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Huge fund shortage is a manifestation of the global crisis

Posted by Yogesh on Tuesday, 7 October, 2008

Is there a credit crunch in India right now? You bet there is! The key question is: are bank loans not being given because investors don’t want funds? No. There is a credit problem because there is no money in the system. How long will it last? We don’t know. In these financial market conditions, it’s really difficult to know anything. Over the past fortnight, banks have been borrowing an average of over Rs 75,000 at the Reserve Bank of India’s LAF (liquidity adjustment facility) window. Call rates have shot up to over 17% on occasion and remained around 13% over the week. Inflows into mutual funds have dried up. Banks do not have funds for loans.

How did this situation come to pass? Where has money gone? The usual suspects are the advance tax outflows, the Rs 10,000 crore borrowing by the Centre brought forward from October. These have contributed, but are only a small part of the problem. The bigger problem is that this huge shortage of funds is a manifestation of India’s having been sucked in into the global crisis.

Portfolio funds have pulled out about Rs 25,000 crore from their equities and debt investments in September alone. Other flows have probably dried up as well. In normal months, for instance, India would have got over Rs 9,000 crore through FDI; this would have been reduced to a trickle. So would have another Rs 6,000 crore of external commercial borrowings. We can also hypothesise that exporters of both goods and services must be holding back on bringing in their foreign currency earnings in hopes of getting a better conversion rate if the rupee depreciated further.

On the demand side, foreign currency lines of credit of corporates would have been cut, forcing a shift into rupee funds. This dire shortage of dollar funds will have put a strong downward pressure on the rupee. To contain volatility, the RBI is bound to have intervened massively in the currency markets, and would have aggravated the problem. When the data is published, we will see that it will have sold over $10 billion; this would have taken out a further Rs 45,000 crore of rupee funds out of the system.

A combination of a shortage of collateral and consequently higher borrowing costs, meanwhile, has shifted demand for overnight funds away from both CBLO (Collaterised Borrowing and Lending Obligations) and market repos into the RBI LAF and failing this, call markets.

What might be done to mitigate this? The situation is likely to improve in the coming days; not much, but a little. Increasing government expenditures will start flowing in into markets. The RBI will keep infusing liquidity through the LAF and probably introduce more temporary facilities to help banks tide over their SLR collateral shortage (which remains even after the temporary relaxation of the SLR by 1%). This relaxation will probably be expanded from the current LAF to some form of a swap of MSS securities (which are also SLR eligible), further weakening the SLR constraints, even if only temporarily.

To specifically address the dollar shortage, the RBI might introduce a domestic version of the dollar swap lines that the Federal Reserve has opened with European central banks, using its foreign currency reserves. Some part of the domestic INR liquidity injected into markets would be exchanged for dollars from the RBI, which will, if need be, open temporary reciprocal lines with the Fed to augment its own reserves.

These are, however, temporary measures. More, however, might need to be done to keep credit pipelines open. There are very persuasive arguments that conditions are now right for a CRR cut.

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