Economic Project

On

Global Economic
Crisis 2008

Name: Puneeth .P. Munoth

Class: 2nd sem B.com ‘F’
Roll no: 09DC1571
 Introduction
The global financial crisis, brewing for a while, really started to show its effects
In the middle of 2008. Around the world stock markets have fallen, large financial
institutions have collapsed or been bought out, and governments in even the wealthiest
nations have had to come up with rescue packages to bail out their financial systems.

On the one hand many people are concerned that those responsible for the financial
problems are the ones being bailed out, while on the other hand, a global financial
meltdown will affect the livelihoods of almost everyone in an increasingly inter-
connected world. The problem could have been avoided, if ideologues supporting the
current economics models weren’t so vocal, influential and inconsiderate of others’
viewpoints and concerns.

When the financial crisis erupted in a comprehensive manner on Wall Street, there was
some premature triumphalism among Indian policymakers and media persons. It was
argued 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 other
developing 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 the
foreign 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 had
in fact wanted to go along the same route. Indeed, for some time now there have been
complaints that these “necessary” reforms which would “modernize” 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, largely because of the still
large role of the nationalized banks and other controls on domestic finance, there is
certainly little room for complacency.

The recent crash in the Sensex is not simply an indicator of the impact of international
contagion. There have been warning signals and signs of fragility in Indian finance for
some 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 seemingly
infinite number of questions emerging about how the crisis developed and spread, how
it is impacting financial institutions as well as other companies, what governments are
doing to address the crisis, and what companies must do to secure their own futures.
 What has actually caused the meltdown
in the financial services 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
making home ownership affordable to more people, financial institutions were awash
with liquidity, and real estate values were rising endlessly. Competition among mortgage
lenders led to innovation – teaser-rate adjustable mortgages and other non-traditional
mortgage terms such as no- and low-documentation loans – that opened up the real
estate 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 to
escalate. In 2004, however, the Federal Reserve began to raise interest rates. In
2006, housing prices started to taper off after rising nearly 50 percent between 2000
and 2006.As the market declined, borrowers who had expected to refinance their
mortgages when their loans re-priced to higher interest rates coupled with higher
monthly payments found they were not able to do so. Consequently, these borrowers
were unable to meet payment requirements, leading to defaults that escalated as real
estate values continued to decline.

Concurrent with the growth in mortgage lending, significant financial innovation was
occurring in the financial markets. Pools of mortgage loans, including those extended to
subprime borrowers, were aggregated into portfolios of structured products based on
the cash flows of the underlying assets – in other words, these loans were securitized.
These securities/investments/derivatives were marketed to both institutional and
retail investors. To enhance the marketability of these instruments, credit default
swaps (CDS) were issued, and the growth in the CDS market paralleled the growth in
the underlying mortgage market. While some of these financial instruments ended up in
hedge fund portfolios, due to the significant volume of this market and the underlying
assets as well as considerable investor appetite, these instruments became widely
distributed throughout the global financial system to buyers ranging from government
sponsored enterprises (GSEs) and financial institutions to mutual funds/money market
funds, pension funds and retail investors.

Given the sponsorship of instruments and retention of key risk components by a number
of the large financial firms and the retention of key risk components of these
products, concerns over the safety, soundness and credit worthiness of a number of
key market participants (including Lehman Brothers, AIG and Merrill Lynch) began to
impact the market negatively as the crisis began to unfold. Since many of the
instruments involved are complex and lack transparent market pricing, they not only are
hard 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 of

competition, innovation, readily accessible credit, and the ballooning of securitization
and resulting leverage created a massive systemic susceptibility to falls in global
residential property values and mortgage defaults, in addition to huge losses incurred
on exposures to the U.S. subprime market. News of massive losses by institutions most
exposed to such risks evolved and escalated, eventually creating a crisis of confidence
among lending banks in the money markets and increasing difficulty among banks that
were most affected to raise or refinance the short- and medium-term borrowing they
needed to fund their long-term assets. That lack of confidence quickly turned into a
“credit crunch” in which some banks could not fund existing loans and most banks were
unwilling 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 they
are 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 bubbles and 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 a
bubble, 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.

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 especially
prolonged 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
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, and
some of its causes, it also needs to be put into context (though not diminishing its
severity).

