Risk management

Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae and Freddie Mac, the world’s largest life insurance company, AIG, Washington Mutual, Wachovia — and more are now said to be on the brink , bankrupt or sold for a song, or bought by the United States of America government in return for payment guarantees. Even an icon like Goldman Sachs is now undergoing public loss of confidence. The bad news keeps coming. The US government is planning unprecedented sums to support financial institutions whose asset values can no longer meet their liabilities. These once impregnable companies were lobbying hard against regulatory overseeing. Now they are resisting proposed restraints on obscene remunerations to their top executives. But they are happy to have government support. It is certain that American, and hence global, financial markets will soon be very different, with more regulation, overseeing and controlled remunerations.

Indians who think that such things can happen only in the US, the land of unbridled private enterprise and buccaneering financial geniuses, must think again. American private enterprise has never been unbridled since Franklin Roosevelt set up regulatory bodies in the 1930s. In 70 years, the nature of financial products and transactions has changed radically. Financial flows are now many multiples of trade flows. Many products are beyond existing regulatory cover. Regulators have not recognized that many financial products live on their own, not backed by adequate assets.

Only recently, companies like Worldtel and Enron cooked their books and rigged their share prices without the regulators suspecting anything. When they collapsed, the US passed the Sarbanes-Oxley Act, which laid down principles of greater transparency and overseeing. This led to many companies preferring listing on the London Stock Exchange and elsewhere than in the US because of the high costs of compliance. Before the unravelling of the financial markets, there were suggestions to dilute Sarbanes-Oxley. India must tighten its corporate regulation and inspection, and not confine itself to comprehensive reporting. The US would perhaps be well advised only to soften Sarbanes-Oxley compliance complexities but leave the act intact.

The unravelling and questioning of almost every aspect of the functioning of commercial banks, investment banks, merchant bankers, brokers and other players have just begun. Hopefully it will lead to tighter overseeing of such institutions, regulation of financial products on offer and emphasis on capital adequacy for all institutions in the financial markets. India needs to closely watch developments and incorporate the changes in our regulatory systems, if we are to safeguard ourselves for the future.

It is clear now that global financial markets cannot be regulated only by individual countries. Money moves at the flick of a button. Domestic regulators cannot keep pace. They need to work together. The world has to configure a regulatory system so that the huge mismatch between financial flows and trade flows is corrected.

With new financial packages combining many house mortgages or such other debts, the ratings are opaque and without clarity on ratings of each component in the packages. The complex financial packages that finally brought down the large investment banks need monitoring and regulation. Earlier, India had a mini crisis because of foreign exchange derivatives which neither buying companies nor selling banks understood fully, leading to lawsuits that the banks had misled the companies. As the American products grow in India, the situation will get worse without tough regulation. All policies must recognize that our insulation from the world is over.

The fall of American investment banks and money-market players will have ripple effects around the world. For example, Lehman insured many of its liabilities with AIG. AIG insures many risks globally, some more unsafe than others. AIG’s balance sheet included risks of investments bankers, house mortgages, and others caught in the subprime crisis and declining house values. AIG’s global interconnections will trigger worldwide problems, and not merely for financial institutions. As AIG sells healthy assets to repay loans, it must look at its most profitable asset, International Lease Finance Corporation — the aircraft leasing company — as a source of immediate capital or greater profit contribution. The ILFC is the largest buyer of planes, with more than 150 Boeing and Airbus aircraft on order. To reduce cash outflows, lower costs, improve margins, the ILFC must cut aircraft orders. This will further weaken Airbus and Boeing, already weakened by delayed products, labour problems and management weaknesses. Aircraft leases will become more expensive, some airlines will close, more jobs will go, and passengers will pay higher fares. Banks, insurance companies, leasing companies, aircraft manufacturers, airlines, hence travel agents, hotel workers and so on will be affected. Each collapse will have global ripple effects on trade, currency values, jobs and stability of financial institutions.

India is not positioned well to safeguard itself from these effects. Its development parameters and macroeconomic fundamentals are unsatisfactory. The fiscal deficit, after adding the fudges in the last two budgets on subsidies on oil, fertilizer and food, and other major expenses that are “below the line”, was high. It will go much higher as expenditures shoot up on account of floods and so on and the gross domestic product growth falls by two per cent or so. The GDP has poor representation from the “real” economy of agriculture and industry. Services will be hurt by the world economy. Balance of payments on current account is in deficit. Our “ample” foreign exchange reserves, unlike China, are not made up of export surpluses and foreign direct investments but of more volatile commercial borrowings, non-resident Indian deposits and declining, volatile, foreign institutional investment inflows. The rupee is fast depreciating, heightening inflationary tendencies.

Overseas banks, financial institutions, airlines, all those who outsourced to India, are in various stages of collapse or restructuring to avoid collapse. They will cut orders, bargain for better terms, squeezing margins. Employment will drop and so will salaries. Bright young people, earning unaccustomed big money, using bank credit to buy expensive homes, cars, durable products, even holidays, will default. Banks and financial institutions that aggressively pursued them will weaken. The tight liquidity will worsen, with higher interest costs and banks reluctant to lend. This will again affect growth in industry and services.

With negative FII inflows, share values have dived. Spasmodic recoveries will be followed by further declines. New capital issuers are already on hold. With debt becoming tight, industrial investment will be adversely affected. The recent wider opening of the window of external commercial borrowings might help bigger companies, especially in infrastructure, at higher borrowing costs. The new freedom to bring the money back even when spending is to be done later will help borrowing companies to arbitrage and make extra profit. But only aggressive private financial players will be hurt, not the conservative nationalized banks and insurance companies that dominate Indian finance. The US, by nationalizing its insurance companies, may be learning from India.

The good monsoon this year will raise agricultural growth. But that will not restore overall growth rates. Merely squeezing liquidity is not enough. Government deficits must fall with lower public expenditures. Private expenditures are already falling. Already inflation is at 12 per cent. With deficits rising, it is unlikely to reach single digit by March and may be higher if oil prices keep rising. This is the time to stop highly volatile financial inflows helped by our exempting short-term capital gains tax if funds come from Mauritius, and the anonymous flows through ‘participatory notes’.

Cutting public expenditure might dampen inflation, growth and employment. If expenditures are not curbed, inflation will worsen. Both will hurt consumers and voters. The present dilemma is due to the government’s poor economic management in the last two budgets. We must prepare for political upheavals in the next elections.