Pandit the global financial crisis and the indian economy (2015)

Some attempts have been made to explain the global financial crisis and its impact on the Indian economy, and one may well ask why another book on the same subject.. The 2008 global fina

The Global

Financial Crisis and the Indian Economy

The Global Financial Crisis and the Indian Economy

B.L Pandit

1 3

The Global Financial Crisis and the Indian Economy

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Preface

As a result of economic reforms in the post-1991 period, India became a favourite destination for foreign investment and transfer of new technology Integration of Indian economy with the rest of the world scaled new peaks in terms of large capital inflows and high rates of growth especially during 2003–2007 The global financial crisis of 2008 dealt a severe jolt to this process Some attempts have been made to explain the global financial crisis and its impact on the Indian economy, and one may well ask why another book on the same subject

In comparison with other books on the global crisis, this book is organized

in a different way It goes deeper into the issues—both at the “policy” and the

“impact” levels For examining the role of monetary policy during the recession which accompanied the crisis, an econometric model is specified For quantifying the impact of the crisis on stock prices in India, an empirical model rooted in the theory of portfolio selection is set up and tested

The systemic issues responsible for the crisis are treated separately in the book One such issue is that after the collapse of the Bretton Woods system in 1971, the US Dollar became de facto reserve currency for the world; something, that Finance Minister to French President Charles de Gaulle had called an “exorbitant privilege” for the USA This systemic problem turned out to be an important rea-son responsible for the global crisis On this count, therefore, there is a need for working towards a new international monetary system

Another systemic issue is that unlike the commodity markets, financial kets are no candidates for unfettered and unregulated market mechanism Market failures of financial institutions carry huge negative externalities Even the diehard votaries of free markets cannot dismiss the merits of prudential regulation of financial markets Financial innovations by highly trained specialists keep on cre-ating new financial products which at times promise very high expected returns Low rates of interest often lure profit-seeking firms to indulge in trading finan-cial derivatives and other assets involving unknown levels and types of risk This makes it necessary to regulate and monitor investments in financial markets.Inept and dishonest rating agencies contributed to the global crisis by handing down false ratings The regulators, some of whom were also under the spell of

mar-Preface vi

regulatory capture, did a bad job of regulation and further messed up the tion On top of this, both regulators and rating agencies were virtually incapable

situa-of accurately assessing the risks situa-of newly engineered complex financial products The number of unsecured and risky financial securities in circulation increased which triggered the financial crisis For ensuring financial stability, therefore, tack-ling these problems is an important systemic issue

In preparing the manuscript, research support by Pankaj Vashisht of ICRIER (New Delhi, India) and Divya Tuteja of Delhi School of Economics is grate-fully acknowledged Sanjeev Sharma, chief systems administrator, Centre for Development Economics, Delhi School of Economics, deserves special thanks for providing programming support

Contents

1 Introduction 1

Part I The Systemic Issues of the Global Crisis 2 Genesis of the Global Financial Crisis 7

2.1 Introduction 8

2.2 Origin and Manifestation of the Crisis 8

2.2.1 Easy Money Policy and Increase in Risk Appetite 8

2.2.2 International Macroeconomic Imbalances 9

2.2.3 Housing Finance for the Low-Income Households 10

2.2.4 Securitisation—originate-to-distribute Model 11

2.2.5 Role of Financial Engineering 14

2.2.6 Problems in Assessment and Pricing of Risk 14

2.2.7 Governance Failure and/or Market Failure 15

2.2.8 Laxity in Supervision and Regulation of Financial Institutions 15

2.2.9 Regulatory Capture 16

2.2.10 Financial Instability Hypothesis 16

2.2.11 The Financial Cycle Hypothesis—A BIS Perspective 17

2.3 Global Impact of the Financial Crisis—A Synoptic View 18

2.4 Concluding Remarks 19

References 20

3 Financial Liberalization, Economic Development and Regulation 23

3.1 Introduction 24

3.2 Micro-economic Issues in Regulating a Financial Firm 24

3.3 Indian Experience in Public Ownership of Financial Institutions—A Digression 25

Contents viii

3.4 Financial Development, Liberalization and Economic Growth 27

3.4.1 Financial Liberalization, Rate of Interest and Savings 30

3.4.2 Financial Growth and Economic Development—The Causality 31

3.5 Regulation of Financial Markets 32

3.5.1 How Financial Markets Differ from Commodity Markets 33

3.5.2 Negative Externalities and Financial Regulation 34

3.6 Concluding Remarks 35

References 35

4 Towards a New International Monetary System 37

4.1 Introduction 38

4.2 Some Developments in International Finance 38

4.3 US Dollar as De Facto International Currency 39

4.4 SDR as International Reserve Currency 40

4.4.1 SDR in the Post-Crisis Period 41

4.5 Post-Crisis Scenario in International Finance 42

4.5.1 A Multi-Currency System in a Multi-Polar World 42

4.5.2 Need for Reforms 43

4.5.3 Benefits of Multipolarity 44

4.6 Concluding Remarks 47

References 47

Part II Global Crisis and Indian Economy 5 Monetary Policy Transmission: Cointegration and Vector Error Correction Analysis 51

5.1 Introduction 51

5.2 Transmission of Monetary Policy 52

5.3 Estimation Framework 54

5.3.1 DF-GLS Test for the Presence of a Unit Root 54

5.3.2 KPSS Unit Root Test 54

5.3.3 Cointegration and VECM Framework 55

5.4 Data and Empirical Model 58

5.5 Empirical Results for the Crisis Period 58

5.5.1 Model A 60

5.5.2 Model B 62

5.5.3 Model C 65

5.6 Empirical Results for the Entire Period 68

5.6.1 Model D 68

5.7 Concluding Observations 72

References 73

6 Monetary Policy and Credit Demand During the Crisis 75

6.1 Introduction 76

6.2 Research Questions 77

6.3 Role of Monetary Policy: Open Cum Developing Market Economies 82

6.4 Impact of Changes in Policy Rate on Lending and Deposit Rates 83

6.5 Model Specification, Data and Estimation Methodology 84

6.6 Empirical Results 86

6.7 Conclusions 89

References 89

7 Global Financial Crisis and the Indian Stock Market 91

7.1 Introduction 92

7.2 Objective of the Study 92

7.3 Recent Studies: A Review 94

7.4 World Markets in Crisis 95

7.5 Global Integration of Indian Economy 97

7.6 Indian Stocks During the Crisis 97

7.7 Analytics of Stock Pricing in a Financial Crisis—Our Model 102

7.8 Empirical Model 103

7.9 Empirical Results 104

7.10 Summing Up 105

References 106

8 Indian Economy Through the Global Crisis 107

8.1 Introduction 107

8.2 Transmission Channels 108

8.3 Immediate Impact of the Crisis on Indian Economy 109

8.4 Monetary Policy Response to the Global Crisis in India 114

8.4.1 Monetary Policy Measures 114

8.5 Fiscal Policy Response to the Global Crisis in India 116

8.5.1 Union Budget 2008–09—Major Counter Cyclical Fiscal Policy Measures 116

8.5.2 Union Budget 2009–10—Major Counter Cyclical Fiscal Policy Measures 117

8.6 RBI Policy Interventions and Financial Stability 118

8.7 Post-crisis Inflation in India 119

8.7.1 Opening of the Economy and Imported Inflation 119

8.7.2 Policy Perspectives in an Open Economy 121

8.7.3 Is the Recent Inflation Rooted in High Rate of Growth of M1 or M3? 121

8.7.4 Structural Aspects of Current Inflation 123

8.7.5 Inflation, Per Capita Expenditures, Wage Rates and Corporate Wage Bill 124

Contents x

8.7.6 Trading of Agricultural Commodity Futures 125

8.7.7 Recent Inflation in India—A Summing up 126

8.8 Globalization, Economic Growth and Employment 126

8.8.1 Survey Data on Unemployment in India 127

8.8.2 Recent Scenario of Employment 128

8.9 Post-Crisis Post-Script 131

8.10 Concluding Remarks 134

References 136

9 Conclusions 137

9.1 Part I 138

9.2 Part II 138

Index 141

About the Author

B.L Pandit has served as a professor and head, Department of Economics, Delhi

School of Economics He got his Ph.D in Economics from Delhi School of Economics, University of Delhi He has taught courses in macroeconomic theory, monetary theory and policy and financial markets at the Delhi School of Economics besides supervising M.Phil and Ph.D students He has published books with international publishers and has also published extensively in peer-reviewed national and international journals His research project studies have been sponsored by Canadian International Development Agency, FICCI and Reserve Bank of India He has presented papers and attended con-ferences in Toronto, Moscow and UNCTAD Geneva

