Column : Liquidity or solvency?

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: During the last month, Indian policymakers have responded with a series of measures including cuts in interest rates and in cash reserve ratios to improve liquidity in the financial sector. These measures were certainly necessary, and I believe we would and should get more such measures.

However, lurking behind the current liquidity problems is a deeper problem of solvency that needs to be addressed quickly and decisively. It appears to me that India is now where the US was a year ago—the measures that we saw in India in October 2008 were broadly similar to what the US and Europe undertook in August and September 2007. In terms of the deflation of the real estate bubble also, India seems roughly where the US was a year ago.

One difference is that the US had early warning signals in the form of house price futures and ABX indices that provided valuable information on asset prices and credit quality. These measures combined with stringent mark to market accounting enabled analysts to make reasonable guesses about which financial institutions would be hit severely and which were likely to remain solvent. In India, we do not have these markets and the health of financial intermediaries has become the subject matter of rumours and gossip rather than reasoned analysis.

The only market signal of solvency that is available in India is the stock price. The majority of the 17 listed private sector banks for which information is available in the CMIE database are today quoting at a price to book ratio of 1.0 or below which is a crude signal of potential solvency issues. Of the same set of 17 banks, only two traded at a price to book of 1.0 or below at the beginning of last year.

At this point of time, accounting data is not quite reliable because the carrying values of assets do not reflect their fair value. This is a serious problem for banks and non-bank finance companies that have exposures to real estate and to other stressed borrowers. It is also difficult to assess the exposure of banks to troubled non-bank finance companies and weak banks. But the problem is much wider and extends also to debt mutual funds that have exposures to real estate, banks and non-bank finance companies.