Recession has hit Indian exports and investment, its severity may harden in the coming quarters. The liquidity shock is palpable in India too. Surging outflow of foreign institutional investors (FIIs); vanishing external trade; liabilities of Indian bank branches abroad drying up and needing credit lines from home base and external financing for ambitious foreign acquisitions by corporates are increasing. All these are putting up pressure for domestic credit.

Fire Fighting by India

After dithering a bit, the RBI (and government) responded. The CRR was cut from 9 percent to 5.5 percent, injecting almost Rs 150,000 crores of primary liquidity in less than a month. The SLR was reduced 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.

The Repo rate (rate at which RBI lends to banks) was reduced from 9 percent to 7.5 percent, effective from early November. The RBI has also announced a plethora of other measures to shore up liquidity, liberalise terms for NRI deposits and external commercial borrowing (ECB), augment export credit refinance and reduce banks’ provisioning norms for loans for housing, real estate, personal loans, credit card receivables and capital market exposure.

No change in interest rate

Despite major loosening of monetary policy, demands from the industry for more reductions in policy interest rates are continuing. Four reasons are holding the hand in cutting interest rates in the near term. 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, further sharp cuts in both policy rates and the CRR will lose control over an already sliding currency as loser monetary policy puts downward pressure on the currency value. Inflation is still high. Given the general scarcity of capital and liquidity banks expect higher risk premia from most borrowers.

Borrowing was India’s bailout

The government’s record increase in true fiscal deficit of over 4 percent of GDP via the supplementary demand passed by Parliament in October points to heavy borrowing requirements from the government sector in the remaining months of the fiscal year.

Though additional fiscal stimulus compensates for declines in exports, investment and consumption demand, India already, had its fiscal stimulus. The government enacted the largest ever-supplementary demand for grants of Rs 2,37,286 crores in parliament and that reflected a record 33 percent increase over budget estimates. Bulk of this money went for government pay increases, fertiliser subsidy, National Employment Guarantee Programme, oil bonds, fertiliser bonds and the farm loan waiver.

This 4.5 percent of GDP supplementary to the budgeted fiscal deficit yields a true central fiscal deficit of nearly 7 percent of GDP for 2008/9. This is in addition to the further supplementaries that may come up and hoping that revenue targets are met. Even if the auction of 3G spectrum nets Rs 30,000 crores in 2008/9, it will only compensate for tax revenue shortfalls. In other words, a consolidated (Centre plus States) fiscal deficit of around 10 percent of GDP still seems quite likely. Put simply, India can ill afford further fiscal stimulus in the present year.

Exchange Rate Policy

Since the downward pressure on the rupee started a few months ago, government and RBI readily permitted a controlled slide, backed by substantial RBI forex sales from time to time. 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 but the havoc wrought by such a policy in Indonesia and other East Asian countries a decade ago can’t be missed. So, the only viable policy remains one of intervening selectively and avoiding excessively loose monetary policy.

In the coming months, the global recession may take its toll on the Indian economy, distress calls are bound to come for ‘bail outs’ from various segments of the economy. There may be not enough resources to bail out everyone who seeks help and selectivity has to be paramount. Bailouts are a must only for those entities whose demise poses systemic risk.

If the government can resolutely forge ahead with economic reforms, it might revive the investment mood. But then, the election coming and is not a time when prudent decisions work.