Impacts of the US Financial Crisis on India & the World Economy

Though in the beginning Indian official denied the impact of US meltdown affecting the Indian economy but later the government had to acknowledge the fact that US financial crisis will have some impact on the Indian economy. The US meltdown which shook the world had little impact on India, because of India s strong fundamental and less exposure of Indian financial sector with the global financial market. Perhaps this has saved Indian economy from being swayed over instantly. Unlike in US where capitalism rules, in India, market is closely regulated by the government. It also created imbalance in the global capital management.

1. Impact on stock market The immediate impact of the US financial crisis has been felt when India s stock market started falling. On 10 October, Rs. 250,000 crores was wiped out on a single day bourses of the India s share market. The Sensex lost 1000 points on that day. This huge withdrawal from the India s stock market was mainly by Foreign Institutional Investors (FIIs), and participatory-notes. Equities Market was down by over 60 % from their peak. No. of new issues declined from 60 to 32 (19 IPOs from Pvt. sector cos. constituting 16% of total resource mobilization) & also Avg. size of Public issue declined to Rs 386 cr from Rs 531. Indian companies with big tickets deals in the international market are seeing their profit margins shrinking.

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2. Impact on India s trade The trade deficit is reaching at alarming proportions. Because of worker s remittances, NRI deposits, FII investment and so on, the current deficit is at around $10 billion. But if the remittances dry up and FII takes flight, then we may head for another 1991 crisis like situation, if our foreign exchange reserves depletes and trade deficit keeps increasing at the present rate. Further, the foreign exchange reserves of the country has depleted by around $57 billion to $253 billion for the week ended October 31.
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3. Impact on India s export With the US and several European countries slipping under the full blown recession, Indian exports have run into difficult times, since October 2008. Manufacturing sectors like leather, textile, gems and jewellery have been hit hard because of the slump in the demand in the US and Europe. Further India enjoys trade surplus with USA and about 15 per cent of its total export in 2006-07 was directed toward USA. Indian exports fell by 9.9 per cent in November 2008, when the impact of declining consumer demand in the US and other major global market, with negative growth for the second month, running and widening monthly trade deficit over $10 billion. Official statistics released on the first day of the New Year, showed that exports had dropped to $1.5 billion in November this fiscal year, from $12.7 billion a year ago, while imports grew by $6.1billion to $21.5 billion.

4. Impact on India s handloom sector, jewelry export and tourism Again reduction in demand in the OECD countries affected the Indian gems and jewellery industry, handloom and tourism sectors. Around 50,000 artisans employed in jewellery industry have lost their jobs as a result of the global economic meltdown. Further, the crisis had affected the Rs. 3000 crores handloom industry and volume of handloom exports dropped by 4.6 per cent in 2007-08, creating widespread unemployment in this sector. With the global economy still experiencing the meltdown, Indian tourism sector is badly affected as the number of tourist flowing from Europe and USA has decreased sharply.

5. Exchange rate depreciation With the outflow of FIIs, India s rupee depreciated approximately by 20 per cent against US dollar and stood at Rs. 49 per dollar at some point, creating panic among the importers & Call money rates up to 15-17% from 6-8% of one week ago & ICICI worst hit as its London subsidiary had purchased Lehman bonds to the tune of Rs. 375 crore

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Daily avg. call rate continued to remain above the repo rate reflecting the impact of hikes in CRR and repo rate & Indian rupee depreciated against major currencies. In credit markets, lending rates of scheduled banks hardened. Yields in govt. securities market decreased. Benchmark lending rates of PSBs increased by 75-125 basis pts from 12.5-14% in Jun 08 to 13.75-14.75% by Sep 08

6. IT-BPO sector The overall Indian IT-BPO revenue aggregate is expected to grow by over 33 per cent and reach $64 billion by the end of current fiscal year (FY2010). Over the same period, direct employment to reach nearly 2 million, an increase of about 375000 professionals over the previous year. IT sectors derives about 75 per cent of their revenues from US and IT-ITES (Information Technology Enabled Services) contributes about 5.5 per cent towards India s total export. So the meltdown in the US will definitely impact IT sector. Further, if Fortune 500 hundred companies started to slash their IT budgets, Indian firms also affected to certain extent.

