T N Ninan: Remembering risk

WEEKEND RUMINATIONS

One reason why there is anger at the Reserve Bank of India today is that most people who had taken housing loans at bargain basement rates of interest (as low as 7.25 per cent) did not work out the likelihood of such low rates of interest continuing for the life of the loans (typically, 15 years). In other words, they did not assess risk. If they had, they might have decided that the cost of paying an extra percentage point on a fixed (as against floating) interest loan was worth the cost, in order to hedge against interest rates climbing in the future. After all, it would be unreasonable to expect that an unusual circumstance (7.25 per cent interest) would prevail for 15 long years.

The flip side of that coin was that pensioners who had relied on bank interest rates staying high (which had been the long-term experience) were shocked as their calculations on monthly interest payment went awry, as interest rates crashed early in this decade. They complained, but the fault was theirs for not assessing risk and hedging with a diversified asset portfolio.

We should not be surprised at such cupidity; it has been in evidence in other contexts too. As with investment in stocks, when people assumed that share prices that had been climbing would continue to climb, and that handsome returns on the stock market were a one-way bet. The dismay when stock prices fell sharply, as they did three times in the first reform decade, finally drove home the lesson to the middle class that there is risk in the stock market. People are wiser now and give more of their money to professional fund managers rather than taking punting decisions themselves.

But why come down hard on lay individuals who are not conscious of the rules of the financial world? Companies managed by professionals have been no wiser in the past. The crisis that many companies found themselves in, in the wake of the financial squeeze of 1995-96, was because many of them had embarked on long-gestation projects, using short-term loans, and assumed loan roll-overs. When the money dried up, the projects either could not be financed or became unviable. It took six long years for the pain to be washed out of company balance sheets. Entrepreneurs and CEOs have not forgotten that hard lesson""the reliance today on debt when financing investment is very much less than it was a decade ago.

But even today, there are elements of financial risk that people do not factor into their calculations. Currency risk, for instance. The RBI policy has a policy of preventing the rupee from rising too sharply against even a weak dollar, and guarding against sharp fluctuations in the rupee's value. The result is that most people do not hedge against the risk of the rupee rising or falling sharply""and, do note that Indian firms have been borrowing in foreign currencies like never before. But what if the RBI policy changes tomorrow, or it is unable to continue with its present policy?

Or take the risk of an economic downturn""which seems a remote possibility to most people whose perception of economic reality is the last four years' average of 8.5 per cent annual economic growth. But the business cycle has not been abolished, and yesterday's benign conditions could change tomorrow""export growth, for instance, has fallen in the space of a year from more than 20 per cent to barely 5 per cent; car sales growth has plummeted in March to 2 per cent; and so on. What will that do to job security and salary hikes""which most youngsters treat as safe assumptions to make while piling on debt?

The fact is that India is still an emerging economy; one of the features of such a system is that there is more risk here than in more fully developed markets. The risk level climbs even higher when uninformed people take financial bets on the future. The occasional financial shock serves as a wake-up call, and may even serve the purpose of alerting people to the rules of the game, in case they had forgotten.