Global economy: Wall St storm at Dalal St

Ajith V Kumar and Shafey Danish

The world economic scenario at the end of 2008 looks something like a house slowly falling in. Some of the pillars have already fallen; some are in an advanced state of decay. The roof threatens to cave in, while the foundations, though not quite ready to give in, appear shaky. Every moment seems to bring the house closer to collapse; though it has not quite collapsed as yet. The edifice of financial capitalism is holding out, for now. But it has received shocks that have placed a question mark on its long term survival. Consider the statistics: The Eurozone, the US, New Zealand, Singapore, Hong Kong, Ireland and Japan are already in recession. Canada and UK will join them soon. Global trade, which fell 50%, is poised to contract for the first time in decades. The World Bank has cut its global growth forecast to a mere 0.9% for 2009. Unemployment in US is above 6% and analysts predict it would go up to 8% by 2009. There are job cuts across the sector, not just in US but in other countries too. China which had posted double digit growth for years is slowing down, it is predicted that GDP growth may fall below the comfort zone of 8%. Germany’s economy is expected to contract by 2.7% in 2009. Dipak Dasgupta, Chief Economist to the World Bank, while speaking at a seminar said that the effects of the drastic fall in world trade is yet to be felt, and it would darken the already dark picture of meltdown All of it, of course, had its genesis in the sub prime crisis of 2007, but soon ballooned into a crisis of confidence in financial markets. Subprime crisis In 2006, Nobel laureate Paul Krugman wrote that “Nowadays, we make money by two means- by borrowing from China, and by selling houses to each other.” He was pointing to the bubble that was fast building up in the housing market, which, he said, the Fed, under Alan Greenspan, had created to replace the Internet bubble that had burst earlier. Americans did really want houses, but in there were others, who saw a quick way to make money on the back of this demand. They bought houses as investment, confident that they would be able to sell them at a higher price later. This continued until house prices had become irrationally high. People were buying houses at exorbitant prices on the belief that they would be able to sell them off. Banks were lending money to those with bad credit records, to those whose incomes were insufficient to pay off the housing loans on the same belief. These borrowers were ‘subprime’ borrowers. That is, borrowers not qualified for the loans that they were getting. Next, the banks themselves sold off the debt to other financial institutions after splitting them into small pieces and combining them with slivers of other financial products. This was supposed to mitigate risks by spreading them around. The secondary agencies that brought these ‘packages’ further slashed them into small slices and combined them with their other offerings to make new packages, creating a financial instrument of extreme complexity. Nobody really knew how to evaluate the risks on these products. These bonds were then insured in the derivatives market. For example, if an agency has a bond which will give it $10 mn at the end of 10 years, it would insure it with another agency which would pay the entire $10 in case the bond does not deliver, in exchange of a certain share of its annual return. This was the derivatives market. On the other hand the public that had taken loans to buy houses (a certain section anyhow), mortgaged them for immediate money. The mortgages were split and sold by primary agencies in the manner explained above. So when house prices started their fall, all of the above bonds went bad. The losses were so widely spread that no one knew who really had how much of debt. The banks which held the mortgages of these houses could not recover their money even by foreclosing. The type of spiral that had caused the prices to rise abnormally, now acted downwards. People anxious to recover as much of their investment as possible in a falling house market started panic selling, leading to a glut of houses in the market, which further pushed down prices. This sudden collapse in the housing market had wide ranging effects. Bank failures Investment banks today are highly leveraged players. For every dollar of actual capital they posses, they borrow up to $30, to $60 dollars. Any big loss therefore has the potential of wiping out their entire capital base. It is a risky business. They are insulated in part because of the liquidity in money markets. If they do face losses they could borrow to quickly meet their obligations and pay off from future profits. In the wake of the Subprime crisis, banks which had had exposure to the products related to the housing market, faced huge losses. The market on the other hand was spooked because it did not really know which firm had had how much exposure. If they lent to, say to company A, and it had these toxic bonds, then it may face a big enough loss to render it unable to payback. This fear froze the markets all together. No lending was taking place. Liquidity had completely dried up. Banks were also not lending to businesses outside the financial sector to keep funds in hand to meet emergencies. In September 2008, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), two US government backed mortgage lenders were placed in conservatorship by the FHFA. The decision was backed by the Secretary of Treasury, Henry Paulson, and Federal Reserve Chairman Ben Bernanke. A week later, on September 14 the US financial system was shaken to it very foundation by bankruptcy filing by the Lehman Brothers, one of the big 5 Wall Street banks. The same day the Merrill Lynch another Wall Street giant was sold off to the Bank of America to avoid bankruptcy. Reports indicated that Lehman’s collapse was precipitated by JP Morgan Chase which froze the bank’s assets well before it filed for bankruptcy. A third company, American International Group (AIG), the largest US insurer, suffered a liquidity crisis two days later, and appeared tottering on the brink of a collapse. The collapse of Lehman had already destabilized the markets. It