Global crisis likely to hurt Indian banks’ overseas ops
With multinational banks cutting down on inter-bank exposure, bank chiefs in India are concerned that foreign lenders may not roll over the line of credit granted to the overseas offices of Indian banks
Sangita Mehta MUMBAI
INDIAN banks fear that worsening of the global credit crunch in the last fortnight will hit their international operations. With multinational banks cutting down on inter-bank exposure, bank chiefs in India fear that foreign lenders may not roll over lines of credit granted to their overseas offices.
These concerns were expressed by Indian banks in a recent meeting with RBI. Bank chiefs are also apprehensive because deposits in the overseas office have dipped in the past fortnight. “In this context, we have asked help from RBI for a contingency plan,” said a senior bank chief present in the meeting. The meeting was attended by RBI’s deputy governor Rakesh Mohan and CEOs of Standard Chartered Bank, HSBC, ICICI Bank, State Bank of India, Union Bank of India, IDBI Bank, Allahabad Bank, Syndicate Bank and Jammu & Kashmir Bank. During the meeting, RBI also assessed the liquidity position of banks and made enquiries regarding credit offtake.
Most Indian banks with an overseas presence have a reciprocal line of credit with their foreign counterpart. Under this reciprocal arrangement, the Indian bank lends to the foreign bank’s branch here while the foreign bank extends similar support to the Indian bank’s overseas arm.
The worsening of the global credit crunch is apparent in the dollar shortage, which has led to inter-bank rates shooting up in financial centres. In fact, in overseas markets like the US and the UK, inter-bank lending had come down sharply due to the shortage cash. Sources said Indian banks have extended loans on expectations that lines of credit by foreign banks would be rolled over on maturity. “However, if those lines, which are due in the very near future, do not get rolled over, banks’ overseas office may face asset-liability mismatch,” said a bank chief.
In such a situation, Indian banks will to swap rupees into dollars in the domestic market to support their overseas operations. “However, foreign banks with Indian operations may suffer higher liquidity problems than Indian banks with foreign operations,” said a treasury head.
Senior bankers have indicated that high credit demand has come from fertilisers, oil and infrastructure companies. Some bankers have also urged RBI to release liquidity in the system by lowering the 9% cash reserve ratio — a slice of deposits that banks maintain with RBI, and the 25% statutory liquidity ratio — gilt that banks have to hold on their books.
“We have asked RBI to reduce CRR and SLR at least for infrastructure loans and allow us to issue tax-free bonds for funding such projects,” pointed out a banker.
The end of the beginning
Risk aversion in financial markets means that emerging economy companies will face problems in rolling over $111 billion of debt falling due over the next year, says Swaminathan S Anklesaria Aiyar
THE US administration and Congress are creating a $700 billion rescue package to resolve the worst financial crisis since the Great Depression. Will it stabilise the US and world economies?
For an answer, remember Winston Churchill’s words in 1942: “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
The financial crunch that began in mid-2007 has worsened so dramatically that all politicians have agreed to a government rescue. In that sense, we have reached the end of the beginning of the current drama.
But two major chapters are yet to unfold. The first relates to problems that will hamstring, and maybe doom, the rescue. The second relates to the global recession that has probably started, and will hit countries like India far harder than mere Wall Street turmoil.
Right-wing analysts sneer that the US has created the world’s biggest sovereign wealth fund. This is skewed badly towards the financial sector alone. But just wait: opportunities for diversification are at hand, since the Big Three auto giants also seek rescues. And, as the recession bites, further opportunities will arise to rescue giants in retail and technology!
Politicians are uninterested in criticism that the rescue will encourage a repetition of profligacy and excessive risk-taking in the future. Right now, they want to appear as saviours, not disciplinarians.
Many legislators resent being asked to sign a blank cheque for $700 billion, and want to attach all sorts of conditions. But populist pressure will probably ensure rapid legislation with minimal conditions.
Yet that will not end the saga. A thousand thorny political issues will follow. Who will decide which securities are toxic and worthy of rescue? The treasury alone? Should one authority have so much power and discretion?
Will the treasury buy only mortgage securities? Or also derivatives such as credit default swaps? What about credit card defaults, which loom ahead? Or corporate bond defaults?
How many companies will be allowed to go bust before the treasury saves others by declaring a new set of instruments to be toxic? What checks and balances are needed on enormous discretionary power over $700 billion, that can make or break fortunes, and can be manipulated by old-boy networks and lobbyists?
At what price will the government buy toxic securities? Merrill Lynch sold some mortgage-backed securities at just 22 cents in the dollar. Will treasury offer more to others? If so why? In setting prices, the scope for fraud, collusion and suspicion is huge. Will vulture funds, which have already bought distressed securities for a song, be allowed to resell these at higher “rescue prices” to the treasury?
Which fund managers will be appointed to manage the huge assets taken over? Why, they will be drawn from the very financial class that has just disgraced itself! The potential conflicts of interest are vast.
Maybe all these issues will be overcome. But a significant risk remains that the rescue will be hamstrung by allegations of fraud and collusion.
MUCH greater is the risk that the financial crisis will keep worsening. Professor Nouri-el Roubini was the first to predict massive carnage. He now estimates bad loans at $2 trillion, large enough to overwhelm the rescue package. Roubini correctly predicted the fall of the shadow financial sector — lightly-regulated financial entities that avoided the tight supervision imposed on banks, such as off-balance sheet SIVs (special investment vehicles), leveraged investment banks, and leveraged hedge funds. He now predicts that the carnage will spread to hedge funds, for whom the rescue package makes no provision.
Meanwhile risk is set to multiply in derivatives. Most at risk are credit default swaps (CDS), which insure against bond and loan default. The size of the CDS market is $62 trillion, four times the GDP of the US! After netting out offsetting transactions, the balance CDS risk is around a trillion dollars.
The future of the CDS market depends on the real economy. A major recession is now unavoidable, and this will mean more corporate and banking defaults. Some experts think at least 4,000 US banks will go bust. Recessions typically lead to a 10% default on corporate bonds. The default rate last year was only 1.8%. So a surge in defaults is coming, and CDS markets are trembling.
Despite a credit crunch starting with the bursting of the US housing bubble 13 months ago, the US and world economy have remained remarkably resilient so far. GDP growth in the US was 3.3% in the last quarter on an annualised basis. The Indian and Chinese economies have slowed, but only modestly.
What explains this resilience? Well, US monetary and fiscal policies have flooded the country — and the world — with dollars to try and stave off recession. The Fed has given financial markets unprecedented access to liquidity, and cut interest rates to just 2%. US Congress has legislated $140 billion in cheques mailed to consumers, just to increase purchasing power. The trade deficit remains high, and is paid for by issuing dollars to the world. This Niagara of dollars has kept purchasing power (and GDP) rising despite the credit crunch.
But a major recession is now unavoidable. Japan and some European countries suffered negative growth in the last quarter, and the US may already be in recession this quarter. Emerging markets are all slowing down.
The credit crunch means that fresh financing of both consumers and industry is going to slow down, in the US and globally. Risk aversion in financial markets means that emerging economy companies will face problems in rolling over $111 billion of debt falling due over the next year. Several companies that had banked on cheap loans and high IPO prices now find doors closed. The problem may persist through 2009-10.
So, the greatest financial crisis since the Great Depression has a long way to go yet. And the journey may be long and painful.
The crisis in the global financial markets holds several lessons for policy reform of the Indian financial system. It would be sad, if the crisis made us more complacent. Our banks do not have global size; our markets do not have adequate products; our institutional investors do not hold diversified portfolios; these portfolios are not actively managed; and growth in credit and free capital flows are something we need quite desperately. Despite extensive work and road maps, our financial sector reforms are seriously delayed. This crisis should prod us ahead, given the valuable lessons that will play out.
Product Structures
When an economy adapts a market-led approach to financing assets, the assumption is that risks are priced, spliced, and distributed across several entities. Securitisation of home loans, the subsequent structures and swaps were based on this assumption. The crash in asset values across several balance sheets, when housing prices fell steeply, tests this assumption. Several of our local financial institutions have not even begun to experiment with new product structures. A better understanding of risk will emerge from this crisis and more choices about how we could deal with risks in product structures.
