global economic crisis 2008

8/9/2019 Global Economic Crisis 2008

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Economic Project

On

Global EconomicCrisis 2008

Name: Puneeth .P. Munoth

Class: 2nd

sem B.com FRoll no: 09DC1571

Introduction

The global financial crisis, brewing for a while, really started to show its effectsIn the middle of 2008. Around the world stock markets have fallen, large financialinstitutions have collapsed or been bought out, and governments in even the wealthiestnations have had to come up with rescue packages to bail out their financial systems.


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On the one hand many people are concerned that those responsible for the financialproblems are the ones being bailed out, while on the other hand, a global financialmeltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. The problem could have been avoided, if ideologues supporting thecurrent economics models werent so vocal, influential and inconsiderate of others

viewpoints and concerns.

When the financial crisis erupted in a comprehensive manner on Wall Street, there wassome premature triumphalism among Indian policymakers and media persons. It wasargued that India would be relatively immune to this crisis, because of the strong

fundamentals of the economy and the supposedly well-regulated banking system.

This argument was emphasized by the Finance Minister and others even when otherdeveloping countries in Asia clearly experienced significant negative impact, through

transmission of stock market turbulence and domestic credit stringency.

These effects have been most marked among those developing countries where theforeign ownership of banks is already well advanced, and when US-style financial

sectors with the merging of banking and investment functions have been created.

If India is not in the same position, it is not to the credit of our policymakers, who hadin fact wanted to go along the same route. Indeed, for some time now there have beencomplaints that these necessary reforms which would modernize the financialsector have been held up because of opposition from the Left parties. But even thoughwe are slightly better protected from financial meltdown, largely because of the stilllarge role of the nationalized banks and other controls on domestic finance, there iscertainly little room for complacency.

The recent crash in the Sensex is not simply an indicator of the impact of internationalcontagion. There have been warning signals and signs of fragility in Indian finance forsome time now, and these are likely to be compounded by trends in the real economy.

As the current financial crisis continues to evolve globally, there are a seeminglyinfinite number of questions emerging about how the crisis developed and spread, howit is impacting financial institutions as well as other companies, what governments aredoing to address the crisis, and what companies must do to secure their own futures.

What hasactually caused the meltdown

in the financialservices industry???

The financial meltdown had its origin in the U.S. mortgage market of the early and mid-2000s. At the time, the economy was booming, the U.S. government was intent on


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making home ownership affordable to more people, financial institutions were awashwith liquidity, and real estate values were rising endlessly. Competition among mortgagelenders led to innovation teaser-rate adjustable mortgages and other non-traditionalmortgage terms such as no- and low-documentation loans that opened up the realestate market to borrowers who previously would not have qualified for credit, i.e.,

subprime borrowers.

All was well, provided that interest rates did not rise and housing prices continued toescalate. In 2004, however, the Federal Reserve began to raise interest rates. In2006, housing prices started to taper off after rising nearly 50 percent between 2000and 2006.As the market declined, borrowers who had expected to refinance theirmortgages when their loans re-priced to higher interest rates coupled with highermonthly payments found they were not able to do so. Consequently, these borrowerswere unable to meet payment requirements, leading to defaults that escalated as realestate values continued to decline.

Concurrent with the growth in mortgage lending, significant financial innovation wasoccurring in the financial markets. Pools of mortgage loans, including those extended tosubprime borrowers, were aggregated into portfolios of structured products based onthe cash flows of the underlying assets in other words, these loans were securitized.These securities/investments/derivatives were marketed to both institutional andretail investors. To enhance the marketability of these instruments, credit defaultswaps (CDS) were issued, and the growth in the CDS market paralleled the growth inthe underlying mortgage market. While some of these financial instruments ended up inhedge fund portfolios, due to the significant volume of this market and the underlyingassets as well as considerable investor appetite, these instruments became widelydistributed throughout the global financial system to buyers ranging from governmentsponsored enterprises (GSEs) and financial institutions to mutual funds/money marketfunds, pension funds and retail investors.

Given the sponsorship of instruments and retention of key risk components by a numberof the large financial firms and the retention of key risk components of theseproducts, concerns over the safety, soundness and credit worthiness of a number ofkey market participants (including Lehman Brothers, AIG and Merrill Lynch) began toimpact the market negatively as the crisis began to unfold. Since many of theinstruments involved are complex and lack transparent market pricing, they not only arehard to price, but illiquid, further exacerbating the funding and capital issues of a

number of financial organizations.

A similar picture then emerged in other developed countries as the combination ofcompetition, innovation, readily accessible credit, and the ballooning of securitizationand resulting leverage created a massive systemic susceptibility to falls in globalresidential property values and mortgage defaults, in addition to huge losses incurredon exposures to the U.S. subprime market. News of massive losses by institutions mostexposed to such risks evolved and escalated, eventually creating a crisis of confidence


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among lending banks in the money markets and increasing difficulty among banks thatwere most affected to raise or refinance the short- and medium-term borrowing theyneeded to fund their long-term assets. That lack of confidence quickly turned into acredit crunch in which some banks could not fund existing loans and most banks wereunwilling to extend new credit either at all or at least on any terms resembling those on

which they had previously extended credit.

Types of financial crisis

Banking crisis

When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank

run. Since banks lend out most of the cash they receive in deposits, it is difficult for

them to quickly pay back all deposits if these are suddenly demanded, so a run may

leave the bank in bankruptcy, causing many depositors to lose their savings unless theyare covered by deposit insurance. A situation in which bank runs are widespread is

called a systemic banking crisis or just a banking panic. A situation without widespread

bank runs, but in which banks are reluctant to lend, because they worry that they have

insufficient funds available, is often called a credit crunch. In this way, the banks

become an accelerator of a financial crisis.

Examples of bank runs include the run on the Bank of the United States in 1931 and the

run on Northern Rock in 2007. The collapse of Bear Stearns in 2008 has also

sometimes been called a bank run, even though Bear Stearns was an investment

bank rather than a commercial bank. The U.S. savings and loan crisis of the 1980s led

to a credit crunch which is seen as a major factor in the U.S. recession of 1990-91.

