The Financial Crisis of 2008 and beyond
The global financial crisis, which really had been in the offing for a while, came through as cracks in the latter half of 2007, only to rear its big ugly head during 2008 with the fall of big investment banks. Playing out through 2008 and for a considerable part of 2009, the crisis brought the global financial sytem down to its knees, with several venerable banks getting swallowed by the crisis. The governments of nations across the world responded to the crisis with fire fighting intended to address the onset of the crisis. While they have been partially successful, several fundamental questions remain.
In this interview with PC Narayan we try to identify the reasons why the financial system has devolved over time, collapsing ultimately in the financial crisis of 2008. During the course of the interview we also seek answers to the several questions raised by the crisis, dissect the India specific consequences and explore specific lessons and positives to take out of the financial crisis.
Genesis and the Immediate Fall Out of the Financial Crisis
In terms of the anatomy of the crisis, how do you think this one is different from the others before it?
PCN: The genesis of the crisis was the over-heated Mortgage Backed Securities market in the United States and the complex structures surrounding it such as Credit Default Swaps (CDS), Collateralized Debt Obligations (CDO), etc. Several unregulated entities such as hedge funds and even the regulated banks from several countries took active positions in this market lured by the possibility of higher returns, amply aided by a favorable (falling) interest regime in the United States. As a consequence, the market had scaled up much faster and grown much bigger than perhaps anyone had intended or anticipated. Once the inevitable downturn in the economic cycle took hold, asset prices fell sharply in too short a time, taking several institutions to bankruptcy and bailout. Hence this crisis was very different from the earlier ones in terms of both scale and speed.
Was the crisis a regulatory failure? Would improving the regulations provide greater financial stability?
PCN:This is perhaps the most debated subject today both among academicians and practitioners alike. The jury is still out on that and hopefully some consensus would emerge in the months ahead. Regulation in the Indian context has always been very strong, and the regulatory oversight has also been partly helped by the fact that the financial markets in India are not as developed and as complex as the financial markets in the West, where the turmoil really began. However, the philosophy of 'regulation' as perceived in several markets such as the United States seems in dire need of immediate review. The crisis of 2008 has clearly demonstrated that the days of 'market-will-regulate-themselves' will be challenged now more than ever before.
When and where do you think the next bubble is likely to take place?
PCN: More than the next bubble, a more serious problem that is likely to haunt us is the global production- consumption imbalance, with vast amount of the production happening in the eastern hemisphere and the consumption happening in the West, led by the United States. China has endowed upon itself the added advantage of administered exchange rates for its currency. This has inevitably prompted the US leadership to call for greater action and a clarion call to countries such as China to stimulate domestic consumption, rather than administer their exchange rates. With the US deficit showing little sign of abating, the US dollar will come under consistent pressure and runs the risk of not being the reserve currency of choice for nations around the world. There are clear signals emanating from several sovereign entities wanting to move away from the US dollar to alternatives such as gold for their reserve. This transition is likely to have very painful outcomes for several nations, particularly the United States. It seems inevitable although not imminent.
There is talk of a pyramid effect taking place even within the banks. Goldman Sachs and Morgan Stanley seem to have done well, during the last quarter. However, Wells Fargo, Citigroup, Bank of America and several others have shown profits through exceptional items. The trace is only starker as we go down the chain- more and more of the banks are piling up huge bad assets. Why is this taking place?
PCN: May I respond to that tongue-in-cheek! The smart guys who caused the problem in the first place got in to it and got out of it early. The late entrants who either did not understand the risks fully or were 'earnings-avaricious' were left with the 'wet-baby'. This is the phenomenon of free markets!
The Aftermath: Cross Border Implications
tejas@iimb: Is the US government right in declaring that the financial crisis is over? Are we seeing changes starting to occur as far as the industries on the ground are concerned?