Bail Outs
Proponents of capitalism swear by creative destruction. The cyclical corrections in markets are seen as the much-needed purging of excesses. The events in the US show that the choice between allowing failure as a natural consequence and bailing out a failing entity, is not a simple one to make. The modified capitalism of bail-out based on judgment is something that appeals to our psyche, but is currently applied selectively (Would the bail-out have been the same, if UTI were in the private sector, for example?). Our handling of IFCI illustrates our muddled thinking. Rather than fantasise a world without crisis, we need ability and willingness for swift action.
OTC Vs Exchange-traded
The large leveraged positions in derivatives, which lost value rapidly and triggered losses for several players, is at the centre of the current meltdown. But much of the risk came from the structure and not the product itself. The credit default swaps were not exchange-traded products, but over-the-counter (OTC). This meant that the counter-party risks were high; there was no margining based on open positions; and valuation and liquidity were questionable. India’s exchange-traded currency contract is a great first step. Introducing exchange-traded products in the interest rate and credit markets is the next crucial step for us.
Mark-to Market
The drop in value of assets in the balance sheets of investment banks, banks, investors and others, has led to the plea that ‘marking-to-market’ might not be the correct thing to do. Several are asking for assets to be shown at costs, and for a write-off of the value, after manifestation of risk, through accounting entries in the income statement. This thinking assumes that a risk, unless accounted for, does not exist. We in India subscribe to this view, allowing banks to value assets depending on how they are classified, and keeping most institutional portfolios (like provident funds) at cost. We need alignment with global standards that will emerge.
Regulation
Every crisis creates spill-over of risks from one segment to another. The defaults of global investment banks have spread into money markets. The takeover and conversion of investment banks by commercial banks, creates dual regulation by the Fed and the SEC. Back in India, we have regulators for each type of institution, with limited understanding of the commonalities in functions they perform and the markets they operate in. We need unification of regulation, as has been recommended for a very long time in financial sector reforms.
Size
We may be fooled into thinking that only large-sized entities can extend themselves. The financial sector in India is badly compartmentalised. Several companies clamour to create new banks; many small banks hope to be taken over at good value; some thousands NBFCs operate with limited supervision; existing banks are constrained from expansion; and we are loathe to allow foreign banks in. The growth of multiple small entities, working in the credit markets in their own ways, creates risks and regulatory challenges, about which we may not even know. We need to implement reforms that enable larger institutions, that are easier to supervise. Regulatory and policy resistance to such change, remains a puzzle.
Leverage
Leverage is seen as the villain of the piece. As asset sizes shrink, spreads increase and lenders shy away, the credit markets in the US will shrink. This may lead US into a recession, as much of their growth is credit-driven. Without the advantages of leverage, it is not possible to expand in size, but this lesson may be lost on several regimes like India, which traditionally discourage borrowing. In an economy that needs capital to grow to its potential, we need more long term borrowing options. If we picked up only the disadvantages of leverage, and shrunk back, we might scuttle growth
Currency
Several economies including India, have built up large reserves as a defence mechanism. They also practice various forms of currency management. They will be impacted by the global recession and dollar depreciation.
The current crisis will have its impact on the currency markets. Last time around, we were able to claim ‘insulation’ due to lack of currency convertibility. Given the size of our resources, and the depreciation of our currency, we may need to act. Our stance on global capital flows, capital controls and currency will need review.
The lessons from this crisis will flow in over the time it takes to spill over, initiate another round of regulatory reforms, and create global realignment of macro-strategies. It is up to us to use the opportunity to implement long overdue reform of our systems, structures and institutions.
When Harshad Mehta and Ketan Parekh used money from the debt markets to play up stocks, they took the markets and a few players down with them — tiny games played over two to three years. When large investment banks use money from the wholesale debt markets for nearly a decade, and go belly up when their favourite bets crash, they can bring a whole nation to its knees. If that nation is as big and influential as the US, voyeurs may rejoice, but pragmatists will worry.
The dominance of investment banks in America’s financial system has been hailed as the triumph of markets over men; about how innovation can expand the pie; and about how credit can swell the size of an economy. Their collapse represents a tectonic shift in the way the financial world will work, going forward. All the votaries of free markets and capitalism will know market-led wind down happens. The confusion about choosing between freedom and control will take a while to settle.
Investment Banks
After the crises of 1930s, the Glass Steagall Act was promulgated, separating commercial banks that accepted public deposits from investment banks that specialised in advisory and broking business. Investment banks spearheaded most of what we now know as components of the modern financial system--- capital market funding of businesses, innovative financial products, structures for reviving and expanding businesses, and so on. They also were large brokers and dealers in equity, debt and derivatives.
Competition
In 1999, the Glass-Steagull Act was thrown out. Deposit-taking banks were allowed to indulge in financial advisory and compete with investment banks. Competition cut into the margins of investment banks. Their trading desks became bigger, and their intellectual prowess was used in creating new products and structures and selling them off to clients. The size of their trading books doubled to $15 trillion since 1999.
Funding
Investment banks were experts in raising institutional money. So when they needed money to back their trades, it was not a difficult deal. Wholesale debt markets were only eager to lend to them, for the short term, to fund assets that were routinely churned and traded. The ability of investment banks to create new products and structures only increased the willing lenders and that included banks.
Engineering
The most important condition for the investment bank, when it used borrowed money to buy assets, was that the return from trading the assets was higher than the borrowing rate. Thanks to Alan Greenspan and the incredulously low Fed rates of the early 2000s, funds were easy to come by. But the assets still carried risks. So investment banks bought only those assets that were liquid and easy to sell off in the markets. Where the assets were not liquid, they created liquidity through financial engineering.
Layering
For example, a 15-year home loan made by a bank, is not liquid. But the cash flows due from the loan can be re-packaged and sold off to another entity like mortgaged backed securities. Investment banks would create new structures with these cash flows, re-arranging them into collateralised debt obligations, and sell them off to others. They can also repackage the risks into newer instruments like credit default swaps. The risk on the original home loan is now spread across at least four different balance sheets. This exercise was expected to reduce the risk of the original loan, enabling a fast growth in all the products that were engineered.
Leveraging
Since the interest rate was low, and housing prices were going up, all participants extended themselves. Households borrowed more than they needed, banks lent more than they could, investment banks held and traded too much of the structured products, and investors bought more and more in the hope of profit. This extension created sub-prime loans, where households could borrow even if they had no income, no papers, no credit rating, or payment record. They only needed to use the money to buy a house, whose price went up.
Bubble
As everyone’s books blew out of proportion, the bubble burst. When housing prices crashed, the domino effect came into play. Across the balance sheets that the loans were spread into, all values dropped. And panicky investment banks tried to sell off what they held, and found that the market had become illiquid. When they wanted to borrow to keep the assets, the rates had moved up, and money was not available. They began to sell in panic what they had, and prices only dropped even further.
Bust
Investment banks now faced a situation where the assets they held were worth less than the amount they had borrowed. So, they went around asking for capital. At the peak of the boom, many of them had $40 of borrowings for every dollar of capital. Now, when the value of the assets fell off to say $20 or less, there was no money to repay the borrowings, unless they got equity capital. Equity capital was not forthcoming because the value of the assets was dropping by the day. The result: they simply went belly up.
Bail out
So what did regulators do? They reduced interest rates so that money would be available to borrow and hold up the assets. But markets only tightened from further fears of default. Money was handed out, through a special window opened for investment banks by the US Fed. When that would not do, there was bailout by taking on the bad assets. Now Central banks across countries have come together to create a $247 billion fund to provide credit where it is needed, to stop further failures. (Illustration: more money pumped into toxic assets)
Fear Factor
Since fear of failures grip the markets, credit has dried out. As value of assets held by large players has shrunk, the market itself has shrunk. Money is difficult to get. Loan is the new bad word and no one wants to lend money to fund risky assets. Safe havens like money market funds have begun to lose value, and investors are holding back cash, worsening the liquidity crunch.
What Now?
