Both India & U.S.A. are facing the heat of credit crunch in the financial markets but the nature of this crisis is not the same in both countries. In U.S. the bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments. These losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs, troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further. Troubles in the U.S. market in turn had a negative impact on India where panic among investors set in & this lead to a domino effect. With depositors’ distrust in the financial market a major chunk of these depositors presented their claims on banks simultaneously. Even the soundest of banking systems would fail under such a scenario.
In response, FED announced a bailout package of 700 billion dollars which will ease the flow of funds which has choked in the recent times. With higher liquidity in the market supply of loanable funds would increase drastically and interest rate in the economy would decline.
In India, R.B.I. has taken some measures which are being misinterpreted as a loose monetary policy. What has actually happened is that CRR & SLR have been reduced to provide liquidity to the market & on the other hand rupee has been mopped up from the market by selling of FOREX reserves on an extensive scale. Thus on an aggregate level this is not loosening of monetary policy and this step is being criticized by many. But is there a need for a lax monetary policy? It is being believed that this sale (of FOREX) has been initiated to strengthen the rupee which has been on a steep downhill slide. Value of exports has significantly declined due to lower level of demand in U.S. & other international markets and import bill has increased due to a depreciated rupee. Thus the budget deficit has moved further into the red. However, this may have another angle to it.
If there was only a loose monetary policy (only cut in CRR & SLR) interest rate would decline as a result of increase in supply of loanable funds .Under such a circumstance there would be a rise in borrowings at this lower rate of interest. With increase in spending, rate of inflation which is presently in double digits would also increase as a result. Now suppose that U.S. economy recovers in the near future. As a result of lax monetary policy inflation would have increased relatively by that time & RBI would again go for monetary tightening. This would jack up the cost of borrowing. Thus people who had taken loans at a lower interest rate might default on higher ones thus putting India in a similar sort of situation as the U.S. is in today.
This is where the selling of FOREX reserves in Indian markets comes into play. It prevents interest rates from sliding down today thus prevents today’s borrowings turning bad tomorrow. Solution to today’s credit crunch in India doesn’t lie in lower interest rates & increase in borrowings but in easing the flow of money in the financial system to prevent a run on banks.
