Why India Needs Derivatives - IMF

Does India Really Need Does India Really Need Derivatives? Derivatives?

Joshua FelmanJoshua FelmanInternational Monetary Fund International Monetary Fund --

IndiaIndia

IMAIMA

CFO Presentation CFO Presentation May 30, 2008May 30, 2008

Warning!Warning!

The views expressed are personal and are not The views expressed are personal and are not necessarily those of the IMF, its Executive necessarily those of the IMF, its Executive Board, or its management.Board, or its management.

Is India out of step?Is India out of step?

Yesterday, the RBI announced that it will soon Yesterday, the RBI announced that it will soon allow exchangeallow exchange--traded currency futurestraded currency futures

The timing seems oddThe timing seems odd Why is the traditionally cautious central bank Why is the traditionally cautious central bank

getting ready to introduce currency futures when getting ready to introduce currency futures when the problems of derivatives are daily becoming the problems of derivatives are daily becoming more apparent?more apparent?

Roadmap of presentationRoadmap of presentation

How should we think about derivatives?How should we think about derivatives?

What caused the Asian crisis?What caused the Asian crisis?

What caused the What caused the subprimesubprime crisis?crisis?

What are the lessons for India?What are the lessons for India?



What caused the East Asian crisis?What caused the East Asian crisis?



The charge sheet/1The charge sheet/1

The argument against derivatives is straightforwardThe argument against derivatives is straightforward Derivatives are said to be inherently complex and Derivatives are said to be inherently complex and

difficult to understanddifficult to understand From which it follows that the parties buying and From which it follows that the parties buying and

selling them donselling them dont really understand the risks that they t really understand the risks that they are takingare taking

In other words, derivatives encourage firms to take on In other words, derivatives encourage firms to take on too much risk too much risk

This leads to crisesThis leads to crises

The charge sheet/2The charge sheet/2

Sophisticated finance was blamed for causing Sophisticated finance was blamed for causing the East Asian crisis of the 1990sthe East Asian crisis of the 1990s

U.S. derivatives are being blamed for the current U.S. derivatives are being blamed for the current subprimesubprime crisiscrisis

In India, a number of firms have suffered large In India, a number of firms have suffered large losses on their currency derivatives losses on their currency derivatives

Driving blind?Driving blind?

First things firstFirst things first

LetLets define what we mean by a derivatives define what we mean by a derivative A derivative is nothing more than a financial A derivative is nothing more than a financial

instrument whose value derives from that of instrument whose value derives from that of another asset (such as an equity) or price another asset (such as an equity) or price (exchange rate)(exchange rate) Typical examples: forwards, futures, optionsTypical examples: forwards, futures, options

The pricing of derivatives is typically complexThe pricing of derivatives is typically complex But most are conceptually quite simpleBut most are conceptually quite simple

A classic exampleA classic example

A classic example is a forward contractA classic example is a forward contract A farmer is worried that the price of wheat will A farmer is worried that the price of wheat will

drop by the time the crop is harvesteddrop by the time the crop is harvested The baker is worried that the price might riseThe baker is worried that the price might rise By agreeing on a forward price, both parties can By agreeing on a forward price, both parties can

actually actually eliminateeliminate their risk!their risk! Of course, there is a cost Of course, there is a cost both parties give up both parties give up

the opportunity to profit if the price moves in a the opportunity to profit if the price moves in a direction that favors themdirection that favors them

The implicationsThe implications

Currency derivatives are tools for managing risksCurrency derivatives are tools for managing risks In some cases they can eliminate risksIn some cases they can eliminate risks Normally, however, they just transfer risksNormally, however, they just transfer risks

They allow those who do not want to bear risks to pass them They allow those who do not want to bear risks to pass them on to those who have the capacity or even the interest to do on to those who have the capacity or even the interest to do soso

Example: corporates transferring risks to hedge fundsExample: corporates transferring risks to hedge funds This transfer of risks is a very valuable serviceThis transfer of risks is a very valuable service ThatThats why the most advanced economies have the s why the most advanced economies have the

most advanced financial systems, and vicemost advanced financial systems, and vice--versaversa

Causes of the East Asia crisisCauses of the East Asia crisis

But what about the claim that derivatives can But what about the claim that derivatives can lead to financial crises?lead to financial crises?

DidnDidnt derivatives cause the East Asian crisis?t derivatives cause the East Asian crisis?

ActuallyActually.no!.no!

