Deceleration Of Economic Growth In Developed Countries And Its Implications On Indian Economy

Deceleration of economic growth in developed countries and its implications on Indian economy

Table of Contents Introduction ..................................................................................................................................... 3 Financial crisis – a close look ......................................................................................................... 4 US financial crisis ........................................................................................................................... 6 The rise of risky debt .................................................................................................................. 6 The root through Asian financial crisis ................................................................................... 6 US Housing market boom ....................................................................................................... 7 The fall of risky debt ................................................................................................................... 8 Impact of financial crisis on US...................................................................................................... 9 Did Emerging Markets decouple from industrialized nations? .................................................... 11 Implications on Indian Economy .................................................................................................. 12 Trade between India and US ..................................................................................................... 12 Black Monday – an another evident ......................................................................................... 13 Macroeconomic Indicators........................................................................................................ 14 GDP....................................................................................................................................... 14 IIP .......................................................................................................................................... 14 PMI ....................................................................................................................................... 15 Impact on various sectors.......................................................................................................... 15 Exports .................................................................................................................................. 15 Metals .................................................................................................................................... 16 Entertainment ........................................................................................................................ 16 Others .................................................................................................................................... 16 India’s guardian angel ............................................................................................................... 17 RBI measures ............................................................................................................................ 17 Learnings....................................................................................................................................... 19 The Road Ahead ........................................................................................................................... 20 References ..................................................................................................................................... 23

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Introduction Year 2007 has seen the deceleration in the world output growth. The developed economies witnessed the weaker demand which reduced the global economic growth to 3.4% from 3.7%, roughly the average rate recorded over the last decade. On the other hand, the contribution of the developing countries to global output growth in 2007 exceeded 40% and the growth in the developing regions was nearly three times the rate recorded in the developed regions. Since 2000 the developing economies maintained the sustained growth of 8 to 10%. The least developed countries also are not the exception. Economic expansion in the least-developed countries fully matched the growth rate recorded by developing countries. But, the domestic demand which contributes more than 50% of the United States output has become weak that in turn reduced the annual GDP to 2.2% the weakest since 2002. Europe recorded GDP growth of 2.8 per cent – a somewhat better performance than both Japan (2.1%) and the United States last year. Higher export earnings and rising investment stimulated the Russia’s economic growth and observed the strongest annual rate of 8% since 2000. In Central and South America, Africa, the Middle East and developing Asia, economic expansion rates showed no signs of deceleration in 2007. The most populous developing countries – China and India – continued to report outstandingly high economic growth. However, what worries more economists is the current financial crisis which soon became the global crisis by which everyone of us are feeling the heat. What appeared to be just a housing market bubble burst in US finally ballooned into a financial crisis that has led to the economic downturn globally. Some of the largest and most venerable banks, investment institutions, and insurance companies have either declared bankruptcy or have had to be rescued financially. Late 2008, credit flows froze, lender confidence dropped, and one after another the economies of countries around the world dipped toward recession. The crisis exposed fundamental weaknesses in financial systems worldwide, and despite coordinated easing of monetary policy by governments and trillions of dollars in intervention by governments and the International Monetary Fund, the crisis continues. This financial crisis which began in industrialized countries quickly entered a second phase in which emerging market and other economies have been struck hard. Investors have pulled their capital in a large chunk from countries, even those with small levels of perceived risk, and caused values of stocks (no wonder India’s stock exchange went down like a mad during the past three months) and domestic currencies to plunge. Also, slumping exports and commodity prices have added to the woes, pushing economies world-wide toward recession. The global crisis now seems to be played out on two levels.  The first is among the industrialized nations of the world where most of the losses from subprime mortgage debt, excessive leveraging of investments and inadequate capital backing credit default swaps (insurance against defaults and bankruptcy) have occurred.

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

The second level of the crisis is among emerging market and other economies who may be ―innocent bystanders‖ to the crisis but who also may have less resilient economic systems that can often be whipsawed by actions in global markets. Most industrialized countries seem to able to finance their own rescue packages by borrowing domestically and in international capital markets, but emerging market economies may have insufficient sources of capital and may have to turn to help from the International Monetary Fund (IMF) or from capital surplus nations, such as Russia, Japan, and the European Union. On the other hand, there has been number of questions raised after the financial downturn. No need to mention about the blame game. What to blame? Securitization or Inaccurate Credit Rating or Market to Market accounting or widespread shortage of liquidity or Financial Globalization or Failure of Basel II?

Financial crisis – a close look Financial crises of some kind occur sparsely virtually every decade and in different locations around the world. In the past, financial meltdowns have occurred in countries ranging from Sweden to Argentina, from Russia to Korea, from the United Kingdom to Indonesia, and from Japan to the United States. These crises can be damaging and contagious, prompting calls for swift policy responses. The financial crises of the past have led affected economies into deep recessions and sharp current account reversals. Some crises turned out to be contagious, rapidly spreading to countries with no apparent vulnerabilities. Economists classify these financial crises into three: 1) Systemic banking crisis - A country’s corporate and financial sectors experience a large number of defaults and financial institutions and corporations face great difficulties repaying contracts on time. As a result, non-performing loans increase sharply and all or most of the aggregate banking system capital is exhausted. This situation may be accompanied by depressed asset prices (such as equity and real estate prices) on the heels of run-ups before the crisis, sharp increases in real interest rates, and a slowdown or reversal in capital flows. 2) Currency crisis - A nominal depreciation of the currency of at least 30 percent that is also at least a 10 percent increase in the rate of depreciation compared to the year before. In terms of measurement of the exchange rate depreciation, the percent change of the end-ofperiod official nominal bilateral dollar exchange rate from the World Economic Outlook (WEO) database of the IMF is generally used. For countries that meet the criteria for several continuous years, the first year of each 5-year window is used to identify the crisis. 3) Sovereign debt crisis