PCN: It would be fair to say that the worst is certainly over as far as managing the financial crisis goes. However, the macro-economic issues will take a lot longer to sort out and will require policy intervention by the concerned governments. Slow growth in the real sector of the economy particularly in the developed countries is more deep rooted and goes far beyond the financial crisis of 2008. Unless these real issues such as cost efficiencies in production are resolved, the unfavorable economic climate could linger on for much longer.
tejas@iimb: Is the US dollar likely to remain weak? Would you allay the fears that have set in, in the light of the recent concerns of the Chinese government that holds a lot of US debt?
PCN:Given the downturn in the US economy over the last few years and the bail out of the banking system that the US government has initiated, the US dollar is bound to weaken. Furthermore, over the last few years, consumption in the United States has not declined, but its production capability has migrated to more cost effective destinations in the eastern hemisphere. This creates a macro-economic imbalance, particularly impacting employment. As an overall consequence, the US government deficit has been on the increase and much of their sovereign debt is held by countries such as China, Japan and several others like India. Paradoxically however, these somewhat adverse fundamentals will not impact the US dollar significantly, since the US dollar continues to be the currency of choice for international trade for want of another alternative! Hence we have an interesting situation where the US economy is weak, but the US currency is not just as weak.
tejas@iimb:How different have the responses of the US and the British governments been after the crisis?
PCN:The two governments have responded to the crisis in markedly different ways, The British Government stepped in and recapitalized their banks, which means one cannot preclude direct government participation as shareholders in the management of banks in the future. The US government on the other hand, has bought some of the impaired assets from the Banks and in return providing them with liquidity needed to overcome the crisis. The British government's response is more time tested and somewhat 'traditional' and 'socialist' in character while the US response is clearly driven more by the free market philosophy. Only time will tell which is the better option.
tejas@iimb:Do you think India and China have emerged stronger, at least in terms of perception, compared to the other major economies?
PCN:An impressive near seven percent GDP growth even in troubled times by both India and China would definitely not go unnoticed. However the route taken by the two countries is markedly different. The Indian government has focused on some key factors such as sustaining the production consumption cycle (largely driven by domestic demand), a well conceived fiscal stimulus programme, managing the interest rates and exchange rates as well as bank capital and reserves. China, on the other hand, demonstrated enormous resilience in getting over the crisis despite an economic engine that was built largely on mass production and export to the very economies in the west that were the worst affected by the financial crisis.
India and the Crisis
tejas@iimb: How would you sum up the response of the Indian government to the financial crisis?
PCN:There was no 'direct' impact on India from the financial crisis, as our financial system had near-zero exposure in the financial assets that were in the eye of the storm such as mortgage backed securities issue by US entities. We were affected indirectly by the unexpected large outflow of FII investments from India which resulted in a rapid weakening of the Indian Rupee and a 'tumble-down' of our equity stock market index. Exports, particularly, software exports, was another area where we had expected a knock-on impact because of the dependence on the US and other Western countries for our software exports. Fortunately, and thanks to the resilience and depth of the Indian economy, we escaped any serious 'assault'. The proactive management of liquidity by the Reserve Bank of India, the financial stimulus provided by the government and, equally important, our real sector being largely driven by domestic demand (unlike China which is driven by export demand) ensured that the financial crisis hurt India a lot less than it hurt other countries in the world. We are of course continuing to feel the pressure in terms of higher than acceptable fiscal deficit, upward pressure on interest rate, inflation etc. But these are transients that will be overcome with time.
tejas@iimb: Is the current rally of the stock market sustainable? Where do you think it might cap off?
PCN:Well, there is a lot of speculation around this. Over the last twelve months or so, we have seen the Indian equity stock market indices more than double. However, primarily on account of expected improvement in economic fundamentals and corporate earnings, the indices seem to have priced in the forthcoming positive news flows, as indicated by the 12 month forward PE. Corporates will be watched closely to deliver on this expectation, which will determine the future upward movement of the stock market indices. What could disturb this equilibrium, as we have seen several times in the past, is the volatility of inflows from Foreign Institutional Investors.
How do banks deal with crises like the one we witnessed in 2008?
