By Vivek Moorthy Indian Institute of Management Bangalore

1. Comments on “An Agenda for Asian Financial Reform”by ChangyongRhee and Nicolas VéronNovember 21, 2011IGE/ADB Seminar, Seoul By Vivek Moorthy Indian Institute of Management Bangalore

2. Summary of their paper There has been a Great (Atlantic) Backlash against financial deregulation after September 2008. Question this poses: Should Asian economies resist or embrace this backlash? Their conclusion: Backlash should be resisted on the following grounds: To begin with, Asian economies are less financially developed (more bank lending, less securitization). Growth in Asia was much less adversely affected. Asian situation is generally different from North America. Hence, their policy recommendation: continue with developing bond markets, and further securitization. IIM Bangalore, November 21, 2011

3. Summary of My View Asian economies should continue with domestic financial liberalization, but external liberalization should be undertaken on a specific country by country basis, based on its economic circumstances. IIM Bangalore, November 21, 2011

4. Rationale - Part I • Bank lending is no guarantee of financial or economic stability. • Of three great collapses since World War I, USA 1929, Japan 1990, and world 2008, securitization and derivatives played a role only this time. We should not over blame them. Low interest rate policies that triggered asset bubbles and then deleveraging played a vital role in all three cases. IIM Bangalore, November 21, 2011

5. Rationale - Part I (Contd.) • In USA, much of the housing credit that went bad was not securitized, made by small banks and S&Ls. • As the number of banks closed by the U.S. Federal Deposit Insurance Corp. has grown rapidly this year, it has become clear that the vast majority of them had nothing to do with the strange financial products that seemed to dominate the news. … What they did do is see loans go bad in volumes that they never thought possible. … Year after year, these bank grew and grew, and took more and more risks. Losses were minimal. Cautious bankers appeared to be missing opportunities. … Any bank that did not lower its lending standard from 2005 through mid-2007 would have stopped growing. – “Bad loans pull banks into failure” by Floyd Norris, International Herald Tribune, August 21, 2009 IIM Bangalore, November 21, 2011

6. Rationale - Part II To justify this conclusion, my approach is to ask: are prices in deregulated domestic and forex market in sync with their fundamentals? Evidence: For interest rates, both short and long term, yes. Fisher effect holds even for short term rates. For exchange rates, no. The Uncovered Interest Parity condition does not generally hold. Failure of UIP manifests itself in ‘carry trade’: country with higher rate has a rising currency for long, then it collapses. This is evident in say US dollar Japanese yen rate movements. IIM Bangalore, November 21, 2011

7. Rationale - Part II (Contd.) Relative performance of Fisher equation versus UIP: Oct 1995-Jan1996 data (before Euro, large sample). IIM Bangalore, November 21, 2011

8. Implications of Parity Conditions Strength of Fisher equation suggests that developing and liberalizing bond markets should continue. However, bond markets can collapse due to panic over unsustainable dept levels or fear of default. Failure of UIP and associated currency crises (defined as a sudden drop of 10% or more under fixed or flexible rates) suggests that mild to moderate capital controls are warranted. Recommendation: Continue developing government and more so corporate bond markets, but financing should be largely domestic. IIM Bangalore, November 21, 2011

9. Features of Indian financial markets • Government bond (G-Sec) market is large, but not active. Corporate bond market is small and inactive. Situation can be described as quasi financial repression. • The SLR (Statutory Liquidity ratio) for commercial banks is not binding, banks hold G-Secs in excess. • But they hold these bonds since they are shielded from price risk. • If interest rates rise, they have been allowed to shift bonds to Held To Maturity category. This enables them to avoid taking a capital loss from rising rates. So bond yields do not keep pace with inflation. IIM Bangalore, November 21, 2011

10. Features of Indian financial markets Source: “India’s Bond Market–Developments and Challenges Ahead” by Stephen Wells and LotteSchou-Zibell, Working Paper Series on Regional Economic Integration No. 22, ADB, December 2008 IIM Bangalore, November 21, 2011

11. Borrowing by Indian Corporates Unless the G-Sec market functions well, the corporate bond market cannot develop. Economy is affected. In India corporate extensively borrow abroad within available limits since Indian rates are much higher. However when rupee suddenly depreciates, the long-term costs of such borrowing are incurred. If there were a developed corporate bond market, corporate investment demand can be met domestically, thereby reducing currency crisis and associated recession. Crucial to bring down inflation to world/ASEAN levels to reduce debt inflows. VM article, FEER, June 2007, IIM Bangalore, November 21, 2011