People's Democracy

India’s Financial Boom In The Light Of The 1997 Financial Crisis

C P Chandrasekhar

JULY 2007 marked the completion of a decade since the Asian financial crisis subverted the growth miracle in East Asia. Prior to the crisis, some of these countries had been growing at a pace and in a fashion that was challenging the dominance of the imperialist powers over the global economy. Their excessive dependence on exports, especially to developed country markets, necessitated a process of financial liberalisation to accommodate global capital in return for access to those markets. And such financial liberalisation, it is widely accepted, triggered the financial meltdown.

The Asian crisis triggered a process of rethinking of policies of financial liberalisation in developing countries. It also set off a debate on ways in which the international financial architecture needed to be restructured in order to prevent the recurrence of that crisis. That this debate did not lead to appropriate concrete action is of course reflected in the fact that since 1997 the world has experienced a series of financial crises in countries such as Russia, Turkey, Brazil, Mexico and Argentina.

VULNERABLE, ONCE AGAIN

What is more, just as the world was recalling the 1997 experience on its tenth anniversary, evidence was accumulating that the global financial system was once again vulnerable. The extent of vulnerability was driven home by the simultaneous collapse of stock indices in the worlds leading financial markets on Friday, July 27, including those in so-called “emerging markets” in developing countries. What is disconcerting is that this synchronized collapse of markets was not the result of developments in each of the countries where these markets were located. Rather, the source of the problem was a crisis brewing in the housing finance market in the US, the ripple effects of which encouraged investors to pull out of markets globally.

The American problem lies in the way in which the housing boom was triggered and kept going. Housing demand grew rapidly because of easy access to credit, with even borrowers with low creditworthiness scores, who would otherwise be considered incapable of servicing debt, being drawn into the credit net. These sub-prime borrowers were offered credit at higher rates of interest, which were sweetened by special treatment and unusual financing arrangements — little documentation or mere self-certification of income, no or little down payment, extended repayment periods and structured payment schedules involving low interest rates in the initial phases which were “adjustable” and move sharply upwards when they are “reset” to reflect premia on market interest rates. All of these encouraged or even tempted high-risk borrowers to take on loans they could ill afford, either because they had not fully understood the repayment burden they were taking on or because they chose to conceal their actual incomes and take a bet on building wealth with debt in a market that was booming.

The first casualties in the crisis have been the mortgage lenders, who used borrowed capital to finance mortgage lending. Firms like New Century Financial, WMC Mortgage and others, which made huge returns during the boom, expanded lending volumes, encouraged by low interest rates and slowing house price inflation in 2006. This required moving into the sub-prime market to find new borrowers. Estimates vary, but according to one by Inside Mortgage Finance quoted by the New York Times, sub-prime loans touched $600 billion in 2006, or 20 per cent of the total as compared with just 5 per cent in 2001.

Mortgage lenders or brokers were encouraged to do this because they could easily sell their mortgages to banks and the investment banks in Wall Street to finance their activity and make a neat profit. And the investment banks themselves were keen to buy into the business because of the huge profits that could be made by “securitizing” these mortgages. Firms such as Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley, and others bought into mortgages, pooled them, packaged them into securities and sold them for huge fees and commissions. Numbers released by the Bond Market Association indicate that mortgaged backed securities issued in 2003 were at a peak in 2003 when they totalled $3 trillion. Even though total values have declined since then because of the deceleration in home price inflation, they are still close to the $2 trillion mark.

With high returns on creating these products and facilitating trade in them, the investment banks were hardly concerned with due diligence about the underlying risk associated with these securities. That risk mattered little to them since they were transferred to the purchasers of those securities. The risks in the final analysis are shared with pension funds and institutional investors which were buying into these securities, looking for high returns in an environment of low interest rates. They are now experiencing a sharp fall in their asset values and threatened with losses. In sum, this whole process, which has at the bottom home owners faced with foreclosure, is driven by layers of financial interests looking for quick profits or high returns.

