October, what a dramatic month! Markets crashed worldwide, taking currencies down with them and creating what has been now been called a ‘financial tsunami’. The madness of the media rivalled the madness in the markets as anchors squeezed out stories from the minute by minute ticker.

All of this was predicted few months back, and we were among those who did so as far back as November 2007 and repeated our concerns in Feb 2008. Indian policy makers however kept up with their pro-inflationary fiscal policies of increased government expenditure on the one hand and liquidity tightening monetary policies on the other. This is a familiar pattern and occurred in the 1990s as well - profligacy and inflation followed by interest rate tightening and growth slowdown. This time it is of course much worse, with the impact of the financial imbalances in the international economy.

This will result in a slowdown in Indian exports, and there will also be a slowdown in Indian investment growth especially in the corporate sector. We do not however expect any recessionary tendencies to affect India. Some sectors will no doubt be affected adversely, and the strong growth momentum will level a bit, India will however sail out of these troubled times relatively smoothly.

Among areas of concern, to inflation is now added financial and macro-economic stability. Given the rapidly changing situation, to its credit the government has approached this crisis in a mature manner. Increasing liquidity and reducing interest rates, strengthening of some institutions that appeared to be weak, and allowing markets to stabilize by themselves have significantly and positively impacted the long term confidence in Indian markets. This augurs well for the future.

Since inflation drives politics and economic policy in India, we would need to keep a close watch on it for some time ahead. On the one hand commodity prices have fallen dramatically, but so has the rupee, thereby reducing its anti-inflationary impact. Combined with a high budget deficit and potential mismatch in supply and demand of some food products (typically of the non-food grain variety), inflation will fall but not dramatically. Economists in the government would find it hard to convince the administrators and politicians to reduce interest rates further.

The PM and others have meanwhile supported ‘pump priming’ the economy through additional infrastructure investments by the government. Though infrastructure investments are generally welcomed, this would not be very helpful for the problem at hand. Since the money flows would only commence in a few years, when the worst of the growth slowdown would anyway have been over. Meanwhile large scale government borrowings would only reduce confidence in the intervening period.

There is only one way to strengthen confidence in India – good fiscal management, and strong market based institutions. Improved monitoring, quality of regulation, and policy all need to be oriented to these, temporary hiccups notwithstanding.

PS: Alan Greenspan admitted that the Fed’s ability to forecast the economy’s trajectory was an inexact science, he said, ‘If we get it right 60% of the time, we are doing exceptionally well.’ True, 60-40 sounds a bit better than 50-50.

Read: Inflation control chokes growth