Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Wed, 12 Nov 2008

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 analysis.

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 year.

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.

Posted at 06:00 on Wed, 12 Nov 2008     5 comments     permanent link


Lee wrote on Wed, 12 Nov 2008 21:48

Re: Liquidity or solvency? (Lee's Dhaba)

I am having difficulty with your thesis comparing India with US and Europe...with regard to Banks and Real Estate. First: Mortgages represent nearly 65% of the housing stock in the USA, similar in UK and much lower in Europe. In India, mortgages represent less than 10% of the housing stock.

Second: The credit worthiness of borrowers in India is higher quality than in the USA and the loan/value ratios much lower. Even after a significant correction in home prices in India.

Third: There has not been a global rush to finance mortgages in India by foreign capital through the securitization route. There has been real purchase of real estate by foreigners. So credit and leverage have not been blown up beyond tolerance limits.

Fourth: Given the relative size of the levered real estate market to the overall Indian market, even a complete collapse would not threaten the banking system in India...this is not true of the United States and UK.

I do not believe the Indian growth story is dependent on DLF or Unitech or one or two banks. The story is dependent on the growth of the middle class...wasting money recapitalizing banks which may collapse due to over exposure to Commercial real estate is a waste of good money.

Let us stay focused on the overall economy and growth.

I find your research enlightening but in this case your conclusions are off the mark.

Gaurav wrote on Wed, 12 Nov 2008 21:50

Re: Liquidity or solvency?

Prof, A lot of people are under the misconception that India is better than US and West because it is relatively underlevered. Could you remind them in your next article that leverage is determined by the denominator (cash flows), and not by the numerator (actual debt). Why RBI still insists that growth will be 7.5% in FY09 growth is beyond my understanding - first, they risk proven wrong soon and second it is almost a meaningless number, because the first half that is now history grew at 7.8% . They need to look at FY10. RBI needs to be proactive, and to do that they first need to stop fooling everyone (and possibly themselves). It is almost like a sell side analyst reiterating his/her price target when the stock falls by 50%.

Anonymous1 wrote on Wed, 26 Nov 2008 18:20