The US already runs a $3 trillion deficit. Adding billions of dollars of bailout money to this is a sure fire way to trigger a full blown recession. The US recession is also likely to draw others along with it. The weakening of the US dollar may then be inevitable in such a situation. Investors face the double whammy of default and depreciating dollar. The crisis in the credit markets shows all signs of extending into the currency markets.
Plan of Action
Everyone seems to blame regulation now. Since commercial banks are more closely regulated and have strict capital adequacy norms, the clamour is to close down or merge investment banks into commercial banks. That may shrink the size of the financial markets as we now know, significantly. The entire edifice of risk-taking and thus expanding capital markets would crumble and we will return to loan officers from market-driven risk takers.
Before we heave a sigh of relief about how we may not be affected so much, we need to worry about global headwinds that will affect markets across the world. We may still keep our jobs, continue our SIPs and pay our EMIs. But the lessons in this crisis are for macro managers of the economy. If we have to be plan for a longer run, the lessons from this crisis can help us ponder over our policy and institution-building choices.
Could we catch the American flu? The broad numbers would say it is highly likely. Of every Rs 100 India made in 2007-08, about Rs 30 were earned abroad by selling our wares and skills or by the proverbial Prodigal Son sending home a fat dollar cheque. And for the same Rs 100, foreigners lent us Rs 4 and bought another Rs 4.50 worth of Indian companies, banks and real estate. All this adds up to a fairly significant exposure to even the most pacific bug emanating from the US financial system. Yet the chances of India coming down with a full-blown viral attack seem remote.
Here’s why. India’s $1 trillion economy exported $158 billion of goods in the previous financial year, slightly under a third each to the US, the EU and China. In the event of the financial meltdown spreading to the broader US economy, the other two could hold out a while longer, particularly those guys across the Great Wall, who in the course of this year will become the biggest buyers of our stuff. And most of this ‘stuff’ is pretty basic: gems, tea, textiles — commodities, led by oil, which are traversing the upper reaches of the business cycle while the global capital market flounders. This year’s $200 billion merchandise export target looks a bit of a stretch under the circumstances.
When it comes to selling our skills though (the only one that matters being our ability to write code), the terrain looks decidedly tricky. Four out of every five of the $40 billion we earned as software exports last year came in from the US, half of which was for services rendered to American banks, brokerage houses and insurance companies. As more of these buckle, Indian software services exports look wobbly this year.
Finally, the Prodigal Son. It’s not love alone for the homestead that sees him sending across a staggering $42 billion. India still offers the best return on investment to its diaspora. Half a decade of the economy growing at about 9 per cent has spawned fabulous profits for India Inc. There’s no reason why this fact should escape the attention of the maid in Muscat or the doctor in Devon. As long as they have something to save, it makes sense for them to remit it back home.
What India earns from the world then is relatively inured, the immediate fallout of the sub-prime crisis in the US limited to software service exports. Not so with what the world invests in or lends India. In just over a week since Lehman Brothers and Merrill Lynch went belly up, portfolio investors have pulled $2 billion out of India. And the cheap foreign loans that were driving a turbo-charged economy have seized up.
Ever since the world recovered from the dotcom bust and found a new mantra —emerging markets — foreign investment, both direct and financial, has been chasing an India story that delivers profits in the region of 25 per cent a year. Beginning as a trickle, financial investors poured $29 billion into our bourses last year. The tide has since turned. Financial investors have sold $9 billion of Indian stock since the beginning of 2008 and with the curtains coming down on a hedonistic era of investment banking, we can safely expect more billions to move out at the click of a jumpy mouse.
Foreign direct investment, at $25 billion last year, drives in a slower lane where sudden U-turns are difficult. Left to itself, the Indian economy was heading for a slowdown, but hardly of an order that warrants a rethink by foreign companies planning to buy plants and set up offices here.
Indians are now saving and investing close to a third of their income. Nearly half this investment is being made by local companies, which borrowed $22 billion overseas last year. Typically, Indian companies wanting to expand operations in the recent past first sold some stock to an investor, mainly an investment bank, and then leveraged the sale to raise debt, preferably overseas, which works out far cheaper. This tap is now dry. With private equity running scared, the second-stage fund-raising through loans is no longer an option, as a clutch of late-comers discovered much to their chagrin earlier this year. Again, India Inc financed nearly all its foreign acquisitions through leveraged buyouts and the predators have to stay at home till last season’s fashion revives.
This scenario offers meagre policy options. There is precious little any government can do to keep hot money from flowing out. But it can very well open the doors wider for the dollars to flow in. In the short term, recently imposed restrictions on borrowing abroad by Indian companies may need to be lifted. Some already have, we should see more as the crisis plays out.
Given its relative stability, FDI is always more welcome than portfolio investment. Yet restrictions remain. A medium-term solution would require political will to dismantle the steeplechase that is our FDI policy today.
The proximate risks of the roiling global financial market are to the two principal scriptwriters of the India story: companies in general and the software industry in particular. If they were to lose their lustre, it could be a long wait for the next star to appear in the East.
Popular culture has an uncanny way of reflecting life. Coldplay is the name of an alternative British rock band. The group’s latest album that bears the unusual subtitle Death and all his friends has become a huge success. It has hit the top of the charts in no less than 28 countries. The opening lines of the title track might as well be about the current state of a mythical character named Uncle Sam on the other side of the Atlantic Ocean: “I used to rule the world/Seas would rise when I gave the word/Now in the morning I sleep alone/Sweep the streets I used to own…”
Columnist for the New York Times Roger Cohen quoted the lines of this song and evocatively wrote: “When you trade pieces of paper for other pieces of paper instead of trading them for real things, one day someone wakes up and realises the paper’s worth nothing.” Therein lies the core of the biggest crisis faced by international capitalism for the last 75 years, to be precise since the beginning of World War II.
It’s no red-rag-waving leftist scumbag who compared the present crisis in the US economy to the Great Depression that started in Wall Street in 1929 and led to a worldwide recession that lasted almost a decade. This comparison was made in April by a great friend of the US, the International Monetary Fund (IMF) that was set up in Bretton Woods the year after the War ended in 1945, ostensibly to foster global economic stability and help countries facing financial crises.
The IMF made this comparison more than four months before Black Monday (September 15) and the week that saw the Federal Reserve and Treasury Department spend close to India’s annual national income ($1 trillion) to bail out a clutch of financial bigwigs bearing now very familiar names — Freddie, Fannie, Lehman and Merrill, not to mention the world’s largest insurance company, American International Group.
A working paper published in March by Claudio Borio of the Bank for International Settlements, based in Switzerland, pointed out that the “unfolding financial turmoil in mature economies…regardless of its future evolution…already threatens to become one of the defining economic moments of the 21st century”. He added: “The turmoil is best seen as a natural result of a prolonged period of generalised and aggressive risk-taking, which happened to have the sub-prime market at its epicentre. In other words, it represents the archetypal example of financial instability with potentially serious macroeconomic consequences…”
The BIS has estimated that the derivatives trade has grown five times between 2002 and 2007 to touch a level in excess of $500 trillion — this ‘shadow’ economy is ten times larger than the ‘real’ economy of the world and five times bigger than the volume of trade in securities that are backed by tangible assets. Derivatives are financial instruments that ‘derive’ their values from other financial instruments — the classic case of paper being traded for more paper.
The US has less than five per cent of the world’s population. It consumes over a quarter of the planet’s resources. Nobel laureate Joseph Stiglitz (who was economic advisor to Bill Clinton) wrote more than a year ago that the principal reason for the underlying volatility in international capital movements is the huge deficit of the US, a country that was borrowing a stupendous amount of $3 billion (or Rs 13,500 crore at current exchange rates) from the rest of the world every day. Two-thirds of this money comes from developing countries. Simply put, the rest of the world has been saving so that American citizens can splurge beyond their means and croon: “I owe, I owe. Therefore, to work I go”.
Many are still unaware of how iniquitous the world’s financial system is. The US has invested in China and India less than half of what these two countries have invested in that country. The bubble had to burst. It has. In January 1981, in his first public speech after becoming President of the US, Ronald Reagan famously said: “…the government is not the solution to our problem; government is the problem”. His words have come back to haunt a country where home prices have crashed by a fifth over a year and job losses have mounted.