Abstract Global financial crisis of 2008 is examined in two parts in this book The

first part comprises Chaps 2 3 and 4 The origin of the crisis is traced in Chap 2

to the subprime housing loans in the USA Laxity in regulation of financial sector, regulatory capture, questionable role of the rating agencies and very low rates of interest in the USA turn out to be some of the other factors—all of which snow-balled into a financial crisis In Chap 3, the analytical issues of financial regulation are discussed It is argued that contrary to the philosophy of free markets, negative externalities of financial sector justify its regulation In Chap 4, it is explained how dominance of the US dollar in international finance created conditions for macro-economic imbalances and thereby the crisis In this chapter, it is suggested that for international financial stability, a multipolar international financial system would

be useful Deploying econometric models, transmission of monetary policy is acterized in a period of crisis in Chap 5 Effectiveness of monetary policy during the crisis is examined in Chap 6 Impact of the financial crisis on the Indian stock market is taken up in Chap 7 Here, it is argued that during a crisis, minimization

char-of risk is the overriding objective, with the result that the logic char-of stock pricing needs to be modified In Chap 8, to start with, interdependence of US and Indian stock markets is highlighted Impact of the crisis on the real sector of the Indian economy is discussed, followed by detailed description of countercyclical mon-etary and fiscal policies Post-crisis problems of inflation and unemployment are taken up in detail

The 2008 global financial crisis is a watershed between two recent periods of global economic growth The pre-crisis years from the year 2003 till 2007 in the global economy have been called a period of “great moderation”—a high growth phase with price stability Immediately after the crisis in 2008, there was a liquid-ity crisis This was sought to be controlled by fiscal stimuli, expansionary mon-etary policies and collaborative international efforts for removing the impediments

in capital flows There was a large dip in the global growth rates, followed by a worldwide recession Following the onset of the crisis, recovery is very uneven

and generally slow The financial crisis has exposed problems of sovereign ruptcy, and persistent high rate of unemployment is observed in several advanced economies The worldwide recession has prolonged for a much longer period than was expected.

bank-The present volume is in two parts In Part I, we begin with Chap 2, by tracing the genesis of the global financial crisis, starting with the initial subprime loan crisis in the US housing sector, followed by the infamous liquidity crisis and the worldwide recession We pick up two themes from the manifestation of the crisis for more detailed discussion One is the issue of regulation of the financial sector, and the other is the problem of dollar-centric international monetary system Both

of these have been widely cited among the important factors leading to the 2008 financial crisis

The first theme taken up in Chap 3 is the issue of regulation of the financial sector Serious irregularities were observed in regulation of financial institutions such as commercial banks and investment banks This was coupled with deteriora-tion in accounting standards in the shadow banking sector and the widespread phe-nomenon of “regulatory capture” While initiating discussion on regulation of the financial sector, we pick up the threads from micro-theoretic models in the own-ership–efficiency debate We then make an important digression in highlighting the positive role of public ownership and control of financial institutions in under-developed countries like India in intensifying growth and making it more inclu-sive The case for regulating the financial sector is based on three solid reasons The first reason is the inter-temporal nature of transactions generating contracts which have to be honoured and therefore enforced by some authority, making use

of stipulated regulations The second reason is problem of information asymmetry between issuers cum guarantors of finance on the one hand and borrowers cum investors on the other Problems of moral hazard, adverse selection and adverse incentives lead to situations of market failure The third reason is that there exist a number of negative externalities with the normal working of financial firms which make regulation imperative for this sector

An important reason cited for the 2008 crisis is that for a number of years, there have been large imbalances in the current account across countries Several devel-oped nations including USA and UK have been running huge current account defi-cits with China, India, Russia and some oil exporting countries The imbalances are a result of a serious flaw in the international monetary system, viz US dollar

as de facto international reserve currency This creates a perpetual hunger for the national currency of a single country, and attempts are made to build up reserves of this single currency This important theme is taken up in Chap 4 The governments

of the crisis-ridden countries are still grappling with recession Soon enough, the member countries of the IMF will have to work for evolving a new international monetary system In the reformed international monetary system, the voting power

of the members must be as per the current share of the countries in world GDP and trade and not what was there in 1944 when IMF was established The objective should be to have a properly weighted multi-currency unit of account for interna-tional transactions and for building of reserves by the central banks

1 Introduction

In India as in other countries, for fighting the recession, fiscal stimuli of various orders were administered by the authorities as a countercyclical measure Monetary policy instruments were deployed as short-run measures to counter the impact of the crisis With Chap 5, we start Part II of this volume We focus here

on monetary policy transmission Cointegration and vector error correction models are used to characterize monetary policy transmission to the real sector during the global financial crisis We focus on three policy instruments—Repo rate, Reverse Repo rate and the Cash Reserve Ratio These three instruments have been chosen because their impact on bank lending is expected to be direct To start with, we check for stationarity of the variables Since in using economic data, endogene-ity and exogeneity of variables are not always clear, we use a vector autoregres-sive (VAR) framework for examining the plausibility and effectiveness of the three monetary policy instruments We deploy Dickey–Fuller generalized least squares (DF-GLS) test for checking for unit root and a cointegration and vector error cor-rection model (VECM) for checking for any long-term relationship among the variables Empirical results show that Cash Reserve Ratio is more effective in influencing log of Index of Industrial Production and Repo rate and Reverse Repo rate are more effective with respect to log M3

In Chap 6, we examine effectiveness of monetary policy during the crisis On the basis of data analysis, it is observed that in India and some select emerging mar-ket economies, changes in policy rate of interest like the Repo rate are followed by changes in market-determined interest rates for loans and deposits A demand func-tion for private corporate credit is specified for India and some EMEs over the crisis period Besides the policy rate, volume of exports, demand pressure and index of stock prices are used as factors influencing demand for credit The empirical results show that when we control for other factors mentioned above, policy rate of inter-est emerges as a significant determinant of credit demand An important inference

of the results is that during the global financial crisis, domestic monetary policy in India and other EMEs has been effective in influencing the real sector variable like private corporate credit demand and thereby the tempo of economic activity

The impact of the global financial crisis on Indian stock market is taken up

in Chap 7 At the outset, we focus on the extent of integration between the US and Indian stock markets following globalization Our main research question here is to examine the impact of the global crisis on Indian stock prices During

a financial crisis, risk management is the primary objective of a company and the efficient set theorem does not hold valid So while discussing the analyt-ics of the stock pricing during a financial crisis at the company level, we distin-guish between risk-enhancing features and risk-mitigating features of a company Using stock market data on 2075 Indian companies for the worst period of the crisis, from September 2008 to March 2009, panel data techniques have been used

to explain the percentage change in stock prices across companies The empirical results show that significant determinants of percentage change in stock prices are share of foreign institutional investors (FIIs) in a company’s capital, its export intensity, β of a company, size of its turnover and ratio of a company’s market value to book value and rate of inflation