A crisis of poverty for much of humanity

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

A global food crisis affecting the poorest the most

While the media’s attention is on the global financial crisis (which predominantly
affects the wealthy and middle classes), the effects of the global food crisis (which
predominantly affects the poorer and working classes) seems to have fallen off the
radar. The two are in fact interrelated issues; both have their causes rooted in the
fundamental problems associated with a neoliberal, one-size-fits-all, economic agenda
imposed 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 expected
that current levels of aid (low as they actually are) can be maintained as donor nations
themselves go through financial crisis. As such the Millennium Development Goals to
address many concerns such as halving poverty and hunger around the world will be
affected.

Almost an aside, the issue of tax havens is important for many poor countries. Tax
havens result in capital moving out of poor countries into havens. An important source
of revenue, domestic tax revenues account for just 13% of low income countries’
earnings, 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 is

unlikely to get much attention or be successful due to the recession fears and the
financial crisis. But this capital flight is estimated to cost poor countries from $350
billion 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 the
need for foreign aid (which many in rich countries do not like giving, anyway), could help
poor countries pay off (legitimate) debts, and also help themselves become more
independent 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; Banks and military get
Money easily

Crippling third world debt has been hampering development of the developing countries
for decades. These debts are small in comparison to the bailout the US alone was
prepared to give its banks, but enormous for the poor countries that bear those
burdens, 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 Western
backing and support), but irresponsible lending (also a moral hazard) from Western
banks 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 poor
countries often turn out to be exaggerated. One recently described “historic
breakthrough” debt relief was announced as a $40 billion debt write-off (though
turned out to hardly be that). To achieve this required much campaigning and
pressuring mainstream media to cover these issues, and so on.

In contrast, the $700 billion bailout as well as bailouts by rich other country
governments were very quick to put in place. The money then seemed easy to find. Talk
of increasing health or education budgets in rich countries typically meets resistance.
Massive military spending, or now, financial sector bail out, however, can be done
extremely quickly.

And, a common view in many countries seems to be how financial sector leaders “get
away” 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 lead
to corruption or weaknesses like this, face almost no such consequence for their action
other 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 Léonard de Sismondi (1773-1842)
provided the first theory of crisis in a critique of classical political economy’s
assumption of equilibrium between supply and demand. Developing an economic crisis
theory becomes the central recurring concept throughout Karl Marx’s mature work.
Marx’s law of the tendency for the rate of profit to fall  borrowed many features of
the presentation of John Stuart Mill’s 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,
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
every period, including both the principal and the interest on loans.
 For speculative finance, a firm must roll over debt because income flows are
expected 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
the firm 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 themselves
to 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 actual
risks 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.

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 models and 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.
 Who’s to Blame?

Finger pointing over who was to blame had run amok and by early 2009 had become a
“national pastime” of sorts. Commercial and investment banks, mortgage lenders, credit
rating agencies, insurance companies, regulators, politicians, government-sponsored
entities, investors, and homeowners all played a role.

Many people believed those in senior management positions in banks and investment
firms were largely to blame for not understanding the highly complex models devised
by their quantitative analysts or “quant’s,” and for their inability to properly manage
how and the degree to which those models became highly sought after products in the
market.41 Some blamed the quant’s for creating financial instruments that were simply
too 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 that
were 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 the
SEC. As Lo explained, the SEC was staffed with lawyers who “don’t have the kind of
training that’s 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 of
Glass Steagall fuelled growth in shadow banking44 institutions like hedge funds. Hedge
funds, he explained, were among the most secretive of financial institutions because:

Their franchise value was almost entirely based on the performance of their
investment strategies, and this type of intellectual property was perhaps the most
difficult to patent. Therefore, hedge funds have an affirmative obligation to their
investors 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 crisis—after
all, hedge funds did do good things including raising tens of billions of dollars since the
mid-2000s for infrastructure investments in India, Africa and the Middle East— they
were 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 to
home 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.

Causes and 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) only
invests 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).

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]

Uncertainty and herd behaviour

Many 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 'œcopathy'.

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.

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.
Fraud

Fraud 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
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 mortgage
crisis; 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 one
country 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.

Recessionary effects
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 currency
crises and banking crises together can cause recessions.
 Impact of Financial Crisis on India

When the financial crisis erupted in a comprehensive manner on Wall Street, there was
some premature triumphalism among Indian policymakers and media persons. It was
argued 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 emphasised by the Finance Minister and others even when other
developing 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 the
foreign 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 had
in fact wanted to go along the same route. Indeed, for some time now there have been
complaints 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, largely
because of the still large role of the nationalised banks and other controls on domestic
finance, there is certainly little room for complacency.

