Posts this month
A blog on financial markets and their regulation
I have a column
in the Financial Express today on the anniversary of the
As we examine what we have learnt in the year since the collapse of
Lehman Brothers, the most important lesson for Indian policymakers is
that for macro risk management purposes, India must now be regarded as
having an open capital account.
From a micro-economic perspective, India has a plethora of exchange
controls that often force businesses to go through several contortions
to perform what would be very simple tasks in a completely open
capital account. But from a macro perspective, these regulations only
serve to impose some transaction costs and frictions in the
process. Exchange controls have ceased to be a barrier – they
are only a nuisance.
Large capital inflows and outflows do take place through three
important channels which are not subject to meaningful cap –
inward portfolio flows, outward foreign direct investment and external
commercial borrowing. In addition, foreign branches of Indian banks
and foreign affiliates of Indian companies have relatively
unrestricted access to global markets. Through all these channels,
Indian entities can build up large currency, liquidity and maturity
mismatches in foreign currency.
Each one of these global linkages was well known to perceptive
observers for a long time, but it took the Lehman collapse to
demonstrate the strength of these linkages taken together. Policy
makers were taken by surprise at the ferocity with which the storm in
global financial markets hit Indian markets.
We must now wake up to the reality that as in the case of East Asia
in 1997, the power of the corporate lobby has ensured that capital
controls have disappeared in substance while remaining deeply
entrenched in form. I believe that in India today, there are only
three effective capital controls that have macro consequences.
First, Indian resident individuals cannot easily borrow from
abroad. This ensured that Indian households did not have home loans in
Swiss francs and Japanese yen unlike several countries in Eastern
Europe. In India, the corporate sector has had the monopoly of
speculating on the currency carry trade. From a socio-political
perspective, this mitigated the impact of the crisis, though it is
doubtful whether the macro-economic consequences were important.
Second, Indian companies cannot borrow in rupees from foreigners as
easily as they can borrow in foreign currency. This contributed to
large corporate currency mismatches which were a huge source of
vulnerability during the Lehman crisis.
Third, it is difficult for foreigners to borrow rupees and
therefore speculation against the rupee is more effectively carried
out by Indians than by foreigners. Currency speculation by foreigners
typically takes the form of portfolio inflows and outflows. This has
potential macro prudential consequences, but it was not a material
factor in the Lehman episode.
This, therefore, is the first lesson from Lehman – Indian
regulators should now think of India as having an open capital account
while framing macro risk management policies.
The second lesson is that, as Mervyn King put it, global financial
institutions are global in their life, but national in their
death. Each nation has to take steps to ensure that failure of foreign
institutions does not disrupt its domestic markets.
The collapse or near collapse of several large US securities firms
did not pose any threat to the solvency of Indian equity markets
because of the margin requirements that we impose on FIIs. Under the
doctrine that each country buries its own dead, foreign creditors of a
bankrupt FII can lay claim to this collateral lying in India only if
there is something left over after the claims of Indian stock
exchanges and other Indian entities have been satisfied.
In this context, the existence of a large over the counter (OTC)
derivative market in India where foreign banks trade without posting
margins is a huge systemic risk. Lehman was a bit player in the
interest rate swap and other OTC markets in India. As such, its
collapse did not create a major disturbance. However, the failure of a
large foreign bank which is very active in the OTC market would be
very serious indeed.
It is absolutely imperative to move the OTC markets to centralised
clearing to eliminate this source of systemic risk.
The final lesson from Lehman is that the idea that emerging markets
are somehow very different from mature markets has been rudely
shaken. The most mature economies of the world have had an
“emerging market style” financial crisis. In the past, the
US did not think that it had anything to learn from crises in emerging
markets, and was therefore completely unprepared for what happened
after Lehman. In retrospect, the US belief in its own exceptionalism
was a colossal mistake.
India must also abandon any belief we might have in our
exceptionalism and learn from the experiences of other countries so
that we do not have to learn the same lessons at first hand.