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Raghuram Rajan's tough battle against bubbles

RBI governor Raghuram Rajan tried to tell his colleagues about the dangers from flood of money from developed countries, but no one wants to listen. Eventually interest rates will rise higher than the present levels either because of uncertainty, inflation fears or tapering


You have to feel sorry for India's new central bank governor, Raghuram Rajan. He recently pointed out that the flood of money from developed countries could have a major impact on the policies of developing countries and sows the seeds of another crisis. He complained, "Are we in a world where we continue to blow up bubbles elsewhere?" The response was less than satisfying. Instead of concern or sympathy all he got was a shrug. Central bankers feel that the problems of emerging markets do not concern them. It is up to emerging markets to fend for themselves. Or, in the words of former US Treasury Secretary John Connolly: the US dollar “is our currency, but your problem.”

 

So far, the flood of cheap money has not had a bad effect in developing or emerging markets. Default rates on corporate bonds in developed markets have been very low. The rate is similar to the levels seen during 2005 to 2007 at 2.4%. But with low cost easy money, more middle market firms have had access to funds. But access to money does not necessarily mean profit growth. In fact, profit growth has been declining in the past few quarters to the low single digits for Standard & Poor’s 500 Index companies. This level of earnings growth is more consistent with a default rate of 6% rather than 2.4%. This implies that there are quite a few “zombie” companies out there: a company that can’t grow, but can survive only because they have access to money at very low interest rates. If interest rates rise, as they have since May, then the number of defaults may increase sharply.

 

This problem is not limited to developed countries. Emerging market (EM) companies have had access to bond markets as never before. Emerging market corporate bond sales have doubled since 2005. In 2012, they reached a record $200 billion. EM corporations surpassed that record by the end of May of this year. The companies account for 80% of all hard currency debt sold in 2013. Many of these corporations are accessing the market for the first time. A fifth of Asian local currency bonds are in debut deals. The proportion in the US and Europe is usually about 3%. The market is now about $1 trillion in size and surpasses US junk bonds as an asset class.

 

As the size of the market has grown, so have the defaults. EM corporate bond defaults rose to $22 billion in 2012, a huge leap from 2011 when there was only $182 million worth of defaults. Of the 25 defaults, just under half were in Latin America, mostly Brazil. There were nine defaults in emerging Europe and five in Asia. The market is much safer than in 1997. The main difference is that much of the debt is now denominated in local currency. Still there is substantial exposure to currency fluctuations and any rises in interest rates could be traumatic.

 

In India defaults reached a 10-year high of 4.5% up from 3.5% a year ago with 32 issuers defaulting. Much of the credit risk is concentrated in ten of the largest companies. According to a report by Credit Suisse, the gross debt of these companies topped $100 billion. The companies are by order of their debt levels: Reliance ADA Group, Vedanta Resources, Essar Group, Adani Group, Jaypee Group, JSW Group, GMR Group, Lanco Group, Videocon Group and GVK Group. The stress of this mountain of credit is showing up also in the banking system where impaired assets have risen from 4% in 2009 to 9% this year and is forecast to rise to at least 12% by 2015. This information is undoubtedly on the low side and much of the bad debt is located in state banks. Worse, much of this debt is not denominates in rupees. India has $225 billion in dollar-denominated debt and more than half is not hedged.

 

The problem of foreign currency lending is far less of a problem than it was during the Asian crises. With often very strong reserves many countries have been able to borrow in their own currencies. But, local currencies bonds protect only against currency depreciation not capital flight. Much of the debt was sold to foreigners. In Indonesia, foreigners now hold about a third of the local currency bonds. The number is about the same in Malaysia. These bonds were purchased for the yield but when the local currency falls as it has by 18% in Indonesia, they become much less attractive.