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Amazingly between 1970 and 2007 alone, there had been 124 systemic banking crisis, 208 currency crisis and 64 episodes of sovereign debt crisis. Each financial crisis is unique, yet each bears some resemblance to others. Among the many causes of financial crises have been combinations of unsustainable macroeconomic policies (including large current account deficits and unsustainable public debt), excessive credit booms, large capital inflows, and balance sheet fragilities, combined with policy paralysis due to a variety of political and economic constraints. In many financial crises currency and maturity mismatches were a salient feature, while in others off-balance sheet operations of the banking sector were prominent. Moreover it was observed that the most of the banking crises tend to coincide with currency crisis, while they rarely coincide with sovereign debt crises. Macroeconomic conditions are often weak prior to a banking crisis. Fiscal balances tend to be negative, current accounts tend to be in deficit and inflation often runs high at the onset of the crisis. Nonperforming loans tend to be high during the onset of a banking crisis, running as high as 75% of total loans and averaging about 25% of loans. It is not always clear though to what extent the sharp rise of nonperforming loans was caused by the crisis itself or whether it reflects the effects of tightening of prudential requirements during the aftermath of the crisis. Government ownership of banks is common in crisis countries, with the government owning about 31% of banking assets on average. Bank runs are a common feature of banking crises, with 62% of crises experiencing momentary sharp reductions in total deposits. Banking crises are also often preceded by credit booms, with pre-crisis rapid credit growth in about 30 percent of crises. Average annual growth in private credit to GDP prior to the crisis is about 8.3% across crisis countries, and is as high as 34.1% in some cases. Crisis-affected countries often suffer from weak legal institutions, rendering a speedy resolution of distressed assets hard to accomplish. As each crisis arrives, policy makers express ritual shock; then proceed to break every rule in the book. The alternative is unthinkable. When the worst is passed, participants renounce crisis apostasy and pledge to hold firm next time. Each time many actions or policies of preventing the expansion of a hostile influence and crisis resolution policies were taken. The emergency liquidity support and blanket guarantees are two commonly used containment measures. Liquidity support is clearly the most common first line of response in systemic crises episodes and it accounts for more than 70% of the crises. Blanket guarantees are often introduced to restore confidence even when previous explicit deposit insurance arrangements are already in place and they are used in roughly 27% of crisis episodes. Coming to resolution policies, Regulatory forbearance is a common feature of crisis management. The policy objective aims at a gradual recovery of the banking system over time, or a gradual transitioning towards stricter prudential requirements. The latter is a common outcome whenever modifications to the regulatory framework are introduced. Another important policy used in the resolution phase of banking crises is recapitalization of banks. Regarding monetary and fiscal policies, monetary policy tends to be fairly neutral during crisis episodes, while the fiscal stance tends to be expansive, arguably to support the financial and real sectors, and to accommodate bank restructuring and debt restructuring programs. It was observed that the IMF has participated 5

through programs in about 50% of the episodes. Fiscal costs, net of recoveries, associated with crisis management can be substantial, averaging about 13.3% of GDP on average, and can be as high as 55% of GDP.

US financial crisis The rise of risky debt The root through Asian financial crisis The present financial crisis takes us back to 1997-98 Asian financial crises that were triggered by the devaluation of the Thai Currency (the baht) in July 1997, which prompted attacks on East Asian currencies and stocks. This situation was accentuated when Malaysia took a snap decision to ban short-selling— the sale of a borrowed stock in anticipation of buying it back later at a cheaper price. The ban on short-selling caused some investors to sell up all together and leave the market. Consequently, the Malaysian currency (the ringgit) plunged to a new all-time low, prompting fresh attacks on East Asian currencies. Panic selling set in amid fears of rising interest rates and slowing economic growth, causing large capital outflows and a flight-to-quality phenomenon with investors seeking a safe haven for their funds. So finally the East Asian countries Thailand, Indonesia and South Korea had to borrow from IMF to service their short term foreign debt and to cope with a dramatic drop in the values of their currency and deteriorating financial condition. During the crisis in 1997, the East Asian Countries were provided financial support packages from various sources such as IMF, World Bank, Asian Development Bank, the United States and Japan. As a resolution measure, not only the East Asian countries but also most of the developing countries were determined not be caught with insufficient foreign exchange reserves. Subsequently they began to accumulate dollars, Euros, pounds and yen in record amounts. By mid-2008, world currency reserves by governments had reached $4.4 trillion with China’s reserves alone approaching $2 trillion, Japan’s nearly $1 trillion, Russia’s more than $500 billion, and India, South Korea, and Brazil each with more than $200 billion. The accumulation of hard currency assets was so huge in some countries that they diverted some of their reserves into sovereign wealth funds that were to invest in higher yielding assets than U.S. Treasury and other government securities. As mentioned earlier, the underlying causes of the global financial crisis most likely can be attributed to a combination of factors. Both the macroeconomic and microeconomic factors contributed their part to build up the bubble. By that what we mean is, the excess liquidity coupled with financial practices & regulations led to the housing market boom. In addition to these factors, the political situation in U.S. also enabled more Americans to buy homes.

