The initial reaction in India has had a very narrow focus. The advanced quantitative financial tools meant to spread risks blamed for triggering the crisis are barely used by Indian financial institutions, which are still tied to traditional deposit and loan-based transactions. Home loans are themselves not refinanced such that debt servicing liabilities end up exceeding the repayment capacities of borrowers, nor can such liabilities be packaged and farmed out by banks as in the case of subprime mortgages in the US. The danger initially perceived for India from the global financial crisis was, therefore, only to institutions like ICICI with some small exposure to US financial tools or those with business links to failed institutions like AIG or Merrill Lynch. It was believed, therefore, that the crisis could be managed by strengthening these institutions’ risk coverage under regulators’ watchful eyes.   

This initial assessment was based on misplaced assumptions. It was believed in India, as in the US, that the crisis could be confined to financial markets and could be tackled by identifying and fully providing for lending and other risks. In the US, however, confidence couldn’t be restored by takeovers by solvent institutions; not even by reasonably reassuring half yearly results. Injecting supportive federal funds won’t be sufficient: a crisis of confidence, leading to refusal of credit by depositors, investors and their institutions, has meant economic activity has contracted. Major financial institutions are deleveraging — reducing their dependence on borrowing and calling in their own funds - implying a drastic depletion of liquidity. So speculators have no money to dabble in commodity markets and push up oil and other commodity prices, bankers cannot raise capital to shore up written-down assets, share indices are hitting rock bottom and producers are unable to access working capital for existing activities — let alone pay for new projects.   

Further de-leveraging is unavoidable: European banks like Barclays, Deutsche, UBS and BNP Paribas have leverage ratios in the forties and fifties. With the demise of investment banking, there is also no scope for restoration of previous liquidity levels in the near future. It will certainly take time for ingenious financial innovators to discover fresh ways of breaking through regulatory controls. Till then, global business activity will necessarily have to operate at a much lower level than hitherto.

The Prime Minister’s concern over the financial meltdown is appreciable. Dr Singh warned of economic slowdown almost 18 months ago. Now, he has suggested we isolate specific areas where our economy would be most vulnerable, so we can react effectively. Also, we need to ensure that our policies gel with global action for sustaining demand and investment.   

There are at least three ways in which we are immediately vulnerable: export demand could fall, investment reduces and employment comes down.   

Exports account for only 16 per cent of GDP, but rapid shrinking of global demand, quickly reflected in cancellation of export orders, can dent growth. Production units that depend on orders from abroad ay have to shed labour and defer expansion plans. Efforts need to made towards exploring alternate markets in the Middle East, South East Asia and the Far East. This applies also to the travel and tourism sectors. We have already seen the first rumbles in the hitherto-expanding aviation industry. The crunch will also be felt in other areas of international trade like shipping, which is particularly susceptible to cyclical movements.   

Direct foreign investment and portfolio investment, as well as external commercial borrowing, account for only 5 per cent of GDP. But our stockmarkets have already been battered FIIs withdrawing. We may have to live with the Sensex below 10000 for some time. Indian investors are shifting to stable but low-yielding fixed deposits and domestic businesses are being forced to postpone public offerings and new projects. On the FDI front, multinationals and foreign corporates are busy revising investment plans and we must be prepared for much lower materialisation of approved FDI clearances.   

As in the developed world, the crisis is moving to the real economy through banks: their lower liquidity is affecting corporates. Equally worrisome, however, is the impact of lower global demand itself on business prospects. It is only if projects financed by banks fail that their solvency will be at risk. Instead of government support to failing banks more effort is required towards coordinated procyclical action to counter recessionary pressures arising out of global developments. Hiking the CRR and lowering the repo rate are only temporary and partial measures. They must be buttressed by budgetary policy for the short and medium term. And while the economy adjusts, there must be measures to ease the pain of sectors and groups that are likely to be most affected during the transition.   

When larger businesses are short of funds, they delay payments to suppliers, shifting the shock farther down the line. Banks are giving short shift to struggling and more vulnerable businesses, which are required to post more collateral when existing working capital limits come up renewal. All this can pose enormous difficulties for small business; many of them could close down. As these are labour-intensive units, unemployment could increase. Effective social security measures are not yet available to cover such unemployed; retraining programs are largely inexistent.   

Managing this requires economy-wide advance action on Keynesian lines.

The writer is a Congress MP

More on specific measures in the concluding installment