Speculative bubblesand crashes

Economists say that a financial asset (stock, for example) exhibits a bubble when its

price exceeds the present value of the future income (such as interest or dividends)

that would be received by owning it to maturity. If most market participants buy the

asset primarily in hopes of selling it later at a higher price, instead of buying it for the

income it will generate, this could be evidence that a bubble is present. If there is abubble, there is also a risk of a crash in asset prices: market participants will go on

buying only as long as they expect others to buy, and when many decide to sell the price

will fall. However, it is difficult to tell in practice whether an asset's price actually

equals its fundamental value, so it is hard to detect bubbles reliably. Some economists

insist that bubbles never or almost never occur.


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Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and

other asset prices include the Dutch tulip mania, the Wall Street Crash of 1929,

the Japanese property bubble of the 1980s, the crash of the dot-com bubble in 2000-

2001, and the now-deflating United States housing bubble.

International financial crises

When a country that maintains a fixed exchange rate is suddenly forced to devalue its

currency because of a speculative attack, this is called a currency crisis or balance of

payments crisis. When a country fails to pay back its sovereign debt, this is called

a sovereign default. While devaluation and default could both be voluntary decisions of

the government, they are often perceived to be the involuntary results of a change in

investor sentiment that leads to a sudden stop in capital inflows or a sudden increase

in capital flight.

Several currencies that formed part of the European Exchange Rate

Mechanism suffered crises in 1992-93 and were forced to devalue or withdraw from

the mechanism. Another round of currency crises took place in Asia in 1997-98.

Many Latin American countries defaulted on their debt in the early 1980s. The 1998

Russian financial crisis resulted in a devaluation of the rubble and default on Russian

government bonds.

Wider economic crises

Negative GDP growth lasting two or more quarters is called a recession. An especiallyprolonged recession may be called a depression, while a long period of slow but not

necessarily negative growth is sometimes called economic stagnation.

Since these phenomena affect much more than the financial system, they are not

usually considered financial crises per se. But some economists have argued that many

recessions have been caused in large part by financial crises. One important example is

the Great Depression, which was preceded in many countries by bank runs and stock

market crashes. The subprime mortgage crisis and the bursting of other real estate

bubbles around the world have led to recession in the U.S. and a number of other

countries in late 2008 and 2009.

Nonetheless, some economists argue that financial crises are caused by recessions

instead of the other way around. Also, even if a financial crisis is the initial shock that

sets off a recession, other factors may be more important in prolonging the recession.

In particular, Friedman and Anna Schwartz argued that the initial economic decline


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associated with the crash of 1929 and the bank panics of the 1930s would not have

turned into a prolonged depression if it had not been reinforced by monetary policy

mistakes on the part of the Federal Reserve, and Ben Bernanke has acknowledged that

he agrees.

A Crisis in Context

While much mainstream media attention is on the details of the financial crisis, andsome of its causes, it also needs to be put into context (though not diminishing itsseverity).

A crisis of poverty for much of humanity

Almost daily, some half of humanity or more, suffer a daily financial, social andemotional, crisis of poverty. In poorer countries, poverty is not always the fault of theindividual alone, but a combination of personal, regional, national, andimportantlyinternational influences. There is little in the way of bail out for these people, many ofwhom are not to blame for their own predicament, unlike with the financial crisis.

A global food crisisaffecting thepoorest the most

While the medias attention is on the global financial crisis (which predominantlyaffects the wealthy and middle classes), the effects of the global food crisis (whichpredominantly affects the poorer and working classes) seems to have fallen off theradar. The two are in fact interrelated issues; both have their causes rooted in thefundamental problems associated with a neoliberal, one-size-fits-all, economic agendaimposed on virtually the entire world.

Poor nations will get less financing for development

The poorer countries do get foreign aid from richer nations, but it cannot be expectedthat current levels of aid (low as they actually are) can be maintained as donor nationsthemselves go through financial crisis. As such the Millennium Development Goals toaddress many concerns such as halving poverty and hunger around the world will beaffected.


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Almost an aside, the issue of tax havens is important for many poor countries. Taxhavens result in capital moving out of poor countries into havens. An important sourceof revenue, domestic tax revenues account for just 13% of low income countriesearnings, whereas it is 36% for the rich countries, as Inter Press Service notes.

An UN-sponsored conference slated for November 2008 to address this issue isunlikely to get much attention or be successful due to the recession fears and thefinancial crisis. But this capital flight is estimated to cost poor countries from $350billion to $500 billion in lost revenue, outweighing foreign aid by almost a factor of 5.

This lost tax revenue is significant for poor countries. It could reduce, or eliminate theneed for foreign aid (which many in rich countries do not like giving, anyway), could helppoor countries pay off (legitimate) debts, and also help themselves become moreindependent from influence from wealthy creditor nations.

Politically, it may be this latter point that prevents many rich countries doing more to

help the poor, when monetarily it would be so easy to do so.

Odious third world debt has remained for decades; Banksand military get

Moneyeasily

Crippling third world debt has been hampering development of the developing countriesfor decades. These debts are small in comparison to the bailout the US alone wasprepared to give its banks, but enormous for the poor countries that bear thoseburdens, having affected many millions of lives for many, many years.

Many of these debts were incurred not just by irresponsible government borrowers(such as corrupt third world dictators, many of whom had come to power with Westernbacking and support), but irresponsible lending (also a moral hazard) from Westernbanks and institutions they heavily influenced, such as the IMF and World Bank.

Despite enormous protest and public pressure for odious debt relief or write-off,hardly any has occurred, and when it does grand promises of debt relief for poorcountries often turn out to be exaggerated. One recently described historic

breakthrough debt relief was announced as a $40 billion debt write-off (thoughturned out to hardly be that). To achieve this required much campaigning andpressuring mainstream media to cover these issues, and so on.

In contrast, the $700 billion bailout as well as bailouts by rich other countrygovernments were very quick to put in place. The money then seemed easy to find. Talkof increasing health or education budgets in rich countries typically meets resistance.