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US Housing market boom Following the Asian financial crisis, the ―dot-com boom‖ resulted in the world’s ―hot money‖ to flow into high technology companies stocks. But the spring of 2000 saw the value of equities of many high technology firms collapsing. This dot-com bust along with thirst to make more money, the countries’ capital began to flow into housing markets in most of the countries. At the same time, china and other countries invested much of their foreign exchange accumulations into U.S. Treasury and other securities. This helped to keep U.S. interest rates low. The subsequent lower mortgage interest rates coupled with political environments enabled more Americans to buy homes. Thus, the excess liquidity fueled domestic demand and in particular residential investment, triggering a significant rise in housing prices which more than doubled in short span of time. At the same time, the industry practices by financial institutions and the factors related to financial regulation also played a crucial role in the build-up of the bubble. The ―originate-anddistribute‖ lending model adopted by many financial institutions during this period seems to have worsened the problem. Under this approach, banks made loans primarily to sell them on to other financial institutions that in turn would pool them to issue asset-backed securities. The underlying rationale for these loan sales was a transfer of risk to the ultimate buyer of the security, backed by the underlying mortgage loans. These securities could then be pooled again and new instruments would be created and so forth. A mispricing of risk of mortgage-backed securities linked to subprime loans led the market to believe that there was an arbitrage opportunity. Such market perception fueled demand for these instruments and contributed to deterioration in underwriting standards by banks in an attempt to increase the supply of loans to meet the demand for securitized instruments. Regulatory oversight missed the build-up of vulnerabilities induced by this process on the account that risks were being transferred to the unregulated segment of the market. The premise was that heavily regulated banks would only be originators and the ultimate holders of securities were beyond the scope of regulation. In this process, however, spillover effects and systemic risks seem to have been neglected by regulators, and the regulated segment ended up being significantly affected. In other words the housing boom coincided with the popularity of the securitization of assets, particularly mortgage debt into collateralized debt obligations (CDOs). On the other hand, in order to cover the risk of defaults on mortgages, particularly subprime mortgages, the holders of CDOs purchased credit default swaps (CDSs). A ―credit default swap‖ is a ―credit derivative contract‖ in which one party (protection buyer) pays a periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity. The reference entity is not a party to the credit default swap. These are a type of insurance contract (a financial derivative) that lenders purchase against the possibility of credit event (a default on a debt obligation, bankruptcy, restructuring, or credit rating downgrade) associated with debt, a borrowing institution, or other referenced entity. The purchaser of the CDS does not have to have a financial interest in the referenced entity, so CDSs quickly became more of a speculative asset than an insurance policy. As long as the credit events (defaults) never occurred, issuers of CDSs 7

could earn huge amounts in fees relative to their capital base (since these were technically not insurance, they did not fall under insurance regulations requiring sufficient capital to pay claims, although credit derivatives requiring collateral became more and more common in recent years). The sellers of the CDSs that protected against defaults often covered their risk by turning around and buying CDSs that paid in case of default. As the risk of defaults rose, the cost of the CDS protection rose. Investors, therefore, 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 credit default swaps had reached $62 trillion, more 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.

The fall of risky debt To reiterate the points again: the origins of the financial crisis point toward three developments that increased risk in financial markets.  The first was the originate-to-distribute model for mortgages. The originator of mortgages passed them on to the provider of funds or to a bundler who then securitized them and sold the collateralized debt obligation to investors.  The second development was a rise of perverse incentives and complexity for credit rating agencies. Credit rating firms received fees to rate securities based on information provided by the issuing firm using their models for determining risk.  The third development was the blurring of lines between issuers of credit default swaps and traditional insurers. In essence, financial entities were writing a type of insurance contract without regard for insurance regulations and requirements for capital adequacy (hence, the use of the term ―credit default swaps‖ instead of ―credit default insurance‖). Much risk was hedged rather than backed by sufficient capital to pay claims in case of default. When the housing bust began in late 2006, the interest rate started going up and economic growth began to slow down. These along with above mentioned problems led to the rise in default mortgages (particularly sub-prime mortgages) and other securities. By July 2008, the notional value of CDSs had declined to $54.6 trillion and by October 2008 to an estimated $46.95 trillion. The system of CDSs generated large profits for the companies involved until the default rate, particularly on subprime mortgages, and the number of bankruptcies began to rise. Soon the leverage that generated outsized profits began to generate outsized losses, and in October 2008, the exposures became too great for companies such as AIG. How the current financial crisis differs from many previous financial crises, especially in developing countries, is that the US and UK have thus far not suffered from a sudden stop of capital flows, which has caused major economic stress in other countries. The dollar did depreciate against the Euro in the years preceding the 2007 turmoil, but demand for US assets did not contract sharply, possibly because of the dollar’s use as a reserve currency. Also, the 8

speed and breath with which stress in US mortgage markets have spread to other continents, financial institutions (notably securities firms), and financial markets (notably money markets) seems to have been fueled by uncertainty about the unfolding of the subprime crisis, as it became more clear that risk had been mispriced and exposures had not been transparent.

Impact of financial crisis on US The plunge downward into the global financial crisis did not take long. It was triggered by the bursting of the housing bubble and the ensuing subprime mortgage crisis in the United States, but other conditions have contributed to the severity of the situation. Banks, investment houses, and consumers carried large amounts of leveraged debt. Some of the largest and most venerable banks, investment houses, and insurance companies have either declared bankruptcy or have had to be rescued financially. 1) $100 billion bailout of Fannie Mae and Freddie Mac 2) Merrill Lynch sold to Bank of America 3) Lehman Brothers filed the bankruptcy 4) Federal Reserve’s $85 billion rescue package to AIG 5) Washington mutual bankrupted and rescued by JP Morgan 6) Bush signs $700 billion economic stabilization plan An immediate indicator of the rapidity and spread of the financial crisis has been in stock market values. As values on the U.S. market moved downward dramatically, those in other countries also were swept down in the undertow. Declines in stock market values reflected huge changes in expectations and the flight of capital from assets in countries deemed to have even small increases in risk. Many investors, who not too long ago had heeded financial advisors who were touting the long term returns from investing in the BRICs pulled their money out nearly as fast as they had put it in. Currency exchange rates serve both as a conduit of crisis conditions and an Data Source: Factiva database indicator of the severity of the crisis. As the financial crisis hit, investors fled stocks and debt instruments for the relative safety of cash often held in the form of U.S. Treasury or other government securities. That increased demand for dollars, decreased the U.S. interest rate needed to attract investors, and caused a jump in inflows of liquid capital into the United States.

