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Could It Happen Here? On Sovereign Debt and Bank Capital

India does not suffer the euro-zone problem of a federal central bank with a restricted mandate. What India does have in common with Europe is capital-constrained banks stuffed full of government debt issued by a fiscally over-extended sovereign, in a slowing economy.

HT PAREKH FINANCE COLUMN

Could It Happen Here? On Sovereign Debt and Bank Capital

Suman Bery

interest rate now being demanded by the private markets to renew this debt implies insolvency. This in turn reflects a judgment that the fiscal adjustment (including asset sales) needed to ensure long-term sustainability at projected rates of growth of the economy is beyond levels that are

India does not suffer the eurozone problem of a federal central bank with a restricted mandate. What India does have in common with Europe is capitalconstrained banks stuffed full of government debt issued by a fiscally over-extended sovereign, in a slowing economy.

Suman Bery (suman.bery@theigc.org) is Country Director, India Central, International Growth Centre.

T
he crisis of the euro dominated the early November meeting of the leaders of the G-20 in Cannes. A week later, as this column is being written, the crisis threatens to move on from the relatively manageable scale of Greece to the potentially much more damaging case of Italy. The bold agenda for global monetary and financial reform articulated by President Nikolas Sarkozy when France assumed the presidency of the G-20 a year ago has been almost completely eclipsed, undermining France’s aspiration to assert European intellectual leadership against an errant United States (US) and a rising Asia.

Instead, at their meeting in Poland some months ago euro area finance ministers had to endure being lectured to by the US secretary of the treasury, Timothy Geithner. More recently, the chief executive of the newly-created European Financial Stability Facility (EFSF), Klaus Regling, has travelled to Beijing for resources to support the rescue of European banks, to no apparent avail. Fearing that China might steal a march over India, Finance Minister Pranab Mukherjee has indicated that India may agree to contribute funds to a European rescue, if channelled through the Inter national Monetary Fund.

There is accordingly little question that India has important economic and political interests in the outcome of the euro crisis. In this column though, I wish to take a look at possible implications of the crisis for India’s domestic financial management. I do this recognising both that the crisis is far from over, and that with any major economic convulsion, there are likely to be multiple underlying causes, both political and economic.

What has been on display in the case of Greece and now threatens Italy is a problem of debt management. Debt obligations of the sovereign are maturing and need to be refinanced (“rolled over”). The

november 26, 2011

politically feasible. Much of this debt is held by euro area banks, both within and outside Greece.

The diversification of ownership to banks outside the host country was encouraged by the introduction of the euro, which was assumed to remove exchange rate risk within the eurozone, and by the riskadjusted capital requirements stipulated by the Basel Committee which have throughout assigned zero credit risk to sovereign obligations. This much is straightforward. What is trickier to understand is how the markets assessed country risk with the introduction of the euro.

By the terms of the Maastricht Treaty that brought the euro into existence, each euro area government remained fiscally independent and sovereign. For those euro members on the periphery of the eurozone the big development was the sharp reduction in borrowing spreads over benchmark German bonds (bunds). This “convergence” was only partial, and resulted in two outcomes, both of which have turned out badly. On the one hand the yield premium over bunds provided an incentive for banks elsewhere in the euro area to load up on peripheral country debt. Second, the dramatic reduction in interest rates touched off by this flood of newly available capital was the trigger for the financial market boom and bust that has since followed, in some (though not all) of the weaker countries. More specifically, while Ireland, Spain and Greece clearly exhibited this syndrome, this was much less true for Italy.

My understanding of these matters has been greatly assisted by recent contributions in the Financial Times (FT) and The Economist both summarising work by Paul de Grauwe of Leuven University, and by the work of Viral Acharya of the Stern School at New York University. I have also been privileged to hear an oral presentation on this matter by the Director

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HT PAREKH FINANCE COLUMN

of the European think-tank Bruegel, Jean Pisani-Ferry.

Confidence Game

As summarised in a FT article by Martin Wolf (“Be Bold, Mario, Put Out That Fire”, 26 October), de Grauwe asks the question: why do rates of interest on the debt of several big eurozone countries exceed that of the UK, even though the fiscal position of the UK is in many respects just as parlous? This leads to a further question: what determines the price of sovereign debt. As Wolf observes, “governments offer no collateral, while claims on tax revenue offer illusory security”. His conclusion is that government debt markets are “lifted by their bootstraps”; the willingness to lend depends on the perceived willingness of others to do so, now and in the future. In other words, at the end of the day it is a confidence game, and like all confidence games it is subject to runs, or to what economic jargon calls “multiple equilibria”.

