesia and other East Asian countries a decade ago. The costs of "overshooting" on the downside could be hideously high, both in economic and political terms. So, the only viable policy remains one of intervening selectively and avoiding excessively loose monetary policy.
One other thought: in the months ahead, as the global recession takes its toll of the Indian economy, there may be distress calls for "bail outs" from various segments of the economy. Each would have its special case. Quite obviously, there may be not enough resources to bail out everyone who seeks help in a growth recession. Selectivity has to be paramount. A good starting point is to consider bail outs only for those entities whose demise poses systemic risk.
Finally, if the government can forge ahead with economic reforms, it might revive the investment mood. But then, the election season is upon us.
The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal.