Global investors are waking up to market crashes, trading halts, bankruptcies and dreary economic news every day. Credit markets in the developed world have come to a standstill, making it hard for companies, states and even colleges to fund their working capital needs. A lot of ink has been expended debating if at first Europe will be spared a downturn and then whether European banks will go unscathed. The result is clear: Neither is insulated. Bailouts, rescue packages—the full cost of such a crises goes beyond direct fiscal costs.
As the tide ebbs, it has uncovered shoddy banks that relied heavily on short-term funding and lent irresponsibly. Perhaps the poster child of poor decision making was Iceland, a country of 300,000 and gross domestic product (GDP) of less than $20 billion (Rs97,480 crore). In the heyday of loose global monetary policy, Iceland saw its household and non-financial corporate debt go from about 200% of GDP to over 400%. Meanwhile, banks lent heavily in overseas markets. The banking system so outsized the economy that banks had to borrow extensively overseas—their external debt went from 55% of GDP in 2002 to 468% in 2007.
Iceland has already nationalized two of its largest banks. With or without a declining currency amplifying the external debt, it’s looking increasingly unlikely that the gargantuan external debt will be serviced.
Ireland is not far behind. The government recently guaranteed deposits and debt of six wholly Irish-owned banks. In a worst-case scenario, this could cost the government $575 billion—twice its GDP and nine times its national debt.
Again, poor decision making was behind the mess. The banks carry loan books that are highly unseasoned and most of the recent loans have gone to a now slumping real estate market. Credit outstanding was twice the country’s deposits in 2007. Some 70% of the lending between 2004 and 2007 was wholesale-funded, and as a result the banks now face punitive debt refinancing.
In India, ICICI Bank Ltd was caught in rumours and had some depositors rushing to take their money out. Such a crisis of confidence is the Achilles heel for any bank. As it stands, Rs1 lakh of an individual’s bank deposit is insured. Meagre as this amount may sound, it actually covers 58% of the deposits in India as per the Deposit Insurance and Credit Guarantee Corp. The insured amount, set in 1993, should be increased to reflect current times. It is easily possible to do so given the soundness of the Indian banking system. Ironically, the statutory liquidity ratio, which mandates banks to hold at least 25% of their deposits in government bonds, and is a great funding source for fiscal mismanagement by the government, itself serves as a protection for the depositors.
Laudably, the Reserve Bank of India has over the years, with a variety of monetary tools, protected Indian banks from falling prey to financial contagion. Speaking of regulators, markets regulator Securities and Exchange Board of India retraced its steps on participatory notes just a year after it unveiled a complicated plan to cherry-pick foreign investors. Aside from increasing paperwork and costs, this plan has achieved nothing. Now, this band-aid solution seeks to prevent stock market gyrations caused by foreign institutional investors’ reversals. Again, we remain unimpressed with the regulators’ fascination with stock market moves.
Coming back to the stock market carnage, much of the US market sell-off has also been exacerbated by hedge funds. Met with redemption calls, hedge funds are liquidating across the board. There are stocks and then there are “hedge fund stocks”—stocks widely held by hedge funds, which are selling irrespective of fundamentals. These stocks are not restricted to any one sector but happen to be favourites in the hedge fund community and, for the past month, have been lambs led to the slaughter. Goldman Sachs Groups Inc. had compiled an index of these names—suffice to say the index has been an outstanding short. Hedge funds liquidation has also hit some of the “hedge fund hot spots” such as Brazil, Russia and, of course, India.
Global markets have been in a seizure of sorts. So when does this all end? What is forgotten in this panic is that the stock market is just a headline, albeit a really colourful one. The real story is in the credit markets where fear is running amok. Frozen credit markets are merely a manifestation of the real problem, namely the US housing market. House prices have to stabilize for any kind of normalcy to return to the credit markets. In the meantime, as the economic downturn hits, a handful of money shufflers go unscathed while the broader population is hung out to dry.
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They will write every other Thursday. Send your comments to firstname.lastname@example.org