Prof. Jayanth R. Varma's Financial Markets Blog

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Lehman Anniversary

I have a column in the Financial Express today on the anniversary of the Lehman failure.

As we examine what we have learnt in the year since the collapse of Lehman Brothers, the most important lesson for Indian policymakers is that for macro risk management purposes, India must now be regarded as having an open capital account.

From a micro-economic perspective, India has a plethora of exchange controls that often force businesses to go through several contortions to perform what would be very simple tasks in a completely open capital account. But from a macro perspective, these regulations only serve to impose some transaction costs and frictions in the process. Exchange controls have ceased to be a barrier – they are only a nuisance.

Large capital inflows and outflows do take place through three important channels which are not subject to meaningful cap – inward portfolio flows, outward foreign direct investment and external commercial borrowing. In addition, foreign branches of Indian banks and foreign affiliates of Indian companies have relatively unrestricted access to global markets. Through all these channels, Indian entities can build up large currency, liquidity and maturity mismatches in foreign currency.

Each one of these global linkages was well known to perceptive observers for a long time, but it took the Lehman collapse to demonstrate the strength of these linkages taken together. Policy makers were taken by surprise at the ferocity with which the storm in global financial markets hit Indian markets.

We must now wake up to the reality that as in the case of East Asia in 1997, the power of the corporate lobby has ensured that capital controls have disappeared in substance while remaining deeply entrenched in form. I believe that in India today, there are only three effective capital controls that have macro consequences.

First, Indian resident individuals cannot easily borrow from abroad. This ensured that Indian households did not have home loans in Swiss francs and Japanese yen unlike several countries in Eastern Europe. In India, the corporate sector has had the monopoly of speculating on the currency carry trade. From a socio-political perspective, this mitigated the impact of the crisis, though it is doubtful whether the macro-economic consequences were important.

Second, Indian companies cannot borrow in rupees from foreigners as easily as they can borrow in foreign currency. This contributed to large corporate currency mismatches which were a huge source of vulnerability during the Lehman crisis.

Third, it is difficult for foreigners to borrow rupees and therefore speculation against the rupee is more effectively carried out by Indians than by foreigners. Currency speculation by foreigners typically takes the form of portfolio inflows and outflows. This has potential macro prudential consequences, but it was not a material factor in the Lehman episode.

This, therefore, is the first lesson from Lehman – Indian regulators should now think of India as having an open capital account while framing macro risk management policies.

The second lesson is that, as Mervyn King put it, global financial institutions are global in their life, but national in their death. Each nation has to take steps to ensure that failure of foreign institutions does not disrupt its domestic markets.

The collapse or near collapse of several large US securities firms did not pose any threat to the solvency of Indian equity markets because of the margin requirements that we impose on FIIs. Under the doctrine that each country buries its own dead, foreign creditors of a bankrupt FII can lay claim to this collateral lying in India only if there is something left over after the claims of Indian stock exchanges and other Indian entities have been satisfied.

In this context, the existence of a large over the counter (OTC) derivative market in India where foreign banks trade without posting margins is a huge systemic risk. Lehman was a bit player in the interest rate swap and other OTC markets in India. As such, its collapse did not create a major disturbance. However, the failure of a large foreign bank which is very active in the OTC market would be very serious indeed.

It is absolutely imperative to move the OTC markets to centralised clearing to eliminate this source of systemic risk.

The final lesson from Lehman is that the idea that emerging markets are somehow very different from mature markets has been rudely shaken. The most mature economies of the world have had an “emerging market style” financial crisis. In the past, the US did not think that it had anything to learn from crises in emerging markets, and was therefore completely unprepared for what happened after Lehman. In retrospect, the US belief in its own exceptionalism was a colossal mistake.

India must also abandon any belief we might have in our exceptionalism and learn from the experiences of other countries so that we do not have to learn the same lessons at first hand.

Posted at 7:30 am IST on Tue, 15 Sep 2009         permanent link