review article

Capture and Exclude: Developing Economies and the Poor in Global Finance edited by Amiya K Bagchi and Gary A Dymski (New Delhi: Tulika), 2007; pp xii + 343, Rs 625.

were the regime of easy money that prevailed in the US in the last decade or so and the rapid pace of innovations in the “institutions, operations and instruments” that constitute the fi nancial sector.

The origin and the persistence of the easy money regime for so long is a matter of some dispute. Conventional wisdom has it that the east Asian economies and China, signed by the 1997 crisis, held their export surpluses as reserves, causing a savings glut in the global economy. The global savings glut in the developing economies resulted in a capital outflow to the US, financing not just its current account deficit but also the boom in the stock, housing and commodity markets. There was a virtual glut of credit available at affordable rates. As housing prices rose and lending rates remained low, those who would be considered “sub-prime” borrowers also joined the bandwagon and were granted loans to buy houses. As the tide of “irrational exuberance” eventually ebbed and the housing bubble burst, the (housing) collateral was found to be worth less than the loan and a series of repayment defaults were set in motion. The excess spending that generated the upswing in the goods and asset markets could not be sustained forever.

While the impact of a regime of easy money, which persists, is not in dispute, doubts have been raised about the nature of its origin. Capital outflows from most developing economies were more a c onsequence of reduced public investment than a “savings glut”. This squeeze, a part of International Monetary Fund (IMF) inspired fiscal orthodoxy, would show up as infrastructural constraints at a later stage.

Further, apart from China, the accumulation of foreign reserves in the developing economies was more a consequence of capital inflows rather than exports. In particular, from 2004, financial institutions in the developed economies served as sources of external finance (through bonds, equity and syndicated loans) for firms in “select” developing economies. Further, a mere emphasis on the impact of easy money would be missing the point – the frenetic pace of innovations in the unregulated part of the financial system, the shadow banking system, forms an integral part of the explanation of the ripple effects of the sub-prime crisis.

Underlying the proliferation of financial instruments and the emergence of new institutions was the end of an era of regulation. Signalling this new era was the abolition of the Glass Steagall Act in 1999, which ended the separation of commercial banking and investment banking. Commercial banks wanted to diversify out of low margin, plain vanilla operations like corporate lending and retail expansion; simultaneously, investment banks wanted to move out of simple brokerage into trading on their own account.

The genesis of the crisis lies in the easy money policy followed by the Fed in the 1990s. There was a virtual glut of credit available at affordable rates. As housing prices rose and lending rates remained low, those who would be considered “s ub-prime” borrowers also joined the bandwagon and were granted loans to buy houses. As the tide of “irrational exuberance” eventually ebbed and the housing bubble burst, the (housing) collateral was found to be worth less than the loan and a series of repayment defaults were set in motion.

The first casualties of the repayment failure were the mortgage lending institutions; the next to get hurt were those financial institutions that were significantly exposed to mortgage backed

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securities. Finally, institutions that sold credit derivatives (instruments for transfer of risk arising from decline in credit worthiness of assets) went under.

At the centre of the financial system are the banks. Banks undertake what could be termed a maturity transformation. Their assets are usually long-term loans to firms on the basis of an illiquid collateral and their liabilities are short-term liquid deposits which can be withdrawn at any point. Despite the maturity mismatch, the law of large numbers ensures that the surpluses of a large number of depositors can be channelled to a small number of borrowers. To hedge against possible defaults in repayments, banks are required to set aside some deposits as reserves. The emergence of new financial instruments in the 1980s encouraged banks to throw caution to the winds in their quest for profitability. According to The Economist, three methods were used to achieve this: loans granted to “sub-prime borrowers”, in part as an element of inclusive economic policy but largely to shore up bank profitability, involved shifting assets off the balance sheets through securitisation.

