Raghuram Rajan, currently professor of finance at the University of Chicago’s Graduate School of Business, has successfully combined an academic life with stints in policy and research. The Indian government has named the erstwhile chief economist of the International Monetary Fund to a committee on financial sector reforms, which is expected to submit its suggestions in a couple of months. Rajan, whose PhD thesis was on banking, was here this week and shared his views on a variety of issues, including the fallout of the subprime crisis and the challenges facing emerging economies such as India. Edited excerpts:
In 2005, you first drew attention to the possibility that the financial sector in developed countries could be a source of global instability. It did not go down well. What are the factors that led to this conclusion?
This was (Alan) Greenspan’s (former chairman of US Federal Reserve) last year and I was asked to think about all that had happened (for a speech). I have a lot of respect for what Greenspan did. When you look at what is going on, certainly people were starting to get worried about the credit boom then, but you started wondering about the structural change that had taken place. Even then, there were stories starting to come out that we were getting too stretched.
So, I did some basic, simple analysis and basically came to the conclusion we were sharing risk more widely and also originating more risk. In some level, the risks banks had on their balance sheet was going up. The argument was these guys are selling risk; that is a good thing because people who can absorb the risk are taking it on. But that wasn’t actually happening, banks were keeping as much risk, but also originating far more. The system itself was getting levered.
Then there were issues of liquidity. So, one of my concerns was that banks were at the centre of liquidity, but as they were taking more of this risk there were concerns whether they would be able to spread liquidity. The problem with any one of these crises is that for it to work itself out, you need enough liquidity so that where the losses are, in a sense, can be absorbed so the system can be reset to zero. If you can’t absorb the losses, the system can freeze up and freeze up with little activity.
Raghuram Rajan, professor of finance at University of Chicago’s Graduate School of Business. (Ramesh Pathania / Mint)
So, you need liquid players here who can buy the undervalued assets, who can re-float the system. Banks have been typically at the centre of this. But if banks are part of the whole structure of risk-taking, there is a worry whether they will be able to do it.
It didn’t go very well for two reasons. One, there were expectations from the people at the Fed (Federal Reserve), it would be a speech in praise of what happened in the US under Greenspan. But it went down very well with the Europeans. I am not saying Fed was ignorant of all this, but I think there was a general sense among US regulators it would be costlier to intervene to fix some of these problems than to let the market find its equilibrium. Yes, there would be some losses, but they would be absorbed in the system. What we have discovered is if you let this kind of thing go, it can be quite problematic.
What I was most worried about then was the incentive structure in the system and I am still worried. There is a huge incentive to take on risk because you get paid for the returns you generate. But the risk is way out there in the future. They are out of there by the time it actually hits. The kind of response some of these CEOs have had...Stan O’Neal (Merrill Lynch and Co.’s erstwhile CEO) walks off with ($)150 million-plus after he has blown a hole in the balance sheet that is bigger than all the profits he ever made for them. How can you have such a compensation structure?
In the subprime crisis, there was a low probability the housing market would blow up, (an) increasing (probability) of course, but reasonably low. So, you load up because you make the money on the mortgage origination, on creating the CDOs (collateralized debt obligation), selling the CDOs and there is somebody buying it also, who likes the 60 basis points they are getting over the AAA (rated debt; the highest rating assigned by Standard and Poor’s), even though it is an AAA. So, it looks (like) money for nothing. You look like a genius until it blows up. If you are too focused on short-term profitability and not on long-term risk, this is what happens.
Is this the extent of collateral damage from the subprime crisis? Or is it just the tip of the iceberg?
Nobody knows. You will have to look at the real economy to get a sense of whether it is going to spread that much. There is one aspect of the whole issue nobody understands, which is the US consumer. The US consumer has been spending like there is no tomorrow. People have justified that by saying it is (because of) the house prices, that their savings are going up. Why do they need to cut back on consumption because their savings are going up automatically?
The trillion-dollar question is, is the consumer going to cut back? If the consumer starts cutting back, there is a whole lot more stress on the system. It really will become a problem if you get demand sort of shrinking, unemployment, then you start getting more and more defaults.
Whether that negative spiral will take place is anybody’s guess.
Shifting the context to India, there’s been a lot of criticism of the central bank with regards to the speed with which it is opening up (the banking sector). With the benefit of hindsight, has it been correct about the pace?
I think, if in hindsight, you look at the stability we have, it is certainly something our regulators, including RBI (Reserve Bank of India) should be commended for. The question is, could we have had more growth and what is the right trade-off between growth and stability?
The argument can be made both ways, right?
