Download COPY FOR “DECCAN HERALD” OF NOVEMBER 1 2008

COPY FOR “DECCAN HERALD” OF NOVEMBER 1 2008
“The Unraveling Economy” by S L Rao
The impending recession is because of rising oil prices and government deficits. It will
lead soon to growing unemployment especially of workers in export industries, workers,
I. T. B.P.O., hotels, restaurants, airlines, etc, the financial sector, durable consumer
products from automobiles to television sets and entertainment electronics. Governments
must devise safety nets especially for the unemployed poor, encourage banks not to
squeeze borrowers who are slow to repay, provide some support in paying fees for
education, and honestly implement social programmes like the employment guarantee
scheme, education and health for all. Above infrastructure projects must be speedily
implemented. All this spending will increase inflationary pressures and government
deficit. However, we need to shake the economy out of an impending recession.
Fiscal deficit for Central and state governments together, will cross 10% of a smaller
GDP. This is a result of massive (uncounted in the deficit) government expenditures
including bonds to oil companies in lieu of funds for meeting losses for selling below
costs, petrol, diesel, cooking gas and kerosene, large parts of the food and fertilizer
subsidies, write-off of around Rs 65000 crores of farmer loans to be reimbursed to banks
over a three year period, acceptance of the Pay Commission report, subsequently added
to by higher pay to the armed forces and others.
Inflationary pressures were not just imported by rising prices of crude. They were
stimulated by rising deficits of governments. The Reserve Bank reacted rightly by
tightening liquidity and raised interest rates. Higher interest rates hurt industrial growth
and hurt demand for consumer goods earlier stimulated by cheap consumer finance.
Static or declining industrial growth was worsened by rising oil prices adding to the
deficit in the balance of payments and putting pressure on the Rupee’s external value.
Then the sub-prime scandal broke in the USA due to the bundling of good and bad
housing and other loans, giving them high ratings and their being sold from one bank or
financial institution to another. When the constantly rising house prices staggered, the
bundles began to unravel. As each buyer demanded encashment, a round of lapses among
banks and institutions started. These were compounded by the collapse of confidence in
the many complex financial products that had led to unregulated global money flows
being around ten times trade and investment flows. Foreign banks began selling assets
everywhere including India to shore up their liquidity.
This saw a rush of dollars flowing out of India, causing the Rupee value to fall
rapidly. India had encouraged foreign investors to invest in Indian stock markets ansd
other investments through routes (like Mauritius). They did not pay short-term capital
gains tax. This brought a flood of money especially to stock markets. The flood also
ebbed as they booked profits and then invested again. The ingenious ‘participatory notes’
enabled volatile funds (including round tripping Indian funds) to come anonymously into
Indian investments. Indian stock markets were a casino for investors who moved stock
prices by huge numbers. The liquidity crisis in the USA led to these investors selling
assets in India, creating panic in stock markets and huge pressure downwards on the
Indian Rupee. Foreign banks may also have pulled funds out of India to shore up liquidity
in their home countries. Thus our liquidity crisis was not entirely imported. It was
enabled by our encouraging inflows and outflows of volatile funds.
Falling prices due to falling global demand for industrial products and crude have
brought their prices down. Indian inflation is declining, helped by a good agricultural
crop. The priority must now shift from controlling inflation to stimulating growth through
greater liquidity and lower interest rates than the 1% recent reduction in repo rates. Banks
are afraid to lend. Layoffs in the many sectors earlier described, demand an urgent and
comprehensive revival package if a small recession is not to become a long depression.
Governments at Centre and states must act. We should not merely, as the RBI Governor
seems to want, merely “react to developing situations abroad”.
Interest rates must be reduced further. Banks must be temporarily protected by
government from losses from the narrowing spread between recent higher deposit rates
and lower lending rates. Deposit insurance must cover all deposits and not the measly Rs
1 lakh deposits now. Government must cut infructuous expenditures. Implementation of
Pay Commission recommendations must be postponed. Banks must be assured that loans
made after a normal due diligence process, will be insured for a limited period.
Government must proceed briskly with its expenditure plans on infrastructure
development, education and health. The NREG scheme adds to purchasing power if
honestly implemented. Government must impose severe penalties on officers and
contractors who do not do so. Short term capital gains tax must be made applicable
equally to all investors, including Mauritius and similar beneficiaries. Participatory notes
must be stopped as must short selling in Indian stocks. Easy funds repatriation by foreign
banks must cease.
These actions could stop a recession in India. They will add to government
expenditures, raise the deficit, and cause unrest among government employees. The
deficits must be reduced when the economy has stabilized. Government has adequate
powers to make employees behave.
The forthcoming state and general elections will prevent these necessary actions.
Without them, resumed growth will be jeopardized.
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