Why RBI Governor Raghuram Rajan may be right about a crash

Article By Soumya Kanti Ghosh

In a series of recent interviews, Reserve Bank of India governor Raghuram Rajan
warned of a 'crash' should there be sudden reversal in risk perception already
distorted by unconventional monetary policies in the West. The rational response
to the exuberance in the prices of financial assets is that they have always been
irrational. And Rajan may be right this time!
Global economic outlook is grounded in optimism despite data showing the
contrary. Interestingly, the word 'geopolitical' appeared only once in RBI's June
statement; in August it appeared thrice. The US and Japan have contracted and
EU is in the midst of a fresh bank bailout. The financial markets around the world,
more so in the US and Europe, continue to rise. The Dow has risen more than 50%
since 2008 and during this hiatus, the US Q2GDP (and also in Q1) expanded by
more than 4%. What could possibly explain this disconnect between the stellar
performance of financial markets in the backdrop of continued modest real growth?
A peep into history shows some structural transformations have occurred in the
financial sector of advanced economies. If the balance sheet (BS) size of banks is
taken as proxy, then the size has grown dramatically in relation to underlying
economic activity over the past century. For example, for the US, there has been a
secular rise in banks' assets from around 60% of GDP in 1950 to over 100% by
2008.
For the UK, from about 50% of GDP in the early 1970s, banks' assets in relation to
national income have risen 10-fold to over 500% of GDP. The return on equity of
financial sector companies has outpaced those in non-financial sector by a factor
of two. Recently, a body of new empirical literature pointed out that
disproportionately higher growth in the financial sector reduces real growth,
dampening long-run productivity in the process. In other words, financial boom is
not growth enhancing as it distorts the allocative efficiency of the economy.

The financial sector, in the run-up to 2008, had grown on high leverage both on
and off balance sheet, and expanding exposure to trading assets vis-a-vis the
traditional assets. Leverage continues to be a serious cause of concern across
regulators even today. The Basel III accord has promptly checked this by
incorporating the leverage ratio and has subsequently followed this up with a
resolution regime mechanism to ensure orderly winding-up of entities that fail.
High debt is not just a problem of the financial sector but also a problem of the
government and household sector in the US and Europe. A Bank of International
Settlement study of 2011 examining linkages between debt and economic activity
in 18 industrial countries found that high debt is bad for growth. Hence, unless the
economic system as a whole delivers, the growth prospects of the global economy
projected at 3% and more by IMF can itself falter. While high debt continues to
plague the major economies, the initial response to the situation in 2008 was a
massive injection of liquidity, reducing interest rates close to zero bound and in
some cases altering the slope of the yield curve. The measures may have restored
peace in financial markets, but with the benefit of hindsight, one must look into the
possible externalities such measures have created
Artificially lower interest rates have distorted investment decisions and made risk
pricing arbitrary. At lower rates, an otherwise unviable project must have been
judged viable. As central bank tries to exit exceptional measures, the ensuing rise
in long yield can make those very viable projects unviable.
In 2012, the Treasury Committee at House of Commons asked the Bank of
England (BOE) to highlight the redistributive impact of monetary policy, and explain
the costs and benefits of their policy actions to groups that are perceived to have
been particularly badly impacted. In response to this question, BOE admitted that
exceptional measures had redistributive costs and there were clear winners and
losers.
Households in the upper quantiles have benefited from the appreciation in asset
prices following the unconventional response. Pension fund and insurance
companies have been squeezed by ultra-low interest rates particularly where

benefits have an embedded guarantee. The interaction of these unintended

consequences with secular rise in dependency ratio over the next decade may
aggravate the hardship.
Back home, the million-dollar question is: when will the RBI cut rate? If we leave
aside inflation, purely on the basis of an uncertain risk appetite and the US
monetary policy will warrant no change in policy rates. In fact, with Fed giving out
hints that "increases in the federal funds rate target could come sooner than the
Committee currently expects and could be more rapid thereafter", the situation
looks more challenging.
After all, going by historical trends, if Fed raises policy rates without a concomitant
raise in repo rate, there is indeed clear evidence of capital outflows! Add to this a
new round of geopolitical risks, with Scotland going for referendum on September
18, the RBI's tone going forward may continue to be hawkish even if retail inflation
cools off.

Opinion about the article

Raghuram Rajan an important governor and economist in India warned of a 'crash'
on the economy primary of the banks, relating their growth with the assets that we
have been studying in class. This is happening because of the big debt that the
banks actually have, also this is a reversal risk for their fixed assets, because
according to this author the balance sheet of this companies are impaired
according to their debts and the debt that they actually have.
Obviously the problem here is that the banks have very low interest and these
cause problems at the time that the balance sheet is analyzed. The high debt has
affected not just to the banks it also affects to the government and the financial
sector, the author mentions an example of the US financial sector in which they
declare that the grown that they are living is irrational and the assets according to
the traditional assets had grown at different time differing from the balance sheet
reports.
According to the article this type of disproportionately growth in the financial sector
reduces in an incredibly amount the real growth and the return on equity of the
financial sector according to the balance sheet companies has been rising more
than those in the non-financial sector by another factor.
This issue causes a fake screen in which the companies were gaining a lot in the
balance sheet but comparing it with the real assets out of the balance sheet the
expanding and the increase of this object was unreal.
This high debt is not the only problem of the banks also the fact that the low
interest that they had been offering to their customers. This cause to the banks to
have a big debt and is not reflected on their balance sheet and in a long term this
cause the stagnation of the economic growth, If everything is not considered on the
balance sheet and the low interest produce a inmense debt, I think that the banks
need to do something to stop this problem, maybe a solution is to increase a little
bit more the interest to have the benefits of the accounts receivable of the
customers,
The thing here is if the banks dont solve this problem in a long term maybe the
unintended consequences will aggravate the economic health in some years

tumbling in an economic depression that will affect to the government and the
society.
References:
Kanti, S. (2014, September 17). Why RBI Governor Raghuram Rajan may be right
about a crash. Retrieved from: http://articles.economictimes.indiatimes.com/201409-17/news/54025163_1_financial-sector-rbi-governor-raghuram-rajan-balancesheet