When good is actually bad for India – what are the steps?
In the time of financial turmoil affecting the world, India isn't fully immune as I’d already said earlier this year. One key deciding factor in India's case is state of foreign fund inflow. However, I clearly notice two things within the Indian context that I don’t really agree with. One, general people priding themselves as being affected by the global credit crunch and two, government (RBI and finance ministry) scrambling with CRR, cash to banks, debt-equity investment ratio etc. to correct the declining stock market. Expectation is that somehow these steps will improve liquidity, transactions, and eventually help rupee rebound against dollar. This will reinstate foreign institutional investor’s (FII) faith in Indian markets and their exit can be checked. So one would think that these steps are good for India, right? Wrong!
My take here is that injecting more liquidity into the system in India is going to be actually bad for Indian economy and government must stop that. In India, actual money flowing in the system is difficult to gauge since bulk of the sectors in India isn’t monetized. Without this knowledge, rushing untold liquidity in a declining growth environment will only push the inflation up. Second, I don’t think the credit crisis has the same nature in India; Indian banks aren't as exposed to the subprime mortgage related securities. Also, Indians still keep a lot of money under their mattresses for rainy days and that they will continue to do so. The fact then is borrowing and hence lending is on the decline in India giving a sense of squeeze in banking. Of course, people aren’t borrowing – would you at this rate? And mind you, as inflation continues to flare up so would this rate leading to even lesser borrowing.
Next, let’s consider the FIIs. These guys are investing in the country to, obviously, make money. They keep close track on the pace of reforms in India and they know it will be a long time before sensex sees 18000 again, so they don’t have any incentive to stay. What happens if rupee declines further against dollar? FIIs further loose faith and exit faster. What happens if rupee strengthens? FIIs cut their losses and exit fast in an uncertain Indian financial market. So if one thinks the exchange rate is going to save Indian market from FII exit, it’s a wrong notion per my hypothesis. So what’s the solution? Before we get to the solution, we must agree that FII’s cash out of Indian market will be a disaster since it’ll start moving overall investments out of the country. So, let’s get to what could be done.
Well, I have already mentioned the cause. So that’s where we need to start. First, I believe that exchange rate movement in either direction won’t help so there should be measures to keep it steady. Second, FIIs do not see any incentive to stay so how about giving them some? I suggest a guaranteed exchange rate in steps for the next few years will be the ideal measure. Government should guarantee to FIIs an exchange rate of 46.55 to dollar by December 2009; 44.22 by December 2010; 42.00 by December 2011; you get the point, right? A guaranteed 5% return on their investments on top of any stock market returns for the next 2-3 years. This will be better return than money can find elsewhere.
Now, the government should use this measure only to buy time and needs to ensure that they don’t get squeezed by this exchange rate promise. So they must also take steps to improve the market and eventually the exchange rate. First step here will be to curb inflation which can be done through two known measures. Control of liquidity and improvement in domestic production. How? Stop pushing unnecessary liquidity into the system and start investing in rural infrastructure. More farm equipment projects, more irrigation projects, and transportation (particularly roadways) to connect rural to urban and suburban India must be started now. This should be done through both deficit financing and available forex reserves (to balance impact on the exchange rate). These steps will spread the wealth down to the primary sector and both manufacturing and services will get a push by demand from primary sector.
An important question now is to understand where to start some of these projects. Government needs to be wise here. If it wants to have sustainable growth and see eventual progress in India, it should also focus on regions like eastern UP, Bihar, Orissa and MP. The idea is not to spread wealth down only to primary sectors but also to every region so the wealth reaches a broader mass. Bihar and UP in particular have large population and highly skilled people who end up migrating to other states due to lack of opportunities. This change will keep them closer to home as well as help ease some of the regional tensions. Keep also in mind one staying close to home always gets involved in its development since one always wants to help those whom one grew up with or whom one cares about.
With growing wealth across regions, industries will notice increased demand from within the country and become profitable. Before long, there will be more demand on concrete houses, services etc. from even rural areas. Construction and other services industries will get a boost and the stress on the property prices in the country will also ease. Result? Stock market will move upwards and at this point it will be easier for the government to ease the control on the exchange rate without seeing FII’s exit as the opportunity cost of exiting a growing market will be higher than the short term gain on the exchange rate.