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Massive military spending, or now, financial sector bail out, however, can be doneextremely quickly.

And, a common view in many countries seems to be how financial sector leaders getaway with it. For example, a hungry person stealing bread is likely to get thrown into

jail. A financial sector leader, or an ideologue pushing for policies that are going to leadto corruption or weaknesses like this, face almost no such consequence for their actionother than resigning from their jobs and perhaps public humiliation for a while.

Theories of financial crises

Marxist theories

Recurrent major depressions in the world economy at the pace of 20 and 50 years have

been the subject of studies since Jean Charles Lonard de Sismondi (1773-1842)

provided the first theory of crisis in a critique of classical political economys

assumption of equilibrium between supply and demand. Developing an economic crisis

theory becomes the central recurring concept throughout Karl Marxs mature work.

Marxs law of the tendency for the rate of profit to fall borrowed many features of

the presentation of John Stuart Mills discussion Of the Tendency of Profits to a

Minimum (Principles of Political Economy Book IV Chapter IV) Empirical and

econometric research continue especially in the world systems theory and in the debate

about Nikolai Kondratiev and the so-called 50-years Kondratiev waves. Major figures

of world systems theory, like Andre Gunder Frank and Immanuel Wallerstein,

consistently warned about the crash that the world economy is now facing. World

systems scholars and Kondratiev cycle researchers always implied that Washington

Consensus oriented economists never understood the dangers and perils, which leading

industrial nations will be facing and are now facing at the end of the long economic

cycle which began after the oil crisis of 1973

Minsky's theory

Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a

closed economy. He theorized that financial fragility is a typical feature of

any capitalist economy. High fragility leads to a higher risk of a financial crisis. To

facilitate his analysis, Minsky defines three approaches to financing firms may choose,


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according to their tolerance of risk. They are hedge finance, speculative finance,

and Ponzi finance. Ponzi finance leads to the most fragility.

For hedge finance, income flows are expected to meet financial obligations in everyperiod, including both the principal and the interest on loans.

For speculative finance, a firm must roll over debt because income flows areexpected to only cover interest costs. None of the principal is paid off.

For Ponzi finance, expected income flows will not even cover interest cost, so thefirm must borrow more or sell off assets simply to service its debt. The hope is

that either the market value of assets or income will rise enough to pay off interest

and principal.

Financial fragility levels move together with the business cycle. After a recession,

firms have lost much financing and choose only hedge, the safest. As the economy

grows and expected profits rise, firms tend to believe that they can allow themselvesto take on speculative financing. In this case, they know that profits will not cover all

the interest all the time. Firms, however, believe that profits will rise and the loans will

eventually be repaid without much trouble. More loans lead to more investment, and the

economy grows further. Then lenders also start believing that they will get back all the

money they lend. Therefore, they are ready to lend to firms without full guarantees of

success. Lenders know that such firms will have problems repaying. Still, they believe

these firms will refinance from elsewhere as their expected profits rise. This is Ponzi

financing. In this way, the economy has taken on much risky credit. Now it is only a

question of time before some big firm actually defaults. Lenders understand the actualrisks in the economy and stop giving credit so easily. Refinancing becomes impossible

for many, and more firms default. If no new money comes into the economy to allow the

refinancing process, a real economic crisis begins. During the recession, firms start to

hedge again, and the cycle is closed.

Coordination games

Mathematical approaches to modelling financial crises have emphasized that there is

often positive feedback between market participants' decisions. Positive feedback

implies that there may be dramatic changes in asset values in response to small changes

in economic fundamentals. For example, some models of currency crises (including that

of Paul Krugman) imply that a fixed exchange rate may be stable for a long period of

time, but will collapse suddenly in an avalanche of currency sales in response to a

sufficient deterioration of government finances or underlying economic conditions.


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According to some theories, positive feedback implies that the economy can have more

than one equilibrium. There may be an equilibrium in which market participants invest

heavily in asset markets because they expect assets to be valuable, but there may be

equilibrium where participants flee asset markets because they expect others to flee

too. This is the type of argument underlying Diamond and Dybvig's model of bank runs,in which savers withdraw their assets from the bank because they expect others to

withdraw too. Likewise, in Obstfeld's model of currency crises, when economic

conditions are neither too bad nor too good, there are two possible outcomes:

speculators may or may not decide to attack the currency depending on what they

expect other speculators to do.

Herding modelsand learning models

A variety of models have been developed in which asset values may spiral excessively up

or down as investors learn from each other. In these models, asset purchases by a few

agents encourage others to buy too, not because the true value of the asset increases

when many buy (which is called "strategic complementarities"), but because investors

come to believe the true asset value is high when they observe others buying.

In "herding" models, it is assumed that investors are fully rational, but only have partial

information about the economy. In these models, when a few investors buy some type

of asset, this reveals that they have some positive information about that asset, which

increases the rational incentive of others to buy the asset too. Even though this is a

fully rational decision, it may sometimes lead to mistakenly high asset values (implying,

eventually, a crash) since the first investors may, by chance, have been mistaken.

In "adaptive learning" or "adaptive expectations" models, investors are assumed to be

imperfectly rational, basing their reasoning only on recent experience. In such models,

if the price of a given asset rises for some period of time, investors may begin to

believe that its price always rises, which increases their tendency to buy and thus

drives the price up further. Likewise, observing a few price decreases may give rise to

a downward price spiral, so in models of this type large fluctuations in asset prices may

occur. Agent-based models of financial markets often assume investors act on the basis

of adaptive learning or adaptive expectations.

Whos to Blame?

Finger pointing over who was to blame had run amok and by early 2009 had become anational pastime of sorts. Commercial and investment banks, mortgage lenders, credit


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rating agencies, insurance companies, regulators, politicians, government-sponsoredentities, investors, and homeowners all played a role.

