Recessionary trends: Need for pragmatism

Resumption of high industrial growth and a decline in inflation can be achieved by India without extreme measures.
With exports declining and industrial growth likely to become negative, India is in imminent danger of plunging into a recession. But unlike the rich nations, and unlike China, a recession, or even a severe slowdown, is not unavoidable. The government has the option of making the present slowdown a short-lived one. But today it is doing everything it can to make sure that this will not happen. In the last seven weeks the Indian financial system has faced an unprecedented crisis of liquidity. But its origins lie 21 months earlier when the Reserve Bank began relentlessly, to raise the Cash Reserve Ratio (CRR) — the proportion of deposits that banks are obliged to keep with the Reserve Bank — and other associated borrowing rates in order to contain what it called ‘inflationary expectations’. This tight money policy had already pushed interest rates sky high and brought spending on real estate and consumer durables down steeply. When share prices also began to fall from January this year, Indian investors postponed their investment plans. A study just released by Credit Suisse estimates that Rs 916,000 crore ($190 billion dollars) worth of investment had been postponed by as much as a year and a half even before the global meltdown began.

As the meltdown began, and liquidity disappeared from the global financial system, foreign portfolio investors and hedge funds began to pull their money out of India at the rate of a billion dollars a day. The resulting crash in share prices caused Indian investors to panic. The demand for cash became an avalanche. Inevitably a few mutual funds were forced to defer repayment to their investors. This added to the panic.If the financial market had seized up the industrial slowdown that had already set in, it would have turned, within days, into a crash. The crisis therefore galvanised the RBI into lowering the CRR by a full 2.5 per cent to 6.5 per cent, and into creating an additional Rs 45,000 crore of borrowing facilities for the cash strapped banks. In all it released Rs 145,000 crore into the market but within a fortnight, as October turned into November, it became apparent that this was not going to be enough. The signal that market conditions had not eased sufficiently came from several directions. After pulling out of equity-based mutual funds, investors began to pull out of debt-linked, and therefore far safer, Fixed Maturity Plan investments as well. The need for cash to meet these demands tightened liquidity conditions in the market once more. The most telling indicator of distress was the attempt by companies that had invested in real estate to sell their unused land in order to raise cash. The fact that they were prepare to sell off their most precious assets for a song showed the dire straits that they were in. Most importantly, interest rates did not budge. These multiple indicators of distress should have prompted the government to lower the CRR again, at least to the five per cent where it had been in December 2006. But it was here that its paranoid fear of inflation surfaced again. Within days of lowering the CRR by 2.5 per cent, it pushed it back up again by half a percent. But this was only the beginning. Its response to the other signs of distress was uniformly the same: a sudden abandonment of the market economy in favour of a return to the Command Economy.Thus public sector companies were told not to shop around for high interest rates and to park their funds in the nationalised banks. The Foreign Investment Promotion Board hastily “clarified” that foreign and Joint venture firms would not be allowed to put their surplus land on the market. The penalty to investors for exiting prematurely from the Fixed Maturity Plans was sharply raised. And lastly, the public sector banks were told to bring down their PLRs to 11.5 per cent , never mind their cost of borrowing. It apparently did not occur to the government that times had changed and few bank managers, even in the public sector, would pay heed to these directives. It also did not occur to it that foreign investors would read into this sudden return to the bad old days a lack of respect for contracts and think twice before returning to India. The one remedy that it was determined not to try out was to increase the supply of money in the economy, for fear that it just might, somehow, prevent inflation from dying out.The pity of it is that India can have both a resumption of high industrial growth and a decline in inflation without having to adopt any of the extreme measures that China or the US are contemplating. The second bumper harvest in a row is within weeks of arriving in the market. As the late 90s showed, this is bound to lead to a sharp increase in rural sales. And the first of three years of salary and pension increases to central and state governments has just begun. As happened in 1998-2000, the bulk of this money will go into consumer durables. All Delhi has to do is loosen the monetary reigns and allow industry to respond.