Looking Back on Recession
Four years have passed away since Lehman Brothers did something which can be regarded as the financial equivalent of the 50 megaton Tsar Bomba. The soviet plane that dropped the bomb barely escaped the fireball. The seismic shock went thrice around the earth. The soviets had tamped the bomb down from its 100 megaton capacity to reduce the fallout. Forty-seven years later, the crew who dropped the Lehman Bomba certainly got away alive, but unlike Soviets, leave alone tamping it down, they were clueless about its explosive yield. The fireball scorched the citizens of the world, governments and taxpayers and will continue to do so for years, as bills and bailouts and stimulus come for due payment.
We are now living in a world where all the major economies are inter-linked with each other. An economic crisis of a local nature can turn into a global financial crisis and result in recession. The sub-prime crisis, which started in the US but soon resulted in an unprecedented economic downturn all over the world, is a glaring example. It completely engulfed the world economy with a varying degree of recessional impact.
In this article, I shall try to explain the reasons for the economic depression, the consequences thereof, and finally its implication on India.
Boom in the US housing market:
In US, low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom. The home ownership rate increased from 64% in 1994 to 69.2% in 2004. More and more people took home loans and hence, the demands for property increased and fueled the home prices further. As there was enough money to lend to potential borrowers, the loan agencies started to widen their loan disbursement reach and relaxed the loan conditions.
The loan agents were asked to find more potential home buyers in lieu of bonuses. Since property prices were soaring, the only aim of lending institutions and mortgage firms was to give loans to as many potential customers as possible. The practice of checking the customer’s repaying capacity was ignored invariably. As a result, many people with low income and bad credit history category were given housing loans in disregard to all principles of financial prudence. These loans were known as sub-prime loans as those were are not part of prime loan market.
The lending companies also lured the borrowers with attractive loan conditions where for an initial period the interest rates were low known as adjustable rate mortgage (ARM). These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term.
This housing bubble resulted in numerous homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.
Bursting of the Housing Bubble
Overbuilding of houses during the boom period finally led to a surplus inventory of homes. The number of new homes sold in 2007 was 26.4% less than in the preceding year. Nearly four million existing homes were for sale, of which almost 2.9 million were vacant. By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. This overhang of unsold homes further lowered house prices. The unexpected decline in house prices meant that many borrowers had zero or negative equity in their homes, meaning their homes were worth less than their mortgages.
Once housing prices started depreciating in many parts of the U.S., refinancing became difficult. Home owners, who were expecting to get a refinance on the basis of increased home prices, found themselves unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts. Under these circumstances, borrowers had an incentive to default on their mortgages As a result, foreclosures accelerated in the United States in late 2006.
The interest rate charged on subprime loans was higher than the interest on prime loans. In case a sub-prime borrower continued to pay his loans installment, the lender would get higher interest on the loans. If the sub-prime borrower could not pay his loan and defaulted, the lender would have the option to sell his home (on a high market price) and recover his loan amount. With housing markets booming, many big fund investors like hedge funds and mutual funds saw subprime loan portfolios as attractive investment opportunities. Hence, they bought such portfolios from the original lenders. Major American and European investment banks heavily bought these loans (known as Mortgage Backed Securities) to diversify their investment portfolios. These loans were brought as parts of Collateralized Debt Obligations. Collateralized Debt Obligations are just like mutual funds with two significant differences. First unlike mutual funds, in CDOs all investors do not assume the risk equally and each participatory group has different risk profiles. Secondly, in contrast to mutual funds which normally buy shares and bonds, CDOs usually buy securities that are backed by loans.
As the home prices started declining in the US, sub-prime borrowers found themselves in a messy situation. Their house prices were decreasing and the loan interest on these houses was soaring. As they could not manage a second mortgage on their home, it became very difficult for them to pay the higher interest rate. As a result many of them opted to default on their home loans and vacated the house. The lending companies, which were hoping to sell them and recover the loan amount, found them in a situation where loan amount exceeded the total cost of the house. Eventually, there remained no option but to write off losses on these loans.
