The Hindu Business Line : Turbulence in financial markets and the way ahead

The Reserve Bank of India will have to take extra care to further tighten monetary expansion to mitigate the effect of inflows of foreign funds on liquidity, particularly following the Fed rate cut on January 22.

M. Y. Khan

The sub-prime mortgage market, which resulted in high credit risk and counter-party risk in the US, is still facing uncertainties and financial instability — an offshoot of imprudent policies of US banks and other financial institutions opearting there. In fact, financial markets across the world have been turbulent.

The US institutions — in particular, Freddie Mc, Boston Financial, Northern Rock, Merrill Lynch and Citi Group — face mortgage losses and massive accumulation of dead assets due to sub-prime financing of borrowers with poor credit history and weak documentation of income. Truly speaking, they committed selection blunders to earn high fees on mortgage deals and sidetracked income recognition norms.

Financial instability

A large number of borrowers were lured by low interest rates and monthly income schemes. Banks, in particular, did not observe transparency and concealed from customers the fact that after two years, interest rates would become variable. As a result of the interest burden, the repaying capacity of borrowers sank to the level of bankruptcy and heavy dead assets, swallowing the bank’s financial viability and net worth.

This viral crept into European Banks too. Since a large number of US banks and other financial institutions are entering the Asian (especially Chinese and East-Asian) and West Asian markets to mobilise funds to rescue themselves from bankruptcy, there is the danger that financial instability may creep into Asia as well.

An unexpected consequence may be a slowdown in the flow of funds from some of these East-Asian countries to the Indian financial markets. There are indications that markets in Hong Kong, China, South Korea, New Zealand, and so on are already becoming uneasy with stock prices falling. On the international front, another visible and emerging source of financial instability is the reckless creation of massive liquidity at lower cost by the Fed to provide cash to the US financial institutions, which may hasten further depreciation of the dollar and the appreciation of other currencies, resulting in greater pressure in international trade relations.

Impact on India

This could have a number of side-effects, especially on the financial markets in India. For instance, Indian banks with branches in the US and the UK may lend to banks affected by the sub-prime debt crisis. This would weaken their balance-sheet in future.

It is interesting to look at branches of foreign banks operating in India. They accept large deposits from Indian depositors. If they do not get out of the financial turbulence in their respective domestic markets, their dead assets in foreign markets may impair their liquidity in India, resulting in the funds of Indian residents being locked up.

Indian exports, particularly to the US, have so far withstood the pressure of rupee appreciation. However, the recent heavy subscription of IPOs by foreign investors will result in further appreciation of the rupee, and this trend may make things more difficult for exporters. Besides, the demand recession in the US is likely to create further instability for Indian exports.

There is also the fear of continued squeezing of bank credit to individual households, despite the Fed’s monetary expansion to contain demand recession. These are going to act as anti-growth factors for India. The Reserve Bank of India will have to take extra care to further tighten monetary expansion to mitigate the effect of inflows of foreign funds on liquidity, particularly following the Fed rate cut on January 22.

Lower growth rates

The recent report of the Economic Advisory Committee to the Prime Minister has indicated a slightly lower GDP growth rate of 8.9 per cent for 2007-08 and 8.5 per cent for 2008-09 instead of the earlier estimated 9 per cent. If so, the market liquidity, which is high now, will have to be reduced to keep inflation under control.

The high liquidity in the market has been supported by the heavily oversubscribed IPOs as well as skyrocketing equity and real assets prices. It would be worth watching the price spiral in the economy, particularly in financial assets.

Again, India has continued to be a safe haven for foreign funds entering the country by way of direct investment, foreign institutional investment, external commercial borrowings and foreign deposits (including NRI deposits).

This may further speed up for reasons of safety and steady return. Of course, the RBI will have to strengthen financial stability measures of domestic banks to mitigate the pressure on monetary policy and credit expansion in the domestic market due to these inflows.

It would be advisable for the RBI not to introduce full capital account convertibility in respect of ECBs , FIIs in the capital market and the real-estate sector.

sDespite the fact that inflation has been fallen to a low of 3.5 per cent and liquidity repeatedly moderated downwards using various instruments (such as Cash Reserve Ratio (CRR), Liquidity Adjustment Facility (LAF) and Market Stabilisation Scheme (MSS)), the RBI will have to discover additional instruments, such as issue of dollar/euro bonds, to mop up foreign exchange inflows and control monetary expansion.

The RBI can also think of using selective credit control in the case of lending to capital markets, real estate, the bullion market as well as the commodity markets, which have witnessed high volatility in terms of price.

Although the financial markets have shown marked resilience due to the RBI’s stability norms, some segments of the financial sector provide evidence of an increase in non-performing assets.

The disastrous meltdown of the Indian stock market, resulting in heavy loses to investors and traders is putting pressure on the monetary authority to cut interest rate, as was done by the Fed recently. Cutting interest rates and easing liquidity would, perhaps, be a hasty decision to help the bulls.

Liquidity in the market

It may benoted that the stock market is still flush with liquidity and money has not moved out of country. FIIs that entered the market to unload their position for profit-making will not do so now because foreign markets are not safe.

Moreover, there cannot be a stock market-driven monetary policy. Money supply and interest rates have to be determined by real variables such as economic growth and their requirement for credit, and the inflation rate.

In fact, growth in market capitalisation should be compared to investment growth in the corporate sector. If real investment growth in terms of production does not happen, we should take a serious look at market capitalisation.

(The author is Chairman of Inter-connected Stock Exchange of India Ltd. He can be reached at my.khan@rediffmail.com)

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