year 2007 began with one more strong "correction"
of the bull-run that has dominated Indian stock markets
in recent months. The first trading day of the year,
April 2, witnessed the second sharpest single-day decline
ever in the benchmark Sensex. The close to 617 points
decline was received as usual with alarmist statements
that suggested that a bull run that keeps stock indices
rising should be the norm in a healthy economy. "A
World of Gloom In Your Cup" declared one newspaper
with a fondness for bizarre banner headlines. It was
another matter that the day following the "crash"
the market recovered and the Sensex rose by 169 points,
indicating that the previous decline was partly the
result of market panic.
Being addicted to buoyancy, it is not surprising that
market movers and sections of the media chose to train
their guns on the proximate force responsible for the
April 2 crash. The decline, it is widely accepted, was
triggered by an unscheduled monetary policy statement
made by the Reserve Bank of India after close of business
on Friday, March 30. The statement and the measures
it incorporated were driven by the central bankís perception
that its monetary policy stance must shift from an "equal
emphasis" on price stability and growth to one
focused on immediately stabilising prices. The reasons
are not hard to find: year-on-year inflation based on
the wholesale price index had by March 17, 2007 ruled
at around 6.5 per cent for the third week in succession
and inflation based on the various consumer price indices
had moved to the 7.6-9.8 per cent range in February
2007 as compared with 4.7-5.0 per cent a year ago.
Under pressure to bring inflation under control, the
central bank has decided to resort to the only measures
it has at hand: those of reducing liquidity in the system
as well as increasing the cost of capital. Not surprisingly,
it has chosen to: (i) hike the cash reserve ratio (CRR)
by 50 basis points to 6.50 per cent in two steps starting
April 14, so as to suck the equivalent of Rs 15,500
crore out of the system; (ii) reduce the interest rates
paid to the banks on reserves in excess of 3 per cent
held with the central bank; and (iii) raise the repo
rate, or the interest rate on funds provided to the
banks by the RBI, by 25 basis points from 7.50 per cent
to 7.75 per cent.
In the two-day period between the RBIís announcement
and the next trading day in the stock markets, speculation
was rife that the RBIís moves would damage corporate
performance and reduce profits, paving the way for the
sell-off on the first Monday of April. These expectations
were not without their basis. They were based on the
correct reading that the high GDP growth of recent times
was driven by an expansion of housing, automobile and
consumer credit that easy liquidity and lower interest
rates had resulted in. If credit growth is reined in
with a more stringent monetary policy and if the interest
to be paid on credit was hiked because the cost of capital
mobilised by the banks was higher, the debt-financed
spending spree on housing construction, automobiles
and consumer durables would falter. Not surprisingly,
the stocks most affected in the one-day meltdown were
those of real estate companies, automobile producers
and the banks. These were the areas in which debt-financed
spending spurred sales and profits, making them stocks
that attracted much attention. Faced with the prospect
of a decline in these industries, investors, including
the FIIs that have led the bull run, chose to exit.
But these were not the only stocks that were affected.
The sell-off was widespread, with all 30 stocks included
in the Sensex losing ground and a total of 1,771 registering
a decline, while only 702 companies recorded a rise
in stock values on the Bombay Stock Exchange. One reason
for this widespread decline could be that the expected
increase in the cost of credit had encouraged some domestic
investors to unwind positions financed with debt. Leveraged
investments in stocks are less profitable when interest
rates rise. They would be even more so if stock prices
fall when interest rates rise.
The message from the market was thus clear: easy and
cheap credit is necessary to keep both the economy and
the markets going. In earlier times the relationship
between finance and the real economy was read very differently.
Finance, it was argued, had a supply-leading role. If
the inducement to invest existed, the financial system
was expected to play its role by making adequate capital
available at reasonable interest rates, so that viable
projects were not abandoned for lack of funds. Liberalisation,
however, has changed the lending practices of financial
institutions. It has encouraged them to focus more on
housing finance, retail lending, and lending against
real estate and stocks than on directly financing production.
This has made the relationship between finance and the
real economy very different. Financial firms by encouraging
credit-financed consumption and housing purchases help
spur demand, and indirectly contribute to growth. They
also fuel speculation, and allow asset and commodity
prices to rise for reasons not warranted by fundamentals.
