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.)

BL Sebastian
1 decade 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
1 decade 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.
Dayananda Kamath k
Replied to Gautam Haldipur comment 1 decade 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
Replied to Dayananda Kamath k comment 1 decade 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
1 decade 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
1 decade 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.
Dayananda Kamath k
Replied to Anil Agashe comment 1 decade 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
1 decade 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
1 decade 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.
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