The recent crash in the Sensex is not simply an indicator of the impact of international
contagion. There have been warning signals and signs of fragility in Indian finance for
some 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. Industrial
growth 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 foreign
institutional investment from the equity market. Foreign institutional investors, who
need to retrench assets in order to cover losses in their home countries and are
seeking havens of safety in an uncertain environment, have become major sellers in
Indian markets.
In 2007-08, net FII inflows into India amounted to $20.3 billion. As compared with
this, 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
financial year 2008-09 (April 1 to October 16). This has had two effects: in the stock
market and in the currency market.

Given the importance of FII investment in driving Indian stock markets and the fact
that cumulative investments by FIIs stood at $66.5 billion at the beginning of this
calendar year, the pullout triggered a collapse in stock prices. As a result, the Sensex
fell from its closing peak of 20,873 on January 8, 2008, to less than 10,000 by October
17, 2008 (Chart 1).
Falling rupee

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 by
nearly 25 per cent, even relative to a weak currency like the dollar, from Rs 39.20 to
the dollar to Rs 48.86 (Chart 2). This was despite the sale of dollars by the RBI, which
was reflected in a decline of $25.8 billion in its foreign currency assets between the
end of March 2008 and October 3, 2008.

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

The result has been the observed sharp depreciation of the rupee. While this
depreciation may be good for India’s exports that are adversely affected by the
slowdown in global markets, it is not so good for those who have accumulated foreign
exchange payment commitments. Nor does it assist the Government’s effort to rein in
inflation.

A second route through which the global financial crisis could affect India is through
the exposure of Indian banks or banks operating in India to the impaired assets
resulting from the sub-prime crisis. Unfortunately, there are no clear estimates of the
extent 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 been
strongly denied by the bank.

Exposure of banks

So far the RBI has claimed that the exposure of Indian banks to assets impaired by
the financial crisis is small. According to reports, the RBI had estimated that as a
result 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 $450
million.

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

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

These fears are compounded by those of the minority in metropolitan areas dealing
with foreign banks that have expanded their presence in India, whose global exposure
to toxic assets must be substantial. What is disconcerting is the limited information
available on the risks to which depositors and investors are subject. Only time will tell
how 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 the
losses sustained by non-bank financial institutions (especially mutual funds) and
corporate, 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 allow
banks to provide loans to mutual funds against certificates of deposit (CDs) or buyback
their own CDs before maturity. These losses are bound to render some institutions
fragile, with implications that would become clear only in the coming months.

Credit cutback
A fourth effect is that, in this uncertain environment, banks and financial institutions
concerned about their balance sheets, have been cutting back on credit, especially the
huge volume of housing, automobile and retail credit provided to individuals. According
to 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 the
year to June 2007, to a little over Rs 4,000 crore up to June this year. Direct housing
loans, which had increased by 25 per cent during 2006-07, decelerated to 11 per cent
growth 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 the
growth of credit that expansion was, at 43 per cent, quite high over the year ending
June 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 consumption

have 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 are
already overexposed and the fears of increasing payment commitments in an uncertain
economic 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 a
group and the US in particular, will adversely affect India’s exports, especially its
exports of software and IT-enabled services, more than 60 per cent of which are
directed to the US.

International banks and financial institutions in the US and EU are important sources
of demand for such services, and the difficulties they face will result in some
curtailment of their demand. Further, the nationalisation of many of these banks is
likely to increase the pressure to reduce outsourcing in order to keep jobs in the
developed countries.

And the slowing of growth outside of the financial sector too will have implications for
both 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 are
not the only causes for the downturn the economy is experiencing, but they are
important contributory factors. Yet, this does not justify the argument that India’s
difficulties are all imported. They are induced by domestic policy as well.

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

By deciding to relax conditions that apply to FII investments in the vain hope of
attracting them back and by focusing on pumping liquidity into the system rather than
using public expenditure and investment to stall a recession, it is indicating that it
hopes 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

By
Rakesh Mohan
Deputy Governor
Reserve Bank of India

While the overall policy approach has been able to mitigate the potential impact Of the
turmoil on domestic financial markets and the economy, with the increasing Integration
of the Indian economy and its financial markets with rest of the world, there is
recognition that the country does face some downside risks from these international
developments. 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 financial
contagion. In India, the adverse effects have so far been mainly in the equity markets
 because of reversal of portfolio equity flows, and the concomitant effects on the
domestic forex market and liquidity conditions. The macro effects have so far been
muted due to the overall strength of domestic demand, the healthy balance sheets of
the Indian corporate sector, and the predominant domestic financing of investment.