The RBIís moves were partly unravelling these relationships,
affecting expectations and triggering the sell-off.
This, however, does not mean that what the RBI is attempting
is unwarranted. The thinking underlying the RBIís moves
is clearly that excess liquidity in the system, resulting
in easy credit and lower interest rates, has spurred
demand, fuelled speculation, overheated the system and
generated inflation. In the circumstances it was using
the only instruments available in its hands to respond
to the situation. The question that remains is whether
these measures would be adequate to curb inflation and
whether they would have collateral effects that affect
the growth potential of the system and damage those
who were not the beneficiaries of the consumption splurge.
The recent monetary measures can be expected to be successful
in curbing inflation if they curb demand growth for
precisely those commodities which are the main contributors
to inflation. With inflation as measured by consumer
price indices ruling higher than that captured by the
wholesale price indices, it can be concluded that there
are two features that characterise the current inflationary
trend. First, that it affects retail prices more than
wholesale prices. And, second, that it is concentrated
in essential commodities which have a larger weight
in the consumer price index than in the wholesale price
index. Essentials are contributing to inflation not
only because demand for them is rising too fast. Rather,
they are the focus of the current inflation for two
reasons: first, the fact that deprived of much needed
investment and access to credit, agriculture has been
languishing while the rest of the economy grows, resulting
finally in a supply-demand imbalance; second, the emergence
of these imbalances has provided the base for speculation
that has increased commodity prices.
One problem here is that the demand for essentials is
not significantly financed with debt and would therefore
not be directly affected by the RBIís measures. Monetary
stringency can contribute to reducing speculation, inasmuch
as such speculation is supported with easy and cheap
credit. Further, to the extent that monetary stringency
limits investment and growth, it can rein in the growth
of employment and consumption and thereby restrain the
growth in demand for essentials. While the any curb
on speculation is welcome, restraints on growth are
Moreover, the efficacy of these measures depends on
the effects that monetary stringency has on supply.
If it constricts supply as much as it restrains demand
prices would still tend to rise. There are reasons to
believe that the RBIís moves could affect supply. Limits
on credit access and increases in the cost of credit
can affect production of essentials, especially because
agriculturalists are considered less creditworthy and
would be rationed out of the credit market. In the event,
unless the restraint on the demand for essentials is
greater than that on the supply of these commodities,
the RBIís actions would not have their intended results.
These possibilities notwithstanding, the RBI has no
option but to rein in the rapid growth of liquidity
resulting from the sharp increase in foreign capital
inflows into the economy, especially the stock markets.
As the central bankís statement makes clear, "accelerated
external inflows" have resulted in the addition
of as much as $18.6 billion to its foreign exchange
reserves over a two-month period, with their levels
rising from $179.1 billion at the end of January, 2007
to $197.7 billion on March 23, 2007.
The markets need this liquidity to keep the recent unprecedented
bull-run going, because a substantial part of that capital
enters the stock market through FII investments. It
also needs those flows because the increase in the foreign
exchange assets of the central bank has as its counterpart
an increase in money supply that underlies the easy
liquidity and credit situation. It is that easy credit
environment that spurs credit-financed housing and consumption
expenditure and delivers the growth in sales and markets
that also keep markets buoyant.
The problem is that while this is good for a small segment
of the corporate sector and for the financial markets,
it passes much of the economy and the people by. In
particular, agriculture languishes, leading to a situation
where, despite the reduced dependence of the non-agricultural
sector on inputs and wage goods from the agricultural
sector, the imbalance of growth finally leads to inflation.
And the response to that inflation, which is destabilising
in a parliamentary democracy, has to be a set of measures
which would adversely affect the pace of growth and
the returns from speculation.
The situation makes clear that something needs to be
done about the surge in capital flows into the economy.
This would help the Reserve Bank deal directly with
the problem of a liquidity overhang. It would also result
in a change in the pattern of growth that makes it less
dependent (directly and indirectly) on external flows.
This of course requires rethinking and reversing the
post-liberalisation trajectory of development that contributed
to the recent acceleration of GDP growth in the country.
The government of course would be reluctant to opt for
such a policy correction. But, the message from the
brief but sharp market meltdown is that if the government
chooses to delay such a correction, markets themselves
would force it on the country.