Rajan Raj II : Prescriptions For The Next Financial Crisis



A lot of the best ideas have already been taken, but here are some new ideas that might help. They will take some guts, but we know that he has them build a good, liquid financial market that reacts every day to this governance mess called India. In the bank OTC markets, you cannot see a good Forward view because corporates are merely managing trade exposures. These exposures don’t come under strain until there is a shortage of cash Dollars.

Declaimer: This article written was originally in January 2014, and some of the data points may be outdated.

In 2011, during the Euro crisis, there was not much shortage of cash Dollars. It was the build-up of positions in the NDF market, which was funded by Indian banks, that created all the trouble. That created a panic in India, and unhedged importers rushed to cover. Exporters who had already sold and fixed their receivables had to cancel because of margin calls.

OTC markets are mostly structured around trade flows and tend to mimic the cash market. Creating space for speculators, jobbers, investors, and traders would give hedgers the counter-parties they need, to manage their exposures.

  • Then comes Forex discipline. One of the best ways in which this can be done is to remove the arbitrage that exists between foreign (say, US) and Indian markets. That would force everybody to pay Indian interest rates, and India’s domestic liquidity would come under strain. The plus side of this is that it takes the pressure off the Forex commercial credit markets.

If all importers are using Rupee lines of credit to fund their imports, but all exporters have not sold their (forward) Dollars, it will create a cushion in India’s commercial credit liabilities, which will simultaneously raise the cost if import finance to reflect its true value, rather than the artificial values reflected just now.

At the moment, a vast array of importing businesses are not covering their import liabilities, i.e. they are not paying the Forward Premium, preferring instead to take the (huge) risk of sudden and catastrophic Dollar appreciation. The last 3 crises have seen many of these businesses go belly up, sinking their entire Net Worth as they rush to cover their import liabilities in the middle of an Fx crisis.

Here’s how it happens: let’s take a particular, say, low-margin importing business like plastics, edible oils, or some chemicals. The Operating Margins in these businesses are around 2%, and they rotate their money in, say, 3 months. That gives them an asset return of 2%*4 times 8%, while Interest Costs are running at 13% in India. That means these businesses are unable to recover their costs and would report a loss if they had to borrow in Indian Rupees.

So what do they do? They borrow in USD @ 4%, hoping that it does not appreciate and they save up on the Forward Premium because it is optional. 75% of India’s import financing was unhedged when the recent crisis hit last August. If paying this Forward Premium became compulsory, it would push up the costs of imported goods but would prevent the next panic buying of Dollars and reduce the Bank NPAs that are being fed into the system by these massive unhedged exposures.

Let us go back to the Edible Oil example. To avoid paying Forward Premium, the industry is focused on “earthquake prediction”, i.e. they are looking at breakouts in the Dollar:: Rupee parity. And they are doing a terrible job of it, almost nobody got out of the way in the last Dollar crisis. And if this current one snowballs into another one, we would have repeated our mistakes.

If by mandate, everybody had to pay the entire Forward Premium (currently ~8.2%), the industry cost structure would shift upwards and all importers would be fully hedged. Forward Premia would rise till Rupee Interest Rates became more attractive and importers would shift to Rupee borrowings.

Since it would not be compulsory for exporters to sell their Forward Dollars, there would be an unspent supply of Dollars in the system while the immediate demand for Forward Dollars from the trade account would be largely exhausted. This would keep a lid on any impending crisis.

In the same manner, make it mandatory for all borrowings on Capital Account to be fully hedged. Again, based on the above logic, the Forward Premia would be pumped up and domestic borrowings would become more attractive. The policy would be slightly growth-negative and would push up domestic interest rates, but those high-interest rates would draw in more domestic savings.

This is where the first point about deepening financial markets comes in. The way to balance all this would be to bring in the speculators, who would be drawn in by the high Forward Premia prevailing in the FX markets. Included here would be the FIIs and foreign debt players, who would find this very attractive and would take Dollar positions, earning ‘structural carry’ (i.e. over-payment of Forward Premia)….they would bring in actual Dollars to close their positions just during a crisis. Hedge Funds would get into the game too.

All this would create an ‘Fx Insurance industry’, which would move very quickly to capture the excess carry that importers would be forced to pay if they were mandated to hedge or stay in domestic borrowings.

In actual practice, the Forward Premia would settle back at the same levels that we see today, I would guess. But we would be having a ‘market-driven Customs Duty’ that would immediately balance out Forward demand for Dollars into the distant future (since all maturities would be allowed, even up to 10 years) with potential investors, including exporters at the short end.

All this would, of course, achieve the objective of ‘deepening financial markets’, but would improve the stability of the short-term FX markets, forcing discipline on the importers, who are the real ‘speculators’ (i.e. people who speculate on the value of the Dollar). The denizens of the currency markets are really financiers, who are there to earn a ‘carry’, in return for taking the risk of sudden and unexpected Dollar surges.

Inflation targeting is a good idea and sends out the right message. The next few Interest rate hikes can be replaced by measures like the one outlined above, or these can be introduced as interest rates start to drop, even as inflation slows down.

  • Most of the effective measures lie in the domain of the Govt, which has not covered itself in glory. The recent letter by the Congress Govt, asking for Customs Duty on gold imports to be brought down, is one such example. It would directly bring down the Havana rate; by the way, the sudden and sharp increase in the Havana rate has had the unintended consequence of bringing down under-invoicing of genuine imports; think about it, and it seems obvious in hindsight.

Under-invoicing made sense when you could send the money abroad by hawala channels. This was mostly in low-margin traded goods, which had high Customs Duties; those were the industries that were most likely to send part of the proceeds through hawala. Now with the havala channel gold playing havoc with rates, it is no longer profitable to under-invoice. This has had a backdoor salutary effect on Indian industry, which competes with Chinese imports



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