Many people believed those in senior management positions in banks and investmentfirms were largely to blame for not understanding the highly complex models devised

by their quantitative analysts or quants, and for their inability to properly managehow and the degree to which those models became highly sought after products in themarket.41 Some blamed the quants for creating financial instruments that were simplytoo complicated for those in senior management to understand.

Still others blamed the regulators. In 2004, the SEC had loosened leverage (debt)rules for investment banks and by 2008 many were plagued by leverage ratios thatwere 30 to 40 times their core holdings, as opposed to 10 to 15 times core holdings.Others pointed to the lack of relevant expertise that existed within the halls of theSEC. As Lo explained, the SEC was staffed with lawyers who dont have the kind oftraining thats necessary to be able to deal with some of these more complex kinds of

strategies.

Many blamed politicians for repealing Glass Steagall. As Lo testified, the repeal ofGlass Steagall fuelled growth in shadow banking44 institutions like hedge funds. Hedgefunds, he explained, were among the most secretive of financial institutions because:

Their franchise value was almost entirely based on the performance of theirinvestment strategies, and this type of intellectual property was perhaps the mostdifficult to patent. Therefore, hedge funds have an affirmative obligation to theirinvestors to protect the confidentiality of their investment products and processes.It is impossible, therefore, to determine their contribution to systemic risk.

While most analysts did not believe that hedge funds caused the current crisisafterall, hedge funds did do good things including raising tens of billions of dollars since themid-2000s for infrastructure investments in India, Africa and the Middle East theywere heavy investors in risky mortgage-backed securities.

Government-sponsored enterprises Fannie Mae and Freddie Mac also shared the blame.

These institutions, which had a charter from Congress with a mission of supporting the

housing market, were responsible for purchasing and securitizing mortgages in order to

ensure that funds were consistently available to the institutions that lent money tohome buyers. As private companies with close ties to the government, Fannie and

Freddie could borrow money at relatively low interest rates.47 Pressured by Congress

to increase lending to lower-income borrowers back in the mid-1990s, Fannie and

Freddie began lowering credit standards and purchased or guaranteed dubious home

loans.


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Causesand consequences of financial

crises

Strategic complementarities in financial markets

It is often observed that successful investment requires each investor in a financial

market to guess what other investors will do. George Soros has called this need to

guess the intentions of others 'reflexivity'.[10] Similarly, John Maynard

Keynes compared financial markets to a beauty contest game in which each participant

tries to predict which model other participants will consider most beautiful.[11]

Furthermore, in many cases investors have incentives to coordinate their choices. For

example, someone who thinks other investors want to buy lots of Japanese yen may

expect the yen to rise in value, and therefore has an incentive to buy yen too. Likewise,

a depositor in Indy Mac Bank who expects other depositors to withdraw their funds

may expect the bank to fail, and therefore has an incentive to withdraw too.

Economists call an incentive to mimic the strategies of others strategic

complementarities.

It has been argued that if people or firms have a sufficiently strong incentive to do

the same thing they expect others to do, then self-fulfilling prophecies may occur. For

example, if investors expect the value of the yen to rise, this may cause its value to

rise; if depositors expect a bank to fail this may cause it to fail.[14] Therefore, financial

crises are sometimes viewed as a vicious circle in which investors shun some institution

or asset because they expect others to do so.

Leverage

Leverage, which means borrowing to finance investments, is frequently cited as a

contributor to financial crises. When a financial institution (or an individual) onlyinvests its own money, it can, in the very worst case, lose its own money. But when it

borrows in order to invest more, it can potentially earn more from its investment, but it

can also lose more than all it has. Therefore leverage magnifies the potential returns

from investment, but also creates a risk of bankruptcy. Since bankruptcy means that a

firm fails to honor all its promised payments to other firms, it may spread financial

troubles from one firm to another (see 'Contagion' below).


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The average degree of leverage in the economy often rises prior to a financial crisis.

For example, borrowing to finance investment in the stock market ("margin buying")

became increasingly common prior to the Wall Street Crash of 1929.

Asset-liability mismatch

Another factor believed to contribute to financial crises is asset-liability mismatch, a

situation in which the risks associated with an institution's debts and assets are not

appropriately aligned. For example, commercial banks offer deposit accounts which can

be withdrawn at any time and they use the proceeds to make long-term loans to

businesses and homeowners. The mismatch between the banks' short-term liabilities

(its deposits) and its long-term assets (its loans) is seen as one of the reasons bank

runs occur (when depositors panic and decide to withdraw their funds more quickly than

the bank can get back the proceeds of its loans). Likewise, Bear Stearns failed in 2007-

08 because it was unable to renew the short-term debt it used to finance long-term

investments in mortgage securities.

In an international context, many emerging market governments are unable to sell

bonds denominated in their own currencies, and therefore sell bonds denominated in US

dollars instead. This generates a mismatch between the currency denomination of their

liabilities (their bonds) and their assets (their local tax revenues), so that they run a

risk of sovereign default due to fluctuations in exchange rates.[16]

Uncertaintyand herd behaviourMany analyses of financial crises emphasize the role of investment mistakes caused by

lack of knowledge or the imperfections of human reasoning. Behavioral finance studies

errors in economic and quantitative reasoning. Psychologist Torbjorn K A Eliazonhas

also analyzed failures of economic reasoning in his concept of 'copathy'.

Historians, notably Charles P. Kindleberger, have pointed out that crises often follow

soon after major financial or technical innovations that present investors with new

types of financial opportunities, which he called "displacements" of investors'

expectations. Early examples include the South Sea Bubble and Mississippi Bubble of

1720, which occurred when the notion of investment in shares of company stock was

itself new and unfamiliar, and the Crash of 1929, which followed the introduction of

new electrical and transportation technologies. More recently, many financial crises

followed changes in the investment environment brought about by financial

deregulation, and the crash of the dot com bubble in 2001 arguably began with

"irrational exuberance" about Internet technology.


