A V Rajwade: Headed for a banking crisis?

WORLD MONEY

Seems unlikely despite many parallels with the US.

Carmen Reinhart and Kenneth Rogoff, two US academics, the latter also a former chief economist of the IMF, have recently published two papers on financial crises. One on the on-going sub-prime crisis in the US, presented at the annual meeting of the American Economic Association earlier this year. The second on the National Bureau of Economic Research (NBER) website (working paper Number 13882). The first is a historical comparison of 18 bank-centred financial crises in OECD countries, five of them “major” in terms of the cost to the exchequer as a percentage of GDP: The 1984 US Savings and Loan crisis fell just outside the definition of major crises, its direct cost being “just” 3.2 per cent of GDP. The indirect costs of such crises in terms of lost investment, employment and growth are of course unmeasurable. Interestingly, the backgrounds to the crises have many common features. Disturbingly, several of those seem to be present in the Indian economy today. Incidentally, all the crises led to a sharp fall in GDP growth.

The common features the researchers identify are as follows:

 

Rationalisation of the excesses. Examples that readily come to mind include the the egregious dotcom equity prices in the late 1990s and, to an extent, the Sensex crossing 20,000 with confident predictions of reaching 25,000 by mid-2008 and 30,000 by the end of the year. Given the ready availability of spreadsheets, by a judicious mixture of the discount rate and the assumed growth in profitability, one can justify almost any price on seemingly plausible grounds. A more recent example is the house-price bubble in the US. “This time is different” is the common expression used to justify the excesses. Sadly, reality has the nasty habit of piercing such rationalisations.

 

Sharp increases in real, i.e. inflation-adjusted housing, real estate and equity prices. The most obvious example of this was the Japanese market in the late 1980s when prime Tokyo land of the size of a postage stamp was costing $10,000 and the Nikkei Index was almost 40,000! Somewhat disturbingly, the real estate prices in India manifest a similar tendency — and so was the run-away growth in equity prices which quadrupled in less than three and a half years ending in January 2008.

 

Current account deficit as a percentage of GDP, in the year preceding the crisis. The average number for the 18 advanced countries, was a little less than 3 per cent. The US’s is currently double that level — and we too are heading for a sharp increase. If the exogenous element of “transfers” is excluded, India’s current account deficit in fiscal 2008-09 could be as high as 7-8 per cent of GDP.

 

Sharp increases in real GDP growth and public debt. The first of this is not quite applicable to India as, for the last four years, growth was reasonably stable, if high; on the other hand, measured properly, both the fiscal deficit and hence the public debt have increased sharply.

In terms of the current account and fiscal deficits, there are disturbing parallels between India and the US. One difference: In terms of the competitiveness of the domestic economy, the needed correction in the exchange rate has already taken place in the US. In our case, the rupee remains overvalued significantly in real effective terms, and is perhaps likely to remain so for the foreseeable future, given the vulnerability of the oil marketing companies’ balance sheets to any fall of the rupee.

Does all this suggest that we could be heading for a banking crisis? Seems extremely unlikely despite various parallels: The banking system’s exposure to asset markets, both real estate and equity, is low. This is not to say that we can afford to blithely overlook the parallels listed above.

As for the NBER research paper, I content myself with the following quote from the paper: “Capital flow/default cycles have been around since at least 1800 — if not before. Technology has changed, the height of humans has changed, and fashions have changed. Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant. As Kindelberger wisely titled the first chapter of his classic book Manias, Panics, and Crashes: A History of Financial Crises, crises are a hardy perennial.”

If the argument “it is different this time”, is often deceptive, so is its opposite — namely that something would not occur because it has not occurred in the last 10-20 years. This was the “logic” used by marketing teams of banks active in currency derivatives, to persuade corporates to take huge short positions in the euro, the Swiss franc, the British pound and the Japanese yen. One nasty habit of financial markets is that the unexpected often happens with more frequency than the expected (“the fat tails”) and one needs to be very conscious of this reality. After all, risk management is focused on asking the question “what happens the remaining 1 per cent of the times?”

avrajwade@gmail.com