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?
Roadmap of presentationRoadmap of presentation
How should we think about derivatives?How should we think about derivatives?
What caused the East Asian crisis?What caused the East Asian crisis?
What caused the What caused the subprimesubprime crisis?crisis?
What are the lessons for India?What are the lessons for India?
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!
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?
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!
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?
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
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?
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