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Unfamiliarity with recent technical and financial innovations may help explain how

investors sometimes grossly overestimate asset values. Also, if the first investors in a

new class of assets (for example, stock in "dot com" companies) profit from rising asset

values as other investors learn about the innovation (in our example, as others learn

about the potential of the Internet), then still more others may follow their example,driving the price even higher as they rush to buy in hopes of similar profits. If such

"herd behavior" causes prices to spiral up far above the true value of the assets, a

crash may become inevitable. If for any reason the price briefly falls, so that investors

realize that further gains are not assured, then the spiral may go into reverse, with

price decreases causing a rush of sales, reinforcing the decrease in prices.

Regulatory failures

Governments have attempted to eliminate or mitigate financial crises by regulating the

financial sector. One major goal of regulation is transparency: making institutions'

financial situations publicly known by requiring regular reporting under standardized

accounting procedures. Another goal of regulation is making sure institutions have

sufficient assets to meet their contractual obligations, through reserve

requirements, capital requirements, and other limits on leverage.

Some financial crises have been blamed on insufficient regulation, and have led to

changes in regulation in order to avoid a repeat. For example, the Managing Director of

the IMF, Dominique Strauss-Kahn, has blamed the financial crisis of 2008 on

'regulatory failure to guard against excessive risk-taking in the financial system,

especially in the US'. Likewise, the New York Times singled out the deregulation

of credit default swaps as a cause of the crisis.

However, excessive regulation has also been cited as a possible cause of financial

crises. In particular, the Basel II Accord has been criticized for requiring banks to

increase their capital when risks rise, which might cause them to decrease lending

precisely when capital is scarce, potentially aggravating a financial crisis.

FraudFraud has played a role in the collapse of some financial institutions, when companies

have attracted depositors with misleading claims about their investment strategies, or

have embezzled the resulting income. Examples include Charles Ponzi's scam in early

20th century Boston, the collapse of the MMM investment fund in Russia in 1994, the


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scams that led to the Albanian Lottery Uprising of 1997, and the collapse of Madoff

Investment Securities in 2008.

Many rogue traders that have caused large losses at financial institutions have been

accused of acting fraudulently in order to hide their trades. Fraud in mortgage

financing has also been cited as one possible cause of the 2008 subprime mortgagecrisis; government officials stated on Sept. 23, 2008 that the FBI was looking into

possible fraud by mortgage financing companies Fannie Mae and Freddie Mac, Lehman

Brothers, and insurer American International Group.

Contagion

Contagion refers to the idea that financial crises may spread from one institution to

another, as when a bank run spreads from a few banks to many others, or from onecountry to another, as when currency crises, sovereign defaults, or stock market

crashes spread across countries. When the failure of one particular financial institution

threatens the stability of many other institutions, this is called systemic risk.

One widely-cited example of contagion was the spread of the Thai crisis in 1997 to

other countries like South Korea. However, economists often debate whether observing

crises in many countries around the same time is truly caused by contagion from one

market to another, or whether it is instead caused by similar underlying problems that

would have affected each country individually even in the absence of international

linkages.

Recessionaryeffects

Some financial crises have little effect outside of the financial sector, like the Wall

Street crash of 1987, but other crises are believed to have played a role in decreasing

growth in the rest of the economy. There are many theories why a financial crisis could

have a recessionary effect on the rest of the economy. These theoretical ideas include

the 'financial accelerator', 'flight to quality' and 'flight to liquidity', and the Kiyotaki-

Moore model. Some 'third generation' models of currency crises explore how currencycrises and banking crises together can cause recessions.

Impact of Financial Crisis on India


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When the financial crisis erupted in a comprehensive manner on Wall Street, there wassome premature triumphalism among Indian policymakers and media persons. It wasargued that India would be relatively immune to this crisis, because of the strongfundamentals of the economy and the supposedly well-regulated banking system.

This argument was emphasised by the Finance Minister and others even when otherdeveloping countries in Asia clearly experienced significant negative impact, throughtransmission of stock market turbulence and domestic credit stringency.

These effects have been most marked among those developing countries where theforeign ownership of banks is already well advanced, and when US-style financialsectors with the merging of banking and investment functions have been created.

If India is not in the same position, it is not to the credit of our policymakers, who hadin fact wanted to go along the same route. Indeed, for some time now there have beencomplaints that these necessary reforms which would modernise the financial

sector have been held up because of opposition from the Left parties.

But even though we are slightly better protected from financial meltdown, largelybecause of the still large role of the nationalised banks and other controls on domesticfinance, there is certainly little room for complacency.

The recent crash in the Sensex is not simply an indicator of the impact of internationalcontagion. There have been warning signals and signs of fragility in Indian finance forsome time now, and these are likely to be compounded by trends in the real economy.

Economic downturn

After a long spell of growth, the Indian economy is experiencing a downturn. Industrialgrowth is faltering, inflation remains at double-digit levels, the current account deficit

is widening, foreign exchange reserves are depleting and the rupee is depreciating.

The last two features can also be directly related to the current international crisis.The most immediate effect of that crisis on India has been an outflow of foreigninstitutional investment from the equity market. Foreign institutional investors, whoneed to retrench assets in order to cover losses in their home countries and areseeking havens of safety in an uncertain environment, have become major sellers inIndian markets.

In 2007-08, net FII inflows into India amounted to $20.3 billion. As compared withthis, they pulled out $11.1 billion during the first nine-and-a-half months of calendar

year 2008, of which $8.3 billion occurred over the first six-and-a-half months of


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financial year 2008-09 (April 1 to October 16). This has had two effects: in the stockmarket and in the currency market.

Given the importance of FII investment in driving Indian stock markets and the factthat cumulative investments by FIIs stood at $66.5 billion at the beginning of thiscalendar year, the pullout triggered a collapse in stock prices. As a result, the Sensexfell from its closing peak of 20,873 on January 8, 2008, to less than 10,000 byOctober17, 2008 (Chart 1).

Falling rupee


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In addition, this withdrawal by the FIIs led to a sharp depreciation of the rupee.Between January 1 and October 16, 2008, the RBI reference rate for the rupee fell bynearly 25 per cent, even relative to a weak currency like the dollar, from Rs 39.20 tothe dollar to Rs 48.86 (Chart 2). This was despite the sale of dollars by the RBI, whichwas reflected in a decline of $25.8 billion in its foreign currency assets between theend of March 2008 and October 3, 2008.

