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Oct-07-2008
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Views expressed here are author"s own and not of this website. Full disclaimer is
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(The author is a Professor in International Economics in Nagasaki University, Japan)
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With the uncontrolled inflation, the diagnosis of the prime minister is that it is imported and so we can do little, but to control the money supply within India by increasing interest rate and making it more difficult for the banks to lend out by increasing the reserve ratios of the commercial banks. The medicine is not new but it is the classic remedy coming from the International Monetary Fund to reduce money supply in an economy facing inflation, irrespective of the nature of the disease.
What is surprising that India has not learned any lesson from the economic crisis that had affected several countries in East Asia ten years ago with similar symptom with the same medicine suggested by the IMF with disastrous results. India has not learned that on the face of the same disease both USA and UK are using applying exactly opposite medicine, although the economists from USA and UK control the IMF.
Speculative money flows and the wrong economic policy:
Sudden currency depreciations due to sudden large outflows of funds took place in East Asia in 1998, many Latin American countries in the 1980s, Mexico in 1994, Sweden and Norway in the early 1990 and in Britain in 1992.
In South East Asia in 1998 the crisis spread from Thailand to Malaysia, Indonesia, the Philippines, then to South Korea. Due to wrong medicine prescribed by the IMF it was transformed into a full-blown recession or depression. With the depreciation of currencies, and expectations of a debt crisis, substantial foreign funds left suddenly as withdrawal of loans and selling off of shares. Share prices fell. With weakened demand and increasing over-supply of buildings and housing, the prices of real estate also went down taking the economy with them. In order to reduce the deficit in the balance of payments following the orthodox policies of the IMF, governments in the affected countries reduced their budget expenditure, introduced very high interest rate and reductions of bank credit.
India is doing the same with the same problem affecting the Indian economy: huge deficit in the balance of trade only compensated by the remittances of the NRIs, high inflation and a mountain of foreign debt. In 1998 the IMF defended their approach of squeezing the domestic economies of their client countries through high interest rates, tight monetary policies and cuts in the government budget. Their argument is that this "pain" is needed to restore foreign investors" confidence, and so strengthen the countries" currencies.
Today Indian monetary authority, Reserve Bank of India, is giving the same justifications. In 1998, Thailand, Indonesia and South Korea, the three countries under the IMF"s direct tutelage went under deep recession. Would it happen to India now?
What is wrong in the financial system:
When a developing country carries out financial liberalization before its institutions or knowledge base is prepared to deal with the consequences, it opens itself to the possibility of tremendous shocks and instability associated with inflows and outflows of funds. Added to it we have certain basic changes in the global financial system: the financial deregulation and liberalization across the world ; the increasing interconnection of markets and speed of transactions through computer technology; and the development of large institutional financial players such as the speculative hedge funds, the investment banks, and the huge mutual and pension funds.
This combination has led to the rapid shifting of large blocks of short-term capital flowing across borders in search of quick and high returns, to the tune of US$2 trillion a day. Only one to two percent is accounted for by foreign exchange transactions relating to trade and foreign direct investment. The remainder is for speculation or short-term investments that can move very quickly when the speculators" or investors" perceptions change.
These massive financial flows have continued since mid 1985 with dramatic results. These huge capital flows are subjected to the "herd instinct". They tend to go in one direction and then suddenly they come out altogether, which triggers a panic withdrawal by large institutional investors and players.
The sequence of events leading to that crisis in 1998 in East Asia has its exact parallal to what is happening to India in recent years since the "Economic Reforms" have started. First, the countries concerned carried out a process of financial liberalisation, where foreign exchange was made convertible with local currency not only for trade and direct-investment purposes but also for autonomous capital inflows and outflows (i.e. for "capital account" transactions); and where inflows and outflows of funds were largely deregulated and permitted. This facilitated the large inflows of funds in the form of international bank loans to local banks and companies, purchase of bonds, and portfolio investment in the local stock markets.