Securitisation involves bundling loans into packages that are then sold to investors as bonds. For instance, the monthly mortgage payments by homeowners accrued to investors as interest payments on their bonds floated by banks – banks were shifting to earning a fee for originating loans and then rapidly pushing these loans off their balance sheets through floating securities based on these loans. Among the buyers of these mortgages were the large Wall Street investment banks: Lehman Brothers, Merrill Lynch, Bear Stearns and Morgan Stanley. By snapping the link between those who vet and monitor borrowers and those who bear the burden of repayment failure, securitisation abetted the easy money regime with easy lending, fuelling the housing boom. The game of passing the risk parcel does not end there. New financial instruments called collateralised debt obligations (CDOs) emerged, instruments that bundled together packages of different bonds and then sliced them into tranches according to investors’ appetite for risk. The Wall Street investment banks sold these new instruments, and thereby transferred risk, to pension

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funds and other institutional investors a ttempting to garner high returns in an environment of low interest rates. And finally, the risk of borrowers defaulting was transferred through derivatives called credit default swaps (CDSs). The buyer of the derivative was “insured” by insurance companies like American International Group (AIG) against the risk of a third p arty defaulting on its payments. This “circular” credit structure amplifies risk because the asset base of several financial institutions such as investment banks, mortgage banks and insurers, gets linked through securitisation (Bhaduri 2009). Yet, perhaps the failure to repay sub-prime loans would not have had the domino effect that it did if these institutions were not so highly leveraged. With mounting losses because of plummeting asset prices, AIG was one of the first to discover that a jittery market was not willing to refinance its position.

At their peak in 2007, financial companies contributed a high 25% of American stock market capitalisation and 40% of corporate profits; the revenge of Ponzi finance was signalled by the collapse of Bear Stearns in 2008. Subsequently, the financial system went into a free fall: the collapse of confidence froze interinstitutional lending and recapitalisation through fire sale of assets became impossible. This marked the beginning of the end of the bubble – sophisticated models built for the pricing of risk which included the capital asset pricing model, the arbitrage pricing model and the Black-Scholes option pricing model were castigated for ignoring tail risks or “outlier” shocks. Most of the Wall Street investment banks had collapsed or had been bought out and the American government was pouring in billions of dollars to socialise the losses of a teetering financial system. Germany and France followed suit with plans to recapitalise their banks with equity injections.

The book under review deals with four sets of issues – the impact of finance capital in the colonial era, the impact of financial liberalisation in the core and the emergence of new patterns of subordination in the periphery, and finally, the question of inclusion in the era of financial l iberalisation.

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2 History of Finance

To serve as the locomotive of the world economy, the leading capitalist country must have a globally accepted currency. It is well known that capitalism draws an increasing number of countries in its fold by showcasing the growth experiences of countries following the capitalist path of economic development. In that a pivotal role is attached to the leader of the capitalist world: it must be willing to run a current account deficit to accommodate the ambitions of the emerging capitalist economies. This should be achieved without the “leader” sliding into a recession or being subject to an increase in its debt-wealth ratio.

At the end of the 19th century and the beginning of the 20th, colonisation was the instrument used to reconcile these two goals: Britain ran a persistent current account deficit vis-à-vis continental Europe, US and other temperate regions of white settlement. At the same time, colonies like India were coerced into serving as ready markets for British textiles and thus Britain enjoyed a current account surplus visà-vis its colonies. This triangular pattern of trade not only bridged Britain’s current account deficit (against the former set of economies) but also provided the wherewithal for her capital exports to the “white” regions (Patnaik 2006).

The stability of capitalism today depends upon a stable exchange ratio between the dollar and other currencies as well as a US current account deficit to legitimise the latter’s supremacy in the eyes of rivals and more recent converts to capitalism. America, the undisputed leader of the capitalist world in the beginning of the 21st century, does not possess colonies which can be prised open to accept American exports, and thus finds it difficult to reconcile the two conditions which would maintain its supremacy. China with its huge surplus in the current account has fundamentally challenged the “as good as gold” status of the dollar while other countries eye the rising US debt-wealth ratio warily. Without massive increases in productivity, America’s writ would soon lack credence.