7. FII and FDI

The contagious financial meltdown eroded a large chunk of money from the Indian stock market, which definitely impacted the Indian corporate sector. However, the money eroded will hardly influence the performance real sector in India. Due to global recession, FIIs made withdrawal of $5.5 billion, whereas the inflow of foreign direct investment (FDI) doubled from $7.5biilion in 2007-08 to $19.3 billion in 2008 (AprilSeptember).

Also not to forget the impact it had on the following India s Macro Indicators: Index of Industrial production fell to less than 1 % in Aug. Fiscal Deficit expected to touch over 5 % of GDP Inflation: Over 8.5%in 2008-09
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Interest Rate: 10 years G-Sec yield is at less than 5 %

Impact on Indian Finacial Sector :

Impact on World Financial stocks :

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Losses of the Banks worldwide :

Impact on the US Housing prices :

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8. Others

 Mass foreclosure and default in subprime loans & job loss across the board

 Collapse of top investment firm s viz. Lehman Brothers, Bears Sterns, Merrill Lynch, AIG, Washington Mutual etc.  $700 billion bailout package from the U.S Federal Reserve  The rescue of the US financial system  As the housing market worsened, delinquencies and foreclosures rapidly increased and loans that Fannie and Freddie backed went bad.  Write downs of Loans  U.S Government t took over & nationalized Fannie Mae and Freddie Mac & it started operating as Government Sponsored Enterprise (GSE), meaning it was privately owned and operated by shareholders but was financially backed by the federal government  Lehman Brothers declare bankruptcy  Bank of America acquires Merrill Lynch  Stocks fall. Worst drop (504.5 pts) on Dow Jones since 9/11 terrorist attacks

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 Govt. Rescue AIG  Indian banks with branches in the US and the UK may lend to banks affected by the sub-prime debt crisis. This would weaken their balance sheet in future.  Northern Rock, an aggressive British mortgage lender filed for rescue. The British public panicked and began lining up to pull their money out of the institution. The Bank of England was forced to bail out the company, subsequently nationalizing it altogether.  Russia shuts down its market , Wachovia acquired by Wells Fargo  US Federal Reserve pumps $180 billion into money markets to combat seizing up of lending
between banks  Govt. proposes Emergency Economic Stabilization Act: Purchase up to $700 billion in mortgage-related assets  Washington Mutual & Bear Sterns are taken over by JP Morgan Chase

 The US real estate industry had a boom between 2001 and 2005 as property prices reached historic highs on account of low interest rates, price-to-rent ratios and other factors. When property prices began to fall due to saturation or lack of demand, the owners had to face mortgage loan, which was higher compared to property value. The collapse of the US market had a direct impact on housing values, mortgage industry, real estate companies, hedge funds etc.

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Impacts on Markets:

US being the biggest borrower in the world since most countries hold their foreign exchange reserve in dollars & invest them in US Securities, any crisis in US has a direct bearing on them Countries with large reserves like Japan China and India were also are at high risk. You thought only home owners, bankers & brokers were affected. The answer is no. Even the multi billionaire, small businesses & even consumers were severely affected as there was no free credit any more. All the good days turned bad & crisis was at the door & all the investors lost their faith in the market as it affected their sentiments very badly. The crisis unfolded as silent Tsunami on Wall Street where by the time people realized the graveness of the mess they were in, it had gone beyond control. Since, most of the player in the market, mortgage brokers, and investment banks were running in debts. They are suddenly caught unaware and are in insolvency and starts tumbling down .many are saved by nationalization as their fall would spread the contagion way far. How could problems with subprime mortgages, being such a small sector of global financial markets, provoke such dislocation? Lenders were afraid of all types of the loans -- subprime bonds, then student loans, then home equity loans, then commercial paper (business, consumer loans), etc. The crisis also led to widening spread of Municipal bonds to 100 basis points and corporate yield spread to 500 basis points and Money market (LIBOR/OS) spread went upto 360 basis points against normal spread of 20 basis points. This crisis is spreading from sub-prime to prime mortgages, home equity loans, to commercial real estate, to unsecured consumer credit (credit cards, student loans, auto loans), to leveraged loans that financed reckless debt-laden leveraged buy outs, to municipal bonds, to industrial and commercial loans, to corporate bonds, to the derivative markets whose risk are indeterminate It has been a total systemic failure that has its roots in the US real estate and the sub-prime loan market. Interbank lending ground to a halt. The spread between what the Bank of England set as its interest rate, and what the banks would use to lend between them ballooned (the LIBOR rate). Even the more conservative European banks are facing the same problems as they rely heavily

