Crisis: What more needs to be done

The government and Reserve Bank have done well to open up new sources of finance to help liquidity-pressured mutual funds that operate in the debt market. The refinancing of certificates of deposit is particularly welcome.

But more action is required. Since quite a few liquid funds have been dropping in value in recent days, investors have lost out - which is not something that ordinarily happens with liquid funds. This suggests that money market mutual funds have become one of the pressure points in the current crisis (and not banks - which have capital adequacy and reserve ratio requirements).

With the provision of liquidity to funds through bank finance, the asset management companies will be better able to deal with exceptional redemption pressures, and will not have to take forced discounts on the instruments that they hold, in order to get cash. It is not clear, however, whether the 14-day window that is on offer will do the trick; nor is it clear that banks will lend to the funds at interest rates that are lower than what have been promised to investors.

That is why what has been done so far is not enough. Given the fact that debt mutual funds have been major financiers of non-banking financial companies (about Rs 1,20,000 crore), and these companies in turn have invested heavily in the troubled real estate sector (upwards of Rs 90,000 crore), it is clear that there is a great deal of stress out there - for both NBFCs and mutual funds.

If this is to work its way through the system without causing ruptures, the Reserve Bank needs to provide more liquidity. It must drop the cash reserve ratio (CRR) by another 100 to 150 basis points, to release a further Rs 40,000-60,000 crore into the system. The CRR will even then be at 6 per cent or higher, which is at least double the statutory minimum and therefore a perfectly acceptable level.

Another sure way to help the funds is to drop interest rates, as that will improve the value of existing debt instruments and therefore give asset management companies the opportunity to raise cash without discounting their holdings. Once the immediate liquidity issue is addressed in substantial measure, the time comes to look at interest rates as well.

It is arguable that dropping a benchmark rate will not make much of a difference in the market when money is tight; but if adequate liquidity is provided for, a rate cut should be effective - and would also be more than justified when commodity prices have continued to fall and when the economic tempo is slackening.

Meanwhile, the global situation seems to have improved dramatically after the crisis phase of last week. The recovery in the stock markets could of course be just a technical relief rally, to correct for over-sold positions.

But with the US, UK, Germany and other countries moving the heavy artillery of the state into the banking system (with equity infusion, more comprehensive deposit guarantees and even loan guarantees), the fear of falling into a financial abyss has faded.

That does not mean the end of all problems; it merely means that the focus of concern shifts from salvaging the financial system to dealing with a recession/slowdown. Still, the international financial system has changed for good; whether for the better, remains to be seen.

The issue now is whether the excesses of an under-capitalised, over-leveraged system run by risk-prone managers with poor risk measurement techniques, can be got rid of without throwing the baby out with the bathwater.

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