The essays by Bagchi, Marc Flandreau and John McGuire delve into the details of the essentially coercive financial

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relationship between the centre and the periphery, with or without colonialism, in the 19th century.

3 Impact of Finance

What has been the impact of finance on the developing economies, on India’s financial sector, and on the metropolitan economies?

3.1 Developing Economies

In the immediate aftermath of independence, it was widely agreed that the fundamental problem facing less developed economies was the paucity of reproducible tangible capital: the rate of investment (and the allocation of this investment to the machine building sector) was seen as vital to the expansion of both output and employment. Following Keynes and K alecki, it was thought that investment could not be constrained by savings and thus the role of the financial sector in mobilising, and optimally allocating savings, was deemed of second order importance. Developing countries, as a group, tended to ignore the McKinnon-Shaw thesis of “fi nancial repression”.

In probably the finest essay in the volume, Chandrasekhar underscores the fact that the problem of resource mobilisation was primarily seen in terms of the inability of the State to tax away surplus to finance its investment programmes. The inability of the private sector (both banks and manufacturing) to finance long gestation lag, high risk and low return infrastructural projects provided a natural rationale for state investment. Deficit financed investment was often not seen as a viable alternative to surplus appropriation through taxes because it could be the cause of potential inflationary flare-ups in a wagegoods constrained economy. Thus, the State in “late industrialisers” used both the interest rate and the direction of credit allocation as instruments to influence the pattern of industrial diversification.

This was true irrespective of the trade orientation of the state: it could be charting out an import substituting or export promoting path of development. In India, the interest rates were administered and the maximum interest rate was low, while banks were forced to hold government debt issued at below market rates.

Prabhat Patnaik goes over issues which have almost become the first principles of heterodox macroeconomic theory – that in a demand constrained economy, a fiscal deficit can simply not crowd out private investment. The increase in the net indebtedness of the government is of little relevance in a mixed economy where a fiscal deficit increases capacity utilisation and absorbs unsold stocks of the public sector. Similarly, in a demand constrained one-good economy, using foreign borrowing for imports would simply prolong the domestic recession. And using foreign borrowing as reserves against which fiscal expenditures are undertaken would be puerile: the country would effectively be “borrowing dear to lend cheap”. And finally, Patnaik shows that full capital account convertibility and a flexible exchange rate system would not stimulate investment because it overlooks the distinction between “capital-in-production”, and “capital-as-finance”. This view is surely mistaken – it ignores the links between foreign capital inflows, the build-up of foreign reserves, the ensuing regime of easy money and debt financed consumption which, through the accelerator, stimulates investment. While the direction and the excessively volatile nature of this growth may be questioned, foreign institutional investment (FII) inflows were clearly the manifest basis of the growth spurt in the Indian economy between 2003 and 2007.

Jayati Ghosh highlights the fact that the transformation of relatively short-term liquid liabilities to long-term illiquid assets by commercial banks exposes them to more than average risks. Three kinds of regulation by the central bank attempted to reduce the probability of commercial bank failure – activity regulation, which marked out operations such as investment banking that commercial banks could not venture into; solvency regulation which imposed capital adequacy norms on bank leverage; and finally, liquidity control that sought to impose reserve requirements to limit the creation of high powered money. Financial liberalisation has changed the nature of all three regulations: there are no marked territories that commercial or investment banks cannot venture into. In Chandrasekhar’s evocative phrase, all banks have turned into

“ financial supermarkets” offering a bouquet of services including stock investment, insurance and plain retail banking. With the growth of securitisation and v arious forms of swap, estimating risk and liquidity has become a mug’s game. The central bank, through its discount rate, controls nothing but the floor nominal i nterest rate: money supply in the system could well be endogenous if the banking system is demand constrained. With the government tying its own hands through self-imposed ceilings on the fiscal deficit, Ghosh points out that the central bank’s role as a banker to the government in monetising deficits too appears to be limited. Why does the government adopt such a debilitating policy if its debt is not explosive? Ghosh provides two reasons – the increased dominance of international rentiers who abhor fiscal deficits and the state’s preference for exports instead of the home market as the path to growth. While the former can be easily accepted, one could quibble about the latter: in the post-war era, no developing economy has witnessed sustained growth without prioritising exports.