As might be expected, the main impact of the global financial turmoil in India has
emanated 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$17.3
billion in April-June 2007 to US$13.2 billion in April-June 2008. Nonetheless, capital
flows are expected to be more than sufficient to cover the current account deficit this
year as well. While Foreign Direct Investment (FDI) inflows have continued to exhibit
accelerated growth (US$ 16.7 billion during April-August 2008 as compared with US$
8.5 billion in the corresponding period of 2007), portfolio investments by foreign
institutional investors (FIIs) witnessed a net outflow of about US$ 6.4 billion in April-
September 2008 as compared with a net inflow of US$ 15.5 billion in the corresponding
period 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 the
current turmoil in advanced economies. With the existence of a merchandise trade
deficit of 7.7 per cent of GDP in 2007-08, and a current account deficit of 1.5 per
cent, and change in perceptions with respect to capital flows, there has been
significant pressure on the Indian exchange rate in recent months. Whereas the real
exchange 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 now
depreciated 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: Data on FIIs presented in this table represent inflows into the country and, thus, may differ from data
relating to net investment in stock exchanges by FIIs.
With the volatility in portfolio flows having been large during 2007 and 2008, the
impact of global financial turmoil has been felt particularly in the equity market. The
BSE 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 corporate
sector. With portfolio flows reversing in 2008, partly because of the international
market turmoil, the Sensex has now dropped to a level of 11,328 on October 8, 2008, in
line 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 global
financial markets for funding, both debt and non-debt, their ambitious investment
plans. The current risk aversion in the international financial markets to EMEs could,
therefore, have some impact on the Indian corporate sector’s ability to raise funds
from international sources and thereby impede some investment growth. Such
corporate would, therefore, have to rely relatively more on domestic sources of
financing, including bank credit. This could, in turn, put some upward pressure on
domestic interest rates. Moreover, domestic primary capital market issuances have
suffered in the current fiscal year so far in view of the sluggish stock market
conditions. Thus, one
can expect more demand for bank credit, and non-food credit growth has indeed
accelerated in the current year (26.2 per cent on a year-on-year basis as on September
12, 2008 as compared with 23.3 per cent a year ago).

The financial crisis in the advanced economies and the likely slowdown in these
economies could have some impact on the IT sector. According to the latest
assessment by the NASSCOM, the software trade association, the current
developments 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 other
sectors of the US economy and worldwide markets. About 15 per cent to 18 per cent of
the 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 reduced
availability of international capital both debt and equity, the perceived increase in the
price of equity with lower equity valuations, and pressure on the exchange rate, growth
in the Indian corporate sector is likely to feel some impact of the global financial
turmoil. On the other hand, on a macro basis, with external savings utilisation having
been low traditionally, between one to two percent of GDP, and the sustained high
domestic savings rate, this impact can be expected to be at the margin. Moreover, the
continued buoyancy of foreign direct investment suggests that confidence in Indian
growth prospects remains healthy.
Impact on the Indian Banking System

One of the key features of the current financial turmoil has been the lack of perceived
contagion being felt by banking systems in EMEs, particularly in Asia. The Indian
banking 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 the
subprime episode on the Indian banks had revealed that none of the Indian banks or
the foreign banks, with whom the discussions had been held, had any direct exposure to
the sub-prime markets in the USA or other markets. However, a few Indian banks had
invested in the collateralised debt obligations (CDOs) / bonds which had a few
underlying entities with sub-prime exposures. Thus, no direct impact on account of
direct exposure to the sub-prime market was in evidence. However, a few of these
banks did suffer some losses on account of the mark-to-market losses caused by the
widening of the credit spreads arising from the sub-prime episode on term liquidity in
the market, even though the overnight markets remained stable.

Consequent upon filling of bankruptcy under Chapter 11 by Lehman Brothers, all banks
were advised to report the details of their exposures to Lehman Brothers and related
entities both in India and abroad. Out of 77 reporting banks, 14 reported exposures to
Lehman Brothers and its related entities either in India or abroad. An analysis of the
information reported by these banks revealed that majority of the exposures reported
by the banks pertained to subsidiaries of Lehman Bros Holdings Inc. which are not
covered by the bankruptcy proceedings. Overall, these banks’ exposure especially to
Lehman Brothers Holding Inc. which has filed for bankruptcy is not significant and
banks are reported to have made adequate provisions.