New York Governor David A. Paterson stated on September 15: “Approximately 11,000 jobs were lost in New York’s finance and insurance sectors between July 2007 and July 2008. More recent data will likely show this number continues to grow and based on past data, approximately 40,000 jobs in the financial services industry in the New York City area can be expected to be lost in the current downturn. All told, approximately 120,000 jobs may ultimately be directly and indirectly affected as a result of financial sector turmoil.”
Now that in the last few months of its existence, the George W. Bush government has ‘socialised’ the losses of many of his country’s corporate captains, it is worth wondering why the incumbent regime in India is so keen to engage with Washington. Prime Minister Manmohan Singh unlearnt his socialism after he advised Indira Gandhi. During his trip to the White House, the economist-politician may desist from offering his words of wisdom on how the US economy can be repaired, if at all.
But Coldplay would have no such hesitation telling Bush Jr: “Revolutionaries wait/For my head on a silver plate/Just a puppet on a lonely string/Oh who would ever want to be king?”
Crisis? IT’s fine with us
Goldman, Morgan’s switch to banks means more biz to India
Chandra Ranganathan CHENNAI
WHEN Goldman Sachs and Morgan Stanley gave up their independent investment banking status, it gave reason for Indian IT vendors to smile. For, more regulations — as a commercial bank — could mean more business for software service providers. While the collapse of the other investment banks in the past few months sent jitters among the software vendors in India, government control of Goldman Sachs and Morgan Stanley gave the Indian IT some reasons to cheer.
Because, morphing into a full-fledged bank not only implies greater access to funds but also more regulation. And tighter regulation could mean tweaking their existing technology by adding more software and processes. They would have to adopt systems in areas such as retail banking, consumer banking, cards and corporate banking.
“It’s an opportunity for IT companies because conversion to traditional banks means they need to add a lot of processes, new functions and areas,” said Frost & Sullivan deputy director-ICT practice Kaustubh Dhavse.
Another analyst, who did not want to be named said, “It’s a bit too early to determine if it will have a positive impact on vendors in India. Currently, it looks like this is a just a window that would help them borrow credit from Fed at a discounted rate. Moreover, they might acquire capability in retail banking by acquisition, instead of building it.” Wall Street, considered the holy grail for the investment banking profession, lost its sheen late Sunday, with news of Goldman Sachs and Morgan Stanley-two of the Street’s institutions that haven’t succumbed to the sub prime crisis as yet-getting converted into commercial banks that would be regulated by the US Federal Reserve. As a result, the investment banking space, often characterised with power and heavy pay packets, would cease to exist as a separate industry.
The development follows the tumble of iconic firms such as Bear Sterns, Lehman Brothers, Merrill Lynch and the near collapse of insurance giant AIG- because of their exposure to derivatives linked to housing and credit. Of the top five Indian IT companies, experts said that while TCS services Morgan Stanley, Goldman Sachs is an important client for Infosys. So, the existing vendors would have an edge if these newly-regulated banks should go for an increasing in their off shoring activity to India.
It’s not clear how seriously they would expand to other areas of commercial banking, but if they do, it would mean a huge business for product makers.
“A one time expense account has to be incurred to support acceptance of retail deposits, install more ATM s and increase reporting requirements. We will see increased spending on technology from Goldman and Morgan Stanley. Expect product vendors to benefit greater than service vendors,” said Mr Shiva Ramani, CEO, Cybernet-SlashSupport (CSS), an outsourcing firm that’s into technology support.
At the same time, products and software services provider Polaris Software Lab’s CFO R Srikanth added, “It’s a good news for the industry. Though they already have vendors in India, it’s a good opportunity for product vendors. Platforms such as retain finance, risk and treasury, cards, consumer and corporate banking would help.” On Monday, the 30-share Sensex dropped 0.34% and the IT index dropped 0.75%.
IT cos find solace in Gartner
N Shivapriya MUMBAI
SOFTWARE firms that were banking on a revival in the second half of the fiscal can take some cheer from the words of Gartner’s top man in India. Partha Iyengar, who heads the India arm of the global research organisation, says the collapse of Lehman and other financial giants will not significantly worsen the slowdown for software firms and a revival could be in the offing before the fiscal end.
“Software firms are already in a slowdown. I don’t see that trajectory changing because of the events of last week. The December quarter will follow the quarter we are in currently. We will start seeing an uptake after the US elections. The sentiment will start to shift after that and software companies may recoup some of the losses they made in the earlier quarter in the fourth quarter,” Mr Iyengar, vicepresident, Gartner India, told ET.
Contrary to the gloom inspired by the fresh bout of bad news, his outlook for FY09 remains ‘cautiously optimistic’ and that for FY10 ‘fairly optimistic’ with growth returning to earlier levels. Mr Iyengar said there were big differences across the key IT markets. There was a higher level of uncertainty and close to a sense of panic among IT buyers in the US and UK (because of its proximity to US). But companies in Asia-Pacific, while being cautious, were going ahead with their IT projects. The sentiment among European buyers fell somewhere between Asia Pacific and US buyers, he said.
Since the events of last week, the BSE-IT index has lost 167 points over worries dogging some of the largest customers of Indian IT companies. Merrill is one of the top financial services clients for number one software exporter Tata Consultancy Services, while Wipro and HCL Tech have exposure to Lehman. On Monday, outsourcing firm eClerx Services Ltd, which went public less than year ago, said it had outstanding receivables of $ 1 million from Lehman. The collapsed investment bank was one of its top five clients, accounting for about 13% of revenues.
However, Mr Iyengar said some of the consolidation among large financial services players such as Bank of America’s acquisition of Merrill Lynch and Lloyd TSB’s takeover of HBOS would provide huge integration opportunities for IT firms. “It’s true, there will be some redundancies and IT vendor consolidation but they will take time to play out. The bigger issue will be the integration opportunity it creates in the near-term — integration is the biggest single issue for banks,” he said.
The most significant difference between the last slowdown in 2001-02 and the current one was the ‘incredible amount of credibility’ Indian firms have built. Gartner is also advising IT firms not go back on job offers they have already made and not cut too deep to the bone when they rationalise recruitment. “Resources (people) tend to have fairly long memories, and when the company gets back to hire-mode, you don’t want it to have negative impact,” he added.
Realty crash shuts investors’ exit options
Investment In Housing Has Become A Liability Due To The Ongoing Credit Turmoil
Sanjeev Choudhary NEW DELHI
It has become well nigh impossible for those who invested in real estate last year to exit the scene as the downturn has deepened and the prices being quoted do not even cover the purchase costs and interest expenses. Moreover, the negative global news flow has set off a panic reaction, inducing investors to close deals at losses.
The 35-year-old Rahul Verma, who works with a Noida-based IT company, exemplifies the experiences of late entrants into the property market. He bought a Rs 50-lakh flat in Greater Noida early last year by arranging for a bank loan to finance 85% of the cost. His EMIs have continuously gone up since the purchase, thanks to a series of rate hikes by the RBI. The flat purchase was a pure investment decision. Rahul had jumped onto the bandwagon after hearing stories of skyrocketing returns made on property investments. However, the prices haven’t climbed as expected and the interest outgo has made the property expensive. Rahul is now left with the only option of selling at a loss. And given the global economic gloom, he is willing to take a hit.
“Several investors are stuck simply because there hasn’t been enough price appreciation in the past one year,” says Raheja Developers Chairman Navin Raheja. Several young investors invested in property at the peak of the property cycle last year. Many purchased two apartments simultaneously, assuming that they would finance one by selling off the other at a premium. They are now caught in a difficult situation as they bought at a higher market rate and are compelled to service two EMIs. Some investors have started defaulting, according to a senior Parsvnath executive. “There is a significant rise in the number of people who are approaching us to cancel their bookings and return the money,” he says.
Property consultants feel that investors will have to bear huge losses if the markets do not improve during the festive season. Home buyers in the country are staying away due to the high interest rate regime and expectations of a correction following the realty crash worldwide.
