Gear up for another crisis

by Subramanian Swamy (former Union Minister)

Indian Express 15/2/2010

The US financial crisis, which triggered the global crisis, began in the US in August 2007. It was then known as the sub-prime crisis, because housing loans had been recklessly advanced by investment banks even to borrowers who on first glance of any banker would not in all probability be able to repay the loans. Such loans were called ‘sub-prime’ because of the high risk of default. These loans however had caused a huge housing boom in the US and an asset bubble to form.

But risk-distributing new financial products invented by computer-savvy MBAs, such new derivatives, which created portfolios of loans extended by banks and of mortgages of different risks and maturities, enabled banks to sell off at a discount their loan mortgages to investment funds, and the funds did not need to worry about defaulting of sub-prime loans because these derivatives had spread the risk, and the funds were earning on the discounts. Banks loved it because they got fresh liquid funds in place of mortgages.

This was possible because the US economy then, due to a loose monetary policy and low interest rates (in 2003-’07), was booming. This boom also fuelled global international trade by rising imports of US and hence also global growth.

In August 2007 a mild recession hit the US economy. It was enough to trigger and cascade bankruptcies in Investment Funds which had bought heavily these financial derivatives and had recklessly assumed that the US economic boom would last forever. This phenomenon is now called ‘greed’, and the culprits were in the ‘Wall Street’ stock market.

Why did India suffer?

By September 2008, the biggest investment funds like Lehman Brothers and AIG declared bankruptcy. The sub-prime loanees, mostly blue collar workers with normal aspiration to own a house, had because of recession become unemployed and could not repay even a fraction of the loan instalments. Lehman had bought heavily the derivatives and thus became saddled with house properties on foreclosures of loan defaulters and these properties they could not auction off because of the recession and growing unemployment.

Lehman and other funds thus declared bankruptcy. Liquidity in funds was vastly reduced thereby causing a stock market collapse. US demand for goods from abroad, i e, imports got reduced, and this affected European economies which had imitated the US sub-prime boom thanks to US multinational investment banks and subsidiaries. China got affected because its economic boom was export-led, enabling that country its huge trade surplus with US and EU and consequently rising foreign exchange reserves.

But why did Indian economy get affected? In the United States, sub-prime loans were possible because of weak oversight of banks. But the Reserve Bank of India strictly regulates the banks in India, and banks are forced to hold reserves in the name of SLR and CRR, and purchase of government treasury bonds. Unlike China, India’s exports to US and EU as a ratio of GDP is still small. Then why did India suffer?

Indian economy had a setback not because of financial contagion spreading from US, or because of the interdependent global trade system, but because of our own perfidious financial derivative called Participatory Notes (PNs) compounded by an anti-national agreement with Mauritius to permit even $1 paid-up companies incorporated in that country to invest in Indian stock markets and not be subject to capital gains tax.

Introduction of PNs

The finance ministry’s PN is unprecedented in world financial history. It is a piece of paper issued by designated financial institutions abroad such as Fidelity Investments and Morgan Stanley, which paper does not carry any detail except the money worth, and can be purchased by anyone with cash even without disclosing to any authority his or her name and the source of the funds. That piece of paper was acceptable for transactions in the Indian stock market for buying and selling shares as also short-selling.  

By a special order, the finance ministry exempted the PNs from the purview of SEBI, RBI, Enforcement Directorate and CBI. The SEBI headed then by Damodaran protested and repeatedly wrote to the ministry to permit it as in any other stock market transaction to require reporting of the buyer and the seller as also the source of funds. The Tarapore Committee on Financial Reforms strongly condemned PNs and wanted them scrapped. The RBI governor Reddy kept warning of dangers from PNs. All were ignored. Damodaran and Reddy were denied usual extensions of tenure. Their successors have fallen in line.  Hence the perfidy continues without any accountability.

Thus, billions of dollars of ‘hot’ money entered into the Mumbai stock exchange, that was used for buying and selling shares with PNs almost like cash, in fact better because cash transactions of over Rs 10,000 have to be reported with details to the Income Tax Department. By September 2008, PNs accounted for 60 per cent of the FII funds in the stock market.

When the financial crisis was officially acknowledged in the US following the collapse of Lehman Brothers in September 2008, a liquidity crunch developed in US and later in Europe. Interest rates rose. Liquidity froze and funds were in demand. The PNs which were ‘hot money’ or portfolio funds, just shipped out of India without any hindrance to the tune of $60 billion between October 2008 and January 2009 causing a stock market crash symbolised by the steep fall in the sensex index. It is this that caused the financial crisis in India and not the US sub-prime loan defaults.

