Investing in India: The Honest Truth by Ajit Dayal
Fw: This Week's Honest Truth - Flowers for Dr. Reddy
It is time to send a bouquet of roses to Dr. Y. V. Reddy.
A really large one.
As a gesture of "Thank You" from all of us for keeping India afloat at a time when the world is reeling under the weight of a scary global financial crises.
Dr. Reddy retired as the Governor of the Reserve Bank of India on September 5th, 2008 but his acts - and actions - while at the helm of the RBI has, in my opinion, saved India from a total meltdown. The meltdown that we are witnessing in the US and Europe and in countries like Iceland which got carried away with access to low-cost easy money.
Dr. Reddy's caution was typified by the old-fashioned suits that central bankers wear. His old-cut and boring grey and dark suits were reminiscent of a visit to the house of a disapproving uncle. An uncle who always wanted to know why the child's hands were dirty and the clothes stained with mud.
The never-ready Dr. Reddy was constantly criticised for not allowing India to dance with the winds of change that had overtaken the global financial markets. The policies of the RBI were often at loggerheads with what the new-age economists wanted. Free markets - they urged - free up banking - free up everything.
But Dr. Reddy worked with one goal in mind: how to keep India and the Indian financial system as immune as possible from the lack of risk control that had enveloped the world. His more well-known peers had succumbed to pressures from the "real" world: The world of unreal financial engineering. The world ruled by the financial geniuses who influenced global economic policy for their personal gain. And pursued it under the guise of "free-markets" .
The International Herald Tribune reported that Gordon Brown, now the Prime Minister of UK and the cheerleader of the rescue pack for the European financial markets, was vehemently opposed to tighter regulation while Mr. Brown was UK's financial representative. Mr Brown's agenda - the article suggests - was to see that London remained the capital for financial transactions and any regulation would threaten that objective. So, lax regulation it was - and the UK public is paying the price for financial innovation.
Alan Greenspan, the Chairman of the Fed, had long ago given up his conservative view of the world. He wore the ragged suits and the old fashioned glasses of the central bankers but his actions of bailing out anyone in trouble and printing money wore little resemblance to the characteristics associated with a central banker. His successor, Helicopter Ben, seems to have surpassed the Master in a short period of time.
But Dr. Reddy did not budge.
And today India can sleep well because - despite what you hear on the idiot box or read in print - Dr. Reddy's job of being a central banker has kept India from being part of the crisis that has kept central bankers - globally - awake throughout the night as they try to figure out what to do.
A crisis that has forced leaders of governments to work on weekends as they huddle together to find band-aid solutions to this crisis of confidence.
India's problems are really of little significance relative to the global crises. Our economy is not crumbling. Our banks are not leveraged. Our consumers are not in debt the way they are in other parts of the world. The problems we have - and we do have them - are of the "Made in India" kind because Dr. Reddy did not allow us to import - duty free - the "Made in Everywhere Else" problem. As a country we still get confused between making policy for the sake of making policy' or making policy with an end objective in mind. Our political leadership, with an election around the corner, looks hesitant and seems to have lost confidence in all the PR stuff they churned out about India Shining, Resurgent India, or !ncredible India.
A few weeks ago, Bloomberg news reported that Chinese Premier Wen Jiabao told a gathering of bankers and corporate executives at a World Economic Forum gathering in Tianjin, "When economic and financial crisis occur, economists and entrepreneurs, people and politicians, should be confident," Wen said. "At the moment, confidence is more precious than gold."
Ahead of the curve
Dr. Reddy had loads of confidence. And acted with determination.
Central bankers have a tough job. They have to protect the value of their country's currency; they need to ensure that inflation does not get out of control; they need to support economic policies that help create jobs.
Politicians get elected by promising the impossible. "Don't worry", the politicians tell the voters, "We will make sure you get jobs at great salaries - and that the prices of essential good will not increase. We will make India a great economic power."
While on the election campaign trail the politicians also promise things like free loans, free rice, or some guaranteed employment schemes. To make life more interesting the politicians may burn a few places of religious worship along the election trail. Occasionally, they will hassle people from some other state who seek a job in their "mother" state. Having left their voters a bagful of candies, the politicians tend to disappear for five years till the next elections.
And once the politicians are gone for five years, the central bankers are left to do the dirty work.
The central bankers are left to worry about the effects of a generation of diabetic patients overstuffed with sugar-coated sweets and chocolates - sometimes laced with adulterated ingredients.
The jobs the politicians promised need to be paid with currency notes.
The handouts the politicians declared and the promises they made - to build roads, bridges, factories - need to be paid for in currency notes.
In most instances, what the government collects by way of taxes is not good enough to meet the costs of all the promises. The RBI has to print the notes to plug the gap, the deficit. The RBI has to print paper currency to pay the bills.
And printing too many notes can lead to a situation where inflation gets out of control.
And if inflation gets out of control, the value of the currency falls. If currencies lose value, it can lead to inflation.
Sometimes, with a view to generating quick growth - another wonderful point to discuss when an election is on the horizon - the policy makers in the government want "growth at any cost". Usually that means asking the central bank to lower interest rates in the country. This allows people to buy what they really cannot afford to buy - but now can afford to buy because the cost of borrowing (the famous EMI) is lowered.
We witnessed the debate played out in the media over the past two years. The Ministry of Finance wanted interest rates to be reduced and the RBI said "no".