PCN:Because of the sudden onset of a liquidity problem following the financial crisis, Indian banks were compelled to take on liabilities (deposits) at a higher cost and this would certainly impact their margins in the near term. However, interest rates have continued to experience upward pressure until now and the impact has been neutralized to a large extent. In the final analysis, we have weathered a serious crisis and the consequent cost to the banks is well worth the cause. It only highlights the resilience of our banking system!
With the inflation moving into the positive territory, how are banks now likely to react?
PCN:With the expected increase in inflation, nominal interest rates will be under pressure to move up. Paradoxically, however, liquidity continues to be high in the system due to lower than expected credit off take and hence interest rates have not hardened. The impact will be felt once the economy goes into high-growth mode, expected in fiscal 2010-2011, and then we could see a rise in interest rates, unless of course, inflation eases by then! In the final analysis, interest rate will be under pressure in the near term but not likely to go up significantly.
Lessons for the Future
tejas@iimb: We hear that the Reserve Bank of India took several timely measures, which in retrospect, proved right. Please elaborate.
PCN:Well before the crisis unfolded, the Reserve Bank of India had taken several steps such as raising the Repo rate, increasing the CRR etc. and tightened monetary policy, which seemed contrarian at that time. However, when the actual crisis broke out, those earlier measures turned out to be a blessing. The Reserve Bank of India could quickly move in to infuse liquidity in the system by reducing the CRR in three to four quick steps. Thereafter, those responsible for the monetary policy and fiscal policy worked in unison to overcome the immediate problems, restore the confidence in the economy and then work towards return to normalcy.
tejas@iimb: With the benefit of hindsight, apart from the fact that the crisis threw up several issues in the financial sector, are there any positives takeaways?
PCN:Most certainly. The need for regulation is far better understood even by the naysayers of regulation and the protagonists of 'self regulation'. We hope that several improvements to the regulatory framework will emerge as a result of the debacle of 2008 across nations. Secondly, the formation of G20, which is presumably a direct outcome of the 2008 debacle, is a clear sign of the changing economic axis of the world. And finally, the role of the governments as lenders-of-last-resort and the consequent impact on the economic health of nations is better understood by all the stakeholders. Hopefully, the global powers would do all possible in a pre-emptive manner to avoid similar outcomes in the future.
tejas@iimb: How significant are the measures taken by the G20 and the G8 summits? Do these help, given the recession could be affecting different countries in different ways?
PCN:Given the gravity of the financial crisis that unfolded, coming together of countries under the banner of G8 and G20 was inevitable. Quite rightly, several concerns were expressed, issues were discussed and possible courses of action were evolved in these meetings. The challenge however is to translate these ideas into action. Given the diverse political realities and the vastly different macro-economic circumstances among the member nations, a one-size-fit-all solution is certainly not feasible and global leaders have to move from rhetoric to consensus and concerted action. That is sure to take a long time.
While the financial crisis, which we witnessed through the latter half of 2008 and most of last year, was triggered by the reversal in housing assets valuations,it also showed that there existed real cracks in the much vaunted global financial markets. The onset and the ensuing onslaught of the crisis brought greater credibility to those who have espoused the cause of better regulation of financial markets. The crisis, while it might have been debilitating to several of the famous investment banking, has presented an opportunity for those who wish to change the financial system for the better. Finally, India and China found their own answers to the crisis, and have emerged stronger, albeit in very different ways.
P.C. Narayan teaches banking and finance at the Indian Institute of Management, Bangalore. An alumnus of XLRI, Jamshedpur and Regional Engineering College, Tiruchirappalli, he also completed an Advanced Management Program from IFAP, Rome, Italy. He started his career at Telco (now Tata Motors) and then moved to Standard Chartered Bank where he served the bank's Middle East and South Asia operations for some years. Thereafter, he moved to a banking consulting firm based in the UK followed by a top management position in one of India's private sector banks. He opted to work full time in academia in 2003, which brought him to IIM Bangalore. Apart from teaching, P.C. Narayan spends considerable time speaking in banking fora, where he is widely recognized and well known. His primary research interests include Risk Management, International Banking, Micro-finance, Monetary Policy and technology related to banking.