Populism and economic crisis
Wednesday, 29 October 2008
M A Taslim
There has been some concern that the domestic commercial banks are lending too much money. Bank credit grew during the past year (Aug 07-Aug 08) at over 22 per cent. The total figure hides the fact that the public sector banks actually decelerated their credit operations significantly (-7.7 per cent), but the private commercial banks increased credit disbursement by a phenomenal 38 per cent.
Since during the same period private bank deposits increased by only 25 per cent, the large increase in credit must mean that the private banks have overextended themselves. The loan-deposit ratio of at least some of the banks must have increased beyond what might be regarded prudent.
There is an intense competition among the private banks for funds, obviously because there is an excess demand for funds. This has pushed up the deposit interest rate to over 13 per cent. Some less reputed financial institutions are even offering 14 per cent. Such high cost of funds necessarily means that the average loan rate will have to be correspondingly high. This could force many banks to relax their vigil and ignore the adverse selection problems that usually plague the loan market. They may lend too much to risky borrowers thus ending up with a toxic portfolio.
One of the reasons of the financial crisis now sweeping through the western world, in particular the USA, is the excessive lending to risky or sub-prime (home) borrowers. Populist policies of successive government encouraged financial institutions to lend to people of modest means who otherwise would not qualify for home loans.
A falling interest rate and a booming home market where the home prices were incessantly increasing apparently protected the investment of the banks and even allowed the borrowers to refinance. The wizards of Wall Street invented financial derivatives that securitised these dubious mortgages of the sub-prime borrowers and sold to financial institutions in some bizarre deals.
As long as the interest rates were low and home prices were rising everyone was happy, but once interest rates rose and home prices started falling the whole financial edifice came under enormous stress. The balance sheets of one financial institution after another went into the red, and some of the most revered names of the western financial world went belly-up. Only a massive bail-out by the western governments averted a complete collapse of the entire global financial system.
Bangladesh has been spared the domino effect that swiftly swamped Europe essentially because the domestic financial institutions including the stock market do not have much exposure to foreign financial assets. This is a consequence of the capital account of the country being not convertible: the domestic residents are not free to buy and sell foreign assets.
If the capital account were fully convertible, as the IMF/World Bank have long advocated, many of our financial institutions would have been lured by the promises of quick bucks to hold toxic foreign assets. We would have been exposed to the same financial meltdown as has occurred in the western countries, but without their strength for countermeasures. This would have put us at the mercy of the IMF/World Bank as was the case with several countries during the last Asian crisis.
Prudential lending and investment practices in the west would have prevented the current financial crisis from developing or getting out of hand. Failure to do so necessitated the massive bail-out of the financial sector, much of it at the taxpayers' expense. Ordinary western people are now paying for the excessive greed of their financial wizards.
Since the capacity of our government to take countermeasures in the scale that would be warranted if a full-blown financial crisis were to unfold is strictly limited, the damage done by such a crisis would be much harsher than what has occurred in the west. Hence, the government needs to be very vigilant against any signs of weaknesses in our financial system. It should not be allowed to engage in any unsustainable activity such as risky lending or dubious investment.
What makes it especially difficult to regulate the financial institutions is the fact that credit is also the circulating life blood of the market economy. The financial institutions must have the autonomy to design credit products to suit the needs of their clients.
The central bank has to ensure that sufficient credit at reasonable terms is available for smooth functioning of the economy. In other words, it is the task of the central bank to determine the optimum amount of credit at any given time and adopt measures to ensure that credit flow remains at this optimum level through various market and non-market operations.
Very recently alarm has been raised over media reports that excessive credit is being funnelled into 'unproductive' sectors. Since the credit growth has been the highest for credit card, consumer product and real estate, presumably these are 'unproductive' ventures.
Credit card and consumer credit provide funds for consumption, hence it would seem that funding consumption is regarded 'unproductive'. Most of the consumer credit actually funds the purchase of durable goods, such as air conditioners, refrigerators etc., and these are sometimes regarded as capital investment since these goods provide service over a period of time.
What is more important is that without the credit many of these goods would not be purchased at all. There would be less demand for the manufacturers of these goods, and production (or imports) would have to be scaled down. Hence, reduction in 'unproductive' loans will end up constricting the 'productive' sector.
Most people consider funding production as 'productive'; hence if the banks were to provide credit to, say, refrigerator manufactures it would get a nod of approval. But refrigerator manufacturers will have suffered a decline in demand due to the reduction in consumer credit. Their increased production cannot be sold, and the investment will turn out to be bad or 'unproductive' investment.