Missed by a whisker

Why was PN invented by the then finance minister of India? Because it was to assist corrupt politicians and businesspersons to earn on their loot parked in Swiss banks, Isle of Man, Cayman Island, Macao etc. Till PNs came into existence this loot was just lying in secret accounts and they were paying service charges to the banks for keeping it secretly. Now these bandits and pirates could earn easily on their ill-gotten money through capital gains without paying taxes thanks to the Mauritius Treaty.

In fact so large PNs have become in value, that the movement of the stock market, bulls and bears, could be manipulated by the free entry and exit of this derivative. Thus today our stock market has become rigged. It can be made to rise and fall at will of PN holders’ cartel of corrupt politicians and businesspersons. The sufferers are middle class people who hang on to shares to improve on the yield of their pensions and provident funds but then who cares for them in India? Even the media has been muffled on PNs by this cartel.

The former national security adviser M K Narayanan was bold enough to warn the country that terrorists too were earning on the Indian stock market (obviously via the anonymous PNs) to finance killing of Indians, but he was silenced. Now he is away as governor of West Bengal.

Thanks to the durability of our manufacturing and software IT sectors, we have survived the crisis, despite a poorly performing agriculture sector — for reasons other than global financial crisis. In fact agriculture has been poorly performing since 2003 due to investment starvation and lack of adequate purchase price. Indian manufacturing sector, unlike the Chinese’, is domestic demand driven. IT software giants were skilful in finding new markets and cheaper labour from tier II and III cities in India.

But no time to breathe easier today. Another financial crisis awaits us which too will be of our making. But when it arrives, we cannot overcome it so easily. The coming crisis is due the developing Union budgetary bankruptcy and an exploding public debt. Can we prevent it? Of course we can, but we will not because it requires major economic and financial reforms which the present dispensation is incapable of implementing.

Weak financial health

We had a financial crisis in 1990-’91 during which period, as Union commerce minister in the Chandrashekhar government, I had prepared the blueprints for reform and to get rid of Soviet socialism. Chandrashekhar’s government was succeeded in June 1991 by Narasimha Rao’s government. Rao invited me to join his government as chairman of the ‘GATT’ Commission with Cabinet rank to help implement the reform package. Rao had the necessary guile, if not the courage, to get implemented what he wanted, so he was able to get the reform package implemented in the teeth of his party’s opposition.

Manmohan Singh as finance minister was surprisingly given credit for the reforms by the media, but if he was so capable, how is it that during the last six years as prime minister he has failed to implement a single major economic or financial reform? How has he allowed PN to flourish when anyone can see it is a perfidious corrupting anti-national derivative that will ultimately ruin the Indian economy by a killer blow of fleeing the country at short notice after a budgetary crisis?

The budgetary crisis looming in the horizon is that the allocations for major heads of expenditure, which cannot be reduced without creating a crisis such as government employees’ salaries, pensions, police, defence, subsidies, interests to be paid for past loans taken by the government, etc, now cover 98 per cent of the current and capital account revenues accruing to government. These allocations are revenue expenditures, and hence not asset building or investments for development projects.

Moreover, in the revenue budget, these expenditures far exceed the revenue. Thus the revenue budget is in a huge deficit which is covered by taking more loans from public sector banks, and regrettably for economic growth by creating a surplus in the capital account. In a financially healthy economy, it should be the other way around — surplus on the revenue account and a deficit in the capital account.

This present situation however cannot continue for long because the loans from the public sector banks to government have to be paid back. But here the government faces a developing debt-trap, i e, a situation when the past loan repayments will exceed the new loans the government would take. At present government pays back 96 paisa for every rupee for new loans. Public debt is now over 90 per cent of GDP and on an exploding trajectory.

Three years before doom

My projection is that by 2013 more than a rupee has to be paid back against a rupee of new loan. Then we are in the debt trap. If the government tries to get out of it by printing new notes in the mint, it will generate unbearable inflation. Already the stimulus has accelerated money-supply growth, and pumped money into the economy excessively. Unscrupulous persons with political clout have got hold of most of the stimulus funds and are using them to engage in forward trading and plain hoarding to cause a galloping inflation today.

Fiscal deficit, which measures this excess money in the system, is already at a dangerous level of 13 per cent of GDP when according to the Fiscal Management Act it should be statutorily near zero. Thus the government is violating a law which it ought to be complying with. Such is the irresponsibility, or desperate situation, the government is in today.

India is of course resurgent today in vitality and spirit of our people, but no thanks to current government policy; instead, it is in spite of it. India is resurgent because of the economic reforms set into motion in 1991-’95. No government has dared to reverse it, but no government since has dared to take it structurally forward. We still have three years to rectify matters with new financial reforms but with the present corrupt dispensation, it is not possible. As in the past, a crisis, this time a budgetary bankruptcy, will turn out to be a blessing in disguise for the country and enable the necessary reforms.

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