In July 2007, investment bank Bear Stern announced that couple of its hedge funds have gone bust. These funds were primarily investing in derivative securities with home mortgages as their underlying. It was later unfolded that the underlying for these derivatives were actually a web of complex financially engineered instruments where actual underlying security was of very poor credit quality. This was the first time when “sub-prime” entered the popular market jargon; which essentially meant that though a derivative financial instrument is rated of investment grade, the actual security underlying that derivative is of sub-standard quality.
The market briefly took note of this event correcting sharply.
However, the event was soon forgotten as a standalone instance that could not
have impacted the overall markets. Subsequent months witnessed one of the
sharpest global markets rallies.
In January of 2008 it was realized that Bear Stern was just a
tip of the iceberg. The malaise of sub-prime was all pervasive and had impacted
trillions of dollars in derivative instruments. What started with Bear Stern,
soon engulfed the entire world. Many large banks and hedge funds were found to
be infested with this termite. Not only banks, it has hollowed finances of many
sovereign governments like Portugal, Iceland, Italy, Greece, and Spain (PIGS)
etc.
What followed was total chaos. The global market froze. Trade
and commerce was hit as banking channels were shut and credit frozen. The
giants like AIG, CITI Bank, The Federal National Mortgage Association (commonly
known as Fannie Mae) and Federal Home Loan Mortgage Corp (commonly known as
Freddie Mac) etc came to the brink of disaster. Some of the top US investment
banks like Lehman Bros, Countrywide and Merrill Lynch etc. could not survive.
To mitigate the disaster, the central banks and governments
devised some innovative monetary policies (commonly known as Modern Monetary
Theory or MMT). Under these large central bankers started an unprecedented
quantitative easing (QE) program, which is nothing but an euphemism for
printing new money and buying stressed assets with that money to support the
market from collapsing. US Treasury also unveiled a US$800bn Troubled Asset
Relief Program (TARP), under which it financed the stressed lenders by infusing
equity or extending liberal credit. TARP was unwound in 2014 with US Treasury
actually earning some money out of this.
The QE program has been extremely successful in at least one of
its stated objective, viz, ensuring financial stability. The sovereign default
crisis in peripheral Europe was totally averted. Global markets reopened
immediately and credit flow restored. The asset prices were not only normalized
but exceeded their fair value in couple of years. The other objective of faster
sustainable growth is however yet to be achieved.
The Central Banks, primarily US Federal Reserve (Fed), European
Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ), however
continued their QE program, though the extent of printing money has been
tapered. To mitigate the impact of pandemic, central bankers have again started
to expand their balance sheets (printing money).
Back at home, RBI had resisted any QE in the wake of global
financial crisis. The stimulus given by the government of India was also very
limited, as Indian economy was not directly impacted by the crisis. None of our
institutions were meaningfully involved in global Ponzy schemes of sub-prime
mortgages and credit default swaps (CDS). Overseas branches of few banks lost
some money in forward forex contracts and underwriting sub-prime papers, but
nothing to threaten their existence or impact the domestic financial system
meaningfully.
The economic crisis due to pandemic is however very different.
It has directly impacted our economy and financial system. Besides, the
financial system was also struggling with the lingering impact of the large
credit defaults of IL&FS etc. RBI therefore has to step in along with the
central government. While the central government has done multiple tranches of
fiscal stimulus, RBI on its part has started its own version of QE program,
with the hindsight gained from the global experience of past one decade.
Through this program, it has successfully managed to keep bonds
and currency market stable; supporting the government’s expanded borrowing
program, improving the current account and comforting the foreign investors who
could be panicked if INR exchange rates fluctuated wildly.
The collateral benefit of RBI’s QE program to the government has
been huge interim dividend of Rs911bn for FY21. The RBI would have made huge
profit in trading of (a) government bonds (LTRO, Twister etc.) in which it buys
bonds of shorter maturities and sells bonds of longer maturities and (b)
trading of INRUSD by selling spot USD (to keep INR stable) and buying longer
term swaps, or the other way round.
Given that RBI usually buys the asset under some stress (bond or
currency), has the ability to print money, and need not bother about the MTM
losses on its positions, the chances of it losing money on its trades are
remote. It is therefore reasonable to assume that RBI shall continue (and even
increase) its trading activities in years to come. It is too easy and lucrative
source of income and managing markets to give up easily.
There will be no surprises to see (a) the finance ministers
providing higher dividend from RBI in years to come; and (b) senior bankers
with rich experience in managing treasuries being at the helm of RBI.