In the aftermath of the turmoil caused by bankruptcy, the Reserve Bank has announced
a series of measures to facilitate orderly operation of financial markets and to ensure
financial stability which predominantly includes extension of additional liquidity support
to banks.

RBI Response to the Crisis

The financial crisis in advanced economies on the back of sub-prime turmoil has been
accompanied by near drying up of trust amongst major financial market and sector
players, in view of mounting losses and elevated uncertainty about further possible
losses 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 large
spreads over policy rates. In response to these developments, central banks in major
advanced economies have taken a number of coordinated steps to increase short-term
liquidity. Central banks in some cases have substantially loosened the collateral
requirements to provide the necessary short-term liquidity.
In contrast to the extreme volatility leading to freezing of money markets in major
advanced economies, money markets in India have been, by and large, functioning in an
orderly fashion, albeit with some pressures. Large swings in capital flows – as has been
experienced between 2007-08 and 2008-09 so far – in response to the global financial
market turmoil have made the conduct of monetary policy and liquidity management
more complicated in the recent months. However, the Reserve Bank has been
effectively able to manage domestic liquidity and monetary conditions consistent with
its monetary policy stance.

This has been enabled by the appropriate use of a range of instruments available for
liquidity management with the Reserve Bank such as the Cash Reserve Ratio (CRR) and
Statutory Liquidity Ratio (SLR) stipulations and open market operations (OMO)
including the Market Stabilisation Scheme (MSS) and the Liquidity Adjustment Facility
(LAF). Furthermore, money market liquidity is also impacted by our operations in the
foreign exchange market, which, in turn, reflect the evolving capital flows. While in
2007 and the previous years, large capital flows and their absorption by the Reserve
Bank led to excessive liquidity, which was absorbed through sterilisation operations
involving 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 liquidity
from the banking system. The daily LAF repo operations have emerged as the primary
tool for meeting the liquidity gap in the market. In view of the reversal of capital
flows, fresh

MSS is suances have been scaled down and there has also been some unwinding of the
outstanding MSS balances. The MSS operates symmetrically and has the flexibility to
smoothen liquidity in the banking system both during episodes of capital inflows and
outflows. The existing set of monetary instruments has, thus, provided adequate
flexibility to manage the evolving situation. In view of this flexibility, unlike central
banks in major advanced economies, the Reserve Bank did not have to invent new
instruments or to dilute the collateral requirements to inject liquidity. LAF repo
operations 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, some
modulations in CRR and SLR have also been resorted, purely as temporary measures, to
meet 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 has
imparted a sense of confidence in the market in terms of availability of short-term
liquidity. The CRR which had been gradually increased from 4.5 per cent in 2004 to 9
per cent by August 2008 was cut by 50 basis points on October 65 (to be effective
October 11, 2008) – the first cut after a gap of over five years - on a review of the
liquidity situation in the context of global and domestic developments. Thus, as the very
recent experience shows, temporary changes in the prudential ratios such as CRR and
SLR combined with flexible use of the MSS, could be considered as a vast pool of
backup liquidity that is available for liquidity management as the situation may warrant
for relieving market pressure at any given time. The recent innovation with respect to
SLR for combating temporary systemic illiquidity is particularly noteworthy. The
relative stability in domestic financial markets, despite extreme turmoil in the global
financial markets, is reflective of prudent practices, strengthened reserves and the
strong 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 a
significant extent, cushioned the impact of the international financial turbulence on
domestic financial markets by absorbing excessive market pressures and ensuring
orderly conditions. In view of the evolving environment of heightened uncertainty,
volatility in global markets and the dangers of potential spill over’s to domestic equity
and currency markets, liquidity management will continue to receive priority in the
hierarchy of policy objectives over the period ahead. The Reserve Bank will continue
with its policy of active demand management of liquidity through appropriate use of the
CRR 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 subprime
turmoil for a variety of reasons. India’s growth process has been largely domestic
demand driven and its reliance on foreign savings has remained around 1.5 per cent in
recent period. It also has a very comfortable level of forex reserves. The credit
derivatives 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 on
investments by residents in such products issued abroad; and regulatory guidelines on
securitisation do not permit immediate profit recognition. Financial stability in India
has been achieved through perseverance of prudential policies which prevent
institutions from excessive risk taking, and financial markets from becoming extremely
volatile and turbulent.
 Bibliography

- Annual Policy Statement for the Year 2008-09, Reserve Bank of

India

-www.protiviti.com/economiccrisis

- www.federalreserve.gov

- www.economist.com

- www.msnbc.msn.com

- www.wikipedia.org