Before the crisis, East Asia was Before the crisis, East Asia was boomingbooming

As ian Cris is Co untrie s : P re -c ris is GDP gro wth rate s (pe r c e nt)

0

1

2

3

4

5

6

7

8

9

10

Malays ia Indones ia Thailand Phillip ines Korea

1991-95 1996

Investment ratios reached 30Investment ratios reached 30--40 40 percent of GDPpercent of GDP

Asian Crisis Countries: Pre-crisis Investment rates (per cent)

0

5

10

15

20

25

30

35

40

45

50

Malaysia Indonesia Thailand Phillipines Korea

1991-95 1996

And to finance this, firms levered And to finance this, firms levered themselves upthemselves up

The perils of leverageThe perils of leverage

The exceptionally high leverage ratios were dangerous, The exceptionally high leverage ratios were dangerous, in and of themselvesin and of themselves If profitability faltered, there was little capital cushion to fIf profitability faltered, there was little capital cushion to fall all

back onback on Firms worsened the situation by funding this leverage Firms worsened the situation by funding this leverage

in dangerous waysin dangerous ways They incurred two types of debt mismatchesThey incurred two types of debt mismatches

Borrowed domestically at Borrowed domestically at shortshort--termterm rates to finance longrates to finance long--term projectsterm projects

Borrowed abroad in Borrowed abroad in foreign currencyforeign currency without hedging without hedging (because exchange rates were linked to the dollar)(because exchange rates were linked to the dollar)

The crisis breaksThe crisis breaks

In 1996, profitability turned downIn 1996, profitability turned down

By 1997, foreign lenders became worried, so By 1997, foreign lenders became worried, so they demanded repaymentthey demanded repayment

Exchange rates consequently depreciated and Exchange rates consequently depreciated and interest rates soared, pushing many of East interest rates soared, pushing many of East AsiaAsias corporates into bankruptcy s corporates into bankruptcy

and growth collapsedand growth collapsed

Asian Crisis Countries: Real GDP growth, 1998 (percent)

-13.7

-9.4

-6.7-5.8

-0.5

-16

-14

-12

-10

-8

-6

-4

-2

0

Indon

esia

Korea

Malay

sia

Philli

pines

Thaila

nd

Where was risk management?Where was risk management?

In other words, the crisis was not caused In other words, the crisis was not caused because of inappropriate use of risk because of inappropriate use of risk management tools (e.g., derivatives)management tools (e.g., derivatives)

It was caused precisely because firms incurred It was caused precisely because firms incurred very large risks very large risks and then did not use any tools and then did not use any tools to manage them!to manage them!

Similarities to the Asian crisisSimilarities to the Asian crisis

A boom period, from 2002A boom period, from 2002--0606 Excessive leverageExcessive leverage

This time in the financial sectorThis time in the financial sector IllIll--fated Carlyle hedge fund invested $23 billion on an fated Carlyle hedge fund invested $23 billion on an

equity base of less than $1 billionequity base of less than $1 billion

Poor risk management Poor risk management U.S. financial institutions had models to assess risk U.S. financial institutions had models to assess risk but but

they clearly proved inadequate to the taskthey clearly proved inadequate to the task

A key difference: derivativesA key difference: derivatives

Unlike in East Asia, derivatives were an important part Unlike in East Asia, derivatives were an important part of the storyof the story

Problem originated because banks made loans to Problem originated because banks made loans to subprimesubprime customers, sometimes even to customers, sometimes even to NINJAsNINJAs(those with No Income No Jobs No Assets)(those with No Income No Jobs No Assets)

Then, they packaged the loans in Collateralized Debt Then, they packaged the loans in Collateralized Debt Obligations (Obligations (CDOsCDOs) and sold them to investors) and sold them to investors

CDOCDO

calamitycalamity

CDOsCDOs proved troublesome for two reasons:proved troublesome for two reasons: The The originate and distributeoriginate and distribute model gave few model gave few

incentives for mortgage originators to contain riskincentives for mortgage originators to contain risk Packaging the loans in Packaging the loans in CDOsCDOs made it difficult for made it difficult for

buyers to assess their buyers to assess their riskinessriskiness They relied on rating agencies, whose judgment proved They relied on rating agencies, whose judgment proved

falliblefallible

Conclusive proof?Conclusive proof?

So, do we now have the So, do we now have the smoking gunsmoking gun proof that proof that sophisticated finance blinds people to risks, eventually sophisticated finance blinds people to risks, eventually triggering crises?triggering crises?