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Another major impact that anyone thinks of during recession/economic slowdown is obviously the rise in unemployment rate. The employment situation in November 2008 clearly states how depth the impact of the financial crisis. According to the household survey data from United States Department of Labor, both the number of unemployed persons (~10.3 million) and the unemployment rate (~6.7%) continued to increase. Since the start of the crisis in December 2007, as recently announced by the National Bureau of Economic Research, the number of unemployed persons increased by 2.7 million and the unemployment rate rose by 1.7 percentage points. Moreover the unemployment rate is expected to go up to 7.5% by the end of year 2009. Sector Manufacturing Construction Professional and business services Health Care Automobile dealership

Job losses since December 2007 604,000 780,000 495,000 369,000 115,000

Data Source: Bureau of Labor statistics, United States Department of Labor

Percent

In November alone, the average workweek for production and nonsupervisory workers on private non-farm payrolls fell by 0.1 hour to 33.5 hours, seasonally adjusted - the lowest in the history of the series, which began in 1964. The index of aggregate weekly hours of production and non-supervisory workers on nonfarm payrolls fell by 0.9% in November. The manufacturing index declined by 1.4%. Without any doubt, lending is predominantly based on trust and confidence. As a result of financial crisis, trust and confidence evaporated as lenders reassessed lending practices and borrower risk. The Libor, the London Inter Bank Offered Rate, the interest rate banks charge for short term loans to each other indicates the trust among financial institutions. During the worst of financial crisis, this rate had doubled from 2.5% to 5.1% in October 2008 and even for a few days much interbank lending actually had stopped. The rise in the Libor coupled with the US monetary authority measures of lowering interest rate to stimulate lending led to widen the ―Ted Spread‖ – the difference between interest Quarter-to-Quarter Growth in Real GDP on Treasury bills and on the Libor for the 6 three months. The greater the spread indicates that the presence of greater anxiety in the marketplace. 4 The real GDP growth of US has also taken a toll. Though the early quarters 2 in 2007-08 showed the growth rate of ~5%, people are worrying about US going into 0 recession in early 2009. US slipping into IV I II III IV I II III IV I II III IV I II III Year 2004 to 2008 (Quarterwise) recession will undoubtedly have its own -2 Source: US Bureau of economic analysis say in the global economy slow-down. 10

Did Emerging Markets decouple from industrialized nations? The pace at which the crisis has impacted emerging market economies has taken many economists by surprise. Since the Asian financial crisis, many Asian emerging market economies enacted a policy of foreign reserve accumulation as a form of self-insurance to face a ―sudden stop‖ of capital flows and the subsequent financial and balance of payments crises. Actually, there are two additional factors that motivated emerging market to reserve accumulation. 1) Export-led growth strategy by many countries 2) A sharp rise in commodity prices Some countries, particularly China and certain oil exporters, also established sovereign wealth funds that invested the foreign exchange reserves in assets that promised higher yields.

Data Source: IMF

Though global trade and financial linkages between the emerging markets and the industrialized countries have continued to deepen in the recent past, many analysts believed that the growth of the emerging markets had been successfully decoupled from those of industrialized countries. The theory of decoupling supported that the emerging market countries have successfully developed their own economies and it was found that while economic growth was highly synchronized between developed and developing countries, the impact of developed countries on emerging countries has decreased considerably over time. The proponents of the decoupling theory went on to say, ―in particular, emerging market countries have diversified their economies, attained high growth rates and increasingly become important players in the global economy. As a result, the nature of economic interactions between industrialized and emerging market countries has evolved from one of dependence to multi-dimensional interdependence‖. Even as late as six months ago, it was intellectually fashionable to subscribe to the 'decoupling theory'– that even if advanced countries went into a downturn, emerging economies will, at worst, be affected only marginally, and will largely steam ahead on their own. But, in a 11

rapidly globalizing world, the decoupling theory was never very persuasive; given the evidence of the last few months – capital flow reversals, sharp widening of spreads between sovereign and corporate debt, and abrupt currency depreciations – the decoupling theory has almost completely lost credibility. Growth prospects of emerging economies have most definitively been undermined by the ongoing crisis with, of course, considerable variations across countries. For example IMF announced series of financial rescue packages to developing markets, $2.1 billion two year loan to Iceland, a $16.5 billion agreement with Ukraine, a $15.7 billion package for Hungary and so on. On the other hand, the countries like Brazil, India, Mexico and Russia drew down their reserves by more than $75 billion to protect their currencies from depreciating.

Implications on Indian Economy As the global trade and financial linkages between the emerging and developed economies have begun to strengthen, it was so visible that the financial crisis did not leave India either. As the impact on India unfolds, most analysts raised their eye brows and shocked by surprise. People even started questioning how India is affected when it tackled the Asian crisis at ease. Moreover India’s exports accounts only 15% of its GDP. The answer to both of their questions can be answered by ―Globalization‖. Common measure of globalization indicates that India’s two way trade (merchandise exports plus imports), as a proportion of GDP, grew from 21.2% in 1997 to 34.7% now. On the other hand, the expanded measure of globalization (the ratio of total external transactions) has increased from 46.8% in 1997 to 117.4% now. These two measures are clear evidence of how much Indian economy is integrated into the world economy. So as far as Indian economy is concerned, we have to look only at the collateral dimension. Collateral damages are in two forms:  One is through a generalized slowdown in the global economy, more specifically in the US. If the US slows down, then the decoupling for emerging markets cannot be too far away.  The other channel is typically we are getting more financially integrated across the world. Capital market integration means that if there is a liquidity crisis coming out of the subprime crisis.