With multinational banks cutting down on inter-bank exposure, bank chiefs in India are concerned that foreign lenders may not roll over the line of credit granted to the overseas offices of Indian banks
Sangita Mehta MUMBAI
INDIAN banks fear that worsening of the global credit crunch in the last fortnight will hit their international operations. With multinational banks cutting down on inter-bank exposure, bank chiefs in India fear that foreign lenders may not roll over lines of credit granted to their overseas offices.
These concerns were expressed by Indian banks in a recent meeting with RBI. Bank chiefs are also apprehensive because deposits in the overseas office have dipped in the past fortnight. “In this context, we have asked help from RBI for a contingency plan,” said a senior bank chief present in the meeting. The meeting was attended by RBI’s deputy governor Rakesh Mohan and CEOs of Standard Chartered Bank, HSBC, ICICI Bank, State Bank of India, Union Bank of India, IDBI Bank, Allahabad Bank, Syndicate Bank and Jammu & Kashmir Bank. During the meeting, RBI also assessed the liquidity position of banks and made enquiries regarding credit offtake.
Most Indian banks with an overseas presence have a reciprocal line of credit with their foreign counterpart. Under this reciprocal arrangement, the Indian bank lends to the foreign bank’s branch here while the foreign bank extends similar support to the Indian bank’s overseas arm.
The worsening of the global credit crunch is apparent in the dollar shortage, which has led to inter-bank rates shooting up in financial centres. In fact, in overseas markets like the US and the UK, inter-bank lending had come down sharply due to the shortage cash. Sources said Indian banks have extended loans on expectations that lines of credit by foreign banks would be rolled over on maturity. “However, if those lines, which are due in the very near future, do not get rolled over, banks’ overseas office may face asset-liability mismatch,” said a bank chief.
In such a situation, Indian banks will to swap rupees into dollars in the domestic market to support their overseas operations. “However, foreign banks with Indian operations may suffer higher liquidity problems than Indian banks with foreign operations,” said a treasury head.
Senior bankers have indicated that high credit demand has come from fertilisers, oil and infrastructure companies. Some bankers have also urged RBI to release liquidity in the system by lowering the 9% cash reserve ratio — a slice of deposits that banks maintain with RBI, and the 25% statutory liquidity ratio — gilt that banks have to hold on their books.
“We have asked RBI to reduce CRR and SLR at least for infrastructure loans and allow us to issue tax-free bonds for funding such projects,” pointed out a banker.
The end of the beginning
Risk aversion in financial markets means that emerging economy companies will face problems in rolling over $111 billion of debt falling due over the next year, says Swaminathan S Anklesaria Aiyar
THE US administration and Congress are creating a $700 billion rescue package to resolve the worst financial crisis since the Great Depression. Will it stabilise the US and world economies?
For an answer, remember Winston Churchill’s words in 1942: “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
The financial crunch that began in mid-2007 has worsened so dramatically that all politicians have agreed to a government rescue. In that sense, we have reached the end of the beginning of the current drama.
But two major chapters are yet to unfold. The first relates to problems that will hamstring, and maybe doom, the rescue. The second relates to the global recession that has probably started, and will hit countries like India far harder than mere Wall Street turmoil.
Right-wing analysts sneer that the US has created the world’s biggest sovereign wealth fund. This is skewed badly towards the financial sector alone. But just wait: opportunities for diversification are at hand, since the Big Three auto giants also seek rescues. And, as the recession bites, further opportunities will arise to rescue giants in retail and technology!
Politicians are uninterested in criticism that the rescue will encourage a repetition of profligacy and excessive risk-taking in the future. Right now, they want to appear as saviours, not disciplinarians.
Many legislators resent being asked to sign a blank cheque for $700 billion, and want to attach all sorts of conditions. But populist pressure will probably ensure rapid legislation with minimal conditions.
Yet that will not end the saga. A thousand thorny political issues will follow. Who will decide which securities are toxic and worthy of rescue? The treasury alone? Should one authority have so much power and discretion?
Will the treasury buy only mortgage securities? Or also derivatives such as credit default swaps? What about credit card defaults, which loom ahead? Or corporate bond defaults?
How many companies will be allowed to go bust before the treasury saves others by declaring a new set of instruments to be toxic? What checks and balances are needed on enormous discretionary power over $700 billion, that can make or break fortunes, and can be manipulated by old-boy networks and lobbyists?
At what price will the government buy toxic securities? Merrill Lynch sold some mortgage-backed securities at just 22 cents in the dollar. Will treasury offer more to others? If so why? In setting prices, the scope for fraud, collusion and suspicion is huge. Will vulture funds, which have already bought distressed securities for a song, be allowed to resell these at higher “rescue prices” to the treasury?
Which fund managers will be appointed to manage the huge assets taken over? Why, they will be drawn from the very financial class that has just disgraced itself! The potential conflicts of interest are vast.
Maybe all these issues will be overcome. But a significant risk remains that the rescue will be hamstrung by allegations of fraud and collusion.
MUCH greater is the risk that the financial crisis will keep worsening. Professor Nouri-el Roubini was the first to predict massive carnage. He now estimates bad loans at $2 trillion, large enough to overwhelm the rescue package. Roubini correctly predicted the fall of the shadow financial sector — lightly-regulated financial entities that avoided the tight supervision imposed on banks, such as off-balance sheet SIVs (special investment vehicles), leveraged investment banks, and leveraged hedge funds. He now predicts that the carnage will spread to hedge funds, for whom the rescue package makes no provision.
Meanwhile risk is set to multiply in derivatives. Most at risk are credit default swaps (CDS), which insure against bond and loan default. The size of the CDS market is $62 trillion, four times the GDP of the US! After netting out offsetting transactions, the balance CDS risk is around a trillion dollars.
The future of the CDS market depends on the real economy. A major recession is now unavoidable, and this will mean more corporate and banking defaults. Some experts think at least 4,000 US banks will go bust. Recessions typically lead to a 10% default on corporate bonds. The default rate last year was only 1.8%. So a surge in defaults is coming, and CDS markets are trembling.
Despite a credit crunch starting with the bursting of the US housing bubble 13 months ago, the US and world economy have remained remarkably resilient so far. GDP growth in the US was 3.3% in the last quarter on an annualised basis. The Indian and Chinese economies have slowed, but only modestly.
What explains this resilience? Well, US monetary and fiscal policies have flooded the country — and the world — with dollars to try and stave off recession. The Fed has given financial markets unprecedented access to liquidity, and cut interest rates to just 2%. US Congress has legislated $140 billion in cheques mailed to consumers, just to increase purchasing power. The trade deficit remains high, and is paid for by issuing dollars to the world. This Niagara of dollars has kept purchasing power (and GDP) rising despite the credit crunch.
But a major recession is now unavoidable. Japan and some European countries suffered negative growth in the last quarter, and the US may already be in recession this quarter. Emerging markets are all slowing down.
The credit crunch means that fresh financing of both consumers and industry is going to slow down, in the US and globally. Risk aversion in financial markets means that emerging economy companies will face problems in rolling over $111 billion of debt falling due over the next year. Several companies that had banked on cheap loans and high IPO prices now find doors closed. The problem may persist through 2009-10.
So, the greatest financial crisis since the Great Depression has a long way to go yet. And the journey may be long and painful.
The crisis in the global financial markets holds several lessons for policy reform of the Indian financial system. It would be sad, if the crisis made us more complacent. Our banks do not have global size; our markets do not have adequate products; our institutional investors do not hold diversified portfolios; these portfolios are not actively managed; and growth in credit and free capital flows are something we need quite desperately. Despite extensive work and road maps, our financial sector reforms are seriously delayed. This crisis should prod us ahead, given the valuable lessons that will play out.
Product Structures
When an economy adapts a market-led approach to financing assets, the assumption is that risks are priced, spliced, and distributed across several entities. Securitisation of home loans, the subsequent structures and swaps were based on this assumption. The crash in asset values across several balance sheets, when housing prices fell steeply, tests this assumption. Several of our local financial institutions have not even begun to experiment with new product structures. A better understanding of risk will emerge from this crisis and more choices about how we could deal with risks in product structures.