 

Bankruptcies are not so far a problem in Southeast Asia, but they are in South Korea. Investors picture corporate South Korea through the lens of Samsung with its ever growing smart phone profits. There is another South Korea. Second tier chaebols exposed to cyclically weak sectors such as construction, shipbuilding and shipping. One of these, Tongyang with interests from financial services to construction and tourism, is on the verge of bankruptcy and may default on $1.4 billion worth of bonds and commercial paper sold to retail investors this year. The problems of the corporate sector are on top of already severe issues associated with consumer debt.

 

China came out with better growth last week, but the cause of the growth was the same as it has been for the past five years: infrastructure spending fuelled by more debt. Earlier this year, China’s debt growth rose at a blistering 52% for the first five months of 2013. It has since slowed and is now closer to 20% year-on-year. In the last five years China’s total debt went from 130% of gross domestic product (GDP) in 2008 to about 200% today. Corporate debt made a large part of this. Chinese corporate debt has grown from 71% of equity in 2007 to 104% today. This compares unfavourably with other BRICs. Corporate debt in Brazil rose from 76% to 92% of equity. In contrast, India’s rise from 67% to 77% of equity looks conservative. Chinese companies owe a total of 64 trillion yuan ($10.45 trillion), and amount that has grown 260% in the past five years from 24 trillion ($3.92 trillion).

 

Brazil’s corporations are in better shape than China’s, but they are still in trouble. Moody’s, Standard & Poor’s or Fitch has negative outlooks on 26 Brazilian corporate borrowers. In total Brazilian corporate debt in doubt is $104 billion triple the amount of negative outlooks for Mexico, which recently had defaults by three large real estate developers in the amount of $2.75 billion. The bonds are now trading at 20 cents on the dollar.

 

But the large amount of corporate debt in emerging markets is not the real problem. The real problem is the illiquidity. Last year, thanks to low yields in the US, these markets were hot. Now they are in the deep freeze. The liquidity of EM corporate debt markets is poor in most cases and abysmal in a few. In some markets, no one is selling these bonds and no one is buying. A don’t ask, don’t tell situation, so it is difficult to value these bonds. Many of these bonds are held by ETFs, who have to maintain the link to an index. This could mean forced sales.

 

Raghuram Rajan tried to tell his colleagues about the dangers, but apparently they don’t want to listen. Eventually interest rates will rise higher than the present levels either because of uncertainty, inflation fears or tapering. Then everyone will definitely feel the effects of Mr Rajan’s bubbles. At that point they will start to pay attention but it is probably already too late.

 

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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    COMMENTS

    BL Sebastian

    6 years ago

    Mr. Gamble has provided a good oversight on the dangers of such bubbles but at a more micro level the problem is more acute. The bonds issued by the corporates are being eventually passed on to the banks by way of restructuring, etc. Now imagine if a bond market is shallow and the issues are subscribed almost entirely by the institutions like banks and HNIs, the bubbles may get obscured but if such issuance is subscribed by retail investors and he burns his fingers in the process; daggers will be immediately drawn with target being the regulators / supervisors / government, et al. There seems to be a direct positive correlation between the banks rising impaired assets and such issues in the market getting bad.

    Gautam Haldipur

    6 years ago

    Excellent article by William Gamble. He has said the ultimate truth. There is a lot more to this Conundrum than meets the eye. The Monetary policy, managed by the RBI has done the right job (much to the short term discomfort of so many)steering us with resolve through very tough times.The Fiscal policy, managed by the Government is the sore point though feeble, lackadaisical attempts are made to address the objectives from time to time.The genesis of this is so called political compulsions.In the greed of short term expediency, we are, in fact sacrificing long term benefits. Second, the list of 10 Companies mentioned are without doubt highly leveraged companies with truncated abilities to withstand severe economic downturns.The only likely thing they would do is lobbying to save their necks. The China Growth story--a disaster in the making! Many will disagree with me on this. But, keep in mind that reckless growth, fuels very high inflation & leads to a vicious Black Hole. Therefore it is better that we choose a path that brings about sustained, consistent & solid growth, which, in the long run will pay good dividends in all respects & take us to a more resilient & vibrant future.Ben Bernanke's system does not have a strong foundation. The day he goes for Q.E. tapering, you will see the fall out yourselves. However, the silver lining is: Raghuram Rajan is a no non-sense man & focussed. Leave him to do his job with full freedom & see how he can kick-start the entire economy.May the Almighty give the requisite strength & perseverance to him to get things going.

