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"A certain idea of globalisation is drawing to a close with the end of a financial capitalism that had imposed its logic on the whole economy and contributed to perverting it. The idea of the absolute power of the markets that should not be constrained by any rule, by any political intervention, was a mad idea. The idea that markets are always right was a mad idea.”
Nicholas Sarkozy,
Outline of the PresentationWhat is Recession?Why Financial Crisis?The Genesis of the current problemImpact on world financial system and
world EconomyGlobal ResponseImpact on IndiaIndia’s ResponseWay Ahead
Recession is the economy shrinking for two consecutive quarters with a decrease in the GDP
If the recession continues for next quarter, (>6 months) then the economy goes through “DEPRESSION”
What is Recession?
RECESSION
= WHEN YOUR NEIGHBOR LOSES HIS JOB
The joke that economists quote to explain theDifference between “Recession & Depression”
Recession Vs Depression
DEPRESSION
= WHEN YOU LOSE YOUR JOB
Recession is nothing newRecessions are something that cannot be
avoided. Even in a healthy economy there are periods
of high growth, slow growth and no growth. In fact in order for the economy to be healthy
there needs to be some contraction and expansion.
But if the contraction lasts for more than 6 months the economy is said to be in recession.
Causes of RecessionGeneral consensus is that a recession is caused by numerous
factors and is the end result of several preceding events; Actions taken to Control the Money Supply in the
economy;Financial Crisis; Bad Investments by businesses; Stock Market crashes;Factors that stunt short term growth in the
economy, such as a sharp increase in OIL PRICES;WarsChange in the nature of the business cycle due to
Globalization;Current global recession is caused by a severe
financial crisis triggered in western developed economies.
What is a financial crisis?
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value.
Why Financial Crisis Occurs??“In the past financial crises have been
generated by combination of factors such as overshooting of markets,excessive leveraging of debt, and credit booms, miscalculations of risk,rapid outflows of capital from a country, mismatches between asset types (e.g., short-
term dollar debt used to fund long-term local currency loans),
unsustainable macroeconomic policies, inexperience with new financial instruments,
and deregulation without sufficient market
monitoring and oversight.
Genesis of Current Crisis….The Current Financial Crisis is a combination of
several interrelated factors:
1. Misallocation of Resources Post Asian Crisis reaction: Self Insurance Accumulation of huge hard currency assets by
some countries (4.4 Trillion $) coupled with huge US current account deficit;
China alone has a Foreign Currency reserve of US$ 2 Trillion
2. Huge Current Account surplus in these countries supported by huge Current Account deficit by US & UK
Genesis of Current Crisis….3. Diversion of some of these reserves into
Sovereign Wealth Funds Reserves mostly invested in US Treasury
Bonds puts pressure on bond yields and interest rates;
Lead to diversion of some Investments into higher yielding assets than U.S. Treasury and other government securities.
Invested in High Tech Business till the collapse of Dot Com Boom in 2000;
After the dot-com bust, more “hot investment capital” began to flow into housing markets —in the United States and other countries of the world.
Genesis of Current Crisis….4. Housing Boom in US encouraged by Govt. Policies
Lower long term interest rates5. Housing boom coincided with greater popularity of the
Securitization of Loan Assets Particularly Mortgage debt (including subprime
mortgages) Pooling of Loans and reselling them as asset- based
securities: Collateralized Debt Obligations (CDOs).6. Securities are repacked, leveraged, tranched, and resold
many times over camouflaging the underlying risks7. So called innovation of exotic products;
To cover the risk of defaults on mortgages, particularly subprime mortgages, the holders of CDOs (FIs) purchased Credit Default Swaps (CDSs).
Rocket Scientists of the Wall Street??Thought that by slicing and dicing,
structuring and hedging, using sophisticated mathematical models to understand and manage risk, they can “create value” by offering investors combination of risk and return which are more attractive than those available from direct purchase of underlying credit exposures.
Credit Default Swaps (CDS)A type of insurance contract (a financial
derivative) that lenders purchase against the possibility of credit event associated with debt, a borrowing institution, or other referenced entity.A default on a debt obligation, bankruptcy,
restructuring, or credit rating downgrade.
As long as the credit events (defaults) never occurred, issuers of CDSs could earn huge amounts in fees relative to their capital base.
Since CDSs were technically not insurance, they did not fall under insurance regulations requiring sufficient capital to pay claims.
Rise of CDS businessAs the risk of defaults rose, the cost of the CDS
protection rose. Investors (mostly investment bankers) could
arbitrage between the lower and higher risk CDSs and generate large income streams with what was perceived to be minimal risk.
