Its time to develop a new risk paradigm
The subprime crisis started with lenders in the US pushing home loans to people who just didn't have the capacity to service them.
These unviable loans do not stay on the books of the lenders for long. They are securitised and sold off to other investors in various esoteric combinations. How risky these instruments were, the investors didn't have a clue — they chose to swallow the triple A rating the credit rating agencies gave them and bought them up by the tonne anyway.
When interest rates went up, as the Fed raised rates to combat inflation, default on these loans began. Worse, fears of large-scale default began to mount. And defaults on loans lead to mortgage foreclosures, bringing houses on to the market.
House prices have not just stopped soaring in the US, but also started declining, as more and more houses come up for sale. The drop in house prices makes the outstanding loans riskier still — the loan-to-house-value ratio goes up. If the loan against a house is larger than the market price of the house, even foreclosure will not prevent loss. So, the closer the value of the loan approaches the value of the house, the riskier the loan.
When this perception of risk goes up, lending freezes up, throwing sand into the economy's machinery. Further, funds undertake a manoeuvre called flight to safety. This is where developing economies like India get hurt. India, and such economies classified as emerging markets, are still seen by developed country fund managers as risky propositions. So the flight to safety will see some funds pull out of countries like India. This could lead to a stock markets slide in these economies, loss of confidence and slowdown of the real economy. This is one source of disruption.
The other source of disruption is construction-led slowdown in the US. This could hit developing economies that export a lot to the US. Around 40% of Chinese exports, for example, go to the US. About 22%of Indian goods exports go to the US and a significantly larger share of India's service exports.
Why should we crib about such disruptions? If the Indian economy is growing at 9% plus rates thanks to globalisation, and we celebrate that, we should also be able to absorb some shocks arising from the same globalisation process; shouldn't we? Wouldn't it make more sense to be a little philosophical about it? Even if the Indian economy is fundamentally strong, and even if the domestic stock market is well governed, Tsunamis from the global economy could still batter us.
Fatalism would be completely the wrong response to the present sort of crisis. It is important to see that developing countries are part of the problem and that they can do something constructive as well.
The original sin in the subprime crisis, apart from the greed of the American loan-pushers, is the surplus liquidity sloshing around in the US. A large contributor to this surplus liquidity is the group of developing economies with trillions of dollars in combined forex reserves. Instead of investing the bulk of their reserves in US treasuries, these economies should invest them in other economies, including themselves. This calls for breaking the paradigm of risk set up by the developed economies and blindly followed by India and the rest.
The crux of the new perspective would be faith in the growth potential of the developing countries. A flight to safety for developing economies should mean investing in themselves, rather than investing in the developed economies.
If Mexican telecom can make Carlos Slim the richest man in the world, isn't Mexican telecom a safe bet for India, China, Brazil and South Africa? Why can't Indian Information Technology, in which firms have routinely been growing at 30% and more a year, be seen as an oasis of safety for the deployment of Russian and Middle Eastern oil surpluses? Why can't South African coal-to-gas-to-liquid technologies and Brazilian aircraft manufacture be seen as feeding and feeding off the robust growth of the developing economies and thus fairly well insulated from risk?
All this, of course, is complete heresy from a traditional standpoint of risk assessment. How can foreign exchange reserves, worth cumulative trillions in the hands of the developing economies, be deployed in anything but the most gilt-edged of developed country debt? But let us appreciate that the government of Singapore has been investing, and investing very profitably, in emerging market companies for quite some time. And even India has turned its back on traditional assessment of political risk while buying into oil blocks in Africa.
Time was when 'developing' was a euphemism for basket cases. The times, they're a-changing — except in official policy
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