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.

While this liquidity shortage has been addressed by RBI through CRR cuts, and now the interest rate cut, there is concern that some sectors and activities will continue to face acute liquidity shortage. A recent paper with Jahangir Aziz and Ajay Shah (tinyurl.com/APS2008) examines the potential impact of the current liquidity crunch and offers some policy responses. One concern is that the downturn in the global economy will impinge on Indian firms. Firms betting on the expansion of sales abroad, those with exposure to commodities and with large leverage for their overseas expansions may suffer in the months to come. Their problems will get exacerbated unless there is adequate liquidity. A strong financial sector can help firms adjust during a crisis. If a firm is unable to get credit and is thus unable to do business, it will rapidly become insolvent.

In addition to the CRR and repo rate cuts, a number of additional steps are necessary. RBI must reduce the SLR to 20 per cent. This will allow banks to use the repo facility to a larger extent. To prevent bond prices from falling precipitously as a consequence, quantitative restrictions on foreign holding of government bonds should be removed.

Second, RBI must make oil and fertiliser bonds both SLR and repo eligible. In addition to these bonds, RBI must explore other avenues for enhancing the range of assets that are repo eligible.

Third, at present most repo transactions are 1-3 days. On October 14, RBI announced a 14-day repo window. To provide stability to the financial system the maturity needs to be extended to 1-3 months repos as well.

Fourth, RBI should provide counterparty risk for inter-bank borrowing (at a price) to make sure that no rumours or glitches in the payment system lead to a loss of confidence in the inter-bank money market in the days to come.

To ease dollar liquidity in the market various avenues for easing capital controls must be immediately created. While the interest rate ceiling on external commercial borrowings has been raised, at the prescribed rates there are hardly a handful of Indian companies who can borrow at those rates. The policy framework should allow roughly 2 per cent of GDP to come in through ECBs without interest rate controls. Rupee denominated corporate bonds should have no caps.

India must be the only country that follows a policy of discrimination against people of Indian origin. A foreign institutional investor has to give an undertaking saying that the funds being invested by it do not have NRI clients even in the second or third layer. In bank deposits there are interest rate ceilings imposed for foreign currency deposits that NRIs can invest in. At a time of crisis, when we need dollar inflows, we should remove these restrictions. NRIs should be given access to Indian capital markets the way any Indian resident is. India’s strong growth story and the relatively stable condition of the banking sector, in contrast to the options NRIs have in other parts of the world, may attract them to bring dollars to India, helping us ease the dollar liquidity shortage.

The redemption of equities in the stock market by FIIs as pressure from their clients rises could be more a function of the loss of confidence in them by their clients than a loss of confidence in the Indian stock market. This is a time to permit foreigners to invest in Indian markets without them having to take the risk of going through an investment bank which they no longer trust. While this may have limited impact in the midst of the crisis, as confidence returns to global equity markets Indian stock markets could gain from it.

In addition to these steps, RBI should take steps to help banks and corporates meet their dollar obligations and reduce currency mismatches that may be building up in the system. At the same time, it is important for RBI not to try to prop up the spot rupee as that would only increase speculative outflows.

With a decline in global commodity prices and the decline in liquidity growth, inflationary concerns have eased. As confidence returns to global markets and the flight to US treasury bills goes down, the dollar is likely to weaken. This will reduce the pressure on the rupee to weaken. Along with slower GDP growth in India and abroad, these factors will reduce inflationary pressure further. Already seasonally adjusted data is showing a decline in inflation rates. RBI should now focus on increasing liquidity and protecting growth.

The writer is senior fellow at the National Institute of Public Finance and Policy, Delhi express@expressindia.com