3.2 India’s Financial Sector

Stephen Hymer once said that the multinational corporations want to create a world in their own image – the statement appears even more true of the Anglo-Saxon financial system. Three papers delineate the impact of neoliberal reforms on the Indian financial sector. In a wide ranging paper, Chandrasekhar delineates the i mpact of financial liberalisation through its impact on the “institutions, operations and the instruments” that constitute the financial sector in India. In what could serve as a primer in development economics, Chandrasekhar draws a sharp distinction between a state-directed financial system, common across late industrialising economies, which predates financial liberalisation and the virtual autonomy enjoyed by the financial sector today. D enationalisation has not only promoted the entry of private and foreign banks – it has led to a reordering of the priorities of the banking sector. The emergence of “universal banks” has implied that distinctions between commercial banking and merchant banking have all but

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d isappeared. Indian banks today do not merely serve as conduits directing financial flows to the “real” sector but are active players in the stock and real estate markets. With loans provided against shares as collateral, as in America, the asset base of banks is becoming increasingly fragile. And with the emergence of new financial instruments such as derivatives, banks are transferring their risks to a spectrum of other institutions. Securitisation tends to slacken “due diligence” when offering credit as the risk is not borne by those originating retail loans. Its increasing importance is evident in the changing profile of bank incomes: fee incomes through mortgage and the personal debt market have become preponderant while incomes from holding treasury bills are insignificant.

Liquidity Growth

An immediate consequence of a system flush with foreign capital inflows, if it is not to lead to a rupee appreciation, is its absorption by the central bank, which then floods the economy with liquidity. Commercial banks cope with this liquidity overhang by lending more than earlier. I ndeed, the credit-GDP ratio which was 30.2% in 1991, climbed to 43.4% in 2004, before skimming 60% by March 2008. This increase did not go into meeting the needs of agriculture or industry – the share of agriculture in the total outstanding credit of the scheduled commercial banks had fallen from 16% in March 1990 to roughly 11% by March 2005; industry too witnessed a decline in its share of credit by 10 percentage points in the same period. In contrast, personal loans increased from “8% of total non-food credit in 2004 to 25% by 2008” (Chandrasekhar 2009). Within this sector, while personal consumption loans for automobiles and consumer durables have been important, housing has accounted for the bulk of the increase in bank credit, rising from 2.4% in 1990 to 11% in 2005. These loans, to attract retail borrowers, are often below benchmark prime lending rates and could have a disastrous impact on banks’ solvency in recessionary conditions.

Budgetary announcements in 2003 ushered in the second generation of financial reforms by making capital gains on equity tax exempt, if the shares were held for

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more than a year. Net capital inflows into India which had, till then, touched a high of $8.2 billion in 2001-02, rose to $15.7 billion in 2003-04, and to a staggering $63.8 billion in 2007-08. The volatility associated with FII inflows is most vividly illustrated through the pendulum swings of the Sensex: as net equity purchases by FIIs increased from a paltry $3.1 billion in 1996 to $8.5 billion by 2007, the Sensex rose from 5,000 in July 2004 to 9,200 in D ecember 2005 before hitting a peak of 21,206 in March 2008.