Credit should be channelled where it is most productive, i.e., it adds most to income generation. Since both demand and supply sides are involved in income generation, exclusive focus on the supply side only will not give the best results. The emphasis on 'productive' sectors is misplaced; the focus should instead be on making credit productive.
Real estate investment is the major part of investment in many, including developed, countries. It is often regarded as a leading indicator of the health of the economy. It is also one of the safest forms of investment that the overwhelming majority of the people of any country engage in. Excessive investment in real estate can initially cause a bubble in the market, but when the bubble bursts it causes a glut in the housing market that imposes uneven costs across the economy as has happened in the USA.
But note that this is not peculiar to the housing market; it can happen in any sector. According to some of our business leaders, there has been substantial over-investment in such sectors as fish processing and edible oil refining. If so, further investment in these sectors would be as 'unproductive' as that in housing sector in a glut.
Whether real estate investment would be 'unproductive' depends on the structure of the market. If most of the housing investment is for self-occupation by creditworthy borrowers, the investment is by definition 'productive'. However, if much of it is for renting or speculation, it is possible for a bubble to develop that will ultimately bust.
The influx of black money in the real estate sector worsens the bubble and bust problem since the holders of black money may not be all too keen about the rate of return on their investment.
Asian financial crisis in some countries such as Thailand was spurred by housing bubble. What is sometimes forgotten is that the crisis in some other countries such as Korea was helped by excessive investment not in housing, but in other industries such as the high-tech semi-conductor industry, presumably a 'productive' sector!
There is little reason to deny individual home buyers credit if they are creditworthy. In fact this would be one of the safest investment for the banks as the credit could be fully collateralised. The utility of such credit could be higher than that in alternative uses. As such there should not be unreasonable restrictions on the banks in lending to home buyers.
The current global crisis is a timely reminder of the harm unsustainable populist policies can do to not only to the very people whom they are supposed to benefit, but also to the entire economy. Policy makers should not jump to populist conclusions without a thorough analysis. (Professor DR. M. A. Taslim is CEO of Bangladesh Foreign Trade Institute and Co-Chair of the Macro-economics Working Group of Bangladesh Business Forum. bdnews24.com)
There has been some concern that the domestic commercial banks are lending too much money. Bank credit grew during the past year (Aug 07-Aug 08) at over 22 per cent. The total figure hides the fact that the public sector banks actually decelerated their credit operations significantly (-7.7 per cent), but the private commercial banks increased credit disbursement by a phenomenal 38 per cent.
Since during the same period private bank deposits increased by only 25 per cent, the large increase in credit must mean that the private banks have overextended themselves. The loan-deposit ratio of at least some of the banks must have increased beyond what might be regarded prudent.
There is an intense competition among the private banks for funds, obviously because there is an excess demand for funds. This has pushed up the deposit interest rate to over 13 per cent. Some less reputed financial institutions are even offering 14 per cent. Such high cost of funds necessarily means that the average loan rate will have to be correspondingly high. This could force many banks to relax their vigil and ignore the adverse selection problems that usually plague the loan market. They may lend too much to risky borrowers thus ending up with a toxic portfolio.
One of the reasons of the financial crisis now sweeping through the western world, in particular the USA, is the excessive lending to risky or sub-prime (home) borrowers. Populist policies of successive government encouraged financial institutions to lend to people of modest means who otherwise would not qualify for home loans.
A falling interest rate and a booming home market where the home prices were incessantly increasing apparently protected the investment of the banks and even allowed the borrowers to refinance. The wizards of Wall Street invented financial derivatives that securitised these dubious mortgages of the sub-prime borrowers and sold to financial institutions in some bizarre deals.
As long as the interest rates were low and home prices were rising everyone was happy, but once interest rates rose and home prices started falling the whole financial edifice came under enormous stress. The balance sheets of one financial institution after another went into the red, and some of the most revered names of the western financial world went belly-up. Only a massive bail-out by the western governments averted a complete collapse of the entire global financial system.
Bangladesh has been spared the domino effect that swiftly swamped Europe essentially because the domestic financial institutions including the stock market do not have much exposure to foreign financial assets. This is a consequence of the capital account of the country being not convertible: the domestic residents are not free to buy and sell foreign assets.
