BOOK REVIEW. Making too much of financial risk?

The 2007-08 global financial crisis has been done to death, meaning analyses of what went wrong and why.

The authors of these analyses describe this research as belonging to three different categories — popular account, academic research and policy briefs. Most of this research has centred on the United States and Europe, specific countries in the case of the latter.

The financial crisis was also an opportunity to introduce structural reforms, an opportunity missed in the case of the US and still unravelling in many parts of Europe.

This book, Financial and Fiscal Policies Crises and New Realities, authored by former RBI governor YV Reddy, academics Narayan Valluri and Partha Ray, is different in two ways. First, it talks about countries that are often ignored in the whole discourse around the 2007-08 meltdown.

Second, the book focuses explicitly on the links between fiscal, financial and monetary policies.

Other than an introduction, the 15 chapters in the book are divided into three detailed sections.

Myriad angles Section one is a bit like a background, with the immediate impact of the crisis on fiscal positions and fiscal responses.

Section two discusses cross-country experiences, with a specific chapter on India. Despite the appellation cross-country, there is a bias towards Europe and one misses a chapter on a country such as China.

Section three is about issues such as public debt management, central banking, sovereign debt restructuring, taxation and regulation of the financial sector and sub-national finance.

To be fair, this is the most interesting part of the whole book. Unfortunately, the section on sub-national finance is all too brief, and given his involvement with the 14th Finance Commission, Dr Reddy probably held his pen (on India, at least).

Although the distinction between the real and the financial is artificial, the impact on India was two-fold, real, as in an export impact, and financial, as in volatility in capital inflows, capital markets and exchange rates.

Let’s ignore global reform and cross-country issues, flagged in Section three. That apart, Indian readers will be interested in Chapter 8, which is specifically on India.

The official line Here is a quote from the introduction’s summary of Chapter 8. “Despite the near-zero exposure of Indian banks, given its extent of globalisation, India was affected by the crisis…” Documenting the monetary and fiscal elements of the Indian stimulus package, the chapter hints at the structural weaknesses of the Indian fiscal situation. The chapter further argues that despite the small size of Indian stimulus package (in comparison to other countries) the fiscal space in India was rather meagre.

Furthermore, says the introduction, coupled with the problem of twin deficits, a major factor that did not expose India to the whims and fancies of sovereign debt market was its avoidance of original sin, whereby India’s public debt was primarily rupee denominated.

However, the quote continues, “in line with India’s policy of calibrated financial and external sector liberalisation, while households, governments, and even financial sector had manageable exposure to foreign currency liabilities, the same is perhaps not true for the larger entities in the Indian corporate sector.”

While there are elements of truth in this argument, notice that this is the official or party line, so to speak. On at least three counts, the argument should be more nuanced.

First, let us go back and look at reactions to the earlier East Asian financial crisis in 1997-98.

It was the prevalent official view that it was just as well that India had not liberalised the capital account.

Otherwise, India would also have suffered, like East Asia did. Similar views were also expressed in 2007 as well, such as that bit about limited and manageable exposure to foreign currency liabilities.

Risk is not bad Here we must ask a simple, but important question: Is exposure to risk and uncertainty a problem?

Surely, if the regulatory structure is sound and risk mitigation instruments exist, risk is very much a part of life and is not necessarily a bad thing.

Therefore, why state that the exposure to foreign currency liabilities by the larger Indian corporate sector was a problem?

Hence, second, was the degree of foreign exchange cover available not broad enough?

Or was it the case that instruments were available, but the corporate sector consciously chose not to hedge because of the way the Reserve Bank of India (RBI) had intervened in foreign exchange markets and influenced the exchange rate in the period immediately preceding the crisis?

Third, India’s so-called counter-cyclical monetary and fiscal policy stimulus package also needs a more graduated enunciation.

There are no quarrels with the monetary part, or the fiscal part, in so far as excise exemptions and recapitalisation of banks is concerned.

But were the rural job guarantee scheme Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS), the farm debt waiver of UPA 1 and the 6th Pay Commission a response to the crisis? They happened before the fall of US financial services giant Lehman Brothers, which triggered the 2007 global crisis.

To describe these as counter-cyclical response is to assume an inordinate degree of forecasting powers to Indian policy-makers. In fairness, the authors do recognise this in Chapter 8.

It is just that they gloss over it and tweak the assertion a bit, understandable in view of Dr Reddy’s official affiliations. Nevertheless, even that chapter on India is a good account of the problems India faces.

This includes fiscal challenges, including those at the state level. Had there been some discussion of fiscal devolution (the Finance Commission point made earlier) and of making RBI truly independent and delinking monetary policy from fiscal policy (such as freeing the RBI from public debt management), the chapter would have been richer still.

For the world as a whole, as the Preface states, expect no unified field theory in this volume. There is none. It is a good discussion of the issues.

Meet the authors

YV Reddy is former governor of the RBI and the chairman of the 14th Finance Commission of India. Narayan Valluri is honorary adviser at the Administrative Staff College of India, Hyderabad. Partha Ray is professor of economics at the Indian Institute of Management Calcutta

(The reviewer teaches at the Centre for Policy Research in New Delhi. He is a permanent member of the National Institution for Transforming India Aayog (NITI Aayog)

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