World - An agenda for long-term stability

Subramanian Swamy

Why an occasional financial crisis can purge the system of economic toxins.

Financial crises in the market economies of democratic countries are not unusual. It is also not unusual for such economies to make policy corrections and come out of the crises. During this first decade of the 21st century itself we have seen economies in the West go through two crises: the first was in 2000, the “dotcom bust,” and the second was after the 9/11 terror attacks. But the market economies came out of it: in fact we saw a boom between 2003 and 2008.

In 1987, the U.S. savings & loan banks crashed, causing a huge slump in the New York Stock Exchange. Many people thought then that the U.S. was sunk and that the Japanese and other East Asian nations would buy up America. But that did not happen. Instead, under President Bill Clinton the U.S. saw the longest economic boom of the 20th century. During the period 1997-99, East Asian nations instead went through a huge crisis, causing widespread bankruptcy in large companies in countries from Thailand to Japan.

Aftermath of crises


The important fact, therefore, to remember about all these crises is that all the affected market economies did recover, and prospered subsequently. In contrast, socialist economies have barely survived economic crises. The Soviet Union broke into 16 countries after a financial crisis induced by Mikhail Gorbachev’s perestroika drive. China was a shambles in the 1970s and the early 1980s after the failure of the Great Leap Forward, the Cultural Revolution, and other Maoist adventurist economic experiments. It has survived only because it quickly sequenced its economy to become an open market system.

Similarly, the nations of East Europe and Yugoslavia crumbled in the 1980s and broke up following an economic crisis. The pieces such as the Czech Republic and Slovakia adopted the market economy and have since prospered. Hence, it is not difficult to predict today that the U.S. economy will come out of the present crisis as well. The crisis is serious in terms of its global spread but it is not a financial holocaust, nor is it comparable to the 1929-33 Depression. The only consequence I see is the demise of market fundamentalism, namely that the market can correct itself in every situation.

Like our body, occasionally we need medicines to cure ourselves of the toxins in our blood. Economic theory also has developed since the Depression to such levels of sophistication that like meteorology there is a high probability of being able to predict a crisis and also lay down prescriptions on what to do to prevent a crisis or to come out of one.

Cause of the crisis


In the case of the current crisis, many economists had warned the U.S. administration that the housing bubble was being fuelled by improperly secured loans issued by banks, especially egged on by those banks which also went into investment banking. This meant that they were themselves making risky purchases in the stock market and investing in poorly analysed projects out of depositors’ money. The present crisis, thus, is an outcome of the sub-prime blowout caused by defaulting mortgage payments in housing loans. Those advances should never have been made in the first place under normal prudential norms. Since the times were good due to a general boom between 2003 and 2008, caution was thrown to the winds. These defaulting payments had a cascading effect on financial institutions since U.S. banks do not have statutory liquidity ratios (SLRs) and cash reserve ratios (CRRs) fixed for them. Therefore, for every deposit of $1, U.S. banks create $8 of loans by opening paper accounts and effecting transfers. In such a situation, when panic sets in as a consequence of rumours, and depositors rush all at the same time to the banks seeking to withdraw their deposits, the lending institutions do not have the reserves to oblige all the depositors. Hence, they declare bankruptcy — as Fannie Mae, Freddie Mac, Lehman Brothers, and AIG all did. This has a fission effect on the stock market, which reacts to every piece of bad news. That is how the present crisis evolved. Since financial institutions are nowadays wired together in a globalised world, this panic and the bearish mood spreads worldwide. Thus, governments have to intervene and restore confidence in the system by means of ad hoc measures to bolster liquidity in banks.

The Bush package


The U.S. President’s proposed package or bailout of $700 billion is one such measure for coming out of the present crisis. The package was first turned down by Congress not because it was a bad idea. It was turned down because, as the former Economic Affairs Secretary in the Finance Ministry, Dr. E.A.S. Sarma, has stated, as designed it envisaged making direct grants to defaulting banks. It would, therefore, have amounted to nationalising at the taxpayers’ cost, losses caused by reckless corporate managements which had irresponsibly fuelled the mortgage spree earlier, causing the sub-prime crisis. Instead, the $700 billion bailout fund should be vested in a sovereign equity fund as suggested by another Indian, Dr. Gitanjali Swamy, who has an MBA from Harvard University and who is and chairman and managing director of the Zuci Group of Boston.

