How India Avoided the Big Bubble

William Krehm

The New York Times (20/12, "How India Avoided a Crisis" by Joe Nocera): "Mumbai – ‘What has taken a number of us by surprise is the lack of adequate supervision and regulation,’ Rana Kapoor was saying the other day. ‘This was despite the fact that Enron had happened and you passed Sarbanes-Oxley. We don’t understand it. May be it’s because we sit in a more controlled economy, but….’ He smiled sweetly as his voice trailed off as if to take the sting out of his comments. But they stung nevertheless.

"Mr. Kapoor is an Indian banker, a former longtime Bank of America executive with a Rutgers MBA who, along with his business partner and brother-in-law, Ashok Kapur, was granted government permission four years ago to start a private bank, which they called Yes Bank. In the US, Yes Bank is the kind of name a go-go banker might give to, say, a high-flying mortgage lender in the middle of a bubble. But Yes Bank is not exactly the Washington Mutual of India. One new release it hands out to reporters who come calling is an excerpt from a 2007 survey by The Financial Express: ‘#1 in Credit Quality Amongst 56 Banks in India’ reads the headline.

"I arrived in Mumbai three weeks after the terrorist attacks that killed 200 people – including, tragically, Yes Bank’s co-founder Mr. Kapur, who had served as the company’s non-executive chairman and was gunned down while having dinner at the Oberoi Hotel. (His wife and two dinner companions miraculously escaped.)"

And yet in the ensuing discussion India’s recent losses from crazed killers emerges in the telling a mere regrettable incident alongside the systematic financial crisis that seems to have cut banking America at the knees, but has left Indian banking relatively intact.

"My hope in traveling to Mumbai was to learn about the current state of Indian business in the wake of both the credit crisis and the attacks. But in my first few days in this grand, sprawling, chaotic city, what I mainly heard was about America, not India. How could we have brought so much trouble on ourselves, and the rest of the world, by acting in such a foolhardy manner? Didn’t we understand that you can’t lend money to people who lack the means to pay it back? The questions were asked with a sense of bewilderment – and an occasional hint of scorn. I didn’t have any good answers. It was a bubble, I would respond with a sheepish shrug, as if that were an adequate explanation.

"‘In India, we never had anything close to the subprime loan,’ said Chandra Kochhar, the chief financial officer of India’s largest private bank, Icici. (A few days after I spoke to her, Ms. Kochhar was named the bank’s chief executive, in a move long anticipated.) ‘All lending to individuals is based on their income. That is a big difference between your banking system and ours.’ She continued: ‘Indian banks are not levered like American banks. Capital ratios are 12 and 13%, instead of 7 or 8%. All those exotic structures like CDO and securitizations are a very tiny part of our banking system. So a lot of the temptations didn’t exist.’"

Non-performing Loans Under 1%

"And when I went to see Deepak Parekh, the chief executive of HDFC, which was founded in 1977 as the country’s first specialized mortgage bank, practically the first words out of his mouth were: ‘We don’t do interest-only or subprime loans. When the bubble was going on, we did not change our policies. We did not change any of our systems. We did not change our thought process. We never gave more money to a borrower because the value of the house had gone up. Citibank has a few home equity loans, but most banks in India don’t make those kinds of loans. Our non-performing loans are less than 1%.’

"Yet two years ago, the Indian real estate market – commercial and residential alike – was every bit as frothy as the American market. High-rises were being slapped up on spec. Housing developments were sprouting up almost everywhere. And there was plenty of money flowing into India, mainly from private equity and hedge funds, to fuel the commercial real estate bubble in particular. Goldman Sachs, Carlyle, Blackstone, Citibank – they were all here, throwing money at developers. So why did the Indian banks stay on the sidelines and avoid most of the pain that has been suffered by the big American banks?

‘"Part of the reason is cultural. Indians are simply not as comfortable with credit as Americans. A lot of Indians, when you push them, will say that if you spend more than you earn, you will get into trouble,’ an Indian consultant told me. ‘Americans spent more than they earned.’

