After three years of buoyant, investment-led growth, the Indian economy started to slow late last year (2007). This growth slowdown was initially welcomed by the RBI, which had been gradually tightening monetary policy (since 2004) in a fight against inflation.
Price pressures were further exacerbated by the sharp rise in commodity prices late last year and early this year. The net effect has been partially to reverse the measured (but inadequate) progress toward fiscal consolidation, as well as to increase the current account deficit in the balance of payments.
The political cycle is at an awkward point. Parliamentary elections are due by next summer, and there is considerable uncertainty as to the government that is to follow. India continues to suffer a series of terrorist incidents in its larger cities, and the political and economic instability in Pakistan adds another layer of uncertainty.
Taking economic and political pressures together, it is perhaps not surprising that, for many Indians the present moment is compared less with 1997 than with 1990-91. That was the year when India suffered a major external payments crisis and was obliged to apply to the IMF for assistance. Thanks, however, to inspired political and economic leadership at that time, that payments crisis was turned into an opportunity for major structural reform from which India continues to benefit till this day.
The interesting question is whether a similar opportunity can be created again. Policy until late August operated on a business-as-usual basis. Even though the financial crisis had been underway for almost a year, policy action was based on the assumption that India could remain largely unscathed.
Government attitudes changed sharply in September. Notwithstanding the generally sound domestic financial position of India’s commercial banks, bank liquidity came under strain as banks’ overseas subsidiaries found their sources of wholesale finance withdrawn.
This effect was compounded by the intensified sell-off by foreign investors in domestic equity markets and the repatriation of funds to meet liquidity calls abroad.
Over the course of October, the RBI has sharply reversed course on the two key instruments at its disposal: the cash-reserve ratio (that is, reserve requirements) that banks are required to hold in their accounts with the RBI; and the overnight secured lending rate at which the RBI lends to banks.
India’s policymakers have both the experience and the tools to ride out the present storm. They will be helped by India’s lower integration with world trade and finance, and by a variety of institutional features.
Yet by itself this is not enough: the larger challenge will be, as in 1991, to use this crisis also to resume the momentum of reforms that have largely stalled. Of this there is as yet little sign.
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