India and the financial crisis: between damage control and the priority of inflation

In the months running up to the Day that Lehman Died, India’s financial regulators were concerned only about slaying the dragon of inflation. And with reason. In a country where five per cent inflation triggers social unrest, the wholesale price index had touched 13 per cent in late summer and remained stubbornly in double digits despite a drastic monetary squeeze by India’s central bank, the Reserve Bank of India.

Which is why many Indian commentators quietly applauded when the second wave of the subprime crisis hit Wall Street. After all, they argued, a key reason for the inflation was an explosion in broad money supply – against a RBI target of 17 per cent growth, the money supply had by July increased by 20.5 per cent. And the key reason for the money oversupply was record levels of foreign capital flowing into India – over $ 100 billion in the first six months of this year.

Therefore, the argument went, Western financial institutional investors pulling their money out of India would ease inflationary pressure and allow the RBI to lower interest rates. In the week or so after the collapse of Lehman Brothers and the bailing out of US insurance giant AIG this argument seemed to hold. Foreign institutional investors sold Rs 67 billion worth of equity in the first eighteen days of September, but domestic buyers bought Rs 70.4 billion. The Bombay Sensitive Index fell only 3.5 per cent the day Lehman Brothers went bottom-up.

A further source of confidence was the perceived insularity of India’s financial sector to the outside world. India does not have a fully convertible currency. Complex financial instruments like multi-tier derivatives and their cousins are largely unknown. The Indian private sector was cash-rich, exports were booming and the country had over $ 300 billion in foreign exchange reserves.

This initial hubris is now being replaced with a recognition India is more vulnerable than was originally understood, especially as the financial crisis spreads beyond the US’s borders. Prime Minister Manmohan Singh, during a trip to Europe at the end of September, said, “The first and foremost challenge is to insure that India is insulated to some degree from the ill effects of the international financial crisis.” India, he admitted, would not remain untouched by the goings-on in Wall Street.

The two economic sectors immediately bloodied by the subprime fallout were India’s software services industry and its real estate sector. Roughly half of the former sector’s export profits come from overseas financial institutions. Real estate was an area where investment banks like Lehman and Merrill Lynch had invested heavily – and some of India’s realty firms are still scrambling for alternative financing.

The primary quandary facing India’s political leadership is that the obvious way to vaccinate against a financial tsunami swamping the domestic economy is to increase liquidity, ensuring banks and other institutions are not left short of funds. However, with an eye to controlling inflation, New Delhi has been trying to do the exact opposite for the past one year.

Since September, through a number of actions like promoting advance taxes, selling dollars and government bond auctions, the Indian government has reduced domestic liquidity by a massive Rs 1 trillion. Combined with foreign portfolio investors pulling out of the stockmarket and sending back $ 9 billion so far this year, this has ensured India now has an extremely tight credit market – mostly because of self-inflicted policies. In the past few weeks, call rates have risen to as much as 17 per cent. Some sectors, notably real estate and small-medium sized enterprises, have been savaged by the dearth of affordable finance.

While the RBI has recently twice eased the cash reserve ratio of Indian banks and made it easier for Indian firms to borrow overseas, the government has preferred to promise to increase liquidity rather than to actually do so. This reflects its concerns about inflation – even at a time when key commodity prices like oil have fallen. On October 1 Singh was still looking for silver lining in the global financial crisis, saying, “Inflation is a major worry, probably one of the side effects of the international financial crisis will be the moderation of inflation.”

The government’s stubbornness is in driven by politics. Singh will have to go for elections by the spring of next year and inflation, more than growth, is what Indian voters are most agitated over. There is an additional problem. The government has been hopelessly profligate. The combined fiscal deficits of the central and state governments are expected to cross nine per cent of GDP this year. This has meant little wiggle room between the conflicting demands of fighting inflation and buffering against the global crisis.

Sceptics are already warning officialdom is overly complacent about India’s overseas exposure. The stockmarket has fallen to roughly half its record high. This has put pressure on many Indian firms who have used equity to back external borrowings or have depended on stock issues to pay for their investments. Their hunt for dollars has been a reason the rupee has fallen by roughly 10 per cent, a decline that has bred its own clutch of problems. Tales abound of unnamed Indian banks borrowing millions at interest rates of 20 per cent to make ends meet.

Optimists note foreign direct investment flows to India have not been affected – private equity investment has been particularly resilient. Consumer credit growth has also remained steady. Ultimately, much will depend on how deep, how far and for how long the global financial crisis continues. At present, though, the Indian government continues to bet the dimensions of the crisis will be limited in every way, allowing it to continue its battle with the dragon of inflation.