Wolf therefore endorses the view of de Grauwe that the fatal flaw in the constitution of the euro from this perspective is not the absence of fiscal union as is commonly asserted, but rather the inhibitions of the European Central Bank (ECB) to act as a lender of last resort. Put differently, in assigning a risk weight of zero to sovereign debt, the architects of the Basel rules on regulatory capital implicitly assume the existence of such a lender of last resort to ensure that sovereign debt markets remain in the good equilibrium. The continuing reluctance of the ECB to provide such comfort without limit out of concern to prevent moral hazard coupled with the German insistence on imposing losses on Greek bondholders are the underlying drivers of contagion in the euro area. This contagion has an impact on national solvency directly, by rendering the existing debt stock unsustainable at market rates, and indirectly by adding the bailout costs of insolvent banks to an already fragile fiscal position.

What in any of this is of interest for India? Clearly India does not suffer the eurozone problem of a federal central bank with a restricted mandate. What India does have in common with Europe (and Japan) is capital-constrained banks stuffed full of government debt issued by a fiscally over-extended sovereign, in a slowing economy. Our capital controls and asset portfolio requirements on the banks (SLR) together allow the RBI to impose an unnatural maturity structure on public debt thereby mitigating the problem of “rollover risk” that currently face Greece and Italy.

That such financial repression does generate collateral damage is demonstrated by recent credit downgrades by Moody’s of the State Bank of India (SBI) initially and Indian commercial banks as a group more recently. In SBI’s case Moody’s expli citly referred to the difficulty being experienced by the SBI in raising capital because of the government’s fiscal constraints, a concern that would apply to the other public sector banks as well.

In a recent paper commissioned by the International Growth Centre, Viral Acharya, citing the US experience with the so-called government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, points out that implicit guarantees have a way of being called (Acharya 2011). In the Indian case the liabilities of the public sector banks are in effect entirely guaranteed by the central government. As such, they present a huge potential fiscal risk, one which India does not have the fiscal space to accommodate.

Similar Symptoms?

To end where we started, the symptoms in the case of India are in many ways similar to those of peripheral Europe, with a potentially dangerous interaction between sovereign debt and bank solvency. But the policy implications are different. To protect its financial system, India needs urgently to demonstrate its commitment to sustained fiscal adjustment to make credible its implicit guarantee for banking system net worth, assuming that bank privatisation is not on the cards. For India, the route to financial stability lies as much through Delhi then, as through Mumbai.

Reference

Acharya, Viral (2011): “The Dodd-Frank Act and Basel III: Intentions, Unintended Consequences, Transition Risks and Lessons for India”, International Growth Centre, London and New Delhi.

Krishna Raj Memorial Scholarships 2011 NSSKPT High School, Ottappalam, Kerala

Six scholarships have been awarded in the school where Krishna Raj studied for a few years. The scholarships cover tuition fees, uniforms, books and special coaching. In 2011-12, the scholarships have been awarded to Sreedevi P K, Ajayan V (VIII standard), Arun C, Amal S R (IX standard) and Vipindas P, Induja V (X standard).

Delhi School of Economics

Summer fellowships were awarded to 17 students (M.A. Economics & Sociology) working in eight groups, for conducting field surveys and writing reports under the supervision of faculty of the DSE: Ashwini Deshpande, Aditya Bhattacharjea, J V Meenakshi and Anirban Kar.

The students awarded fellowships were Dheeraj Mamadule, Vimmy, Swati Sharma, Arnab Kumar Maulik, Ashutosh Kumar, Debapriya Bhowmik, Yesh Vardhan Agarwal, Sandhya Srinivasan, Keshav Maheshwari, Madhulika Khanna, Ravideep Sethi, Resham Nagpal (all Economics); Shagua Kaur Bhangu, Maria Ann Mathew, Ujjainee Sharma, Trishna Senapati, Aaradhana Dalmia (all Sociology).

The seven projects were (i) Rehabilitation and Resettlement of Slums in Delhi, (ii) Social Networks of Migrant Women Employed at Construction Sites, (iii) Reading Spaces: A Study of Libraries and the Reading Public in India, (iv) Marriage Practices of the Knanaya Community of Kerala, (v) Socio-Economic Impact Analysis and Replicability Study of Alternative Energy Programme in the Sunderbans, (vi) Impact of FPS on Slums in Delhi, and (vii) Addressing Poverty through NTFPs: An Analysis of Madhya Pradesh.

Economic & Political Weekly

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november 26, 2011 vol xlvi no 48

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