With exports declining and industrial growth likely to become negative, India is in 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 this will not happen. For while every government is worried sick by the prospect of recession, India is still cringing before the will-o-the-wisp of inflation.
<b1>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 of India (RBI) began relentlessly, to raise the cash reserve ratio (CRR) — the proportion of deposits that banks are obliged to keep with the RBI — and other associated borrowing rates to contain ‘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 CreditSuisse estimates that Rs 916,000 crore ($190 billion) worth of investment had been postponed by as much as a year-and-a-half before the global meltdown began.
As the meltdown began, and liquidity disappeared from the global financial system, foreign portfolio investors and hedge funds that had rushed to India during the previous 21 months began to pull their money out at the rate of $1 billion 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 would have turned within days into a crash. The crisis, therefore, galvanised the RBI into lowering the CRR by a full 2.5 percentage points 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.
Cash-rich public sector companies found, to their delight, that they could literally auction the right to hold their deposits to the highest bidder. The most telling indicator of distress was the attempt by companies that had invested in real estate to sell their unused land to raise cash. The fact that they were prepared 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. The prime lending rate (PLR) stayed up at 13.5-14.25 per cent, a full 4 percentage points above where it had been in 2006.
These multiple indicators of distress should have prompted the government to lower the CRR again, at least to the 5 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 percentage points, it pushed it back up again by half a percentage point. 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. So 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 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. Hence the absurd situation that when the US is contemplating a zero per cent interest rate, and China has announced a $ 580 billion revival investment package to be spent in two years, New Delhi is still trying to finetune a non-existent growth with an uncontrollable inflation.
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 1990s 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 to loosen the monetary reins and allow industry to respond.
Prem Shankar Jha’s latest book is The Twilight of the Nation State: Globalisation, Chaos and War.