The Hindu Business Line : Fiscal spurs may be in order

The international financial crisis promises to keep policy-makers and people of the world on tenterhooks. The time has, perhaps, come for the Government of India and the RBI to consider propping up demand in affected sectors by fiscal concessions, if need be, says S. VENKITARAMANAN.

The impact on the real economy of India tends to be ignored in our preoccupation with stock markets.

While the mayhem continues in the US’ financial sector, with its ripple effect on the economies of the world as a whole, statesmen of different countries are trying to formulate an agenda for reforms. In one of his impressive statements, Dr Manmohan Singh recently laid out an analysis of the international problem when he addressed a gathering of world leaders at Beijing on October 24.

He quoted the famous economist, Lord Keynes, that it was unwise to base a country’s economic development on the working of a casino. Lord Keynes had also said the position is serious when an enterprise becomes a bubble in a whirlpool of speculation and not the reverse. When the capital development of a country becomes a by-product of the activities of a casino, said Keynes, the job is likely to be ill-done.

Dr Manmohan Singh was at his professorial best when he concluded that this leads to a call for a total reform of the international financial system. In his view, the present situation was a result of failure of regulation and supervision in major developed countries as also of risk management in private financial institutions and of the market discipline mechanism.

Dr Singh said that we have a global economy of thought, but it is not supported by the global polity to provide effective governance. He directed the attention of the meeting to the immediate task facing the world, viz. de-clogging the credit market. It is hoped that the Prime Minister’s advice will be heeded by not only the US Administration but also by the policy-makers who decide on the international architecture, in particular, the IMF and the World Bank.

Significantly, Dr Singh advised the IMF to create a special drawing facility of SDRs to assist the infrastructure development and other needs of vulnerable countries, in effect, enabling a contra-cyclical economic expansion. He was spelling out the broad lines of a reform agenda.

Consequence of deleveraging

While the Prime Minister is right in emphasising the role of regulation and supervision in managing the complexities of a modern financial system, the roots of the present problem go far deeper. They lie in the excessive leveraging, viz. use of debt financing by institutions in advanced economies.

What the world is now confronted with is as a consequence of deleveraging. Wall Street firms are trying to reduce their debts from an unconscionably high level they had reached before. In particular, economies such as India and China have felt the effect of the deleverage of financial institutions having shortage of liquidity as a result of deleveraging and therefore not having enough funds to invest in the stock markets.

This has, in turn, led to an exit of many foreign institutional investors from the Indian equity market and a consequent fall in stock market indices. Shortage of dollars has also led to the rupee becoming weaker than as justified by fundamentals. There is legitimate concern that this depreciation, although export-friendly, will lead to adverse fiscal consequences.

President Bush has convened a conference to discuss the same subject next week in Washington. It is unfortunate that this conference comes at the very end of his tenure. The credibility of the Administration as it evolves responses to the international financial crisis is definitely muted. One wishes that the next US President, whoever he may be, will carry on what President Bush starts in this respect at least.

The US has distinguished itself in a manner of speaking by being the originator of the present crisis, which is an American export, so to say. The crisis itself was led by a housing boom and excessive securitisation of mortgage loans by Wall Street firms.

Irony indeed

It is indeed an irony that in 2000, the Chief Executive of a leading Wall Street firm approached the Security Exchange Commission (SEC) of the US to relax some of the capital rules, which had prescribed a minimum capital requirement for a financial institution. The argument advanced by the CEO was that this was leading to US business migrating overseas.

Unfortunately for the US, after four years, the SEC conceded the point and relaxed the rule allowing institutions to increase the leverage by which they could borrow more for the same equity. Thus, it was in the recent crisis that institutions such as Lehman Brothers had borrowed up to 30 times their capital. They had violated the basic canon of finance that capital should be protected when taking risks, thanks to the SEC relaxing the rules. This violates the basis of Basel norms, which prescribed at least 9 per cent as the capital-asset ratio.

The irony I referred to lies in the fact that it was Hank Paulson, the present Secretary of the US Treasury, who as CEO of Goldman Sachs had pleaded with the SEC for relaxing the capital rule. He is now presiding over the reconstruction of financial sector in the US from the mess that has been created by institutions such as Lehman Brothers, which borrowed many times their capital. He has had, as a result, to undertake an anti-free market device of injection of State capital into distressed banks and financial institutions such as Bear Stearns, A.I.G, Fannie Mac and Freddie Mac.

There are many repercussions of the market failure of America on the real economy of the world. The reduction in consumption and demand in the US is affecting various industries in India and China, to mention just two instances.

‘Out-of-the-box’ thinking required

It is unfortunate that the impact on the real economy of India tends to be ignored in our preoccupation with stock markets. News has come that many auto majors are reducing their activities as a result of falling demand, which is a result of the tightened liquidity.

The time has perhaps come for the Government of India and the RBI to consider propping up demand in affected sectors by fiscal concessions, if need be. When there is a slowdown in an economy, it is inevitable that fiscal action is to be undertaken. This is also part of the advice of Lord Keynes, whom Dr Manmohan Singh had quoted in another context.

Incidentally, the latest buzz is that some of the corporates of India may be in trouble on repayment of dollar loans as a result of reduction in their market and hence earnings. Defaults of any corporate in India may have repercussions on the overall credit rating of the country.

It behooves the Government and the RBI to take steps to guarantee the dollar credit taken by corporates and banks in India. I mention this particularly because I recall that the 1991 crisis arose not because of any default by the Government of India but by threatened default by SBI, which had borrowed from the bankers’ acceptance market of the US.

It is to be hoped that the RBI will not permit such an event to occur in respect of any corporate or bank. It is necessary that “out-of-the-box thinking” is resorted to and the RBI takes steps to guarantee dollar loans taken by corporates and banks. This is a practice that has been followed by many advanced countries of the world and India should not be far behind. The international financial crisis promises to keep policy-makers and people of the world on tenterhooks. It is to be hoped that the proposed Washington conference will be a fitting successor to the Bretton Woods Conference, which initiated a new era of world finance and development.

( blfeedback@thehindu.co.in)

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