Trade between India and US It seems that the direct effects of sub-prime on the Indian markets are pretty limited. The good part of the story is that unlike China, which had an export oriented economy, the Indian economy was based on the domestic market. The India's trade theory is changing a lot as it is turning out to be more of a manufacturing export oriented country. The net trade of services done by India accounts to about just 22% just reflecting the risk on trade services is tried to be minimized. Also in the current scenario the trade practices of India with US has decreased and

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on the other hand has relatively increased with China reflecting out that the risk of US recession has been deflected. % Share of India's Total Trade

Imports to India 13.44

11.64 10.65

17.5

4.4

5

7

2002-03

2003-04

2004-05

9.5

11.7

2005-06

2006-07

4.18

2002-03

Improt from US

6.99

6.52

7 4

9.8 8.25

10.8

2.8

10.63

Imports from China

4.94

2003-04

2004-05

China

2005-06

2006-07

US

Black Monday – an another evident The most immediate effect of that crisis on India has been an outflow of foreign institutional investment from the equity market. The liquidity crisis has just begun in the foreign market which might reflect out the Indian markets too as the FII's inflows has started drying up all around the globe after 'Black Monday'. Foreign institutional investors, who need to retrench assets in order to cover losses in their home countries and are seeking havens of safety in an uncertain environment, have become major sellers in Indian markets. The major chunk of FII investments from US would be negative as most of these investors will pull out money from the equity market, with European countries at a risk after the US crisis will restrict their investments in the domestic markets. In 2007-08, net FII inflows into India amounted to $20.3 billion. As compared with this, they pulled out $11.1 billion during the first nine-and-a-half months of calendar year 2008, of which $8.3 billion occurred over the first six-and-a-half months of financial year 2008-09 (April 1 to October 16). This has had two effects: in the stock market and in the currency market. In addition, this withdrawal by the FIIs led to a sharp depreciation of the rupee. Between January 1 and October 16, 2008, the RBI reference rate for the rupee fell by nearly 25 per cent, even relative to a weak currency like the dollar, from Rs 39.20 to the dollar to Rs 48.86. This was despite the sale of dollars by the RBI, which was reflected in a decline of $25.8 billion in its foreign currency assets between the end of March 2008 and October 3, 2008. It could be argued that the $275 billion the RBI still has in its kitty is adequate to stall and reverse any further depreciation if needed. But given the sudden exit by the FIIs, the RBI is clearly not keen to deplete its reserves too fast and risk a foreign exchange crisis.

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The result has been the observed sharp depreciation of the rupee. While this depreciation may be good for India’s exports that are adversely affected by the slowdown in global markets, it is not so good for those who have accumulated foreign exchange payment commitments. Nor does it assist the Government’s effort to rein in inflation.

Macroeconomic Indicators GDP

GDP (in %)

The gross domestic product growth (GDP) slipped from 9.3 % in September 2007 to 8.8 % in the two succeeding quarters, further to 7.9 % in June 2008 and to even lower 7.6 % in the September quarter of this year. 10 9.3 8.8 8.8 Quarterly GDP growth has slipped 9 7.9 7.6 8 below the 8 % mark for the first time 7 since December 2004. The 6 deceleration was caused equally by 5 4 slowing manufacturing and 3 agricultural sector, which saw a fall in 2 growth rate from 9 % and 4.6 % a year 1 0 earlier to 5 % and 2.7 % respectively Sept.07 Dec.07 Mar.06 Jun.08 Sept.08 in the last quarter. However, four Quarters quarters of slower growth may not be indication enough of a further decline as there have been past instances when GDP numbers have rebounded strongly from a depressed phase. IIP The IIP (Index of Industrial Production) numbers, which capture factory output, have historically shown a close correlation to the profit trends of the corporate sector. Growth in the 14

IIP index has declined from 12.2 per cent in October 2007 to a negative 0.4 percent this October. It is to be noted here that the contraction in IIP is the first reported in 15 years. If the steep increases in interest rates are indeed behind the slowdown in IIP, recent cuts in lending rates should help. However, we can expect a lag of a few quarters before the lower interest rates filter down to interest costs of companies.

Growth Rate in Industrial Production 10.9

10.6

8.9

8.3 7.4

7.4

5.4

4.8

4.4

1.3

May

June

July

2007

Aug

Sept

2008

PMI The PMI is a lead indicator of manufacturing output and is based on a survey of purchasing managers of 500 companies. It measures various indicators, ranging from purchases to new orders and output. The index declined from 57.3 in September to a record low reading of 45.8 in November. Assuming a reading of 50 implies a ―no change‖ scenario, the PMI number heralds a further decline in the IIP numbers in the future. A most probable reason for this could be the falling number of new domestic orders. This also adds to the trend of declining new export orders since September, and is a clear sign that the manufacturing slowdown has attained a domestic dimension.

PMI Output New Orders New Export Orders

November 45.8 44.6 43.2 46.7

October 52.2 54.1 54.4 49.7

September 57.3 61.7 62.6 53

Source: Bloomberg

Impact on various sectors Exports As compared to a deficit of $39 billion in April-September of 2007, India faced a deficit of $59.77 billion in its trade balance April-September of 2008. The growth of exports has drastically reduced from 19.3% in September 2007 to 10.4% in September 2008. We can assign this down trend to demand side and supply side factors. While the demand side factors include slack demand conditions in the global market following the sub-prime crisis and protectionist policy measures in the form of non-tariff barriers to name a few, the supply side factors involving government regulations and inability to provide 15

necessary logistics, higher borrowing cost Export Growth, in % which is 13% now as compared to 7-8% 45.7 during the early part of this decade are hurting India’s exports. The recent star performers of 31.2 27.6 26.9 Indian exports such as fertilizers, steel and 23.5 petrochemicals were successful because of 10.4 industry leaders in India taking initiatives on their own. Apr May Jun Jul Aug Sep Recession may be a cause of worry for exports from emerging economies such as 2008 India, but taking care of the supply-side factors will enable exporters to remain competitive and productive in this era.

