The recent crisis in global financial markets has clearly demonstrated the shortcomings of a deregulated financial regime. The crisis, although it erupted in the core of the capitalist system, has severely impaired the health of all economies. Indian economy, that was initially thought to have remained unscratched from this crisis, has witnessed a tailspin after the meltdown of the world financial system in September 2008 (although sobering tendencies could be observed from the beginning of the previous year itself). Almost all indicators of economic activity- GDP growth rate, exports, employment- have deteriorated in the last few months. What are the channels through which global crisis has affected the Indian economy? Exports, needless to say, shrank as a result of contracting world demand. At the same time, India’s integration with the world financial system led to massive deflation of domestic stock prices as foreign investors dumped equity on Indian stock markets to make good their financial losses due to sub-prime crisis. Exodus of FII eroded the value of rupee and led to liquidity crunch in the economy. The risks were higher this time since financial institutions (such as mutual funds and NBFCs) that faced liquidity crisis are not regulated by the Central bank. The crisis has thus highlighted the risks posed by sudden outflow of foreign investment, the accompanying crunch in domestic liquidity and the activities of unregulated financial entities. These risks have arisen because of the developments in the financial markets under the rubric of financial liberalisation.
Understanding Financial Liberalisation
Prior to initiation of economic reforms in 1991, Indian financial sector was designed to meet the overall goals of planned development. For this reason, the banking system was publicly owned and its resources were channelled to priority sectors like agriculture and small industries. To ensure that the system was internally consistent and the bulk of the savings were channelled to the banking system, wide array of controls were imposed on the financial instruments available to savers. This, in turn, meant restricting the size of the stock and bond markets. Needless to say, control over speculative foreign investment flows was an integral part of this strategy. Financial liberalisation is a catchall phrase for policies that result in dismantling of government control over financial sector and increase the space for private players within the financial system. This means that with financial liberalisation banking system faces less control on the assets it can acquire and savers have greater choice to invest in instruments like stock, bonds, derivative products etc. This also means sanctioning new financial institutions like mutual funds and non-bank finance companies that virtually face no restrictions on their choice of asset portfolio. At the same time, firms have a greater menu of liabilities to choose from; in particular they can scout for funds outside India through External Commercial Borrowings (ECB) and American Depository Receipts (ADR) route. The most talked about element of financial liberalisation in India has been the opening up of Indian economy to hot money flows in the form of foreign institutional investment (FII).
Financial liberalisation in a developing country like India can be attacked on two fronts. Firstly, as has been widely acknowledged, financial liberalisation leads to squeezing of credit to small borrowers and petty producers. The drying up of institutional credit in rural areas has forced farmers to rely on higher cost credit from exploitative money lenders and has significantly contributed to agrarian distress and peasant suicides throughout the country. Secondly, financial liberalisation especially the free play of thinly regulated non-bank institutions and volatile capital flows enhance the fragility of the financial system and expose it to dislocations that can have serious real implications. It is this second aspect of Indian financial sector that will detain our attention in the following.
Global Crisis Exposes the Frailty of the Indian Financial System
Although the origins of the recent crisis can be traced to summer of 2007, the crisis reached its peak in September 2008 when some of the biggest investment banks in US finally admitted that they could not continue in business any further. Some went bankrupt, others became bank holding companies and still others had to be put on government lifeline. The downfall of large investment banks sent shockwaves throughout the US financial system. Distrust between market participants grew so much that credit markets in the US virtually froze. Unable to meet their requirements for funds from credit markets, investors were forced to sell assets. Since portfolios of large investors usually include assets from across the world, forced sale of assets resulted in a fall in asset prices in many countries. Particularly affected through this channel were emerging markets like India that had been successful in attracting short term foreign investment prior to the crisis.
As foreign investors deserted the Indian stock market, stock prices fell and the value of rupee came under considerable pressure. To illustrate this point, we have taken some figures on net capital flows from the Reserve Bank Bulletin (Table 1). It emerges from these figures that almost all forms of foreign investments have suffered due to the crisis. Particularly drastic is the reduction in FII whose contribution has turned from a large positive in 2007-08 to a significant negative in 2008-09. In the third quarter of 2007-08, for example, India received FII worth $14,851 million. The corresponding figure for 2008-09 is an outflow worth $5,794 million. Such massive and sudden outflow of foreign capital had several implications for the Indian economy.
