The traditional intuition of India as a closed economy was shattered in the last month. When the money market in London seized up after the failure of Lehman, a large number of Indian companies who were borrowers there were scrambling for dollar liquidity. They borrowed on the Indian money market and took dollars to London. This simultaneously gave tightness in the Indian money market and pressure on the rupee to depreciate. To some extent, it seems that RBI sold dollars in trying to prevent rupee depreciation. The tightness on the money market brought some firms down to their knees. RBI and the government responded with uncharacteristic alacrity. The CRR was dropped by 250 basis points and numerous other measures were put in place. On Thursday, the first signs were visible that these measures were having the desired effect, when the interest rate on the call money market dropped to 6.9%. This is an important achievement and speaks for a new maturity and tactical capability of Indian policy-making. Traditionally, such challenges would have generated a large systemic crisis in India (possibly accompanied by dirigiste policy decisions like banning stock market trading or short selling in bank equities). But this time, policymakers have performed well.
The task is, however, only half complete. Much more needs to be done to ensure ample rupee liquidity, ample dollar liquidity, adequate depth in currency derivatives markets to support currency hedging requirements of Indian companies who are funding dollar obligations by borrowing in India. Recent months have exposed the vulnerabilities of the Indian financial sector which are linked to the reforms programme articulated by the Patil, Mistry and Rajan reports. India urgently needs the bond-currency-derivatives nexus, a set of deep and liquid markets where short-term bonds can be bought, sold or hedged without the fear of a liquidity collapse, as happened recently. The silo system where NBCFs and real estate companies are cut off from mainstream finance, and only have mutual funds as a funding source, has been shown to be unhealthy and needs to be dispensed with. Substantial liberalisation of capital controls against FIIs is now required on both equity and debt markets, both to increase the liquidity of markets and to infuse dollar liquidity into the country.