Oct -15

Metals Various factors are responsible for the sudden change in the fortunes of the metals sector. First, there has been a lowering of the global growth expectation. This manifested itself when steel, copper and platinum prices crashed. Contraction in liquidity and rising inventories are also posing problems, which has also led to a rise in the LME stocks of base metals. Lastly, among market participants, there is a desperate desire to reduce risk exposure. Speculators holding long position in the futures market have exited by liquidating their positions. Indeed, there has been an aggressive shorting of the market. All these have sent the metals market on a tailspin. Entertainment The pause button has been pressed on 30 big Bollywood movies. Most of the listed entertainment companies and banks are backing out. As is evident, tight liquidity conditions are prevailing. According to a recent prediction due to the slowdown, the industry will be cut in size, the honeymoon phase between corporate houses and artists will be over, and there will be unavoidable correction. Others Other major impact was observed in automobile sales during the last six months alone. The sales, one of the first to bear the brunt of demand depression, have slumped. Be it commercial vehicles, two wheelers or passenger cars, everything has shown the negative growth in October month. Also the rail freight movement slowed down. This is the indicator by which one can deduce the exchange of goods between producers and consumers. This also followed the same trend as exports, automobile sales and other manufacturing sectors.

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Overall, wealth erosion has happened for large number of investors. It was observed huge job losses and insecurity of income & jobs. Finally as global economy gets worse, trade and FDI also had a big blow.

Growth Rate in Rail Freight 14.4 10.9

10.1 8.4

India’s guardian angel

9.5 8.18

7.8

5.4

Two years ago, Indian real estate -0.14 Jan Feb Mar Apr Jun Jul Aug Sep Oct market — commercial and residential alike — 2008 was every bit as effervescent as the US market. Yet Indian banks stayed on the sidelines and avoided most of the pain that has been suffered by the big American banks? Part of the reason is ingrained in the Indian culture. Indians are simply not as comfortable with credit as Americans. But there was also another factor, perhaps the most of important of all. India had a bank regulator who was anti-Greenspan. His name was Y V Reddy, and he was the governor of Reserve Bank of India (RBI). Seventy per cent of banking system in India is nationalized, so a strong regulator is critical. RBI had exactly the right man in the right job at the right time. He started sensing that real estate, in particular, had entered bubble territory. One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved — and then only to make construction loans. Then, as securitizations and derivatives gained increasing prominence in the world's financial system, the RBI sharply curtailed their use in the country. When Mr. Reddy saw US banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India. As a result, banks in India wound up holding onto the loans they made to customers. Seeing inflation on the horizon, Mr. Reddy pushed interest rates up to more than 20 per cent, which of course dampened the housing frenzy. He increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of capital banks were required to hold in reserve in case things went awry. He made banks put aside extra capital for every loan they made. In effect, Reddy was creating liquidity even before there was a global liquidity crisis. As a result the credit crisis has spread these past months, no Indian banks have come close to failing the way so many US and European financial institutions have. None have required the kind of emergency injections of capital that Western banks have needed. None have had the huge write-downs that were par for the course in the West.

RBI measures Contemporary economic history shows that all such crises as the one we are facing today are engendered by the monetary authority which then goes through the equally painful process of

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readjusting the interest rates to counter the crisis, and just as things start to seem better, it is time for the next round. In a very similar manner, RBI has taken some steps to tackle the scenario. The RBI had assiduously increased interest rates from May onwards to counter inflation and has now reverted to provide liquidity to address growth. This is in sync with what has been happening in so many banks across the world who has been trying to increase the flow of liquidity as well as lowering interest rates. The lowering of the rates by the Federal Reserve once again to 1 per cent (with an effective rate of 0.25 per cent now) brings in the feeling of déjà vu as this was also the situation when the derivative-cum-housing bubble evolved. The RBI has taken several measures aimed at infusing rupee as well as foreign exchange liquidity and to maintain credit flow to productive sectors of the economy. Measures aimed at expanding the rupee liquidity included significant reduction in the cash reserve ratio (CRR), reduction of the statutory liquidity ratio (SLR), opening a special repo window under the liquidity adjustment facility (LAF) for banks for on-lending to the non-banking financial companies (NBFCs), housing finance companies (HFCs) and mutual funds (MFs), and extending a special refinance facility, which banks can access without any collateral. The Reserve Bank is also unwinding the Market Stabilization Scheme (MSS) securities, roughly synchronized with the government borrowing programme, in order to manage liquidity. The Reserve Bank has also instituted a rupee-dollar swap facility for banks with overseas branches to give them comfort in managing their short-term funding requirements. To improve the flow of credit to productive sectors at viable costs so as to sustain the growth momentum, the Reserve Bank signaled a lowering of the interest rate structure by reducing its key policy rate viz., the repo rate by 250 basis points from 9.0 per cent as on October 19 to 6.5 per cent by December 8, 2008. But the announcements made relating to provisioning requirements are quite alarming. RBI has reduced provisioning requirements on standard assets for residential housing loans as well as personal loans to .40% from 1% and 2% respectively. Banks have always thought these sectors to be lucrative. Actually this has been helpful in improving the bottom line. In fact, it could be more enticing for banks to lend more to the unrated companies today where they could charge a higher rate at a time when their spreads are under pressure, without the encumbrance of higher provisioning. However there are many who feel that this is not a right approach as it is analogous to lowering the pass marks in an exam so that more students can pass, in other words ―fatal‖. Hence the monetary authority, RBI whose function is to monitor liquidity and ensure that the rate structure is in consonance with the overall macroeconomic targets that have been set forth in terms of inflation and growth should exercise prudence in determining how far it can go in protecting the banking system.