    REPLY

    Dayananda Kamath k

    In Reply to Gautam Haldipur 6 years ago

    the ecent statment of our great finance minister that he is happy with the credit growth. i should wan the rbi governor that today bankers are doing banking for statistical data so that they can show better performances. by increasing the advnces you are reducing the percentage of npa to total advnce. i still remember a chairman of a nationalised bank pressurising to give tractor and tiller loans in late 1980's and one zone recklesly sanctioned loans without any meaning ful appraisal. and the justification is even if there is non repayment we will achive our lending target for agriculture as by then interest recivable on advances head has been abandoned and interet i being debited to the loan account and shown as profit and prudential norms were not being in vogue then. suden increase in npa as soon as cmd is changed is also one of the effects of banking for satistical performance. and raghuram rajan has already given and evidence that he can be fooled by statistics in gujrat development report.

    Gautam Haldipur

    In Reply to Dayananda Kamath k 6 years ago

    This type of a regime came into being the moment Banks in the country were nationalised about 4 decades ago. The day the order was passed, we cud see a veritable change, the very next day in the Banks. In a short you have clearly pointed out at "Window Dressing" Balance sheets & performance parameters.The Real Test comes when you are able to face severe long drawn downturns in the
    economy.Given the right freedom & more Fiscal prudence from the Government of the day, RR I think can do it.

    nagesh kini

    6 years ago

    The US Treasury Secretary, Connally's statement that the $ is "our currency and your problem" ought to be an eye opener and RBI Governor's warnings ought to be taken extremely seriously.
    Mr. Gamble's well written article needs to be read by all concerned who are all ga-ga on FDI and FIIs.Little do they know that all that comes in here is nothing but "hot money" that is looking for higher returns with an element of safety that India along among the emerging economies offers. They don't simply come out of love for India. They've a hidden agenda - greater returns!
    Listen to Raghuram Rajan!

    Anil Agashe

    6 years ago

    I believe Raghuram Rajan is absolutely correct. Others seem to have a very narrow view of things and will suffer in the long run.
    The companies mentioned in the article are financially weak and can easily default and put good corporate plans to borrow abroad in jeopardy and may affect India's credit rating as well.
    it is quite possible that China will collapse under the weight of its debt one day in future.
    We should be watchful now and suffer in short run and be safe in the long run.

    REPLY

    Dayananda Kamath k

    In Reply to Anil Agashe 6 years ago

    problem is the way the economy is being managed by the chandal cowkadi the short term suferring can continue to long term sufferring also. we adopted the policy of america when we never had the problem of america. the present uptrend is only because of postponing the problem.

    Dayananda Kamath k

    6 years ago

    when entire govts policy is seling everything to fiis and debar local investors from the markets through unimaginative rules, what raghuram raan can do.every institution is currupted by these currupt politicians. bubbles are created so that somebody can benefit. the credit policy of banks itself is proof. if can controll that lot can be corrected.how you can lend at base rate for housing and vehicle loans and at exorbitant rates to manufacturing industry. it has only helped land sharks. during prime rate regim how banks could grant 70% of advances at less than primerate.that has led to the reckless borrowing and now they are facing the problem.

    Jose Koshy

    6 years ago

    The Gov. is trying to get the structural model right in India by controlling NPA's and going behind Defaulters & also exposing them to all Banks and getting a Score like CIBIL. These moves in the Long term will auger well for the Banking system & the economy..Some Short term pains will have to be digested. He would go on to increase Repo by 25 Bps on 29th Oct Vs Market expectation of 50 Bps cut..Inflation & gush of foreign Liquidity will keep his hands tight.

    Are present market valuations justified by forecasts of growth?

