Financial Crisis Ppt Fms 1

Recession to Recovery: A Road Map

S. S. Das [email protected]

"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 Presentation What is Recession? Why Financial Crisis? The Genesis of the current problem Impact on world financial system and

world Economy Global Response Impact on India India’s Response Way Ahead

What is Recession? 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”

Recession Vs Depression The joke that economists quote to explain the Difference between “Recession & Depression” RECES SION = WHEN YOUR NEIGHBOR LOSES HIS JOB

DEPRE SSION = WHEN YOU LOSE YOUR JOB

Recession is nothing new Recessions 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 Recession General 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; Wars Change in the nature of the business cycle due to Globalization;

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: 3. 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 4. 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 rates 5. 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 assetbased securities: Collateralized Debt Obligations (CDOs).  Securities are repacked, leveraged, tranched, and resold many times over camouflaging the underlying risks 7. So called innovation of exotic products;

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,

Rise of CDS business

As 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 trillion more than the combined gross domestic product of the entire world ($54 trillion),

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 base 9. Globalization of the financial system  leading to large scale arbitrage of funds and flight of capitals

Collapse of Mortgage Market CDSs 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 freeze

Inter bank lending almost stops Crisis spread to other assets and institutions Flight of capital leads to Meltdown of the stock markets across the

Impact of the Crisis Current crisis appears worse than even a liquidation crisis Lack of mark to market accounting creates uncertainty as to who is solvent Government rescue policies inconsistent (Lehman was allowed to sink) Nobody knows who will survive and parties refuse to lend to each other Financial system freezes!

Spread of the Crisis and Impact Meltdown 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, BRICs

Mark to Market Accounting System to value that

stock according to market values

capital 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 cash Lead to rise in Demand for Dollar and fall in

Impact of the Crisis Collapse of Financial Institutions in several

parts of the world Lehman Brothers; AIG, Freddie Mac and Fannie Mae etc. Central Banks in vulnerable countries such as Iceland become Bankrupt Investors across the globe lost huge amount of their investments Severe Credit squeeze and Liquidity crunch for the industry Housing; Automobiles; Retail; Services etc.

Impact of the Crisis…. Crisis of confidence leads consumer

aversion to spending Fall in housing and real estate prices Fall in Demand for goods and services Resorting to Trade Distorting Protectionism

Leads to drop in international trade in

commodities and services Gets into a Vicious Cycle Job cuts and serious unemployment problem followed

Onset of a recessionary spiral

tarting Point = Unwillingness to buy

How to come out of recession 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 have 2 policy instruments Fiscal Policies (By Govt.)

Monetary Policies (By Central Banks)

Central Banks manipulate Governments influence the economy by changing howthe available supply of The Governments spend money in the country and collect money

How to come out of recession?

Government influences the economy by changin Fiscal how it (Government) spends and collects money Policies 1] Tax cuts for businesses or for individuals

More money available for spending

2] More Spending by Govt. to create jobs

Individuals get salary and spend money

3] Automatic fiscal policy; Unemployment Insurance

Some income to unemployed people to spend

Demand picks up; Market can recover;

How to come out of recession?

Central Bank manipulates the available supply Monetary of money in the country Policies

More money 1] Reduce reserve available for bank ratio to give loans

Demand picks

Individuals take 2] Lower the up; Market interest rates more loan

can recover;

3] Use its own reserved money to buy Govt. bonds

It becomes an income to Govt. to inject money into the market

Global Response to the Crisis Varied Response and Intervention to protect

financial system and the tumbling economy  Short 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 made to 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 government Facilitation of mergers and acquisitions. Large Scale Government bailout packages for affected industries  US 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

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

Road Ahead: Third phase of Response Action 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

Road Ahead: G-20 initiatives Issue of misallocation of resources across the

globe Role of the “Invisible Hand of the Market Forces” and Government Intervention G-20 Initiatives New Financial Architecture: Global coordination and oversight of Financial

Market Executive Compensation Regulation of Derivative Segments of Financial Market

Fourth Phase of Global Response The 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

Depression Financial capitalism brought enormous economic and social benefits to hundreds of millions of people

It is possible that financial repression will

follow with nationalization of banks, severe control of

lending and trading, etc

More likely, will get more regulation This might be a good idea Good examples: securities and banking

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 lending Over reaction to inflation during the first half of 2008 and tightening of monetary policy

Impact on India

Significant Currency devaluation Demand 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 India External 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 Intervention Broad direction of the interventions on

monetary policy side has been to 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 Intervention Easing 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 Intervention Directed at stimulating demand for goods

and services through tax cuts Counter-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