Message from the meltdown

C.P. CHANDRASEKHAR
Frontline, April 7-20

The RBI's recent moves partly unravelled relationships between finance and the real economy, affecting expectations and triggering the sell-off in the markets.

FINANCIAL year 2007 began with one more strong "correction" of the bull run that has dominated Indian stock markets in recent months. The first trading day of the year, April 2, witnessed the second sharpest single-day decline ever in the benchmark Sensex. The close to 617 points decline was received as usual with alarmist statements that suggested that a bull-run that keeps stock indices rising should be the norm in a healthy economy.

"A world of gloom in your cup" declared one newspaper with a fondness for bizarre banner headlines. It was another matter that the day following the "crash" the market recovered and the Sensex rose by 169 points, indicating that the previous decline was partly the result of market panic.

Being addicted to buoyancy, it is not surprising that market movers and sections of the media chose to train their guns on the proximate force responsible for the April 2 crash. The decline, it is widely accepted, was triggered by an unscheduled monetary policy statement made by the Reserve Bank of India after close of business on Friday, March 30.

The statement and the measures it incorporated were driven by the central bank's perception that its monetary policy stance must shift from one that put "equal emphasis" on price stability and growth to one that focussed on stabilising prices immediately. The reasons are not hard to find: year-on-year inflation based on the wholesale price index had, by March 17, 2007, ruled at around 6.5 per cent for the third week in succession and inflation based on the various consumer price indices had moved to the 7.6-9.8 per cent range in February 2007 compared with 4.7-5.0 per cent a year ago.

Under pressure to bring inflation under control, the central bank decided to resort to the only measures it has at hand: those of reducing liquidity in the system as well as increasing the cost of capital. Not surprisingly, it has chosen to: (i) hike the cash reserve (CRR) by 50 basis points to 6.50 per cent in two steps starting April 14, so as to suck out of the system the equivalent of Rs.15,500 crore; (ii) reduce interest rates paid to banks on reserves in excess of 3 per cent held with the central bank; and (iii) raise the repo rate, or the interest rate on funds provided to banks by the RBI, by 25 basis points from 7.50 per cent to 7.75 per cent.

Debt-financed spending

In the two-day period between the RBI's announcement and the next trading day in the stock markets, speculation was rife that the RBI's moves would damage corporate performance and reduce profits, paving the way for the sell-off on the first Monday of April. These expectations were not without basis. They were based on the correct reading that the high GDP (gross domestic product) growth of recent times was driven by an expansion of housing, automobile and consumer credit that easy liquidity and lower interest rates had resulted in. If credit growth is reined in with a more stringent monetary policy and if the interest to be paid on credit was hiked because the cost of capital mobilised by the banks was higher, the debt-financed spending spree on housing construction, automobiles and consumer durables would falter.

Not surprisingly, the stocks most affected in the one-day meltdown were those of real estate companies, automobile producers and the banks. These were the areas in which debt-financed spending spurred sales and profits, making them stocks that attracted much attention. Faced with the prospect of a decline in these industries, investors, including the foreign institutional investors (FIIs) that led the bull run, chose to exit.

But these were not the only stocks that were affected. The sell-off was widespread, with all 30 stocks included in the Sensex losing ground and a total of 1,771 registering a decline, while only 702 companies recorded a rise in stock values on the Bombay Stock Exchange. One reason for this widespread decline could be that the expected increase in the cost of credit had encouraged some domestic investors to unwind positions financed with debt. Leveraged investments in stocks are less profitable when interest rates rise. They would be even more so if stock prices fall when interest rates rise.

The message from the market was thus clear: easy and cheap credit is necessary to keep both the economy and the markets going. In earlier times the relationship between finance and the real economy was read very differently. Finance, it was argued, had a supply-leading role. If the inducement to invest existed, the financial system was expected to play its role by making adequate capital available at reasonable interest rates so that viable projects were not abandoned for lack of funds.

Liberalisation, however, has changed the lending practices of financial institutions. It has encouraged them to focus more on housing finance, retail lending, and lending against real estate and stocks than on financing production directly. This has made the relationship between finance and the real economy very different. Financial firms by encouraging credit-financed consumption and housing purchases help spur demand, and indirectly contribute to growth. They also fuel speculation and allow asset and commodity prices to rise for reasons not warranted by fundamentals. The RBI's moves were partly unravelling these relationships, affecting expectations and triggering the sell-off.

