The Reserve Bank of India’s interest rate cut is among the many steps Indian policy-makers need to take to reduce the impact of the global crisis on India. Governments around the world are trying to minimise the dislocation the financial crisis is causing to their economies. The Indian government has been responding fast. It must now look forward and take steps to minimise the potential damage to the economy.

The global liquidity crunch became a full-blown financial crisis on September 14, 2008, when world money markets froze in response to Lehman Brothers filing for bankruptcy. The response in India was instant. Call money rates in India on Monday, September 15, rose to 9.8 per cent, from 6.15 per cent on the previous working day. Two days later, on September 17, call rates were at 13 per cent and India was witnessing a sharp liquidity crunch. The speed with which the global crisis hit India is unprecedented. This crisis has put an end to all notions of the Indian capital account being only partly open.

How might this have happened? In terms of numbers, the FII withdrawals in equity markets are not enough to explain the tightness in money markets even if RBI sold dollars back to back to prevent rupee depreciation. There seems to be much more going on. A large number of Indian corporations are now operating overseas. As money markets dry up abroad, they are likely to have turned towards rupee markets to meet their dollar liabilities abroad. This might be a significant factor in the liquidity shortage that has arisen in India.

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