The effects of these losses were huge. In just two weeks of September 2008, the world’s two biggest mortgage lenders, four biggest investment banks and the biggest insurance company went under. The two biggest mortgage companies in the world, Fannie Mae and Freddie Mac were taken over by the US government. AIG, the world’s largest insurance company was taken over by the government. Merrill Lynch was brought over by Bank of America. Morgan Stanley and Goldman Sachs converted themselves into commercial banks. Lehman Brothers went bust. In March, Citibank, world’s largest bank, looked like collapsing, but was rescued by US government. Bear Sterns was bought out by JP Morgan Chase with some help from the US Federal Bank. On the whole it has been estimated that losses amounting to $260 billion have been suffered by US-based firms, $227 billion by European firms and a relatively modest $24 billion by Asian ones.
Since banks and other financial institutions form the backbone of major industries by providing them with investment capital and loans, a loss in the net capital of banks meant a serious threat in their capacity to disburse loans for various industries. This presented a serious cash crunch situation for companies who needed cash for performing their business activities, and this has led to devastating consequences.
The losses suffered by banks have directly affected their money market the world over. As the housing loan crisis intensified, banks grew increasingly suspicious about each other’s solvency. The inter-bank market shrank as a result and this began to hurt the flow of funds to the ‘real’ economy. So the global economy froze. Panicky US households, which had been living beyond their means, suddenly started saving, and demand collapsed even as production collapsed for want of finance. This soon led to the bankruptcy of the largest automaker in the world, General Motors and Chrysler. The nadir came in March 2009, when Citibank, the world’s largest bank, looked like collapsing, but was rescued by the government. The negative feedback loop between finance and industry threatened take the world into another Great Depression. The overall effect of all this is zero or negative growth of economy for both developed and developing countries all over the world.
As a result, Governments and central banks of all the major economies of the world have tried hard to stabilize the markets. US passed the Emergency Economic Stabilization Act of 2008, a law enacted in response to the sub-prime mortgage crisis authorizing the government to spend up to US$700 billion to purchase distressed assets, especially, and make capital injections into banks. The American Recovery and Reinvestment Act of 2009 was passed with the intention to provide a stimulus to the U.S. economy in the wake of the economic downturn. The Act includes federal tax cuts, expansion of unemployment benefits and other social welfare provisions, and domestic spending in education, health care, and infrastructure.
Implications on India
India has maintained a respectful 6-7% growth even in the times of recession. However, this does not mean that recession left India completely unaffected. India faced heat on following grounds:
(1) Our Share Markets fell, and
(2) Rupee weakened against dollars
Our stock market was touching new heights thanks to heavy investments by Foreign Institutional Investors (FIIs). However, when the parent companies of these investors found themselves in a severe credit crunch as a result of sub-prime mess, the only option left with these investors was to withdraw their money from Indian Stock Markets to meet liabilities at home. As a result our Share Markets touched new lows. Since, the money, which FIIs get after selling their stocks, needs to be converted into dollars before they can sent home, the demands for dollars suddenly increased. As more and more FIIs were buying dollars, the rupee started losing its strength against dollar.
Under these circumstances, the current financial crisis started affecting Indian Industries, The textile, garment and handicraft industry were worst affected. Continuing recession in the global markets took a toll on the country’s garment exports with the latest figures revealing a 15.4% decline in the first quarter of the 2009 - 2010 fiscal year. The real estate sector was also hit really hard because of the ongoing recession. The adverse impact of the recession started showing on the pharma industry with the value of exports in dollar terms down 2 per cent, during October 2008. The global microfinance industry saw a fall in growth and funding due to the economic crisis and declining investor confidence, a survey says. There were reports of significant declines in output of automobiles, commercial vehicles, steel, petrochemicals, construction, finance, retail activity and many other sectors.Moreover, Companies in India had most outsourcing deals from the US.
There was a significant drop in hiring process which became a cause of great concern. Companies like TCS, Wipro, and Infosys more or less freezed new hiring process and asked students with offer letters to wait. Close to 70,000 engineering students passing out in 2008 and 2009 faced the prospect of sitting at home with no near-future job prospects.