One might question whether this is possible in such a short time frame given the vastness of the country but then one needs to keep in mind that money doesn’t come in at the market’s peak but at the signal of right direction. So the role of government is to ensure that it shows its commitment to bring broader mass of population into play and thereby also removes stress on labor market due to concentration of industries in specific regions. Once the broader mass is invigorated there is no stopping their demand; and that doesn’t exclude demand for better governance from the politicians. The final question then is: are the Indian politicians up for this challenge?
My take here is that injecting more liquidity into the system in India is going to be actually bad for Indian economy and government must stop that. In India, actual money flowing in the system is difficult to gauge since bulk of the sectors in India isn’t monetized. Without this knowledge, rushing untold liquidity in a declining growth environment will only push the inflation up. Second, I don’t think the credit crisis has the same nature in India; Indian banks aren't as exposed to the subprime mortgage related securities. Also, Indians still keep a lot of money under their mattresses for rainy days and that they will continue to do so. The fact then is borrowing and hence lending is on the decline in India giving a sense of squeeze in banking. Of course, people aren’t borrowing – would you at this rate? And mind you, as inflation continues to flare up so would this rate leading to even lesser borrowing.
Next, let’s consider the FIIs. These guys are investing in the country to, obviously, make money. They keep close track on the pace of reforms in India and they know it will be a long time before sensex sees 18000 again, so they don’t have any incentive to stay. What happens if rupee declines further against dollar? FIIs further loose faith and exit faster. What happens if rupee strengthens? FIIs cut their losses and exit fast in an uncertain Indian financial market. So if one thinks the exchange rate is going to save Indian market from FII exit, it’s a wrong notion per my hypothesis. So what’s the solution? Before we get to the solution, we must agree that FII’s cash out of Indian market will be a disaster since it’ll start moving overall investments out of the country. So, let’s get to what could be done.
Well, I have already mentioned the cause. So that’s where we need to start. First, I believe that exchange rate movement in either direction won’t help so there should be measures to keep it steady. Second, FIIs do not see any incentive to stay so how about giving them some? I suggest a guaranteed exchange rate in steps for the next few years will be the ideal measure. Government should guarantee to FIIs an exchange rate of 46.55 to dollar by December 2009; 44.22 by December 2010; 42.00 by December 2011; you get the point, right? A guaranteed 5% return on their investments on top of any stock market returns for the next 2-3 years. This will be better return than money can find elsewhere.
Now, the government should use this measure only to buy time and needs to ensure that they don’t get squeezed by this exchange rate promise. So they must also take steps to improve the market and eventually the exchange rate. First step here will be to curb inflation which can be done through two known measures. Control of liquidity and improvement in domestic production. How? Stop pushing unnecessary liquidity into the system and start investing in rural infrastructure. More farm equipment projects, more irrigation projects, and transportation (particularly roadways) to connect rural to urban and suburban India must be started now. This should be done through both deficit financing and available forex reserves (to balance impact on the exchange rate). These steps will spread the wealth down to the primary sector and both manufacturing and services will get a push by demand from primary sector.
An important question now is to understand where to start some of these projects. Government needs to be wise here. If it wants to have sustainable growth and see eventual progress in India, it should also focus on regions like eastern UP, Bihar, Orissa and MP. The idea is not to spread wealth down only to primary sectors but also to every region so the wealth reaches a broader mass. Bihar and UP in particular have large population and highly skilled people who end up migrating to other states due to lack of opportunities. This change will keep them closer to home as well as help ease some of the regional tensions. Keep also in mind one staying close to home always gets involved in its development since one always wants to help those whom one grew up with or whom one cares about.
With growing wealth across regions, industries will notice increased demand from within the country and become profitable. Before long, there will be more demand on concrete houses, services etc. from even rural areas. Construction and other services industries will get a boost and the stress on the property prices in the country will also ease. Result? Stock market will move upwards and at this point it will be easier for the government to ease the control on the exchange rate without seeing FII’s exit as the opportunity cost of exiting a growing market will be higher than the short term gain on the exchange rate.
One might question whether this is possible in such a short time frame given the vastness of the country but then one needs to keep in mind that money doesn’t come in at the market’s peak but at the signal of right direction. So the role of government is to ensure that it shows its commitment to bring broader mass of population into play and thereby also removes stress on labor market due to concentration of industries in specific regions. Once the broader mass is invigorated there is no stopping their demand; and that doesn’t exclude demand for better governance from the politicians. The final question then is: are the Indian politicians up for this challenge?
posted by TheFlipSide @ 4:56 AM
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