In 2007, the notional value (face value of underlying assets) of CDS had reached $62 trillionmore than the combined gross domestic
product of the entire world ($54 trillion),although the actual amount at risk was only a
fraction of that amount
Genesis of Current Crisis…..8. Emergence of highly Leveraged
Investment Banks Not subjected to capital adequacy norms
applicable to commercial banks Could raise and invest funds as high as
30 times their equity base9. Globalization of the financial system
leading to large scale arbitrage of funds and flight of capitals
Collapse of Mortgage MarketCDSs generated large profits for the
companies involved until the default rate, particularly on subprime mortgages, and the number of bankruptcies began to rise.
The leverage that generated outsized profits began to generate outsized losses,
Defaults and declines in values of CDO’s put big holes in balance sheets of financial institutions;
By October 2008, the exposures became too great for companies such as AIG.
The spread of the crisis
Banks around the world have similar exposures to subprime and other declining assets
Nearly universal uncertainty about bank solvency
Crisis of Confidence and credit freezeInter bank lending almost stopsCrisis spread to other assets and institutionsFlight of capital leads to
Meltdown of the stock markets across the Globe
Exchange Rate Crisis
Impact of the CrisisCurrent crisis appears worse than even a
liquidation crisisLack of mark to market accounting creates
uncertainty as to who is solventGovernment rescue policies inconsistent
(Lehman was allowed to sink)Nobody knows who will survive and parties
refuse to lend to each otherFinancial system freezes!
Spread of the Crisis and ImpactMeltdown of stock prices across the globe
Market price of stock in Freddie Mac plummeted from $63 on October 8, 2007 to $0.88 on October 28, 2008.
reflected huge changes in expectations and lead to flight of capital from assets in countries even with small increases in risk.
From Emerging Markets, BRICsMark to Market Accounting System to value that stock
according to market valuescapital base of banks shrank and severely curtailed
their ability to make more loans : Lead to Credit Freeze
Investors fled stocks and debt instruments for the relative safety of cashLead to rise in Demand for Dollar and fall in currency
value of other countries
Impact of the CrisisCollapse of Financial Institutions in several
parts of the worldLehman Brothers; AIG, Freddie Mac and
Fannie Mae etc. Central Banks in vulnerable countries such as
Iceland become BankruptInvestors across the globe lost huge amount
of their investmentsSevere Credit squeeze and Liquidity crunch
for the industryHousing; Automobiles; Retail; Services etc.
Impact of the Crisis….Crisis of confidence leads consumer
aversion to spendingFall in housing and real estate pricesFall in Demand for goods and servicesResorting to Trade Distorting
Protectionism Leads to drop in international trade in
commodities and servicesGets into a Vicious Cycle
Job cuts and serious unemployment problem followed
Onset of a recessionary spiral
Starting Point = Unwillingness to buy
Governments have 2 policy instruments
Fiscal Policies(By Govt.)
Monetary Policies(By Central Banks)
Governments in Market economies do not have direct control on Producers’ & the Consumers’ behavior; But, they can influence millions of Producers & Consumers with Government’s policies;
Governments influence the economy by changing howThe Governments spend and collect money
Central Banks manipulate the available supply of money in the country
How to come out of recession
How to come out of recession?
Government influences the economy by changing how it (Government) spends and collects money
1] Tax cuts for businesses or for individuals
More moneyavailable forspending
Demand picksup; Market can recover;
2] More Spending by Govt. to create jobs
Individuals getsalary and spendmoney
3] Automatic fiscal policy; Unemployment Insurance
Some income tounemployed people to spend
Fiscal Policies
How to come out of recession?
1] Reduce reserve ratio
More moneyavailable for bankto give loans
Demand picksup; Market can recover;
3] Use its own reserved money to buy Govt. bonds
It becomes anincome to Govt.to inject moneyinto the market
Central Bank manipulates the available supply of money in the country
MonetaryPolicies
2] Lower the interest rates
Individuals takemore loan
Global Response to the CrisisVaried Response and Intervention to protect
financial system and the tumbling economyShort term Keynesian response to boost
demand for goods and services to revive the economy by pumping in more money to the system
Structural adjustment to correct the distortion in the financial system
Long Term solution : Address the problem of misallocation of resources
Global Response: First phase of intervention First and Immediate intervention by the
governments across the globe has been to prevent collapse of the financial system.
Effort has been madeto stop the financial bleeding,to coordinate interest rate cuts, and pursue
actions to restart and restore confidence in credit markets.
rescue of financial institutions considered to be “too big to fall,”
Government take over of Banks and Financial Institutions on the verge of Collapse to prevent the financial system collapsing
Freddie Mac and Fannie Mae; AIG etc.