    Hopefully the market’s optimism over the Washington negotiations will prove correct and the US economy and global markets will not collapse. But that does not mean that the present valuations are justified by forecasts of growth both for the global economy and corporate earnings

    On Thursday, the US markets had one of their best days this year. World markets across the globe followed suit. The reason is that the US has ‘solved’ its debt limit crisis. Of course, the ‘solution’, which has only been proposed, was not really a solution. It was just a proposal to delay the decision for an additional six weeks. It did nothing to get the government working. It provides no fiscal stability to help businesses invest. It simply guaranteed that we will again be entertained with Debt Ceiling II, the sequel. Besides, the proposal was not accepted by anyone and the parties are still deadlocked as of Sunday. But it doesn’t really matter, does it?
     

    Despite the shenanigans in Washington, the easy money policies around the world are promoting lasting growth. We can count on easy money from the Federal Reserve. They have concluded, with brilliant circular logic, that any taper causes market conditions that make a taper impossible. So it goes on along with more money from the central banks of Japan, Europe and more loans from China.
     

    Markets couldn’t be happier. With about 20 bureaucrats running the world, they are all up. Emerging markets such as India, Indonesia, and Brazil have all recovered from their woes of earlier this year by over 14%. The US markets are near their all time highs and European markets have risen by double digits this year. London and its financial markets have overtaken Germany as the leading market for Ferraris in Europe.
     

    This implacable global growth ‘story’ has defeated any attempt at a correction. It goes something like this. Developing countries growth is indeed slowing, but is still quite vibrant. In the meantime, after years of slow growth or even recession, the developing world of the US and the Eurozone are finally beginning to recover. But is this really the case?
     

    Apparently the IMF doesn’t think so. Its most recent World Economic Outlook has cut its forecasts for this year from 0.3 percentage points to 2.9%. Next year’s forecast was cut from 0.2 percentage points to 3.6%. This forecast is down from the last one in barely two months ago. But that is not the bad news.
     

    The bad news is: this is the sixth consecutive downward revision from the IMF. But it gets worse. In Chapter 1 or the report page 12 chart 1.13, you will find something truly disturbing. The chart shows forecasts made in 2008, 2009, 2010, 2011 and the most recent. There are five charts: one for Japan, Euro area, US, developing Asia and Latin America. With the possible exception of Japan, the most recent forecast is way below all of the others. In light of the new forecast all of the old ones look wildly optimistic.
     

    The strains are beginning to show. A measure of 21 key risk indicators for Asia covering everything from investor complacency to bank to bank trust shows systemic risk on the rise. The most disturbing is a spike in borrowing costs and default swaps for some of the region’s largest banks. This is especially troubling because any problems with Asia’s banks will be transmitted globally. Cross border lending to emerging markets surged by $267 billion to an estimated $3.4 trillion in the first quarter of 2013, according to the Bank for International Settlements.
     

    This was not supposed to happen. The numbers from early September were relatively good. China’s manufacturing and services indexes showed impressive gains and Europe turned positive. But the trend did not continue. The rate of growth in Chinese manufacturing slowed to a fractional pace. Exports fell 0.3% in September compared with the year-ago period, sharply down from 7.2% growth in August and far below expectations of a 5.5% expansion. This trend does not bode well for the famous restructuring, where China’s growth is supposed to pivot from infrastructure spending and export to consumption. Worse the recent growth was based on the shadow banking system whose share of financing rose from 11% in 2011 to possibly 25% today. According to the World Bank, “China’s credit boom may have run its course”. But not to worry! The Chinese assure us that their economy will beat estimates and grow at more than 7.5%, and they probably know the numbers before they are published or even created.  
     

    One of the recent stars in the emerging markets was Mexico. Tied to a slowly growing US economy without the problems of Brazil, it was supposed to do quite well. It hasn’t. Its economy was forecasted to grow at 3.5% last December. The most recent official forecast is less than half that at 1.7%. Private forecasts have been cut to 1.1% partially because US demand for Mexican products has been unchanged for several quarters.
     