was felt that the collapse of AIG could seriously harm the market, the government gave emergency funding amounting to $85 billion to the company in exchange for a 79.9% stake in the company. Though AIG was saved it was left bruised and battered. Of the big 5 firms on Wall Street only two were left standing after the crisis. JP Morgan and Goldman Sachs. Goldman Sachs one of the most venerable financial institutions in the world, which only a few years ago was giving out bonuses to the tune of hundreds of thousands, and millions in some cases, recorded a 53% fall in profit mid 2008. In December the firm recorded its first quarterly loss since it went public in 1999, around $2.29 bn in the 4th quarter 2008. Screaming headlines around the globe dubbed it the worst week in the history of Wall Street. Analysts predicted that the era of swashbuckling investment banking had ended. More than 500,000 jobs were lost in the US in November alone. In mid September, when the extent of the financial crisis was just becoming apparent, job losses in the financial sector already stood at 110,000 (computed for 2008). JP Morgan Chase itself announced a cut of 9,200 jobs in December. Others went so far as to see the mayhem on Wall Street, as the beginning of the end of US’ economic dominance. The Fed on its part kept aggressively lowering its lending rate; it was to reach near zero by mid December. The Federal Reserve also poured in $105 billion into the markets on September 18th to stave off an immediate market collapse. For better or worse (we are still to know the answer) the US government had embarked on an aggressive interventionist policy to prevent financial meltdown, when it decided to lend to AIG. The financial crisis was not limited to the US. On October 16, the Swiss government announced a rescue plan for the Swiss banks UBS and Credit Suisse. Three days later, the government of the Netherlands rescued ING from imminent collapse with a €10 billion package. Germany’s BayernLB too decided to apply for funds from the German €500 billion rescue program. After the forced nationalization of Northern Rock, the UK government decided to inject GBP37 billion in the nation’s three largest banks, Royal Bank of Scotland (RBS), Lloyds and HBOS. The government would own majority stake in RBS and 40% stake in the other two banks. France also announced a €10.5 billion rescue plan for six of its largest banks, including Crédit Agricole, BNP and Société Générale. Oil Prices There was a time when it seemed that the world economy would implode not because of the financial crisis, which was just a blinker on the economic radar, but due to rising commodity prices. Prices of crude in particular were rising very fast. They had gone up from the $60 a barrel to a high of $147 a barrel. Other commodity prices were also rising. Rising demand was only one of the reasons; speculation, and fear that it would rise further (reports saw it climbing to $200 a barrel by the end of the year), were also major contributors. Investors were building up huge inventories to safeguard against future price rise, which was ironically, pushing up the prices. Only then the economic crisis set in, and it became clear that the world is in for a prolonged period of recession, and falling productivity, crude prices started sliding. Now they are hovering around $45 a barrel mark, a 4-year low. Despite OPEC’s announcement of production cuts twice, the prices are refusing to climb up. The reason of course is the inventories built during the high price period. Unless those inventories are substantially reduced, and industrial production once again picks up, there is little chance of oil prices climbing up soon. India amidst turmoil The global financial tsunami hit Indian shores in 2008, albeit in a marginal way. The general lack of sentiment in the markets, nose-diving industrial production, shrinking GDP all reassert the, known yet not believed, truth that it’s a small world. Undoubtedly India is facing the storm but importantly this storm is not of India`s making. Although, the global financial crisis has its genesis in some of the most developed economies with the largest contributor being the United States, the ripple effect is being felt across the world. In context of India and its economy, it’s well accepted that our economy, although weak, the fact that it is based on strong fundamentals with reasonably good amount of checks and balances has not gone unnoticed. But India is prone to the menace known as “risk sentiment” that has crept into the world system and making it looking battered. The theory that the “problem” is very much real but not that serious in India gains credence as the rescue package announced by the government is worth only Rs 30,000 crore which is far less than the billions being pumped in by other global economies. Considers this: The bailouts announced by governments across the world has crossed USD 10 trillion (about Rs 50,00,000 crore) -- an amount equivalent to nearly 10 times the size of the Indian economy. On the GDP front, not everyone one is enthused enough to predict a good showing. International Monetary Fund (IMF) has also predicted that global economic growth would further slow to 2.2 percent from the earlier projection of 3 percent In the Indian context, the matters are made worse with one global rating agency after the other downgrading India’s economic outlook and predicting a GDP growth rate of anywhere between 6% to 7.5%. Banks stand tall Amidst all the gloomy news from Wall Street about big-ticket marquee brands falling like a pack of cards, the sentiment in the Indian financial system at the most bordered concern but never alarmist. There were strong reasons for it - Firstly, the Indian financial sector is dominated by the nationalised banks that are fairly well regulated by the RBI, so chances that they have ventured into high-risk investments is considerably less. Secondly, they have limited or no exposure to the subprime crisis. Thirdly, the Indian economy per se was not going through a downtrend at the start of the bloodbath in the West, thereby allowing Indian banks to breathe easy. But cracks became evident slowly, underlying the fact that no matter how hard we try to project ourselves as