Development Bank Research Bulletin

Will India collapse in balance sheet crisis? a worse scenario analysis

Special note: this analysis is more a stress-test/worse-scenario type of exercise and "thought experiment". I don’t think a crisis is imminent for India, neither do I think it is a large-probability event. An external debt crisis is in particular impossible. The analysis however, by dissecting the problem, helps you identify the weakest links of the system and hopefully may help inform policy-makers in addressing the problem ealier than later.

Will India collapse in balance sheet crisis?

My evaluation is that: India’s national balance sheet is unsustainable in the long term, but financeable  in the short term. Nouriel Roubini has the same opinion in his article “A balance sheet crisis in India” (PDF file)

First, let me tell you why it is unsustainable in the long term. When evaluating a country’s vulnerability to crisis, we need to examine the overall balance sheet of the country, which include not only the corporate and banking sector, but also the government sector.  This is particularly true in India and China, where the liability can be easily moved between balance sheets of the banking sector and the government as a result of strong state intervention in the economy.

In both India and China, governments are heavily involved in loss-making projects. But the losses are recorded differently.

In China, government forces state-owned banks to extend so-called “soft loans” to industries and enterprises favored by the government’s fiscal goals, and thus the huge losses are recorded in the banking sector as non-performing loans.

In India, the government directly involves in subsidizing these “white elephant” projects,  and then finance the expenditure through issuing government bonds to captive state-owned banks. Indian government thus accumulates huge public debts, which amount to more than 400% of its annual revenue.

We have to understand that, although the losses are recorded differently in India and China, if we examine the balance sheet of the country as a whole, they are not better than each other. If Chinese government increases its public debt to the level of India, she can use the revenue to write off the bad loans of the banking sector for many times. Similarly, if Indian government is to default or restructure on its debts, or there are doubts among depositors about the government’s repayment capacity, Indian banking sector will be broke over night as more than 35% of Indian banking sector’s total assets are in the form of government securities. Currently, government papers are treated as very safe and capital and loss reserve is not allocated to safeguarding against potential future losses, which results in misleading capital adequacy ratios.

In a worse scenario, such structure can cost you dearly. According to Professor Roubini, anything that can go wrong tend to go wrong together:

“Note also that if a bank run were to eventually occur—when and if depositors become concerned about the quality of the bank assets and the sustainability of government  debt—the ability of the Indian government to stem the run via explicit guarantees of deposits may be limited. A solvent government running a low deficit and with little debt may credibly guarantee deposits since it has resources to finance a bailout of the financial system. But an insolvent government cannot credibly backstop the banking system and promise to protect deposits given that the cause of the run is, in the first place, concerns about the solvency of the sovereign. Thus the risks of a bank run and the necessity of a deposit freeze become more severe when the government is effectively insolvent or semi-insolvent.”

Will Indian government default on its debt? India’s public debt to GDP ratio is some 85% and the government is still running large fiscal deficits every year, and even if India can maintain its 7%-8% economic growth rates and the interest rates do not go up, the debt ratio is heading toward 90% by the end of this decade, maybe even faster with the coalition government that will certainly spend more. However, high debt ratio alone will not trigger crisis. India’s public debts have long maturity terms (which however also means that banking sector will experiences large losses when short-term interest rates hike), and are mostly denominated in local currencies (which make India relatively free from crisis in external sector).

Nevertheless, everything that can go wrong will go wrong. When the balance sheet is unsustainable in the long run, it becomes very fragile in the short term too, as participants in the economy are forward-looking. Nothing will happen if India can maintain high growth and low interest rates, and (2) No large scandals happen in state-owned enterprises and banks. But if any one of these factors (growth, interest rate, confidence in public sector) goes wrong, investors will start to reevaluate the situation, and some of them may start to think: hey, the whole system is unsustainable in the long run, someone will eventually have to pay the bill, and I don’t want to be the last one to liquidate my position! 

One may point out that European countries also accumulate huge public debt, and why don’t you worry about them. Well, since when has India become a developed country?

