Jaimini Bhagwati: Financial contagion risks

It is ironic that poorer countries should continue to lend to the US, Europe and Japan by stocking their government bonds.

International prices of oil, real estate, and stocks are currently at historically high levels. In India, housing and stock prices are at unprecedented levels. Concurrently, international and Indian interest rates have been persistently low. Investors seem to have been lulled into a sense of complacency that business cycles are a thing of the past and are not demanding adequate risk premiums. In August 2005, Greenspan (former US Federal Reserve Chairman who retired on January 31, 2006) suggested caution, saying, "History has not dealt kindly with the aftermath of protracted periods of low risk premiums". In this context, an increasingly open Indian economy faces financial contagion risks from the rest of the world. This article discusses the anticipatory steps that could be taken, domestically and multilaterally, to be better prepared for financial shocks that may originate from external sources.

The US is running high current account deficits (about 5.5 per cent of GDP in 2005) and this may lead to a weaker US$ in the future. US$ depreciation could push up interest rates, which in turn may burst the real estate "bubble" in the US. Higher US interest rates could also reduce the flow of capital to emerging markets including India. And US$ depreciation could lead to yet higher oil prices in US$ terms. Additionally, the volume of floating stock available for trading in India is small compared to the stock of investments made by foreign institutional investors. This makes our equity market particularly vulnerable to a reversal of capital flows.

A contrary line of reasoning is as follows. In the US the federal funds rate, the interest rate for overnight loans between banks, was raised for a 14th time, since June 2004, by 0.25 percentage point on January 31, 2006, to 4.5 per cent. However, the 2-30 year maturity interest rates have not moved up commensurately, resulting in a US government yield curve that is mildly inverted to almost flat from 6 months to 30-year maturities. Consequently, forward interest rates are at the same levels as current spot rates, i.e. interest rates are not expected to rise in the future. Further, the predictions of a sharp fall in the value of the US$ have proved to be premature in the past. And in 2006 we may again find that the US current account deficit continues to grow without adverse consequences for the US$.

On balance, nobody has a crystal ball and we have to perforce think in terms of reducing contagion risks from sources outside India. Derivatives markets provide mechanisms for hedging most commodity price and financial risks. However, the maturities and volumes for exchange-traded or non-exchange-traded instruments such as swaps and forwards are limited. More importantly, such hedging provides protection against expected movements in prices. The better-managed Indian institutions have financial risk management systems in place and take the exercise of estimating a daily Value-at-Risk (VAR) seriously. The margining, clearance and settlement mechanisms and the regulatory controls over our financial sector provide confidence to international investors about management of exposure to expected market risks.

Price movements in the commodity, equity, real estate, foreign exchange and bond markets are usually not correlated. However, to take a company-specific example, in 1998 the US-based firm Long Term Capital Management (LTCM) was a source of global risk because its very large loss-making net positions could not be unwound when several markets took a "downturn" simultaneously and turned illiquid. To attract foreign capital and have a better chance of retaining it in a "melt-down" situation we need to bolster international confidence in our ability to address systemic risk. We have to be seen to be providing for worst-case scenarios in which various markets go sour at the same time under circumstances which could not have been modelled or forecast.

Asian countries (including India) and others (e.g. Russia) are continuing to add to their foreign exchange reserves. A significant proportion of these reserves is invested in US Treasury bills and bonds. US$ dollar fixed-income securities are exposed to the foreign exchange risk of a depreciation of the US$ and "duration" risk of an increase in US interest rates.

Accordingly, countries with large US$-denominated financial assets are considering risk reduction options. For example, China's foreign exchange reserves, as of December 2005, were over US$800 billion and are expected to exceed US$1trillion within 2006-2007. In December 2005, China indicated that it intended to diversify the currency composition of its foreign exchange reserves. The statement reverberated around the world's foreign exchange markets and the US$ dipped a bit. It is likely that the Chinese were testing the waters. They would like to diversify their FX holdings but obviously do not want any precipitate devaluation of the US$. Given its trade surplus with the US, about US$ 190 billion in 2005, China would also not want to jeopardise this trading relationship with brinkmanship.

The purpose of diversifying the currency composition of foreign exchange reserves would be advanced if countries with "excess" dollar-denominated reserves were to invest in each other's national currency bonds. However, given the relatively low credit rating of Asian countries and differing levels of capital account convertibility, a multiple currency unit would reduce default risk. One option would be for a multilateral organisation e.g. an Asian Monetary Fund to promote an Asian Currency Unit (ACU). Over time the ACU could be built up as a supplementary reserve currency in addition to the US$ and the euro. There is no incentive for developed countries to help create such a currency. Further, Asian economies that are heavily dependent on exporting to the US and West Europe are likely to have reservations about "ganging" up to create an ACU. As usual, "nothing ventured nothing gained"""it is time we got together with like-minded countries in Asia including perhaps those that are part of Eurasia e.g. Kazakhstan and Russia to push the concept of an ACU.

Apart from issues related to management of market and systemic risks, it is ironic that poorer countries should continue to indefinitely lend to the US, Europe and Japan by stocking large volumes of their government bonds. It is US consumption that principally fuels the accumulation of FX reserves in Asia. Poorer countries need to consume more from each other. Consequently, the growing move in that direction as far as consumer durables are concerned needs to be consciously encouraged.