The large inflows of foreign funds, either as loans to the banking system and companies directly, or as equity investment in the stock markets, contributed to an asset price boom in property and stock markets in East Asian countries. When that build-up of short-term debts became alarming, there were in Thailand, Indonesia and South Korea the sharp and sudden depreciation of their currencies. When the currencies depreciated, the burden of debt servicing rose in terms of the local- currency amount required for loan repayment. Foreign reserves fell as the short- term foreign funds started pulling out sharply. When reserves fell to dangerously low levels, or to levels that could not allow the meeting of foreign debt obligations, Thailand, Indonesia and South Korea sought IMF help.
For the countries afflicted with sharp currency depreciations and share market declines, the problems involved: (a) The much heavier debt servicing burden of local banks, companies and governments that had taken loans in foreign currencies; (b) The fall in the value of shares pledged as collateral for loans by companies and individuals, and the fall in the values of land, buildings and other real estate property. This has led to financial difficulties for the borrowers; (c) The higher interest rates caused by liquidity squeeze and tight monetary policies have caused added financial burdens on all firms as well as on consumers that borrowed; (d) As companies and individuals face difficulties in servicing their loans, this has increased the extent of non-performing loans and weakened the financial position of banks, and (e) Higher inflation caused by rising import prices resulting from currency depreciation.
In South East Asia in 1998 and also in Britain in 1992, the financial crisis has been transformed to a full- blown recession in the real economy of production due to the tight monetary policy as suggested by the IMF.
For companies already hit by the declines in the currency and share values, the interest rate hike became a third burden that broke their backs. But even worse, there were many thousands of firms, mainly small and medium sized, were then hit by the sharp rise in interest rates, a liquidity squeeze as financial institutions were tight-fisted with or even halted new loans, and the slowdown in orders as the public sector cuts its spending. A higher interest rate regime, in other words, may not boost the currency"s level but could depress it further if it induces a deep and lengthy recession.
Britain in 1992, and South-East Asia in 1998 paid for through huge losses in domestic output and national income, the decimation of many of the large, medium and small firms of these countries, a dramatic increase in unemployment and poverty, and social dislocation or upheaval.
The countries should have been advised by the IMF to reflate their economies through increased lower interest rates and increased government spending. High rates push them much more quickly from illiquidity towards insolvency, forcing them to cut back purchases, sell inventories, delay debt repayment and fire workers. Banks then accumulate a rising proportion of bad loans and refuse to make new ones. The IMF"s insistence that banks meet strict Basle capital adequacy standards only compounds the collapse of credit.
Today"s problem in USA and UK:
A speculative real estate bubble inflates over many years. A poorly supervised financial sector misallocates high-risk credits extended on the back of foreign borrowing. Then the bubble bursts, real estate prices decline, financial institutions run into difficulty, rating agencies downgrade creditworthiness, the currency weakens and credit is tightened.
Today"s problems in the United States have these features. Drastically lower interest rates, a fiscal stimulus package, rescue operations for financial institutions, bailouts for distressed home owners and expansionary lending by public mortgage companies are all pursued by both Clinton and Bush administration.
However, The IMF has applauded the "timely and targeted fiscal stimulus" and the "critical role played by central banks in .providing necessary liquidity". The IMF has suggested a totally different policy for East Asia in 1998. East Asia could not rely on its own resources but had to turn to the IMF and the G7 for financial support. East Asians were told to raise interest rates, cut public spending, shut down banks and investment houses and let asset prices-stocks, real estate and currencies-find their market level. In return, East Asians received modest financing from the IMF and from some advanced economies. The result: their economies collapsed.
The IMF subsequently concluded that some of the advice and some of the conditions imposed at the time were unduly harsh, that a less deflationary policy stance would have been preferable, and that better communication of the logic of the program with the public and markets would have boosted ownership and credibility. For the affected East Asian economies, which had been used to growing at over 6 percent per year, the costs were enormous. It took Indonesia 8 years to regain its pre-crisis income level. Meanwhile, most foreign banks escaped with minimal losses thanks to the current account surpluses that were produced by the draconian macroeconomic programs.
However, USA and UK have lowered their interest rates, make more liquidity available for the banks and started nationalizing important financial institutions by giving massive subsidies to those who are about to go bankrupt. All these policies are considered by the IMF as populist and imprudent for the developing countries like India, but USA and UK these are virtuous. The United States authorities after the 1987 stock market crash had acted to keep markets highly liquid whatever the cost, yet in Asia the IMF acted to contract liquidity.
