Does India Really Need

Derivatives?
Joshua Felman
International Monetary Fund - India
IMA CFO Presentation
May 30, 2008

Warning!

The views expressed are personal and are not

necessarily those of the IMF, its Executive
Board, or its management.

Is India out of step?

Yesterday, the RBI announced that it will soon

allow exchange-traded currency futures
The timing seems odd
Why is the traditionally cautious central bank
getting ready to introduce currency futures when
the problems of derivatives are daily becoming
more apparent?

Roadmap of presentation

How should we think about derivatives?

What caused the Asian crisis?

What caused the subprime crisis?

What are the lessons for India?

Roadmap of presentation

How should we think about derivatives?

What caused the East Asian crisis?

What caused the subprime crisis?

What are the lessons for India?

The charge sheet/1

The argument against derivatives is straightforward

Derivatives are said to be inherently complex and
difficult to understand
From which it follows that the parties buying and
selling them dont really understand the risks that they
are taking
In other words, derivatives encourage firms to take on
too much risk
This leads to crises

The charge sheet/2

Sophisticated finance was blamed for causing

the East Asian crisis of the 1990s
U.S. derivatives are being blamed for the current
subprime crisis
In India, a number of firms have suffered large
losses on their currency derivatives

Driving blind?

First things first

Lets define what we mean by a derivative

A derivative is nothing more than a financial
instrument whose value derives from that of
another asset (such as an equity) or price
(exchange rate)

Typical examples: forwards, futures, options

The pricing of derivatives is typically complex

But most are conceptually quite simple

A classic example

A classic example is a forward contract

A farmer is worried that the price of wheat will
drop by the time the crop is harvested
The baker is worried that the price might rise
By agreeing on a forward price, both parties can
actually eliminate their risk!
Of course, there is a cost both parties give up
the opportunity to profit if the price moves in a
direction that favors them

The implications

Currency derivatives are tools for managing risks

In some cases they can eliminate risks
Normally, however, they just transfer risks

They allow those who do not want to bear risks to pass them
on to those who have the capacity or even the interest to do
so
Example: corporates transferring risks to hedge funds

This transfer of risks is a very valuable service

Thats why the most advanced economies have the
most advanced financial systems, and vice-versa

Causes of the East Asia crisis

But what about the claim that derivatives can

lead to financial crises?

Didnt derivatives cause the East Asian crisis?

Actually.no!

Roadmap of presentation

How should we think about derivatives?

What caused the Asian crisis?

What caused the subprime crisis?

What are the lessons for India?

Before the crisis, East Asia was

booming
As ia n Cris is Co untrie s : P re -c ris is GDP g ro wth ra te s (pe r c e nt)
10
9

1991-95

1996

7
6
5
4
3
2
1
0
M alays ia

Ind o nes ia

Thailand

Phillip ines

Ko rea

Investment ratios reached 30-40

percent of GDP
50

Asian Crisis Countries: Pre-crisis Investment rates (per

cent)

45

1991-95

40

1996

35
30
25
20
15
10
5
0
Malaysia

Indonesia

Thailand

Phillipines

Korea

And to finance this, firms levered

themselves up

The perils of leverage

The exceptionally high leverage ratios were dangerous,

in and of themselves

If profitability faltered, there was little capital cushion to fall

back on

Firms worsened the situation by funding this leverage

in dangerous ways
They incurred two types of debt mismatches

Borrowed domestically at short-term rates to finance longterm projects

Borrowed abroad in foreign currency without hedging
(because exchange rates were linked to the dollar)

The crisis breaks

In 1996, profitability turned down

By 1997, foreign lenders became worried, so

they demanded repayment

Exchange rates consequently depreciated and

interest rates soared, pushing many of East
Asias corporates into bankruptcy

and growth collapsed

Asian Crisis Countries: Real GDP growth, 1998 (percent)

-6

-6.7

-8
-10

-9.4

-12
-14
-16

-13.7

-5.8

an
d

-0.5

Th
ail

pi
ne
s

ys
ia

Ph
illi

-4

M
ala

or
ea
K

In
do
ne
s

-2

ia

Where was risk management?

In other words, the crisis was not caused

because of inappropriate use of risk
management tools (e.g., derivatives)
It was caused precisely because firms incurred
very large risks and then did not use any tools
to manage them!

Roadmap of presentation

How should we think about derivatives?

What caused the Asian crisis?

What caused the subprime crisis?

What are the lessons for India?

Similarities to the Asian crisis

A boom period, from 2002-06

Excessive leverage
This time in the financial sector
Ill-fated Carlyle hedge fund invested $23 billion on an

equity base of less than $1 billion

Poor risk management

U.S. financial institutions had models to assess risk but

they clearly proved inadequate to the task

A key difference: derivatives

Unlike in East Asia, derivatives were an important part

of the story

Problem originated because banks made loans to

subprime customers, sometimes even to NINJAs
(those with No Income No Jobs No Assets)

Then, they packaged the loans in Collateralized Debt

Obligations (CDOs) and sold them to investors

CDO calamity

CDOs proved troublesome for two reasons:

The originate and distribute model gave few
incentives for mortgage originators to contain risk
Packaging the loans in CDOs made it difficult for
buyers to assess their riskiness

They relied on rating agencies, whose judgment proved

fallible

Conclusive proof?

