Projecting the course of the world economy over the next few decades is a daunting task. One only need look at the history of the last half century to see precisely how difficult it is. How accurately, for example, would we have been able to predict the 1995 world economy in 1965? To take a single economy as an example, 1965 forecasts of the 1995 US economy would almost certainly have missed all of the following: the sharp decline of the US steel industry, the rapid increase in market share by Japanese automobile manufacturers, the explosion of the computer industry, the decline in manufacturing employment and the expansion in services, the sharp decrease in energy use per capita and per unit of GDP brought about by the oil price shocks, and the transition of the US from international creditor to net debtor. Moving from the US economy to the world as a whole adds countless more events which would probably not have been predicted in 1965, ranging from the extraordinary growth of Japan to the rapid increase in the volume of world trade.
History holds at least three lessons which are important to remember. The most obvious is simply that today’s projections are unlikely to be right. The immediate consequence of this is that projections of the world economy should be used more to discover which variables are important than to develop point estimates of future GDP or other variables. The second lesson is that the most interesting and important events are likely to lie in the details of individual industries and countries. The third lesson, demonstrated vividly by the oil shocks of the 1970's, is that people respond to changes in prices. Together these lessons mean that projecting aggregate GDP is unlikely to be useful: it will almost certainly be wrong and it will fail to capture the most important events. To put this another way, the 1995 world economy is clearly not a simple scaling of the 1965 economy.
Capital account convertibility refers to a policy change that permits capital to flow more freely in and out of a country. Ishii and Habermeier (2002) provide a thorough analysis of the implications of capital account convertibility for financial stability. In India, recent policy discussions culminating with the publication of the Tarapore Report (2006) have reopened the debate about the risks and benefits of capital account convertibility. A debate which had lost steam after the Asian crisis. This paper attempts to contribute to this debate and takes a closer look at the prudential and regulatory measures needed to prepare India’s financial system to manage the risks arising from fuller capital account convertibility (FCAC).
There are benefits to fuller capital account convertibility for financial institutions, including increased diversification, greater access to capital, and a broader range of risk management tools. However, policymakers, financial institutions, and their clients typically face additional challenges with fuller capital account convertibility. At about US$104 billion, total foreign bank claims on India are comparable to those on China and Russia. In contrast, Indian banks claims on other countries are four times less than this total. With fuller capital account convertibility, new risks will arise as cross border transactions increase. Such activities will not only involve different currencies and span many countries but also include on balance sheet lending and funding, as well as off-balance sheet derivatives and other complex financial transactions.
Today, the world economy is in recession and the financial sector is experiencing a severe credit crisis. The origins of the credit crisis can be traced back to the subprime mortgage market in the U.S., where subprime refers to mortgagees who are unable to qualify for prime mortgage rates due to myriad reasons. These include past payment delinquencies, personal bankruptcies, low credit scores, large existing liabilities, or high loan to value ratios. As such, they represent a high-risk class of loan-borrowers with respect to defaulting on prospective payments.
In the last five years or more, a boom in subprime lending was fueled by, and it in turn propelled, a bull-run in the market for mortgage-backed securities. A Mortgage-backed security (MBS) is simply a merged pool of multiple mortgages that has a recurring stream of annuity payments associated with it over a horizon of 15 to 30 years. The annuity stream originates from the monthly mortgage payments that are purportedly expected from the corresponding loan borrowers. The lending boom sparked a spike in demand for homes, which in turn artificially inflated home prices and made investments in MBS assets very attractive for the banking sector. Banks consequently invested heavily in MBS assets, many of which had significant exposure to underlying subprime borrowers. They sought to neutralize the default risk to the associated annuity streams by investing in a form of insurance known as Credit Default Swaps (CDS). However, this turned out to be a superficial and temporary transfer of the underlying default risk. This is because of the high counterparty risk that was later realized in the overextended CDS market when subprime borrowers started to default en masse, and home foreclosures started to rise. Defaulting-led foreclosures in turn led to depressing home prices, particularly in subprime zip codes. These dynamics implied a significant downward pressure on the value of MBS assets as well as real physical home assets that ended up on the books of the banking sector through write-downs. A faster depreciation of assets relative to liabilities in turn put a downward pressure on the capital held by various banks.