This, however, does not mean that what the RBI is attempting is unwarranted. The thinking underlying the RBI's moves is clearly that excess liquidity in the system, resulting in easy credit and lower interest rates, has spurred demand, fuelled speculation, overheated the system and generated inflation. In the circumstances, it was using the only instruments available in its hands to respond to the situation. The question that remains is whether these measures would be adequate to curb inflation and whether they would have collateral effects that affect the growth potential of the system and damage those who were not the beneficiaries of the consumption splurge.

The recent monetary measures can be expected to be successful in curbing inflation if they curb demand growth for precisely those commodities that are the main contributors to inflation. With inflation as measured by consumer price indices ruling higher than that captured by the wholesale price indices, it can be concluded that there are two features that characterise the current inflationary trend. First, that it affects retail prices more than wholesale prices. And, second, that it is concentrated in essential commodities, which have a larger weight in the consumer price index than in the wholesale price index.

Supply-demand imbalance

Essentials are contributing to inflation not only because demand for them is rising too fast. Rather, they are the focus of the current inflation for two reasons: first, the fact that deprived of much-needed investment and access to credit, agriculture has been languishing while the rest of the economy grows, resulting finally in a supply-demand imbalance; second, the emergence of these imbalances has provided the base for speculation that has increased commodity prices.

One problem here is that the demand for essentials is not significantly financed with debt and would, therefore, not be affected directly by the RBI's measures. Monetary stringency can contribute to reducing speculation, inasmuch as such speculation is supported with easy and cheap credit. Further, to the extent that monetary stringency limits investment and growth, it can rein in the growth of employment and consumption and thereby restrain the growth in demand for essentials. While any curb on speculation is welcome, restraints on growth are not.

Moreover, the efficacy of these measures depends on the effects of monetary stringency on supply. If it constricts supply as much as it restrains demand, prices would still tend to rise. There are reasons to believe that the RBI's moves could affect supply. Limits on credit access and increases in the cost of credit can affect the production of essentials, especially because agriculturalists are considered less creditworthy and would be rationed out of the credit market. In the event, unless the restraint on the demand for essentials is greater than that on the supply of these commodities, the RBI's actions would not have their intended results.

These possibilities notwithstanding, the RBI has no option but to rein in the rapid growth of liquidity resulting from the sharp increase in foreign capital inflows into the economy, especially the stock markets. As the central bank's statement makes clear, "accelerated external inflows" have resulted in the addition of as much as $18.6 billion to its foreign exchange reserves over a two-month period, with their levels rising from $179.1 billion at the end of January 2007 to $197.7 billion on March 23, 2007.

The markets need this liquidity to keep the recent unprecedented bull-run going, because a substantial part of that capital enters the stock market through FII investments. It also needs those flows because the increase in the foreign exchange assets of the central bank has as its counterpart an increase in money supply that underlies the easy liquidity and credit situation. It is that easy credit environment that spurs credit-financed housing and consumption expenditure and delivers the growth in sales and markets, which also keep markets buoyant.

The problem is that while this is good for a small segment of the corporate sector and for the financial markets, it passes much of the economy and the people by. In particular, agriculture languishes, leading to a situation where, despite the reduced dependence of the non-agricultural sector on inputs and wage goods from the agricultural sector, the imbalance of growth finally leads to inflation. And the response to that inflation, which is destabilising in a parliamentary democracy, has to be a set of measures that would adversely affect the pace of growth and the returns from speculation.

The situation makes clear that something needs to be done about the surge in capital flows into the economy. This would help the Reserve Bank deal directly with the problem of a liquidity overhang. It would also result in a change in the pattern of growth, making it less dependent (directly and indirectly) on external flows. This, of course, requires rethinking and reversing the post-liberalisation trajectory of development that contributed to the recent acceleration of GDP growth in the country. The government, of course, would be reluctant to opt for such a policy correction. But, the message from the brief but sharp market meltdown is that if the government chooses to delay such a correction, the markets themselves would force it on the country.