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on three month loan financing to maintain their positions vis a vis their long term investments. Additionally the Hedge funds, investment funds and associated groups are facing heavy margin calls against their leveraged positions as the markets dramatically drop, added to high levels of customer withdrawals from their funds, as everyone clambers to get off the sinking investment ship. This created further problems as most banks borrow short term to provide long term loans. CRB index which tracks the commodities prices also fell to 2003 levels. Institutional investors, who had invested in securitized paper from the sub-prime home loan market in the US, saw their investments turning into losses. Most big investors have a certain fixed proportion of their total investments invested in various parts of the world. So...Once investments in the US turned bad, more money had to be invested in the US, to maintain that fixed proportion. In order to invest more money in the US, money had to come in from somewhere. To make up their losses in the sub-prime market in the United States, they went out to sell their investments in emerging markets like India where their investments have been doing well. So these big institutional investors, to make good of their losses in the sub-prime market, began to sell their investments in India and other markets around the world. Since the amount of selling in the market is much higher than the amount of buying, the Sensex began to tumble. The flight of capital from the Indian markets also led to a fall in the value of the rupee against the US dollar. The crisis also had severe impact on the currency market as USD depreciated against major currencies on account of weaker global equity market, slowing manufacturing growth, higher unemployment and low housing sales. All these lowered the consumer and investors confidence On September 18, the US Federal Reserve along with the European Central Bank, the Bank of England, the Bank of Canada, the Bank of Japan, and the Swiss National Bank authorized $180 billion to be pumped into money markets in order to pump more short-term liquidity into the financial system. In doing so, the Fed expanded its temporary reciprocal currency arrangements, known as swap lines, to allow banks to borrow at lower rates in money markets. Although $700 billion is a really large number, it is no way large enough. It is only a fraction of the accumulated bad debts and likely debts moving forward. The Washington Post reported on

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the 29th of September that 20 of the US s largest financial institutions owned $4.7 trillion in mortgages and mortgage backed securities (with non recorded CDOs on top of that). CDS losses are also now beginning to hurt and this too is unregulated, unreported, and huge. It is now very questionable as to whether the assorted bailout, loans, and guarantees from the US/UK/European governments will ever be paid. Amounts which as of December 4, 2008 were in excess of $10 trillion. On September 16, the government rescued AIG by injecting $85 billion into the company for an 80% ownership stake. As AIG was deemed by the federal government to be too big to fail, this rescue was done to avert a collapse of the company, which would have likely caused further failures in the financial industry. A steep rise in the rate of subprime mortgage borrowers & lenders filed for the bankruptcies most prominently, New Century financial corporation, previously the nation s second biggest subprime lenders. The failure of these companies has resulted into falling prices of these mortgages backed securities. When possible buyouts by Bank of America and Barclays fell through, 158 years old Lehman Brothers was forced to declare bankruptcy on September 15 as a result of its exposure to risky real estate related investments and inadequate capital. This bankruptcy was the largest bankruptcy in US history. On September 14, Bank of America acquired 94 years old Merrill Lynch for approximately $50 billion in an all-stock transaction. Leading up to this acquisition, Merrill Lynch had been experiencing many financial struggles due to billions of dollars of its assets being tied to mortgages that had decreased tremendously in value. On September 25, Washington Mutual was taken over by JP Morgan Chase in a deal brokered by the FDIC, making it the largest bank seizure made by the government in US history. JP Morgan Chase paid $1.9 billion for WaMu s deposits and branches. On September 22, Morgan Stanley and Goldman Sachs became bank holding companies, abandoned investment bank status, and submitted to supervision by the Federal Reserve. The Federal government also proposed the Emergency Economic Stabilization Act. The purpose of this act, which authorized the US Treasury to spend up to $700 billion to purchase distressed Io