If the capital account were fully convertible, as the IMF/World Bank have long advocated, many of our financial institutions would have been lured by the promises of quick bucks to hold toxic foreign assets. We would have been exposed to the same financial meltdown as has occurred in the western countries, but without their strength for countermeasures. This would have put us at the mercy of the IMF/World Bank as was the case with several countries during the last Asian crisis.
Prudential lending and investment practices in the west would have prevented the current financial crisis from developing or getting out of hand. Failure to do so necessitated the massive bail-out of the financial sector, much of it at the taxpayers' expense. Ordinary western people are now paying for the excessive greed of their financial wizards.
Since the capacity of our government to take countermeasures in the scale that would be warranted if a full-blown financial crisis were to unfold is strictly limited, the damage done by such a crisis would be much harsher than what has occurred in the west. Hence, the government needs to be very vigilant against any signs of weaknesses in our financial system. It should not be allowed to engage in any unsustainable activity such as risky lending or dubious investment.
What makes it especially difficult to regulate the financial institutions is the fact that credit is also the circulating life blood of the market economy. The financial institutions must have the autonomy to design credit products to suit the needs of their clients.
The central bank has to ensure that sufficient credit at reasonable terms is available for smooth functioning of the economy. In other words, it is the task of the central bank to determine the optimum amount of credit at any given time and adopt measures to ensure that credit flow remains at this optimum level through various market and non-market operations.
Very recently alarm has been raised over media reports that excessive credit is being funnelled into 'unproductive' sectors. Since the credit growth has been the highest for credit card, consumer product and real estate, presumably these are 'unproductive' ventures.
Credit card and consumer credit provide funds for consumption, hence it would seem that funding consumption is regarded 'unproductive'. Most of the consumer credit actually funds the purchase of durable goods, such as air conditioners, refrigerators etc., and these are sometimes regarded as capital investment since these goods provide service over a period of time.
What is more important is that without the credit many of these goods would not be purchased at all. There would be less demand for the manufacturers of these goods, and production (or imports) would have to be scaled down. Hence, reduction in 'unproductive' loans will end up constricting the 'productive' sector.
Most people consider funding production as 'productive'; hence if the banks were to provide credit to, say, refrigerator manufactures it would get a nod of approval. But refrigerator manufacturers will have suffered a decline in demand due to the reduction in consumer credit. Their increased production cannot be sold, and the investment will turn out to be bad or 'unproductive' investment.
Credit should be channelled where it is most productive, i.e., it adds most to income generation. Since both demand and supply sides are involved in income generation, exclusive focus on the supply side only will not give the best results. The emphasis on 'productive' sectors is misplaced; the focus should instead be on making credit productive.
Real estate investment is the major part of investment in many, including developed, countries. It is often regarded as a leading indicator of the health of the economy. It is also one of the safest forms of investment that the overwhelming majority of the people of any country engage in. Excessive investment in real estate can initially cause a bubble in the market, but when the bubble bursts it causes a glut in the housing market that imposes uneven costs across the economy as has happened in the USA.
But note that this is not peculiar to the housing market; it can happen in any sector. According to some of our business leaders, there has been substantial over-investment in such sectors as fish processing and edible oil refining. If so, further investment in these sectors would be as 'unproductive' as that in housing sector in a glut.
Whether real estate investment would be 'unproductive' depends on the structure of the market. If most of the housing investment is for self-occupation by creditworthy borrowers, the investment is by definition 'productive'. However, if much of it is for renting or speculation, it is possible for a bubble to develop that will ultimately bust.
The influx of black money in the real estate sector worsens the bubble and bust problem since the holders of black money may not be all too keen about the rate of return on their investment.
Asian financial crisis in some countries such as Thailand was spurred by housing bubble. What is sometimes forgotten is that the crisis in some other countries such as Korea was helped by excessive investment not in housing, but in other industries such as the high-tech semi-conductor industry, presumably a 'productive' sector!
There is little reason to deny individual home buyers credit if they are creditworthy. In fact this would be one of the safest investment for the banks as the credit could be fully collateralised. The utility of such credit could be higher than that in alternative uses. As such there should not be unreasonable restrictions on the banks in lending to home buyers.
The current global crisis is a timely reminder of the harm unsustainable populist policies can do to not only to the very people whom they are supposed to benefit, but also to the entire economy. Policy makers should not jump to populist conclusions without a thorough analysis. (Professor DR. M. A. Taslim is CEO of Bangladesh Foreign Trade Institute and Co-Chair of the Macro-economics Working Group of Bangladesh Business Forum. bdnews24.com)