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Sub prime hurricane: Needed a contingency plan

By BS Reporter in New Delhi
September 30, 2008 13:23 IST
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The sub-prime hurricane is wreaking havoc on the global financial system. After a series of relatively small, firm-specific rescue missions, the US government has now cast all its dice on a $700 billion bail-out package.

Opinion is divided on whether this will work, and there is widespread scepticism.

Meanwhile, all governments should be giving serious thought to their own economic contingency planning.

What kinds of threats does India face in today's context, and what mechanisms does it have in place to deal with them?

The question assumes urgency when the Sensex has dipped to its lowest point in the year, and when net sales by overseas investors in the secondary market have already topped $18 billion this year.

If as much more were to flow out again in the next six months (and the FIIs still hold $150 billion worth of stocks), bears could be in command on Dalal Street.

One risk here is the robustness of the clearing and settlement systems. Fortunately, India's trading systems have held up quite well; even in the bloodbath of May 2004, by far the worst one-day fall, they did not let traders down. A second area of concern is liquidity.

As large amounts of money are withdrawn and repatriated, domestic liquidity is compressed and this disrupts the normal course of business.

Credit costs significantly more already, and could become more difficult to access. This may render an otherwise viable business activity infeasible.

Over the past several weeks, the attention of central banks around the world has been focused on maintaining appropriate levels of liquidity, though no one is quite sure how much is needed.

The Reserve Bank of India did its bit on September 8, but the situation appears to have tightened again, suggesting the need for further measures, including some unwinding of the Market Stabilisation Scheme holdings, built up earlier.

A third pressure point is the downward thrust on the exchange rate because of escalating outflows, which add to the pressure that oil companies are exerting on the forex market by virtue of their buying up dollars to pay for imports.

Taking the latter out of the market, by resuming the dollars-for-oil bonds swap that was tried in June, will help stabilise the exchange rate, but cannot guarantee it.

Meanwhile, managed depreciation of the rupee could aggravate capital outflows as foreign investors act to minimise their losses in dollar terms. However, it is probably better than risking a free fall in the currency.

The RBI needs to decide where it stands on the issue -- resist depreciation by drawing down on reserves, or let the rupee fall where it may.

If it chooses the former, how far down is it willing to let reserves go? Fourth, for both exporters and financial institutions, there is a very real risk of exposure to bankrupt counter-parties. ICICI Bank has already been impacted by its investment in Lehman Brothers' securities.

Others may be hurt as more institutions go under - and one seems to be going down every day now.

For exporters, payment schedules may be thrown out of gear if banks that had extended credit to importers fail.

The only thing that is clear is that a contingency plan needs to be put in place, if it hasn't already been. At the very least, this is going to require effective co-ordination between the ministry of finance and the two main financial regulators, RBI and the Securities and Exchange Board of India.

 

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BS Reporter in New Delhi
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