Sunday, March 31, 2019

How a market bubble and crash can strengthen your country

As the Indian elections approach a fever pitch, there are lots of debates going in social media about the Credit Crisis that led to NPAs escalated during the UPA1 years. There has been rampant and mindless credit growth and the credit control processes were significantly weakened. There was a feeling all around that 'This crisis' was different from other 'Credit Risk Crises' due to the following reasons.
  1. Credit risk has been globalized and hence insignificant for any one country
  2. Securitization and collateralization of debt has ensured that the credit risk is spread across many people and hence is insignificant for one person
  3. Technology has ensured that adequate controls are in place. 
  4. Credit risk has been transferred those who can pay. 
  5. There is no credit risk. Housing prices are going to stay where they are or are only going to go up.
This was a bubble. It was a matter of time before the cookie crumbled. 

The NPAs exploded and banking system was in severe turmoil. Everyone was looking for scapegoats. 

But how you react in crisis will have long-term implications to the systems and processes in place. Let me give an example of how two countries differed in their response to the crisis. 

US faced its worst economic crisis in the great depression of 1929 that lasted for over three years. Economy was decimated, markets tanked by 80%, millions of people went bankrupt, unemployment exploded...

There was a lot of calls for finding and punishing scapegoats. Of course there were a few of them.

But the main benefit out of the depression was that US created one of the best financial markets processes anywhere in the world. They created SEC to oversee the workings of the markets. They formalized short selling and made the investment process more transparent. They introduced the Glass Steagall Act that separated commercial banking from investment banking. 

US brought in forward looking policies. They created enduring systems and institutions which serves the country well after almost a century. The stock market acted as a catalyst for economic growth in the country for many years into the future. 

Now let us look at UK and how they handled the 'Railway Mania Bubble of 1840'.

The seeds of the bubble was sown in 1825 when British Government repealed the Bubble Act, enacted after South Sea debacle of 1720 and was designed to regulate joint stock companies. By about 1845, Bank of England reduced interest rates to stimulate economy and this coincided with the first ever steam locomotive, the Liverpool and Manchester Railway (LMR) that was opened in 1830. The new technology caught the fancy of investors aided by cheap credit and a bubble was born. 

Railroad companies became the promoters of their stock and even came up with stock purchases with 10% down payment. The ensuing bubble was almost the same scale as dot com bubble of early millennium.Almost all the UK households held investments in railroad companies and the number of companies mushroomed by 1845 and 46. 

As BoE tightened the interest rates, and investors found that many new railroad companies were scam, markets started to tank. This was exacerbated when railroad companies exercised the call option and asked the investors to pay the remaining 90% of their purchase price. Many UK households were financially ruined.

The country was looking for revenge and the government obliged. They went after the scamsters, and focused on giving exemplary punishment to them rather than strengthening the systems and processes. The end result was a labyrinth of small railway networks that makes the UK rail network the most complex network in the world and which acts as a drag on the country's economy.

The real question is which way will India go after the current crisis? Will we go for short term solutions or will we put in systems and oversight mechanisms in place? 

A review of history will help. After the Forex crisis in 1991, the GoI (Government of India) put in place some far reaching economic reforms and the country is getting the benefits out of them even after many years. Even after the current crisis, the NDA (National Democratic Alliance) government has put in place reforms like IBC (Insolvency and Bankruptcy Code) that will create a strong oversight over the credit excesses. 

Bubbles are economic phenomena. They will keep happening in regular cycles and people will end up losing money. The question is what lessons do you learn from each bubble.Has the country became stronger as a result of this experience.

That is the real question. That applies to life as well, doesn't it?

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