Parthapratim Pal maps out the links between the stock market and the sources of corporate finance in India. The “Pecking Order” theory of finance holds that in the presence of asymmetric information, a firm prefers to draw on retained profits to finance investment. Debt and equity lie lower down the pecking order in terms of financing investment. Several studies, including the pioneering one by Ajit Singh and his associates have drawn attention to the reversal of this pecking order for India between 1980 and 1990 – external debt is a more important source of finance for I ndian firms than internal finance. Oneway capital account convertibility, introduced in India in 1992, could have led to a realignment of corporate financing patterns akin to those in the metropolitan countries. Pal’s study, which updates earlier findings for the period 1989 to 1998, finds that external finance has remained the primary source of corporate investment. However, equity finance which had gained in importance in the early 1990s gave way to external debt as the more significant source of finance from 1995. The d eregulation of the interest rate in the early 1990s led to a decline in the relative cost of equity finance and several firms floated shares to “capitalise” on the stock market boom. However, by early 1995, the decline in the rate of interest changed the relative costs again.

The more interesting part of Pal’s paper concentrates on the period 1997-98-2002

03: resource mobilisation from the primary market had shrunk to less than 5% of gross capital formation of the p rivate sector vis-a-vis the high of 26% between 1987-88 and 1995-96. Following the strict disclosure norms imposed by the Securities and Exchange Board of India after the

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stock market scams in 1994-95, the corporate sector has relied on the lightly regulated private placement market for r esource mobilisation. This finding has important implications – the boom in the stock market is not mirrored in household savings being funnelled into corporate i nvestments. In fact, so large were the r elative gains from speculation that s everal corporations were using their savings to play the stock market rather than engaging in investment, production and innovation.

‘Denationalisation’

Further, a process of denationalisation had set in with the FIIs owning more shares of the large Sensex companies than any other investor group. In a stock market which is both narrow and shallow, the FIIs had, by 2003, grabbed 30% of the equity of the top 50 Indian firms. The basis of FII participation in the Indian stock market includes the returns on equity in competing developing economies or other events which have little to do with the state of the Indian economy. This was not matched by a similar urge to participate in the initial public offerings (IPOs) of shares in the primary market: Indian retail investors accounted for more than nine-tenths of the shares allocated through the initial public offerings.

These trends were soon reversed – in the de-leveraging following the sub-prime crisis, there was a net FII outflow of $13 billion in 2008-09 and the Sensex dived down to 10,527 in October before touching a nadir of 9,092 in November 2008. The impact has, alas, not remained limited to the stock market. The withdrawal of FIIs has been followed by a liquidity crunch and an accompanying credit squeeze that has drained industry of its growth impulse.

Chandrasekhar points out that the two facets of financial liberalisation – free capital inflows and a deregulated financial system – are closely intertwined. It is well known that an independent monetary policy, capital account convertibility and a fixed exchange rate constitute an impossible trinity. In fact, the “first generation” balance of payments crises were caused by reserves being driven to critically low levels because of monetised deficits in a

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regime of fixed exchange rates. It has been argued that capital flows following the collapse of the Bretton Woods system in 1972 have led to an optimal allocation of the world’s investible resources and facilitated the reduction of risk through a vastly diversified array of assets available to investors. This perspective, in retrospect, appears blinkered – the whimsicality of hot money inflows have ensured that excessive capital inflows have either led to an appreciating currency and a consequent current account deficit. To keep the exchange rate at its medium term equilibrium value, a central bank often mops up foreign exchange which, while maintaining the exchange rate, is potentially inflationary for an economy operating without excess capacity. To sterilise the impact of this purchase of foreign exchange, the central bank compensates through the sale of treasury bonds which pushes up interest rates, robbing it of monetary levers.

Indrani Chakraborty traces out the impact of free capital inflows on the real exchange rate in India post-1991. She, however, has strange ideas of the objectives of fiscal policy in the post-1991 period: the “major thrust of fiscal policy was to reduce the fiscal deficit to control inflation” (p 246; emphasis mine). The government might have been coerced by the IMF to reduce the fiscal deficit but the goal of a reduced fiscal deficit was certainly not to reduce inflation. She uses variance decomposition and the impulse response function within a vector autoregressive model to capture the feedback between the capital inflows and the real exchange rate. Her conclusions that the instability of the real exchange rate “acted as an obstacle in realising the full potential of liberalisation of capital flows” (p 255) and that policymakers should not limit themselves to p olicies which promote investment but take “measures to stop the flight of capital” (p 256) are simplistic at best.