being independent, we are very much connected to the global economy. For the start Indian banks are grappling with the all-evident liquidity crunch that arose after the FIIs started to pull out money to tackle the fires at home. And, a liquidity crisis led to upward movement of interest rates and an apparent reluctance by banks to lend money to industry, especially the real estate sector. Thereby ensuring that the Indian economy as a whole is now feeling the impact. Additionally, the departure of much-valued foreign funds also reduced the collateral value of shares of Indian companies as well, a situation that further aggravated the problem of capital inadequacy. The hardest hit is the Non Banking Financial Companies (NBFCs). Banks are facing a very tight liquidity situation and since liquidity is what NBFCs need the most, these companies are feeling the pinch. And, expectedly thier profits have fallen from the peak of 60.3% last year to just 18.2% in September ’08. The RBI, like always acted guardian angel to contain the damage by reducing the CRR, SLR and repo rates and swiftly providing fresh lines of credit to pump in Rs 2.5 lakh crore in to the system. Undoubtedly, Indian banks would have to go through Litmus Test in early 2009 and if they pass off unscathed, the new world order where India along with China play the lead roles is for sure in the making! Inflation, rupee worries If there’s any good news coming in the present scenario that has been on the inflation front which has come down to acceptable levels at 6.84% after hitting the high at over 12% in September. The fall is mainly attributed to the slide in fuel prices and would undoubtedly help the central bank some much needed breathing space on the interest rates and liquidity fronts. Therein lies the classical dilemma facing economists. On one hand the RBI is under pressure to offset the effects of global slowdown by giving booster shots to enhance money supply in the market and on the other the overall cost of living including the prices of bread & butter items has to maintained at reasonable levels RBI Governor Subbarao will certainly seek to follow the middle path, as the government will not at any cost want a situation where prices go up; that too in an election year. But, certainly, there would be moves to ease the money supply in the market to ensure growth. That’s why after months of tightening the belt in way of raising cash reserve ratio and maintaining interest rates at near to steady levels, the RBI is now slowly but surely testing waters in way announcing sops for realty sector before going all out to bring in more liquidity in the system. Rupee With investors pulling out money out of the Indian rupee and aggravated by speculation that more will flow out, the rupee has slumped to the lowest since 2003. Although, this might come as good news to the IT companies and the export oriented sectors, the weakening rupee for sure would play havoc with the government’s finances. The substantial fall in the rupee’s value can be attributed to: 1. The global strengthening of the dollar as investors, fearing uncertain times ahead, are pulling out money from other currencies and putting it in US Dollars. 2. FII’s exiting from the Indian stock markets to due to financial crisis at home 3. Widening trade deficit has also played a role as exporters are earning fewer dollars compared to what importers are spending, thus negating the value of rupee.. The Rupee has also been dropping in reaction to the deteriorating current account situation. The current account deficit rocketed to USD 10.7 billion in the three months from April to June, up from a USD 1.04 billion gap in the previous quarter. The Nano effect Seldom does a product launch gather the type of hype like what surrounded Ratan Tata’s dream beauty the Rs 1 lakh Nano. Middle class Indians looked at it gleefully, as finally here was the car they could afford – no more rain soaked journeys to office, no more fears of safety while coming back home late at night, Nano was like the ultimate wish that finally got granted. On the other hand, the automotive industry looked at it with trepidation, wondering how could a car be sold at Rs 1 lakh and Tata still goes smiling to the bank? Whatever may be the emotions, one thing was clear in everybody’s mind, Nano might be small in size but it represented a very big leap in India’s prowess in the manufacturing sector. Although, the Nano was to roll out by Oct-Nov, but thanks to Mamata Banerjee and the Singur agitation, it is now expected to roll out in March ’09. Nano may be late, but it will arrive for sure. After all Nano is too big a thing to go down in history unnoticed! Aviation: Wings clipped Till recently, the Indian aviation sector was one that held great promise. Thousands of youth queued up to start a glamorous career and let their aspirations soar sky high. And, then the first air pocket came in form spiralling oil prices wiping out airline profits and before the industry could recover came the second turbulence in form of falling traffic due to the economic recession. All airlines, full-frill and low-cost are sky diving as they have suffered major losses in revenue but somehow managed to survive by sticking together and joining hands to curtail flights and other costs; as in the case of Jet and Kingfisher. Jet even tried to shed flab by giving pink slips to 2000 employees, only to retract in view of widespread outrage over the move. The only ray of hope was that no airline in the country declared bankruptcy during the year, although 31 airlines have gone bust across the globe. However, the threat is as real in India with the IATA projecting a cumulative loss of USD 1.5 billion for Indian carriers this year – the largest losses outside the US. Indian carriers are deep in the red as the year comes to a close and as per their own submission it will take sometime before its back to “happy flying”. The government on its part is bringing out all tricks in its bag to avoid a crisis similar to that of 1990s when several carriers closed down. Lowering ATF prices, abolishing customs duty to allowing airlines to stagger payment of dues till March 2009, the government is doing all that it can to give back wings to the Aam Admi.