So, do we now have the smoking gun proof that

sophisticated finance blinds people to risks, eventually
triggering crises?
Not quite!
Note the key word: crisis
Certainly, there is a financial crisis, but is there a real
crisis -- an East Asia-style collapse in growth?

A real crisis?

Not at all!

In fact, the current debate is whether the US will even

enter into recession or not

The IMF forecasts that US growth will decelerate to

percent in 2008 and 2009 from 2 percent last year

That would certainly be a disappointment -- but hardly

a crisis!

Financial/real linkages

This (likely) development has important implications

Since 1997, people have worried about financial crises
precisely because it was believed that they lead to real
crises
Consequently, efforts were focused on regulating the
financial sector tightly
But what if the link between financial and real crises
isnt as tight as we once thought?
Then, the focus needs to be on insulating the real
economy from financial crises

Insulating the economy

How has the U.S. managed to insulate its real economy,

while East Asia could not?

Answer in a word: leverage

Corporate leverage was low

100

2.3
2.2
2.1

U.S. no nfarm no nfinancial

co rpo ratio ns' ratio o f assets to net
wo rth (left scale)
Credit market debt to
net wo rth (percent,
right)

90
80
70

2.0
60
1.9
50
1.8
1.7

40
30

Debt to market value o f equities (percent,

20
i ht)
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

1.6

and profitability was high

US: Corporate Profits (percent GDP)
15.0

13.0

11.0

9.0

7.0

M
ar
-0
1
Se
p01
M
ar
-0
2
Se
p02
M
ar
-0
3
Se
p03
M
ar
-0
4
Se
p04
M
ar
-0
5
Se
p05
M
ar
-0
6
Se
p06
M
ar
-0
7
Se
p07

5.0

Source: CEIC database. Profits with Inventory Valuation Adjustment (CPIVA): seasonally adjusted

Lessons from East Asia and the US

Real risks come from:

Overconfidence during a boom period
High leverage
Debt mismatches

Firms need to limit these risks, and use tools to

manage them
But they also need to understand the tools!
Conclusion: good risk management systems are
critical

Roadmap of presentation

How should we think about derivatives?

What caused the Asian crisis?

What caused the subprime crisis?

What are the lessons for India?

Does any of this have implications for India?

Wellyes!

Currently, corporate leverage is low and profits high,

just like in the US

But..

India is in the midst of an

East Asian-style investment boom
India - Nominal Investment (in percent GDP)

45
40
35
30
25
20
15
10
5

@ Provisional estimates;* Quick Estimates; ** Advance Estimates

*
20
07
-0
8*

20
06
-0
7*

20
05
-0
6@

20
04
-0
5

20
03
-0
4

20
02
-0
3

20
01
-0
2

20
00
-0
1

And firms are incurring East-Asia

style debt mismatches

Many of these investments are infrastructure projects,

involving huge outlays, long time spans, and uncertain
revenues
How are these projects being financed?
Like in East Asia, much of the funding is

Short term (banks), incurring interest rate risk

Foreign currency (ECBs), incurring exchange rate risk

Over time, risks could build up for the corporate sector

and the financial firms that lend to them

Leverage levels could rise rapidly

Investment is large relative to the banking sector

So, modest failure rates could have a large impact on bank capital

What needs to be done?

Task 1: improving corporate risk

management systems

In December, Mecklai Services and Business Standard

rated 45 firms on their risk management
The sample was evenly divided among small, medium,
and large firms
They found:

The average score was only 46, on a scale of 100

Large firms did not do better than smaller ones
Half of the firms did not have a documented risk
management strategy
One-third of the large firms had no measure at all of the risk
they were carrying

If you cant measure it, you cant manage it!

Task 2: Reducing Debt Mismatches

The risks of debt financing need to be curbed

Ideally, India needs to create a corporate bond market

Firms will then be able to obtain long-term finance, in rupees

But experts have been saying this for more than a

decade, and nothing has happened
While we wait, firms will need to use tools to handle
the inevitable debt mismatches

Currency derivatives to manage exchange rate risk

Interest rate futures for short-term rate risk

Importance of currency derivatives

India already has a forward market

Why are futures important?
Partly for the standard reasons they will:

But also because they will eliminate participation and hedging

restrictions

Introduce pricing transparency

Eliminate counterparty risk, a big problem in recent months

Participation will be open to all domestic players and eventually to foreign

players
No hedging requirement

Trading allowed on existing (and new) exchanges, though with

separate membership criteria, trading rules, risk management
framework, etc.

Now, we are finally in a position to answer the

question posed at the outset

The need for derivatives

Yes, India needs derivatives

It can exercise the advantage it has of being an EM it can

avoid some the untested financial innovations coming from
the mature markets, such as CDOs

Instead, it can focus on introducing some tried-and-true

tools for managing risk, such as interest rate and currency
futures

All of which explains why the conservative RBI is planning

to introduce these tools