The performance of the Indian economy during the global crisis, fiscal and monetary policy measures, and a more detailed discussion of twin problems of inflation and unemployment are taken up in Chap 8 We give a detailed account

of the immediate impact of the crisis on the Indian economy Using charts, the level of integration of the real sector of Indian economy with rest of the world is explained Causality tests are deployed to determine the interdependence of stock indices of the USA with those of the Indian economy The impact of the crisis

on the performance of the corporate sector, stock market indices, magnitudes of foreign direct investment and foreign portfolio investment is discussed Problems

of inflation and unemployment in India during and after the crisis are discussed

in greater detail A short post-crisis post-script is presented before concluding the chapter Here, we review the broad parameters of economic growth, foreign invest-ment and stock market indices in the Indian economy in the post-crisis years The signs of recovery are unmistakably clear Our optimism about the future growth is, however, subdued due to a number of factors listed at the end of this chapter This

is where Part II of this volume comes to a close

Chapter 9 brings together the main conclusions

Part I The Systemic Issues of the Global Crisis

Abstract This chapter traces the genesis of the global financial crisis of 2008

as it started in the USA and later spread across the world After the US dot-com bubble burst in 2001, the US Federal Reserve Board followed an easy money policy for boosting up aggregate demand This policy was facilitated by a large increase in investment in the US Federal financial instruments by China, Japan, Germany and oil exporting countries As the liquidity increased in the USA, the Fed Funds Rate and Real Interest Rate touched the levels close to zero Simultaneously, complying with the US government policy of providing cheap housing finance to the poor, the banks reduced the margins for such housing loans to almost zero level This encouraged borrowing for houses by the sub-prime borrowers Demand for houses increased which resulted in rise in house prices A bubble was created in the US housing market due to several reasons Very low rates of interest increased the risk appetite of investors leading to the increase in speculative investment in real assets Through time, securitization of assets became popular As a result, instead of originate-to-hold model, originate-to-distribute model of housing loans was used by the lending banks This along with other financial innovations made it possible for financial intermediaries to distribute risks and unload them on unsuspecting investors Lax regulatory prac-tices in general as also regulatory capture and flawed credit ratings given by rat-ing agencies resulted in underestimation and underpricing of risk Investment in risky and tainted assets multiplied In 2006, following policy-induced increase

in the Fed Funds Rate, house prices in the USA started falling leading to scale foreclosures of housing loans resulting in bank losses and a drastic fall in liquidity This triggered the financial crisis Given the negative externalities of the market failure in the financial sector and the linkages across markets and countries, the crisis became global

large-Keywords Genesis · Global financial crisis · Dot-com bubble · Subprime

borrowers · Originate-to-distribute model · Regulatory capture · Financial engineering · International macroeconomic balances · Glass–Steagall Act

Genesis of the Global Financial Crisis

© Springer India 2015

B.L Pandit, The Global Financial Crisis and the Indian Economy,

DOI 10.1007/978-81-322-2395-5_2

8 2 Genesis of the Global Financial Crisis

2.1 Introduction

By now, a number of studies have been conducted on the global financial crisis of

2008 Greenspan (2010), Reinhart and Rogoff (2009), Stiglitz Commission Report (2010), Krugman (2009), Rajan (2010), Sheng (2010), RBI (2010) and Reddy (2010), to name some of them In this chapter, we discuss some of the factors responsible for the origin and manifestation of the crisis The hypothesis of finan-cial instability earlier advanced by Minsky (1986, 2008) is discussed as a possible analytical framework for the crisis The Bank of International Settlements (BIS) perspective on the crisis is also discussed We explain briefly the role of financial engineering in generating financial products as a combination of securities whose actual risk level was not properly assessed The “originate-to-distribute model”

is taken up in some detail It shows how the possibility of offloading the risks of lending banks to a sequence of investors was a big change in sharing of risks in comparison with “originate-to-hold model” However as is pointed out in this chapter, serious lapses in regulation and failure of rating agencies in assessment

of risks resulted in mispricing of risks which precipitated the crisis The present study is focused on the theme—Indian economy through the global financial cri-sis However, before we take up the impact of the crisis on India and India’s policy response in detail in the later chapters, a brief overview of the immediate impact

of the crisis on the global economy is presented in this chapter towards the end

2.2 Origin and Manifestation of the Crisis

In the USA, prior the 2008 crisis, the period from mid-1980s to 2007 was marked

by macroeconomic stability Very mild recessions were experienced in the US economy during these years High economic growth amidst macroeconomic sta-bility in this period, also called “great moderation” is attributed to two major fac-tors First, as Mcconell and Perz-Quiros (2000) say that in this period, service sector has played a relatively larger role and there has been considerable improve-ment in inventory management Second, as Romer (1999) says that high and stable economic growth in this period was largely due to the low inflation policies imple-mented by the US authorities

2.2.1 Easy Money Policy and Increase in Risk Appetite

Along with this high and stable economic growth, certain important developments were taking place in the US economy The easy money policy pursued in the USA, after the dot-com bubble burst in 2001, kept the Fed rates very low Low inter-est rates on Fed financial assets prompted investors to look for higher yields else

where In Chart 2.1, given below, graphs of Effective Fed Funds Rate and Real Interest Rate very clearly illustrate the profile of the two important rates from January 1999 to July 2009 (Source: Reserve Bank of India 2010) Policy of low interest rates reduced the borrowing cum opportunity costs of investible funds Low interest rates during a period of relatively high and stable economic growth during 2003–2006 made the market participants optimistic and increased the risk appetite of investors This encouraged financing of “risky and unsafe” investments including the subprime housing loans.

2.2.2 International Macroeconomic Imbalances

Large inter-country macroeconomic imbalances in the form of current account deficits emerged in the post-Bretton Woods international monetary and finan-cial system and persisted for longer periods Some factors are said to be respon-sible for delayed adjustments in global balances (see Kishore et al 2011) First,

in the post-Bretton Woods era, the US dollar has emerged as the most preferred reserve currency for the central banks For accumulating US dollar reserves, the central banks invest in safe, albeit low return financial instruments floated by the

US Federal Reserve As a result, the USA gets an option to finance costlessly, its current account deficit for an extended period without adjusting its exchange rate Second, countries holding current account surpluses with the USA can opt

to delay their upward exchange rate adjustment vis-a-vis the US dollar and reap the benefits in terms of higher net exports and larger capital inflows China is an example in the current context

For many years especially after 2006, the current account deficit of USA and some other developed economies such as UK and France kept on increasing vis-a-vis

Chart 2.1 US Real Interest

Rate (green) and effective

Fed Funds Rate (blue)

10 2 Genesis of the Global Financial Crisis

China, Japan, Germany, oil exporting countries, and Russia This is mirrored in scale investment of the current account surplus of these countries in the US financial instruments The result was a sustained increase in liquidity and further fall in the interest rates in the USA, as is discussed in Sect 2.2.1 above Table 2.1 presents the data on international macroeconomic imbalances from 2006 to 2009

large-2.2.3 Housing Finance for the Low-Income Households

A home provides shelter, identity and security in old age, and as such, owning

a house is a primary need of a household In a democracy, the politicians trying

to capitalize on this urge of households—as potential voters—at times initiate policies for “dream housing” projects Around 1997, US Congress supported by President Clinton legislated for two things; first, real estate capital gain tax was eliminated on primary home real estate held over two years This was a big tax cut, and because of this, investment in real estate became a popular investment Following this, real estate prices increased in an unprecedented manner for the fol-lowing ten years Also, around the same time, the Congress was persuaded to put pressure on mortgage companies to provide housing loans to the poor and to those who did not qualify earlier for such loans

In the USA, under the Glass–Steagall Act of 1933, conventional banking was segregated from securities business and the bank management was forbidden to lend to businesses owned by them The commercial banking network was thereby segregated from the network of investment banks However, the Glass–Steagall Act was repealed in 1999 in the USA The “universal banking” model was adopted

in the USA and other countries This was a development with far reaching quences As a result of this policy change, the firewalls between the investment banking network and commercial banking were removed and business of banking

conse-Table 2.1 Macroeconomic

imbalances (US$ billion)

2006–2009

Note (−) indicates deficit

Source IMF, Word Economic Outlook, database

China 253.3 371.8 426.1 283.8 France −11.6 −25.9 −64.8 38.8 Germany 188.4 253.8 245.7 160.6

attracted big money Through time, banking became more concentrated with large banks cornering big chunks of banking business Concentration of banking busi-ness made it possible for big banks to afford high salaries of the financial wizards with proficiency in using complicated theoretical models of derivative pricing, using state-of-the-art superfast computers As risks were being undertaken on a wider scale, the number of hedge funds increased Hedge funds began operating

in markets for equity, debt, commodities, derivatives, foreign exchange and real estate As a result, financial markets were getting interlocked on a larger scale, making contagion inevitable

