India Mustn't Stem Stock Slide With Cheap Money

Bloomberg Columnists

India Mustn't Stem Stock Slide With Cheap Money

By Andy Mukherjee
(Andy Mukherjee is a columnist for Bloomberg News. The opinions expressed are his own.)
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May 25 (Bloomberg) -- With $120 billion of India's stock- market wealth wiped out in just eight trading days, Finance Minister P. Chidambaram was busy convincing investors this week that tumbling shares presented an ``opportunity to buy.''

I hope this is just the minister's personal view as an armchair equity analyst and not an official assessment.

If it's the latter, one must worry about just what steps the administration might take to reward those ``genuine'' investors who do heed Chidambaram's advice and buy stocks.

The first risk is that the government might use some of its meager resources to try to prop up the markets. And sure enough, India's communications minister announced yesterday that the postal department would dabble in stocks.

A second danger is that a widely expected interest-rate increase in India may be shelved next month.

The threat is real enough. After the benchmark Sensitive Index fell 4.2 percent on May 22, adding to its 11 percent decline in the previous week, some analysts began ruling out an increase in the overnight rate, which the Reserve Bank of India pays to drain liquidity from the banking system.

``The impact from the stock market is going to seriously dent confidence, and tightening liquidity will be the last thing the markets would be looking for,'' Bhanu Baweja, a strategist at UBS AG in Singapore, said in a May 22 note to clients. ``Certainly, politically speaking, if tightening was difficult earlier, it would be totally unacceptable now.''

And that reluctance to raise rates will have its own ugly consequences. In the process of protecting stock-market wealth, the government might end up stoking inflation, which will erode the purchasing power of the local currency and hurt the poor.

Currency Value

The external value of the currency may be better protected. With almost $164 billion in foreign reserves, the Indian central bank shouldn't have much trouble preventing the kind of currency meltdown that has gripped Turkey and Indonesia the past 10 days.

Even so, a sliding rupee may spook overseas investors and cause further slippage in equity prices, defeating the whole purpose of fueling a stock-market rally with cheap money.

Inflation in India has been controlled artificially by the government. Oil-refining companies, most of them state-owned, have been told to absorb the losses arising from high crude-oil prices, rather than pass the costs on to consumers.

Indian fuel costs have risen 15 percent in the past year, compared with a 43 percent advance in global crude-oil futures. The fuel-price controls are ``unsustainable,'' the Organization for Economic Cooperation and Development said this week.

Inflation

The eventual -- and inevitable -- increase in energy prices will fuel inflation unless the central bank is allowed to tighten money supply and reduce aggregate demand in the economy. Gross domestic product expanded 8 percent in the year to March 31, 2006, and may grow as fast as 8.5 percent in the current fiscal year, according to Credit Suisse Group.

The inflation being generated by such rapid growth isn't showing up on India's benchmark price index, which has recorded year-on-year gains of less than 4 percent for seven weeks now. This pretty picture of high growth and moderate inflation is an illusion. The fact is that India is lagging behind the U.S. Federal Reserve in monetary tightening and must catch up.

Including a quarter-point increase in January, the overnight rate in India has gone up a measly 1 percentage point since June 1, 2004, while the Fed has quintupled its target rate to 5 percent in the same period.

Monetary Tightening

``Left to itself, the Reserve Bank of India would have wanted to tighten policy much sooner, we believe, but the Ministry of Finance wanted to keep a good thing going by keeping liquidity loose,'' UBS's Baweja said. ``The actual conduct of monetary policy has confirmed that the Reserve Bank of India is not the most independent central bank.''

Now that the utopia of ever-rising asset prices -- the Sensex set record highs for eight straight days before the plunge -- is under threat from a global liquidity squeeze, the Indian Finance Ministry might be even more reluctant to allow the central bank to tighten money supply.

``The genuine retail investor who's investing for the long term will stay invested, is staying invested and my advice to him is, `You should stay invested, all this should not worry you at all,''' Chidambaram told Bloomberg News on May 23. The Sensex fell 2.3 percent yesterday.

It will be better if the finance minister lets investors worry about asset prices and turns his attention to the real economy, which urgently needs normalization of interest rates.

Even if higher rates cause more pain in the short term, they will help investors avoid a bigger crash down the road.

(Andy Mukherjee is a Bloomberg News columnist. The opinions expressed are his own.)

Last Updated: May 24, 2006 15:54 EDT