Not quite!Not quite! Note the key word: crisisNote the key word: crisis Certainly, there is a financial crisis, but is there a Certainly, there is a financial crisis, but is there a realreal

crisis crisis ---- an East Asiaan East Asia--style collapse in growth?style collapse in growth?

A A realreal

crisis?crisis?

Not at all!Not at all!

In fact, the current debate is whether the US will even In fact, the current debate is whether the US will even enter into recession or notenter into recession or not

The IMF forecasts that US growth will decelerate to The IMF forecasts that US growth will decelerate to percent in 2008 and 2009 from 2 percent last yearpercent in 2008 and 2009 from 2 percent last year

That would certainly be a disappointment That would certainly be a disappointment ---- but hardly but hardly a crisis!a crisis!

Financial/real linkagesFinancial/real linkages

This (likely) development has important implicationsThis (likely) development has important implications Since 1997, people have worried about financial crises Since 1997, people have worried about financial crises

precisely because it was believed that they lead to precisely because it was believed that they lead to realrealcrisescrises

Consequently, efforts were focused on Consequently, efforts were focused on regulating the regulating the financial sectorfinancial sector tightlytightly

But what if the link between financial and real crises But what if the link between financial and real crises isnisnt as tight as we once thought?t as tight as we once thought?

Then, the focus needs to be on Then, the focus needs to be on insulating the real insulating the real economyeconomy from financial crisesfrom financial crises

Insulating the economyInsulating the economy

How has the U.S. managed to insulate its real economy, How has the U.S. managed to insulate its real economy, while East Asia could not?while East Asia could not?

Answer in a word: leverageAnswer in a word: leverage

Corporate leverage was lowCorporate leverage was low

1.6

1.7

1.8

1.9

2.0

2.1

2.2

2.3

1990 1992 1994 1996 1998 2000 2002 2004 2006 200820

30

40

50

60

70

80

90

100U.S. nonfarm nonfinancial

corporations' ratio of assets to net worth (left scale)

Credit market debt to net worth (percent,

right)

Debt to market value of equities (percent, i ht)

and profitability was highand profitability was high

US: Corporate Profits (percent GDP)

5.0

7.0

9.0

11.0

13.0

15.0

Mar-0

1Sep

-01Ma

r-02

Sep-02

Mar-0

3Sep

-03Ma

r-04

Sep-04

Mar-0

5Sep

-05Ma

r-06

Sep-06

Mar-0

7Sep

-07

Source: CEIC database. Profits with Inventory Valuation Adjustment (CPIVA): seasonally adjusted

Lessons from East Asia and the USLessons from East Asia and the US

Real risks come from:Real risks come from: Overconfidence during a boom periodOverconfidence during a boom period High leverage High leverage Debt mismatchesDebt mismatches

Firms need to limit these risks, and use tools to Firms need to limit these risks, and use tools to manage themmanage them

But they also need to understand the tools!But they also need to understand the tools! Conclusion: good risk management systems are Conclusion: good risk management systems are

criticalcritical

Does any of this have implications for India?Does any of this have implications for India?

WellWellyes!yes!

Currently, corporate leverage is low and profits high, Currently, corporate leverage is low and profits high, just like in the USjust like in the US

ButBut....

India is in the midst of an India is in the midst of an East AsianEast Asian--style investment boomstyle investment boom

India - Nominal Investment (in percent GDP)

0

5

10

15

20

25

30

35

40

45

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06@

20

06-07

* 20

07-08

**

@ Provisional estimates;* Quick Estimates; ** Advance Estimates

And firms are incurring EastAnd firms are incurring East--Asia Asia style debt mismatchesstyle debt mismatches

Many of these investments are infrastructure projects, Many of these investments are infrastructure projects, involving huge outlays, long time spans, and uncertain involving huge outlays, long time spans, and uncertain revenuesrevenues

How are these projects being financed?How are these projects being financed? Like in East Asia, much of the funding isLike in East Asia, much of the funding is

Short term (banks), incurring interest rate riskShort term (banks), incurring interest rate risk Foreign currency (Foreign currency (ECBsECBs), incurring exchange rate risk), incurring exchange rate risk

Over time, risks could build up for the corporate sector Over time, risks could build up for the corporate sector and the financial firms that lend to themand the financial firms that lend to them Leverage levels could rise rapidlyLeverage levels could rise rapidly Investment is large relative to the banking sectorInvestment is large relative to the banking sector

So, modest failure rates could have a large impact on bank capitSo, modest failure rates could have a large impact on bank capitalal

What needs to be done?What needs to be done?