For quite some time, the US political class and policy makers have been ing their concern for providing affordable housing finance to households with modest incomes For making mortgages available to such people, in 1938, Federal National Mortgage Association (FNMA) popularly called Fannie Mae was cre-ated as a government agency for securitizing house mortgages In 1968, Fannie Mae was made a publicly traded company and Government National Mortgage Association GNMA, popularly called Ginnie Mae was established as a wholly owned government company In 1970, Federal Home Loan Market Corporation (FHLMC), also called Freddie Mac, was created to give competition to Fannie Mae In 1992, for promoting affordable houses for the poor, Office of Federal Housing Oversight was set up Around the same time, the Congress was per-suaded to put pressure on mortgage industry to provide loans to those who had been denied in the past, such as the poor and the blacks In the year 2000, Federal Housing Department wanted the housing finance agencies to declare that 50 % of newly funded houses are affordable for the low-income households Following this, among the Fannie Mae, Freddie Mac and Ginnie Mae corporations, the first two guaranteed their own mortgage-backed securities and the third guaranteed mortgage-backed securities issued by private firms These institutions were run by politically appointed people from both the Republican Party and the Democratic Party and as such were feeding the mortgage industry with billions of dollars ear-marked for loans to those who previously did not qualify for such loans

show-By 2003, Freddie Mac and Fannie Mae admitted that their financial statements could not be relied upon because of unsound financial practices As long as home prices were rising, these unsound practices did not bother most people In fact, the mortgage firms managed to sell their mortgages to firms such as Bear Stearns and Lehman Brothers who were on the look out for higher profits from their portfolios These companies borrowed heavily for purchasing the mortgages, and ratio of lev-erage of these companies increased up to 30:1 This went on till the bubble burst

2.2.4 Securitisation—originate-to-distribute Model

The familiar model of relending the deposits by commercial banks is called nate-to-hold” model In this model, a loan advanced by a bank remains in its balance sheet till it is paid off This is true of all kinds of loans including the housing loans

“origi-12 2 Genesis of the Global Financial Crisis

which last for long periods This model has been gradually replaced by what is called

“originate-to-distribute” model Here, financial institutions with limited working capital originate mortgage loans and then securitize these loans in order to multiply the reach of their working capital Home buyers go in for long-term mortgage loans, sometimes as long as for thirty years The lenders securitize the mortgages and earn more money while using the same capital The lender who originates the mortgage charges origination fee for it, sells the mortgages to another institution for cash and transfers the right of payments to it This company that buys the mortgages resells them to another party with a much larger resource base, say a pension fund After col-lecting a fairly large number of mortgages, the last intermediary creates another com-pany called a mortgage trust or “special purpose vehicle”—a legal entity This trust buys a pool of mortgages and simultaneously creates a bond or a security These secu-rities are sold to fixed-income investors, and in this way, “mortgage-backed securities” also called collateralized debt obligations (CDOs) are created which have the backing

of several mortgages The mortgages are then classified into senior and junior tranches depending on the underlying risks The junior tranches which are more risky are com-pensated by higher yields to them, and senior tranches would be paid first in a situa-tion of a fund crunch In case of mortgages fully financed by banks, the motivation for the bank is to make sure that payments come in time This is not true for mortgages where brokers are involved In such cases, the originators and the brokers do not hold

on to the mortgages They are motivated to deal in bigger and riskier loans In this way, the share of mortgage-backed securities magnified in a big way This is shown in Chart 2.2 (see Rosen 2007)

Insurance on CDOs is done through credit default swaps (CDS) The client promises to pay the insurance agency or the guarantor a fixed fee in exchange for the guarantee that if a bond defaults, the guarantor shall redeem it AIG and some other monoline insurers sold credit default swaps, and when a large number

of securities experienced a fall in their value, the financial position of guarantors became precarious and the US authorities had to bailout AIG

Chart 2.2 Share of

mortgage securities in total

US mortgage debt (%)

Source Rosen ( 2007 )

Traditionally in the USA, before getting housing loans, borrowers had to pay margins of 20 % or more of the total loan and the lending bank would lend out

80 % of the sum Later in compliance with the government’s policy stance, US banks somewhat relaxed these practices in order to cater to lower income borrow-ers This increased their lending volumes Subsequently, loans were given equal to the entire value of the house with the result that now borrowers had no stake This

is what was called “wholesale lending” loans which were given to people without documented income, jobs and assets, later nicknamed as NINJA loans Lending banks bundled several loans together through securitization, calling the bundle a mortgage-backed security By the middle of 2007, the size of subprime household loans was as big as 1.4 trillion US dollars Financial engineers of the Wall Street had packed these loans into complicated financial instruments called collateralized debt obligations (CDOs)

Some banks offered “Teaser Loans” These loans initially carried low est rates which were reset after sometime Initial attraction of low interest rates attracted many low-income borrowers When interest rates were raised, poor bor-rowers could not pay Lending banks were unconcerned as they had sold their loans through securitization

inter-In this way, US home lending and home prices shot up As long as the omy and housing market were going good, borrowers paid instalments regu-larly Eventually, housing prices peaked and then declined as shown in Chart 2.3 (Source, Shiller 2007)

econ-Chart 2.3 Behaviour of house prices Notes Real US home prices, real owners’ equivalent rent

and real building costs, quarterly 1987-I to 2007-II Source Shiller (2007 ) [attachment to this timony] Real US home price is the S&P/Case-Shiller US National Home Price Index deflated by the Consumer Price Index (CPI-U) for the first month of the quarter rescaled to 1987-I = 100 Real owners’ equivalent rent is the US Bureau of Labor Statistics Owners Equivalent Rent december

tes-1982 = 100 from the CPI-U divided by the CPI-U, all items, tes-1982–4 = 100, both for the first month

of the quarter, rescaled to 1987-I = 100 Real building cost is the McGraw-Hill neering News Record Building Cost Index for the first month of the quarter (except for the years

Construction/Engi-1987, 1988 and 1989 where the index is only annual) deflated by the CPI-U for that month

14 2 Genesis of the Global Financial Crisis

As house prices declined, US banks were facing borrowers who could not pay back their loans because of lack of income Further, borrowers had not paid any margin money against their housing loans Loans were secured only by the mort-gage property, and the borrowers were free of any obligation, if they returned the property When house prices declined, such borrowers would not pay loan instal-ments for houses which were now worth less than the contracted loan amount When such defaults increased, the value of mortgage-backed securities declined in a big way Losses were inflicted on the holders of mortgage-backed securities and invest-ment banks including the big financial giants such as Citibank and Bank of America

2.2.5 Role of Financial Engineering

The US financial sector is historically very vast and deep In the USA and other developed economies, financial engineering created financial derivatives and repackaged financial products whose risk levels were difficult to ascertain Such financial instruments were intermediated through global financial giants such as Citibank and were subsequently easily offloaded on other unsuspecting agents, largely because of the “too big to fail” theory, which is of course discredited now.The IMF estimated (see Sheng 2010) that as of 2007, total value of global financial assets comprising of (a) banking assets, (b) stock market capitaliza-tion and (c) bond market value amounted to 230 trillion US dollar, four times the global GDP, at 55 trillion US dollar By contrast, the total “notional” value of global derivatives amounted to 596 trillion US dollar roughly 11 times the world GDP and 2.6 times of underlying financial assets

Roche (2007) estimated that financial derivative products constituted 1012 % of global GDP and 80 % of liquidity; debt and asset-backed securities formed 129 %

of global GDP and 10 % of world liquidity; broad money was 115 % of global GDP and 9 % of world liquidity; and high-powered money was 8 % of world GDP and only 1 % of world liquidity

2.2.6 Problems in Assessment and Pricing of Risk

Can the risk levels of newly engineered financial products be measured and priced accurately by using the well-known Markowitz models used in the literature? Professor Persaud (2007) rightly comments that Value at Risk (VaR) models, used

in the literature for measuring and controlling risk, make the simplifying assumption that when an investor is buying or selling in the market, he is the only one doing so

In reality, when every market participant has more or less the same information and/

or the same model, an investor shall be selling with the herd and buying with the herd Such a behaviour will not diversify risk but will concentrate it Given this herd behaviour, when an investor, confronted with price volatility, plans to sell a security

to cut his losses, others do the same This results in a deeper cut in security prices The VaR approach therefore fails in assessing the risk and pricing it correctly With financial innovations, financial instruments turn to be more complicated As Sheng (2010) has noted that value of complex financial instruments with “embedded lever-age” can change very rapidly within days or even hours This makes assessment and pricing of risk of derivative products all the more difficult.