Emerging markets are fragile in nature. Let’s review some famous Murphy’s laws:
(1) Anything that can go wrong will go wrong.
(2) If there is a possibility of several things going wrong, the one that will cause the most damage will be the one to go wrong. Corollary: If there is a worse time for something to go wrong, it will happen then.
(3) If anything simply cannot go wrong, it will anyway.
(4) If you perceive that there are four possible ways in which a procedure can go wrong, and circumvent these, then a fifth way, unprepared for, will promptly develop.
(5) Left to themselves, things tend to go from bad to worse.
(6) If everything seems to be going well, you have obviously overlooked something.
(7)It is impossible to make anything foolproof because fools are so ingenious.
(8) Whenever you set out to do something, something else must be done first.
(9) Every solution breeds new problems
I more and more feel that Mr. Edward A. Murphy is such a damn-good economist! World-class!

Recommended Readings:

Deutsche Bank Research: India’s public finances: do they matter? (PDF file)

Also two of my previous articles on India's banking sector:

Why is India’s financial system less solvent than China’s

Fix Mexico’s banks, not China’s

McKinsey says financial sector reform could raise Chinese GDP by 17% a year

A study recently published in May by the McKinsey Global Institute, titled "Putting China's Capital to Work: The Value of Financial System Reform", has found that financial sector reforms in China, if properly executed, would raise gross domestic product by an astounding 17 per cent, or $321bn.

According to the report: better capital allocation would raise GDP by $259bn, while improving the efficiency of the banking system, switching from paper-based to electronic payments, and diversifying the mix of funding vehicles for corporations would raise GDP by $62bn annually.

Another report by McKinsey points out that Chinese domestic banks are more fragile then we thought, when facing foreign competition likely incoming in 2007.

We usually think that foreign banks cannot compete with Chinese local banks in retail banking, because it is prohibitively expensive for any foreign banks to attempt to replicate a nationwide branch network.  McKinsey report however identify an opportunity: just 2 per cent of local banks’ customers account for half of total household deposits and the bulk of banking profits in retail banking. 

This means that it is actually not that difficult for foreign banks to poach away these small number of "high net-worth individuals"  without setting up a huge branch network. These wealthy customers are more likely to have private transport vehicles and shouldn’t care that much about the location of the bank branches, so long as they are located in the posh financial districts.

Bad news for gigantic Chinese local banks though. The report warns that "If even a small number of customers from this group shift to the foreign competitors, existing banks could face a liquidity crisis"

Hat tip: Financial Time: Ready to compete in global markets

Inefficient banking sector in China is actually an optimal way of taxation

It is well perceived that China's state-monopoly banking sector (with the help of capital control) is a powerful tool in channelling private sector wealth into loss-making state-owned enterprises and numerous white-elephants public infrastructure projects.

A paper written by several Chinese economists however argues that such a mechanism is actually optimal. The idea is as follows.

In developing countries, it is usually very difficult for the government to collect taxes (everyone hides their income), and official taxation is usually very inefficient (it creates a lot of distortion in the economy and a disproportionate burden on hard-working and smart people). Formal taxation thus becomes very costly and creates a lot of dead-weight costs.

But the government needs money and by whatever means the government will try to extract revenue from the private sector. Conditional on the "grabbing hand" nature of the government, an “implicit taxation” by channeling private sector wealth into low-return public projects, through the monopoly banking sector, becomes an optimal and efficient solution:  it is efficient because (1) the cost of “tax “collection is low (you can avoid it only if you completely go underground) (2) the “taxation” is relatively fair and less distorting (it is proportionate to your existing wealth).

Certainly it is even better if the government does not try to extort the private sector in the first place. But if the government does do it, it is better that it does it through the banking sector. At least you don’t need to pay the robber to rob you, and at least hard-working people don’t have higher chance of being robbed.

When a gun is pointed at you, it makes no sense to fight. Take my money but don't hurt me.

Financial Repression and Optimal Taxation (pdf file)

Chong-en Bai, David D. Li, Yingyi Qian, Yijiang Wang

Financial repression entails an implicit taxation on savings. When effective income-tax rates are very uneven, as common in developing countries, raising some government revenue through mild financial repression can be more efficient than collecting income tax only.

William Seidman (former FDIC chairman)’s banking jokes

L.William Sediman was chairman of Federal Deposit Insurance Corporation (FDIC). He has produced numerous banking jokes. Below I put together some of them.

On Russian banking problem:
“Ivan asked his mother – mother, why have I got the biggest feet in the third grade? Is it because my dad was communist? She says, no son, it’s because you’re 19”

On Russian lending problem:
“I went into one small bank and there were three or four of the tougher looking Russians sitting around with AK47s and I said, I know that crime is awful around here, but do you need to have a real army here to defend this small of a bank? They said, well, they are not here to defend the bank, those are the people who collect our loans.”

