by Arvind Subramanian, Peterson Institute for International Economics
Op-ed in the Business Standard, New Delhi
October 24, 2008
© Business Standard
"Brand India" is being buffeted by the global financial crisis. India has been more financially integrated than was generally supposed, and hence more affected by financial contagion than expected. The stakes are high because policy hesitancy or missteps can turn mild contagion into virulent disease.
One lesson that countries are learning is that during a crisis of confidence, policymakers have to get ahead of the curve in order to reassure markets. Governments have discovered the hard way that responses that are reactive, piecemeal, and uncoordinated risk undermining rather than adding to confidence. A formidable policy arsenal needs to be deployed to have any chance of restoring stability. In western financial markets confidence is returning, slowly, only after a series of ambitious actions, boldly initiated by the United Kingdom and then followed by Europe and the United States.
Between last week's actions to shore up the financial system and Monday's cut in interest rates, Indian policymakers can legitimately claim to have risen to the challenge. But will these actions be enough? What more will be necessary?
Broadly, more will need to be done on the financial sector side in order to do less on the monetary policy side. Put differently, if confidence in the financial system is not restored, the easing, even substantial easing, of monetary policies that we have recently seen may not have enough traction, and may even entail risks.
First and foremost, the plight of individual financial institutions should be addressed. A benchmark should be that no Indian bank should have credit default swap (CDS) spreads exceeding 300 or so basis points. It is likely that perilously elevated CDS spreads reflect problems with foreign funding. So, high on the action list would be to provide foreign currency resources from the Reserve Bank of India's (RBI) reserves. The RBI's liquidity injections operations that have so far been in rupees need to be expanded to foreign currency.
One way to do this would be to hold foreign currency auctions for all domestic financial institutions to meet either their own needs or those of their corporate clients that face foreign currency funding pressures. The Federal Reserve and European Central Bank responded to dollar shortages in Europe through extensive swap operations that made available enormous lines of dollar credit in European markets. The RBI foreign currency auctions should be held quickly and flexibly so that liquidity can virtually be provided on tap. The RBI's foreign exchange reserves have been accumulated for rainy days, and these are not just rainy but stormy days, justifying their liberal use today.
If these measures prove inadequate, the government may need to step in to guarantee the foreign-currency debt of domestic financial institutions. This may need to be complemented with government recapitalization, especially if private banks are unable to raise capital from private sources within a very short period of time. India just cannot afford to have financial institutions that are flashing amber or red in these times.
Moving beyond individual institutions, and given the crisis of confidence, it may be worth requiring all banks to raise their capital adequacy ratio (CAR) to about 15 to 18 percent, within a short period. If meeting this higher CAR requires additional government capital injection, that should be seriously considered. Ways could be found for this capital to be returned to the government once the crisis subsides. If all banks were seen to be meeting this high standard, it could have a significant impact in reassuring markets. The rationale for the higher CAR, apart from the confidence boosting impact, is the more substantive one that banks' nonperforming assets are bound to rise as the economy weakens. An apparently cushion-providing 15 percent CAR today could very easily become an 8 percent CAR within a short space of time.
Next, it might be worth imposing additional transparency requirements on all the major banks to reassure investors and the public. Uncertainty in this environment leads to markets believing the worst. All banks should therefore be required to immediately clarify and publish key variables of concern, including foreign currency exposure, especially on the liability side, the extent and sources of wholesale funding, and exposure to derivatives and other such instruments. A strong transparency effort, under the RBI's supervision, could have an important reassuring function.
Finally, what about exchange rate and monetary policies? On the former, the RBI should refrain from foreign exchange intervention, which at the moment sends contradictory signals because it sucks out liquidity at the very time that the RBI is pumping enormous amounts of liquidity back into the economy. Far better to use the RBI's foreign exchange reserves to meet the foreign funding requirements of domestic financial institutions rather than to defend some level for the rupee.
On monetary policy, the RBI has been doing the juggling act of easing interest rates and injecting rupee liquidity, on the one hand, while trying to encourage capital inflows and discourage outflows through a variety of measures such as raising interest rates on foreign currency deposits. Make no mistake that there is an inherent tension, even plain contradiction, between these actions, which the RBI has been able to avoid because residents, unlike foreign investors, are not fleeing rupee assets. The risk of aggressive easing is that it might trigger the move away from rupee holdings, at a time when confidence in the rupee is so shaky, when current and prospective depreciation would offset the favorable effects on inflation from declines in commodity prices, and when credit is still growing at a whopping 30 percent. It is worth noting that while the repo rate has been cut to 8 percent, the call rate—which reflects market conditions—is at 6 percent, below CPI inflation, resulting in negative real interest rates.
A loss of confidence in the rupee is an outcome devoutly to be avoided. At this juncture, restoring confidence in individual financial institutions and the financial system is key to achieving that objective and to avoid unreasonably burdening monetary policy.
"Brand India" has come to connote not just rapid growth but a reasonable ability of policymakers to respond to challenges. Of course, this response will be assessed by outcomes. But critical to this assessment will be whether processes for arriving at outcomes are effective, and specifically, whether all concerned institutions play their rightful roles and maintain their credibility. "Brand India" must pass all these tests.
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