By allowing banks to convert more of their treasury holdings (government securities) into high-quality liquidity assets, the banking regulator, the Reserve Bank of India, has released nearly ₹ 2 lakh crore into the market to calm a jittery market worried over a host of factors, including a deterioration in macroeconomic fundamentals.

However, ever since the “Freaky Friday” of September 21—when the bellwether BSE Sensex fell 1,500 points in intra-day trading only to recover some ground later—the market has lost much of its sheen. The trigger for the meltdown was the fear that further defaults by India’s premier infrastructure financing company, Infrastructure Leasing & Financing Company, could set off a chain of events that would put the entire financial sector at risk. What spooked the markets was a belief that mutual funds and banks—the biggest investors in NBFCs—would stop lending to these companies, thereby freezing the credit market.

No wonder shares of Dewan Housing Finance crashed 42%, while Indiabulls Housing Finance slumped 8.2% and YES Bank fell over 30%. But what was disturbing was the fact that despite the right noises from the market regulator, the Securities and Exchange Board of India and the central bank, investors were not fully convinced. Hence, the RBI move, as they say in credit rating agencies, was credit positive for the market.

Yet, in hindsight, it seems that the reaction of the investors in the bond and equity market over the IL&FS issue was a bit overdone but still there are enough reasons to be sceptical about the direction of the economy.

Escalating trade war fears between the U.S. and China are already leading to risk aversion among global investors, seeking the safe haven of the U.S. markets. Rising interest rates in the U.S.—the third hike this year—elevated oil prices, a weak rupee, bankrupt banks and a widening current account deficit are issues weighing heavily on the investors’ mind.

Hence, gaining the confidence of the investors would require much more, as the investors seek macro-economic stability in an uncertain world. To begin with, government agencies need to reduce the country’s widening balance of payment (BoP) situation and bring down the prices of petrol and diesel. While keeping prices of petroleum products high may cut down consumption and reduce overall demand,  it will feed into inflation across goods and services in this pre-election year.

As Kapil Gupta and Prateek Parekh of Edelweiss Securities point out in their recent report called “Blind spot”—which talks about tightening liquidity conditions in India and its causes and consequences—tightening liquidity conditions are essentially a reflection of the deteriorating BoP situation in the country. While all that may be true for most emerging economies, the pain is far more acute for India. After all, India imports nearly 83% of its crude requirement, irrespective of the price. Moreover, recent U.S. sanctions on crude exports from Iran and the steep drop in Venezuela oil production are likely to put further pressure on oil prices and hence on India’s import bill.

A slowdown in the country’s high-frequency activity indicators like the Index of Industrial Production, manufacturing Purchasing Managers’ Index (PMI), stagnation in the country’s exports for past four to five years, which are yet to revive despite a sharp depreciation in the currency in recent times, has become a cause of concern. According to RBI figures, the past seven years have seen just a 26% increase in exports or 3% every year—from $210 billion in FY11 to $265 billion in FY18. The badly implemented goods and services tax (GST) too had not helped matters.

Pinning one’s hopes on software and other services exports to narrow down the current account deficit too is fading fast. Exports in services have not kept pace with the rising oil import bill and are unlikely to do in the near future. For instance, in FY18 while the oil import bill touched $85 billion, the net services surplus was around $61 billion.

There are many ways to shore up the rupee against the dollar—hiking interest rates, intervening in the foreign exchange market by releasing dollars in the system or cutting down on imports. While one is yet to see the impact of the government’s recent decision to raise import duty on a number of non-essential items, any decision to hike interest rates may not be the ideal thing for an economy, which is still recovering from the twin attacks of demonetisation and the GST. Even the 8.2% GDP growth in the first quarter of 2018-19 came on a low base. Any hike in interest rates now, especially in these times of a challenging domestic and external environment, has the potential to bring down the growth rate because companies will not be able to pass on the burden of higher interest rates to the consumer.

Moreover, rate-sensitive sectors like automobiles, real estate, and financials will take a major hit. It will be especially damaging for the real estate sector, which is just coming out of a prolonged downturn. For the auto industry too, whose success in the past four to five years has been dependent on low interest rates and ample money supply in the economy, things can turn gloomy.

As the Edelweiss report points out, passing on the burden of higher interest rates to the consumers by these companies would have been far easier under normal conditions. But under the current subdued macroeconomic conditions and a weak job and wage scenario, it would result in subdued consumption and lower the growth trajectory.

For the first time in the past four years, the Modi government is faced with extremely challenging economic conditions. The days of benign crude and other commodity prices are over. Gone too are the days of ultra-cheap global money sloshing into the stock markets of emerging nations. The synchronised global growth of the past years, too has been derailed by the U.S.-China trade wars, the protectionist stance of the country’s global partners, and a financial system that is both unable and unwilling to lend because of its past mistakes. How they manage the current crisis will not just be a true test for the administration but also for the government’s other agencies. But one thing is sure, it will require much more than just liquidity infusion to bring back the confidence of investors.

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