The Central Bank (CB) has further the Statutory Reserve Ratio by 1.5%. But will that bring down the inter-bank interest rates, not to talk of the bank/s lending rates to the private sector? There’s a better chance of that happening but as long as the foreign exchange outflow continues, shortages of liquidity will be a fact f life and the banks will have to resort to the low interest Reverse Repo window.

Loose Monetary Policy

But is the loosening of monetary policy the right remedy for the current situation?

Heavily dependent on exports and foreign commercial and short term investments, our stock and bond markets have declined steeply and the construction boom is over. Private sector firms are finding their markets, both local and foreign, shrinking and are unable to hold the prices of their goods. The interest rates are too high and the banks are restricting credit owing to their revised perception of risks faced by their borrowers.

The banks are generally sound but then they never took any risks in the first place. The CB has shifted its focus from concern over inflation to growth and exchange rate stability. It assumes that inflation will continue its downward journey. But hitherto it has come down due to the fall in world prices of oil and food and not to the tightening of monetary policy. Core inflation has not come down. Continued expansionary fiscal policy saw to that.

There is something called stagflation which is inflation plus zero growth - the worst of both worlds. But cheaper money is required for the private sector and the CB cannot be blamed for fiscal irresponsibility. The fact is that not even the USA could carry normal public expenditure and welfare policies (the Great Society of Lyndon Johnson) plus the Vietnam war. Tight money will only be at the expense of the private sector which is the innocent victim of state policy and profligacy.

The current global financial crisis has led to a fall in asset prices, tighter credit conditions and declining confidence the world over, leaving firms and consumers unable or unwilling to spend and invest.

Despite the bail out of banks and investment banks by governments, the commercial banks in UK, USA etc have not resumed their lending as previously.

Last week I heard that the CB Governor has persuaded the EPF to invest a few billions in the stock market. It will no doubt improve volumes and turnover in the market. But whether it will increase prices will depend on whether it will stimulate the private investors to come in on the back of the EPF moving in. That will depend upon how much and how long the EPF will invest.

Nevertheless it is a good move from a government which is starved of ideas. It may be better to set up a Fund with a government guarantee to attract private sector money which could be thereafter invested in the stock market. The Government will guarantee the investor the capital value but no interest will be paid. Foreign investors may be given the same guarantee in rupees.  Every rupee invested in the fund by an outside investor is a rupee which taxpayers or the EPF contributors don’t need to shell out.

Bail out plans have not restored bank credit

The $700 billion bailout plan by USA to financial firms has so far not worked and the economy continues into a recession as banks used the injection of government funds to strengthen their balance sheets rather than lend. Meanwhile economic conditions deteriorate; people are scrambling to make ends meet. They are slashing discretionary spending. So the U.S Treasury had decided to use its $250 billion investment plan not only to increase banks’ capitalization but also to steer funds to stronger banks to purchase weaker ones.

We have probably arrived at a similar situation due in part to the insatiable demand of the Government to borrow to fund budget deficits in the name of the war and development. The CB printed money for years and stopped only after public criticism. Money printing enabled the government to run up enormous budget deficits and debts, while facing low real interest rates (below rate of inflation), but now the government cannot any longer borrow what it needs and hence the problem of payment arrears.

It has cut down on capital votes for the rest of this year. Most people do not know economic realities. But businesses have to adapt to the situation. Durable goods makers in particular are finding it harder to move their products, especially now that credit is drying up. A credit crunch will act as a penalty on productive growth, but will we head for negative growth? Probably not - for as long as the Government spends on the war. But of what good is that for the people when there is no increase in the supply of goods. Who will pay the bill for the war - the private sector?

Recapitalizing financial firms

There is broad agreement among economists that there is no uniform prescription for all countries to overcome the fallout from the global financial crisis. For our equity markets to improve, it is vital that the credit markets revive first and make available access to money supply at reasonable rates. Along with this, there has to be a slowdown in the selling of stocks by foreign investors which is causing prices to fall unnaturally. In the short-term, the picture looks unclear. However, I am confident of the revival of the equity markets for the following two reasons.

First, central banks the world over are opening the flood gates of the dam of money supply slowly. With numerous CRR cuts and reverse repo rate window liberalization announced by the CB, it is a matter of time before world capital markets revive. Our interest rates will also ease at least to some extent although not much as long as the foreign exchange outflow continues.  This will definitely boost our credit markets and give cash strapped companies a breather. Also, with easier access to money, there would be a boost in private economic activity via consumption of capital goods, autos, real estate etc. But inflation will continue as long as the government continues with fiscal expansion.

What the financial system needs right now is not only an injection of liquidity but also a recapitalization of the non-banking financial firms and firms in the private sector.  The essence of the current financial crisis is that many firms selling to the government or exporting and importing cannot manage to raise the required financial resources to continue on same scale.  

The question for the moment is how we can get funds and capital back into the real economy. Ideally, it would be great if the firms can raise capital from the public through the stock market or from international financial institutions. But the attempt by Sampath Bank to raise capital from the IFC failed. Nor can the private sector raise capital from abroad. 

Some economists abroad have proposed forcing the banks to lend more freely to private sector businesses. Perhaps regulators can twist the arms of the financial institutions. Other economists have suggested that the government itself inject capital. That raises several questions. First, which firms are to benefit? The government should not put taxpayer money into "zombie" firms that are in fact deeply insolvent but have not yet recognized it. Second, from where does the cash-strapped government get money except by printing it?

An economist abroad has suggested that the government be a silent partner of any institutions, local or international, that are willing to provide loans or better still new capital. It could work as follows. Whenever any company needs new private capital -loan or equity in an arms-length transaction, it can access an equal amount of public capital from the Central Bank. The CB should of course stop printing money for the Treasury and utilize only the government securities it already holds (Rs 100 billion at a recent count). The government should guarantee the loans or underwrite the share issues. 

``It’s not a stimulus; it’s not an economic growth plan," Mr. Kashkari the author of this idea told lawmakers in USA "It’s an economic stabilization plan."

You understand the difference, right? An economic stimulus plan is what happens when the economy is looking shaky and the government spends lots of money in an attempt to stop things getting worse. An economic stabilization plan, on the other hand, is what happens when the economy is looking shaky and the government acts in an attempt to stop things getting worse, paying due attention to the macro picture .

CB or Treasury equity is the same as debt to the CB. If there is a market in such equity or debt in the Stock Market then those who hold them may be allowed the re-finance facility of the CB.