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Learnings As the crisis exposed fundamental weaknesses in worldwide financial systems, the process for coping with the crisis across the globe has been manifest in four basic phases. 1) Intervention to contain the contagion and restore the confidence in the system 2) Coping with the secondary effects of the crisis, particularly the slowdown in economic activity and flight of capital from countries in emerging markets 3) Make changes in the financial system to reduce risk and prevent future crises 4) Dealing with political and social effects of the financial turmoil Also, financial intermediation is indispensable for the success of an economy as it acts as a bridge between people who need funds and people who save and insist upon safe and liquid outlets for their money. Acting as the bridge involves risk – credit, market, event and maturity. One of the main institutions performing this role is commercial banks. The children of the bull market have realised that they too are not invincible after all and are humbler, wiser and more careful with their trading acumen. The current downtrend will help brokers sharpen their skills as analysts. It’s worth mentioning about the action plan announced after the G-20 nation’s leaders’ summit which includes 1) Addressing the weaknesses in accounting and disclosure standards for off-balance sheet vehicles 2) Ensuring that credit rating agencies meet the highest standards and avoid conflicts of interest, provide greater disclosure to investors, and differentiate ratings for complex products 3) Ensuring that firms maintain adequate capital, and set out strengthened capital requirements for banks’ structured credit and securitization activities 4) Developing enhanced guidance to strengthen banks’ risk management practices, and ensure that firms develop processes that look at whether they are accumulating too much risk 5) Establishing processes whereby national supervisors who oversee globally active financial institutions meet together and share information 6) Expanding the Financial Stability Forum to include a broader membership of emerging economies Also it was observed that though the emerging markets have diversified their economies and the interaction between countries has evolved from one of dependence to multidimensional interdependence in the recent past, they were not able to completely decouple themselves from financial crisis. This is mainly due to strong global financial and trade inter-linkages. This concludes that it would be very difficult for any countries to isolate completely themselves from the crises if it happens in future. Below are the some of the learning from sub-prime crisis for India:

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Sound banking practices: The root cause of the sub-prime mortgage crisis is the unsound credit practices that emerged in the US market. Fake certification, which helps an ineligible person to raise a home loan, cannot be ruled out in India. Housing loan frauds are not uncommon in the cities of India and the aggressiveness with which housing loans are being sold by banks and financial companies in violation of sound credit practices cannot be ignored. Personal loans and overdue credit cards are the other sectors which the regulators and bankers should handle carefully because they have the potential to plunge the Indian banking sector into a crisis. Controlled Derivatives market: Derivatives are financial instruments, which can spread the default risk attaching to loans. All the same, indiscriminate use of such derivatives can lead to havoc as in US. Derivatives lead to such a chain reaction that it will be nearly impossible to quantify the risk of exposure to bad loans and advances subsequently. RBI and GOI should prohibit indiscriminate use of such derivatives if they intend to introduce such products in India. Limited investment by Indian companies abroad: Prudent investment abroad should be the order of the day. Reckless investment in the derivatives market abroad by banks and financial institutions has to be controlled. In the recent crisis, BNP Paribas of France and Macquarie Bank of Australia have been affected because of such overseas investments. The exposure of Indian banks to the sub-prime crisis of US is minimal. Quality Inward Investment: FDI should be given priority over FIIs as history has shown that flight of capital in case of FDI is low compared to that in respect of FIIs. Due to their stable nature, FDI can help in the growth of the country's infrastructure.

The Road Ahead India’s economy has been one of the glittering stars in global business in recent years. The growth has been supported by markets reforms, huge capital inflows, foreign exchange reserves rise and both an IT and real estate boom. As we have seen, like most of the countries India also is facing the economy slowdown in 2008. Whilst gloom seems to be the overriding signal coming out of the world markets, it is exactly such times which should prompt us to look at the new opportunities that are emerging and develop the themes with courage into a new world order. All we have to is to amplify weak signals, see a pattern of opportunity and have the courage to pursue them. Looking ahead, what do we do now? 

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The slow-down in the global economy will definitely create strains on the local economy as well. As we have recognized the full impact now, the country’s GDP will slow to around 7% this year and 5-6% next year. We need to act aggressively on both monetary and fiscal fronts. The drivers which can help us in aggressive action are low inflation, low oil and commodity prices and liquidity available in SLR, CRR. We can take a bet and aggressively lower interest and duties to kick the economy which should bring our growth rate back to the blooming 8%. Merge and Emerge is the new mantra in the globalized economy. Dealmakers see more multinational firms with strong balance sheets acquiring Indian companies. The strategy 20

