At what costs are we averting a financial crisis?

Thu, 14 Nov Pre-Open

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While a financial crisis seems to be brewing in India since quite some time, it has not yet struck us in full fury. Bad policies, twin deficits, currency depreciation and the recent slowdown, while all pose a huge risk to the sovereign rating, we have escaped a catastrophe so far. But as an article in Livemint points out, we have been paying a huge price for averting this disaster and things are unlikely to remain stable for long. Let us see how.

Some of the credit for this stability can be given to banks. The Government has been avoiding a fiscal crisis by financing its deficit from bank funds via statutory liquidity ratio (SLR) window. SLR requires banks to invest in the Government bonds. However, considering the risks to the sovereign credit ratings, the possibility of a banking crisis in the future cannot be ruled out. And that is not the only drawback. With 23% of bank funds meeting SLR regulation and most of the other funds meeting the cash reserve ratio (CRR) needs and priority sector lending, banks are left with less credit. As such, the borrowers end up with higher interest rates on loans while interest rates on deposits fall. The low returns divert funds to speculative sectors like real estate and stock markets that are fraught with own set of problems. Now that even stock markets seem to be out of tune with basic economic prospects, we are facing high volatility risks. If Fed starts tapering, the Indian stock markets are likely to lose all gains seen recently.

A bubble in the real estate has often been a precursor to some of the worst financial crises that the global economy has witnessed so far. Let us see how India fares in this regard. The real estate prices in India are much higher than the other parts in this world. India seems to have managed to escape a crisis so far. Thanks to the license-permit-quota raj that has led to supply lagging demand thus sustaining high prices. However, this has also deprived masses of the basic need of shelter at reasonable prices.

Similarly, we have avoided hitting a currency crisis by holding huge reserves of foreign exchange. And in the process have missed the option of investing the same for more productive purposes with higher returns. Ironically, what has rescued us from debt crisis is high inflation (since it reduces the debt in real terms). The same has led to more investment in gold and real estate sectors that are considered good hedge against inflation. While inflation concerns might have been addressed to some extent, this has deprived country of productive investments and affected the real growth.

But is there a solution to the current situation? Can we keep the crises away without being slapped with huge opportunity costs? While the mess is too deep to be sorted soon, some steps can always lead to better prospects for Indian economy. This will start with Government avoiding wasteful expenses on subsidies and focus on rational taxation. The funds should instead be invested in more productive segments such as infrastructure creation and priority sectors. This will also reduce burden on banks with regards to priority sector lending and free them to play a better role in the economic development. As far as individual sectors are concerned, almost all are in dire need of reforms. But for that the policymakers need to keep the vote bank politics aside and work with broader economic interests .