Firstly, stock prices received unprecedented hammering and this affected everyone including domestic financial institutions, brokers and households with significant exposure to stocks.
Secondly, as foreign investors tried to convert rupees into dollars on their way out of the country they increased the demand for dollars and its value in terms of rupees. In other words they caused, what is known in economics as depreciation of rupee. Clearly, the Reserve Bank (RBI) does not like to see rupee depreciating too much. There may be many reasons but atleast two seem rather straightforward. Firstly, if more rupees are to be shelled out for one dollar, imported goods (that have to be paid for in dollars) become more expensive in rupee terms. Therefore, depreciation of rupee exposes the economy to a possible inflationary threat that the RBI is supposed to check. Secondly, depreciation also increases the rupee value of foreign debt. Companies that take debt outside India through the ECB route will find that the value of their debt has increased without any increase in the value of their assets. Such erosion in the quality of balance sheet of companies can deter their investment plans with serious implications for economic growth.
Thirdly, there were implications of the RBI intervention to check depreciation of rupee. Specifically, RBI tried to arrest the depreciation of rupee by selling dollars in the currency market. Since dollars are sold against rupees, the amount of dollars that the RBI infuses into the system is equal to the amount of rupees that it sucks out of it. RBI’s intervention in the currency market created “shortage of rupees”. As a result, interest rate in call market in which banks with surplus cash lend short term to deficit banks hit the stratosphere. On some days in September and October, this short term interest rate was as high as 20%. Not surprisingly with such high short term interest costs, banks found it difficult to borrow from each other and to lend to borrowers outside the banking system. In this manner, problems shifted from banking system to the rest of the financial sector.
Many channels may have been at work here but the one that attracted considerable attention was the influence of falling credit or (even the perception of such decline) on corporate behaviour. In the recent years, corporates have invested their short term cash surpluses in fixed income mutual funds. These mutual funds allow withdrawal of investment at short notice but invest in securities with significantly longer maturity. As uncertainty regarding the availability of credit from the banking system developed, corporates and other businesses decided to withdraw surplus cash invested in mutual funds. But invested in significantly longer term assets, these institutions found it difficult to redeem their liabilities. Some mutual funds even responded to the situation by putting a cap on the amount of redemptions. Investors began to doubt whether mutual funds are simply facing shortage of cash or whether their asset portfolios have become non-performing. This suspicion was not unreasonable (although the realisation came late) since mutual funds face virtually no restriction on their assets. They can invest any amount they want in real estate, capital markets etc. All in all, with massive redemptions, the business model of mutual funds has gone kaput. For the period April to December of 2008, mutual funds have witnessed a net outflow of Rs 30432 crores1.
But with mutual funds facing difficulties, another set of unregulated financial entities namely Non-bank finance companies (NBFCs) got into trouble. NBFCs are similar to banks in that they are in the business of lending. On the liability side, they rely on retail deposits and commercial paper sold to both banks and mutual funds. But with mutual funds getting into problems, NBFCs found it difficult to obtain funds to continue business. The problem with NBFCs is that like mutual funds, their assets are of a significantly longer maturity than their liabilities. More than 50% of NBFCs’ borrowings have maturities of less than one year, while most of the assets have tenures of about three years2. As funding dried up, NBFCs found it increasingly difficult to continue in business and to hold on to their longer-term assets. Moreover, as in the case of mutual funds, doubts were raised about the quality of assets held by these institutions. Needless to point, these institutions face no restrictions on their asset holdings. They were exposed both to capital markets through loans to investors as well as to the risky real estate sector. As a result of funding problems, disbursements of NBFCs suffered heavily leading to significant squeeze of credit for sectors dependent on NBFCs for credit.
All in all, the recent crisis has exposed the frailty of Indian financial system on various fronts. There are risks posed by sudden outflow of FII on the value of currency and domestic credit availability. There are risks posed by the reliance of mutual funds and NBFCs on maturity mismatch (the practise of using short term debt to finance acquisition of longer term assets) and their investments in risky sectors like real estate and capital markets.
