India’s high NPAs, China’s corporate debt could trigger the next global financial crisis
Capital is the lifeblood of a modern economy. Traditionally, capital was the money that was saved and lent. But in modern banking, with fractional-reserve lending, banks can create capital digitally out of thin air. This increased availability of capital helps economic growth, but if not properly managed, it can be disastrous. Economist Hyman Minsky blamed excessive debt for most financial crises. He identified three types of debt. The safest debt, which he called ‘hedge financing’, is responsible for creating economic growth. The borrower invests capital in productive economic activities, from which cash flows can service the interest and eventually pay off the principal. A riskier debt, called ‘speculative financing’, involves credit to marginal businesses—often forced by the government through priority-lending schemes—where current cash flows are sufficient only to pay the interest, and the principal has to be rolled over to a later date. Sometimes that works out, but an economic downturn exacerbates the risk of default. The third kind of debt, which Minsky called ‘Ponzi financing’, was most dangerous because borrowers use the capital not to invest in productive activities, but to buy assets hoping to flip them at a higher price, repay the debt, and book a profit.
Minsky’s concluded that protracted periods of stable economic growth, where hedge financing and sound investment opportunities dominate, encourage both borrowers and lenders to take more risk until speculative and Ponzi financing start to dominate. This leads to inflation in asset values, particularly real estate and stocks. When asset prices stop rising, and the bubble pops, bad loans pile up, and the entire scheme starts to unravel. An example is the 1997 Asian crisis that destroyed wealth across many countries including Thailand, South Korea, Indonesia, Malaysia, Singapore, Hong Kong, Taiwan and, to some extent, Japan. These countries saw rapid economic growth in the 1980s and early 1990s, which led to higher risk-taking.
Government-owned banks started giving risky loans to borrowers with access to levers of political power. Much of this money found its way into financial assets, creating bubbles in both real estate and equity markets. When asset prices stopped rising, borrowers started to default on their loans. Foreign investors began to flee. This put pressure on local currencies. The Thai baht was the first to crumble, and as the dominoes started to tumble, panic spread. The Minsky moment repeated itself in 2008 when housing prices collapsed in the US. People, who borrowed and had invested in homes in the hope of repaying the loans from the price appreciation, started to default. Financial products with payoffs tied to these loans began to unravel, and financial institutions that had insured these products became insolvent overnight. The rest is history, as over $20 trillion in global wealth was lost within a short time.
The situation in India is eerily similar to 1997 Asian and 2008 global financial crisis. State-owned banks have recklessly lent money to borrowers with dubious business models, but with access to levers of government power. Much of this money has found its way into financial assets, resulting in massive bubbles in real estate and subsequently stock market. Large amounts of foreign money chasing yields have added fuel to these price bubbles. The drop in real estate prices has exposed Indian banking’s ‘Ponzi financing’. Almost 10% of outstanding loans in the banking system are bad loans and have been declared non-payable. With yields in the US rising, would foreign investors flee to their local markets? If foreign investors pull out and the rupee starts to devalue, RBI may be left with no choice but to let the rupee tumble—as it did in 2013 when the rupee dropped from 54 to a dollar in May 2013 to 68 by September 2013.
Raising interest rates, which is the standard economic recipe to stave off currency devaluation, may not be a viable option because higher rates will compound the bad loan problem. Also, it is doubtful the BJP government would allow a hike in interest rates before the elections.The lessons of economic history are clear. Capital is the lifeblood of an economy, but it must be channelled to its most productive use based on economic realities and not as a result of government interference. Without the discipline imposed by risk-based lending, capital gets routed away from productive activities into creating asset bubbles.
India and China are both susceptible to the ills of government interference and speculative and Ponzi financing. Both have large state-run banks that have lent unwisely to political cronies and industries targeted for support by the government.The Minsky moment may have already started in India, and China with its massive corporate debt approaching 200% of its GDP, may not be far behind. The next global financial crisis could very well start in these two countries.