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Coping with the crisis

In what is perhaps the most critical phase yet in the present financial sector crisis, the government and the regulators in India have managed to assuage investors’ concerns at least for now. Last week, SEBI and the RBI reassured the markets of the strength and capabilities of the domestic financial system to withstand the pressures emanating from abroad in areas such as payments and settlements systems and liquidity. Indian stock markets relatively unaffected by the initial rejection of the bailout package by the U.S. Congress have since slumped in response to global cues. On Monday, the leading indices were at a two-year low. The credibility that the regulators enjoy with the markets and, more generally, the relatively tight financial sector regulation are very significant factors in cushioning the impact of the global turbulence. In the developed world, investors seem to have lost confidence in the mainline financial system. In the United States, as well as in Europe, banks are coming under stress with a disconcerting frequency and one is not sure where the next failure would occur. Restoring the confidence of investors and markets in the U.S. is going to be a stupendous task even after the heavily damaged financial sector is repaired with dollops of cash from the taxpayers.

Prime Minister Manmohan Singh has pointed out that India cannot remain insulated from the crisis. If the developed economies are dragged into a prolonged recession, obviously Indian exports would suffer. Even now the drying up of credit markets has had serious repercussions on companies tapping international markets for debt and equity. Indian stock markets, like most Asian markets, have been moving in tandem with the U.S. markets even before the financial sector crisis acquired menacing proportions. The earlier theory of Indian stock markets being “decoupled” from their Western counterparts has been discredited. The pull-out by foreign institutional investors has been a principal reason for the sharp drop in share prices this year. Recently, they have become aggressive sellers as they see their problems in the U.S. intensifying. So far, the all-round decline in capital flows is a major cause of concern for the country’s balance of payments. The rupee has been depreciating sharply — it has dropped below Rs.47 to the dollar — and this, along with declining asset prices and a widening current account deficit, threatens macroeconomic stability. Any strategy to cope with the fallout of the financial sector crisis should build on the success of existing policies that have so far enabled investors to retain their confidence.

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