The net result is that the housing market crisis threatens to build into a crisis of the US financial sector as a whole, resulting in a liquidity crunch that can aggravate the slowdown and precipitate a recession. All this has occurred also because of the regulatory forbearance that has characterized the ostensibly “transparent” but actually opaque markets that are typical of modern finance. Investment banks did not reveal the weak credit base on which the mortgage securities business was built, investment analysts routinely issued reports assuaging fears of a meltdown, credit rating agencies did not downgrade dicey bonds soon enough, and the market regulators chose to look the other way when the speculative spiral was built.

WEALTH & INCOME INEQUALITIES

Underlying all of this is a fundamental tendency: the rapid increase in financial wealth looking for new and profitable avenues for investment. This burgeoning of finance is itself the result of the wealth and income inequalities generated by the process of corporate globalization. Across the world corporate profits and rentier incomes are rising rapidly, even as real wages stagnate or rise marginally, resulting in a rise in the share of surplus in national income. Such global and national inequalities concentrate incomes among a few, whether they be the millionaires in the developed and developing world who accumulate savings looking for avenues of investment or sections of the middle class that accumulate financial capital through investments in mutual and pension funds, that need to be invested to meet future commitments. Neo-liberal reform by reducing State provisions for social security only aggravates this process, since it requires the middle class to save for contingencies or old age. The financial component of neo-liberal reform permits pension funds and insurance companies to invest this capital in a wider range of assets, resulting in the expansion of an asset class like private equity. The financial system adjusts by courting risk. And developing countries succumb to the pressure to benefit from this liquidity by opening up their economies and liberalising their financial sectors.

The problem is that if these factors result in the accumulation of doubtful assets by investors such as banks, pension funds and mutual funds, any downturn spreads the effects into markets where these institutions have made unrelated investments. In fact, institutions overexposed to complex structured products whose valuation is difficult are saddled with relatively illiquid assets. If any development leads to liquidity problems they are forced to sell-off their most liquid assets such as shares bought in booming emerging markets. The effect that this can have on those markets would be all the greater the larger is the exposure of these institutions in these markets.

Unfortunately the exposure of these institutions has been increasing in most emerging markets including those in Asia. There has been an acceleration of financial flows to developing countries during recent years when as a group they have been characterised by rising surpluses on their current account. Net private debt and equity flows to developing countries have risen from a little less that $170 billion in 2002 to close to $647 billion in 2006, an almost four-fold increase over a four-year period. What is more, there is a high degree of concentration of these flows to developing countries, implying excess exposure in a few countries

When liquidity problems arise, even for reasons unrelated to these markets themselves or the countries in which they are located, these investments are quickly unwound precisely because those markets are still liquid and a collapse of the kind seen in end-July ensues. That is, one consequence of the large and concentrated flow of capital is that when assets have to be retrenched by financial firms because of developments in any component of their portfolio, a few emerging markets can become the sites of that sell-off. This partly explains why stock exchanges in emerging markets have turned bearish and volatile in recent weeks, primarily because of the ripple effects of the subprime mortgage crisis in the US. Investors incurring losses in those markets are reordering their global portfolios to meet immediate commitments, resulting in a sell-off that has global repercussions. This is not because all, or even most, of these investors are directly involved in mortgage financing. Rather, it is because of their investments in assets — derivatives or collateralized debt obligations — linked to sub-prime mortgages.

There are many lessons that countries like India should derive from the international experience since 1997, of which two are of immediate significance. First, they should be cautious about resorting to financial liberalisation that is reshaping their domestic financial structures in the image of that in the US. That structure is prone to crisis, as the dotcom bust and the current crisis illustrates. Second, they should beware of international financial institutions and their domestic imitators, who are importing unsavoury financial practices into the domestic financial sector. The problem, however, is that they have already gone too far with processes of financial restructuring and are increasingly vulnerable.

(Excerpted from the 22nd AKG Memorial Lecture delivered by the author on July 31, 2007 in New Delhi. The lecture was organised by Jansanskriti)