D. Murali

Chennai: Crafting newer solutions almost on a daily basis, the global leaders and market regulators are grappling with a meltdown that refuses to be contained, much like a rogue elephant on the rampage despite tranquiliser shots. So, where are we now in the current financial crisis?

Pose this question to Mr Satyajit Das, the author of ‘Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives’ (2006, FT-Prentice Hall), and he observes, “The financial crisis has some way to go. I can do no better than refer you to Winston Churchill’s famous statement: ‘this is not the end. It is not even the beginning of the end…it is perhaps the end of the beginning…’”

And, stirring up your curiosity further, Mr Das says that the current problems are the ‘cure’ not the ‘disease.’ The ‘disease’ is the excessive debt and leverage in the financial system. The ‘cure’ is the reduction of the level of debt (the great ‘de-leveraging’), he explains, in the course of a recent email interaction with Business Line.

“The initial phase of the cure is the reduction in debt within the financial system. The overall losses to the financial institutions (net of re-capitalisation via new equity issues) are $400 to $600 billion and may well go higher. This requires reduction in financial sector balance sheets (assuming bank system leverage of around 10 times) of around $4 to $6 trillion through reduction in lending and asset sales.”

If that is a mind-boggling number, there is also the second phase of the cure, which according to Mr Das, is the higher cost and lower availability of debt to the real economy. “This forces corporations to reduce leverage by selling assets, reducing investment and where possible raising equity. This also forces consumers to reduce debt by selling assets and reducing consumption.”

Feedback loops mean reduction in investment and consumption lowers economic activity placing stresses on corporations and individuals setting off defaults that trigger losses for the financial system that further reduces lending capacity, he elaborates.

“De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt. The process of destruction echoes W.B.Yeats’ words: ‘All changed, changed utterly: A terrible beauty is born.’”

From those literary heights, Mr Das returns to the discussion on hand, and notes that within the financial sector, de-leveraging is well advanced. “In the real economy it is in the early stages.”

Excerpts from the interview.

What needs to be done to address the problems?

In May 2008, I wrote a piece for the Financial Times that argued that actions to stem the crisis must be directed at three areas. Banks must be forced to write-off bad loans without delay. Bank capital needs must be addressed by forced mergers and restructuring, new equity issues and (in the absence of other options) nationalisation or liquidation. Central bank guarantees of all major borrowings and other transactions to reduce solvency risk must be put in place to enable normal transactions between parties in the financial markets to resume.

I received “hate mail” accusing me of being “a communist” (I think it was intended as an insult!). In October 2008, the necessary coordinated global action appeared at last to be under way. I guess we are all communists now!

The steps are positive but there are problems with the actions taken. The appearance of global coordination is misleading – there are substantial differences in the details of programmes and also the philosophy underlying the actions.

A more fundamental flaw relates to the fact that the three identified steps must be undertaken in an internally consistent manner. The most obvious failure is that it is not clear whether all necessary write-downs of assets have been completed. This means that the exact amount of the re-capitalisation needs cannot be established.

The US approach – fixed capital injections with no relationship to transparent solvency requirements – creates new moral hazards. Banks use the capital to further competitive ambitions, lower cost of capital or other unintended applications.

The guarantee of bank debt may crowd out other borrowers creating a further negative feedback loop that accelerates the de-leveraging process.

Are the actions of governments and central banks working?

It remains to be seen whether the most recent global initiatives achieve the required re-capitalisation of banks, improve the normal supply of credit to sound borrowers and also reduce fear of default allowing normal activity between institutions to resume.

Money markets remain dysfunctional and inter-bank lending rates are still at high levels relative to government rates. The failures are unsurprising.

Money being supplied to the banks is not being lent through. Banks are parking the money in short dated government securities in anticipation of their own funding requirements. Around $3-5 trillion of assets are returning to bank balance sheets from the “shadow” banking system – off-balance sheet structures – that can no longer finance themselves.

In addition, banks have large amount of maturing debt (estimates suggest $1.5 trillion by the end of 2008) that they must fund. Fear of bank failure (especially after the bankruptcy of Lehman and restructuring of WaMu) and shortages of capital also limit ability of banks to on-lend.

The central banks have pumped in trillions of dollars. Why isn’t this working?

At the height of the boom, banks used a variety of techniques to increase the velocity of money. As the system de-leverages, the velocity of money has sharply decreased.

Gillian Tett of the Financial Times coined the phrase “candy floss money”. New financial technology spun available “real” money into an exaggerated bubble that, like its fairground equivalent, collapses ultimately.

Markets placed great faith in the volume of money available to support asset prices and assist in alleviating shortages of liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage as well as the structure of global capital flows. As the financial system de-leverages, it is becoming clear, unsurprisingly, that available capital is more limited than previously estimated.

What is the impact of the crisis on India?

The outlook for India is poor. In 2007, India and the emerging markets had apparently de-coupled from developed markets! They have, in one sense, the Indian stock for example, has fallen about 60 per cent (in dollar terms) versus the US market which has fallen around 45 per cent. Unfortunately, investment ideas can often be narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts.

The slowdown in the US and European consumption will slow down exports. Financing India’s significant budget deficits (both Federal and State) and a significant current account deficit in a period of contracting credit and higher borrowing costs will be difficult. Indian companies have expanded overseas using debt which will prove challenging to refinance. Also remittances from Indian working overseas will also slow.

Slower growth may also necessitate diversion of government funds away from infrastructure spending to subsidies. Private sector infrastructure projects may be difficult to get off the ground, as finance proves more difficult. Speculative bubbles in property in parts of India will deflate causing problems.

All this does not augur well in the short term. Medium to long term growth prospects depends on what the world overall looks like and what kind of internal generated growth India can sustain.

Will the government actions help ultimately alleviate the crisis?

Fairy tales in financial markets focus on the “superhuman” abilities of regulators and governments to avoid the de-leveraging under way.

The initiatives are sensible short-term measures to stabilise markets. In the longer run, they transfer the problem onto the government and taxpayer balance sheet. For example, the US Government support for financial institutions in this financial crisis is already approaching 6 per cent of GDP (compared to less than 4 per cent for the Savings and Loans crisis). The bailout of Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) has almost doubled the US national debt. This will ultimately place increasing pressure on the US sovereign debt rating and vitally the ability of US to finance its requirements from foreign creditors.

Ultimately, “All the king’s horses and the king’s men” cannot prevent the de-leveraging of the financial system under way. The extent of de-leveraging is substantial and likely to take time. In recent years, money was cheap and other assets were expensive. As each of the global economy’s credit creation engines breaks down and systemic leverage reduces, money becomes scarce and more expensive triggering substantial adjustments in asset prices in a reversal of the process.

David Roche of Independent Strategy, a consulting firm, estimates that $4 to $5 of debt is now required to generate $1 of economic growth. As credit creation slows and debt levels fall, the sustainable level of global economic growth may fall as well.

At best, the government and central bank actions can smooth the transition and reduce the disruption to economic activity in the transition to a lower debt world. The risk is that well-intentioned steps prevent the required adjustments from taking place, delay recognition of problems and discourage action that must be taken by financial institutions, corporations and consumers.

Like a giant forest fire the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.

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