During the East Asian financial crisis in 1997, banks in Japan and South East Asia were faced with rapidly decreasing asset values on their books, and turned to US banks for help. I had occasion to come across the remnants of one such correspondence. It was from a major US bank to a Japanese counterpart, basically telling them that banks in Asia did not understand complicated instruments and, in particular, warning against leveraging without underlying assets. During the Mexican and the Argentinian crisis in the 1990s, those countries had to listen to a lot of advice from the American financial sector and multilateral agencies on the follies of leveraging of bonds and derivatives that had no underlying asset value and how these countries did not know much about finance.
It is not surprising that these emails have been pulled out of archives by several South East Asian bankers and are doing the rounds now within the banking community. The comment also is that even at the worst of the 1997 crisis, individual greed and wrongdoing was not as rampant as it appears to have been this time in the US. Not surprisingly, the pillars of international finance such as the International Monetary Fund and the World Bank have little to say in the face of the US treasury secretary beseeching the leader of the house (literally on bended knee) to stave off the financial crisis.
It is now fairly evident that the $700 billion bailout may not be adequate, and that there will be more to come. It is also clear that delays in decision making have cost the country dearly. If the decision to buy off stressed assets from all financial institutions had been taken a year ago, within a couple of months of the subprime problems surfacing, the bailout would have cost only around $200 billion. During the last one year, the value of the underlying assets, and more importantly, the instruments that were created on the back of these assets, has probably dropped to about one-third of what it was last year. Even now, the end value of this paper is not known. To take a simple example: AIG has more than $1trillion in assets, more than $700 billion in outstanding debt and, in addition, has underwritten around $600 billion in insurance for credit default swaps. Even if 5% of the insured documents default (a low estimate today), the cost is close to $30 billion for this firm alone. For several insurers, the liability has multiplied over the past year, as more and more insurance has been underwritten against default after the problems surfaced, thus exacerbating the impact of the meltdown.
The other interesting feature is that the bailout is essentially a Wall Street rescue. Mopping up illiquid assets does not solve the problem of liquidity in the economy. There is a severe shortage of credit for businesses, and banks are unwilling to lend any long term debt. The Libor has become almost non-existent, with inter-bank rates being quoted at least 170 points above. Yields on treasury bonds are in a steep fall as the demand for treasury bills has increased significantly.
Finally, the fiscal burden of raising the total ceiling of borrowing by the US government to more than $11.6 trillion, something that translates into a large amount of debt for every citizen of that country. It’s not clear how and over what period that debt will be called, but it appears that growth of revenue in future, alone, would not be able to take care of it.
The only surprise, viewing the scene from India, is that there is no evidence of any effort or strategy to deal with the aftermath. It is not surprising that our ministers are no longer saying that we will not be affected by the crisis. There is reliance on the softening of oil and commodity prices to hope that inflation will go away. The relaxation of external commercial borrowing guidelines is likely to have little effect, since longer-term credit is no longer available, and the Reserve Bank of India ceilings of Libor plus 300 basis points would no longer be relevant. Availability of credit for projects, infrastructure and for growth is likely to become a serious problem, and the first to be affected would be the small and medium enterprises, whose costs of operation would go up considerably. The dollar price of Rs46 does not help either. There is a need for pragmatic solutions to be taken quickly to ensure that there is not a steep slide in growth. It is important to realize that Wall Street concerns will not stop at Dalal Street and will affect the services and manufacturing sectors very soon. One would hate to see a situation where the only option for policymakers in the next budget is to reflate the economy through huge budget deficits and add to taxation to curb inflation.
S. Narayan is a former finance secretary and economic adviser to the prime minister. Comments are welcome at firstname.lastname@example.org