The world finacial situation is very bad. All over there are banks failing and filing for bankruptcy. Today a big Japanese insurer also filed for bankruptcy in the morning. This financial overboil is sure to spill into the other sectors now. The bubble is too big to control. After US, European banks have come to the panic scene. Iceland has declared that their economy is heading towards bankruptcy. They had put too much money outside Iceland in such mortgage bonds. Last 1 month, US banks like Morgan Stanley and Goldman Sachs who are cash hungry have withdrawn tons of money out of Indian markets. This has led to a fall of markets from 21000 to 10200 few minutes ago within a span of 6 months. This is not a good news for anyone. Everyone is losing money because of this.
The liquidity cruch has finally hit India. The worst part is that, the money that is being withdrawn is going out of India. This has taken toll on the rupee as markets are facing a shortage of USD. Dollar has touched 49 and is slated to cross 50 this time unless RBI pumps dollars in the market. However, it wont be of much use as final destination of that money too will be US which is already under recession.
Let me explain Indian situation again. We are close to 12% on inflation. People of India have way too much cash with them which is driving prices up. These cash rich individuals are investing in stocks. However as explained earlier, this money is going to US. So its a high risk proposition to dwindle your portfolios now. If the money is with people then it is not with the banks as economics goes this way. Banks are facing the crunch to sustain and honour their prior commitments on derivatives and asset trading. RBI shelved CRR by 150bps today. This will infuse cash into these banks to the tune of 60000 crore. However this money will also go to USA. The reason being that banks are non manufacturing entities. The only way they can make profits is by investing in markets or lending loans. Nobody needs loans now as rate is too high and people have enough money now. So other options they have is to invest in markets which is taking nose dives everyday. So this is a critical time for such banks. To honour their commitments they are lifting loans at exhorbitant rates. This is not going to help their books in anyways.
So now is the time that Manmohan and his team should pitch in. They should take money out of these individual investors who are not only losing money in the market to US, but also keeping the inflation rate at a very high level. One way could be to float high interest giving government bonds with a 7yr lockin period. This will attract these individual investors to these bonds. The money will then be safe with government who then doesn't have to reduce CRR anymore. They can directly loan to banks in distress at lower rates. These banks can then cut their interest rates and hence taking a loan will again become a interesting proposition. Thus one source of revenue for banks will be ensured. Once investors enter into bond agreements with government, the share markets will stabalise as the volumes traded will reduce. Thus volatality in the market can be kept at bay. This will also reduce liquidity in the market with people and distribute it to the banks where it should be. Once the money reduces in hands of people, the inflation will come down automatically. The dollar will stay at 50 for some time. Once share markets become less active the big investment banks will hold their trades for some time. This will stabalise dollar for some time. India cannot afford a high dollar as we depend more on imports than exports. So future will be costly for government, but in all this game its better that only government loses and rest of the economy stays stable. Dollar can only be stabalised by increasing your exports, be it services or manufacturing. Now the time has come when its imperative for India to earn lots of dollars from international projects where ever there is an opportunity. After 7 years who knows the economic cycle will change its course and government can then invest heavily in the stocks and recover whatever it was supposed to lose.
Another option is to have heavy taxation to reduce inflation. However with elections coming in January, government can exercise this option only after that. Before that above method can keep a check on situation. Later on taxes can be increased and good tax incentives can be given to locals public for investing money in government bonds. The money distribution has to happen. Its important to check inflation now and everything else can bee tackled!!!
So all in all following steps should help:
1) Government should sell high interest bonds to people with a lockin of 7 years
2) Lend this money at lower rates to banks and stabalise CRR
3) Increase taxes after 1 year to control inflation
4) Promote exports and give tax breaks for the same
5) Bring down trading volumes somehow to control volatality
6) Restrict government investments into stocks for now!
Please give me feedback on tha above method. If am wrong somewhere, I will correct it accordingly!!
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FII pullout is no doubt causing the stock market to go down. But not greatly. FIIs have pulled out $9.1 billion from Indian market (http://www.blonnet.com/2008/10/02/stories/2008100251971500.htm). That is above 32,000 crore. That explains the movement of rupee v/s dollar. However, we need to track movement of rupee v/s other currencies especially asian currencies. Asian FIIs are investing the Indian market. Also, FIIs are looking to invest in the more lucrative debt instruments (http://www.in.com/active18/watchnow/watchvideo_mc.php?autono=345077).
Is there a credit crunch in the Indian economy is however the real question? It is definitely true that Indian banks are feeling cash-pinched. But with interest rates hovering around 10% for fixed deposits, they can raise enough deposits. I guess the reason that banks haven't been able to raise deposits quickly is the hesitation on their part as well as investors' part. Investors as well as banks know that this inflationary period is only short term. Commodity prices (metal, oil, etc) have gone down. The effects will take time to trickle down to the economy. The transmission mechanism anyway is longer in India. Opportunities will open up in few months. It makes sense to hold on to cash for investors for now rather than get locked into long term deposits with bank where the returns will be relatively low once the market looks up. Indian bankers I suppose are aware of the situation and would just want to control burn-rate so as to survive this period, which I suppose they should be able to because of the steady income from home-loan interests (many of which were floating). Although, they might face a short term slowing of growth (or even decline). Indian Banks as even RBI has assured are in stable situation. The decrease in CRR also signals confidence in the long term solvency of Indian banks. CRR is the quickest mechanism to provide cash to banks so that they can survive this slump. The decline in stock prices is I believe due to a lot of profit-booking going on right now in Indian stock markets by ill-diversified domestic investors. Holding on to cash to enter a low points is the strategy. The monetary measures taken by RBI should hold good for a while and sustain economy. Regulatory factors will also make it easier for India to bear this through - such as lack of Full Capital Account Convertibility and restrictions on investing in the stock market for Banks and NBFIs.
Stabilize rupee v/s dollar is important, because it makes capital goods (dominant imports) expensive in India (current a/c deficit has grown to $11bn - http://www.business-standard.com/india/storypage.php?autono=335976). But capital costs are depreciable and can be borne over a relatively longer period of time by individual firms. Yes, dollars will be lost. Indian companies have started hedging against currency movements, however and losses may be restricted. Those who are planning to purchase equipments may delay their purchase. So I don't think there will be too much effect on Indian companies costs. Earnings capacity in short term will however be affected.
With major clients of IT services in trouble, we can expect some slump in our services-dominated exports. However, there has been considerable investment in manufacturing (automotive/steel primarily) in India of late. The low rupee dollar will help exports once the economy looks up. But rupee will not climb to 39 levels again for a long period of time. The interest rate arbitrage will reduce once interest rates in economy reduces. Along with liquidity issues in US economy, lack of unregulated investment banks, dollar flows won't be as fast as they were earlier. But they will start flowing and rupee-dollar will stabilize eventually.
I am not certain if fiscal measures should be employed now. It might be an adverse signal and might usher in liquidity for nothing. The best option for now is to let equilibrium return naturally in the Indian economy. The measures can be implemented - if situation in western economies becomes too severe - which is severe but not to the extent of recession (successive decline in gdp in two quarters : official definition of recession).
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