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The Nirav Moment : When Instability Follows Stability

Sanjeev

Sanjeev

In 1992, for those old enough to remember, there was a sub-scam to the Harshad Mehta scam, the LC scam. In which, I recall hazily, LC (security) paper was forged, and documents discounted by various banks, which (funds) ended up in the stock markets, or other financial activity. It was merely the diversion of bank money meant for trade finance, to ‘speculative’ activity, which was frowned upon by the RBI.

Declaimer: This article was originally in March 2018, and some of the data points may be outdated

The greatest of crime

Not exactly the greatest of crimes. I mean, nobody got murdered. The LC used to be retired on the due date, and life went on. A spinoff of this activity was the ‘accommodation bill’ market, a subset of the LC bill industry. Certain foreign (and later, the newly minted private) banks used to charge a ‘premium’ to look away from the ‘accommodation’ nature of the underlying bills. One foreign bank used to open LCs, with a single small clause ‘documents evidencing despatch’, and that LC used to be discounted like a Banker’s Cheque. Over many years, the Bank had developed a reputation for paying on its LCs without any questioning of whether there was an underlying trade transaction.

I don’t remember whether this used to be before the ‘end-use’ guidelines came into force. An entire range of activities, from unsecured lending, speculative activities financing, promoter financing, the financing of losses (business or otherwise), that needed to be papered over, or financing the promoter’s assets (to be repaid from the future bleeding of the company), all of these used to be financed by this ‘Accommodation Bill’ market. It used to be just that the RBI frowned at it, nothing illegal about it, especially if the bills got paid back.

Another application of these funds used to be, that if the purchase was in black, the resulting assets therefore could not be declared to the Bank. If the promoter did not have access to the thriving ‘cash lending’ market, he would resort to various stratagems to ‘convert’ this money to black and then convert it back to pay off the bank.

“Success breeds a disregard of the possibility of failure.” – Hyman Minsky

Minsky said that there is a moment in time, after a long period of stability, that complacency sets in. My metaphor to explain this is that a carefully balanced seesaw is destabilized by a single kid who jumps off too suddenly. Minsky explained that the buildup of debt happens during periods of high complacency (like before 2006-08, when huge amounts of 30-year bonds were lapped up by Asian Central Banks to hold down long-term mortgage interest rates and promote consumption).

 The point at which the buildup of debt becomes a debt bubble, and then bursts, came to be called a Minsky Moment. It is seen often in derivative markets, which are essentially synthetic debt markets. We saw one recently, when the VIX rose 118% in a day, in the US. This is from historic lows, at which it spent a long time.

A fundamental characteristic of our economy

 “A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.” [Wikipedia]

Which brings us to the Nirav Moment. There comes a point in a financial system, after a long period of complacency, when sudden reforms expose the fragility of the system. If you impose sudden changes on a system used to crony capitalism, you will expose ridges and fissures that have the potential to bring the whole house down.

The Accommodation Bill market has always existed. Various stratagems have been used to ‘leak’ Bank funds into activities that the regulators do not encourage. Some of these end-uses are downright immoral/ illegal, while some of them are mere ‘diversions’ of funds. I am not suggesting that regulators turn Nelson’s Eye to all such shenanigans. I am merely sounding caution that tightening a crony system too soon, too hard could bring down the entire system.

The actual Nirav Modi scam seems to have crossed the line into fraud and forgery, and thankfully, it is not large enough to destabilize the banking system. But a large chunk of the Promoter Funding market, for example, resorts to Accommodation Bills. Somebody in the government should sieve out what the regulators should go after and what they shouldn’t, at least for now.

Minsky’s Financial Instability Hypothesis separated the various kinds of debt into three categories:
  • Hedge Financing is the simplest form of borrowing. You invest in buying a new asset, use it to produce something which produces a cash flow, then use part of it, (typically a third), to pay off the loan, both interest and principal, over a reasonable [period.
  • ‘Speculative financing’ is the kind that is put into an asset (Working Capital) that produces a cash flow, enough to pay the interest, but not the principal over a reasonable time. This is one of the big problems. Indian lending standards don’t have a repayment period for Working Capital lending, and everyone seems to be okay with it.
  • The third kind of debt, Ponzi debt, is when the debt goes into assets that don’t create a cash flow (gold/ diamonds), but essentially wait for someone to come and pick it up at a higher price. Some real estate financing that is for ‘investment’ falls under this category, the lending Banks were saved by the significant Black (cash) component that was equity. A lot of ‘industries’ in India are Ponzi assets, and they have access to Bank finance. The repayment of Ponzi finance is dependent on good, (or fortunate) timing, but the last guy always comes a cropper. And that, in India, is usually some hapless PSU bank.

The US Housing market of 2003-07, which changed the world forever, was a Ponzi market, where people started borrowing to buy houses and flip them over for a profit. India too, went the same way, but on a smaller scale, limited to Delhi-NCR and maybe North India.

Thankfully, India does not allow lending for capital market activities. And total debt is still low in an economy that has significant potential to grow. But as the Banking industry ensures the financialization of the economy, somebody has to keep a hawk’s eye on the classification of the debt sitting on Bank books. Most likely, that should be the RBI, which needs to be more proactive in classifying the various kinds of stability risks posed by the incipient growth of Ponzi debt.

Minsky pointed out that an economy starts with Hedge Financing early in the credit cycle, then goes over into Speculative Financing, and finally the Ponzis take over. India must be in the middle right now, just suffering the consequences of the last binge in Ponzi financing from 2008 and later.

One big problem is the prevailing consensus that growth is good at all costs. And when growth slows down, we should resort to debt, to push it. Or lower interest rates artificially to ‘promote growth’. Stable economies have low debt, and we can’t seem to find any big economy believing in that philosophy. This headlong rush over the cliff seems to be sparing nobody, except the rarest of individuals who understand this and have the forbearance to keep their self-gratification under control.

But large economies, are made up of herds (a.k.a. markets). Minsky questioned the prevailing belief that markets if left to operate unchecked, will deliver good outcomes. He pointed out the inefficiency of markets, which leads to crisis.

In India, for example, the way to stay out of Ponzi debt is to first define and classify it. Working Capital financing should have a repayment period, however long. Even a 2% reduction in Working Capital limits every year, will have a salubrious effect on the credit culture. And Ponzi should be defined tightly. Even a second house bought by an HNI (easy to locate if you have Aadhar-linking of property records), is Ponzi debt and should attract steep margin requirements. Once we do this, we will slow down growth but will promote economic stability. The problem in India is to create (and hold) a consensus that stability should be favored over growth. This extracts a political cost, which is nearly impossible in a democracy.

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