Sudip Bandyopadhyay’s Blog

John Maynard Keynes is alleged to have said: “When the facts change, I change my mind” . Investors and lenders have moved from trusting anybody to trusting nobody.  The fear driving today’s breakdown in financial markets is as exaggerated as the greed that drove the opposite behaviour a little while ago.  But unjustified panic also causes devastation.  It must be halted, not next week, but right now.  The time for  institution-by-institution and country-by-country approach is over.  It took the regulators time realize the full dangers.  Maybe it was errors at the US Treasury, particularly the decision to let Lehman fail, that triggered today’s panic.  First of all, the panic must be dealt with.  This has already persuaded some governments to provide full or partial guarantees of liabilities.  These guarantees distort competition.  Once granted, however, they cannot be withdrawn until the crisis is over.  So European countries should now offer a time limited guarantee (maybe six months) of the bulk of the liabilities of systemically important institutions.  In the US, however, with its huge number of banks, such a guarantee is neither feasible nor necessary.  This time-limited guarantee should encourage financial institutions to lend to one another.  If it does not do so, central banks must lend freely, even on an unsecured basis, to institutions too systemically significant to be allowed to fail.  By these means, the flow of credit should restart.  But governments cannot allow banks to gamble freely with the public  money.  During the period of the guarantee, governments must exercise close oversight over the institutions they have decided to protect.  Ending the panic will require something else: the recapitalization of the banking sector.  Lacking a queue of eager investors, that will be achieved either through the forced conversion of debt to equity, or by governments taking a stake themselves.

Meanwhile, India must be careful to draw the right lessons from the US crisis liberal finance is not a bad thing in itself, but certain bits of the system need tinkering.  For one, the role of credit rating agencies, somehow not highlighted in the midst of this crisis, needs to be critically looked at by regulators.  There seem to be too many conflicts of interest in the way these agencies operate, even in India.  We need to do something about them now.  Second, we must understand that while financial inclusion is a good thing, too much of it, too fast may be counterproductive.  This is not to argue that everyone should not have access to a bank account:  they certainly should.  But banks and financial institutions need to be more prudent in giving too much credit to high risk borrowers.  Third, policy makers must keep track of asset bubbles, usually a common occurrence in times of excess liquidity, and disincetivise bubbles.  This is tough to do and carries the risk of overcorrection.  But regulators should start thinking about broad guidelines.  If India keeps these lessons in mind while continuing to liberalise its financial system, we can reap the benefits and minimize the risks and costs.

Global pain in the US and European financial markets during this week had a disastrous fallout on the Indian markets which was reflective of a new 52 week low for both the NIFTY and the SENSEX. The market indices witnessed a drop of almost 15% in just one week, with clearly panic overriding fundamentals completely. This was reflected in share prices of almost all front line large cap stocks dropping sharply by 8-10% on continued heavy unwinding by the FII’s. Moving swiftly RBI, announced two quick CRR cuts, one by 50bps early this week and the second one by another 100 bps on Friday taking the final CRR to 7.5% effective 11th Oct 2008. This move by the RBI is undoubtedly a positive step as this will further infuse fresh liquidity to the extent of almost Rs 60000 crs in the system, which will ease the present liquidity crunch faced by banks and other financial institutions.

Globally, the Dow witnessed one of the worst ‘sell offs during the week and touched a low of 8570  from a high 10124,  despite frantic attempts by the Fed and the US government to infuse confidence in the markets which was clearly missing. In an unprecedented joint move, the seven central banks around the world announced coordinated Interest rate cuts, as the worst financial crisis since 1930 increased the downside risk to growth, amid extremely tight liquidity conditions. The US Fed in an emergency meeting cut the benchmark interest rate further by 50 bps to 1.5% as the financial crisis is now being seen deepening and spilling over to other sector of the US economy. The fact that Fed rate cut has come much before its scheduled meeting later this month which clearly underlines the gravity of the financial crisis.

On the domestic macro front while crude prices continued to soften further and dropped below the $80 per barrel level and Inflation numbers for this week also continuing to moderate on the lower side to 11.80%, the news on the IIP numbers front for the month of Aug 08 was extremely shocking.  IIP growth for Aug’08 recorded a growth of just 1.3% against a consensus estimate of 5.5%, and compared to last year corresponding month number of 10.9% which is the lowest since Oct, 1998.  Reflecting the weak macro environment both globally and for India, IMF has cut  its world growth forecast to 3% from 3.9% earlier and downgraded India’s GDP growth this year to 6.9% from 7.4% estimated earlier. The rupee also witnessed a fall of 3 percent to touch a high of Rs 49.30 per dollar this week which  is the biggest weekly decline since November 1997. In fact one has observed a total dollar outflow of $7.9 bn during this week which is the single biggest outflow seen till date with cumulative foreign exchange reserves standing at $283.94 bn as on date.

The markets have broken all earlier support levels and now are in a totally different orbit as far as downside is concerned. The market sentiment has been badly hurt by the continued FII unwinding seen till date and ‘fear factor’ has now clearly gripped the markets resulting in panic selling across the board.  On the whole markets may take some more time to stabilize and for normalcy to return. Nervousness is likely to continue this week. However the oversold status of the markets may give some intermittent bounce back rallies, which could be used by panic struck institutional investors or hedge funds for further offloading.

( ** this is the transcript of the weekly column I write for Economic Times )