2.2.7 Governance Failure and/or Market Failure

The IMF (2009) attributes the global crisis primarily to the failure in governance,

to the extent the central banks focused on control of Consumer Price Index (CPI) inflation and lost sight of systemic financial stability At the board level of corpo-rate governance, internal audit and controls failed to check the risky and tainted portfolios External auditors and other consultants also seemed to have failed in discharging their duties The rating agencies which are normally expected to use their rating scales for correct assessment of risks also failed miserably

The ideology that unfettered markets are self-equilibrating was given a free run in the USA Loose monetary policy and market led growth between August

2003 and December 2007 created 8.25 million jobs in the USA and overall perity in other countries (see Sheng 2010) This created an euphoria about mar-ket efficiency and resulted in general complacency in regulatory policymaking and its enforcement Economists like Krugman (2009) attribute the crisis to failure of free market philosophy in which the world capitalist structure is rooted Stiglitz Commission (2010) in its report observed that the governments were deluded by market fundamentalism and forgot lessons of economic theory and historical expe-rience that financial markets need to be effectively regulated The Commission fur-ther observed that the case for financial deregulation has been pushed too much and this sector has become the main driver of economic activity Stiglitz (2012) pointed out that the root cause of the financial crisis of 2007 in the USA was increasing income inequality and weak effective demand Interventions by the Federal Reserve Board create demand bubbles which inevitably burst and create instability Taking a closer look at the 2007 crisis, Rajan (2010) also points out that increasing income inequality, resulting in weak effective demand, is a deep-rooted fault in the free market economy of the USA

pros-2.2.8 Laxity in Supervision and Regulation

of Financial Institutions

An important reason for the global financial crisis has been a number of weaknesses

in the supervisory and regulatory structure for financial institutions Lax supervisory oversight and relaxations in standards of prudential regulation have been cited widely

16 2 Genesis of the Global Financial Crisis

The IMF surveillance has come in for serious criticism Article IV Report of the IMF on Surveillance of the USA, dated 11 July 2007 said “Core commercial and investment banks are in a sound financial position and systemic risk appears low” (Report, page, 14) This type of surveillance report was filed by the supervi-sors of the IMF in spite of the fact that the severity of the subprime housing loan crisis in the USA was very much in the public domain The report also turned a blind eye to the systemic risks associated with huge current account imbalances across countries and gave a clean chit on that account as well

Regulators could not recognize systemic risks and due to lack of skills at their end could not measure risks of complex financial products in circulation For quite some time, off balance sheet activities of banks and operations of nonbanks or the so-called shadow banks have remained outside the purview of regulators Over time, financial institutions have been pushing the accounts of some of their activi-ties outside the regulatory boundaries and escaping from compliance of capital adequacy requirements This increased their exposure to risk

2.2.9 Regulatory Capture

Regulatory capture means the regulated exercising undue influence on the regulators

In the years immediately preceding the crisis, in advanced economies and in tant financial centres, rate of growth of the financial markets was disproportionately higher than that of the real sector The financial sector had grown faster in size, wealth and its influence over the media, relative to the nonfinancial sector Benefits

impor-of deregulation impor-of the financial sector were advocated frequently in the media There

is a view expressed by several responsible high-profile scholars (see Reddy 2010; Sheng 2010) that the central banks and other financial regulators in many advanced economies facilitated excess supply of financial services with high leverage Also, there is the widespread practice of former financial regulators being hired by finan-cial firms for lobbying with the current regulators in seeking relaxations

One may here raise the question of independence of central bank governors

as regulators vis-a-vis the government Alan Greenspan, while testifying before

a House Panel, admitted that in his long innings as the Chairman of Federal Reserve, he was often following “will of the Congress” and did “what I am sup-posed to do, not what I would like to” (see Scannell and Reddy 2008)

2.2.10 Financial Instability Hypothesis

Minsky (1986, 2008) advanced the view of financial instability as a cause of all economic crisis in his book The crux of the Minsky’s theory is that speculative investment bubbles are endogenous to financial markets In an upswing, corporate cash flow increases beyond what is needed to pay off debt, generating speculative

over-euphoria Soon debt exceeds what borrowers can pay off from current incoming revenue which results in financial crisis As a result of such bubbles, banks and lenders tighten credit supply and the economy contracts This slow movement of the financial system from stability to fragility is followed by the economic crisis Minsky calls it Financial Instability Hypothesis.

The key mechanism that pushes an economy into a crisis is accumulation of debt by three types of borrowers in the private sector These are “hedge borrowers”,

“speculative borrowers” and “ponzi borrowers” In the Minsky model of the cial system, hedge borrowers earn enough from their investments and pay back the loan and the interest For a speculative borrower, cash flow from investment can service the debt, but the speculative borrower must reborrow the principal Ponzi borrower borrows on the belief that appreciation of the value of the asset must

finan-be enough to refinance the debt, but such a borrower cannot pay back principal amount and the interest Only appreciation of asset values keeps such borrowers afloat When asset prices stop rising, speculative borrower can no longer refinance his principal even if interest can be paid back As with a line of dominoes, collapse

of speculative borrowers can bring down the hedge borrowers who are unable to find credit though they have made “apparently” sound investments

It is abundantly clear that there have been definite Minsky elements in the tial subprime lending crisis and also in the subsequent scarcity of overall liquidity

ini-2.2.11 The Financial Cycle Hypothesis—A BIS Perspective

Borio (2012) points out that “a financial system just does not allocate but also generates purchasing power” Through the global financial markets and input and output markets, the global economy is highly integrated Borio defines a financial cycle as “self reinforcing interactions between perceptions of value and risk, atti-tudes towards risk and financing constraints which translate into booms followed

by busts” Borio says that financial liberalization weakens financing constraints and it supports the self reinforcing interplay between perceptions of value and risk, risk attitudes and funding conditions

This typical BIS view clearly points towards financial liberalization resulting in easy availability of finance as the root cause of excessive risk-taking leading to a boom and ending in the inevitable bust Post facto it can be argued that excessive risk exposure of financial institutions was one of the important reasons behind the crisis

It is observed that financial institutions tend to over-expand their lending ing an upswing and tend to retrench it in the downturn When financial institutions lower their standards of accounting and regulation during the upswing and go in for excessive risk-taking, the result is deterioration in asset quality Rajan (2005) calls it “herd behaviour” Guttentag and Herring (1986) call it “disaster myopia”

dur-or shdur-ortsightedness in clearly seeing through the loss in high-return high-risk investments In fact, in the 2008 global crisis, if accounting standards and regula-tory mechanisms were strict, the rot could have been stemmed at the very outset

18 2 Genesis of the Global Financial Crisis

2.3 Global Impact of the Financial

Crisis—A Synoptic View

The impact of the global financial crisis was transmitted very fast across countries The first tremors were experienced through stock markets (for details see Chap

7 below) Portfolio capital inflows were reversed in a number of EMEs such as Brazil, Russia, India, South Africa and also Japan (see Table 2.2) Financial insti-tutions were in the dark about the proportion of tainted assets in each others’ portfolios and their exposure to risk This created scarcity of liquidity in national and international capital markets Demand for merchandise exports decelerated (see Table 2.3) With fall in export demand, rates of growth of GDP came down and turned negative in many countries including the advanced economies (see Table 2.4) The adverse impact of the crisis on aggregate demand in advanced economies was comprehensive The data in Table (2.5) show that gross fixed investment in USA, UK, Euro area and Japan turned negative in 2008 and 2009

Table 2.2 Portfolio Investment during the crisis (US$ billion)

Source IMF, International Financial Statistics, June 2010 “ na” is not available

crisis on export demand in

selected Asian economies

(Merchandise export growth

Rates of growth of private consumption in USA, UK, Euro area and Japan turned negative in 2009 In these countries, only public sector consumption increased dur-ing 2007 through 2009 because of fiscal stimuli administered in these economies.

