Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Liquidity or solvency?

I wrote a column
in the Financial Express about the potential
solvency problems in the Indian financial sector today.

During the last month, Indian policymakers have responded with a
series of measures including cuts in interest rates and in cash
reserve ratios to improve liquidity in the financial sector. These
measures were certainly necessary, and I believe we would and should
get more such measures.

However, lurking behind the current liquidity problems is a deeper
problem of solvency that needs to be addressed quickly and
decisively. It appears to me that India is now where the US was a year
ago – the measures that we saw in India in October 2008 were broadly
similar to what the US and Europe undertook in August and September
2007. In terms of the deflation of the real estate bubble also, India
seems roughly where the US was a year ago.

One difference is that the US had early warning signals in the form
of house price futures and ABX indices that provided valuable
information on asset prices and credit quality. These measures
combined with stringent mark to market accounting enabled analysts to
make reasonable guesses about which financial institutions would be
hit severely and which were likely to remain solvent. In India, we do
not have these markets and the health of financial intermediaries has
become the subject matter of rumours and gossip rather than reasoned

The only market signal of solvency that is available in India is
the stock price. The majority of the 17 listed private sector banks
for which information is available in the CMIE database are today
quoting at a price to book ratio of 1.0 or below which is a crude
signal of potential solvency issues. Of the same set of 17 banks, only
two traded at a price to book of 1.0 or below at the beginning of last

At this point of time, accounting data is not quite reliable
because the carrying values of assets do not reflect their fair
value. This is a serious problem for banks and non-bank finance
companies that have exposures to real estate and to other stressed
borrowers. It is also difficult to assess the exposure of banks to
troubled non-bank finance companies and weak banks. But the problem is
much wider and extends also to debt mutual funds that have exposures
to real estate, banks and non-bank finance companies.

Mutual fund net asset values have become unreliable for two
reasons. First in respect of short-term financial instruments, mutual
funds have the ability to carry the assets at amortised cost rather
than market value. Second, some of the really distressed paper does
not trade at all and this makes the valuation judgmental. SEBI has
allowed greater freedom to mutual funds to mark down the valuation of
debt paper by using higher discount rates rather than the rating based
spreads that were mandated in the past. This is a good step, but its
usefulness depends on the voluntary decisions by funds to mark down
the net asset values of their funds.

Solvency problems should be addressed at the earliest possible
stage because the longer the corrective action is delayed, the greater
the eventual costs of solving the problem. It is necessary to move
swiftly to triage financial intermediaries into three categories:
those that are financially sound, those that need to be recapitalised
or restructured and those that should be shut down. This requires
price discovery for stressed assets. Indian policy makers should
therefore move swiftly to put in place structures similar to what the
Americans and Europeans have done in the last couple of months to
restore the health of the financial sector.

A strong financial sector is essential to confront the challenges
of a slowing world economy. Unlike during the Asian crisis, this time,
emerging economies face a shrinking world market for their
exports. The threat of a “beggar thy neighbour” policy of
competitive currency depreciation is very real.

The Korean won today trades lower than it did as it was emerging
out of the Asian crisis in 1999. The news coming out of China is also
quite bad, and the Chinese seem determined to boost their economy
through all possible measures. At some stage, these measures will
probably include a depreciation of their currency. To make matters
worse, many East European currencies are also in danger of going into
free fall, and some of them could be formidable competitors in the IT
and BPO industries despite a language handicap.

All of this could make the economic slowdown even worse than it
would be otherwise. A slowing economy increases non-performing assets
and induces financial sector weakness that in turn impacts credit
availability and weakens the economy further. The way to stop this
vicious spiral is through aggressive recapitalisation and
restructuring of the financial sector. We have a window of a few
months to do this before India enters election mode.


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