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Hobson's choice for the United States

By Abheek Barua
September 29, 2008 15:27 IST
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The devil, as is often the case, lies in the detail. US economic policy czars, Ben Bernanke (who heads the central bank) and Henry Paulson (the treasury secretary) have presented a rescue plan for the beleaguered American financial system to the US Congress.

They are hoping that US lawmakers will approve of this salvage plan that costs a whopping $700 billion. The cost will have to be borne by US tax-payers. $700 billion works out to roughly 5 per cent of the US and about 70 per cent of India's GDP.

The size of the package does not necessarily guarantee success. Whether the package brings succour to the US financial system or not depends critically on how quickly and how well the nitty-gritty of its implementation can be spelled out.

If it cannot be effectively "operationalised", the entire global financial system might be in for another major upheaval. It is unlikely that Indian markets will be spared. If the Bernanke-Paulson (B-P from now) plan fails to work, local asset prices -- stocks, real estate and bonds -- will come in for another round of severe battering. So, be prepared.

B-P plan to use the money to buy up the illiquid mortgage-linked assets that are sitting on the books of banks and insurance companies. This, they hope, will help achieve two things. For one, it will shore up liquidity in the banking system and help the flow of credit for productive uses. It will also help the banks get a "fair" price for these securities (well, at least a higher price than the "firesale" prices that they currently fetch).

This will limit capital losses for banks. What's in it for the tax-payers if they support this plan? B-P have sounded quite ominous about the prospect for the US and the global economy if this plan is not vetted. Thus the American taxpayer really has a Hobson's choice -- he either whips out his wallet or goes bust.

B-P, however, promise payback for taxpayers in the long term. They argue that if the US government holds these securities long enough and tides over the financial crisis, these security prices would appreciate and move up to some "fair value".

Thus, the treasury actually stands to make a profit if they hold these securities long enough. These profits would then be transferred back to the tax-payers.

Theoretically, this seems like a consistent plan. In practice, it might just prove quite daunting. Remember, this bailout is not just about rescuing a bank or an insurance company. It involves identifying and extracting "problem assets" from, potentially, hundreds of balance sheets.

These are not simple assets like loans -- most of the illiquid instruments that banks hold at this stage are complex derivative structures. So, the treasury will have to un-bundle these structures, extract the underlying assets and then figure out the right price for them. That's no mean feat.

Finding a buyer for them at a subsequent stage would also be a problem unless the fundamentals of the US housing market improve. There are other issues as well. Selling these mortgages to international investors amounts to auctioning claims on large chunks of US real estate. If B-P are betting on getting international buyers to buy this, there could be questions about internal security as well.

In short, over the next few days, B-P will have to answer a lot of hard questions about the specifics of their rescue plan. There are two possible risks going forward. The first is that Congress vetoes the plan and B-P have to come up with an alternative.

That seems unlikely. The bigger risk is that the bailout plan is passed but with significant dilution and fails to impress the markets. That would defeat the very purpose of the rescue-effort, which is to bring back financial stability into the system.

What if the plan gets the approval of the US lawmakers and the markets think it's a credible plan? If the market believes that the US government has addressed the key source of market risk, there would be a sigh of relief. Investors would tend to reduce holdings of low-yielding, safe assets like US government bonds and seek higher yields.

Emerging markets could rally as a result and the Indian stock-market could move up sharply. The rupee, which has been under pressure for the past few months, could get a reprieve.

But make no mistake -- this is not the end of the bear market. For one, the bail-out will not get the US economy or the financial system out of the doldrums immediately. If the US continues to decelerate, it will pull the rest of the world down with it. It is unlikely that high-yielding assets like stocks will fare well.

This includes Indian stocks. Thus a brief bull-run represents the opportunity to sell risky assets and park your money in a safer haven. For some time to come, bank deposits, government bonds and gold will remain a safe bet.

Finally, it is important to recognise the fact that the entire global financial system is going through a process of "de-leveraging". Investors who had borrowed cheap -- that is "leveraged" -- to buy higher-yielding assets -- are now drastically cutting down on debt. The bubble in asset prices that had built up over the past few years was inflated by high levels of leverage.

Once the leverage goes, so will the bubbles. My sense is that asset prices will deflate quite a bit more before some contrarian investor gets a whiff of "value". The current bear market will then come to an end.

The author is chief economist, HDFC Bank. The views here are personal.

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Abheek Barua
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