On a learning curve

Moreover, this crisis cannot be blamed on the fundamental edifice of free market reform. Iceland, Hungary and Ukraine benefited greatly from free trade and privatisation. What is to blame, instead, is a toxic mix of human greed, availability of abundant cheap credit from abroad, and flawed central bank policy. Consider the dynamics of this implosive combination.

Let8217;s take greed first. Wall Street has taken much of the flak for conjuring up fancy instruments with clever mathematics to disguise blatantly unwarranted risk in a bid to become really rich, really fast. What is often missed in this discourse is the desire to become rich on the part of subprime borrowers in the US, who took home loans which they couldn8217;t fundamentally afford. The greed may be more basic in its end 8212; say, a small house compared with a banker8217;s private yacht, but the idea of living beyond what one can reasonably and safely afford permeates all income classes.

Icelanders and Hungarians were doing the same. Individuals, firms and banks were borrowing massively from abroad, at very cheap rates. Some of this money was used purely to fuel consumption 8212; buying cars and houses. Some was used in unproductive asset bubbles like real estate. This borrowing was supported by pliant but independent central banks which maintained high domestic interest rates to curb inflation which was being spurred by the borrowing-led boom. High interest rates also helped maintain a strong and mostly overvalued exchange rate, which made borrowing from abroad cheap. Such a policy, while it brought short-term prosperity masked fundamental weaknesses in these economies particularly in the real sector and lulled economic actors into a false sense of permanent economic prosperity.

The drying up of international credit markets after the collapse of major financial institutions in the US burst the bubble. Suddenly, there was no money to borrow and creditors were calling in the debt. What followed was a collapse of the artificially strong exchange rate 8212; which not only induced price inflation, but also an inflation in the debt and thus near-bankruptcy of those whose debt was denominated in the foreign currency but held in the sharply depreciating local currency. Being a small country doesn8217;t help 8212;

Iceland8217;s government couldn8217;t guarantee bank debts which were six times the country8217;s GDP.

Now consider India. We have a huge middle class which is no longer averse to taking debt in order to afford a better lifestyle 8212; a two-wheeler, car, or house. Prime lending rates in India are very high, around 14 per cent. Given the freedom, Indian residents would justifiably borrow abroad at lower levels of interest. So would firms and banks. Firms are indeed allowed to borrow abroad but up to a certain limit. Individual residents are, however, not. Most PSU banks, which form the bulk of our banking system, do not take the risk. With hindsight this may have been a good policy decision as it saved India a massive consumption bubble. That said, in the absence of an option to borrow cheaply abroad, at least prime borrowers in India ought to be able to take debt at more affordable rates than a punitive 14 per cent. It8217;s time that RBI cut interest rates further and then pressed banks to pass rate cuts to consumers and firms, a majority of whom are indeed prime borrowers.

The risk of hot money from abroad is amply evident from the massive outflow of FIIs from our stock markets, the major reason behind the Dalal Street crash. This has caused the rupee to depreciate massively despite attempts by the RBI to defend the currency by using foreign exchange reserves. Imagine the pressure on the rupee and on debt and price inflation if the Indian middle class had huge borrowings from abroad which were being recalled in a panic.

The truth is that with a current account deficit and limited FDI, we don8217;t really have a solid forex reserve base, like China does. Foreign exchange earned through exports and a current account surplus and received in the form of massive FDI is more stable. China, therefore, is sitting on earned money, or invested money in assets, which will not disappear.

Full capital account liberalisation is bound be put on hold in light of the crisis. But economic reform should not meet the same fate. This is not an argument against free markets. India needs to do more to attract FDI and to drive exports which will put us in a better position to liberalise the capital account in the future for which a second generation of reforms is needed 8212; liberalising FDI restrictions, reforming labour laws, privatising PSUs, even reforming the financial system to make it more competitive and responsive.

The real lesson from this crisis is the need for caution, particularly against bubbles created by borrowing which are bound to be followed by bust, as surely as night follows day. It is also important to remember that policies are not an end in themselves, economic growth and development are. If a small part of free market reform 8212; capital account liberalisation 8212; has to be put on hold for the sake of sustainable growth, so be it. The good news is that India8217;s growth, even if it slows down, as it is bound to, is in the sustainable category.

dhiraj.nayyarexpressindia.com