Panics in India

(The following was written by Sunanda Sen and first appeared at TripleCrisis)

A panic of unprecedented order has struck the crisis-ridden Indian economy. It brings to the fore the question of what led to this massive downturn, especially when the country was touted, not long back, as one of the high-growth emerging economies of Asia.

A volte-face, from scenes of apparent stability marked by high GDP growth and a booming financial sector to a state of flux in the economy, can completely change the expectations of those who operate in the market, facing situations with an uncertain future. Such possible transformations were identified by Kindleberger in 1978 as a passage from manias, which generate positive expectations, to panics, which head toward a crisis. While manias help continue a boom in asset markets, they are sustained by using finance to hedge and even speculate in the asset market, as Minsky pointed out in 1986. However, asset-market bubbles generated in the process eventually turn out to be on shaky ground, especially when the financial deals rely on short-run speculation rather than on the prospects of long-term investments in real terms. With asset-price bubbles continuing for some time under the influence of what Shiller described in 2009 as irrational exuberance, and also with access to liquidity in liberalised credit markets, unrealistic expectations of the future, under uncertainty, sow the seeds for an unstable order. The above leads to Ponzi deals, argues Minsky, with the rising liabilities on outstanding debt no longer met, even with new borrowing, since borrowers are nearing insolvency. Such situations trigger panics for private agents in the market, who fear a possible crisis situation. These are orchestrated with herd instincts or animal spirits in the market, as held by Keynes in 1936. In the absence of actions to counter the market forces, a possible crisis finally pulls down what in hindsight looks like a house of cards!

Indeed, when markets have the freedom to choose the path of reckless short-run financial investments, with high risks and high returns, the individual’s profit calculus eventually proves wrong in the aggregate, leading to a path of downturn; not just for the financial market, but for the economy as a whole. This is how manias lead to panics and then to crisis in an economy.

Characterisations like the above help to explain the slippages in the Indian economy. GDP growth has decelerated from annual averages around 9 percent during 2005-11, to the current rate of less than 5 percent. The changing scene also featured a sharp decline in the growth of industrial production, to less than 1 percent in 2012-13. The stock of official exchange reserves, which was above $300 billion until 2010/11, is today down by $30 billion. There has also been a worsening in both the current account deficit and fiscal deficit, as proportions of GDP. Today, the two are at respective levels of 4.8 percent and 5.1 percent, considered to be too large for financial stability.

The changing scene in the Indian economy has also featured a classic bursting of bubbles in asset prices over the decade. With rising capitalisations in the stock market, which doubled between 2009 and 2012, and rising price/earnings ratios, which reduced the costs of new investments in financial assets, the expansionary spate in India’s financial asset market continued as long as the main agents in the market continued to invest. Turnover in India’s secondary market of stocks was considerably facilitated by Foreign Institutional Investor (FII) entry, fully liberalised since 1999, and by transactions in exchange-traded derivatives, treated at par with equities since 1999. Inflows of short-term capital also entered markets for real estate and commodities, including gold, thus inflating transactions as well as prices. Liberalisation of futures trading in commodities worked to initiate use of derivatives in the commodity market, often with spiraling prices.

Market expectations in India, which have turned adverse over the last two years, rest on the sharp depreciation of the rupee (hitting a record low of near Rs69 per dollar in August 2013, followed by a moderate recovery). Also, outflows of FII-led short-term funds; steady declines in the stock of official reserves; rising current-account deficit and fiscal deficits; stock-market volatility with a drop in turnovers as well as prices; a rise in external debt (at near 21 percent of GDP, and short-term debt at 31 percent of official reserves); and finally, a state of stagflation which is ineptly handled by the state machinery, are all aspects which similarly affect such expectations.

Facts like the above have created concerns of an impending insolvency with further downgrading of credit ratings, even below the current rating at the lowest investment grade of “Baa3” by Moody’s. With volatile FII flows, the lifeline of all short-lived booms in asset markets, expectations have further worsened. One can notice here the sharp drop in net FII flows to the equity and bond markets, from $708.9 billion to a negative total of (-)$188.4 billion between Jan-March 2013 and July-Sept 2013.

This worsening of the financial scene gets reflected in the sharp declines in the financial balance in India’s international accounts. The balance nearly halved between Q3 and Q4 of 2012-13. Much of that was due to the declines in portfolio investments driven by the FIIs. A rise in pre-payment of short-term trade credits abroad and bank lending from India, both to avert further decline in the rupee rate, were also there, as reflected in the drop in “other investments” on a net basis. Net capital flows fell miserably short of what was needed to meet the rising current account deficit, fed by unrestricted imports.

Concerns over the sagging financial market in India reinforce themselves as one witnesses the slump in the real sector. Not much is forthcoming in the near future from fiscal expansion, given the stringent clauses of the Fiscal Responsibility and Budget Management Act, which seems to have been already violated by the current fiscal deficit. Nor is much respite offered by the Reserve Bank of India (RBI), India’s central bank, which continues to be bothered about its prior goals of inflation and exchange-rate management in the face of free capital flows (or even the whims of US monetary authorities in their quantitative easing programme). None of the above permits much autonomy to the bank in setting monetary policy in the interest of domestic growth. The recent use of stop-go policies by the RBI have so far been incapable of reversing the current slide in the economy.

Looking back, the current scene of a discredited Indian economy, which has lost its past glory as a major investment destination in terms of stability and growth, can be traced back to the process of formation of a bubble economy, which originated from the welcome signals provided by the state to speculation, short-term finance, and the irrational exuberance on the part of agents in the market to make a fortune while the sun shone. The run on the system was avoidable, with timely interventions to stop the build up of the bubble economy supplemented by policies to direct finance toward long-term investments for growth.