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would be to get a bigger presence in one of the few markets where they can hope to grow when the global economy is going through the bad patch. At the same time, India Inc would use this market meltdown to acquire global technologies at lower cost for future expansion besides building a base in developed markets. Another area which can see a lot of M&A activity is distressed assets. With the global economic slowdown, the domestic industry would see consolidation in various sectors where the inefficiently managed players would be bought over. Given the correction in the stock market, promoters’ expectations looking to sell-out has also moderated which would allow M&As to sail through. If entrepreneurial journey is all about managing risk and crises, it is baptism of fire for entrepreneurs. The ability to bounce back from crises is something most entrepreneurs have in abundance. So it’s right time to look ahead with big thinking to tap the untapped opportunities. The global recession may not be such a bad thing for the country’s $50 billion IT-BPO sector. Most industry players believe that the ability to grow up the value chain and also the emergence of some new business will see Indian companies emerging stronger in 2009, despite uncertainties in the markets that bring most of their revenues. The focus for the IT industry will be to expand market coverage in verticals, geographies and services. Companies with strong values and an ability to adapt will thrive. Though the projected growth has come down to 21-24% from 30%, the IT-BPO industry still will grow at a decent pace as more global companies will offshore work to cut cost. Companies will also have to look at the domestic market, mainly large government contracts, to reduce their dependence on global business. There are immense opportunities in e-governance in India with states like MP, Tamil Nadu, Maharashtra and Bihar having undertaken major e-governance initiatives. Real estate is the second largest employer in India after agriculture. In the last five years alone the real estate and construction industry has grown at a compounded rate of more than 35% per annum. Considering the housing and construction sector have been one of the important sector contributing to the country’s GDP, the constructions sector if properly motivated could increase the country’s GDP growth by at least 2%. The private sector, government and local authorities will have to join hands to cause a housing revolution and ultimately lead to creation of affordable housing to all. The reason we say is because there is no denying fact that if the economy has to maintain its growth momentum, the real estate sector cannot be held back for long. Internationally the financial services sector is said to grow at approximately 1.5-2 times of economic growth – the Indian financial services sector has grown pretty at the same range, with estimated growth of 16% per annum over the last five years. While the Indian banking sector has shown strong growth in the last few years, the profitability has been well aided by Treasure profits during a period of falling interest rates. Going ahead, there are two main areas for emphasis: 1) consolidation and recapitalization 2) operational aspects. The process of consolidation and capitalization of the Indian Banking sector, if undertaken, can evolve a mutually beneficial relationship for the sector with financial sponsors, including private 21

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equity investors. These are investors who have the largest investible capital pools in present times, and who can enable long-term investment horizons of 10-15 years. This will also come with the benefits of heightened focus on corporate governance, risk management practices, international business associations and international industry best practices which are long term drivers for a more productive industry. With the largest economies of the world coming under the grip of a recession, the clamor for protectionist measures is bound to become louder. In fact, there should be higher import duties to protect local players form cheap imports from countries such as Russia, Ukraine and China. With their major markets – the US, Europe and Japan – shrinking due to recession, exporters from these countries are left with no option but to liquidate their inventories at any cost. So if the government want India to grow, then protectionist measures are vital. In any case there has been a sharp fall in global trade ever since the liquidity crisis started. There should be a two-pronged strategy to tackle this – raise customs duties and levy lower duties in the local market. In 2008, financial markets around the world were a casualty of Murphy’s Law – anything that could go wrong, did go wrong. Investor money will once again start flowing into India. Also one can be optimistic about the prospects of telecom and drug companies, along with state-run banks. But for the long term, still one can bet on automobile companies.

As rightly quoted by India’s prime minister Dr. Manmohan singh ―in a typical Keynesian situation where there is a lack of demands, private sector demand is very weak, but strong government demand, both for social services and investments will provide the essential stabilizers‖. Today the Government is doing its best to help revive demand, be it in the form of bank rate cuts or a downward revision of excise. As the crisis evolves we may well see more stimulus packages of the kind through the year. Even though there is liquidity in the system, the banks are not willing to lend money to the firms. There is a lack of credit for manufacturing and retail borrowers because banks have become risk-averse. Banks must move away from government securities and open up to lending to private firms. On the other hand one has to keep in mind that major public spending will boost private sectors and banks confidence. Their positive impact on the macro-economic situation will benefit all. But the key differentiator among corporates would lie in their capacity to transform the evolving situation in their favor through brave action. An ability to look beyond the immediate and the obvious will be critical. In today’s crisis situation the key hence would lie in not getting deterred by the gloomy forecast for tomorrow but building a perspective for ―the day after‖. Surviving the present danger is compelling worry of the weak, winning in the aftermath is a compulsive thought for the brave.

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References 1) CRS Report RL34742, The US Financial Crisis, by Dick K. Nanto. U.S. Foreign affairs, defense and trade division, ―The Global Dimension with Implications for U.S. Policy‖. November 2008 2) Reuters. Factbox - Global foreign exchange reserves. October 12, 2008. 3) U.S. Joint Economic Committee, ―Chinese FX Interventions Caused international Imbalances, Contributed to U.S. Housing Bubble,‖ by Robert O’Quinn. March 2008. 4) International Swaps and Derivatives Association, ISDA Applauds $25 Trillion Reductions in CDS notional, Industry Efforts to Improve CDS Operations. News Release, October 27, 2008. 5) CRS Report RL34412, Averting Financial Crisis, by Mark Jickling. U.S. Joint Economic Committee, ―The U.S. Housing Bubble and the Global Financial Crisis: Vulnerabilities of the Alternative Financial System,‖ by Robert O’Quinn. June 2008. 6) CRS Report RL34336, Sovereign Wealth Funds: Background and Policy Issues for Congress, by Martin A. Weiss. 7) International Swaps and Derivatives Association, ISDA Applauds $25 Trillion Reductions in CDS notional, Industry Efforts to Improve CDS Operations. News Release, October 27, 2008. 8) The global financial crisis: An African Perspective, Mohammed Nureldin Hussain, Kupukile Mlamba and Temitope Oshikoya, 1998. 9) The employment situation: November 2008, released by Bureau of Labor Statistics, United States Department of Labor, December 5, 2008. 10) The economic times, News daily 11) www.rbi.gov.in 12) www.worldbank.org 13) www.sebi.gov.in 14) www.businessline.in 15) Business Today

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