Bail Outs
Proponents of capitalism swear by creative destruction. The cyclical corrections in markets are seen as the much-needed purging of excesses. The events in the US show that the choice between allowing failure as a natural consequence and bailing out a failing entity, is not a simple one to make. The modified capitalism of bail-out based on judgment is something that appeals to our psyche, but is currently applied selectively (Would the bail-out have been the same, if UTI were in the private sector, for example?). Our handling of IFCI illustrates our muddled thinking. Rather than fantasise a world without crisis, we need ability and willingness for swift action.
OTC Vs Exchange-traded
The large leveraged positions in derivatives, which lost value rapidly and triggered losses for several players, is at the centre of the current meltdown. But much of the risk came from the structure and not the product itself. The credit default swaps were not exchange-traded products, but over-the-counter (OTC). This meant that the counter-party risks were high; there was no margining based on open positions; and valuation and liquidity were questionable. India’s exchange-traded currency contract is a great first step. Introducing exchange-traded products in the interest rate and credit markets is the next crucial step for us.
Mark-to Market
The drop in value of assets in the balance sheets of investment banks, banks, investors and others, has led to the plea that ‘marking-to-market’ might not be the correct thing to do. Several are asking for assets to be shown at costs, and for a write-off of the value, after manifestation of risk, through accounting entries in the income statement. This thinking assumes that a risk, unless accounted for, does not exist. We in India subscribe to this view, allowing banks to value assets depending on how they are classified, and keeping most institutional portfolios (like provident funds) at cost. We need alignment with global standards that will emerge.
Regulation
Every crisis creates spill-over of risks from one segment to another. The defaults of global investment banks have spread into money markets. The takeover and conversion of investment banks by commercial banks, creates dual regulation by the Fed and the SEC. Back in India, we have regulators for each type of institution, with limited understanding of the commonalities in functions they perform and the markets they operate in. We need unification of regulation, as has been recommended for a very long time in financial sector reforms.
Size
We may be fooled into thinking that only large-sized entities can extend themselves. The financial sector in India is badly compartmentalised. Several companies clamour to create new banks; many small banks hope to be taken over at good value; some thousands NBFCs operate with limited supervision; existing banks are constrained from expansion; and we are loathe to allow foreign banks in. The growth of multiple small entities, working in the credit markets in their own ways, creates risks and regulatory challenges, about which we may not even know. We need to implement reforms that enable larger institutions, that are easier to supervise. Regulatory and policy resistance to such change, remains a puzzle.
Leverage
Leverage is seen as the villain of the piece. As asset sizes shrink, spreads increase and lenders shy away, the credit markets in the US will shrink. This may lead US into a recession, as much of their growth is credit-driven. Without the advantages of leverage, it is not possible to expand in size, but this lesson may be lost on several regimes like India, which traditionally discourage borrowing. In an economy that needs capital to grow to its potential, we need more long term borrowing options. If we picked up only the disadvantages of leverage, and shrunk back, we might scuttle growth
Currency
Several economies including India, have built up large reserves as a defence mechanism. They also practice various forms of currency management. They will be impacted by the global recession and dollar depreciation.
The current crisis will have its impact on the currency markets. Last time around, we were able to claim ‘insulation’ due to lack of currency convertibility. Given the size of our resources, and the depreciation of our currency, we may need to act. Our stance on global capital flows, capital controls and currency will need review.
The lessons from this crisis will flow in over the time it takes to spill over, initiate another round of regulatory reforms, and create global realignment of macro-strategies. It is up to us to use the opportunity to implement long overdue reform of our systems, structures and institutions.
When Harshad Mehta and Ketan Parekh used money from the debt markets to play up stocks, they took the markets and a few players down with them — tiny games played over two to three years. When large investment banks use money from the wholesale debt markets for nearly a decade, and go belly up when their favourite bets crash, they can bring a whole nation to its knees. If that nation is as big and influential as the US, voyeurs may rejoice, but pragmatists will worry.
The dominance of investment banks in America’s financial system has been hailed as the triumph of markets over men; about how innovation can expand the pie; and about how credit can swell the size of an economy. Their collapse represents a tectonic shift in the way the financial world will work, going forward. All the votaries of free markets and capitalism will know market-led wind down happens. The confusion about choosing between freedom and control will take a while to settle.
Investment Banks
After the crises of 1930s, the Glass Steagall Act was promulgated, separating commercial banks that accepted public deposits from investment banks that specialised in advisory and broking business. Investment banks spearheaded most of what we now know as components of the modern financial system--- capital market funding of businesses, innovative financial products, structures for reviving and expanding businesses, and so on. They also were large brokers and dealers in equity, debt and derivatives.
Competition
In 1999, the Glass-Steagull Act was thrown out. Deposit-taking banks were allowed to indulge in financial advisory and compete with investment banks. Competition cut into the margins of investment banks. Their trading desks became bigger, and their intellectual prowess was used in creating new products and structures and selling them off to clients. The size of their trading books doubled to $15 trillion since 1999.
Funding
Investment banks were experts in raising institutional money. So when they needed money to back their trades, it was not a difficult deal. Wholesale debt markets were only eager to lend to them, for the short term, to fund assets that were routinely churned and traded. The ability of investment banks to create new products and structures only increased the willing lenders and that included banks.
Engineering
The most important condition for the investment bank, when it used borrowed money to buy assets, was that the return from trading the assets was higher than the borrowing rate. Thanks to Alan Greenspan and the incredulously low Fed rates of the early 2000s, funds were easy to come by. But the assets still carried risks. So investment banks bought only those assets that were liquid and easy to sell off in the markets. Where the assets were not liquid, they created liquidity through financial engineering.
Layering
For example, a 15-year home loan made by a bank, is not liquid. But the cash flows due from the loan can be re-packaged and sold off to another entity like mortgaged backed securities. Investment banks would create new structures with these cash flows, re-arranging them into collateralised debt obligations, and sell them off to others. They can also repackage the risks into newer instruments like credit default swaps. The risk on the original home loan is now spread across at least four different balance sheets. This exercise was expected to reduce the risk of the original loan, enabling a fast growth in all the products that were engineered.
Leveraging
Since the interest rate was low, and housing prices were going up, all participants extended themselves. Households borrowed more than they needed, banks lent more than they could, investment banks held and traded too much of the structured products, and investors bought more and more in the hope of profit. This extension created sub-prime loans, where households could borrow even if they had no income, no papers, no credit rating, or payment record. They only needed to use the money to buy a house, whose price went up.
Bubble
As everyone’s books blew out of proportion, the bubble burst. When housing prices crashed, the domino effect came into play. Across the balance sheets that the loans were spread into, all values dropped. And panicky investment banks tried to sell off what they held, and found that the market had become illiquid. When they wanted to borrow to keep the assets, the rates had moved up, and money was not available. They began to sell in panic what they had, and prices only dropped even further.
Bust
Investment banks now faced a situation where the assets they held were worth less than the amount they had borrowed. So, they went around asking for capital. At the peak of the boom, many of them had $40 of borrowings for every dollar of capital. Now, when the value of the assets fell off to say $20 or less, there was no money to repay the borrowings, unless they got equity capital. Equity capital was not forthcoming because the value of the assets was dropping by the day. The result: they simply went belly up.
Bail out
So what did regulators do? They reduced interest rates so that money would be available to borrow and hold up the assets. But markets only tightened from further fears of default. Money was handed out, through a special window opened for investment banks by the US Fed. When that would not do, there was bailout by taking on the bad assets. Now Central banks across countries have come together to create a $247 billion fund to provide credit where it is needed, to stop further failures. (Illustration: more money pumped into toxic assets)
Fear Factor
Since fear of failures grip the markets, credit has dried out. As value of assets held by large players has shrunk, the market itself has shrunk. Money is difficult to get. Loan is the new bad word and no one wants to lend money to fund risky assets. Safe havens like money market funds have begun to lose value, and investors are holding back cash, worsening the liquidity crunch.
What Now?