"Mr. Parekh said, ‘Savings are important. Joint families exist. When one son moves out, the family helps them. So you don’t borrow so much from the bank.’ Even mortgage loans tend to have down payments in India that are a third of the purchase price, a far cry from the US, where 20% is the new norm. (Let’s not even think about what they used to be.)

"But there was another factor, perhaps the most important of all. India had a bank regulator who was the anti-Greenspan. His name was Dr. V.Y. Reddy, and he was governor of the Reserve Bank of India. 70% of the banking system in India is nationalized, so a strong regulator is critical, since any banking scandal amounts to a national political scandal as well. And in the irascible Mr. Reddy, who took office in 2003 and stepped down this past September, it had exactly the right man in the right job at the right time.

"He basically believed that if bankers were given the opportunity to sin, they would sin. For all the bankers’ talk about their higher lending standards, the truth is that Mr. Reddy made them even more stringent during the bubble.

"Unlike Alan Greenspan, who didn’t believe it his job even to point out bubbles, much less try to deflate them, Mr. Reddy saw his job as making sure Indian banks didn’t get too caught up in the bubble mentality."

Purchase of Raw Land Left to US Banks to Finance

"About two years ago he started sensing that real estate, in particular, had entered bubble territory. One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved – and only then to make construction loans. (Guess who wound up financing the land purchases? United States private equity and hedge funds, of course!)

"Then, as securitizations and derivatives gained increasing prominence in the world’s financial system, the Reserve Bank of India sharply curtailed their use in the country. When Mr. Reddy saw American banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India. As a result, banks in India wound up holding the loans they made to customers. On the one hand, this meant they made fewer loans than their American counterparts because they couldn’t sell off the loans to Wall Street in securitizations. On the other hand, it meant they still had the incentive – as American banks did not – to see those loans paid back.

"Did India’s bankers stand up to applaud Mr. Reddy as he was making these moves? Of course not. They were naturally furious just as American bankers would be if Mr. Greenspan had been more active. Mr. Parekh told me that while he had been saying for some time that Indian real estate was in bubble territory, he was still unhappy with the rules imposed by Mr. Reddy.

"‘For a while we were wondering if we were missing out on something,’ said Ms. Kochhar of Icici. Banks in the US seemed to have come up with some magical new formula money: make loans that required no down payment and little in the way of verification – and post instant, short-term profits.

"Ms. Kochhar said that the underlying risks of having ‘a majority of loans not owned by the people who originated them’ were not apparent during the bubble. Now that those risks have been made painfully clear, every banker in India realizes that Mr. Reddy did the right thing by limiting securitizations.…

"None of this is to say that the global credit crisis hasn’t affected India. It certainly has. September 15, the day Lehman Brothers defaulted – changed everything, even here, on the other side of the world."

The next significant change that remains to be recognized: how the immense investments in human capital still appear on the government books of developed countries at token one-dollar values. From that unrecognized store there is enough prepaid surplus investment that merely awaits recognition to support further investment in human capital. That was recognized on the carefully assessed lessons of the reconstruction of Germany and Japan from the destruction in World War II as the most productive investment a government can make. So to stave off the mass unemployment that we are heading into, our government must use that vast unrecognized investment to make capital expenditures in essential human capital. That in fact will constitute further investment – of the most productive sort a government can make. And we learned how that was done with the unrecognized physical investment of government – in 1996 in the US and in 2002 in Canada. We need only follow our noses, with a minor amount of mental exertion to recapture our own history.

Isn’t this an urgent time for a little serious public discussion on our own fairly recent history? Canadians owe it to themselves not to allow politicians of any party to continue making fools of them by suppressing our knowledge of our own quite recent history. COMER will be happy to provide spokesmen to carry on public discussions on these points.

William Krehm

– from Economic Reform, January 2009