In commentary on the current crisis, villainous roles have been assigned to collateralised debt obligations (CDOs). There is nothing wrong with the basic principle or mechanism of CDOs or asset-backed securitisation and the sale of repackaged debt stocks. They are useful for transforming maturities/durations and liquefying assets. Used properly, the risks of firm-level, and systemic, illiquidity can be substantially reduced by CDOs and ABSOs. The same is true of much-maligned derivatives both simple/traded and complex/tailored. Yet both are now condemned (especially in India) as inherently flawed; in particular, derivatives. This mindless vilification is reaching insane proportions in India with the losses recently suffered on currency hedges. Indian corporates who made the wrong bets on currency hedges have incurred collective losses alleged to be Rs 200 billion (or $5 billion). They are now crying foul and blaming their bankers for tailoring these hedges to their specified needs. They are pleading ignorance and lack of understanding of what was involved and what the risks were. So everyone is blaming derivatives when they should be focusing on unsound judgements across the board.
The RBI is joining in the chorus. Is it blameless for not having permitted a market to develop in exchange traded currency derivatives in the first place? Had such a market developed, corporates could have traded on it and not gone to their banks. Talk of these instruments being inherently deadly and dangerous is plain wrong. Yet, the retroactive ‘modern finance-is-wrong-RBI-is right’ strain of virus is infecting many. It is being propagated by the Indian media and a Left uncomfortable with capitalism. Such criticism is often motivated by: wrong interpretation of the evidence; ignorance; and a failure (or unwillingness to make the effort) to understand what is involved. Since no one (especially a central banker) wants to admit to being ignorant, or slow on the uptake, it’s easier to cast aspersions and make the case that these instruments are too dangerous for public use. Yet, derivatives and synthetics are indispensable in a modern financial system. They are its traffic signals, its price discovery mechanisms, as well as its trading nuts and bolts; grist for the financial mill that would otherwise be confined to only four plain vanilla functions (buy, sell, borrow, lend). If that was all finance could offer we would be back in pre-historic times.
Of course, in the domestic context, another question has been highlighted implicitly and explicitly: In view of what’s happening abroad, hasn’t the RBI been wise in deliberately retarding: financial liberalisation; innovation and competition to protect antediluvian state-owned banks (SOBs); development of the derivatives, corporate bond and currency markets; and employing draconian regulatory practices over congenitally non-compliant banks and financial operators? In other words, hasn’t India been fortunate in having financial authorities who believe that modern finance is un-Indian, thus emphasising primitivism over modernity, simply to continue exercising command-control?
These questions obscure the reality that, irrespective of what has happened globally, India has had its own homegrown financial scams, scandals and failures. They have involved massive losses in value. And they have recurred with alarming regularity, despite our supposedly terrific regulation! But, in India, the peculiar view has taken hold that regulators are always right, even when they are wrong. They are naturally cautious, conservative and protect the public interest. Conversely operators are always wrong. They take risks with other people’s money and create crises that then require public bailouts.
No one pays enough attention to the contradictory macroeconomic, monetary and exchange rate signals emitted by the authorities in ways that heighten uncertainty and risk. When people like Ajay Shah and Ila Patnaik do that, they are branded as heretics or as people who have temporarily lost control of their senses. No one believes that strangulating financial systems artificially in the name of conservatism, caution and (false) security, also involves costs. Unfortunately, these are opportunity costs that remain invisible. If the financial sector were further deregulated, if currency markets were freed, India’s financial sector would generate additional value added and export revenues amounting to 1-2% of GDP. The efficiency gains of further financial market development would result in another 1-2% of GDP growth.
Non-pre-emption by the fiscus of scarce resources (unproductively deployed by government), and the privatisation of SOBs/SOEs, would reduce India’s public debt and its annual debt service obligations. That would yield further growth gains of another 2-3% of GDP. So we are implicitly surrendering potential gains of 4-7% of GDP annually just to maintain command-control in the name of financial safety (which has often proven illusory). If we chose the alternative path of financial liberalisation and sophistication, we could afford a financial crisis every decade that costs us 3% of GDP, and still come out well ahead.
What is obscured in the Indian debate is an awkward but very real asymmetry. No one complains when they are making easy money in stock or property markets (because they are brilliant). But they ululate, and demand redress when they lose it (because it is someone else’s fault). It goes unnoticed that a financial system is in distress when asset prices are rising too rapidly. It is emitting sound signals when such prices correct to realistic levels. But aam aadmi never sees it that way. In fact, the opposite: that is, financial markets are healthy when portfolios are increasing in value at 10% a month, but not when that moderates or reverses.
It is pointless to keep making the wrong arguments for the wrong reasons. Let’s not give credit where it is not due and let’s not thank our authorities for keeping our financial system unsophisticated and primitive. That does not suit the image of India in the 21st century—an image of being at the cutting edge, and not at the thicker end, of human intelligence and progress.
—Percy S Mistry, economist and corporate finance expert, chaired the high-powered committee on making Mumbai an international financial centre