Time to Tame Free Finance: Some Proposals for Re-regulating Indian Financial System
Some clear lessons follow from the previous discussion on the need to re-regulate the financial sector. Firstly, India’s vulnerability to hot money flows needs to be curbed. To this effect, some degree of capital controls should be implemented. In the aftermath of the crisis there has been a tendency on the part of some policymakers to undermine the risk posed by such flighty foreign capital. Their complacency stems from the large foreign exchange reserves held by the RBI. But foreign exchange reserves are large because capital started flowing out in 2008 after the country had received large inflows for almost four years since 2004. The situation would not have been as rosy had inflows started later, say sometime in 2007 and reversed soon thereafter in 2008. In event of such a scenario, RBI would not have enjoyed the reserve cushion it enjoys today and the economy would have been teetering on the brink of a serious external crisis. The conclusion that some degree of capital controls has become necessary is thus inescapable.
Secondly, the crisis has highlighted the need to regulate non-bank entities. Non-bank entities run the risk due to the maturity mismatch. Commercial banks also run this risk since deposits are freely withdrawable but loans are longer term. However commercial banks are better regulated in this regard; they are mandatorily required to hold reserves in cash and near-cash forms, their deposits are insured and most importantly they can fall back on the Reserve Bank for funds whenever other sources of funds dry up. These cushions are not available to non-bank entities so the risk is much greater. An obvious regulatory conclusion is that non-bank entities should be regulated in the same manner as banks; at the very minimum they should be asked to hold some form of their assets in cash and securities that are easily convertible into cash3. Secondly, inspite of the maturity mismatch, public confidence in commercial banks stems from the fact that their exposure to sensitive sectors like capital markets and real estate (although much larger when compared to pre-reform years) is much smaller compared to non-bank entities. Therefore, caps on exposure of these non-bank entities to sensitive sectors needs to be introduced. Reserve requirements, by imposing costs in the form of idle cash holdings, and caps on sensitive sector investment, by reducing their ability to assume risks, will reduce the potential of these entities to generate returns superior to commercial banks and limit their future growth. But if their growth is not checked now, such institutions may become so large in future that their failure will have serious implications for the stability of the entire financial system.
The above proposals to re-regulate the Indian financial system require the government to go back on the policies of financial liberalisation. The government, however, seems ideologically wedded to the agenda of financial liberalisation. Instead of controlling capital flows, it has responded to the crisis by liberalising foreign investment regulations further. In October 2007, SEBI had prohibited FIIs from issuing participatory notes if the underlying security was a derivative4. This rule was scrapped in October 2008. The participatory note limit of 40% of the total assets under custody of FII was also done away with. This move has allowed unknown and unregulated entities to increase their exposure in the Indian stock markets. It has also diluted norms for raising finance through ECB route. Specifically, the maximum amount that the Indian companies can borrow from this route and the interest rate they can offer on these borrowings has been increased. Moreover, the government remains wilfully ignorant of the risk posed by thinly regulated non-bank entities. The need of the hour is to bring issues of financial stability and regulation within public discourse and to build suitable pressure on the government to make Indian financial system both safe and equitable.
|Table 1: Net Capital Flows (US$ million)|
|2007-08 (PR)||2008-09 (PR)||2007-08 (PR)||2008-09 (PR)||2007-08 (PR)||2008-09 (P)|
|1.||Foreign Direct Investment||2,736||8,989||2,128||5,564||2,041||820|
|4.||External Commercial Borrowings||6,953||1,480||4,210||1,751||6,247||3,883|
|6.||Banking Capital excluding NRI Deposits||-472||1,882||6,274||1,872||1060||-5,998|
|7.||Short-term Trade Credit||1,962||2,397||4,627||1292||4,130||-3,142|
|8.||Rupee Debt Service||-43||-30||-2||-3||0||0|
|Total (1 to 9)||17,792||11,123||33,155||7,852||31,017||-3,683|
|P: Preliminary. PR: Partially Revised.|
Source: RBI Bulletin, April 17, 2009