Abheek Barua: The post-crisis financial system: Some reflections

If the history of crises is any guide, the intensity of the present one is likely to wane in a few months, says Abheek Barua

The best and perhaps only way to handle the current financial crisis seems to be to jettison the text-book and think on one’s feet. Concerns about lingering inflation pressures, the ill-effects of “moral hazard” and the principle of letting the market sort things out for itself have given way to aggressive intervention by governments and central bank. This is the time to batten down the hatches, not take pot-shots through a porthole.

For the next few months, global and domestic economic policy is likely to be driven by the exigencies of tackling the meltdown in the financial and credit markets, not by macroeconomic data. Take the case of the cut in the cash-reserve ratio by a percentage point and a half by the RBI last week. The textbook-wallahs would argue that it was perhaps ill-advised. Inflation is still in double digits and liquidity, despite being temporarily short, would improve as some of the seasonal effects (like the festival season demand for cash) waned. If the RBI had followed their advice, it would pave the road to disaster. The inter-bank money market had frozen over, this was hurting credit disbursal and the possibility of default by some financial entities was getting stronger. The least that the RBI could do was to send a signal that it was sensitive to these concerns.

Bankers would argue that it is perhaps not enough. The haemorrhage in external liquidity is likely to continue as international investors pull out of Indian markets. The government’s cash calls on the market have become aggressive (the scheduled central government borrowing programme will suck out Rs 39,000 crore in the last quarter of this year; unscheduled borrowings are likely to follow). That is perhaps true. We will need more infusions of liquidity, going forward. However, I see the CRR cut as a sign that the Indian policy establishment is getting out of the “denial” mode. Instead of harping on the fact that the Indian financial system is somewhat insulated from the global system because of incomplete integration, the government and central bank seem to be acknowledging the gravity of the crisis and responding to it.

For those who still feel that India will remain somewhat immune to the crisis, here are some data. Foreign branches of Indian banks have a balance sheet size of close to $50 billion. Their sources of liquidity have dried up completely and it is left to the domestic banking system to provide them some succour. This means that domestic liquidity will have to flow out to support the external liquidity needs. This will keep the squeeze on domestic liquidity. India has short-term debt of $89 billion (by residual maturity). This is likely to leave Indian shores out over the next twelve months. FIIs may have pulled out about $11 billion this year but there is still a stock of about $60 billion left in local markets. Things could get much worse before they get better.

It is impossible to predict when and how the current crisis will end. None of the efforts by governments or central banks to stabilise markets is paying off. However, if the history of crises is something to go by, its intensity is likely to wane over the next few months. I would bet on the fact that markets will look far more stable early next year. That said, the after-effects will linger for a couple of years at least and the contours of the global financial order will change considerably. Here are some of the likely developments over the medium term that we should prepare for.

For one, global markets will remain extremely risk-averse for a while. Regulators will wield the stick and make sure that banks and funds handle lending and investments with extreme caution. The bailouts offered during the current crisis have resulted in extensive government ownership of financial institutions in the US and partly in Europe. This would help ensure regulatory compliance. This could lead to some kind of medium-term “de-rating” of emerging market assets, traditionally considered risky. Thus, even if the crisis abates, there might not be a flurry of paper chasing yields in emerging markets like India. This aversion to risk might also affect the flow of funds into private equity deals in unlisted companies, venture capital funding where risk reward ratios are skewed.

Second, Europe and the US will have to fund their bailouts. For the US alone the price tag will be at least $1.5 trillion. This means a large supply of government debt in the next couple of years that is likely to compete with other claims on the global pool of resources. This will be low-risk sovereign debt that could in a generally risk-averse environment to give private issuers a run for their money. Thus we could see a phase of crowding out of the private sector by the government across economies.

Third, the fundamental premise of the US bailout is that the government will hold “toxic securities” until market conditions improve and then sell these securities, hopefully make a profit and then return the money to share-holders. Other governments could follow this model. Governments will try to offload the stakes that they have taken in financial institutions (Freddie Mac and Fannie Mae in the US, for instance) after they have been appropriately restructured. Thus, as market conditions improve, there will be a large supply of asset-backed paper and chunks of share-holding that will come into the markets. This overhang will keep the financial markets (particularly the securitised debt market) subdued for a while with every rally being capped by a fresh and large supply of securities.

All this is clearly negative for the markets and every attempt by the markets to bounce back could be thwarted by vigilant regulators or the government’s trying to recover the costs of bailouts. The worst of the bloodshed could be over in a couple of months but slow systematic blood-letting could continue.

The author is chief economist, HDFC Bank. The views here are personal
abheek.barua@hdfcbank.com