The Hindu Business Line : US bailout drama: No Act II

The US’ bailout plan for the financial crisis is hopefully being approved soon. It is expected to be received favourably by members of the US Senate and Congress. President Bush has tried to point out to his colleagues in both parties that the plan is an effort that has the nature of a last resort. If it does not get approved and implemented, the financial system of the US would be damaged beyond repair.

Perhaps, in the opinion of some observers, the disaster as an event was waiting to happen. Various commentators have been quick to point out that the American financial system was “innovating” beyond reason with demons of its own design, such as hedge funds and derivatives, which were leading the investment banks taking very risky positions in the market.

Various investment banks had “leveraged” their position by borrowing up to 20-30 times their equity, for investing on various kinds of derivatives, such as credit default swaps. When the crisis came, they realised they had over-borrowed. They had no reserves to fall back on.

The Federal Reserve Chairman, Ben Bernanke, and Treasury Secretary, Hank Paulson, must be credited for their remarkable ingenuity in formulating and pushing through a solution, which immediately transcended their own admitted ideological position. They opted for the socialist solution for State to take over distressed institutions, such as Fannie and Freddie. They were also willing for the Fed to take a massive stake as high as $85 billion in the ailing insurer, AIG.

The proposed bailout, costing upwards of $700 billion in immediate outgo, contemplates the creation of a special entity, which will acquire all the distressed assets and recover their costs when they finally sell off these assets at an appropriate occasion. Obviously, this is following the model of the Resolution Trust Corporation, which the US Administration had set up to avert the problems created by the failure of the Savings and Loan Associations in the 1980s.

The expectation that the proposed bailout and sale of the distressed assets taken over would create “value” depends on these assets obtaining a good enough market price on their disposal. If they do not succeed in getting fair and attractive value, a heavy burden will be cast on the US tax-payer.

‘It’s un-American’ charge

There have been criticisms both in the Congress and the Senate that the solution proposed by the Administration is very “un-American”. It involves an element of nationalisation of private institutions while putting the State forward as a repository of last resort for failing or failed institutions. This criticism, which is partly a reflection of the fact that America has been so long a strong cheer leader of market-based solutions and the bailout is far removed from solutions based on the market.

A wit has remarked that the US is, in fact, fast becoming a United Socialist State of America (USSA) instead of being a model of market-based democracy. Observers have been quick to point out that the US was only too willing to suggest similar solutions to the Asian countries in the last crisis. Commentators point out that other precedents are available to the US, such as the Swedish example of the Government’s takeover of distressed banks’ assets in the 1990s, which resulted in a successful outturn on sale of take-over assets.

It is hoped that the bailout plan succeeds. As some Senators have pointed out, there is no Act II to this drama. If the bailout fails, there are no obvious further solutions except total chaos. Let us hope that for the good of the world, the Bernanke-Paulson solution works out.

Bailout and Indian economy

The question arises as to what would be the impact of these bailouts on the Indian economy. The fact that liquidity in the US financial institutions will be at a very low ebb will dictate a decrease of capital flows into India. It will also have an impact on Indian corporates’ ease of access to foreign credit sources. It is ironic in this context that the Government of India has seen it fit to raise the ECB ceiling just at a time when the US markets have seized up.

But observers of the Indian macroeconomic situation are, however, quick to point out that India does not depend too much on external capital flows for growth. Indian savings themselves account for more than 30 per cent or so of GDP.

India’s economic growth is not predicated too much on foreign flows. These currently amount to 3 to 4 per cent of GDP. While the shortage of foreign inflows will not adversely affect growth too much, it has, however, a different impact. As capital flows dry up, whether on FII or FDI, the rupee will drop further as dollar supply decreases. This will lead to higher prices for imports and a heavier burden on subsidies for a Government keen on keeping ultimate consumer prices lower for petroleum products.

The current situation may well dictate the RBI’s stance on further tightening of monetary policies. If liquidity continues to be tight in the Indian monetary system because of reduction in capital flows, the RBI may have to think, as it seems to have already done in past, of easing some of the liquidity constraints, such as CRR increases.

Whether the RBI will reduce interest rates further is, however, doubtful because of continuing high inflation. The fact that international crude oil prices have shown a temporary decline does not mitigate the position since the consumer prices do not reflect a full pass-through. The ensuing monetary policy will, hopefully, show whether the Governor proposes a further tightening or a relaxation to suit the changing times.

Don’t ease up on reforms

Does the present crisis on the international front give a signal to the Government of India to ease up on financial reform? Should the Government of India consider further liberalisation of FDI norms for insurer? The question is inappropriate. Reforms are necessary in India for the sake of good of Indian macroeconomic system and we should not borrow from the recent American experience to dictate what we should or should not do in respect of FDI.

While it is true that our regulatory system has been relatively robust and we have kept our NPAs at an appropriately low level, the important lessons for India from the American crisis are more to the extent that our commercial banks should retain their characteristics of commercial banks.

The Glass-Steagal Act 1933 had rightly drawn a barrier between investment banking and commercial banking. The fact that venerable American investment institutions are becoming commercial banks shows a superiority for the commercial bank model. This is especially true for India. This is so because the commercial bank’s expanding outreach qua commercial bank inspiring confidence is necessary for social and financial inclusion in the countryside.

Whether or not the American experience teaches us lessons of how to manage the crisis, it definitely inculcates lessons on how to avoid it in running a financial system. Especially, it teaches us that innovation for the sake of innovation is definitely to be avoided. Particularly is this true in regard to the Percy Mistry model — adumbrated in the report of the Committee on making Mumbai an International Financial Centre — which was predicated on following the New York Financial Centre model for Mumbai.

blfeedback@thehindu.co.in

Related Stories:
Convulsive crisis of capitalism
FDIC data hints at more financial trouble in US

More Stories on : Financial Markets | Financial Markets | Economy | S Venkitaramanan

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page