A year after Lehman: India saved by default, not design
by Virendra Parekh on 24 Sep 2009 4 Comments

September 15 marked a year to the day when the iconic investment bank Lehman Brothers filed for bankruptcy. Its repercussions were felt across the globe with lightning speed and nearly bankrupted most of the world. Within weeks reputed names on Wall Street and across the Atlantic were on the brink. By the year-end, the entire global financial system was showing signs of coming apart. Government after government rushed to prop up institutions, in vain. The flow of credit froze over. With the big banks reluctant to do business with one another, let alone their customers, it was not long before the realty sector also was sucked into the meltdown.

One year after the event, there is little question that the global recession has bottomed out and major economies are beginning to crawl out of the pit. Massive infusions of liquidity, the shoring up of the balance sheets of fragile financial institutions and, in some cases, fast-acting public spending combined to arrest and eventually reverse the post-Lehman slide.

It is pertinent to ask a few questions at this juncture. Have we learnt proper lessons from the crisis? How has India weathered the storm? And what does it tell us about the strength of our banking system and growth potential of Indian economy?

Sadly, the world is yet to address most of the factors that led to the crisis in the first place. At macro level, the crisis could be traced to poor financial sector regulation and global imbalances i.e. excess savings by China and excess consumption by the US, made possible by role of the US dollar as the international reserve currency.

When massive bank credit flows into any activity which is price-sensitive (real estate, commodities, capital market) and there is an upsurge in prices, then there is bound to be trouble when prices fall.  Overvalued markets always run this danger. The trouble is no one can be certain when a market is overvalued and when the inevitable downturn will happen. The situation becomes more explosive when you have perverse incentives provided by over-generous salaries skewed in favour of excessive risk-bearing, inordinately loose monetary policy, complex financial instruments and over-leveraged banks.

So, at industry level, the crisis had been building for long. First, financial institutions were able to make investments, in large multiples of their owned capital, in assets whose risk was hugely under-estimated and, consequently, underprovided for. Second, this risk was spread throughout the global financial system in the form of securitised loans (bonds issued against receivables of loan repayment) and credit default swaps (the business of guaranteeing loans taken by someone else).

Under normal circumstances, this would have reduced vulnerability of lenders by distributing the risk. In the present case, however, as the risk was significantly underestimated, every institution that took an exposure became vulnerable and thereby the risk became magnified, not reduced. Third, when it came to rescuing failing institutions, it was found that many financial players had grown to a size that made it difficult for their home governments to save them, even if they wanted to.

The response of central banks to these vulnerabilities is a convergence towards common standards of disclosure and a collective emphasis on transparency.  Institutions that have exposures in several countries need to provide their investors with a reasonably comparable picture of their assets in different countries.

This is fine as far it goes. But it does not go far enough. Risk is difficult to quantify in a dynamic setting. Secondly, even if it is quantified, providing efficient ways of hedging against it will be a challenge, particularly in the emerging economies. Finally, setting up and implementing workable prudential norms for large multinational institutions requires cross-country co-ordination of an order which has never been attempted before. It seems therefore, that a year after Lehman, policymakers, law-makers and regulators may have understood what caused the crisis, but are not sure that they can prevent a recurrence.
Cut to India. The RBI has marked the anniversary of Lehman collapse with self-congratulatory noises. The fact is that, like everybody else, RBI also could not anticipate the eventuality of the crisis.
Should RBI be applauded? To answer that, we need to differentiate between the financial crisis and the liquidity crisis which resulted from the former. Unlike developed countries, there was no financial crisis in India. No Indian bank failed or needed a rescue operation. This was more due to the tight regulation and conservative nature of the banking system than any far-sighted pro-active measures taken by monetary authorities. A banking system where over 30 percent of deposits are locked in government securities and lending of other 40 percent is directed by the central bank cannot really face a crisis.
Indian banking has, by and large, been conservative in its operations. It has evolved a strong system where risk is low but growth is normal and innovation is minimal. The last is the crux of the matter. No Indian bank failed because none took the risks that were taken by their US counterparts. They never dealt with sophisticated financial instruments and financial engineering remained confined to textbooks. In fact, few bankers really knew about securitisation and CDSs; and any such knowledge was restricted to textbooks or seminars conducted by professors from US universities. They were not sure how these instruments worked in practice and prudently preferred to keep away from the unknown.

Therefore, to say that the RBI did not encourage such operations is not convincing. It is like a mother claiming to be one up on another simply because her children never went out to play and so did not get hurt.
On the other hand, RBI has done a great job in managing liquidity. As FIIs withdrew $6.42 billion (around Rs 33,000 crore) from the Indian stock markets between September 2008 and March 2009, RBI sold $29 billion (Rs 149,706 crore) to check the rupee’s free fall and ensured that over Rs 6,00,000 crore primary liquidity was pumped into the system. In addition, the government stepped up spending and cut tax rates to spur demand.

Now with FIIs investing over $10 billion (around Rs 49,000 crore) into the stock markets this year, the rupee has shown some strength and call rates have eased to around 3 percent. Banks do not have to access short-term funds at double-digit rates.

The crisis showed that India is now so closely integrated with the world economy that a global crisis means an Indian crisis too. GDP growth slumped by 3 percentage points in the quarter after the Lehman collapse (compared to a year earlier, and the same level of fall as in China). The share index levels dropped 60 percent, the inflation curve dipped well below zero, jobs evaporated, and pay cuts became the order of the day.

For all this, however, India displayed a resilience that is the envy of more advanced economies. In the worst quarter after the Lehman collapse, India’s GDP growth was 5.8 percent. Now, that was the average growth achieved by India during the quarter-century before it took off five years ago. So what was the long-term average five years back is now the worst performance. India remains the second fastest growing economy in the world today, behind only China. In the previous drought years, growth was much lower: 4 percent in 2002-03 and 3.3 percent in 1987-88. In socialist 1970s, GDP used to actually shrink in drought years, as in 1972-73 and 1979-80.

Even more remarkably, despite a widespread drought and recession in industry, GDP growth in 2009-10 is still expected to exceed 6 percent. If the monsoon is normal next year, we may return to a GDP growth of over 8 percent.

The worry now is that this message of resilience and buoyancy should not be used to put financial sector reforms on back burner.

The author is Executive Editor, Corporate India, and lives in Mumbai

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