On Japan banking problem:
“A doctor calls up his patient and says, I have bad news for you and worse news for you. You have only 24 hours to live. The patient says, oh, that’s terrible. What could be worse news? The doctor says, I’ve been trying to get you since yesterday”

On World Bank’s blank check aids
“I was there for the World Bank and we had $2 billion to spend, and if you want to really be treated royally, just wander through Russian with $2 billion that you can provide  them I got so full of caviar that I couldn’t look at a fish egg again.”

On Japan’s stagnation:
“They’ve been in a non-growth economy for many years now... if something like that was going on this country, there would be a revolution. The fact of the matter is in Japan, the average Japanese citizen may be better off than he was seven years ago... since they  have experienced deflation in effect, the average person in Japan is living as well or better than he did in the past. As a matter of fact, the crash in real estate prices ahs allowed lots of Japanese to now live somewhere closer to their work than a two-hour commute by train to Tokyo”

Finance professors rush to China

2006 seems to be a Year of China for economics and finance professors. Although many professors already realized the importance of China very early on, it is in this year that people start to think that the next research frontier has to be China, and you better start working on some China-related topics before others publish them. Professors are no different from multinational corporations that rush to China to seek for profits.

A keystone is that the Financial Intermediation Research Society, a prestigious association of U.S. and European finance professors, headed by Wharton Professor Franklin Allen, decided to host its biennial conference in Shanghai, China.

Here I recommend two papers by Franklin Allen that I think can help you better understand the past, present and future of China’s financial system. They are not very technical papers, so you shouldn’t need any academic background to understand them.

China's Financial System: Past, Present, and Future  (pdf file) (by Franklin Allen, Jun "QJ" Qian, and Meijun Qian)

Abstract:  We examine and compare the role of China's financial system in supporting the growth of firms and the economy with that in other countries, and explore directions of future development. First, we find that the current financial system is dominated by a large but inefficient banking sector, and reducing the amount of non-performing loans among the major banks to normal levels is the most important objective for reforming the financial system in the short run. Second, despite the fast growth of the stock market, its role of resource allocation in the economy has been both limited and ineffective. Further development of China's financial markets is the most important long-term objective. Third, we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is a non-standard sector that consists of alternative financing channels, governance mechanisms, coalitions, and institutions. This sector should co-exist with banking and markets in the future in order to continue to support the growth of the Hybrid Sector (non-state, non-listed firms). Finally, in order to sustain stable economic growth, China should aim to prevent and halt damaging financial crises, including a banking sector crisis, a real estate or stock market crash, and a "twin crisis" in the currency market and banking sector.

Law, Finance, and Economic Growth in China  (pdf file)

Abstract:      China is an important counterexample to the findings in the law, institutions, finance, and growth literature: neither its legal nor financial system is well developed by existing standards, yet it has one of the fastest growing economies. We examine 3 sectors of the economy: the State Sector (state-owned firms), the Listed Sector (publicly listed firms), and the Private Sector (all other firms with various types of private and local government ownership). The law-finance-growth nexus established by existing literature applies to the State and Listed Sectors: with poor legal protections of minority and outside investors, external markets are weak, and the growth of these firms is slow or negative. However, with arguably poorer applicable legal and financial mechanisms, the Private Sector grows much faster than the State and Listed Sectors, and provides most of the economy’s growth. This suggests that there exist effective alternative financing channels and governance mechanisms, such as those based on reputation and relationships, to support this growth.

A disturbing inside peek at China's financial mania

Christopher Whalen has some great insights into Chinese banking sector in his article “The Next Great Pyramid Game: a disturbing inside peek at China’s financial mania” . Investors, read it before buying into Chinese banks!

“China’s leaders do not recognize or even understand what it means to operate private banks with private borrowers and private property in a market economy where corruption is not the dominant factor in everyday life.”

“China’s economy is like the old burlesque comedian with a loose string that when pulled disintegrates his suit.”

He however does have some hope on the ongoing baking reforms in China.

“If American manufacturers think they are having a tough time competing against Chinese manufacturers now, just wait until the day Chinese manufacturers have access to capital at market rates!”

