Column : Liquid, but now what

Written by Bibek Debroy | Updated: Oct 18 2008, 05:29am hrs
The discussion should now shift from increasing liquidity to questions of what happens to that liquidity. Of measures announced so far, cut in CRR is the most significant, though quite clearly, the market expects further cuts in CRR, perhaps to around 6%. How important are reductions, permanent or temporary, in SLR, or even changes in definitions of SLR so as to grant banks more flexibility SLR is a minimum requirement. There may be the odd bank that has found 25% (or even 24%) to be a binding constraint. But in general, banks have far more in government paper, probably fairly close to 35%. The generic question remains. Why do banks find government paper more attractive The answer has to do with risk-aversion (partly due to some laws) towards lending and interest rates on government borrowing. In similar vein, few banks have capital adequacy ratios lower than 12%. Should interest rates on non-resident deposits be artificially high Given sentiments, and possible rupee depreciation, will that trigger capital inflows Even if it does, should one create distortions in rates For similar reasons, will an increase in FII investment limits in corporate bonds trigger inflows Or should one instead focus on generic reforms that can develop the domestic corporate bond market

On the liquidity issue proper, several questions still remain. First, government borrowing cannot be indefinitely postponed. How will the farm debt waiver or Pay Commission be financed otherwise In addition, there are oil and fertiliser bonds and expenditure for rehabilitation in Bihar. Though firm figures (on supplementary grants) arent available, impressions suggest that across several ministries/departments, expenditure has overshot budget estimates. Consequently, what implication does government borrowing have for future liquidity Second, how does RBI handle the exchange rate More FII pull-out is inevitable and there may even be some slackening in FDI inflows. Data we have are till June 2008, too early for any slowdown to show, though the June 2008 figure was about $1.5 billion lower than the April and May numbers. One shouldnt read too much into monthly figures. Nevertheless, the global shock will almost certainly dampen FDI inflows, infrastructure being an instance. In an attempt to counter inflation, is RBI then going to prevent rupee depreciation, with that intervention sucking rupees out of the system, quite apart from the issue of that not being a particularly sensible idea Third, what happens to the inflation bogey

The trend rate of inflation, measured by something like GDP deflator, is around 7%, a far cry from 5-5.5% government wants. Once knee-jerk reactions to a perceived liquidity crunch are over, will monetary policy be tightened once again For that matter, will we actually have a cut in repo rate a few days from now There is no way we can get an inflation rate of 5-5.5% by GDP deflator anytime soon. And if one continues to use point-to-point WPI as a policy indicator, we are probably stuck with an inflation rate of at least 9% throughout 2008-09. The liquidity crunch led to some knee-jerk reactions. Will these responses continue But a more fundamental problem remains and that has nothing to do with the global financial crisis. However, before that, will these responses lead to reduction in lending rates At least one bank has announced lower rates. Price of capital is one thing, availability is another. Other than attractiveness of government paper, why have banks not been lending Growth figures on commercial bank credit are misleading, as are figures on fiscal deficit. The former includes oil and fertiliser bonds, the latter does not. The Centres true deficit, as share of GDP, is probably in excess of 5% now. Those are resources being pre-empted from private uses.

Until that problem is addressed, increased liquidity wont translate into greater bank lending, exhortations by North Block to lend notwithstanding. Nor will greater liquidity necessarily flow into the capital market. Retail investors continue to stay away and even sell. Lower IIP and GDP growth figures, accounts of lay-offs (not just in aviation) and less-than-expected corporate profitability results dont help. Foreign institutional investment sell-out hasnt been completely neutralised by domestic institutional investment purchases. Imagine the consequences if agencies now lower Indias credit rating. Unlike a liquidity crunch, this sentiment problem is more difficult to address. But a first step is to recognise systemic problems and articulate a coherent policy response, including recognition that these problems pre-date the Wall Street-triggered financial crisis. Instead, the impression one forms is of knee-jerk and ad hoc reactions to a crisis perceived to be exogenous and Wall Street is blamed for everything that has gone wrong. However, slowdown preceded Wall Street and there are endogenous problems too. At best, there was an exogenous trigger. Fundamentals may be strong, but the word fundamental has an etymological common root in the word for bottom.

The author is a noted economist