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Publication: Times of India Mumbai;Date: Oct 12, 2008;Section: Front Page;Page: 1
Anatomy Of A Crisis
Over the past several weeks, TOI has sought to bring you a sense of the tectonic changes in the global financial order, and their impact on economies and people. In our ‘Learning With The Times’ series, we have traced the origins of the meltdown—in the US sub-prime loan crisis—as well as the reasons for the spread of fear to stock and credit markets around the world. As the situation assumes grave proportions, even in India, investors and to an extent depositors are hitting the panic button. Many don’t follow business closely and are spooked by economic jargon. That doesn’t mean they don’t want to know what’s happening to their money. We therefore invited economist Abheek Barua to explain as lucidly as possible the unfolding crisis, and what it means for all of us
If your palms start to sweat whenever you see the business headlines or flip to a business channel, you might draw solace from the fact you share these symptoms with millions. Investors across the world are in a state of absolute panic. As they dump risky assets like shares and rush to safe havens like gold and government bonds, stock markets and currencies across the world keep falling. The origins of today’s crisis can be traced back to mid-2007 when three things became clear. One, low income or sub-prime US households that had borrowed heavily from banks and finance companies to buy homes were defaulting heavily on their debt obligations. Two, the size of this sub-prime housing loan market was huge at about $1.4 trillion. Three, Wall Street’s financial engineers had packaged these loans into really complicated financial instruments called CDOs (collateralized debt obligations). American and European banks had invested heavily in these products. However, no amount of financial engineering could protect investors from one simple and irrefutable principle—if these housing loans turned ‘bad’, the instruments that were based on these loans would lose value. CDO prices started plummeting as defaults on US home loans rose. Falling prices dented banks’ investment portfolios and these losses destroyed banks’ capital. The complexity of these instruments meant that no one was too sure either about how big these losses were or which banks had been hit the hardest. Banks usually never hold the exact amount of cash that they need to disburse as credit. The ‘inter-bank’ market performs this critical role of bringing cash-surplus and cash-deficit banks together and lubricates the process of credit delivery to companies (for working capital and capacity creation) and consumers (for buying cars, white goods etc). As the housing loan crisis intensified, banks grew increasingly suspicious about each other’s solvency and ability to honour commitments. The inter-bank market shrank as a result and this began to hurt the flow of funds to the ‘real’ economy. To cut a long story short, today’s financial crisis is the culmination of these problems in the global banking system. Inter-bank markets across the world have frozen over. Indian banks are in the middle of a severe cash crunch. Wall Street blue-chips like Bear Stearns and Merrill Lynch have been acquired by other more ‘solvent’ banks at bargainbasement prices. Lehman Brothers, which had survived every major upheaval for the past 158 years, went bust. Panic begets panic and as the loan market went into a tailspin, it sucked other markets into its centrifuge. The meltdown in stock markets across the world is a victim of this contagion. Some questions need answers at this stage. Why are the sensex and the rupee getting hurt so badly by the woes of the American and European banks? Their presence in India is minuscule compared to the nationalized banks or the bigger private banks. A glance at Indian banks’ balance sheets will show that their exposure to complex instruments like CDOs is almost nil. A word, ‘globalization’, and a phrase, ‘risk aversion’, should explain why India has not been spared the contagion of the US and European banking crisis. Global investors are seriously concerned about the prospect of a great upheaval, if not a complete collapse in the banking system in the developed world. This, they fear, would affect all financial transactions in the near term. Going forward, this disruption could trigger a global recession (that is about 3% growth in 2009 for all economies put together). Agencies like the International Monetary Fund have endorsed this view. The upshot is that the global investment community has become extremely riskaverse. They are pulling out of assets that are even remotely considered risky and buying things traditionally considered safe—gold, government bonds and bank deposits (in banks that are still considered solvent). Emerging markets like India have over the last
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Thus. ‘Risk-aversion’ among international lenders could limit access to international capital.Anatomy Of A Crisis http://epaper. for instance. In 2007-08.com/Repository/getFiles. It is not surprising that they have got the short shrift in the flight to safe haven. Governments and central banks (the RBI’s counterparts) are trying every trick in the book to stabilize the markets. we depend more on external markets to sell our goods and services. It also means that we depend more on external funds to support our growth. Both India’s financial markets and the real economy will be hurt in the process. That said. we should be happy to clock 7% this fiscal year and the next.. the worst of the mayhem is over. This. it reflects anxieties about our prospects of future growth. The US government has set aside $700 billion to buy the ‘toxic’ assets like CDOs that sparked off the crisis.timesofindia.5% of our goods to foreign buyers. Does India deserve to be treated differently? Are we the victim of irrational ‘herd’ behaviour where differences across economies are getting blurred in this mad rush to safety? Yes and no. I would not be surprised if by early next year. None of this has stabilized the global markets. The sell-off in the stock markets is not entirely the effect of global contagion. The blood-letting in the financial markets is unlikely to stop soon. 2 of 2 10/12/2008 11:31 PM . It is true that our economy depends more on domestic rather than external drivers.asp?Style=OliveXL. Large financial entities have been nationalized. a fact that we keep touting endlessly. Central banks have got together to co-ordinate cuts in interest rates. In 1995-96. it is also true that we have embraced ‘globalization’ fairly enthusiastically over the past decade-and-a-half. from an economic perspective. A global recession would hurt external demand.. The wounds that it leaves behind could take longer to heal. we sold 13. we borrowed $29 billion from foreign lenders and got $34 billion of foreign direct investment. means two things. it is impossible to predict when the haemorrhage will stop and what will stem it. For one. To a degree. They have pumped hundreds of billions of dollars into their money markets to try and unfreeze their interbank and credit markets.1% of our goods abroad. The 9% growth target doesn’t seem that ‘doable’ any more. However. 7% growth target realistic In the last fiscal year alone. we sold 9. few years offered spectacular returns but have always been considered ‘risky’. history tells us that financial crises end as suddenly as they start.