People's Democracy

(Weekly Organ of the Communist Party of India (Marxist)


No. 42

October 26, 2008


Financial Crisis In The US:  Lessons For Indian Policymakers
Prasenjit Bose

THE crisis which has engulfed the financial sector of the US has far-reaching implications, both for the international economic order underlying globalisation – especially the global financial architecture – as well as the policy regimes in developing countries. Till not so long ago, the deregulated and liberalised financial system of the US was being held out as a model by the advocates of globalisation. Developing countries like India were told to emulate the US financial system and integrate with the international financial markets in order to benefit from the globalisation of finance. Over the last decade, policy makers in India were all too eager to listen to such advice. Since the formation of the UPA government, hardcore neo-liberals like the prime minister and the finance minister, far from reversing the course adopted by the erstwhile BJP-led government, sought to accelerate the pace of financial liberalisation. The Left parties, which resisted such a course, were constantly attacked and vilified by the policy establishment for stalling “reforms” and thus impeding “economic growth”. The financial meltdown in the US and other advanced economies has come as a fitting rebuff to such neo-liberal hubris. The chickens of financial liberalisation and globalisation are now coming home to roost. For Indian policymakers, it is important at this juncture to understand the root cause behind the US financial crisis, disabuse themselves of neo-liberal dogma and draw proper policy lessons.

Causes and Consequences

Credit driven consumption growth kept the US economy going since the mid-1990s. The level of indebtedness of American households reached unprecedented levels during this period — mainly due to housing loans (mortgages) and consumer loans (credit cards). Much of the increase in household indebtedness was because of the stock and property market booms, which increased the financial wealth of many households, made them feel richer and drove them into greater borrowing and spending. The first jolt to this debt-induced consumption spending in the US came with the stock market crash and the collapse of the IT boom in the US in 2000. This led to a recession in the US in 2001, which also caused a global slowdown. However, the real estate boom resumed, which led to economic recovery both in the US as well as in the global economy from 2002. This boom was partly engineered by repeated cuts in interest rates. Liberalised rules for banks coupled with easy liquidity conditions enabled mortgage lending banks to adopt reckless lending strategies, fuelling housing demand. In order to push up their credit business, these mortgage lenders indulged in sub-prime lending – giving housing loans even to those borrowers whose ability to repay the loans were doubtful. Such borrowers were enticed into housing loans by misleading offers of concessional interest rates and easier terms of repayment, which were devised by the lenders in order to boost demand for housing and construction related activities and increase property prices. These loans were then packaged into securities and were sold off to other financial institutions like the Wall Street based investment banks and hedge funds, in complex transactions that were made possible by financial deregulation.

The assumption underlying financial deregulation was that “financial innovations” would enable the mortgage lenders as well as the banks to insulate themselves against loan defaults by spreading the risks associated with these loans. This, however, was a flawed assumption since spreading of risks through complex derivatives cannot make the risk disappear completely. Thus, when defaults on such housing mortgage loans started rising, all the financial institutions involved in sub-prime lending were affected. Eventually a full-blown crisis surfaced in the US in 2006 when the housing bubble went bust. With increasing defaults and repossession of houses by the mortgage lenders, suddenly there were only sellers and no buyers left in the housing market. Sharp falls in property prices also led to the collapse of hundreds of mortgage lenders engaged in sub-prime lending, with even the largest mortgage lender in the US, Countrywide Financial, heading towards bankruptcy. Wall Street based banks, which had made huge investments in sub-prime mortgage based securities in order to reap speculative gains on the basis of the property bubble, also suffered huge losses.

The recent bankruptcy of Lehman Brothers, the fourth largest investment bank in the US, marks a considerable deepening of the financial crisis in the US, precipitated by the collapse of the real estate bubble. Merrill Lynch was taken over by the Bank of America through government facilitation, similar to the manner in which Bear Stearns got taken over by JP Morgan Chase some time ago. Lehman Brothers declared itself bankrupt. Goldman Sachs and Morgan Stanley have decided to transform themselves into ordinary deposit-receiving banks. Thus, investment banking in the US, representing the most powerful force in the Wall Street which led the financial globalisation offensive from the front, has been virtually decimated by the financial crisis. Two other mortgage lending institutions, Fannie Mae and Freddie Mac have been nationalised to prevent their collapse. AIG, the world’s largest insurance company, has managed to survive for the present through the injection of funds worth $85 billion from the US government. Similar problems are being faced by financial institutions in other OECD countries, which also witnessed similar real estate bubbles over the past decade and are now witnessing a downturn in their property markets leading to huge financial losses for banks engaged in such lending. UK based mortgage lending bank Northern Rock was also nationalised some time ago.
Two facts emerge clearly out of these significant events occurring in the US and other advanced capitalist economies. Firstly, the deregulated financial system of the US, which was held up as a model for the rest of the world to emulate, has clearly failed. It has failed because far from bringing efficiency in the financial markets, deregulation has only promoted reckless speculation and greed. “Financial innovations” have meant the proliferation of complex derivative instruments, which do not reduce but only conceal the real risk involved in underlying assets, and therefore lead to a systemic underestimation of risk. Secondly, as the debate in the US Congress over the $700 billion bailout package proposed by the Bush administration showed, financial liberalisation involves a huge moral hazard problem. While the investment banks and other financial entities, especially their executives, have made enormous profits out of their speculative operations over the past few years, once they suffer losses the government feels obliged to bail out these companies using taxpayer’s money. The need to stabilise the financial system is cited as the rationale for the bailout. However, there is hardly any attempt to fix responsibility for the speculative excesses let alone penalise those who have profited from those excesses. Such bailouts embolden such elements to indulge in reckless speculative activities knowing fully well that the government will be ever willing to underwrite their losses.

