IMPACT OF FINANCIAL DISRUPTIONS ON TRADE CREDIT

TC= Trade Credit

Over the years TC was working more or less smoothly until it faced a systemic disturbance since late 1990s. Negative liquidity shock arising from disruptive developments in FS in post-1997 period as described above led to disruptions in continuous circulatory flow of credit. This resulted into default/delays in payments to suppliers. Effects of the unanticipated defaults/delays in TC payments propagated to many firms through TC network. Many firms faced credit-default-led financial sickness. It heightened credibility concerns about trade debts.

Upward shift in risk perception in TC has been reinforced by decadence of credit culture in the recent times. Feeling of moral guilt/shame and social stigma attached to default /bankruptcy maintain trust and integrity in TC. These values are now on wane. Further, it does not handicap a defaulter/bankrupt to continue his business. Cases of purposefully delaying/defaulting on credit while having repayment capacity are on rise. Not punishing a firm that behaves opportunistically encourages further opportunism. These undermine integrity in business dealings; the very ethical basis upon which the economic society stands. Uncertainty stemming from credibility concerns about trade-debtors and weak contract enforcement impact efficiency and normal working of TC.

Today credit sales carries higher risks of bad debts, delays, uncertainty, higher realisation costs and even possibilities of spoiling business relations. Businesses now adopt a pre-cautionary approach in extending TC. They become very selective in credit matters. TC flows become skewed in favour of large/ reputed firms and firms with regular dealings. Small, young and financially weak firms even with sound base find it difficult to get TC which is essential for their survival, growth and getting bank credit at later-stage. With tightening of TC to new businesses, the signaling effect of TC to bank credit for the new units is now muted. TC tightening also increases risk for bank credit as it affects efficiency of a firm's working capital management.

ASSET PRICE BUBBLES

The most significant phenomenon in recent times in prolonged build up and sharp collapses in asset prices which we call asset price bubbles that tend to alternate between under valuation and

over valuation.

Asset price bubbles have a significant role in current subprime crisis. The momentous cause behind every major financial crisis like Japanese Liquidity Trap, Great Depression, and Dot.Com Crisis and so on is the formation and burst of asset price bubbles.

The main motivation for holding a speculative asset is the expectation that the price will continue to raise and hence asset price bubbles are permanent features of economic environment because of the nature of human behaviour.

The conventional view on this problem is that, monetary policy has very less to do with the asset price bubble formation and collapse considering its subjectivity. Also does central banks have to intervene in this issues is again a debatable question. Buying some arguments from research papers by Bank of International Settlements, Bernanke and Gertler (1999) conclude that “The inflation targeting approach dictates that central banks should adjust monetary policy actively and pre-emptively to offset incipient inflationary and deflationary pressures. Importantly for present purposes, it also implies that policy should not respond to changes in asset prices, except insofar as they signal changes in expected inflation.”

Against this, Cecchetti et al (2000) argue that “A central bank concerned with both hitting an inflation target at a given time horizon, and achieving as smooth a path as possible for inflation, is likely to achieve superior performance by adjusting its policy instruments not only to inflation (or its inflation forecast) and the output gap, but to asset prices as well. Typically modifying the policy framework in this way could also reduce output volatility. We emphasize that this conclusion is based on our view that reacting to asset prices in the normal course of policymaking will reduce the likelihood of asset price bubbles forming, thus reducing the risk of boom-bust investment cycles.” But having witnessed the recent subprime crisis, I would like to say that “It is central bank’s responsibility to control the heating up of asset price bubbles and should be able to find them out in early stages”

This leads us to one more interesting question; can asset price bubble be identified? US Supreme Court Justice Stewart view of macroeconomic asset price bubble “I could never succeed in defining them, but I know them when I see them”, to this BIS adds “when they see them, policy makers should be concerned” If crises are like accidents or natural calamities that happen or rare events that are beyond the realm of normal expectations, which Nassim Nichloas called them as Black Swan events, then there is nothing that can be done about it and we should take the after math effects. But even a crisis like subprime crisis has been predicted clearly by famous economists like Nouriel Roubini and hence he termed such an event as “White swan” in his famous book “Crisis Economics”. There may be a lot of subjectivity left in identifying bubbles, but it is not impossible to identify.

And hence we say though it is possible, but identifying bubbles is very difficult, even if they are identified, the growth of the bubble can be due to phenomenon of growth like credit growth, Industrialization, Demand growth etc…. Hence this arguments segregate this question into two more questions, are bubbles rational or irrational? Central banks have to curb irrational bubbles and not rational ones. Otherwise, it might hamper growth and might even push the system into more distress. Hence the instruments should be precise.

