Google Translate

Friday, February 21, 2014

Wall Street Crisis: Lessons for India

Way back in 2000, the Per Jacobsson Foundation organized a panel discussion on “Strengthening the Resilience of Financial Systems” at the Lucerene Culture and Convention Center in Switzerland, in which Arminio Fraga, Governor of the Central Bank of Brazil, made a set of very interesting observations. First and foremost is: “If one looks back at the history of international debt crisis, certain regularities emerge.” To prove his point he cited a few instances: one, the Latin American debt crisis of the 1980s—too much borrowing to finance government budget deficits; two, Mexico crisis of the 1990s—too much borrowing to finance consumption; and three, the more recent Asian crisis—too much borrowing to finance investment, whereunder, somewhere along the line all these countries ended up with the problem of weak balance sheets—too much of short-term debt, which he termed stock stories, rather than flow stories. He proposed two reasons for such weak balance sheets: one, weak macroeconomic regimes; and two, a weak banking environment and a weak corporate governance environment. Then he went on to proclaim that even if we “succeed in strengthening macroeconomic regimes, banking structures, and capital markets, crisis will always happen” because “markets adjust their risk- taking to the riskiness of the environment.” For instance, when the overall business conditions are deemed safer, more leverage will become the business norm.

Ironically, these remarks that Arminio Fraga made, keeping in view the financial instability noticed in developing economies, now appear to be well applicable to the credit crisis emanating from the US home loans, particularly the failure of century-old investment banks of the Wall Street. Looking at the failure of Bear Stearns, Lehman Brothers, and Merrill Lynch, one wonders if the long period of rapid growth, low inflation, low interest rates, and macroeconomic stability made these so-called specialized investment banks, which claim to have had sophisticated risk-management techniques, to take more risk with little or no awareness thereof. Weak regulation, which is often ascribed to the developing world as a ground for their financial failures, appears to have drowned the icons of the American capitalism in the form of too much reliance on free markets, which simply encouraged free play with securitization, off-balance sheet financing, and what not in the name of innovation. All this led to ‘over-leveraging’—to stratospheric heights—that has ironically transformed the stability in the global financial market into instability.

The most immediate question that the failure of these three top investment banks poses is: Can investment banks survive as stand-alone entities? The answer is, perhaps, ‘No’, for they need a stable base of funds for sustainability. It is also being increasingly realized that in the light of the availability of government insurance, deposits are the best bet to fight the credit crunch than securitization. That is, perhaps, one of the driving forces behind international banks, such as Commerzbank AG of Germany and Credit Mutuel of France, going for buying deposit-rich local banks. Secondly, it is slowly dawning on the financial think tank of the globe that these investment banks—which are known to be mostly into a kind of money game, in which funds available for potential investment are constantly moved around the globe to chase the highest possible rate of return with scant regard for the real economy—are an eternal threat to global financial system. It means that commercial banks, the traditional depository institutions, alone are perhaps well-placed to survive for long, provided they are again well-managed.

The second important question, particularly in the context of India, is: What lessons can India learn from the recent Wall Street meltdown? The current happenings in the most sophisticated financial market like that of the US tell us that some fundamentals ascribed to free markets do not work always. No country, perhaps, can afford to let the market punish an erring financial player if it is embedded with a systemic risk. As Arminio Fraga observed, there is always a need for a lender of last resort and its timely intervention—lest markets should take a long time to bounce back to normalcy—to maintain the growth rate. And a fall in growth rate, particularly in developing countries, would badly affect the living style of those at the bottom of the pyramid. This calls for the immediate attention of our policy makers.

Despite a good India Inc. story, the immediate effect of the US crisis will be a drying up of liquidity in our market. In the coming six to ten months, foreign capital is likely to move out of our stock market, which means turbulence in the already volatile stock market. Weak sentiment in the secondary market is in turn sure to disturb the investment plans of businesses that are on an expansion curve via mobilization of fresh capital through public offer. Secondly, if the current reports are any indication, domestic borrowings from the banking system are likely to become costlier. At the same time, borrowing from global financial markets will no longer be easy for Indian corporates. All this cumulatively, impacts the profitability of corporates and their competitiveness among the global players.

In a scenario of depreciating rupee, the hitherto flow of foreign capital noticed in the debt market will also dry up, for there will no longer be the advantage of interest rate arbitrage. All this can cumulatively exert pressure on rupee, leading to its depreciation. Of course, the RBI has already indicated its readiness to address the liquidity fears by offering additional borrowing facilities to banks through a second LAF auction. Simultaneously, it has made available adequate supply of dollars along with raising the interest ceiling on non-resident deposits with a view to increase dollar inflows into country to check downward pressure on rupee. That aside, a depreciating rupee is sure to make imports costlier. This obviously necessitates a relook at the RBI’s monetary policy.

The other victim of the current global financial market crisis is India’s outsourcing business. With the Wall Street businesses in tatters, many financial companies have downsized their operations by closing their back offices in India, laying off many people. Even software majors, such as Infosys, Wipro and TCS who earn a significant portion of their revenues from the banking, financial services and insurance, may be in for a disturbance in their cash flows, of course, in the immediate short run. The resulting reduction in well-paid jobs would mean a fall in the demand for goods in certain product segments. It does not, however, mean that all is lost for India. The industrial production data for July reveals a rise of 7.1% over July of last year. Our growth story is intact: GDP grew during first quarter by 7.9%; and our banking sector is healthy, well-regulated, and adequately capitalized, and is ready for the adoption of Basel II. Market reports also indicate that our banks do not have exposure of significance to these failed banks.

There is, however, an aggressive demand from a section of society for greater deregulation, and perhaps rightly so. But in the light of what is happening in the global financial markets, there is a need for a conscious debate on this, instead of simply getting carried away by the blind faith that economic freedom means economic growth. Contrarily, there is an urgent need to build a robust regulatory mechanism that effectively monitors financial markets as our markets get more and more integrated with global financial markets in the days to come— without of course, stifling them. True, we cannot insulate our banks from the happenings in global financial markets; nonetheless, we must put in place appropriate checks and balances that ensure financial stability in the country. It means, the RBI has to show more imagination, flexibility, and importantly, speed in keeping India’s growth story from being weakened by the fallout of the US financial crisis. Which means, a big challenge there to the new Governor.

(October, 2008)


Post a Comment

Related Posts Plugin for WordPress, Blogger...

Recent Posts

Recent Posts Widget