Implications for India

Over the past one decade, global economic growth has mainly been driven by the US economy. This found reflection in the widening external deficit of the US. The current account deficit of the US, which was around $140 billion in 1997 or 1.7 per cent of the US GDP, witnessed a continuous and dramatic increase to over $800 billion or 6 per cent of the US GDP in 2006. This unprecedented level of current account deficit enabled several countries across the world to grow through exports of goods and services to the US market. While globalisation meant shrinking public expenditure and a shift away from domestic market oriented growth in most countries, the US provided the major market for export-oriented growth regimes. Growing current account deficits also meant that the US economy became increasingly indebted, but the growing indebtedness of the US economy was sustained by huge capital inflows into the US from the rest of the world. This ability of the US to attract capital inflows despite growing external indebtedness is based upon dollar hegemony. Since the dollar is conceived as the most stable currency, the bulk of the wealth and assets in the world are held in dollars and most international transactions are undertaken in dollars. This has ensured a high and stable international demand for the dollar and enabled the US to borrow cheaply from the rest of the world. Developing countries together hold over $3 trillion of foreign exchange reserves, typically held in “secure assets” in developed countries, including US Treasury Bills.

With crisis engulfing the US financial sector and the consequent downturn in the US economy, serious questions have arisen regarding the very sustainability of the current international economic order. The worldwide credit crunch following the financial crisis, coupled with a recession in the US and other advanced economies will have serious adverse impact on global growth, especially in developing countries like India. The spate of financial crises witnessed in the developing countries since the late 1990s starting from South East Asia have already shown that such crises tend to be even more lethal for the real economy in terms of shrinking output and employment and deterioration of the living standards of the working people.

Following the financial meltdown in the US, stock markets across the world, from the Wall Street to the Asian markets, are already witnessing gyrations. In India, the rupee has slided considerably vis-à-vis the dollar due to capital outflows caused by the portfolio adjustments by the FIIs. The FIIs have been net sellers in the Indian stock markets over the past few months, taking out $4.2 billion from India during the first quarter (April to June) of 2008. The current account deficit reaching a record $10.7 billion during the first quarter of 2008, despite a weakening rupee, does not reflect a healthy trend. Indian policymakers need to rethink their economic strategy in this backdrop. The stimulus for domestic economic growth is surely not going to come from global markets in the near future. There is an urgent need therefore to shift the focus away from trade liberalisation and external markets and work towards generating domestic market based stimuli for economic growth. More importantly, the Indian financial system needs to be insulated from the turbulence being witnessed in the financial markets of the US and elsewhere. Not only should the ongoing moves towards greater financial liberalisation and deregulation be stalled, regulations need to be tightened in several areas where recklessness is already visible.

Reversing Financial LiberaliSation in India

Abandon Liberalisation of Pension, Banking and Insurance: Serious rethinking is required on a host of financial liberalisation measures in India, which are already underway or are in the pipeline. The Pension Fund Regulatory Development Authority Bill (PFRDA Bill) is one such proposed measure, which seeks to establish the New Pension Scheme (NPS). The NPS has already replaced the earlier pension scheme of government employees by a contributory scheme. The attempt is to now allow the pension funds to be invested in the stock market. The new scheme does not guarantee a minimum pension for government employees and makes the pension amount contingent upon conditions in the stock market. Privatisation of pension funds is now being reconsidered and revised in some of the developing countries, which were pioneers in its implementation, like Chile and Argentina. The pension funds of employees must not be left to the mercy of speculative forces, which have played havoc in stock markets across the world. The PFRDA Bill, which enables investment of employees’ pension funds into the stock market should be discarded and the pension scheme for government employees reworked to ensure minimum guaranteed pension.