It could be argued that the $275 billion the RBI still has in its kitty is adequate tostall and reverse any further depreciation if needed. But given the sudden exit by theFIIs, the RBI is clearly not keen to deplete its reserves too fast and risk a foreignexchange crisis.

The result has been the observed sharp depreciation of the rupee. While thisdepreciation may be good for Indias exports that are adversely affected by theslowdown in global markets, it is not so good for those who have accumulated foreignexchange payment commitments. Nor does it assist the Governments effort to rein ininflation.

A second route through which the global financial crisis could affect India is throughthe exposure of Indian banks or banks operating in India to the impaired assetsresulting from the sub-prime crisis. Unfortunately, there are no clear estimates of theextent of that exposure, giving room for rumour in determining market trends. Thus,ICICI Bank was the victim of a run for a short period because of rumours that sub-prime exposure had badly damaged its balance sheet, although these rumours have beenstrongly denied by the bank.


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Exposure of banks

So far the RBI has claimed that the exposure of Indian banks to assets impaired bythe financial crisis is small. According to reports, the RBI had estimated that as aresult of exposure to collateralised debt obligations and credit default swaps, the

combined mark-to-market losses of Indian banks at the end of July was around $450million.

Given the aggressive strategies adopted by the private sector banks, the MTM lossesincurred by public sector banks were estimated at $90 million, while that for privatebanks was around $360 million. As yet these losses are on paper, but the RBI believesthat even if they are to be provided for, these banks are well capitalised and can easilytake the hit.

Such assurances have neither reduced fears of those exposed to these banks or toinvestors holding shares in these banks.

These fears are compounded by those of the minority in metropolitan areas dealingwith foreign banks that have expanded their presence in India, whose global exposureto toxic assets must be substantial. What is disconcerting is the limited informationavailable on the risks to which depositors and investors are subject. Only time will tellhow significant this factor will be in making India vulnerable to the global crisis.

A third indirect fallout of the global crisis and its ripples in India is in the form of thelosses sustained by non-bank financial institutions (especially mutual funds) andcorporate, as a result of their exposure to domestic stock and currency markets.

Such losses are expected to be large, as signalled by the decision of the RBI to allowbanks to provide loans to mutual funds against certificates of deposit (CDs) or buybacktheir own CDs before maturity. These losses are bound to render some institutionsfragile, with implications that would become clear only in the coming months.

Credit cutback


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A fourth effect is that, in this uncertain environment, banks and financial institutionsconcerned about their balance sheets, have been cutting back on credit, especially thehuge volume of housing, automobile and retail credit provided to individuals. Accordingto RBI figures, the rate of growth of auto loans fell from close to 30 per cent over the

year ending June 30, 2008, to as low as 1.2 per cent.

Loans to finance consumer durables purchases fell from around Rs 6,000 crore in theyear to June 2007, to a little over Rs 4,000 crore up to June this year. Direct housingloans, which had increased by 25 per cent during 2006-07, decelerated to 11 per centgrowth in 2007-08 and 12 per cent over the year ending June 2008.

It is only in an area like credit-card receivables, where banks are unable to control thegrowth of credit that expansion was, at 43 per cent, quite high over the year endingJune 2008, even though it was lower than the 50 per cent recorded over the previous

year.

It is known that credit-financed housing investment and credit-financed consumptionhave been important drivers of growth in recent years, and underpin the 9 per cent

growth trajectory India has been experiencing.

The reticence of lenders to increase their exposure in markets to which they arealready overexposed and the fears of increasing payment commitments in an uncertaineconomic environment on the part of potential borrowers are bound to curtail debt-financed consumption and investment. This could slow growth significantly.

Finally, the recession generated by the financial crisis in the advanced economies as agroup and the US in particular, will adversely affect Indias exports, especially its

exports of software and IT-enabled services, more than 60 per cent of which aredirected to the US.

International banks and financial institutions in the US and EU are important sourcesof demand for such services, and the difficulties they face will result in somecurtailment of their demand. Further, the nationalisation of many of these banks islikely to increase the pressure to reduce outsourcing in order to keep jobs in thedeveloped countries.

And the slowing of growth outside of the financial sector too will have implications forboth merchandise and services exports. The net result would be a smaller export

stimulus and a widening trade deficit.

Domestic policy

While these trends are still in process, their effects are already being felt. They arenot the only causes for the downturn the economy is experiencing, but they areimportant contributory factors. Yet, this does not justify the argument that Indiasdifficulties are all imported. They are induced by domestic policy as well.


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The extent of imported difficulties would have been far less if the Government had notincreased the vulnerability of the country to external shocks by drastically opening upthe real and financial sectors. It is disconcerting; therefore, that when faced with thiscrisis the Government is not rethinking its own liberalisation strategy, despite thebacklash against neo-liberalism worldwide.

By deciding to relax conditions that apply to FII investments in the vain hope ofattracting them back and by focusing on pumping liquidity into the system rather thanusing public expenditure and investment to stall a recession, it is indicating that ithopes that more of what created the problem would help solve it. This is just to

postpone decisions that may prove critical till it is too late.

Impact of the Crisis on India

ByRakesh MohanDeputy Governor

Reserve Bank of India

While the overall policy approach has been able to mitigate the potential impact Of theturmoil on domestic financial markets and the economy, with the increasing Integrationof the Indian economy and its financial markets with rest of the world, there isrecognition that the country does face some downside risks from these internationaldevelopments. The risks arise mainly from the potential reversal of capital flows on a

sustained medium-term basis from the projected slow down of the global economy,particularly in advanced economies, and from some elements of potential financialcontagion. In India, the adverse effects have so far been mainly in the equity marketsbecause of reversal of portfolio equity flows, and the concomitant effects on thedomestic forex market and liquidity conditions. The macro effects have so far beenmuted due to the overall strength of domestic demand, the healthy balance sheets ofthe Indian corporate sector, and the predominant domestic financing of investment.