Probing into the reasons for bubbles that make them blow out of their fundamental values, in research paper “Asset Price Bubbles and Stock Market Interlink ages,” by Franklin Allen and Douglas Gale, authors have presented a theoretical model based on an “agency problem” of the amount of credit provided for speculative investment. Bubbles in capital markets and real estate emphasize the agency conflict that exists between borrowers and lenders when information is asymmetric. Risk is shifted if the ultimate providers of funds (banks) are unable to analyze their investments due to the lack of financial sector expertise and resulting opacity. The shifting of risk increases the return to investment in the assets and causes investors to bid up asset prices above their fundamental value.

The World Bank Group and the Federal Reserve Bank of Chicago cosponsored a conference on

Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies. I would

pick some statements that were made in this conference.

1) Though it is matter of serious concern, Central banks should not introduce asset prices into their monetary policy reaction function the reasons being, it is difficult to implement a sound monetary policy while focusing on highly volatile indicators and there are doubts whether asset prices can be determined scientifically.

2) Monetary policy is a blunt instrument for responding to a narrow class of asset markets. Therefore, the suppression of most asset price volatility through monetary policy is neither

feasible nor desirable.

Coming back to the square one, I would again like to reaffirm the statement; monetary policy is not the right instrument to curb “irrational asset price bubbles”. And having seen the repercussions of the crisis created by asset price bubbles, these are not something that can be ignored and left to the market to adjust to itself. Gone are the Old theories that say “market adjusts itself to demand and supply”. It is now central banks role to identify the bubbles and prick them in early stages and hence I would like to re-quote the question stated by Dr. Duvvuri Subbarao “What is the role of central banks in preventing asset price bubbles?”

A thin line between Price Stability and Financial Stability

In this post I would like to quote some theories and real time cases at a very basic level to mock the relation between Price Stability (PS) and Financial Stability (FS). There is a very sensitive and interesting relationship between them. The thin line between the two makes them go hand in hand and also hamper each other.

To start with Schwartz Hypothesis .It says that sustained inflation encourages speculative investment and borrowing because there exists an expectation that prices will continue to rise. When inflation abruptly declines borrower incomes may prove insufficient to repay loans that had been made with the expectation of continued price increases. The resulting rise in borrower defaults reduces the equity of lenders, possibly causing an increase in financial institution failures. In the absence of inflation and disinflation, real shocks, such as those affecting commodity markets in the 1970s and early 1980s, might still cause significant financial distress. The Schwartz Hypothesis argues, however, that if the aggregate price level is stable, or at least if its movements are fully predictable, then resources will be employed more economically, and financial distress, regardless of its proximate cause, will be less severe.

That means with this hypothesis it is clear that

Price Stability α Financial Stability

Hence more stable (Stable doesn’t mean static It mean a slow pace increase) the prices, more predictable economy and encourages better investment which leads to financial stability.

As we know price stability depends upon the “monetary policy” of the economy which is in the hands of the respective central bank.

The years before the crisis saw a powerful intellectual consensus building around inflation targeting. A growing number of central banks, starting with New Zealand in the late 1980s and currently numbering over 20, geared monetary policy almost exclusively to stabilizing inflation. Even where central banks did not target a precise inflation rate, their policy objectives were informed, if not dominated, by price stability. This approach seemed successful. There was an extended period of price stability accompanied by stable growth and low unemployment. In the world that existed before the crisis, central bankers were a triumphant lot. They had discovered the Holy Grail.

The unravelling of the Great Moderation during the crisis has diluted, if not dissolved, the consensus around the minimalist formula of inflation targeting. The mainstream view before the crisis was that price stability and financial stability reinforce each other. The crisis has proved that wrong. We have seen that price stability does not necessarily ensure financial stability. Indeed there is an even stronger assertion - that there is a trade-off between price stability and financial stability and that the more successful a central bank is with price stability, the more likely it is to imperil financial stability.

So here,

Price Stability α 1/(financial Stability)

All in all, the crisis has given fresh impetus to the ‘new environment hypothesis’ that pure inflation targeting is inadvisable and that the mandate of central banks should extend beyond just price stability.

Hence the Million or the Billion or even more costlier question here is

“Should central banks persist with pure inflation targeting? “

Diplomatic answers like

1) There should be a trade off between restriction and development

2) Should be dealt by case to case

can easily be given.

But I personally think both the answers keep us grope in the darkness to find the thin line between the PS and FS. A clear framework is required to thicken the line.

And the stage is now left to the policy makers and economists to come out with the right extinguisher to address this burning problem. I am ending my article with a question, because it is yet unanswered.