India’s economic environment has uncanny similarities with the Asian crisis which plunged stock markets and currencies across the region. Without bold action, it faces a similar situation
By Sanjiv Bhatia
As we turn into a new year, here is a prediction for the Indian economy. Economic predictions are notoriously difficult because, unlike in the physical sciences, controlled experimentation is not possible. But there are now enough episodes in economic history to find similarities and to allow for causal interpretations.
One such episode is the uncanny similarity between India’s current economic environment and the Asian crisis that started in Thailand in 1997, a crisis that within a very short period plunged stock markets and currencies across seven East Asian countries. Hundreds of banks, builders, and manufacturers went bankrupt. The Thai baht, Indonesian rupiah, Malaysian ringgit, Philippine peso and the South Korean won depreciated by between 40 percent to 80 percent.
All this happened despite the fact that Asia’s fundamentals looked good: inflation was low; fiscal deficits remained largely within limits; the existence of independent and well-run central banks; relatively high domestic savings (albeit dropping); a large and growing middle class; an educated workforce (paid relatively low wages); a vibrant entrepreneurial class and a stable political environment. But these fundamentals painted a false picture. Underneath the seeming calm, investors were getting concerned about serious structural deficiencies and policy inconsistencies. Weakening export growth, increasing trade and fiscal deficits, high short-term foreign debts and financial systems that were rotten to the core were creating a heightened sense of uncertainty among investors.
The unwinding of the 1990s boom and the eventual crisis suffered by the East Asian countries were a complicated and multifaceted process. Four significant elements precipitated the sequence of events that led to the crisis. And there is an eerie similarity to conditions that currently exist in India and maybe a harbinger of things to come in 2020.
MORAL HAZARD & CRONY CAPITALISM
Moral hazard is a term used to describe a tendency to take on more risk than is warranted, given the knowledge that one is protected against any loss. This was at the heart of the Asian crisis. The governments in the affected countries directly or indirectly controlled the commercial banking system, and this allowed the banks to operate injudiciously with the knowledge that the state would protect the downside. The South Korean government, for example, directed the banking system to lend to companies that it viewed as economically strategic. As a result, financial institutions were encouraged into funding risky projects with little regard for their profitability. This problem was compounded by crony capitalism, where people favourably connected with the government were able to borrow large amounts of money without proper due diligence. Without the discipline that free capital markets impose on bank lending, the result was overinvestment and inflation in the prices of assets in short supply such as real estate.
India has a similar legacy of state-run banks with investment directed by the government. Currently, through the public sector banks, the government controls 70 percent of the banking assets. And through its mandated statutory buying of government securities (SLR) and state-directed priority lending, it sucks up roughly 47 percent of national savings. Mudra loans are an excellent example of misdirected government-mandated lending as it causes banks to overlend to risky borrowers, which in turn leads to bad loans and eventually to fiscal deficits when the government uses tax revenues to recapitalize failing banks.
Excessive state intervention in the capital allocation process and the associated policies of implicit guarantees combined with crony capitalism and lax banking supervision were significant factors in the 1997 Asian crisis. These same conditions exist in India and have led to poor credit decisions and a massive misallocation of resources. This reckless lending has created a large stock of non-performing loans, posing a high risk to the banking system.
Till 1990, India was a relatively closed economy with less than 15 percent of its GDP coming from international trade. This changed dramatically after the 1991 liberalization reforms. By 2011, almost 56 percent of the country’s GDP was associated with trade. During this period, India’s exports grew dramatically, clocking an annual growth of 25 percent in 2007.
This was very similar to the East Asian countries before the 1997 crisis. Those economies saw fast economic growth fuelled by large increases in exports. But the party ended when China entered the global market, affecting exports from Thailand, Malaysia, South Korea and Indonesia. The rise of the dollar, to which their currencies were pegged, made things worse. Exports started to plunge as these countries became less competitive. Capacity utilization rates and profits on huge investments in production capacity started to plunge. The Asian central banks responded to this loss of export competitiveness by devaluing their currencies, providing speculators with an incentive to attack those currencies almost simultaneously and forcing another round of devaluations.
India faces a similar deterioration in exports. In the first seven months of this year, exports dropped by 2.2 percent. Key export sectors such as leather, gems and jewellery, readymade garments and petroleum have all posted negative growth for four consecutive months and the end is nowhere in sight. From 2003 to 2014, India’s exports grew at an annual rate of 17 percent, but over the last five years, the growth rate of exports dropped to a mere 0.9 percent per year. In contrast, exports from other countries that are competitors of Indian products grew at an annual rate of 20 percent over these five years. Bangladesh garment exports have increased by 40 percent in the past five years while India’s have dropped by 6 percent in the last two years.
India’s export deterioration is reminiscent of the drop suffered by the East Asian countries in the period leading up to the 1997 crisis. In 2013, exports accounted for almost 26 percent of India’s GDP, but today that number is close to 18 percent—a steep drop. Let’s hope that the RBI doesn’t react by forcing a devaluation of the rupee. That could invite the same speculative attacks on the rupee that precipitated the Asian crisis.