As might be expected, the main impact of the global financial turmoil in India hasemanated from the significant change experienced in the capital account in 2008-09 so

far, relative to the previous year (Table 1). Total net capital flows fell from S$17.3billion in April-June 2007 to US$13.2 billion in April-June 2008. Nonetheless, capitalflows are expected to be more than sufficient to cover the current account deficit this

year as well. While Foreign Direct Investment (FDI) inflows have continued to exhibitaccelerated growth (US$ 16.7 billion during April-August 2008 as compared with US$8.5 billion in the corresponding period of 2007), portfolio investments by foreigninstitutional investors (FIIs) witnessed a net outflow of about US$ 6.4 billion in April-


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September 2008 as compared with a net inflow of US$ 15.5 billion in the correspondingperiod last year.

Similarly, external commercial borrowings of the corporate sector declined from US$7.0 billion in April-June 2007 to US$ 1.6 billion in April-June 2008, partially in

Response to policy measures in the face of excess flows in 2007-08, but also due to thecurrent turmoil in advanced economies. With the existence of a merchandise tradedeficit of 7.7 per cent of GDP in 2007-08, and a current account deficit of 1.5 percent, and change in perceptions with respect to capital flows, there has beensignificant pressure on the Indian exchange rate in recent months. Whereas the realexchange rate appreciated from an index of 104.9 (base 1993-94=100) (US$1 = Rs.46.12) in September 2006 to 115.0 (US$ 1 = Rs. 40.34) in September 2007, it has nowdepreciated to a level of 101.5 (US $ 1 = Rs. 48.74) as on October 8, 2008.

Table : Trends in Capital Flows

(US $ million)

Component Period 2007-08 2008-09

Foreign Direct Investment to India April-August 8,536 16,733

FIIs (net)@ April Sept 26 15,508 -6,421

External Commercial Borrowings (net) April- June 6,990 1,559

Short-term Trade Credits (net) April- June 1,804 2,173

Memo:

ECB Approvals April-August 13,375 8,127

Foreign Exchange Reserves (variation) April-September 26 48,583 -17,904

Foreign Exchange Reserves (end-period) September 26, 2008 2,47,762 2,91,819

Note: Dataon FIIspresented in this tablerepresent inflows into thecountryand, thus, maydifferfrom data

relating tonet investment instockexchangesby FIIs.

With the volatility in portfolio flows having been large during 2007 and 2008, theimpact of global financial turmoil has been felt particularly in the equity market. TheBSE Sensex (1978-79=100) increased significantly from a level of 13,072 as at end-March 2007 to its peak of 20,873 on January 8, 2008 in the presence of heavy

portfolio flows responding to the high growth performance of the Indian corporatesector. With portfolio flows reversing in 2008, partly because of the internationalmarket turmoil, the Sensex has now dropped to a level of 11,328 on October 8, 2008, inline with similar large declines in other major stock markets.

As noted earlier, domestic investment is largely financed by domestic savings. However,the corporate sector has, in recent years, mobilized significant resources from globalfinancial markets for funding, both debt and non-debt, their ambitious investment


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plans. The current risk aversion in the international financial markets to EMEs could,therefore, have some impact on the Indian corporate sectors ability to raise fundsfrom international sources and thereby impede some investment growth. Suchcorporate would, therefore, have to rely relatively more on domestic sources offinancing, including bank credit. This could, in turn, put some upward pressure on

domestic interest rates. Moreover, domestic primary capital market issuances havesuffered in the current fiscal year so far in view of the sluggish stock marketconditions. Thus, onecan expect more demand for bank credit, and non-food credit growth has indeedaccelerated in the current year (26.2 per cent on a year-on-year basis as on September12, 2008 as compared with 23.3 per cent a year ago).

The financial crisis in the advanced economies and the likely slowdown in theseeconomies could have some impact on the IT sector. According to the latestassessment by the NASSCOM, the software trade association, the currentdevelopments with respect to the US financial markets are very eventful, and may have

a direct impact on the IT industry and likely to create a downstream impact on othersectors of the US economy and worldwide markets. About 15 per cent to 18 per cent ofthe business coming to Indian outsourcers includes projects from banking, insurance,and the financial services sector which is now uncertain.

In summary, the combined impact of the reversal of portfolio equity flows, the reducedavailability of international capital both debt and equity, the perceived increase in theprice of equity with lower equity valuations, and pressure on the exchange rate, growthin the Indian corporate sector is likely to feel some impact of the global financialturmoil. On the other hand, on a macro basis, with external savings utilisation havingbeen low traditionally, between one to two percent of GDP, and the sustained highdomestic savings rate, this impact can be expected to be at the margin. Moreover, thecontinued buoyancy of foreign direct investment suggests that confidence in Indiangrowth prospects remains healthy.

Impact on the Indian Banking System

One of the key features of the current financial turmoil has been the lack of perceivedcontagion being felt by banking systems in EMEs, particularly in Asia. The Indianbanking system also has not experienced any contagion, similar to its peers in the rest

of Asia.

A detailed study undertaken by the RBI in September 2007 on the impact of thesubprime episode on the Indian banks had revealed that none of the Indian banks orthe foreign banks, with whom the discussions had been held, had any direct exposure tothe sub-prime markets in the USA or other markets. However, a few Indian banks hadinvested in the collateralised debt obligations (CDOs) / bonds which had a fewunderlying entities with sub-prime exposures. Thus, no direct impact on account of


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direct exposure to the sub-prime market was in evidence. However, a few of thesebanks did suffer some losses on account of the mark-to-market losses caused by thewidening of the credit spreads arising from the sub-prime episode on term liquidity inthe market, even though the overnight markets remained stable.