2.4 Concluding Remarks

This chapter explains the origin and manifestation of the global financial crisis Following the dot-com bubble burst in 2001, the US Fed followed a policy of easy money in order to boost aggregate demand Current account deficit of the

Table 2.4 Rates of economic growth during the crisis

Source IMF, World Economic Outlook, various issues

Table 2.5 Impact of the crisis on aggregate demand in advanced economies (annual % change)

Source IMF, World Economic Outlook, April 2010

Country Private consumption Public consumption Gross fixed investment

2007 2008 2009 2007 2008 2009 2007 2008 2009 USA 2.7 −0.2 −0.6 1.4 3.0 1.8 −1.2 −3.6 −14.5

Euro Area 1.6 0.4 −1.1 2.3 2.1 2.2 4.8 −0.4 −11.1 Japan 1.6 −0.7 −1.0 1.5 0.3 1.6 −1.2 −2.6 −14.3

20 2 Genesis of the Global Financial Crisis

USA increased, financed as it was by investment of current account surpluses of other countries in US financial instruments Complying with the US government policy of providing cheap housing finance to the poor, banks reduced the margins

to almost zero level for housing loans Demand for houses increased, resulting

in rise in house prices This encouraged large-scale borrowing for housing in the subprime category Evolution of originate-to-distribute model of long-term lend-ing made it possible to spread the risks and unload these on unsuspecting inves-tors On top of this, the regulatory failures and flawed credit ratings handed down

by the rating agencies, resulted in underestimation and underpricing of risk Speculative investment in assets increased, creating bubbles in the real estate market Remaining too busy with controlling CPI inflation, central banks as reg-ulators, ignored the abnormal asset price behaviour In 2006, following increase

in Fed Funds Rate, house prices declined in the USA This triggered the crisis Foreclosures of loans and bank losses became rampant Given the externalities

in the financial sector, the crisis became contagious Due to the global linkages, transmission of the crisis across countries was fast and soon all the countries were engulfed in the crisis

References

Asian Development Bank, Asian Development Outlook, Various Issues

Borio C (2012) Financial cycle and macroeconomics: what have we learnt BIS Working Paper

395 December 2012

Greenspan A (2010) The crisis Brookings Papers Econ Act 1:201–246

Guttentag JM, Herring RJ (1986) Disaster myopia in international banking Essays Int Finance,

164 Princeton

International Monetary Fund (2009) World economic crisis and recovery

International Monetary Fund, World Economic Outlook, Various Issues

International Monetary Fund (2010) International financial statistics: CD rom data base

Kishore A, Patra MD, Partha R (2011) The global economic crisis through an Indian looking glass Sage Publications, Thousand Oaks

Krugman P (2009) How did economists got it so wrong New York Times, September 6

Mcconell MM, Perz-Quiros G (2000) Output fluctuations in the US: What has changed since early 1980’s Am Econ Rev 90:1464–1476

Minsky H (1986, 2008) Stabilising an unstable economy McGraw Hill, New York City

Persaud AD (2007) Risky business: Why the risk transfer model frequently championed by investment banks, credit rating agencies and regulators creates liquidity black holes London Business School Lecture, London

Rajan RG (2005) Greenspan era: lessons for the future A symposium of federal reserve board Jackson Hole August, Kansas City

Rajan RG (2010) Fault lines Collins Business

Reddy YV (2010) Global crisis, recession and uneven recovery Orient Black Swan

Reinhart CM, Rogoff KS (2009) This time is different—eight centuries of financial folly Princeton University Press, Princeton

Reserve Bank of India (2010) Global financial crisis and the Indian economy Report on Currency and Finance 2008–09

Romer CD (1999) Changes in business cycles: evidence and explanations J Econ Perspect 13:23–44

Rosen R (2007) The role of securitisation in mortgage lending Chicago Fed Lett, Chicago, USA Roche D (2007) The global monetary machine Wall Street J, 17 December

Scannell K, Reddy S (2008) Greenspan admits errors to hostile house panel Wall Street J 24 Sheng A (2010) From Asian to global financial crisis Cambridge University Press, Cambridge Shiller R (2007) Understanding recent trends in house prices and home ownership 2007 Jackson Hole Symposium, Kansas City Federal Reserve

Stiglitz J (2010) UN Commission Report, Black Swan

Stiglitz J (2012) The Price of Inequality, Norton

markets was an important factor responsible for the onset of global financial crisis

of 2008 This chapter takes up the analytical aspects of regulation of financial kets We start with the question—can unregulated financial firms deliver efficient outcomes and is efficiency ownership-neutral? A well-known micro-economic model of the theory of firm is referred to which shows why private ownership of

mar-a firm is efficient However, in this chmar-apter, it is mar-argued thmar-at this micro-theoretic result need not hold valid for financial firms due to special features of financial markets It is further argued that the model is irrelevant at the macro-level when the role of financial sector is considered in the context of economic growth in a developing economy We first digress on the role of public ownership and control

of financial institutions in India We explain how in India, this strategy has tated faster economic growth and promoted “inclusive growth” mainly through priority sector lending by banks Further, pursuing the policy of “prudential regu-lation” of banks and other financial institutions, Reserve Bank of India has suc-ceeded in maintaining financial stability in the Indian economy even during the global financial crisis Next, we focus on the asymmetric information between borrowers and lenders as an important feature which distinguishes financial mar-kets from nonfinancial markets Due to this distinctive feature, Walrasian equi-libria do not always hold in financial markets This results in market failures To make markets function efficiently, regulation is imperative Finally, negative exter-nalities of the financial markets are discussed The externalities make a solid case for treating financial markets differently and for regulating the financial markets

facili-Keywords Geneva report 2009 · Negative externalities of financial sector · Arrow–

Debreu assumptions · Supervision model · Prudential regulation · Asymmetric information · Priority sector lending

Chapter 3

Financial Liberalization, Economic

Development and Regulation

© Springer India 2015

B.L Pandit, The Global Financial Crisis and the Indian Economy,

DOI 10.1007/978-81-322-2395-5_3

3.1 Introduction

This chapter focuses on the analytics of regulation of the financial sector in a modern economy Starting with two well-known micro-theoretic models, our first question is, can an unregulated financial firm deliver the best outcomes and can efficiency level of firm be ownership-neutral? We next digress on the analytical aspects of role of finance in economic development Here, we refer to the role of public ownership and control of financial institutions in India This digression is necessary because an important aspect of regulating the financial sector is how best can these experiments in financial control and regulation speed up economic growth and also make economic growth more inclusive Problems of information asymmetry are referred to and how there would be inefficient outcomes in absence

of regulation Towards the end, the Geneva Report on World Economy No 11 (2009) on negative externalities of the financial sector and the consequent need for financial regulation is taken up

3.2 Micro-economic Issues in Regulating a Financial Firm

If the well-known Arrow–Debreu assumptions are satisfied in financial markets

as well, competitive equilibrium in these markets will be Pareto efficient The important implication is that for efficient outcomes there is no need to regulate financial markets In fact, in an Arrow–Debreu world, free markets will outper-form regulated markets Under these conditions, investment in stock markets will

be a fair game where prices of stocks reflect all information about the companies whose stocks are traded Major Arrow–Debreu assumptions are the existence of complete markets, availability of information without cost and zero uncertainty about the time path of variables An important question is that in the real world when Arrow–Debreu assumptions do not hold, can an unregulated financial sector deliver efficient outcomes

