Rx: Start With Consumption, Start Small

The trick to jump-starting the economy might lie in creating demand for basic goods, besides increasing liquidity and other revival measures

IN THE movie Batman & Robin, arch-villain Freeze gate-crashes into an antiquities exhibition and announces: “In this universe, there is only one absolute. Everything…freezes.” Credit markets across the world have frozen over, and though there’s no nasty piece of work yet (at least not on the scale of Freeze), there are no early signs of thawing. Spring may still be far away, but attempts by regulators and governments from across the world to end the economic chill don’t seem to be working. In India too, the government and the central bank, Reserve Bank of India, seem to be working hard to loosen winter’s cold grip over the Indian economy, but with little success.

The RBI has been infusing the economy regularly with large doses of liquidity ever since the system was beset with worries of money drying up. The RBI tried everything in the book — cut cash reserve ratio, freed up part of the statutory liquidity ratio, opened a special lending facility for banks to on-lend to NBFCs, housing finance companies and mutual funds, created a special refinance window from where banks could borrow without providing any collateral. Additional liquidity was pumped in by buying back bonds issued under the market stabilisation scheme. In all, since mid-September, the RBI pumped in Rs 300,000 crore through the sluice gates.

But, even that did not help hydrate the financial system. When banks were swamped with liquidity, they took the cash and dumped it with the RBI for a 6% return, even when lending it to prime borrowers might have fetched better returns. The central bank even cut its benchmark repo rate by 150 basis points (bps) to 7.5% on October 19 in an attempt to get some of that money moving out of the bank vaults. Still no go.

The RBI recently turned up the thermostat once more, this time to prod banks to start lending at reduced interest rates. It cut its benchmark repo and reverse rate by 100 bps. But, again, there’s hardly any movement. The banks are still carting their surplus cash over to the RBI and dumping it there for safe-keeping, for even as a low a return as 5%. Take a look at the money being tipped over at the RBI window.

For the first five days of the month, till the RBI cut the rates, banks plonked Rs 243,310 crore with the Reserve Bank, for a return of only 6%. Then on December 6 — a Saturday — it cut rates again. Over the next three working days, banks again deposited Rs 84,635 crore with the central bank, for a return of just 5%. The total — for just eight days — works out to over Rs 327,000 crore! In fact, the RBI was forced to comment, while announcing the new rate cuts, that the liquidity adjustment facility operated by the central bank, “has largely been in an absorption mode.”

In effect, this means banks are still wary of lending to corporates, despite the sea of liquidity and rate cuts unleashed by the central bank. This also then conveys how banks are still uncertain about the future and that they are doubtful about the ability of their corporate clients to pay up in time. In short, the vital glue of financial system — trust — seems to be missing and the authorities designing the various economic packages are unable to supply it in sufficient quantities.

Here's an example — a public sector unit was able to issue five-year bonds to banks with a coupon of 9.33%. Around the same time, one of the Top five India Inc companies also borrowed three-year money, but at 10.10%. Clearly, banks are willing to take a risk on the government, even if it is a subsumed sovereign guarantee, but not on even AAA-rated private companies. Banks have not forgotten the nightmares of the early 1990s, when bank NPAs ruled around 10-14%. This time, despite the prodding from the government and the central bank, they are unwilling to stick their necks out. The RBI has allowed banks to restructure loans — a euphemism for looking the other way when a loan turns bad — that might in ordinary times have been called for stricter treatment. But, the banks are still not biting.

The problem also seems to be in the system’s liquidity absorption capacity. Whatever steps the government takes at the moment — such as, providing cheap cash to corporates through a variety of refinance windows — not only are banks reluctant to lend, even corporates are loath to load up their balance sheets with fresh debt. Many of them are drawing down their existing credit lines with banks — emboldened somewhat by the new restructuring space — to finish existing projects but are unwilling to bet on new projects. With aggregate demand having fallen, India Inc is also contending with reduced topline and bottom line projections. In such a scenario, they may not be in a mood to pile up additional debt.

Therefore, the key to the current economic impasse might lie on the demand side. The government has tried addressing the issue by spending on infrastructure and by cutting taxes to boost demand. These are also not without their associated problems. Any investment in infrastructure will yield results only after a long lag, and the nature of improved technology does not allow for the higher employment generation that one saw a few years ago. Plus, to get an infrastructure project started is also time-consuming — financial closure in these days of clammy credit markets is a tough call.

Some economists say that the production orientation of the economy has changed in favour of expensive consumer products, a sector that might be slow off the blocks in reviving. In such a situation, reviving demand for wage goods might just do the trick. Even this hypothesis needs to be tested. The occasion might present itself soon — with experts forecasting a better-than-average winter crop, the government should facilitate hassle-free movement of the harvest to the markets and consumables to centres where the ensuing agricultural income can be spent. This may sound simplistic, but sorting the physical, infrastructural infirmities could be one of the first achievable steps on the long road to recovery.

Published as an Op-Ed in The Economic Times (December 15, 2008)