This fund should buy fixable assets and companies at negotiated prices and sell them off in the market after the crisis has blown over. In the meantime, as dividends and capital appreciation become possible, the taxpayer can recover the bailout amount in instalments. The Bush bailout package has been re-designed now and has been passed by Congress. But the above suggestions have not been incorporated. President George W. Bush has appointed an Indian, Neel Kashiri, as the administrator of the Fund. Hopefully, he will implement the suggestions.

Impact on India


What will be the impact of the crisis on the Indian economy? In the sub-prime instance, two negatives had cancelled each other in India: the crisis “virus” from abroad versus the local financing of the housing boom in India by black money — which is immune to interest rates and grows like a financial amoeba. In the present larger crisis, we would have been largely unaffected if the Mauritius-routed black money “washing machine” called Participatory Notes (PNs) had not been permitted. PNs need not conform to the regulations of the Securities and Exchange Board of India (SEBI), or comply with international standards of disclosure as to who owns them and how they were paid for. More than 55 per cent of the foreign fund inflow comes today from these PNs, which even the terrorists, not to mention financial buccaneers and corrupt politicians, have used to earn money on the Bombay Stock Exchange, and make the Sensex go up or down at the will of a small cartel. Recently, All India Anna Dravida Munnetra Kazhagam leader Jayalalitha openly challenged Finance Minister P. Chidambaram to answer certain basic questions about the financial propriety of PNs and the violation of disclosure norms that they involve, but the Finance Minister tucked tail and ran away from the challenge. As of now, three things will happen. First, foreign funding will reduce due to a global liquidity crunch, interest rates abroad will rise, and the rupee will depreciate as the existing PNs will exit the country. In panic, the government has made PNs even easier to use, but in this situation of uncertainty that will not help much. All that PNs will do anyway is to pump rupees into the economy and cause inflation. This will affect our investment and the cost of imports that are essential for our export industries. This is why while the dollar is sinking the rupee-dollar rate has risen from Rs. 39 to Rs. 49 in just a month. Therefore, with a rise in import cost due to the devaluation of the rupee, we should expect a deceleration in the growth rate of the gross domestic product (GDP) and a recession till correctives are applied — including voting out the incompetent United Progressive Alliance from office in the next elections.

While the government has cut the CRR claiming that the step would bring down the interest rate, the prime lending rate (the rate at which banks lend) has actually gone up from 10 per cent to 12 per cent, reflecting the tight liquidity position after foreign inflows have slowed down.

Remedial action


For the present, I suggest to ordinary household investors in the stock market to tighten their belts and sit out this crisis. It will not last more than six months since the toxin of excessive and reckless borrowing in the U.S. has to be purged, which the present crisis and the corrective measures will achieve. I also recommend that the government use the foreign exchange reserves in U.S. treasury bonds to help Indians buy up through mergers and acquisitions U.S. companies that are up for sale. But, for long-term financial stability India will have to embark on financial reforms which have been on hold since 1996. What is to be done is clear: many government committees have outlined the necessary steps. A special mention needs to be made of the Tarapore Committee and the internal notes of SEBI. These have been ignored by the Finance Minister because inter alia the abolition of PNs has been recommended. The first reform measure needed is to liberate banks from being required to buy government Treasury bonds. At present, more than 50 per cent of bank funds have to be invested in this low-yield bond or be kept in reserve with the Reserve Bank of India. Besides this, banks have to buy oil bonds for which there is no margin. Hence the private sector has to go abroad to get funds at low interest rates — which it cannot do anymore. Second, a commission should be empowered to have a re-look at the budget allocations and their actual deployment, and suggest re-structuring. This commission should independent of the Finance Ministry. Third, all State Electricity Boards should be abolished and replaced by private operators which have to tender for it and make handsome deposits. Fourth, the law should require that the capital account in the budget should always be in deficit or balanced, while the revenue account should be in surplus: it is the other way round now. This should be achieved within the next three years.

These reforms require a new government with a new mandate. It will require gutsy and rational risk-taking leaders. They are there, but the people must demand them and vote for them. That is the bottom line of our agenda for stability.

(Dr. Subramanian Swamy is a former Union Commerce Minister and a Harvard-trained economist.)