The Hindu Business Line : Global shockwaves from US financial system

The failure of the American financial giants means that the growth prospects of America will be affected. Many of our industries, especially in the service sector, depend on markets in the US and they will be affected, says S. VENKITARAMANAN
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Outsourcing industry, which depends on the level of demand in the US and Europe, may take a hit.

Recent events have shown that the American financial system is not as robust as its advocates claim. In fact, it has been the practice of American ideologues to canvass in other countries for copying the American financial system with all its checks and balances.

The power of stock markets to raise and allocate capital is their climb to pre-eminence. The “efficient markets hypothesis” claims that markets are particularly efficient in discovering process and determining where capital should flow. It is important to realise, however, that in recent years the American financial system has encountered serious problems.

Sparked by sub-prime crisis

Some of these arose as a result of the sub-prime crisis, followed by fall in house prices and exploitation by lenders to credulous sub-prime borrowers by offering them loans at initially low interest rates and subsequently raising the rates. What made matters worse was that the sub-prime loans were packaged, securitised so to say, and marketed to investment banks.

The investment banks did not, however, have a direct contact with the borrowers. They did not have a clue as to how reliable the sub-prime borrower was. When defaults started, the investment banks realised they were getting on worthless securities.

What was worse was that the sub-prime related securities were also invested in by various international banks, including those in Europe, such as UBS. Many of the banks, which had such exposures, were persuaded to make such investments because of optimistic rating by various reputed rating agencies.

The latest episode of failures was led by the collapse of the State Guaranteed Mortgage Institutions, known as Fannie and Freddie. Apart from the fact that these institutions accounted for the bulk of the mortgage lending in the US, they were also attracting investments in their debt securities from various central banks of the world, especially because their debt was implicitly guaranteed by US Government. However, the collapse of Fannie & Freddie became a national crisis.

In view of their importance both domestically and globally, the US Treasury Secretary, Mr Hank Paulson, and the US Administration decided to bail them out, a bailout that was hailed by many observers as a victory for the US financial managers’ pragmatism.

Heavy burden on US taxpayers

It must be granted that this saved various investments by international investors in the Fannie & Freddie debt securities, but the fact remains that the bailout will leave a heavy burden on US taxpayers, especially because the prices of houses, which form the basis of securitisation, cannot be expected to be at a level to sustain the value of the debt paper. The gap will be a burden on US taxpayers.

While the US Treasury managers tried to stave off a widespread effect of Fannie & Freddie crisis, they did not do so when the latest victim of the crisis came in the form of the century old investment bank, Lehman Brothers. Lehman Brothers have links with many other financial institutions in the US and elsewhere.

The arguments in favour of the bailout of Fannie & Freddie and Bear Stearns could apply equally to Lehman Brothers. But Hank Paulson must have thought that enough is enough and the market should learn to live with the consequences of its actions.

The result of this decision not to intervene in Lehman Brothers’ case has been that the American financial market has seized up. Liquidity has become very low and the American stock markets have collapsed, leading to further failures of some banks and financial institutions.

The venerable insurer, AIG (American International Group) has been bailed out with a $85-billion infusion. The Federal Reserve has agreed to extend a two-year loan to AIG in exchange for a 79.9 per cent equity stake in the company and change in the top management.

What was the proximate reason for this catastrophe? Analysts have been quick to point out that the bursts of irrational exuberance in the Greenspan years set by low interest rates was partly responsible for creating a complacent attitude amongst the markets and the investment banks. It led to a built-in sentiment that catastrophes would be averted and further the Government would take care if any unforeseen events happen.

Impact on rest of the world

Whatever the causes for its failures, the American financial system, the main engine that drives the world’s economy, is indeed in trouble. This has had some disturbing consequences. America’s financial investments are looking to Sovereign Wealth Funds, their bete noire, to save them. They are also driven to the ultimate irony of nationalisation of their private sector.

This leads me to the question of the impact of these collapses on India and the rest of the world. Despite all the talk of India decoupling from the American economy, the fact remains that India, like the rest of Asia, is very much linked to the health of the American financial system. For one thing, capital flows in the Indian stock market under FII depend on the easy liquidity in the American financial system. When the recent catastrophic events blocked the liquidity, we saw a corresponding fall in the stock markets of the US, Asia and Europe. Further, the failure of the American financial giants means that the growth prospects of America will be affected. Many of our industries, especially in the service sector, depend on markets in the US and they will be adversely affected.

Outsourcing industry vulnerable

This takes me to the unintended effects of globalisation. The outsourcing industry of India depends very much on the likes of AIG, Citibank and Lehman Brothers. Our service industry will lose business substantially when there are serious problems in these institutions. The same is the case with reference to our textile exports, which depend on the health of demand in the US and Europe.

Perhaps, one offsetting fact is the decline in the price of oil as a result of likely “de-growth” of the American economy. Consequent on the financial sector collapse, among other reasons, crude oil has been touching sub-$100 prices. This is a bit of good news for the Indian economy where inflation may abate.

But there is another down-side to it, namely, that decline in capital flows into the stock market as a result of fall of share prices has led to a change in exchange rate and fall in the rupee vs dollar. While this is cheering news for the exporting community, it is not so good news for the fisc. The declining rupee means that imports will cost more and the subsidy on crude oil may not decrease in tandem with the decline of oil prices.

In conclusion, it is difficult to insulate India or any other country from the effects of the American problems. While it is true that we can learn many lessons from the crisis of the American imbroglio, the answer is not quite simple.

Better regulation is not by itself an answer. The problems arose because of the complexity of the financial products and innovations introduced in the American financial system. Innovation for the sake of innovation can be disastrous.

The American experience should be a guide to us to avoid such pitfalls. Governor Reddy took a tough line in regard to encouraging innovations, but with sufficient safeguards. May Dr Subbarao continue the same tradition, learning from the US experience!

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