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In the shadow of the storm

As the weeks unfold they bring more bad news and the mighty continue to fall. Citibank now joins a growing list of financial institutions that are reportedly on the verge of collapse. By next week it is conceivable that Citi will merge with another bank, seek a taxpayer-funded bail-out or sell some of its assets to fund its desperate capital requirements. Either way, it may be the end of an era for one of the world’s leading banking institutions that dominated international finance for several decades.

India’s woes, too, continue to mount. Many industrial product companies have sheepishly admitted production cuts varying between 20 and 30%. Several smaller ones specifically in the exporting sector are precariously hanging on, as order books shrink and liquidity virtually collapses. Some anecdotal evidence, whilst not substantiated, suggests that as many as 1.5 – 2 million people are in serious danger of losing their jobs (a recent Assocham report conservatively estimated that 700,000 jobs have been lost in the textiles sector alone). The urban economy is now on the verge of contraction.

The existing economic scenario is, figuratively speaking, not dissimilar to the formation of a ‘perfect storm’ where three unrelated incidences have taken shape simultaneously, and subsequently advanced in collusion. First, India’s business cycle, that witnessed several years of buoyancy due to sustained capital outlays and capacity creation, has turned downwards. This is a cyclical phenomenon where booms are usually followed by downturns. Second, reckless business practices by Indian companies, that sought to acquire assets at unreasonable prices, resulting in untenable over-leverages, have reached unsustainable levels. The process of de-leveraging has now commenced as businesses, and specifically banks, begin to shrink their balance sheets and reduce their asset portfolio. Third, the near evaporation of liquidity in foreign markets, due to the global banking crisis, put unforeseen demands for funds locally . Quite suddenly thereafter, market conditions in India promptly deteriorated and what made things worse was the fact that the government and Reserve Bank were caught unaware.

The government has now made promises about pump priming through infrastructure spends to generate demand. These sound hollow in the context of the fact that government departments are essentially hopeless at spending money due to inherent inefficiencies within their structure. Twenty states of the Union have, for instance, spent nothing of their allocated funds for road projects over the past year. Prompt intervention by government in times of a crisis is clearly therefore not an option that India is blessed with. Moreover, the government’s own finances are dismal, with falling revenues, a mounting fiscal imbalance and the absence of overseas funding sources. The Prime Minister’s recent visit to the Gulf States was primarily to seek backing from their sovereign funds. It remains unclear whether he was able to convince them on the long-term robustness of the India story.

However, the Reserve Bank, albeit belatedly, stepped in by easing liquidity through reductions in the repo rate and the cash reserve ratio. These helped in restoring some confidence that may have prevented a complete meltdown. More recently, there is some discussion about negotiating dollar swap facilities with the United States’ Federal Reserve along the lines offered recently to Singapore, South Korea, Brazil and Mexico to tide over foreign currency and funding shortages.

On balance we believe that there is a 70% probability that the worst would be over by April 2009. The economy should then manage growth of 5-6% in the fiscal year 2009-10. However, there remains a 30% probability of things getting worse. The stock markets may not have fully discounted worsening business conditions – the production cuts and falling orders by Indian manufacturers. If so, the Bombay Stock Exchange’s sensitive share index may slip by a further 30-40%, wiping out billion of dollars of personal fortune. This may in turn lead to further corrections in other asset prices, specifically real estate. Retail consumption which is already suffering will then collapse totally as urban consumers go into a sulk in the wake of a negative wealth effect phenomenon. Losses in the markets will not remain ‘notional’. Other expressions of downside risks could stem from the agricultural sector. Three to four years of satisfactory monsoons are often followed by a year or two of insufficient rains and if this should occur in 2009, the present ‘urban’ adversity would swiftly transform into a grave national calamity. Job losses would add to personal and housing loan defaults and the process of de-leveraging by banks would extend a lot longer, adding to contraction pressures on the economic system. The rupee will come under a bear hammering and may fall by a further 20-25%. The absence of political leadership – due to national elections – may hinder decisive intervention by the federal government. In such a scenario, economic growth may slip to levels beyond imagination.

Ultimately, the way things play out will be consequent upon the manner of intervention by the government. In the short term – three to six months – the crucial thing to do would be to keep liquidity flowing. The Reserve Bank must keep credit lines open for refinancing banks, which would encourage them to lend to various segments of industry (small scale, real-estate, exporters etc) on acceptable levels of spreads. The RBI must structure a dollar swap facility with the Federal Reserve, which provides for inexpensive funds and more importantly dollar supplies to meet current shortages. The government must declare that it will protect every bank deposit to the penny to reinstall declining confidence.

In the middle-term the government needs to structure a mechanism that will provide financing for infrastructure projects sponsored by the private sector. There are thoughts on using some of India’s foreign exchange reserves invested in US treasury notes for funding projects through the UK branch of the India Infrastructure Finance Company. In the longer term the government ought to get its own act together to execute infrastructure projects and effectively disburse funding that has been allocated. Most State Public Works Departments are frankly incompetent and rotten to the core. The solution may well lie in amending laws to bypass them completely and execute projects through an entirely new mechanism.

The conditions that now prevail are no less treacherous than those involving a nation engulfed in serious conflict albeit not of the military kind. What would be imprudent would be to draw conclusions that suggest the failure of the capitalist system. The right lessons should include efficient use of capital, less leverage and reckless risk-taking by industry, but most significantly greater efficiency in the functioning of government departments. Throughout the course of human history, banks have failed and will continue to do so in the years to come. That cannot construe the end of the world or for that matter the end of a market-based economic system that is pivoted on the principles of efficiency in the use of capital. The role of the sovereign must remain limited to regulation. Intervention, when so warranted by conditions, should be swift, efficient and transitory.

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