T N Ninan: Better safe than sorry

WEEKEND RUMINATIONS

For years, the wunderkinds of the financial world have railed at the Reserve Bank's dullness and stupidity, its unwillingness to allow innovations, and its excessive caution. But the RBI seems about to have the last laugh. Those super-bright financial brains who created those wondrous hedging options, innovated away with structured products till no one knew or understood what was going on, and who thereby created massive value for their firms (the profits of financial firms in the US have grown to account for 41 per cent of all US corporate profits!) while earning fat bonuses for themselves, have to explain why they and their firms have to be saved by the American taxpayer. The US fiscal giveaway is already $150 billion, and the Fed has shelled out more and more money to keep the financial wheels greased while crashing interest rates despite the risk of inflation "" all this to salvage the wreckage created by Manhattan's 'masters of the universe'.

So why is India safe amidst this turmoil? Because the Reserve Bank has done the things that people laughed at. It issued market stabilization bonds and absorbed dollars; now if overseas investors suck out dollars after selling shares, there is no shortage of dollars to sell to them; and, there will be no domestic liquidity crisis because the RBI can buy back those bonds and pump rupees into the market. Further, the RBI has made banks keep 7.5 per cent of their deposits in cash, and another 25 per cent of their deposits in government bonds. So even if there were to be a run on a bank "" as with Northern Rock and Bear Stearns""they would have the liquidity to tackle the situation, so long as they are solvent; and bank solvency has improved because of financial reforms over the past 15 years.

In the two areas where freedom was given to companies and banks to innovate "" hedging of foreign currency transactions, and convertible loans to be taken overseas "" the results have been disastrous. On currency derivatives, Indian firms have lost at least Rs 20,000 crore on current valuations "" though they will report these only in stages because of lax accounting norms. On the foreign loans, the potential hit on company debt levels if the loans do not get converted is yet to be assessed. Both are significant risk factors when considering the financial health of hundreds of firms, and will affect quarterly profit figures.

This is therefore playing out as a repeat of 1997 "" India was seen then as being free from the East Asian virus because it had not fully integrated with the region, on trade or capital flows. Now, the lack of sophistication in the Indian financial market is providing protection in a world marked by financial contagion. Hastening slowly when it comes to financial innovation seems to be a wise rule.

Such an argument will invite strong ripostes from experts who will argue "" with reason "" that India pays the price in many ways for the lack of sophistication in its financial markets. After all, markets that are made broader and deeper and provide more options will be more stable than others. But while that is true, there is no year in which one country or the other is not consumed by financial implosion. The emerging market economies are particularly vulnerable to shocks, and many shocks come with a bill that totals 10 per cent of GDP. When poor countries have to pay that, it can cause economic disaster and provoke political convulsions. One therefore has to treat with respect the RBI position that financial liberalisation should follow fiscal correction and the reform of the physical economy, not precede it. After all, we are arguing from within the safe financial confines provided by the RBI's policies.