First Phase…..Injections of capital and government takeovers of
certain financial institutions,Government guarantees of bank deposits and money
market funds, and governmentFacilitation of mergers and acquisitions.Large Scale Government bailout packages for
affected industriesUS Bailout package for affected Industries; Banks
and FIs exceeds 1 trillion US$Major economies such as European nations, Japan,
Russia, China come out with huge bailout packages and stimulus packages to bail out institutions and kick start their economies
The second phase: Keynesian path to global recovery
In the second phase of intervention Governments have turned to traditional monetary and
fiscal policies to deal with recessionary economic conditions, declining tax revenues, and rising unemployment,
Several countries have turned to funding from the IMF, World Bank, and capital surplus countries.
Effort is to Improve liquidity in the system by infusion of cash into the
system; Restart credit flow by building confidence in the system; Stimulate investment and demand for goods and services;
and Prevent collapse of industries and institutions
Road Ahead: Third phase of ResponseAction is being coordinated to decide what changes
may be needed in the financial system to prevent future crises;
Some issues being addressed are:weakness in fundamental underwriting principles,the build-up of massive risk concentrations in firms,the originator-to-distributor model of mortgage
lending,insufficient bank liquidity and capital buffers,overall regulatory structure for banks,
brokerages, insurance, and futures,lack of a regulatory ties between macroeconomic
variables and prudential oversight, andhow financial rescue packages should be structured.
Road Ahead: G-20 initiativesIssue of misallocation of resources across the globeRole of the “Invisible Hand of the Market Forces”
and Government InterventionG-20 Initiatives
New Financial Architecture:Global coordination and oversight of Financial
MarketExecutive CompensationRegulation of Derivative Segments of Financial
MarketCall for restraints on protectionism
Fourth Phase of Global ResponseThe fourth phase of the process will be
dealing with political and social effects of the financial turmoil.
The questions that have been raised are:Will the financial crisis work to diminish the
influence of the United States and its Dollar in financial circles relative to Europe and its Euro/pound?
Growing influence of the newly emerging economies (India, China, Brazil) in addressing global financial issues.
Is this the end?
Not likely, Given that US Capitalism survived the Great
DepressionFinancial capitalism brought enormous economic
and social benefits to hundreds of millions of peopleIt is possible that financial repression will
followwith nationalization of banks, severe control of
lending and trading, etcMore likely, will get more regulation
This might be a good ideaGood examples: securities and banking regulation
after the Great DepressionEmergence of new Global Financial Architecture???
Financial Crisis and Impact on India
Subprime Lending is not a major issue in India
Limited exposure of Indian banks to overseas mortgage and derivative products
One of the bystanders affected by development elsewhere??
Major problem is the liquidity crunch and crisis of confidence of banks for lendingOver reaction to inflation during the first
half of 2008 and tightening of monetary policy
Impact on IndiaSignificant Currency devaluationDemand side problem
Drying up of external demand for goods and services due to major problems in US and Europe: India’s major trading partners
Lower domestic demand due to buyers hesitation to spend
Exports down by about 20%Year on Year export growth remains negative Major affected sectors are: Real Estate; Auto
Industry, Textiles; Gem and Jewelry; Chemicals and Allied Products; Iron and Steel; Capital Goods etc.
Impact on IndiaExternal dependant service sectors shows sign of
stress.However, India is not likely to face recessionary
trend.GDP Growth likely to remain above 6% in spite of
recession and negative growth in the developed economies.
Still has a sizeable Foreign Currency reserve.It is felt that India and China, with their robust
domestic demands and savings, would lead the recovery of world economy.
India’s Response: Monetary Policy InterventionBroad direction of the interventions on
monetary policy side has beento increase liquidity; reduce interest
rates; restore confidence in the banking system; restore banker’s confidence for lending; and stimulate domestic demand
Easing of liquidity in the market by reduction of CRR; SLR
Lowering Bench Mark interest rates by lowering Repo and Reverse Repo rates;
Making special arrangements/windows for lending to vulnerable sectors;
Monetary Policy InterventionEasing External Commercial Borrowing
norms for providing access to cheaper funds abroad;
Interest subvention for exports credits for certain labour intensive sectors and longer tenure of export credit at concessional rates;
Increasing liquidity to NBFCs for lending to affected sectors such as Auto and Housing at affordable rates to stimulate demand;
India’s Response: Fiscal Policy InterventionDirected at stimulating demand for goods
and services through tax cutsCounter-cyclical pump-priming the
economy though higher and accelerated government spending
Additional spending on large infrastructure projects like Roads, Ports etc. to kick start the economy