The Banking Regulation (Amendment) Bill, which seeks to remove the cap of 10 per cent applicable on exercise of voting rights by shareholders in banks, is meant to facilitate the takeover of Indian banks by foreign banks. Not only should this move be abandoned, fresh restrictions on foreign ownership of banks in India in order to prevent majority foreign control in any Indian bank need to be brought in. There is an ongoing move to increase the FDI cap in the insurance sector from the present 26 per cent to 49 per cent by amending existing legislation and also allowing foreign reinsurance companies without any capital base in India to open branch offices. Hectic lobbying by foreign insurance companies has continued over the past few years to bring about this policy change. In the backdrop of the involvement of insurance companies like the AIG in the sub-prime lending crisis, this move needs to be abandoned. There is also a need to tighten regulation of insurance products linked to the stock market, i.e. the Unit Linked Insurance Products (ULIP).
Reverse Reckless Lending Practices: The scorching pace of expansion of retail credit over the past few years is a matter of concern. Non-food gross bank credit had been growing at 38 per cent, 40 per cent and 28 per cent respectively during the three financial years ending March 2007. This points to a substantially increased exposure of the scheduled commercial banks to the retail credit market comprising of housing loans, credit cards, auto loans and loans against consumer durables. Overall personal loans amount to more than one-quarter of non-food gross bank credit outstanding. This increase in retail exposure of commercial banks is a direct outcome of increased competition among banks, which has forced them to diversify in favour of more profitable lending options. The resulting search for volumes and returns has encouraged diversification in favour of higher risk retail credit. Besides the risks involved in such fast-paced expansion of retail credit, which arise out of the same factors which precipitated the US sub-prime crisis, the lopsidedness of the credit system in catering to the urban upper classes at the cost of priority sectors like agriculture and small industries distorts the development process in the country. The Indian financial sector has also begun securitising personal loans of all kinds so as to transfer the risk associated with them to those who could be persuaded to buy into them. Although a proliferation of credit derivatives has not happened yet, the transfer of risk through securitisation is well underway. As the US experience has shown, this tends to slacken diligence when offering credit, since risk does not stay with those originating retail loans. The Securities Contracts Regulation (Amendment) Bill, which was pushed through parliament by the UPA government ignoring Left dissent, seeks to provide a legal framework for trading in securitised debt, including mortgage-backed debt. This is an attempt to imitate the “financial innovations” in the US and other advanced economies, which have been encouraged by financial liberalisation. Trading in securitised debt has to be strictly regulated so as to prevent a sub-prime crisis like predicament. Most importantly, the regulation of securitised debt should also cover private placements and Over The Counter (OTC) transactions besides the exchange traded ones.

Avert Real Estate Bubble: At the end of the financial year 2007, the exposure of scheduled commercial banks to the so-called “sensitive” sectors, like real estate and the capital and commodity markets, was around a fifth (20.4 per cent) of aggregate bank loans and advances, out of which 18.7 per cent comprised of real estate loans and 1.5 per cent comprised of loans to the capital market. In the case of the new private sector banks and foreign banks, however, real estate loans comprised of a much higher proportion of their total loans; 32.3 per cent and 26.3 per cent respectively. In the light of the US experience, such high exposure of private and foreign banks and financial institutions to lending for commercial real estate is a matter of concern. The RBI has made some attempts to check the disproportionate flow of credit to this sector. However, those steps have not succeeded in curbing speculative capital inflow into the realty sector. In fact, efforts are on to ease the curbs on lending to SEZ projects, which the RBI had rightly classified as real estate lending, inviting a higher risk weightage. This dilution of regulation, which can fuel a real estate bubble, needs to be resisted.

Discard Capital Account Liberalisation: Despite the experience of the South East Asian Crisis, where liberalised capital accounts were primarily responsible for the currency meltdowns, the Indian government has continued with moves to make the rupee fully convertible, step by step. Following the recommendations of the Tarapore Committee, several steps have already been taken by the Reserve Bank of India to dilute capital controls and liberalise inflows and outflows of speculative finance capital into the Indian economy. These include among others, raising the remittance limit for resident Indians to $200,000 per financial year, easing of norms for external commercial borrowings by banks and other entities, raising the limit on FII investments in government securities to $5 billion and corporate debt to $3 billion and enhancing the extant ceiling of overseas investment by mutual funds upto $5 billion. These measures, which have considerably liberalised our capital account, need to be reversed.

The use of Participatory Notes (PNs) by FIIs to invest in Indian capital markets is another serious area of concern. The RBI has repeatedly advocated the phasing out of these non-transparent derivative instruments, which conceal the source of funds from the Indian regulators. The UPA government, however, has shown reluctance to ban PNs even after the National Security Advisor alleged that terrorist funds are being invested in India through these instruments. The phasing out of PNs cannot wait any longer. The wide fluctuations experienced in the Indian stock markets over the past few years have mainly been on account of the FIIs. While the desirability of such FII inflows, which merely comprise of “hot money” and are totally incapable of meeting the long-term development financing needs of India, is itself highly questionable. Allowing speculative hedge funds and other dubious entities to invest in Indian markets without any adherence to disclosure norms is the antithesis of prudential regulation.


The reason why India has remained immune to financial crises of the magnitude that is now being witnessed in the US or was earlier seen in South East Asia is because the Indian financial sector has remained less liberalised compared to most capitalist economies. Yet the Indian policy establishment has been hell bent upon going down the same road, despite stiff resistance from the Left parties, the trade unions, employees and officers of the public sector financial institutions and other sections. During the tenure of the UPA government, while some legislative measures were successfully resisted by the Left parties, others have been implemented through executive fiat. The global financial turmoil being witnessed today provides an opportunity for introspection for the champions of liberalised finance to revise their policy positions. Failure to do so will only mean meeting the same fate as that of neo-liberal policy makers elsewhere in the world.