The turbulence experienced by Greece is apparently on the way to being resolved. Only time will tell whether or not the proposed solutions work. In the meanwhile, the unhappy populace will need to endure it.
But why did it have to happen? The discussion regarding causes, somewhat simplistically, centres on the fact that heavy fund raising had been secured by access to the global financial markets. Populism, over-ambition, greed (and some fudging of books) are said to have existed. The "global" financial crisis of 2007-08 exposed these and what happened, happened.
This explains it from the side of the borrower. But what allowed the balloon to become so big that it needed to burst? Greece is not the first such country to command newspaper headlines in recent times. Iceland and Ireland had sparkled recently. Portugal and Spain have also occurred.
One common answer is that reckless lending by greedy bankers and so on is the root cause. Is it really so? Banks et al can undoubtedly be called greedy...but are they collectively foolish? What made them negligent?
This question leads us to issues regarding the architecture of international finance - and, in particular, the structure of risk management. All banks' risk management structures are monitored by their respective regulators. Most comply with Basel norms and so on. How could Greece happen despite these structures? Or is it that it happened because of them?
In the simpler, original Basel norms, banks were required to maintain capital based on their aggregate assets. In the late 1980s and early 1990s, the concept of "differentiated risk" became popular. This was because of intensive marketing by the risk rating companies regarding the accuracy and robustness of their mathematical models, constructed on a detailed study of over 50 years of corporate credit behaviour of a majority of US companies. It was argued that mathematical probability calculation of default risk was not only possible but also verifiable. The international group of regulators and banks bought into this argument. Basel-II and-III have a system of differentiated risk weights. Capital and risk buffers are stipulated on this basis. Higher leverage of capital is allowed if higher credit-rated assets are acquired.
Concurrently, and without much supporting analysis, the concept of country risk ratings came in, in order to differentiate loans to sovereign countries on the basis of risk. The logic of the country rating models, the behavioural studies on which they were based, the countries studied and the period of study have never been discussed.
On the face of it, the sovereign risk indicators look scientific. About 130 countries are rated and classified under 27 risk categories by virtue of scores earned in approximately 35 parameters, spanning five categories, on a six-point scale. The discussions regarding these parameters are known. It is only a subsequent reading which brings out that there are no fixed processes for combining the scores to arrive at a rating. The analytical variables are too many and often inter-related. It is not clear whether the weights are fixed across sovereigns or over time; or whether risk perception still goes down significantly for indebted countries regardless of, say, the ratio of external debt to GDP or of currently verifiable cash flows. Why is recent debt default still condoned just because China, post-revolution, had once repudiated?
Both Iceland and Greece had straight 'A's till the crises broke. India has always been BBB- or lower, ie four categories or more below. India has a GDP of a little over $2 trillion and export trade of over $300 billion. Its macroeconomics, especially of the past few years, has been heavily criticised for populism, weaknesses, etc. But for all that, it has an external debt (net of foreign currency reserves) of about $130 billion. Greece has a GDP of about $240 billion (with exports of $30-35 billion) and an external debt of about $470 billion. Iceland has a GDP of $20-odd billion (with exports of $5 billion) on an external debt of around $90 billion. How could such rating abnormalities occur?
Then again, currently, only a couple of countries, like Argentina and Grenada, are under the default category. None of the European countries under discussion figures there, despite large creditor haircuts and/or bailouts. Iceland has already climbed back to India's rating level despite its recent default history.
About 40 countries are in the 'A' range. Rich oil exporters and reserve currency countries account for about a third. The blowout percentage of the residual is higher than that of the non-'A' list, whereas it should have been significantly lower.
What causes over-exposure? Banks seek to balance risk with returns and respond to regulatory or watchdog signals. Rating agencies are supposed to be watchdogs to caution lenders, not encourage them.
Where was the original sin? What was the penance?
Unless country ratings are logically transparent across nations, over-financing will continue to be experienced in unnecessarily better-rated sovereigns, compelled by the regulatory logic of differentiated risk weights. Accidents will again occur, as and when trust is shaken by an external event of which, given the current state of international politics and macroeconomics, there is no dearth today. And, as usual, again only the innocents will suffer.
The need for enforcing accountability warrants a debate.
The writer is former Chairman and Managing Director, Export-Import Bank of India