    Brazil has gone from one of the most promising emerging markets to one of the weakest. Unfortunately it did not use the boom years to reform its economy. So it boasts the world’s most burdensome tax code. Large durable goods like cars and appliances can cost 50% more than in other countries. Consumers pay 21% of their incomes to service their debts. The infrastructure especially the roads, railways and ports are woefully inadequate. In addition, it has a large deficit. A problem it shares with Indonesia, Turkey, South Africa and India.
     

    Manufacturing data from companies around the globe last month was very uneven. While data from the US was positive other countries were not as strong. Indonesia had a good month in August, but the September numbers were not encouraging. Imports fell 5.7% and exports fell by 6.3% both missing estimates. Korea had the same problem. Its imports fell by 3.6% and its exports fell by 1.5%. Manufacturing production figures for Europe were just as discouraging. They fell or missed estimates in France, Belgium, Italy and Sweden. The only country that rose was Germany. Manufacturing data for Asia was not much better. It was basically flat for India, China, Singapore and Australia for most of the summer. Whatever the outcome of the US political standoff, the episode is sure to have made a dent in the real economy.
     

    In a recent interview with the Financial Times, Nassim Taleb, the author of the famous “Black Swans” was asked if the global financial system was more prone to a ‘black swan’ or improbable tail event than in 2007. His response was that it was more fragile. It was a more vulnerable one because the bureaucrats running the system have no risk exposure.
    They won’t lose their jobs or pensions if things go wrong. So they are free to work on programs like Quantitative Easing, which Taleb regards as a ‘scam’. Taleb’s point is very relevant to the present situation. Simply because an event is unlikely, it does not mean that it won’t happen. They do happen. Hopefully, the market’s optimism over the Washington negotiations will prove correct and the US economy and global markets will not collapse. But that does not mean that the present valuations are justified by forecasts of growth both for the global economy and corporate earnings.

     

    (William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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    What does Raghuram Rajan think of Ben Bernanke’s quantitative easing programme?

    How does Raghuram Rajan, the governor of the RBI, view the experiment of fiscal stimulus that the US Federal Reserve, under Ben Bernanke, has been pursuing? Remember, Rajan had correctly warned in 2005 that a combination of low interest rates, financial innovation, rising asset prices, and behavioural biases was a matter of great concern. The 2008 crisis proved him right. He has similar warning for Fed’s current policies

    Since 2008, the US Federal Reserve under Ben Bernanke has been using an unconventional monetary policy tool known as quantitative easing (QE). It includes massive bond-buying programme that frees up capital for the banks, making it easy for banks to lend, which it is hoped would create economic growth and jobs. The programme is controversial, with some saying that is what is helping the US and world economy grow while others criticise it has adding to exactly the kind of instability we saw in 2007-08. Some of this money eventually found its way to emerging markets, including India. Is this a good thing? Not quite, according to Dr Rajan.
     

    Remember in 2005, Raghuram Rajan gave a similar speech at Jackson Hole, Wyoming, to a conclave of the best and brightest financiers and bankers. He had warned that the risks in the system due to low interest rates, rising asset prices and perverse incentives for banks and investors were not be calculated accurately and that there was a small chance of a catastrophic meltdown. A meltdown did happen in 2008, as he had feared and it put Dr Rajan on world stage as a thinker to be reckoned with.
     

    So it is worth paying attention to what he thinks of the US Fed Reserve’s current policy is. A brilliant speech given at the Bank of International Settlements (BIS), on 23 June 2013, underscores what Raghuram Rajan views are about QE.
     

    “The Fed, led by perhaps the foremost monetary economist in the world, proposed creative solutions that few in policy circles, including the usually conservative multilateral institutions, questioned.” Though he doesn’t name him explicitly, Dr Rajan feels that Bernanke, among many other central bankers, have turned into technocrats humbled by his inability to control economic narrative. He goes on to say, “If there is one myth that recent developments have exploded it is probably the one that sees central bankers as technocrats, hovering cleanly over the politics and ideologies of their time. Their feet too have touched the ground.”
     