The US already runs a $3 trillion deficit. Adding billions of dollars of bailout money to this is a sure fire way to trigger a full blown recession. The US recession is also likely to draw others along with it. The weakening of the US dollar may then be inevitable in such a situation. Investors face the double whammy of default and depreciating dollar. The crisis in the credit markets shows all signs of extending into the currency markets.
Plan of Action
Everyone seems to blame regulation now. Since commercial banks are more closely regulated and have strict capital adequacy norms, the clamour is to close down or merge investment banks into commercial banks. That may shrink the size of the financial markets as we now know, significantly. The entire edifice of risk-taking and thus expanding capital markets would crumble and we will return to loan officers from market-driven risk takers.
Before we heave a sigh of relief about how we may not be affected so much, we need to worry about global headwinds that will affect markets across the world. We may still keep our jobs, continue our SIPs and pay our EMIs. But the lessons in this crisis are for macro managers of the economy. If we have to be plan for a longer run, the lessons from this crisis can help us ponder over our policy and institution-building choices.
Could we catch the American flu? The broad numbers would say it is highly likely. Of every Rs 100 India made in 2007-08, about Rs 30 were earned abroad by selling our wares and skills or by the proverbial Prodigal Son sending home a fat dollar cheque. And for the same Rs 100, foreigners lent us Rs 4 and bought another Rs 4.50 worth of Indian companies, banks and real estate. All this adds up to a fairly significant exposure to even the most pacific bug emanating from the US financial system. Yet the chances of India coming down with a full-blown viral attack seem remote.
Here’s why. India’s $1 trillion economy exported $158 billion of goods in the previous financial year, slightly under a third each to the US, the EU and China. In the event of the financial meltdown spreading to the broader US economy, the other two could hold out a while longer, particularly those guys across the Great Wall, who in the course of this year will become the biggest buyers of our stuff. And most of this ‘stuff’ is pretty basic: gems, tea, textiles — commodities, led by oil, which are traversing the upper reaches of the business cycle while the global capital market flounders. This year’s $200 billion merchandise export target looks a bit of a stretch under the circumstances.
When it comes to selling our skills though (the only one that matters being our ability to write code), the terrain looks decidedly tricky. Four out of every five of the $40 billion we earned as software exports last year came in from the US, half of which was for services rendered to American banks, brokerage houses and insurance companies. As more of these buckle, Indian software services exports look wobbly this year.
Finally, the Prodigal Son. It’s not love alone for the homestead that sees him sending across a staggering $42 billion. India still offers the best return on investment to its diaspora. Half a decade of the economy growing at about 9 per cent has spawned fabulous profits for India Inc. There’s no reason why this fact should escape the attention of the maid in Muscat or the doctor in Devon. As long as they have something to save, it makes sense for them to remit it back home.
What India earns from the world then is relatively inured, the immediate fallout of the sub-prime crisis in the US limited to software service exports. Not so with what the world invests in or lends India. In just over a week since Lehman Brothers and Merrill Lynch went belly up, portfolio investors have pulled $2 billion out of India. And the cheap foreign loans that were driving a turbo-charged economy have seized up.
Ever since the world recovered from the dotcom bust and found a new mantra —emerging markets — foreign investment, both direct and financial, has been chasing an India story that delivers profits in the region of 25 per cent a year. Beginning as a trickle, financial investors poured $29 billion into our bourses last year. The tide has since turned. Financial investors have sold $9 billion of Indian stock since the beginning of 2008 and with the curtains coming down on a hedonistic era of investment banking, we can safely expect more billions to move out at the click of a jumpy mouse.
Foreign direct investment, at $25 billion last year, drives in a slower lane where sudden U-turns are difficult. Left to itself, the Indian economy was heading for a slowdown, but hardly of an order that warrants a rethink by foreign companies planning to buy plants and set up offices here.
Indians are now saving and investing close to a third of their income. Nearly half this investment is being made by local companies, which borrowed $22 billion overseas last year. Typically, Indian companies wanting to expand operations in the recent past first sold some stock to an investor, mainly an investment bank, and then leveraged the sale to raise debt, preferably overseas, which works out far cheaper. This tap is now dry. With private equity running scared, the second-stage fund-raising through loans is no longer an option, as a clutch of late-comers discovered much to their chagrin earlier this year. Again, India Inc financed nearly all its foreign acquisitions through leveraged buyouts and the predators have to stay at home till last season’s fashion revives.
This scenario offers meagre policy options. There is precious little any government can do to keep hot money from flowing out. But it can very well open the doors wider for the dollars to flow in. In the short term, recently imposed restrictions on borrowing abroad by Indian companies may need to be lifted. Some already have, we should see more as the crisis plays out.
Given its relative stability, FDI is always more welcome than portfolio investment. Yet restrictions remain. A medium-term solution would require political will to dismantle the steeplechase that is our FDI policy today.
The proximate risks of the roiling global financial market are to the two principal scriptwriters of the India story: companies in general and the software industry in particular. If they were to lose their lustre, it could be a long wait for the next star to appear in the East.
Popular culture has an uncanny way of reflecting life. Coldplay is the name of an alternative British rock band. The group’s latest album that bears the unusual subtitle Death and all his friends has become a huge success. It has hit the top of the charts in no less than 28 countries. The opening lines of the title track might as well be about the current state of a mythical character named Uncle Sam on the other side of the Atlantic Ocean: “I used to rule the world/Seas would rise when I gave the word/Now in the morning I sleep alone/Sweep the streets I used to own…”
Columnist for the New York Times Roger Cohen quoted the lines of this song and evocatively wrote: “When you trade pieces of paper for other pieces of paper instead of trading them for real things, one day someone wakes up and realises the paper’s worth nothing.” Therein lies the core of the biggest crisis faced by international capitalism for the last 75 years, to be precise since the beginning of World War II.
It’s no red-rag-waving leftist scumbag who compared the present crisis in the US economy to the Great Depression that started in Wall Street in 1929 and led to a worldwide recession that lasted almost a decade. This comparison was made in April by a great friend of the US, the International Monetary Fund (IMF) that was set up in Bretton Woods the year after the War ended in 1945, ostensibly to foster global economic stability and help countries facing financial crises.
The IMF made this comparison more than four months before Black Monday (September 15) and the week that saw the Federal Reserve and Treasury Department spend close to India’s annual national income ($1 trillion) to bail out a clutch of financial bigwigs bearing now very familiar names — Freddie, Fannie, Lehman and Merrill, not to mention the world’s largest insurance company, American International Group.
A working paper published in March by Claudio Borio of the Bank for International Settlements, based in Switzerland, pointed out that the “unfolding financial turmoil in mature economies…regardless of its future evolution…already threatens to become one of the defining economic moments of the 21st century”. He added: “The turmoil is best seen as a natural result of a prolonged period of generalised and aggressive risk-taking, which happened to have the sub-prime market at its epicentre. In other words, it represents the archetypal example of financial instability with potentially serious macroeconomic consequences…”
The BIS has estimated that the derivatives trade has grown five times between 2002 and 2007 to touch a level in excess of $500 trillion — this ‘shadow’ economy is ten times larger than the ‘real’ economy of the world and five times bigger than the volume of trade in securities that are backed by tangible assets. Derivatives are financial instruments that ‘derive’ their values from other financial instruments — the classic case of paper being traded for more paper.
The US has less than five per cent of the world’s population. It consumes over a quarter of the planet’s resources. Nobel laureate Joseph Stiglitz (who was economic advisor to Bill Clinton) wrote more than a year ago that the principal reason for the underlying volatility in international capital movements is the huge deficit of the US, a country that was borrowing a stupendous amount of $3 billion (or Rs 13,500 crore at current exchange rates) from the rest of the world every day. Two-thirds of this money comes from developing countries. Simply put, the rest of the world has been saving so that American citizens can splurge beyond their means and croon: “I owe, I owe. Therefore, to work I go”.
Many are still unaware of how iniquitous the world’s financial system is. The US has invested in China and India less than half of what these two countries have invested in that country. The bubble had to burst. It has. In January 1981, in his first public speech after becoming President of the US, Ronald Reagan famously said: “…the government is not the solution to our problem; government is the problem”. His words have come back to haunt a country where home prices have crashed by a fifth over a year and job losses have mounted.
