See-saw markets

Needed, a policy tailored for volatility.

As Asian markets continued to fall on Friday, the bigger fear is not that India’s markets would go into secular decline — they may not — but rather that volatility will become the norm, rather than the exception, for a while to come.

This would make it that much harder for private companies to raise money from the market or for the government to meet huge disinvestment targets. Further, macroeconomic management will become much more difficult.

The government and the Reserve Bank of India (RBI) may be able to put their heads together and come up with a plan of action to deal with sustained inflows or with sustained outflows. But dealing with wild swings in flows is much more problematic.

For instance, during the period April-December 2009, forex reserves increased by $11 billion compared to a decline of $20 billion during the corresponding period a year ago, a swing of $31 billion. And that was before the Greek tragedy unfolded.

If, as is feared, the contagion spreads to other European economies like Spain, Portugal and Ireland, we could see a huge influx of funds seeking higher short-term returns, especially since global liquidity continues to be abundant.

However, at the first sign of recovery or even if level of fear crosses an undefined threshold, we could see an equally strong flow out of the country, either to other markets or the traditional safe haven, the US dollar.
    
Any policy that we frame must, therefore, contend with a much higher level of uncertainty on the external environment. The problem is globalisation gives us nowhere to hide.

Surges of foreign capital, either way, impact not only the stock markets but also the exchange rate and depending on the policy response, domestic liquidity, prices, employment and inevitably growth.

After the record 54% export growth in March 2010, it might be tempting to think our exports have become impervious to exchange rate appreciation but that would be to ignore the fundamental laws of economics.

And if there is one lesson the crisis has taught us, it is that we ignore fundamental lessons at our peril.