Sudip Bandyopadhyay’s Blog

“History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively.” So said Ben Bernanke, Federal Reserve chairman, last  week in London.  It sounds obvious, but it is also fundamental - and for three reasons. First, banks allow people to pay each other easily - without them commerce would be severely impeded. And second, along with the wider financial system, they act as vital intermediaries allowing credit to flow from savers to borrowers with viable ventures. The third strut is potentially the shakiest - by their nature of lending for long periods but borrowing short, banks rely on confidence for their existence; fear or disruption in one part of the financial system can spread like a virus and bring it crashing down.Their crucial role underpinning economies means the authorities are loath to let them fail. The big lesson of Lehman Brothers’ catastrophic demise, and the huge disruption it caused to markets in the months that followed, was that no leading economy could afford to let another bank of significant size fail.  No other industry has the potential to spread its woes to the rest of the economy like this. So, however obscene the public finds the taxpayer support for the banks, the crude reality is that, regardless of who was to blame for the mess, there has been no alternative but to offer support until the crisis is over.

But for all the importance of the financial system and banks, it is difficult to attribute the deepening recessions in all leading countries to a sudden drop in credit availability after the banking crisis of September and October. That happened later.  Instead, the evidence suggests the shock from the banking failures alongside already strained economic conditions shattered confidence and caused a sudden reduction in demand worldwide. At the same time as companies began retrenching and scaling back investment plans, the financial system has been tightening the supply of credit. Combined, this has set in motion the vicious circle of economic woes now gripping the world. Companies’ sales and profitability have dropped, and the proportion of corporate defaults has risen, so weakening banks’ balance sheets further. As banks’ fears over the weakness of their balance sheets have mounted, they have naturally become ever more conservative in their lending, with their corporate customers suffering the consequences.  The authorities in all advanced economies are determined to break the downward spiral. In all countries, monetary policy has been loosened to encourage confidence and risk-taking in the real economy, and the US has taken the next step by allowing the Federal Reserve to create money and purchase assets to ease the flow of credit, force down market interest rates across the economy and add cash to the economy.  In an attempt to tackle the root problem, authorities across the world are seeking to reduce the uncertainties over banks’ balance sheets by increasingly transferring the risk from the institutions to the public sector. Further action along these lines is inevitable until it becomes clear the crisis is over.

Indian Capital Market continued to remain under severe pressure throughout the week with indices falling by about 5%. Both domestic and global corporate quarterly earnings numbers impacted the market sentiment adversely.  Also with the confidence in the banking systems especially in the U.S and U.K. having plummeted to a all time low, due to fears of over exposure to bad loans, fresh panic has spread across the global financial markets.  The week also saw the new U.S. President Barrack Obama taking office on Jan 20th 2009. But this hardly had a positive impact on markets, as widespread negative macro and corporate news flows continued to dampen the market sentiments.  This was reflected from the fact that the U.S. economy showed further signs of deterioration with initial jobless claims rising. Also Tech major, Microsoft Corp stunned Wall Street with disappointing Q4 results and declared plans of slashing 5,000 jobs and a warning that Profit and Revenue could drop substantially over the next two quarters.

On the domestic front, inflation moved up marginally this week to 5.60% from previous week’s level of 5.24% due to higher food prices.   There are  strong expectations on reduction in petroleum product prices very soon which if happens could boost the market sentiments.  FIIs remained aggressive sellers in cash segment last week. Next week is a truncated week and also having an ‘expiry’ in F&O segment. Data suggests markets are in ‘oversold’ state now and could stage a ‘come-back’ with emergence of ‘value-buying’ at lower levels. With the RBI monetary policy scheduled to be announced in the coming week on 27th Jan 09, there are expectations of another rate cut considering the significant drop in inflationary levels.Banks play an important role in any economy – so much so that, by efficiently channeling funds to productive uses, they can meaningfully improve prospects for employment and wealth creation. Yet, if they run into difficulties, they become sources of turmoil and painful contraction in economic activity.The Indian Central Bank has been taking pro-active steps during the last few months to improve liquidity and increase lending activity.  The liquidity crisis of October – November 2008 ,is definitely behind us and there is ample liquidity in the system, now.  However, the lending activities of the Banks and Non-Banking Financial Institutions are not yet back on track.  Lending is much below the desired levels and both mid-cap and small-cap companies are suffering. Thus, apart from further improving liquidity & cost of funds ,  RBI should take appropriate measures to ensure easy availability of credit.  This would be the biggest challenge for RBI in the forthcoming credit policy. Any ‘positive’ surprises from RBI credit policy or other government measures may trigger ‘short-covering’ which may push indices higher. However low ‘volumes’ are still the concern and may remain so for sometime.

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