Accompanying this decline in exports is a sharp deterioration in terms of trade—calculated as the value of exports as a percent of the value of imports. Increasing terms of trade suggest that a country can buy more imports from the sale of its exports. All the major East Asian countries experienced a sharp increase in terms of trade till about 1996, after which there was a sudden decline as the prices on the goods they imported (oil) increased, while at the same time, prices of their electronics and semi-conductors exports declined. India faces a similar situation. Its terms of trade increased by over 20 percent from 2006 to 2011 but have now dropped back to the pre-2006 levels. India’s exports are just not competitive globally and a depreciating currency makes imports more expensive.
CORPORATE LEVERAGE & GOVERNANCE
There was a pattern of increased vulnerability to capital market shocks that emerged among the Asian countries prior to the 1997 crisis. Companies were highly leveraged and when profits started to drop, their ability to service debt was severely compromised. Indian companies currently suffer from the same malaise. In 1997, the average debt-to-equity ratio of companies in the five countries most affected by the crisis was 85 percent—very similar to the current debt ratio for Indian companies which stands at 88 percent. And profitability of corporate India has been declining, down from a high of 7.1 percent of GDP in 2007 to now only around 2.7 percent. When economic growth slows down, and companies don’t make enough profits to service their debts, things start to unravel.
In a recent article, Arvind Subramanian, the former chief economic advisor to the government, calculated that the cost of debt for Indian businesses now exceeds their profit growth by a staggering 4.3 percent and the share of debt owned by companies that cannot service their debt has risen to 45 percent. This is eerily similar to the situation for companies in the Asian countries in 1997.
There was also a sizeable maturity mismatch in the balance sheets of financial institutions in countries like Korea, Malaysia and Thailand. Short-term debt was being used to finance long-term projects. The problems associated with mismatched liabilities and overleveraging were exacerbated by poor corporate governance. Similar mismatches exist in India. Last year, the IL&FS crash, which has had a considerable impact on lending by the non-banking financial sector, was precipitated by the same set of problems—mismatched balance sheets compounded by poor governance.
REAL ESTATE BUBBLE
Financial excesses inevitably lead to asset bubbles. Typically, a financial cycle is generated by waves of optimism (greed) that result in the underestimation of risk, overextension of credit, excessive price inflation in real assets and buoyant consumer expenditures. Real estate plays a central role in this cycle because it allows banks to lend larger amounts against increasing property values. With rising prices, the value of bank capital increases commensurate with their holding of real estate denominated assets, allowing them to lend even more.
The dramatic turnaround in the fortunes of the East Asian countries from high seven percent growth rates to economic stagnation was preceded by a sharp deterioration in the performance of the real estate sector. A massive construction boom during the eighties and nineties created a huge oversupply of properties and when the real estate bubble burst in countries like Thailand and Malaysia, there were large losses in the unregulated shadow banking sector. India has also experienced a large real estate bubble that started around 2003 with massive investments by developers in housing projects. Rising real estate prices kept feeding into this, and both the regulated and the unregulated banking system poured increasing amounts of capital into this sector. But as with every asset bubble, the underlying fundamentals did not support the run-up in prices. Incomes did not match asset valuations and soon the real estate bubble burst.
Unsold inventory in the top eight cities has risen to nearly 10 lakh units by June 2019, compared to annual sales of just over 2 lakh units. In other words, there are four to five years of sales in inventory, which means there is unlikely to be much capacity expansion in the real estate sector in the foreseeable future. Also, the existing inventory will need to be financed. But after the IL&FS crash, there has been a sudden and deep collapse in NBFC lending—which provides almost 55 percent of total real estate financing. Developers are finding it difficult to stay afloat and we are beginning to see bankruptcies among large developers which will add to the stress in financial markets. This is similar to what precipitated the 1997 Asian crisis.
When an asset bubble bursts, it starts the dominoes falling. As asset prices fall, so do their collateral values. NPAs begin to increase and when investors realize that the government does not have the resources to bail out banks, confidence drops.
By the end of this fiscal year, the government of India will have poured in Rs 3.5 lakh crore to bail out India’s failing public banks—a massive cost to the taxpayers. Investors know that this will soon end because the government faces a massive fiscal crisis of its own. The combined fiscal deficit of all government entities (central, state and PSUs) is expected to reach 8 percent of the GDP—among the highest in the world.
Recent surveys by the RBI are already showing steep declines in both business and consumer confidence. As confidence declines, foreign capital starts to flee, the currency depreciates, exports drop and growth slows down dramatically. All these are now beginning to happen in India.
The only way out as Confucius put it, ‘‘is through the door’’. The strategy the East Asian countries adopted was to quickly and methodically restructure their financial systems by shutting down and selling failing state-run banks and disposing the collateral underlying the bad loans. The key to India’s recovery is also a massive institutional shakeup of the financial system. Merging failing public sector banks will only aggravate systemic risk. These banks need to be shut down, and government intervention in, and regulation of, capital markets should immediately be reduced to a minimum.
The RBI needs to clear the overhang of bad loans in one swell swoop by buying the roughly Rs 9.5 lakh crore in bad loans from the commercial banks and transfer them to its balance sheet. This will give a tremendous boost of confidence to the capital markets. Once the pipeline is cleared of the NPA junk, capital can start flowing again and the economy can start producing goods and services again.
Without bold and immediate action to restore confidence in the financial system, India faces a 1997 Asian crisis of its own in 2020.
—The writer is a financial economist and founder, contractwithindia.com
Lead pic: Banks in Thailand failed and its currency collapsed during the 1997 Asian crisis/Photo: Image by pereslavl from Pixabay