If you don’t know what a CDO (collateralized debt obligation) or a CDS (credit default swap) is, don’t worry. Nor does 99.9999 percent of the US populace, which will soon vote for its next President in the midst of the biggest financial crisis since 1929. These acronyms refer to some opaque financial instruments, which have spread the contagion of billions of dollars of “sub-prime” (meaning “very risky”) mortgage loans in the US throughout that country’s financial system and to much of the industrial world. With US house prices falling over the last 18 months and sub-prime mortgages going sour, these CDOs and CDSs have wrought havoc on the US financial industry. Wall Street, as we knew it, no longer exists. The crisis, which has been simmering since July 2007, came to a boil this month.
On September 7th the US government conducted a bail-out and de facto nationalization of the giant, government-sponsored (but privately-owned) mortgage financiers, Fannie Mae and Freddie Mac. The following Sunday, Lehman Brothers, the fourth largest investment bank, toppled into bankruptcy, while Merrill Lynch (the third largest) was bought out by Bank of America. On the 17th (a weekday for a change) the “dynamic duo” of Treasury’s Paulson and Fed’s Bernanke carried out a bail-out and quasi-nationalization of the world’s largest insurance firm, AIG. Last Sunday, the 21st, the Fed engineered the transformation of the two remaining (and largest) investment banks, Morgan Stanley and Goldman Sachs, into bank holding companies, thereby ensuring that standalone investment banks joined dinosaurs in the march of evolution. Over the weekend the US government also unveiled a $700 billion rescue fund aimed at detoxifying the US financial industry by buying out its “troubled assets”.
This unprecedented and ongoing, global financial crisis will have many lessons and consequences for India, most of which are currently obscured by the fog of financial destruction and upheaval still under way. Let me point to a few. First, the hugely varied and heterodox responses of the US authorities (especially Treasury and Fed) have been remarkable. The actions have encompassed deep interest rate cuts, massive liquidity injections, ban on short selling, managed buyouts of ailing giants (Bear Stearns and Merrill), allowing bankruptcy (Lehman), de facto nationalizations (Fannie Mae, Freddie Mac and AIG), guarantee of money market fund accounts and now the newly proposed “bail-out fund”. Textbook dicta against “moral hazard” and central bank lending to non-banks have been ignored. In the face of financial meltdown, pragmatism has been the order of the day. Two principles seem to have guided these policies: let markets punish shareholders of the failing institutions, but bail out those posing high systemic risk. The policy responses adopted by Paulson, Bernanke, Geithner and Cox will be debated for decades. It is a reasonable prediction that our local finance ayatollahs will applaud their heterodox approach. It would have been nice if they had been equally charitable to the heterodox and largely successful policy response of the RBI to the unprecedented foreign capital surge experienced by India in 2003-07.
Second, the speed and apparent effectiveness of coordination between the Treasury, Fed, SEC and others has been impressive. Note that this has been achieved without any formal structure such as the Financial Sector Oversight Agency (FSOA) recommended for India by the Raghuram Rajan report. This vindicates my earlier expressed doubts (BS, April 10, 2008) about the wisdom of an FSOA. What matters is the quality and knowledge of the people at the helm, not the bureaucratic structures. On this score we need to worry, following the recent departures of top-notch policy administrators/advisers ex-Governor Reddy and ex-EAC Chairman Rangarajan. Their replacements are able people but still lacking in financial domain knowledge. The situation will worsen with the likely exit of RBI deputy governor Rakesh Mohan, currently the person with the greatest money/finance domain knowledge in the sarkari system.
| COMMITMENT OF US PUBLIC FUNDS IN THE FINANCIAL CRISIS ($ billion) | ||
| Date | Institution / Activity | Amount |
| March 17, 2008 | Fed guarantee for J.P. Morgan takeover of Bear Stearns | 29 |
| September 7, 2008 | Treasury bail out of Fannie Mae and Freddie Mac | 200 |
| September 17, 2008 | Treasury-Fed bail out of AIG | 85 |
| September 22, 2008 | Treasury Plan for bail out of “troubled assets” | 700 |
| Total (up to September 22, 2008) |
1014 | |
What are some likely implications of this global crisis for India? First, thanks to Reddy’s policies, the Indian banking system is well-capitalized and has very little exposure to the toxic instruments swilling around in international finance. Second, again thanks to him, the RBI is armed with nearly $300 billion of forex reserves, more than enough to ride out the inevitable drop in capital inflows (in 2008, through August, about a billion dollars a month net have been withdrawn by FIIs as they strove to shore up their capital positions in home jurisdictions). Third, faced by a short-term surge in capital outflows, the correct policy (already in place) is for the RBI to allow some downward flexibility of the nominal exchange rate, while keeping the “brakes on” through dollar sales. The wrong policies would be to try and defend a particular nominal rate or to signal panic by suddenly liberalizing guidelines for external commercial borrowing or relaxing the norms for Participatory Notes (good KYC norms are especially pertinent at the present highly uncertain juncture).
Fourth, this is obviously the wrong time for further capital account liberalization, with the merchandise trade deficit running at around 10 per cent of GDP, rebounding oil prices, a rising fiscal deficit and likely weakening of goods and software exports (this last is extremely likely as the effects of the global financial crisis increasingly stall economic activity in industrial countries and thereby dampen growth of international trade). It is also important to avoid restrictions on the current account (such as tighter time limits on export proceeds repatriation), since these could end up disrupting trade and normal current transactions.
Fifth, as the world economy inevitably slows and transmits a deflationary impulse to India over the next year or two, our monetary policy will need to be calibrated accordingly to avoid any steep and prolonged decline in investment and economic growth. The deflationary impulse has already been under way but could gain significant momentum from the recent financial drama in the US.
Finally, against this background of inevitable, if temporary, deceleration in global and Indian economic growth, it is very important to avoid other big blows to domestic economic confidence, such as through possible disruptions in country-wide oil supplies triggered by cash shortages in government oil marketing companies. It would be wiser to give these companies subsidies directly (if prices can’t be raised) rather than through roundabout and tardy devices like oil bonds (see my piece in BS, May 22, 2008). In any case, the fiscal and economic impacts are very similar.
This story is far from over. Its consequences and lessons will be with us for a long time to come.
The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal.