The flip argument is that South Korea was at our per capita GDP in 1960 and has had three or four crises since then, but is now an OECD (Organisation for Economic Co-operation and Development, the developed bloc) country. You can find examples all over the world for one or the other. I do think, to the extent we can enhance the financing sector and its ability to allocate savings effectively, it is going to add to growth, and to do that we have to enlist expertise of all kinds. I would say, let’s be happy if we avoid crises and let’s also be not so conservative going forward that we miss out on growth we could have.
I don’t think management and supervision in an emerging market are easy by any means. So, all kudos to our regulators who have maintained a decent system. But when you look forward, you have to ask if status quo is enough or whether we have a need to change. Status quo can be more destabilizing than change.
On currency inflows, you have written a paper which says that if the economy does not have the absorptive capacity, it can actually regress growth.
Yes, the point in the paper was large and rapid capital inflows don’t necessarily help your growth process. That didn’t mean that once you have the inflows, you try and stop them. You may not have an alternative, but to find ways to absorb them more effectively.
What are the ways you can absorb them? One is to send them out. But to send them out through reserve build-up is only one way of absorbing them. You can also use this as an opportune time to open up all the taps that allow the private sector to send them out. You have already started doing that with these large acquisitions.
But what about the retail investor? Yes, you have these schemes, the mutual funds. I am speaking as a finance professor, for you to have all your money in India, you are overly exposed to India risk. I am not saying India is going to go south.
This would be a good time to encourage that process (overseas exposure). We have one of the strongest home biases in the world, close to 100% in the way our investors have their money. So, that would be one thing.
Also, when you absorb, you don’t want to consume as much as you want to invest. So, one way to prevent consumption is to fix your fiscal deficit. It is one of the few things you have control over. This is a good time to build up your fiscal strength and it will also prevent exchange rate appreciation.
If you want to channel it into investments, it is a great time to expand on structural reforms.
Finally, I would say let us not be overly concerned about exchange rate appreciation. First, there is no clear evidence it is hurting our companies across the board.
Our IT (information technology) companies are still making pretty serious profits; but wage rates are not going down there. That means they are making some profits. Yes, there are some sectors that seem to be hurting, textiles for example, but again we have anecdotal evidence. But don’t immediately start turning around to giving them sops, that is rent seeking (when organizations seek to make money by manipulating the economic system). Let’s not forget exchange rate appreciation is a source of opportunity because our costs are lower.
It’s sort of extremely mercantilist to think you are richer, but you don’t like it. We are investing by buying capital equipment from abroad that is going to become cheaper.
We don’t want the exchange rate moving too fast, too quickly. Apart from that it is good in the long-run it appreciates, it shows we are a wealthier nation.
Given the problems in the financial sector in the developed world, is there a fear of finance drying up for emerging economies?
I don’t think we can take for granted we will always get inflows of this magnitude. So, this is one more reason why we should be careful trying to inflict body blows on it now because you will establish a reputation now for whatever you do. Savings glut (globally) is not going to last forever.
China is not going to be sending out 10% of its GDP. I think we need to be a little careful.
What are the global economic risks associated with oil price hikes and grain shortage?
My greater concern would be oil. Grain...there are some special factors such as poor harvests and bad policy. I think if grain prices persist to be high, more land will move away from other crops to grain. There will be some stabilization of grain prices. I think over time, technology will help us.
Energy, I am a little more worried about. I think there is a huge amount of state intervention, therefore, the amount of investment we need to keep up with the growing economy are not taking place. You look at the nominal investment in energy, it looks like a lot, but the prices have shot up in many of the investment goods.
So, real investment is not there as much as you want it to be. I think oil is a bigger medium-term issue.
But I don’t buy the idea that in order to deal with the problem, we have to go and buy oil companies in all godforsaken places of the world. If you want to protect yourself against the price of oil, go and buy Exxon shares. Oil price goes up, those share prices will go up. You don’t need to explore yourself.
So long as there is going to be a market, there is oil going to be available for a price. What you have to do is hedge the price risk, not quantity because you just have to bid against somebody else for that quantity even if there is a quantity constraint.
If, in fact, the world had a major crisis and there was so little oil that people started seizing oil supplies, your owning an oil firm in Kazakhstan is not going to help you.
They have a great incentive to expropriate—I am not talking about Kazakhstan specifically—but any country, where you own the company, has an incentive to nationalize at that point.
Typically, nationalizations take place when the price is high. So, I don’t think you get security by holding little pieces all over the world and especially buying them now when the oil price is high. Invest some of your reserves if you want in some of the oil companies.
I think the best form of energy security is to let that market work effectively. You don’t control oil 3,000 miles away. You control oil within your borders.