assets, was to purchase bad assets, reduce uncertainty regarding the worth of remaining assets and restore confidence in the credit markets. Also, Troubled Assets Relief program, to purchase troubled assets of USD 700 Billion was passed. On November 4, democratic President-elect Barak Obama was elected to the White House with 365 electoral votes and 53% of the popular vote (21) October concluded as the worst month for the Standard & Poor s index of 500 stocks in 21 years, down 16.9% for the month. The Dow Jones Industrial Average and Nasdaq both also experienced a volatile month, decreasing 14.1% and 17.4%, respectively, through October 31. On November 10, Circuit City declared bankruptcy and filed for Chapter 11.

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On November 10, AIG received a reworked $152.5 billion deal from the federal government, with significant changes made to its initial rescue plan. At the November 13 hearings, the banking committee heard testimony from executives of Bank of America, Goldman Sachs, JP Morgan Chase, and Wells Fargo on how the companies are using the funds they received as part of the rescue plan. On November 12, Treasury Secretary Henry Paulson announced that the rescue plan s $700 billion would not be used to purchase troubled assets as originally planned. Instead, he said the plan would continue to use $250 billion to purchase stock in banks to encourage them to resume normal lending. Paulson also said that the program should support financial markets which supply consumer credit in areas such as credit card debt, student loans and auto loans. All these also resulted into the current account deficit as high as 6% of GDP.

When the subprime market began to collapse, home mortgage borrowers began to default on their payments, and the value of the mortgage portfolio investments began to decline. As a result, investors began to accumulate huge losses. Financial institutions began to be afraid to deal with one another because they did not know who was able to make good on debt obligations and who wasn t. As a result, investors reduced their purchasing of short-term bonds (commercial paper) and instead began investing in stable Treasury bills. The lack of commercial paper being purchased began to freeze the credit market. Everyone will be impacted by the frozen credit markets if banks continue to not lend to one another. If the credit market remains frozen, there will not be enough credit available for businesses and

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individual consumers. Businesses will need to begin to cut costs back to avoid bankruptcy if they don t have access to short-term borrowing. Day-to-day expenses such as projects and payroll will be affected. Individual consumers will experience difficulty in receiving loans necessary for purchasing homes, cars, college, and other items. The major credit-rating agencies , Moody s, Standard and Poor s and Fitch, assign credit ratings for debt obligations, such as the mortgagebacked securities (MBS). They gave the majority of MBS investments AAA ratings, which indicated that the investments were safe, even though they contained high-risk, subprime mortgages. There are a couple of reasons that these MBS investments incorrectly received excellent ratings from the rating agencies. First, rating agencies are paid by the firms that organize and sell the debt being rated to investors, which critics say, created a conflict of interest. Second, the rating agencies were using historical data on subprime mortgages to rate the MBSs, which was, in fact, irrelevant data because it didn t take the current relaxed qualification standards and unqualified borrowers into consideration. The collapse led to property prices falling more than 50% of their peak in 2006 & lenders left with less the value of their loans to book hefty losses. This turned into systematic crisis because original lenders had further sold their portfolio to other players & nobody was aware of the exact size of losses & who had taken how much hit. SEC Securities & Exchange Commission, a US Regulator banned short selling in 799 financial companies stocks & $800 bn pumped in worldwide. Europe - European banks have lost more money than American banks due to investments in the U.S. mortgage market & this created mini subprime in Europe. The crisis also raised the questions of risk assessment models for structured finance complex instruments & over reliance on the rating agencies. Government stepping in to bail out banks from going under in Denmark and U.K. & threat of recession in Irish Republic and Spain ,France, Germany, Italy and Portugal follow suit Millennium Development Goals are unlikely to be met as it created more inequality & poverty, unemployment. Some countries were directly impacted & some were indirectly affected like Japan, wherein Mizuho, second largest bank lost more than $6 bn, China which was sitting on huge surplus goods, Singapore where Teamsek & GIC became the biggest shareholders of ML & UBS bonds. As the surprise spread, the pillars of faith that had supported the credit boom started to crumble & Investors woke up to the fact that it was dangerous to use the ratings agencies as a guide for complex debt securities. Many banks had not yet passed on the risk to others. Many