In the context of deregulation of the financial sector in India, Pandit (1992) raises a broader question—is efficiency of a firm ownership-neutral? (Here, we follow Pandit 1992 till the end of Sect 3.4) Our reference here is the supervi-sion model by Alchian and Demsetz (1972)—a path breaking piece of research related to theory of firm The authors show how private ownership of a firm will create strong incentives for high profits The authors focus attention on the prob-lem of incentives in case of joint production and control It is assumed that two workers form a partnership When inputs of the two workers are quantifiable, it

is possible to ensure that the workers work at the maximum level of efficiency This can be ensured by compensating one worker for his contribution to total out-put by paying him his input cost The residual output can be given to the other worker as his compensation However, if individual inputs cannot be metered say, due to increasing returns to scale, there can be a free rider problem Any one of the

two workers could work at a sub-optimal level and not get detected To resolve the free rider problem, the two workers hire a supervisor who is asked to supervise the inputs of the two proprietor-workers and ensure that the two are paid as per their inputs Will this ensure efficiency? Alchian and Demsetz raise the question of incentives and ask why should the supervisor monitor the workers efficiently? As long the supervisor gets a fixed wage, he has no incentive to monitor efficiently But if the supervisor gets the residue after paying the two workers, his monitor-ing will be more efficient Efficiency level of a firm is thus not ownership-neu-tral The important implication is that in case of privately owned firms, there are strong incentives to be organizationally more efficient than other forms of firm ownership

The famous theory of incomplete contracts (Coase 1937; Williamson 1975) also takes up the ownership-efficiency debate An economic organization involves some short-term and long-term contracts If these contracts were complete and/or

if transaction costs of modifying these contracts were zero, then any form of nomic organization would be as efficient as any other The four types of transac-tion costs are (a) legal costs of enforcing a contract, (b) monitoring costs, (c) costs

eco-on account of neco-onforesee-ability of the ceco-ontingencies and (d) costs of ceco-ontingen-cies, which though foreseeable, could not be included in the contract just because these were too many Under private control and ownership, the owner can exe-cute and monitor the contracts and also modify them in a situation of unforeseen contingencies In public ownership and control, external arbitration is required External arbitration involves additional costs Also, since the external arbitrator will not get the residue after all factor payments have been made, this type of arbi-tration need not be efficient

contingen-These two analytical models show that private ownership of an economic organization promotes efficiency Can these analytical considerations hold valid for financial sector firms—is an important issue Can an unregulated financial sector deliver efficient results in an underdeveloped country? In what ways are financial firms different from nonfinancial firms? Are there any externalities in the financial sector? These are important questions which will be discussed below So the verdict on the need for regulating the financial sector must await our interface with two issues First, the special features of transactions in financial markets; and next, a number of negative externalities of these markets The case for regulation is based on these two sets of considerations

3.3 Indian Experience in Public Ownership

of Financial Institutions—A Digression

Historical experience from other countries suggests that private ownership of financial institutions is associated with increase in their efficiency levels (see White 1983, 1984; Hall 1987) The experience in India is different Public sec-tor involvement and ownership of financial institutions in India has resulted in

3.2 Micro-economic Issues in Regulating a Financial Firm

remarkable growth of the financial sector Reports of Chakravarty Committee (1985) and Narasimham Committee (1991) have provided a detailed account

of the growth of the financial sector in India under public ownership However, Narasimham Committee in particular focused on the problems with public owner-ship of financial institutions Directed lending by banks under the directions from state authorities at times encroached upon the discretionary power of the bank man-agement in extending credit A low capital base of banks, deterioration in their cus-tomer service, lack of competitiveness and long delays in adopting new technology

by the Indian financial institutions were other problems facing the financial sector

In 1992 along with other economic reforms, a whole series of reforms were implemented in the Indian financial sector A number of new private sector banks and foreign banks were established, interest rates were decontrolled and all this was accompanied by important reforms in the stock market, foreign exchange market and government securities market RBI ensured that banks observe the capital adequacy ratios, quality of their loan portfolios do not deteriorate and over-all financial stability is maintained These regulatory measures constituted what is called “prudential regulation”

During the global financial crisis and in the post crisis period as well, dential regulation of the Indian financial sector by the RBI has been hailed as a success story Public sector banks along with other scheduled banks in India strengthened their capital base Most of these banks are now on the threshold of implementing Basel III norms In addition, the priority sector lending programme initiated by RBI for more than three decades has been successful in increasing the share of bank credit to small and cottage industries, agriculture and economi-cally weaker sections In its report, Chakravarty Committee (1985) lists tangible benefits of priority sector lending and in this respect hails the Indian public sector banking as “quite unique” Report of the Khusro Committee on Agricultural Credit (1990) says that without policy mandate from the government, commercial banks would not have moved so rapidly in providing agricultural credit RBI has also taken the lead in linking bank credit to micro-finance institutions This will in a large measure, facilitate “inclusive growth”

pru-It is very clear that Indian policy ethos is not rooted in the belief that free kets can always deliver the best outcome Policy makers in India have been care-fully steering the intermediary functions of public financial institutions and banks

mar-in particular, not only for the maximization of their profits, but also for the nomic growth and a better access to finance for lower income classes

eco-We have labelled the Indian experience in public ownership of financial tions as a digression The reason is that it does not fit into the neoclassical para-digm on which the incomplete contract model and the supervision model referred

institu-to above are based In such models, state ownership and control of firms are viewed as a serious distortion In the Indian case, policy makers have pioneered the growth of the financial sector, demarcated the priority areas and legislated on the broad contours of the policy frame and also implemented necessary reforms

In respect of the role of state in financial development, the World Bank seems

to have become wiser after the global financial crisis The Bank in its Report

(2013) emphasizes the role of state in financial development of an economy It says that the state needs to provide strong prudential regulation, ensure healthy competition and develop financial infrastructure The Bank visualizes that the state can help develop the domestic capital market, long-term financing and play an important role in health-care finance and pension

3.4 Financial Development, Liberalization

and Economic Growth

Economic growth requires the building-up of financial infrastructure for effective mobilization of surplus resources and their efficient deployment Money and the financial system have always been on the policy radar of policy makers so as to ensure that savers’ funds with the financial institutions are deployed in such a way

as to ensure safety, solvency and liquidity of the system Towards this end, tary authorities keep a watchful eye on the lending policy and quality of portfolios

mone-of financial institutions

Pioneering work by Mckinnon (1973) and Shaw (1973) has inspired interest

in the role of financial sector in economic development One can identify two prominent views The first is the “financial structuralist” view of Goldsmith (1966, 1969) which emphasizes that growth of financial institutions and diversification of financial instruments will stimulate savings, investment and economic growth.The second is the “financial repressionist” view pioneered by Ronald Mckinnon

It says that ceilings on nominal rates of interest in face of high and varying rates of inflation give rise to financial repression which acts as an impediment to financial deepening and thereby economic growth The policy implication is that interest rates should be decontrolled and financial markets be made free and competitive

Another view is credited to Taylor (1983), Van Wijnbergen (1982) and Buffie (1984) They argue that financial liberalization implies removal of restrictions on interest rates in the organized segment of an economy This will lead to a transfer of surplus resources from the informal sector, where the reserve ratio is as low as zero,

to the organized segment, where this ratio is high In this way, these economists argue, financial liberalization would reduce the total volume of productive lending.Such a view however neglects the role played by reserves of commercial banks The reserves apparently impounded by the central bank of a country are used to meet the immediate cash demands of banks and enable the depositors to make withdrawals from time and saving deposits Further as Kapur (1992) argues, reserves provide a seignorage gain to the government which can be used to lend newly created high powered money to the financial institutions In this way, this third view is completely rebutted

The structuralist view is that for purposes of increasing investment, savings in terms of financial assets are important An increase in the size of the financial sec-tor, ceteris peribus, leads to an increase in the amount of financial savings avail-able as investment funds Size of the financial sector, therefore, is directly related

