Subir Gokarn: Global warning

Collective action, the solution suggested in 1997 to deal with financial crises, may be considered again.

The behaviour of stock markets around the world last Thursday and Friday has provoked fears that we are on the threshold of a financial meltdown. From an Indian perspective, the higher the indices rise, the more the number of people who begin to believe that the party is coming to an end. As that belief becomes more widespread, negative signals emanating from global markets can take a huge toll on domestic asset prices. This risk is exacerbated by the very large role played by foreign investors in the buoyancy in Indian markets over the last couple of years.

Although it is still way too early to read into last week's developments any signs of a sustained fall, it would still be of some value to assess the global environment for factors that point to such an outcome. As it happens, this year is the tenth anniversary of the Asian crisis, the last occurrence of a multi-national, if not truly global, shock. A year after that episode, we saw the collapse of the hedge fund LTCM, induced by a very complicated sequence of investments, whose cumulative risks eventually became impossible to measure, let alone manage.

Both these occurrences provide an appropriate historical context for the current global financial scenario. Looking back over the past ten years, while it is quite clear that some of the vulnerabilities that were exposed by them have been addressed, it is also a source of concern that others may have intensified.

Let's first look at the macroeconomic scenario. In and of itself, it really shouldn't induce any nervousness. While the decline in the US stock markets last week was apparently in response to the widening impact of sub-prime housing loans, this phenomenon has hardly spilled over into the broader economic landscape. Growth, inflation and unemployment rates are all behaving consistently with a soft landing and the US Federal Reserve is evoking praise for its discretion and timing.

Asia as a whole is also keeping the momentum growing, due partly to demand from the US, but increasingly driven by expanding domestic and regional markets. One concern that has recently re-surfaced is oil prices, but since the global economy has withstood an oil shock for three years without being worse for the wear, it is an unlikely trigger for reversal. In short, the conventional list of macroeconomic indicators suggests continuing good performance, or at worst, is neutral; there is hardly anything visible that is ominous.

To look for the vulnerabilities, we have to go somewhat beyond the conventional list. One of the key lessons from the Asian crisis of 1997 related to the difficulties in dealing with the capital market implications of an undervalued exchange rate. This arrangement provides an incentive for larger than otherwise capital inflows, because there is little risk of the currency depreciating, when the going is good.

When things get tough, the resultant exodus of capital becomes unmanageable, triggering massive currency depreciation, which, in turn, stokes the flight. The Asian economies that experienced this vicious spiral have all taken similar precautions, even if these deviate from theoretical best practices and create further problems.

Be that as it may, they all feel relatively secure with the size of their foreign exchange reserves, which are many multiples of what they were ten years ago and more than adequate to cover even massive capital flight. Even if investors decide to exit these markets, however temporarily, the reserves provide assurance that the sharp depreciation that reinforces the motivation to exit is unlikely to happen this time around.

In other words, even as the increasing inter-linkages between financial markets around the world do render all of them vulnerable to a shock emanating from anywhere, in general, emerging markets appear to have built up at least one line of defence against market developments spilling over into currency and balance of payments crises.

However, the second historical reference, the LTCM episode, may well be pointing in the opposite direction. Since that took place the quantum of funds being managed by similar institutions has increased exponentially. Their significance clearly points to the many benefits that they have brought their clients - relatively affluent investors who can afford to spend some money looking for the best deals available in the global marketplace.

Even as these benefits are acknowledged, there have been growing expressions of concern that the cumulative risks inherent in these portfolios may well be beyond the capacity of entire financial systems to absorb, let alone individual institutions. The recent collapse in the Amaranth fund did not eventually threaten the system, but with the magnitude of funds at stake, a more severe shock, which destroys a few large funds, could, through a domino effect, have a much more significant impact, even up to the macroeconomic level. Since there is no public information about the multiple exposures of these funds, there is no ability to predict where the shock may originate and how it will be transmitted across the globe.

The question that policymakers and financial regulators have to ask is: are the current protective devices, stretching from large foreign exchange reserves to the increasingly sophisticated risk management systems that are being implemented, enough to mitigate these risks? At this moment, it is impossible to provide an answer, simply because of the absence of knowledge. Obtaining that knowledge will require a fundamentally new regulatory paradigm, in which disclosure standards are justified not only by the need to protect direct clients but also the global investor community! Even visualising this as a regulatory responsibility, let alone designing a system that can implement such standards, is a challenge.

Nevertheless, the facts about the nature of global financial risks must be faced. After the Asian crisis, there was a great deal of discussion about a new international financial architecture. This did not go very far in terms of implementation, mainly because most of the affected countries decided that collective solutions, even though more efficient in theory, could not be relied on in times of real crisis. They all decided to rely on themselves alone and the huge build-up of reserves by each of them was the result. But, in today's circumstances of deep and possibly invisible financial market integration, it may be worthwhile resurrecting that discussion to address the different nature of the risks and the possibility of credible collective mechanisms to deal with them.

The author is chief economist, Crisil. The views here are personal