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November 30, 2008

Why India too got sucked into the liquidity crisis

Business Today has used a recent research paper titled "The current liquidity crunch in India: Diagnosis and policy response" by Jahangir Aziz, Ila Patnaik and Ajay Shah, to review why India got sucked into the global liquidity crisis.
Their hypothesis in brief: in trying to manage the exchange rate, growth and inflation, the central bank had kept the system chronically tight on liquidity. Several Indian companies that had been using the London money market fell short of dollar liquidity in mid-September. So they borrowed on the money market and took US dollars out. At the same time, corporations were liquidating their holdings in mutual funds. Mutual funds, too, then started making claims on the money market, leading to a colossal shortage of liquidity. This was accentuated by factors such as advance tax payments and sale of dollars by RBI to prop up the rupee.

Plausible? Perhaps, but that may not be the only explanation for the domestic turmoil, say finance heads of companies. “Yes, we did sell over Rs 200 crore of our holdings in mutual funds; yet, that was to meet our domestic requirements. The redemptions would not have happened if the consumer market was growing,” says the Chief Financial Officer of a consumer durables company. The rupee’s fall also hastened the outflow.

...Is there a way to manage this extraordinary crisis? In their paper cited above, the three economists point to a four-pronged strategy—increase rupee liquidity, increase dollar liquidity, refrain from artificial exchange rate stability, and remove currency mismatches. Author Ajay Shah believes the RBI has moved quite a bit on providing rupee liquidity but the weakest links in the coming days will be dollar liquidity and currency mismatches.



Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports. Email the author at arun@ventureintelligence.in