LEARNING WITH THE TIMES: Anatomy of a crisis
12 Oct 2008, 0051 hrs IST,TNN (Times News network)
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.
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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
bargain-basement 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 would 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 risk-averse. 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
few years offered spectacular returns but have always been considered
'risky'. It is not surprising that they have got the short shrift in
the flight to safe haven.
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. It is true
that our economy depends more on domestic rather than external
drivers, a fact that we keep touting endlessly. However, it is also
true that we have embraced 'globalization' fairly enthusiastically
over the past decade-and-a- half.
This, from an economic perspective, means two things. For one, we
depend more on external markets to sell our goods and services. In
1995-96, for instance, we sold 9.1% of our goods abroad. In 2007-08,
we sold 13.5% of our goods to foreign buyers. It also means that we
depend more on external funds to support our growth.
In the last fiscal year alone, we borrowed $29 billion from foreign
lenders and got $34 billion of foreign direct investment. A global
recession would hurt external demand. 'Risk-aversion' among
international lenders could limit access to international capital.
Both India's financial markets and the real economy will be hurt in
the process. Suddenly, the 9% growth target does not seem that
'doable' any more; we should be happy to clock 7% this fiscal year and
the next.
The sell-off in the stock markets is not entirely the effect of global
contagion. To a degree, it reflects anxieties about our prospects of
future growth. The blood-letting in the financial markets is unlikely
to stop soon. Governments and central banks (the RBI's counterparts)
are trying every trick in the book to stabilize the markets. They have
pumped hundreds of billions of dollars into their money markets to try
and unfreeze their inter-bank and credit markets. Large financial
entities have been nationalized. The US government has set aside $700
billion to buy the 'toxic' assets like CDOs that sparked off the
crisis. Central banks have got together to co-ordinate cuts in
interest rates. None of this has stabilized the global markets. Thus,
it is impossible to predict when the haemorrhage will stop and what
will stem it.
That said, history tells us that financial crises end as suddenly as
they start. I would not be surprised if by early next year, the worst
of the mayhem is over. The wounds that it leaves behind could,
however, take much longer to heal.
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