However, one positive point in favor of India is the fact that Indian Banks were more or less secured from the ill-effects of sub-prime mess. A glance at their balance sheets would show that their exposure to complex instruments like CDOs is almost nil. In India, the major banking operations are in the hands of Public Sector Banks who exercise extreme caution in disbursing loans to needy people/companies. As a result, chances of a sub-prime crisis in India are rare.
Steps taken by the Indian Government
Recession has been one of the biggest challenges faced by the Indian Government and the Reserve bank of India (RBI). In October 2008, the RBI pumped over Rs. 3, 20,000 crore into the monetary system to usher in a low interest regime, especially when inflation was coming down in the wake of the fall in the prices of fuel, metals and farm commodities. The RBI had slashed its key policy rates in February 2009 to inject an additional Rs. 20,000 crore into the banking system.
Indian Government came up with 3 stimulus packages introduced in the months of December 2008, January and February 2009. The 1st stimulus package aimed at bringing down prices and providing relief to sectors hardest hit by the global financial crisis. 2nd stimulus package aimed at reversing the economic slowdown. The 3rd stimulus package gave a slew of indirect tax reductions and other fiscal measures to revive a rapidly slowing down economy. The interim budget and the Union budget, presented in February 2009 and July 2009 respectively, did not give any substantial relief as far as this economic downturn was concerned, as they focused more on rural development.
These packages have gone a long way in countering the shock of recession in India. However, there are certain loopholes. Government had relied solely on tax cuts to stimulate the economy. What was required was a much higher public expenditure programme aimed at generating employment and enhancing incomes of the working people through increased public investment in agriculture, higher allocations for health and education, infrastructure like rural roads, housing for the middle and lower-income groups and universalization of the Public Distribution System.
As I had already mentioned in the beginning, in this age of globalization, the rumblings of a local nature have the potential of spiraling into a global crisis. Therefore, it is imperative that policymakers begin to recognize the importance of regional co-operation. Regional co-operation could help in sharing the dynamism of economies for mutual benefit. Regional co-operation would also involve broadening, deepening and consolidating existing trade agreements. There is a large potential for monetary and financial co-operation. Other areas of financial co-operation include swap-agreements such as the Chiang Mai initiative to cover more countries and developing the Asian Bond market. Another area of fruitful regional co-operation could be the building of a global financial architecture supportive of the region’s needs. This would involve collective effort in seeking the implementation of various aid and debt-relief commitments made by the international community.
Weaknesses in financial regulatory systems, abetted by regulatory failures and an under-appreciation of how leverage could generate a systematic rather than an institution-specific risk, were a key problem. However, it may also be pertinent to mention here that financial sector was the most regulated sector even before this crisis. Hedge funds, the least regulated of all financial entities, survived the crisis without any bailouts, even as banks, the most regulated entities, suffered badly. Investment managers faced perverse incentives to take large gambles that could bring down not just their institutions but the whole edifice.
Special care needs to be taken to ensure that greed and avarice does not prevail over prudence and caution so that such devastating consequences are avoided. Broadly speaking, it is high time to have a rethink on the very idea of free markets and capitalism. Time has come to evolve a form of capitalism where everything works under a broad regulatory framework and we do not see a repeat of this condition where greed of few affects the lives of billions.
# U.S. Census Bureau. 26 October 2007.
# The End of the Affair, The Economist, 30th October, 2008
# "New home sales fell by record amount in 2007 - Real estate - MSNBC.com". 2008.
# “Economist-A Helping Hand to Homeowners”. The Economist, 23rd October, 2008
# The Estimated losses for major banks as of August 2008 were-Citigroup: $55.7bn, UBS: $44bn, Merrill Lynch: $51.7bn, HSBC: $27.6bn, Bank of America: $21.9bn, Morgan Stanley $14.6bn, Royal Bank of Scotland: $15bn, JP Morgan Chase: $14.7bn, Washington Mutual: $14.3bn, Deutsche Bank: $10.5bn, Wachovia: $22.3bn, Credit Agricole: $7.6bn, Credit Suisse: $10.3bn, Lehman Brothers:$8.2bn, Mizuho Financial $5.5bn, Bear Stearns: $3.2bn, Barclays: $9.2bn,Goldman Sachs: $3.5bn., Societe Generale: $6.8 bn, Lloyds TSB: $5bn, Fortis:$7.4bn,BNP Paribas :$4bn .