New York Governor David A. Paterson stated on September 15: “Approximately 11,000 jobs were lost in New York’s finance and insurance sectors between July 2007 and July 2008. More recent data will likely show this number continues to grow and based on past data, approximately 40,000 jobs in the financial services industry in the New York City area can be expected to be lost in the current downturn. All told, approximately 120,000 jobs may ultimately be directly and indirectly affected as a result of financial sector turmoil.”
Now that in the last few months of its existence, the George W. Bush government has ‘socialised’ the losses of many of his country’s corporate captains, it is worth wondering why the incumbent regime in India is so keen to engage with Washington. Prime Minister Manmohan Singh unlearnt his socialism after he advised Indira Gandhi. During his trip to the White House, the economist-politician may desist from offering his words of wisdom on how the US economy can be repaired, if at all.
But Coldplay would have no such hesitation telling Bush Jr: “Revolutionaries wait/For my head on a silver plate/Just a puppet on a lonely string/Oh who would ever want to be king?”
Crisis? IT’s fine with us
Goldman, Morgan’s switch to banks means more biz to India
Chandra Ranganathan CHENNAI
WHEN Goldman Sachs and Morgan Stanley gave up their independent investment banking status, it gave reason for Indian IT vendors to smile. For, more regulations — as a commercial bank — could mean more business for software service providers. While the collapse of the other investment banks in the past few months sent jitters among the software vendors in India, government control of Goldman Sachs and Morgan Stanley gave the Indian IT some reasons to cheer.
Because, morphing into a full-fledged bank not only implies greater access to funds but also more regulation. And tighter regulation could mean tweaking their existing technology by adding more software and processes. They would have to adopt systems in areas such as retail banking, consumer banking, cards and corporate banking.
“It’s an opportunity for IT companies because conversion to traditional banks means they need to add a lot of processes, new functions and areas,” said Frost & Sullivan deputy director-ICT practice Kaustubh Dhavse.
Another analyst, who did not want to be named said, “It’s a bit too early to determine if it will have a positive impact on vendors in India. Currently, it looks like this is a just a window that would help them borrow credit from Fed at a discounted rate. Moreover, they might acquire capability in retail banking by acquisition, instead of building it.” Wall Street, considered the holy grail for the investment banking profession, lost its sheen late Sunday, with news of Goldman Sachs and Morgan Stanley-two of the Street’s institutions that haven’t succumbed to the sub prime crisis as yet-getting converted into commercial banks that would be regulated by the US Federal Reserve. As a result, the investment banking space, often characterised with power and heavy pay packets, would cease to exist as a separate industry.
The development follows the tumble of iconic firms such as Bear Sterns, Lehman Brothers, Merrill Lynch and the near collapse of insurance giant AIG- because of their exposure to derivatives linked to housing and credit. Of the top five Indian IT companies, experts said that while TCS services Morgan Stanley, Goldman Sachs is an important client for Infosys. So, the existing vendors would have an edge if these newly-regulated banks should go for an increasing in their off shoring activity to India.
It’s not clear how seriously they would expand to other areas of commercial banking, but if they do, it would mean a huge business for product makers.
“A one time expense account has to be incurred to support acceptance of retail deposits, install more ATM s and increase reporting requirements. We will see increased spending on technology from Goldman and Morgan Stanley. Expect product vendors to benefit greater than service vendors,” said Mr Shiva Ramani, CEO, Cybernet-SlashSupport (CSS), an outsourcing firm that’s into technology support.
At the same time, products and software services provider Polaris Software Lab’s CFO R Srikanth added, “It’s a good news for the industry. Though they already have vendors in India, it’s a good opportunity for product vendors. Platforms such as retain finance, risk and treasury, cards, consumer and corporate banking would help.” On Monday, the 30-share Sensex dropped 0.34% and the IT index dropped 0.75%.
IT cos find solace in Gartner
N Shivapriya MUMBAI
SOFTWARE firms that were banking on a revival in the second half of the fiscal can take some cheer from the words of Gartner’s top man in India. Partha Iyengar, who heads the India arm of the global research organisation, says the collapse of Lehman and other financial giants will not significantly worsen the slowdown for software firms and a revival could be in the offing before the fiscal end.
“Software firms are already in a slowdown. I don’t see that trajectory changing because of the events of last week. The December quarter will follow the quarter we are in currently. We will start seeing an uptake after the US elections. The sentiment will start to shift after that and software companies may recoup some of the losses they made in the earlier quarter in the fourth quarter,” Mr Iyengar, vicepresident, Gartner India, told ET.
Contrary to the gloom inspired by the fresh bout of bad news, his outlook for FY09 remains ‘cautiously optimistic’ and that for FY10 ‘fairly optimistic’ with growth returning to earlier levels. Mr Iyengar said there were big differences across the key IT markets. There was a higher level of uncertainty and close to a sense of panic among IT buyers in the US and UK (because of its proximity to US). But companies in Asia-Pacific, while being cautious, were going ahead with their IT projects. The sentiment among European buyers fell somewhere between Asia Pacific and US buyers, he said.
Since the events of last week, the BSE-IT index has lost 167 points over worries dogging some of the largest customers of Indian IT companies. Merrill is one of the top financial services clients for number one software exporter Tata Consultancy Services, while Wipro and HCL Tech have exposure to Lehman. On Monday, outsourcing firm eClerx Services Ltd, which went public less than year ago, said it had outstanding receivables of $ 1 million from Lehman. The collapsed investment bank was one of its top five clients, accounting for about 13% of revenues.
However, Mr Iyengar said some of the consolidation among large financial services players such as Bank of America’s acquisition of Merrill Lynch and Lloyd TSB’s takeover of HBOS would provide huge integration opportunities for IT firms. “It’s true, there will be some redundancies and IT vendor consolidation but they will take time to play out. The bigger issue will be the integration opportunity it creates in the near-term — integration is the biggest single issue for banks,” he said.
The most significant difference between the last slowdown in 2001-02 and the current one was the ‘incredible amount of credibility’ Indian firms have built. Gartner is also advising IT firms not go back on job offers they have already made and not cut too deep to the bone when they rationalise recruitment. “Resources (people) tend to have fairly long memories, and when the company gets back to hire-mode, you don’t want it to have negative impact,” he added.
Realty crash shuts investors’ exit options
Investment In Housing Has Become A Liability Due To The Ongoing Credit Turmoil
Sanjeev Choudhary NEW DELHI
It has become well nigh impossible for those who invested in real estate last year to exit the scene as the downturn has deepened and the prices being quoted do not even cover the purchase costs and interest expenses. Moreover, the negative global news flow has set off a panic reaction, inducing investors to close deals at losses.
The 35-year-old Rahul Verma, who works with a Noida-based IT company, exemplifies the experiences of late entrants into the property market. He bought a Rs 50-lakh flat in Greater Noida early last year by arranging for a bank loan to finance 85% of the cost. His EMIs have continuously gone up since the purchase, thanks to a series of rate hikes by the RBI. The flat purchase was a pure investment decision. Rahul had jumped onto the bandwagon after hearing stories of skyrocketing returns made on property investments. However, the prices haven’t climbed as expected and the interest outgo has made the property expensive. Rahul is now left with the only option of selling at a loss. And given the global economic gloom, he is willing to take a hit.
“Several investors are stuck simply because there hasn’t been enough price appreciation in the past one year,” says Raheja Developers Chairman Navin Raheja. Several young investors invested in property at the peak of the property cycle last year. Many purchased two apartments simultaneously, assuming that they would finance one by selling off the other at a premium. They are now caught in a difficult situation as they bought at a higher market rate and are compelled to service two EMIs. Some investors have started defaulting, according to a senior Parsvnath executive. “There is a significant rise in the number of people who are approaching us to cancel their bookings and return the money,” he says.
Property consultants feel that investors will have to bear huge losses if the markets do not improve during the festive season. Home buyers in the country are staying away due to the high interest rate regime and expectations of a correction following the realty crash worldwide.