Consequent upon filling of bankruptcy under Chapter 11 by Lehman Brothers, all bankswere advised to report the details of their exposures to Lehman Brothers and relatedentities both in India and abroad. Out of 77 reporting banks, 14 reported exposures toLehman Brothers and its related entities either in India or abroad. An analysis of theinformation reported by these banks revealed that majority of the exposures reportedby the banks pertained to subsidiaries of Lehman Bros Holdings Inc. which are notcovered by the bankruptcy proceedings. Overall, these banks exposure especially toLehman BrothersHolding Inc. which hasfiled for bankruptcy isnot significant andbanksare reported tohave made adequate provisions.

In the aftermath of the turmoil caused by bankruptcy, the Reserve Bank hasannounced

a seriesof measurestofacilitate orderly operation of financial marketsand toensurefinancial stability which predominantly includesextension of additional liquidity supporttobanks.

RBI Response to the Crisis

The financial crisis in advanced economies on the back of sub-prime turmoil has beenaccompanied by near drying up of trust amongst major financial market and sectorplayers, in view of mounting losses and elevated uncertainty about further possiblelosses and erosion of capital. The lack of trust amongst the major players has led to

near freezing of the uncollateralized inter-bank money market, reflected in largespreads over policy rates. In response to these developments, central banks in majoradvanced economies have taken a number of coordinated steps to increase short-termliquidity. Central banks in some cases have substantially loosened the collateralrequirements to provide the necessary short-term liquidity.

In contrast to the extreme volatility leading to freezing of money markets in majoradvanced economies, money markets in India have been, by and large, functioning in anorderly fashion, albeit with some pressures. Large swings in capital flows as has beenexperienced between 2007-08 and 2008-09 so far in response to the global financialmarket turmoil have made the conduct of monetary policy and liquidity management

more complicated in the recent months. However, the Reserve Bank has beeneffectively able to manage domestic liquidity and monetary conditions consistent withits monetary policy stance.

This has been enabled by the appropriate use of a range of instruments available forliquidity management with the Reserve Bank such as the Cash Reserve Ratio (CRR) andStatutory Liquidity Ratio (SLR)stipulations and open market operations (OMO)including the Market Stabilisation Scheme (MSS)and the Liquidity Adjustment Facility


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(LAF). Furthermore, money market liquidity is also impacted by our operations in theforeign exchange market, which, in turn, reflect the evolving capital flows. While in2007 and the previous years, large capital flows and their absorption by the ReserveBank led to excessive liquidity, which was absorbed through sterilisation operationsinvolving LAF, MSS and CRR. During 2008, in view of some reversal in capital flows,

market sale of foreign exchange by the Reserve Bank has led to withdrawal of liquidityfrom the banking system. The daily LAF repo operations have emerged as the primarytool for meeting the liquidity gap in the market. In view of the reversal of capitalflows, fresh

MSS is suances have been scaled down and there has also been some unwinding of theoutstanding MSS balances. The MSS operates symmetrically and has the flexibility tosmoothen liquidity in the banking system both during episodes of capital inflows andoutflows. The existing set of monetary instruments has, thus, provided adequateflexibility to manage the evolving situation. In view of this flexibility, unlike centralbanks in major advanced economies, the Reserve Bank did not have to invent new

instruments or to dilute the collateral requirements to inject liquidity. LAF repooperations are, however, limited by the excess SLR securities held by banks.

While LAF and MSS have been able to bear a large part of the burden, somemodulations in CRR and SLR have also been resorted, purely as temporary measures, tomeet the liquidity mismatches. For instance, on September 16, 2008, in regard to SLR,the Reserve Bank permitted banks to use up to an additional 1 percent of their NDTL,for a temporary period, for drawing liquidity support under LAF from RBI. This hasimparted a sense of confidence in the market in terms of availability of short-termliquidity. The CRR which had been gradually increased from 4.5 per cent in 2004 to 9per cent by August 2008 was cut by 50 basis points on October 65 (to be effectiveOctober 11, 2008) the first cut after a gap of over five years - on a review of theliquidity situation in the context of global and domestic developments. Thus, as the veryrecent experience shows, temporary changes in the prudential ratios such as CRR andSLR combined with flexible use of the MSS, could be considered as a vast pool ofbackup liquidity that is available for liquidity management as the situation may warrantfor relieving market pressure at any given time. The recent innovation with respect toSLR for combating temporary systemic illiquidity is particularly noteworthy. Therelative stability in domestic financial markets, despite extreme turmoil in the globalfinancial markets, is reflective of prudent practices, strengthened reserves and thestrong growth performance in recent years in an environment of flexibility in the

conduct of policies.

Active liquidity management is a key element of the current monetary policy stance.Liquidity modulation through a flexible use of a combination of instruments has, to asignificant extent, cushioned the impact of the international financial turbulence ondomestic financial markets by absorbing excessive market pressures and ensuringorderly conditions. In view of the evolving environment of heightened uncertainty,volatility in global markets and the dangers of potential spill overs to domestic equity


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and currency markets, liquidity management will continue to receive priority in thehierarchy of policy objectives over the period ahead. The Reserve Bank will continuewith its policy of active demand management of liquidity through appropriate use of theCRR stipulations and open market operations (OMO) including the MSS and the LAF,using all the policy instruments at its disposal flexibly, as and when the situation

warrants.

Concluding Observations

India has by-and-large been spared of global financial contagion due to the subprimeturmoil for a variety of reasons. Indias growth process has been largely domesticdemand driven and its reliance on foreign savings has remained around 1.5 per cent inrecent period. It also has a very comfortable level of forex reserves. The creditderivatives market is in an embryonic stage; the originate-to-distribute model in India

is not comparable to the ones prevailing in advanced markets; there are restrictions oninvestments by residents in such products issued abroad; and regulatory guidelines onsecuritisation do not permit immediate profit recognition. Financial stability in Indiahas been achieved through perseverance of prudential policies which preventinstitutions from excessive risk taking, and financial markets from becoming extremelyvolatile and turbulent.

Bibliography


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- AnnualPolicy Statement for the Year 2008-09, Reserve Bank ofIndia

-www.protiviti.com/economiccrisis

-www.federalreserve.gov

-www.economist.com

- www.msnbc.msn.com

-www.wikipedia.org

global economic crisis 2008

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