3.3 Indian Experience in Public Ownership of Financial …

to the rate of capital formation Ronald Mckinnon advances the financial sionist view and puts forward what has come to be called “complementarity” hypothesis According to this school of thought, in a private sector-dominated self-financed economy, real cash balances serve as a conduit for capital formation In such an economy, accumulation of real cash balances must precede real capital formation Demand for real cash balances is, however, positively related to real rate of return on cash balances Capital formation is therefore an increasing func-tion of this rate of return Keeping real rates of interest low either by administra-tive fiat or as a result of high inflation amounts to “financial repression”—and this puts the clock back on real capital formation and growth Mckinnon concedes that beyond a certain limit “conduit effect” of high rates of interest on complementary savings and investment would be out weighed by “asset competing” effect leading

to the familiar negative impact of higher rate of interest on investment The sionist view can be explained with some rigour using the following equation:where

repres-(I/Y )∗ and (S/Y )∗ stand for desired investment and saving ratios;

(I/Y) is observed rate of investment;

R is the average rate of return on capital; and

(r − π ) e is the expected real rate of interest

Mckinnon argues that in financially repressed economies, investment nities are abundant so that desired rate of investment is always greater than the desired rate of savings Applying the minimum condition of Eq (3.1) given above, actual rate of investment is determined by desired rate of savings So substituting

opportu-Eq (3.3) into (3.1),

The restriction of d2> O implies that real cash balances and real capital formation are complementary—what has been called the “conduit effect” Once (r − π ) e rises above the equilibrium level, conduit effect is outweighed by the “asset competing” effect Therefore, rate of interest and investment are negatively related It should be pointed out here that under equilibrium conditions and when market imperfections are zero both in the real and financial sectors, all kinds of rates of return including the rate of interest converge to an equilibrium level The only kind of investment under these circumstances is the replacement investment Needless to say, such

a situation is not a real-world phenomenon In the de facto world, disequilibrium conditions and market imperfections are in abundance so that conduit effects and asset competing effects as described, above, can be easily observed

What kind of evidence is there is on financial repression and how is this nomenon to be gauged? The prevalence of low or negative ex ante real rates of interest is generally identified as financial repression Fisher equation (1930) is usually deployed to test for the prevalence of financial repression, making use of the concept of ex ante real rate of interest

phe-To determine the ex ante real rate of interest, the Fisher equation is deployed as follows:

where

Err = ex ante real rate of interest,

Nr = nominal rate of interest, (expected to prevail in future)

πe = expected rate of inflation—all nominal rates are in fact rates for future

To know Err one has to somehow find πe i.e expected rate of inflation This can

be done by using either a distributed lag model or a rational expectations model Once πe is estimated, ex ante real rate of interest is estimated using Eq (3.5) above Using this approach, Gupta (1984) has found that for Indian economy, there is evidence of financial repression during the sixties and the seventies Pandit (1991) however finds that despite negative real rates of interest, household sav-ings have remained steady, since savings are also motivated by factors other than a positive real rate of interest

How about the evidence on the structuralist view? How are the growth of the financial sector and that of the real sector related to each other? To this we turn now

It is generally agreed that financial intermediation through money and capital market institutions would make resource allocation more efficient The conven-tional wisdom is that these markets would float appropriate financial instruments catering to the varied risk-bearing capacities of almost all categories of investors The rates of return would be determined by forces of supply and demand in such a way that optimum levels of savings and investment are generated

Verifying the efficiency effect of financial intermediation however is a bit dicey Fry (1981) has tried using an indirect method Using marginal output capital ratio

as a proxy for allocative efficiency, he tests the following model for 12 Asian countries including India:

where

r = real rate of interest on deposits,

FX = foreign exchange receipts,

V = Output capital ratio,

M − M = excess of imports over their trend, and

Y = real national income

Maxwel Fry finds that for India and some other countries, coefficient for r is positive and statistically significant It implies that higher the real rate of interest,

higher would be the output capital ratio The inference drawn from the tion is that if real rates of interest are positive and increase through time, allocative efficiency proxied by output capital ratio and increases.

specifica-The mechanism behind the relationship between rate of interest and tal output capital ratio is postulated as follows:

incremen-where

K and L represent capital and labour, respectively;

ΔY /ΔL can be assumed to remain constant at the level of g Using a CES tion function L/K shall be a function of w/r In other words in Eq (3.7)

produc-where

w = wage rate

It may be noted here that in a situation of equilibrium, rental of capital is equal to

the rate of interest, so that r represents rate of interest as well In Eq (3.8), fore higher the r, higher would be V It should be pointed out here that this result

there-of Maxwel Fry is highly sensitive to the validity there-of the underlying assumptions

3.4.1 Financial Liberalization, Rate of Interest and Savings

In a stage of financial underdevelopment what Gurley and Shaw (1960) call mentary finance”, an economy is beset with the twin problems of inefficient use

“rudi-of resources and inadequate savings effort We have discussed above a model that relates the level of rate interest to efficiency in resource use We have however noted that this result is based on some strong assumptions Let us now examine how would financial intermediation and growth of the financial sector influence the savings effort Financial markets, in the first instance, reduce risks through pooling, otherwise involved in financial transactions This increases net returns and therefore, the magnitude of savings Second, Gurley and Shaw (1960) point out that financial development implies presence of an array of financial assets which stimulates savings

Conventional wisdom is that by removing ceilings on deposit rates, financial repression would be given a go by But the question can still be asked that fol-lowing deregulation of the financial sector, would increase in the rates of inter-est result in a net increase in savings? The rate of interest is no doubt generally considered an important influence on savings Its significance as a determinant of capital accumulation is explicitly recognized in the classical and neoclassical para-digms Given the level of income and prices and a quasi-concave utility function,

(3.7)

V = �Y /�K = (�Y /�L)/(�L/�K)

(3.8)

V = g/(�w/�r) or V = g(�r/�w)

the rational individual is seen to decide between present and future consumption Since the price ratio between present and future goods depends on the rate of interest and expected prices, current consumption decreases, (saving increases) as rate of interest rises If price stability does not hold, expected real rate of interest would fall by the expected rate of inflation, but the effect on savings would be similar

However, doubts have all along been expressed about the effectiveness of role

of rate of interest in influencing savings According to Alfred Marshall—“The greater the rate of gain from present sacrifice, the greater will be savings, but not always” (1890, p 315) Similarly, Knut Wicksell held that influence of rate of interest on savings was uncertain and ambiguous In spite of these reservations, classical economists asserted that the rate of interest is crucial in equilibrating sav-ings and investment

Keynes (1936) on the other hand said that it is the level of income rather than rate of interest that equilibrates savings and investment The current mainstream macroeconomic theory rooted in micro-foundations assumes lifetime maximiza-tion of utility For an individual, if inverse of elasticity of substitution (coefficient

of relative risk aversion) between change in consumption through different ods is given and real rate of interest equals the consumer’s rate of discount for expected utility, rate of interest is ineffective in influencing an individual’s lifetime consumption or savings At the aggregate level, the rate of interest is considered

peri-to be relevant only in allocating the available savings among competing uses, and the magnitude of savings being determined by income and other parameters (see Pandit 1991)

3.4.2 Financial Growth and Economic

Development—The Causality

Quite a few development economists hold the view that in a given economy, growth of the financial sector is an important determinant of the pace of economic development Fry (1980) among others has provided empirical support to this hypothesis This is done by using a multiple regression model in which growth in the real sector is regressed on some measures of development of financial sector However, such regression procedures do not give unambiguous results The direc-tion of causation can go either way In other words, the empirical results indicate two-way causation—growth of the financial sector causes economic development and economic development causes growth of the financial sector

To settle the controversy about the direction of causality, one could follow Patrick (1966) and distinguish between “supply leading” and “demand follow-ing” financial development In the “demand following” case, development of the financial sector and its deepening is a consequence of growth in the real sector In the “supply leading” case, growth of the financial sector precedes and is assumed

to facilitate thereby the growth of the real sector Hugh T Patrick advances the

3.4 Financial Development, Liberalization and Economic Growth