Lowering interest rates, felt the RBI, would lead to a lack of pricing discipline and risk assessment by the banks. The RBI was under tremendous pressure to reduce interest rates. They did not. Since 2006 they raised interest rates. The RBI raised the amount of capital that banks had to keep aside against loans given for homes, loans given against real estate projects, and receivables against credit cards. They controlled the borrowings of Indian banks from international sources. The RBI was not keen to see India hostage to an unfriendly world. They, like a true central bank, were concerned about what could go wrong when and if the world turned. Not about the rewards of being a friendly central banker.
(And by the way the RBI has been saying "no" to P-Notes since December 2003. Remind me to send Dr. Reddy a bouquet for that, too.)
Saving India from financial catastrophe.
Source - Bloomberg
This chart shows the India 10 year Bond Yield (dotted orange line) and the Repo Rate (the rate at which banks borrow from the RBI). The period between the two red vertical lines was when Dr. Reddy was the RBI governor. Dr. Reddy was making money expensive to control a super-fast economy.
From default to choice
India has been witness to many crises in the past. And some pretty big ones after we began on our own economic reforms in 1991.
There was the Tequila crisis when Mexico went bust in 1994.
There was the Asian Crisis when the magical Asian Tigers went bust in 1997.
There was the LTCM collapse which led to South Korea and Russia going bust in 1998.
In each of these crises, the central bankers of these countries had set themselves up for the fall. They had allowed the companies and banks under their jurisdiction to borrow excessively and rely on foreign capital. While the world was greedy and no one priced risk correctly, all these countries enjoyed boom years. When risk got re-priced - as is being done now - and capital was in short supply, all the Salsa dancers and Tigers sunk into disaster.
But, during those crises, India was still a relatively closed economy. Our total trade with the free world was less than 10% of GDP for a long time. Today it is over 25% of GDP. India is now a more open economy.
The RBI has allowed Indian individuals to invest overseas; they have allowed us to use Indian credit cards anywhere in the world; they have allowed Indian companies to buy companies overseas.
The uncle has had no problem letting the child play in the mud - but he has first used a stick to ensure that the mud is not quicksand.
But that did not make our finance companies happy. Like the finance companies monitored by Mr. Gordon Brown during his tenure, our "Made in India" finance companies wanted India to have access to any and all capital. The colour of money is green, they said, why should the RBI care where it came from.
Thank god, the RBI did care.
Thank god, Dr. Reddy did care.
Unlike the central bankers in Iceland, who must have been so enthralled by that classic line from "Gone with the Wind": "Frankly, my dear, I don't give a damn"
The top 3 banks in Iceland borrowed US$ 60 billion from the global financial markets. The value of their liabilities is 12x the size of Iceland's GDP. Their foreign currency reserves are only US$ 3.7 billion.
Now the top 3 banks in Iceland are bust.
And so is Iceland.
It is seeking US$ 8 billion from the IMF, Russia, and some Nordic countries. CLICK HERE to read what my colleague had to say about Iceland in 2006).
If Dr. Reddy had not done what central bankers are supposed to do - the Indian banks would have all been in an Icelandic mess.
Remember: financial geniuses - in India and overseas - have generally been rewarded for some mythical annual profit and have left the mountains of debt to be cleaned up by tax payers' money from bailout programmes. Their rewards stay with them. And they live in prime health. Sub-prime is the problem of the public.
A new era, a new response
But despite all the great work that Dr. Reddy has done, India still got hit a bit. Some cracks have appeared in the system.
The stock market continues to show its true colours as a casino rather than a place where savers (like you and me) provide capital to companies to build long term businesses. The P-Notes are the mysterious Phantoms who have left the Opera - and us wailing as we see a meltdown in the Indian stock markets.
Yes, some companies were over extended and some banks did not have great pricing models for the risks they took. Many banks focused on market share, rather than profits. They will stay solvent and they will not fail - but these banks are not likely to see the profit growth the investors in their shares had expected. A minor crisis. But an expensive one if you own shares in these "market-share" banks.
This is a new era and it requires a new response.
The new Governor of the Reserve Bank of India, Mr. Subbarao, has responded firmly. He has thrown money back into the system and started the process of lowering interest rates.
Dr. Bimal Jalan, who was the RBI Governor till 2003, lowered interest rates in India as a response to the technology bubble, UTI going bust, 9/11, and SARS. The situation needed some money pumping. The plumber was there to turn on the faucet.
Dr. Reddy, who took over as the Governor of the RBI in September 2003, inherited a weak economy but began to see significant capital inflows and solid economic growth since 2004. Once the plumber sees the tap flowing fully, he reduces the pressure of the water flow. Sometimes he shuts down the tap. Dr. Reddy set forth the appropriate response and began the long journey of increasing interest rates and slowing the pace of financial innovation (see Chart 1).
Dr. Reddy had stalled the introduction of the Credit Default Swap markets, one of the root causes of the global financial crisis. If CDS was allowed in India, we would have been an Iceland by now! Why am I so sure? Look around you and see what the "market-share" banks have done - would they not have enjoyed an opportunity to make another quick quarterly profit - and leave the garbage for someone else to clean up? That is the DNA of the current financial reward-me-now generation of market-share bankers.
On October 20th Prime Minister Manmohan Singh read out a statement in Parliament to confirm that India is quite safe from the turmoil. "Our banks", said the Prime Minister, "both in the public sector and in the private sector, are financially sound, well capitalised, and well regulated."
We believe that - and we know we have the RBI and Dr. Reddy to thank for that.
Thank you, Dr. Reddy, and I hope you get more flowers from the bankers whose very banks you have saved.
Note: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt Ltd and Quantum Asset Management Company Pvt Ltd.. Views expressed in this article are entirely those of the author and may not be regarded as views of the Quantum Mutual Fund or Quantum Asset Management Company Private Limited.