Why financial deregulation was bad for OECD countries but will be good for China?

There is a theory that financial deregulation may be bad for China.  The idea is that when liquidity constraints on households are removed, people may save less, and if high saving/investment  rate is important for rapidly growing countries such as China, China may lose steam as a result of financial sector deregulation.

This is true in the history. Empirical results suggest that financial deregulation in the 1980s has contributed to the decline in national saving and growth rates in the OECD countries.

China however is a different case. She already saves too much, and now everyone agrees that domestic demand/consumption  needs to be jump started. Chinese financial sector is also terribly inefficient, and deregulation of financial sector will improve it mostly in asset allocation front instead of consumer lending front.  For cultural reasons, it is also hard to convince Chinese consumers to take out loans from banks to increase spending.

Currently consumer lending has very small share in Chinese banks’ loan portfolio. This is increasing over time because banks are seeing it as a more profitable and safer business, and foreign banks (e.g. Citibank) are particularly interested in developing products for high net-worth consumers and the rapidly emerging middle class.

Anyway, I can see no reason why cost of financial deregulation (in reducing saving rates) will outweigh its benefit (in increasing consumption and transform China’s economic growth  into a demand-driven model)

Saving, Growth, and Liquidity Constraints
By Tullio Jappelli and Marco Pagano (published in the Quarterly Journal of Economics)
Abstract : In the context of an overlapping-generations model, the authors show that liquidity constraints on households (1) raise the saving rate, (2) strengthen the effect of growth on saving, (3) increase the growth rate if productivity growth is endogenous, and (4) may increase welfare. The first three positions are supported by cross-country regressions of saving and growth rates on indicators of liquidity constraints on households. The results suggest that financial deregulation in the 1980s has contributed to the decline in national saving and growth rates in the OECD countries.

China bad loans may reach total of $900 billion; IMF urges China to restrain lending

(1) “China’s total liabilities for non-performing loans may be as high as $900bn, dwarfing official estimates and outstripping the country’s massive foreign exchange reserves, according to a study of Beijing’s bad debt problem. The study, part of Ernst & Young’s annual global survey of NPLs, says China’s big four state banks alone have bad loans worth $358bn, or more than twice official estimates.” – Financial Times

Update (05/15/06): Ernst & Young withdrew the report admiting that the report contains errors and did not go through normal internal approval procedure. But it is not clear whether they do it because of government pressure and/or concerns for losing lucrative clients among Chinese state-owned companies.

(2) “The International Monetary Fund urged China on Tuesday to tighten access to credit, saying that last week's modest interest rate increase was insufficient to stave off economic overheating. China's M2 measure of money supply, which includes all cash and bank deposits, rose 18.8 percent in March from a year earlier to 31.1 trillion yuan, or $3.88 trillion. The value of new lending in China rose more than 60 percent in the first three months from a year earlier.” --- International Herald Tribune

How could one of the most successful bank regulatory systems fail so easily? The case of 2001 Argentina

Found an old working paper written by Charles Calomiris (Professor in Columbia University) and Andrew Powell (then Chief Economsit of Central Bank of Argentina) back in 2000, in which they portrayed Argentine banking regulatory system as one of the two or three most successful in emerging economies and a role model for every one to follow.

Browsing through the paper, I am deeply impressed by the quality of Argentine system at that time. The Central bank even had an online database of debtors (I don’t know whether they still supply this service) where general public can enter a company name and know the name of the bank extending the credit, the amount of the credit, the quality category of the loan, and the details of any guarantees extended. Bank depositors, shareholders, and researchers thus were able to monitor banks’ credit exposure at real time. Absolute disclosure as a tool for market discipline! This is what any economists would theoretically advise and seldom expect to be realized in the real world. The Central Bank of Argentina however managed to make it happen. If I read this paper in 2000, I would have invested all my money in these wonderful Argentine banks.

Within a year, however, as everyone has known, Argentine banking system failed. Not the bankers' fault; not the bank regulator's fault. The government screwed up in macro policies and brought down the banking system -- something that Calomiris and Powell thought wouldn't happen, not again!