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were holding asset-backed securities in warehouses and were working on splicing them up into CDOs, getting them rated by a credit agency such as Moody s or Standard & Poor s. Several banks were caught out not only because it took time to structure the securities but because they deliberately held on to what they regarded as safe tranches of loans. Assumption that banks would be better protected from a crisis because of risk dispersion also cracked. As

investment vehicles lost their ability to raise finance, they turned to their banks for help. That squeezed the banks balance sheets at the very moment that they were facing their own losses on debt securities and finding it impossible to sell on loans. As a result, western banks found themselves running out of capital. Banks started hoarding cash and stopped lending to each other as financiers lost faith in their ability to judge the health of other institutions or even

their own. The London interbank offered rate (LIBOR), the main measure of interbank lending rates, rose sharply. Firms became reluctant to participate in money markets ... as a result subprime credit problems turned into a systemic liquidity crunch. Mark-to-market accounting forced banks to readjust their books after every panicky price drop. Investments in all the forms were devalued across the globe. In addition to the government bailouts, distressed lenders are looking to the suspension of "mark to market" accounting rules as a means of salvation. These rules required institutions to value their mortgage assets according to the most recently traded price. However, changes recently implemented by the Financial Accounting Standards Board (FASB) under pressure from the large banks to allow more advantageous model based valuations have now been brought in. Lenders are now able to pretend that the losses do not exist, or defer accounting for them, thereby dangerously removing the transparency that investors so desperately need. The US government is faced with the choice of: massively curtailing expenditure on social, health and welfare projects, raising taxes dramatically, increasing borrowing from overseas, or literally printing the money. The money will come from either foreign loan including the holding of US Treasury bills or via printing money which will effectively devalue the currency and cause a hike in inflation. It is questionable as to whether foreign governments will continue to fund the US particularly as the US consumer will slow down in its purchase of Chinese and Japanese goods. The Chinese government which already holds $1.8 Trillion in US bonds is also unlikely to want to further increase its holdings of a currency which could go into meltdown.

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If the US government fails in extracting this money from foreign sources then there is no alternative but for a massive increase in the US money supply which will be inflationary or hyperinflationary. With Governments buying up bank s bad debts Governments themselves become riskier propositions for investment. Governments are vulnerable to defaults. The risk of this is greater now than at the start of the crisis as Western economies rapidly contract with tax revenues falling and public spending on the rise. Thus a financial crisis precipitates an economic crisis leading to a political crisis. Perhaps the most startling aspect of the crisis is that it is in fact a human rather than financial crisis. It is real people that are losing their homes, jobs and savings, yet the headlines focus upon the mechanics, the companies and the dollars. This spills over into Government policy which in this crisis has focused on preserving companies and an elusive commodity called confidence in the system, not the individual. The irrational emphasis upon growth in GDP at all costs and misplaced notions of the trickle down positive effect of growth to the poor in society have been proven repeatedly to be false as the division between the wealthy and poor in Capitalist society continues to widen.

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