3.3 Metropolitan Economies

Ajit Singh et al draw similar conclusions in tracing out the links between the US stock market and the real sector. Ajit Singh points to two processes which are central to supposed efficiency of the stock market

– the pricing of stocks and the process of corporate mergers and takeovers which penalise managerial inefficiency. While the stock market may be in an “efficient market” in terms of the absence of informational advantage to any player because of public announcements (termed “information arbitrage efficiency” by Tobin), it is difficult to believe that the relative stock prices provide accurate information about the long-term profits of various firms or that stock prices reflect “fundamental valuation efficiency”. In the absence of the latter, there is a hollow ring about the claims of efficient resource allocation through the stock market. Following K eynes, it has been conjectured that investors often follow the herd or use crude rules of thumb in placing their bets. How can we dismiss claims about the stock market leading to efficient resource allocation when the Information and Computing Technology (ICT) sector in America grew at a breakneck pace in the 1990s, in part financed by venture capital? Ajit Singh’s empirical investigations unearths that “inter-country data provide little evidence of any robust relationship between stock market development and ICT development and usage”. Parenthetically, in developing countries, Ajit Singh feels that an active interventionist industrial policy could well simulate the role assigned to venture capital in fostering technological progress.

In a somewhat similar empirical exercise for a long American time series, O lpadwala and Mansury find that finance (GDP adjusted stocks, bonds and futures and options) is negatively related to indices of production, manufacturing productivity and manufacturing profits and positively related to indices of prices and income inequality. The only surprise is the positive association between finance and employment.

4 Social Inclusion

Dymski highlights the pertinent, and often ignored, issues relating to financial exclusion and market access in the debate over globalisation of financial markets. Even without financial liberalisation, the poor remained largely “financially excluded” from the formal banking system and the absence of tangible collateral made them vulnerable to the

usurious interest rates that were levied by the moneylenders in the informal sector. Archaic agrarian relations and the consequent existence of pre-capitalist ground rent act not only as a built-indepressor for agricultural growth but also excludes the vast majority of the peasantry from sharing the fruits of growth. The Grameen Bank microfinance schemes in Bangladesh sought to co-opt (and promote entrepreneurship) the marginalised through community lending schemes.

It can be argued that financial liberalisation would not thwart such schemes. What is often not realised is that the i mpressively high rate of growth in manufacturing is the outcome of an increase in labour productivity rather than employment. Between 1999 and 2004, there has been little or no increase in wage employment in the organised sector. It is the self-employed who now constitute almost 50% of the workforce: workers who have been pushed into petty, low productivity activities with uncertain incomes, hoping to eke out precarious livelihoods.

In these circumstances, the National Rural Employment Guarantee Scheme is the only form of social security being provided to those being pushed to the economic margins. The end of priority sector lending with financial liberalisation has dried the flow of funds to the 58 million small non-farm producers in India. These small-scale producers certainly need access to credit and marketing facilities and must form the spearhead of any drive t owards “financial inclusion”. It is possible that State-led systems were ineffective and inefficient but a marketled financial system, as we have attempted to show, would certainly accentuate the existing economic polarisation.

Rajiv Jha (rajivjha_8@hotmail.com) teaches economics at the Shri Ram College of Commerce, University of Delhi, Delhi.

References

Bhaduri, Amit (2009): “Understanding the Financial Crisis”, Economic & Political Weekly, 28 March. Chandrasekhar, C P (2009): “Learning from the C risis”, ISID Foundation Day Lecture, 1 May. Patnaik, Prabhat (2006): “Diffusion of Development”, Economic & Political Weekly, 6 May.

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