India is facing the same problem:
India"s external debt rose by 30.4 per cent to touch $221.21 billion in financial year 2007-08 as high interest rates in the country encouraged Indian companies to raise funds from abroad. Rise in short-term debt, particularly due to increasing oil imports, and dollar depreciation during the year contributed to the surge in the external debt. While funds borrowed from abroad by Indian companies, called external commercial borrowings (ECB), contributed 28 per cent of the total debt, short-term debt constituted 20 per cent of the total debt. ECB rose by 49 per cent to touch $62.02 billion as on 31 March 2008 from $41.66 billion a year ago. Short-term debt rose by 68 per cent to touch $44.31 billion mainly due to larger trade credits owing to higher imports during the year, particularly oil imports.
In response interest rates have been rising in India as the Reserve Bank has been tightening money supply to control the runaway inflation, forcing banks to up their lending rates, including those to the Indian corporations.
Cause of India"s problem and Solutions:
In India, the liberalization of rules regarding foreign capital inflows and the reduced taxation of capital gains made in the stock market that have accompanied these reforms, has implied that while monetary policy is independent of fiscal policy; it is driven by the exogenously given flows of foreign capital.
Net inflows of foreign institutional investments into India"s stock and debt markets that had risen significantly starting with 2003, and averaged $8.8 billion a year during 2003 to 2006, has registered a sharp jump to $18.6 billion over the first 10 months of 2007.
This kind of accumulation of reserves obviously makes it extremely difficult for the central bank to manage money supply and conduct monetary policy as per the principles it espouses and the objectives it sets itself.
The Indian government has liberalized the laws relating to FDI in February 2005. Now Non Resident Indians (NRI"s) and Overseas Corporate Bodies (OCB"s) can invest up to 100% in the real estate sector. Foreign Direct Investment in real estate is now possible without the need for permission by the Foreign Investment Promotion Board. Currently, FDI in India is targeting township, housing, construction development projects, built-up infrastructure etc. The Indian government repealed the Urban Land Ceiling Act in 2001 and a large quantum of land is now free for construction. Investment is now also allowed for smaller projects of just 25 acres.
Low interest rates in recent past and a stronger rupee have boosted consumer demand. The excessive global liquidity fed by incredible amount of exports of US Dollars to the world economy has facilitated buoyant growth of money and credit. Crucially, this incremental flow of foreign exchange into the country has resulted in increased credit flow by the banks.
Reserve Bank of India"s strategy of dealing with excessive liquidity through the Market Stabilization Scheme (MSS) provides not much safeguards against the floods of foreign money coming in. The increase in "repo rates" (the rate at which the RBI lends money to banks) to make credit over extension costly, and increase in CRR rates ( credit to reserve ratio) to restrict excessive money supply, are policy interventions also ineffective given such huge foreign exchange inflows. The sustained flow of foreign money, due to the excessive global liquidity in the world, has fuelled the rise of the stock markets and real estate prices in India to some unprecedented levels.
Conclusion:
Short-term borrowings are highly volatile elements in the financial system and normally create a speculative bubble, which can be burst soon creating serious recession in the economy even bankruptcy. It is not possible to control these speculative flows of money by raising domestic interest rates and making credit difficult for the private sector to obtain. It can only be controlled through restrictions of short term borrowing from abroad, restrictions on the entry of foreign financial institutions in domestic money markets whether stock market, pension funds or real estate business. At the same time, Reserve Bank of India should reduce the interest rates and make more credit available for productive investments, through selective credit controls.
The experience of Britain in 1992 and the East Asian countries in 1998 showed very well the damage these short term flows of foreign money can cause. It normally push up domestic prices so that exports prices will go up causing increased balance of payments deficits. As a result Rupee would start falling causing an outflow of these short-term money. That will lead to further fall of Rupee and very soon the government will be unable to repay the foreign debt. Situation like this has ruined the East Asian countries for many years. India should try to avoid that wrong medicine suggested by IMF.
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