# In March 2009, Britain's Daily Telegraph reported the following declines in industrial output, from January 2008 to January 2009: Japan -31%, Korea -26%, Russia -16%, Brazil -15%, Italy -14%, Germany -12%, Italy and Greece-6.6%
# The ILO has predicted that at least 20 million jobs will have been lost by the end of 2009 due to the crisis. In the US alone, there have been 5.1 million job losses till March 2009 since the recession began in December 2007
# Money Market is actually an inter-bank market where banks borrow and lend money among themselves to meet short-term need for funds
# Canada’s GDP growth was negative in Q1 and the recession officially started in Q4. Ireland in the first quarter of 2008 reported a contraction in GDP of 1.5%. In Germany the economy contracted by as much as 1.5 %in the second quarter because of declining export orders. France’s economy declined by by 0.3%, Finland by 0.2% while the Netherlands showed zero growth in the second quarter, Denmark showed a contraction of 0.6% in the first quarter of 2008 following a contraction of 0.2% in the fourth quarter of 2007. The economy of Brazil shrank 3.5% in the fourth quarter of 2008. Argentina’s has been seeing its growth rate forecast reduced from nearly 7% in 2008 to 0% in 2009. Australian economy contracted by 0.5% in the last quarter of 2008. New Zealand's economy contracted 0.3 percent in the first quarter. The IMF predicts GDP growth for China will drop from 9.7% in 2008 and to 8.5% in 2009. HongKong economy is predicted to grow at 2 % in 2009. Singapore's economy saw its biggest drop in five years in the second quarter, falling by 6.6 %
# The Hindu Business Line, 5th August, 2009
# The Economic Times, 13th February, 2009
# “Now, pharma exports facing recession blues”, The Hindu Business Line, 4th March, 2009
# Shankar Acharya, Business Standard, 11th December, 2008
# The Hindu Business Line, 26th March, 2009
# Main features were- Plan, non-plan expenditure of Rs.300,000 crore ($60 billion) in four months, Across-the-board cut of four percent in the ad valorem and central value-added tax, Interest subvention of two percent on export credit for labour intensive sectors, Additional allocations for export incentive schemes, Full refund of service tax paid by exporters to foreign agents, Incentives for loans on housing for up to Rs.500,000, and up to Rs.2 million, Limits under the credit guarantee scheme for small enterprises doubled, Lock-in period for loans to small firms under credit guarantee scheme reduced, India Infrastructure Finance Company allowed to raise Rs.100 billion through tax-free bonds, Norms for government departments to replace vehicles relaxed, Import duty on naphtha for use by the power sector is being reduced to zero, Export duty on iron ore fines eliminated, Export duty on lumps for steel industry reduced to five percent
# The main features were- State governments were allowed to borrow an additional 0.5 per cent of their Gross State Domestic Product (GSDP), amounting to about Rs 30,000 crore, for capital expenditure, The package provided for liberalisation of External Commercial Borrowing norms and raising FII investment limit in rupee-denominated instruments to $15 billion from $6 billion now, the package also withdrew exemptions on countervailing duties on cement, TMT bars and structurals that were originally given to contain inflation. Indian Infrastructure Company Limited was allowed to borrow Rs 30,000 crore by issuing tax-free bonds, Non-banking finance companies (NBFCs) would be provided a line of credit by the public sector banks, the RBI will provide a credit line of Rs 5,000 crore to Exim Bank, which will provide export credit at a time when financial institutions have developed a risk-aversion to lending.
# The main features were- Package included a 2 per cent cut in the median excise duty and service tax rates—down from 10 per cent to 8 per cent, the 4 per cent across-the-board reduction in excise duty announced as part of the first package in early December was extended beyond March 31, 2009, States will not be penalized for having to borrow, up to certain limits, for investment in infrastructure and other employment-generating schemes, duty concession on naphtha for production of power segment will carry on beyond Mar 31, 2009
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