» Business » Financial crisis: Why bailouts are not the answer

Financial crisis: Why bailouts are not the answer

November 21, 2008 11:45 IST
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Disasters and wars provide excellent opportunities for businesses to make money. Governments are in a mood to open the tap, there are fewer checks on decisions taken in a rush, and special interests can make merry.

The airlines who were hit by the 9/11 attacks seven years ago wrested big concessions from the government, though smaller businesses that were equally badly hit got nothing. A similar attempt in the United States has just failed, with the big American car companies failing in their bid to get a $50 billion bailout package -- which is just as well, because the history of such bailouts is not encouraging.

It is far better for the companies (which have continued to stress the production of gas-guzzlers because they are more profitable) to file for bankruptcy if and when they run out of cash, and then undertake the long-delayed restructuring of their businesses under creditor protection, as the airlines eventually did.

It is re-assuring in this context that the authorities here at home have moved carefully. When people argued that non-banking finance companies should not be allowed to fail, the government did not rush in with bailout packages. But the decision to raise the import duty protection available to steel can and should be questioned because steel prices are still too high, by historical standards, and downstream units need lower input costs if they are to cut their own product prices -- as the finance minister has exhorted them to do.

An unusual challenge has been thrown up by the foreign currency convertible bonds issued by companies. With share prices having fallen below the prescribed conversion rates for the bonds, and with many companies unlikely to have the money to buy back the bonds on maturity, the risk of corporate default is high -- and is reflected in the deep discounts at which these bonds are being traded.

There is an obvious opportunity here to buy back the bonds at the discounted prices. Less obvious is the wisdom of the move to finance this by issuing fresh bonds. Such financial engineering must be approached carefully. Spreads on foreign loans have gone up sharply, and will be even greater for companies facing repayment crises and those whose share prices are much lower than before. The net benefit therefore may be limited, and could even be illusory.

The RBI move to reverse an earlier decision that increased the risk weighting for real estate loans is another step that should be questioned. It cannot be that real estate assets have become less risky; although prices have come off their peaks, there are few transactions in the market and all indications are that prices need to dip further.

It is understandable that the RBI might want credit to flow into a frozen real estate sector, but risk needs to be correctly priced if banks are not to be placed at risk. The risk weighting for loans to farmers and to small and medium enterprises has also been lowered -- once again, prudential considerations seem to have been made subservient to the desire to address sector-specific issues.

On the evidence so far, banks are not lending to the troubled sectors because they have their own commercial judgment with regard to risk; indeed, lending rates in the market have dropped by much less than the RBI's benchmark rates, so the problem is that bankers are still careful about the quality of assets they take on.

Rather than trying to prod bankers with sector-specific measures, the RBI should force more liquidity into the system so that interest rates get driven down across the board. When deflation is the danger of the moment, today's interest rates are much too high for virtually all categories of borrowers.
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