By now, everyone is aware of the hits taken by the
US banks and financial institutions on account of
sub-prime mortgages and collateralised debt
obligations (CDOs). Everyone expects more hits in
the coming months, with the total write-down in the
US to be around $ 450 billion. What has caught the
market unaware is the additional hit that the system
may have to take on account of monoline bond
US bonds need their credit risks to be underwritten
by insurers. There are some insurers called the
monolines, who ‘rent’ their AAA ratings to
underwrite municipal bonds. Since municipal bonds
are very safe, it is a good model: small capital
base, AAA ratings, underwriting tons of safe papers
for small fees resulting in good profits. In the
aggregate, the monolines underwrite some $ 2.5
trillion of debt.
During the sub-prime and CDO frenzy, some monolines
got lured by higher fees, and began underwriting
sub-prime paper and related CDOs. For instance, the
Ambac Financial Group had a direct exposure of $ 8.8
billion in sub-prime mortgage backed securities and
another $ 29 billion in CDOs. MBIA, another monoline,
had an exposure of $ 5 billion in sub-prime paper,
and $ 25 billion in CDOs. As defaults rose, so too
did the losses of these firms. In Q4, 2007, Ambac
lost $ 3.26 billion loss; and MBIA wrote down assets
by $ 5.3 billion.
Given these large losses and relatively thin capital
bases, the monolines are hard-pressed to re-capitalise
— and face ratings downgrades. For instance, Fitch
has already reduced Ambac’s rating from AAA to AA.
This downgrade creates systemic problems. When an
insurer’s credit rating is downgraded, so too is the
rating of all the bonds that it has insured. Hence,
for each monoline getting a lower rating, there is
an identical downgrading of all the bonds
underwritten by it —involving several billions of
dollars. That, in turn, triggers mark-to-market
losses of all institutions holding such bonds.
Bloomberg estimates that a downgrade from AAA to AA
can cost up to $ 200 billion in market-to-market
losses. That is huge and unanticipated.
Now on to the RBI policy — which maintained status
quo on the bank rate, repo and reverse repo and the
CRR. The RBI is a sound institution. However,
sometimes even the best make mistakes, and this time
the RBI has erred in not loosening interest rates.
First, interest rate arbitrage. At end-November
2007, the interest rate on 3-month US treasury bills
was 4.4 per cent, versus 7.50 per cent on Indian
G-sec. With the 125 basis point Fed cuts, interest
on 3-month T-bills has dropped to 2.83 per cent,
while 3-month Indian G-SECs are ruling at 7.17 per
cent. The arbitrage opportunity has widened
dramatically, and will encourage global investors to
borrow in dollars to invest in rupee bearing
instruments. That will exert stronger pressure on
appreciating the rupee.
Second, high real interest rates. The prime lending
rate (PLR) is between 12.75% and 13.25%. At today’s
cost of living inflation of 5.1%, this is one of the
highest real rates in emerging economies. Thousands
of small and medium businesses who borrow at, or
over, PLR are hurting very badly.
Third, investments and corporate profits. The
results of Q3, 2007-08 show that sales and profits
are down for many manufacturing firms. Also, with
higher interest rates and various bans on ECB, many
companies are postponing or paring investment
decisions. With industry running at full capacity,
this is something that India cannot afford.
Fourth, India will achieve lower growth in 2008-09 —
most likely 8 per cent, with a possibility of it
going down to 7.5 per cent. Already, growth in the
three-month moving average of the Index of
Industrial Production has come down from 13.5% in
January 2007 to 8% in November. Construction growth
is also down. Anything that facilitates growth is
welcome. The RBI’s status quo has not helped.
Finally, the RBI’s extreme stance inflation. The RBI
clearly stated that inflation was down according to
all measures: Wholesale price inflation down to 3.8
per cent; manufacturing inflation down to 3.9 per
cent; and each CPI-based inflation was down. Yet the
RBI believed that there were “upside inflationary
risks in the period ahead”. Keeping interest rates
high and choking growth because of an
ultra-monetarist fear of inflation is not what India
needed today. Pity that the RBI thought otherwise.
Published: Business Standard, February 2008