Task 1: improving corporate risk Task 1: improving corporate risk management systemsmanagement systems

In December, In December, MecklaiMecklai Services and Business Standard Services and Business Standard rated 45 firms on their risk managementrated 45 firms on their risk management

The sample was evenly divided among small, medium, The sample was evenly divided among small, medium, and large firmsand large firms

They found:They found: The average score was only 46, on a scale of 100The average score was only 46, on a scale of 100 Large firms did not do better than smaller onesLarge firms did not do better than smaller ones Half of the firms did not have a documented risk Half of the firms did not have a documented risk

management strategymanagement strategy OneOne--third of the third of the largelarge firms had no measure at all of the risk firms had no measure at all of the risk

they were carryingthey were carrying If you canIf you cant measure it, you cant measure it, you cant manage it!t manage it!

Task 2: Reducing Debt MismatchesTask 2: Reducing Debt Mismatches

The risks of debt financing need to be curbedThe risks of debt financing need to be curbed Ideally, India needs to create a corporate bond marketIdeally, India needs to create a corporate bond market

Firms will then be able to obtain longFirms will then be able to obtain long--term finance, in rupeesterm finance, in rupees

But experts have been saying this for more than a But experts have been saying this for more than a decade, and nothing has happeneddecade, and nothing has happened

While we wait, firms will need to use tools to handle While we wait, firms will need to use tools to handle the inevitable debt mismatchesthe inevitable debt mismatches Currency derivatives to manage exchange rate riskCurrency derivatives to manage exchange rate risk Interest rate futures for shortInterest rate futures for short--term rate riskterm rate risk

Importance of currency derivativesImportance of currency derivatives

India already has a forward marketIndia already has a forward market Why are futures important?Why are futures important? Partly for the standard reasons Partly for the standard reasons they will:they will:

Introduce pricing transparencyIntroduce pricing transparency Eliminate counterparty risk, a big problem in recent monthsEliminate counterparty risk, a big problem in recent months

But also because they will eliminate participation and hedging But also because they will eliminate participation and hedging restrictionsrestrictions Participation will be open to all domestic players and eventuallParticipation will be open to all domestic players and eventually to foreign y to foreign

players players No hedging requirementNo hedging requirement

Trading allowed on existing (and new) exchanges, though with Trading allowed on existing (and new) exchanges, though with separate membership criteria, trading rules, risk management separate membership criteria, trading rules, risk management framework, etc. framework, etc.

Now, we are finally in a position to answer the Now, we are finally in a position to answer the question posed at the outsetquestion posed at the outset

The need for derivativesThe need for derivatives

Yes, India needs derivativesYes, India needs derivatives

It can exercise the advantage it has of being an It can exercise the advantage it has of being an EMEM it can it can avoid some the untested financial innovations coming from avoid some the untested financial innovations coming from the mature markets, such as the mature markets, such as CDOsCDOs

Instead, it can focus on introducing some triedInstead, it can focus on introducing some tried--andand--true true tools for managing risk, such as interest rate and currency tools for managing risk, such as interest rate and currency futuresfutures

All of which explains why the conservative RBI is planning All of which explains why the conservative RBI is planning to introduce these toolsto introduce these tools

Does India Really Need Derivatives? Warning!Is India out of step?Roadmap of presentationRoadmap of presentationThe charge sheet/1The charge sheet/2Driving blind?First things firstA classic exampleThe implicationsCauses of the East Asia crisisRoadmap of presentationBefore the crisis, East Asia was boomingInvestment ratios reached 30-40 percent of GDPAnd to finance this, firms levered themselves upThe perils of leverageThe crisis breaksand growth collapsedWhere was risk management?Roadmap of presentationSimilarities to the Asian crisisA key difference: derivativesCDO calamityConclusive proof?A real crisis?Financial/real linkagesInsulating the economyCorporate leverage was low and profitability was highLessons from East Asia and the USRoadmap of presentationSlide Number 33India is in the midst of an East Asian-style investment boomAnd firms are incurring East-Asia style debt mismatchesSlide Number 36Task 1: improving corporate risk management systemsTask 2: Reducing Debt MismatchesImportance of currency derivativesSlide Number 40The need for derivativesSlide Number 42

Documents

Why India Needs Derivatives - IMF