    Dr Rajan’s speech has raised the dangers of adopting QE. He says, “The bottom line is that unconventional monetary policies that move away from repairing markets or institutions to changing prices and inflationary expectations seem to be a step into the dark.” In other words, it has unintended, dangerous consequences.
     

    The whole purpose of central bankers is to put the economy back on track and create employment, or in Keynesian jargon – full employment equilibrium. Yet, this has not happened. Instead, according to Rajan, businesses and citizens were actually retaining their savings, postponing purchases and not reinvesting back into the economy. The dollars printed are not circulating back into the American economy in form of real investments viz jobs creation, businesses, etc. In fact, it caused businesses to cut back on jobs! After all, Ben Bernanke’s premise for QE was precisely that: job creation. Dr Rajan explains, “...accommodative policies may reduce the cost of capital for firms so much that they prefer labour-saving capital investment to hiring labour...excessive labour-saving capital investment may defeat the very purpose of unconventional policies, that is, greater employment.”
     

    The reason the Federal Reserve resorted to so called “creative solution” of QE is because the interest rates could not go below zero and therefore the Fed has resorted to alternative or “creative” solutions.
     

    Dr Rajan is critical of this approach. He says, “That the equilibrium or neutral real interest rate is ultra-low—has become the justification for more and more innovation.....the view that the full employment equilibrium real interest rate is strongly negative can be questioned. Once that is in doubt, the whole program of pushing rates lower as a way of moving the economy back to full employment is also questionable.”
     

    Dr Rajan says, “By changing asset prices and distorting price signals, unconventional monetary policy may cause overinvestment in areas where asset prices or credit are particularly sensitive to low interest rates and unanchored by factors such as international competition.”
     

    In other words, money has gone to riskier areas, including emerging markets. Moreover, central bankers in emerging markets are confused as whether to contain incoming flows or revel in greater infusion of foreign capital. The Federal Reserve’s experimentation in the dark, has stumped them. This has put the spotlight on emerging market central bankers who weren’t trained properly. He says, “Few had the training and confidence to question the orthodoxy, and the ones that nevertheless did were considered misguided cranks. Multilateral institutions, empowered by their control over funding, dictated policy from the economic scriptures.” It is pertinent to note the last part of the sentence in the Indian context: Indian bankers and politicians still believed in India’s growth story and ignored the consequences of relying too much on foreign inflows instead of taking difficult decisions to fix the economy and bridge the deficit.
     

    “The dilemma for central bankers is particularly acute when the immediate prospect of a terrible economic crisis is necessary for politicians to obtain the room to do the unpleasant but right thing,” quips Dr Rajan. This is particularly relevant in the Indian context. He says, “For the receiving country, it is unclear whether monetary policy should tighten and attract more inflows, or be accommodative and fuel the credit boom. Tighter fiscal policy is a textbook solution to contain aggregate demand, but it is politically difficult to tighten when revenues are booming, for the boom masks weakness, and the lack of obvious problems makes countermeasures politically difficult.” Simply put: the foreign capital inflows created economic growth which camouflaged the real problems India has. Nobody did anything.
     

    Towards the end of his speech, he fears that such “creative” tools like QE are increasingly becoming a norm rather than an exception. With the global financial world in crossroads, central bankers have been given a free hand to do what they want as they run out of options. Dr Rajan says, “The central banker has to be confidant, and will constantly refer to the many bullets he still has even if he has very few... Perhaps it was the political difficulty of doing nothing after spending billions rescuing the private bankers that encouraged central bankers to act creatively. .. Was it that once central bankers undertook the necessary rescues of banks, they were irremediably entangled in politics, and quantitative easing was an inevitable outcome?”
     

    The speech transcript is a must read for anyone who wants to know more about central banking and economics, and what the future holds for the financial world.

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    COMMENTS

    nagesh kini

    6 years ago

    Will PC at the MOF and his Babus care to listen and not be driven by the US?

    We are listening!

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