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Understanding liquidity crunch
D. MURALI
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The liquidity crunch in Indian markets is largely a localised and short-term phenomenon, triggered by factors such as advance tax payments, regulatory intervention in forex markets to stabilise the depreciating rupee, and so on..
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MR N. MUTHURAMAN, CO-FOUNDER, RIVERBRIDGE CAPITAL ADVISORS
What is `liquidity
crunch' that is in
great focus these
days? Why is it a
problem? Where are its roots?
What is its magnitude? Do we have
examples of such a crisis in our history
books? These and more questions
are currently top on the minds
of most of us.
"Liquidity crunch is a situation
where it becomes considerably difficult
(and expensive) to raise funds
for banks as well as for businesses,"
explains Mr N. Muthuraman, former
Director-Ratings, Crisil Ltd.
"At present, we are witnessing liquidity
crunch both in global and
Indian credit markets, though for
very different reasons," he adds,
during the course of a recent email
interaction with Business Line.
Mr Muthuraman, an engineer
and a management graduate from
IIM, Bangalore, is the Co-founder
of RiverBridge Capital Advisors
Pvt. Ltd, a financial consulting and
investment banking firm with focus
on assisting SMEs (small and medium
enterprises) to access mainstream
capital sources, including
venture capital, private equity and
strategic investors.
Excerpts from the interview:
How different are the reasons
for liquidity crunch in India, as
compared to the global scene?
The liquidity crunch that is playing
out in the global markets is a
result of crisis of confidence among
banks. The collapse of large banks
and financial institutions such as
Bear Stearns, Lehman Brothers and
AIG has shaken the confidence of
banks to freely lend to each other,
as everyone is guessing who is next.
As a result, many banks which relied
on short-term wholesale funds
from other banks, are finding it difficult
to raise such funds any longer,
leading to a liquidity crunch.
The roots for this crisis can be
traced to securities invested by
banks that are backed by sub-prime
mortgages. Sharp erosion in value
of such securities and lack of transparency
(about the quantum and
nature of such toxic assets that still
remain in various banks' books) are
the main causes for the crisis of
confidence in global markets.
In contrast, the liquidity crunch
in Indian markets is largely a localised
and short-term phenomenon,
triggered by factors such as advance
tax payments, regulatory intervention
in forex markets to
stabilise the depreciating rupee,
etc.
There is some rub-off effect of
the global liquidity crisis on India
as well, because foreign institutional
investors are selling domestic equities
exacerbating pressure on
rupee.
However, this has only a marginal
impact on liquidity; there is no
crisis of confidence among banks in
India to lend to each other, as is
being seen in global markets.
Every country has gone through
liquidity crises in the past - for
instance the US in 1998 during the
LTCM (Long-Term Capital Management)
collapse, Egypt in 2001,
the UAE (United Arab Emirates) in
recent times have all seen liquidity
crises.
However, the simultaneous occurrence
of this crisis in all major
financial markets and the magnitude
make the current crises the
most severe in anyone's living
memory!
Can you tell us about the countermeasures
to tackle the liquidity
crunch? To what extent will
the current steps taken by the
central bankers (such as reducing
the CRR) help?
To tackle the liquidity crunch in
the Indian credit markets, the CRR
(cash reserve ratio) cuts announced
by the RBI (Reserve Bank of India)
in recent times are welcome moves,
as these infuse the much-needed
liquidity into the banking system.
As I said earlier, the liquidity crisis
in Indian markets is temporary,
and I believe the move by the RBI is
sufficient, at least for the time being,
to ease the liquidity pressure.
Moreover, the regulator still has
significant lee-way in managing the
domestic liquidity well, though this
may interfere with its efforts in
containing inflation.
In contrast, the measures taken
by global regulators still lack clarity,
and have not yet eased the crisis
of confidence among banks despite
repeated attempts to inject liquidity.
In my view, getting to the root
of the problem, viz. forcing all
banks to simultaneously disclose all
their sub-prime related exposures
and losses (both on and off balance
sheet), and significant direct capital
injection into the weakest banks
will be the most effective way to
bring back confidence among banks
to freely transact with one another.
Other indirect measures, such as
guarantee of all inter-bank transactions,
or lowering rates have not
yielded any results so far and may
only prolong the current crisis.
Over the recent weeks we are
getting used to reading about big
bankruptcies and mega institutional
failures. Were these avertable? Also, should there be
major rescue efforts in the face
of imminent failure?
Though the current crisis looks
complicated with new acronyms
being thrown around every day -
RMBS, CDO, CDS, etc. - the basic
problem has been reckless lending,
a fairly well-documented problem
that has caused innumerable financial
sector crises worldwide.
(Portrait by R. Rajesh)
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