Tuesday 21st Oct 2014
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GREATER RELIANCE
ON EQUITY IS NEEDED

Cover Story

By M. UMER CHAPRA

There is a close relation between easy availability of credit and living beyond means and macroeconomic imbalances. Of course the credits could be long term as well as short term. But in the present day circumstances a substantial part of the credit is short term which is easily reversible. The borrowers are willing to get back their debt, their financing, as soon as possible whereas debtors are unable to pay.  And this leads to a financial crisis….

Let us take, for example, some countries where there has been crisis. Let us take the East Asia Crises. The countries where these crises took place were shining success stories. They had high domestic saving and investment, healthy fiscal and monetary policies. They were envy of a large number of developing countries. But in spite of this there was a crisis because there was rapid growth in bank credits in local currency. A lot of money was coming from foreign banks to these countries and the local banks kept on lending and lending and lending – a very excessive lending that cannot be used productively. Consequently there was a lot of flow of this credit to the speculative sector of the economy, the stock markets, the commodities markets, the foreign exchange markets.

In such a situation the credit tends to be largely short term as for long term financing there is the need of project valuation. The foreign banks gave a large number of credits without evaluating the risks they were getting. Sixty-four per cent of the total credit was short term. Now in such a situation any shock can drive away the creditors....

As a result of this, these countries were not able to export as much as they were exporting before and they were not able to get back their loans. So there was a rush to withdraw the funds. The local banks could not repay because they had given some loans on long term and medium term. And the borrowers could not pay immediately. There could have been an international financial crisis; therefore the IMF came to the rescue of the international banks. They pumped in a lot of credits to these countries to save the Western Banks. As a result what happened, the private sector debts became public sector debts. And who is going to suffer? The taxpayers in these countries have to ultimately suffer the losses.

Let us take the LTCM (Long Term Credit Management). This is a hedge fund in the United States. These hedge funds generally speculate. Their main purpose is supposed to be hedging but it is really not hedging but speculating. They speculate and create risks. They are highly leveraged short term lending. You know when you are able to get ten dollars against one dollar of capital, the leverage is ten. But even in the case of these LTCMs the leverage before the crisis was 25, which means that they were able to get 25 dollars against each dollar of their own capital. A little after the crisis the leverage rose to 50 because they had to borrow more and the value of their asset also got down. So the leverage rose to 50. And before the Federal Bank came to the rescue of this institution the leverage had risen to 167…. With such a high leverage the financial system is bound to become unstable.

Now look at the United States’ imbalances. The US has been borrowing and borrowing and borrowing, heavily – both the private sector and the public sector. As a result there is a large discrepancy in the Federal budget, also in the state budgets and the municipalities and so on. And the savings in the United States is only about one per cent of GDP. And the investment is high. Not all of this productive investment. A lot of this is in the speculative market. Any time the foreigners who are providing these funds may get scared and may refuse to lend more. I hope this does not happen, because if it happens there will be financial crisis throughout the world. The value of dollar would go down, interest rate would rise up in the US, and the economy will go into a recession. Because the US is a very important market in the world; therefore the whole world will suffer. 

What is the way out of this situation? It is necessary to have less reliance on debt and greater reliance on equity.

 

[Excerpts from the lecture of Dr. Chapra in the international seminar on Islamic Banking organised by Jamaat-e-Islami Hind on 18-19 February, 2006]



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