In 1977, Minsky presented the ‘financial instability hypothesis’, an interpretation of John Maynard Keynes’ General Theory that examines the impact of debt financing on the economy. He expounded three types of debt financing: hedge, speculative and Ponzi.
The first, hedge financing, is safe. Future cash flows of a firm are sufficient to repay all borrowings. The typical example is profitable firms in the manufacturing sector that borrow small amounts to finance incremental investment. The second, speculative financing, is risky. Future cash flows are sufficient to repay interest, but not principal. To repay principal, firms rely on their ability to roll over debt at maturity. A good example in recent memory is the interest-only housing loan, where the principal has to be repaid only at maturity as a balloon payment.
The third, Ponzi financing, can be dangerous. Future cash flows are not sufficient to repay either interest or principal. Firms can repay their borrowings only if the underlying assets appreciate in value. Examples of Ponzi financing emerged during the US housing bubble with the explosion of exotic mortgage products and derivatives.
According to Minsky, if hedge financing dominates, the economy will be stable. However, if speculative and Ponzi financing start to dominate, the economy becomes unstable and is likely to experience distress. Apart from the subprime mortgage crisis in the US, the recent stock market bubble in China is a great example of distress due to speculative and Ponzi financing.
Minsky’s work has direct implications for India’s current situation. It is critical to ensure that the sudden inflow of deposits due to demonetization is used mainly for hedge financing. At the same time, speculative financing needs to be controlled and the crackdown on Ponzi financing should be severe.
This is where the RBI can play a role. It can easily translate Minsky’s criteria into simple lending rules for banks that depend on cash-flow statements of borrowing firms. Money should flow into profitable, under-leveraged firms with a sustainable business model and stay away from creating bubbles in housing or stock markets.
The government can also use this new infusion of debt for targeted financing of priority sectors: micro, small and medium enterprise (MSME), infrastructure and renewable energy, to name a few. If the government can help direct the new loans towards labour-intensive sectors, India can move away from the jobless growth it has experienced. It can also use the new loans to infuse fresh vigour into important initiatives such as Make in India and Startup India. Demonetisation has placed a large kitty in the hands of the banks. It is up to the RBI and the government to ensure that it is used wisely.
By Rohan Chinchwadkar (Assistant Professor, IIM Trichy)
As appeared in The Economic Times (dated: 23/12/2016)
DISCLAIMER: Views expressed above are the author's own.
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