Several lessons for observers:
(1) It is always more risky to praise a country than criticize it. When you criticize a country, you can never be falsified because you can always argue that the arrival of crisis is just a matter of time. When you praise a county, however, the natural law of mean-reversion will always prove you wrong. Things can only get worse.
(2) As a banker, however smart, honest and hard-working you are, the state is always trying to screw you up by some irresponsible fiscal and exchange rate polices. Don’t under-estimate the evilness of government. In the wake of every crisis, Argentines think: “the government won’t do it (freeze the deposit)  again.”. The government won’t change.
(3) When everything looks so wonderful, something must be wrong! If you cannot find it after doing extensive research, something very big must be wrong.

Can Emerging Market Bank Regulators Establish Credible Discipline? The Case of Argentina, 1992-1999 By Charles W. Calomiris, Andrew Powell
Abstract: In the early 1990s, after decades of high inflation and financial repression, Argentina embarked on a course of macroeconomic and bank regulatory reform. Bank regulatory policy promoted privatization, financial liberalization, and free entry, limited safety net support, and established a novel mix of regulatory and market discipline to ensure stable growth of the banking system during the liberalization process. Argentina suffered some fallout from the Mexican tequila crisis of 1995, but its response to that crisis (allowing weak banks to close) and the redoubling of regulatory efforts to promote market discipline after the crisis made Argentina’s banking system quite resilient during the Asian, Russian, and Brazilian crises. Argentina’s bank regulatory system now is widely regarded as one of the two or three most successful among emerging market economies. This paper traces the evolution of the regulatory policy changes of the 1990s and shows that the reliance on market discipline has played an important role in prudential regulation by encouraging proper risk management by banks. There is substantial heterogeneity among banks in the interest rates they pay for debt and the rate of growth of their deposits, and that heterogeneity is traceable to fundamental attributes of banks that affect the riskiness of deposits (i.e. asset risk and leverage). Moreover, market perceptions of default risk are mean-reverting, indicating that market discipline encourages banks to respond to increases in default risk by limiting asset risk or lowering leverage.

What do Brazilian firms get for contributing money to politicians? More money.

Businessmen are not running charity organizations; They are pragmatic and calculating;  They wont’ give you money for free. For every dollar they give you, they will at least recover the costs. Last time I covered an academic paper about Thai elections, which shows that businessmen-cum-politicians reap huge benefits after they get into power. This is true for Brazil too. Let me show you a recent study.

Stijn Claessens and  Luc Laeven (World Bank) and Erik Feijen (University of Amsterdam) examine political campaign finance in 1998 Brazilian elections and find that elected politicians might  be  able to feed back to their financial supporters by directing more banks credits (presumably from state-owned banks) to them.

Every investor in Brazil (I would say it is more the case in Italy where everything is about politics) understand such game; As a matter of fact, we find that stock prices of those listed firms that contributed to politicians rose sharply over  election days.

A further question I would like to ask is: if the rule of the “game” is so clear, why do some firms contribute while the others do not?  Well, certainly I don’t believe that those who don’t contribute are cleaner in their conducts. But why don’t they contribute?

In many developing countries, those who contribute to politicians are actually the least connected. Politicians in Brazil routinely request kick-backs or "monthly-payment" from the business community. A tape revealed that Waldomiro Diniz (an advisor to the Minister Jose Dirceu) was extorting the gambling mafia of Rio de Janeiro to gain funds for Worker's Party political campaigns. These mafias are just underdogs. Those who are truely connected sit on corporate boards.

Those tycoons who really hold de facto power don’t give a shit to these politicians: In January 2002, Celso Daniel, who had already been appointed coordinator of Lula's campaign for the October elections was murdered. Unless there emerges a strongman military dictator, it is more likely that the tail (business tycoons) will wag the dog (politicians)!

Does Campaign Finance Imply Political Favors? The Case of the 1998 Brazilian Elections

Abstract: This paper provides empirical evidence that campaign contributions are strongly associated with market expectations of future firm-specific political favors, including preferential access to external financing. Using a novel dataset, we find that firms in Brazil providing contributions in the 1998 campaign to (elected) federal deputies experienced higher stock returns following the election, even after controlling for industry-specific effects. This suggests that federal deputies were expected to shape policy to benefit these firms in particular. Consistent with such political favors, we find that these firms relative to a control group substantially increased their financial leverage in the four years following election, suggesting that contributions gained firms preferential access to finance.

For a review on campaign finance's role in Brazilian politics, please read Professor David Samuels' article: Money, elections, and democracy in Brazil