Liquidity Crunch And Its Corrective Mechanisms

LIQUIDITY CRUNCH AND ITS CORRECTIVE MECHANISMS A STUDY OF THE INDIAN AND GLOBAL RESPONSE

By: Adnan Khan Rushdia Khan Misbah-ul-Islam Amritanshu Pandey Asad Hasan Siddiqui BA Economics Hons. 3rd Year, JMI

CONTENTS

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LIQUIDITY: FORMULATING A BASIC UNDERSTANDING

3

THE WORLD’S TRYST WITH LIQUIDITY SO FAR

6

THE SITUATION TODAY

9

THE CHALLENGES BEING POSED

14

THE FIGHT BACK

21

REFERENCES

24

SOURCE ARTICLES

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LIQUIDITY – FORMULATING A BASIC UNDERSTANDING: -

Various sources tell us that these are the definitions of Liquidity: •

The degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by a high level of trading activity.

•

The ability to convert an asset to cash quickly. Also known as "marketability".

•

Liquidity means how easy it is to buy and sell a financial instrument for cash without causing any significant change in its price.

•

Liquidity refers to the ease with which investments can be converted to cash at their present market value. Additionally, liquidity is a condition of an investment that shows how greatly the investment price is affected by trading.

•

A function of volume and activity in a market. It is the efficiency and cost effectiveness with which positions can be traded and orders executed. A more liquid market will provide more frequent price quotes at a smaller bid/ask spread.

However, for all practical purposes the term liquidity is used in various ways, all relating to availability of, access to, or convertibility into cash. An institution is said to have liquidity if it can easily meet its needs for cash either because it has cash on hand or can otherwise raise or borrow cash. Similarly, a market is said to be liquid if the instruments it trades can easily be bought or sold in quantity with little impact on market prices. Also, an asset is said to be liquid if the market for that asset is liquid. The common theme in all three contexts is cash. A corporation is liquid if it has ready access to cash. A market is liquid if participants can easily convert positions into cash. An asset is liquid if it can easily be converted to cash. The liquidity of an institution depends on: i.

The institution's short-term need for cash;

ii.

Cash on hand;

iii.

Available lines of credit;

iv.

The liquidity of the institution's assets;

v.

The institution's reputation in the marketplace—how willing will counterparties be to transact trades with or lend to the institution?

The liquidity of a market is often measured as the size of its bid-ask spread, but this is an imperfect metric at best. More generally, Kyle (1985) identifies three components of market liquidity: i.

Tightness is the bid-ask spread; Page | 3

ii.

Depth is the volume of transactions necessary to move prices;

iii.

Resiliency is the speed with which prices return to equilibrium following a large trade.

Persaud (2001) identifies a fourth component, which he calls diversity. This is simply the degree of diversity among market participants in their market views and desired trades. Persaud argues that lack of diversity can lead to liquidity black holes. These are conditions where liquidity dries up, and a decline (or increase) in prices brings out more sellers (or buyers), further exasperating the price move. This is the exact opposite of what would be expected in a regularly functioning market, where, a price decline would bring out bargain hunters. Perhaps the classic example of a liquidity black hole is the 1987 stock market crash.

Examples of assets that tend to be liquid include foreign exchange, stocks traded on the New York Stock Exchange or on-the-run Treasury bonds. Assets that are often illiquid include limited partnerships, thinly traded bonds or real estate. ____________________

CREDIT CRUNCH – CONVERGING ONTO THE PROBLEM: -

A credit crunch is a sudden reduction in the general availability of loans (or credit), or a sudden increase in the cost of obtaining loans from banks.

There are a number of reasons why banks may suddenly increase the costs of borrowing or make borrowing more difficult. It may be due to an anticipated decline in value of the collateral used by the banks when issuing loans, or even an increased perception of risk regarding the solvency of other banks within the banking system. It may be due to a change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises interest rates or reserve requirements) or even may be due to the central government imposing direct credit controls or instructing the banks not to engage in further lending activity.

A credit crunch is often caused by a sustained period of careless and inappropriate lending which results in losses for lending institutions and investors in debt when the loans turn sour and the full extent of bad debts becomes known. These institutions may then reduce the availability of credit, and increase the cost of accessing credit by raising interest rates. In some cases lenders may be unable to lend further, even if they wish, as a result of earlier losses.

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The crunch is generally caused by a reduction in the market prices of previously "overinflated" assets and refers to the financial crisis that results from the price collapse. In contrast, a liquidity crisis is triggered when an otherwise sound business finds itself temporarily incapable of accessing the bridge finance it needs to expand its business or smooth its cash flow payments. In this case, accessing additional credit lines and "trading through" the crisis can allow the business to navigate its way through the problem and ensure its continued solvency and viability. It is often difficult to know, in the midst of a crisis, whether distressed businesses are experiencing a crisis of solvency or a temporary liquidity crisis.

In the case of a credit crunch, it may be preferable to "mark to market" - and if necessary, sell or go into liquidation if the capital of the business affected is insufficient to survive the post-boom phase of the credit cycle. In the case of a liquidity crisis on the other hand, it may be preferable to attempt to access additional lines of credit, as opportunities for growth may exist once the liquidity crisis is overcome.

A prolonged credit crunch is the opposite of cheap, easy and plentiful lending practices (sometimes referred to as "easy money" or "loose credit"). During the upward phase in the credit cycle, asset prices may experience bouts of frenzied competitive, leveraged bidding, inducing hyperinflation in a particular asset market. This can then cause a speculative price "bubble" to develop. As this upswing in new debt creation also increases the money supply and stimulates economic activity, this also tends to temporarily raise economic growth and employment.

Often it is only in retrospect that participants in an economic bubble realize that the point of collapse was obvious. In this respect, economic bubbles can have dynamic characteristics not unlike Ponzi schemes or Pyramid schemes. As prominent Cambridge economist John Maynard Keynes observed in 1931 during the Great Depression: "A sound banker, alas, is not one who foresees."

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THE WORLD’S TRYST WITH LIQUIDITY SO FAR After learning the basics of what liquidity and liquidity crunch are, let us, before we go ahead with the present scenario, have a close look at a similar situation that rose in the past and also that how it affected the global market

THE GREAT DEPRESSION: -

In 1929 a panic on the New York Stock Exchange introduced a world-wide decline of business activities. International trade and industrial production dropped sharply. Wages shrank, unemployment rose, and widespread misery proved that something was wrong with the economic system. The whole world felt the impact of this economic dislocation but some countries suffered more acutely than others. The effects of the Great Depression in the United States you are no doubt familiar with by now. Here we will simply attempt to estimate its influence on the world as a whole. This is a difficult task because values and currencies fluctuated sharply and accurate statistics are unavailable for many regions. Even when dependable calculations on production and consumption were compiled, and on prices, wages, and unemployment, such figures did not tell the whole story. There is no yardstick for measuring human misery, no formula for computing what the loss of a job, increasing privation, and the necessity of asking for public relief may mean to a man and his family.

Still less is it possible to estimate what the shrinkage of international trade meant to inarticulate millions in Asia, Africa, and Latin America, who found they could not sell their crops and raw materials in the declining world markets. For the nations that felt its effects most severely the Great Depression had the qualities of a nightmare. Some malign irresistible force seemed to have seized control and all efforts to arrest the decline appeared futile. Banks collapsed, factories closed down, millions of workers were discharged from their jobs. The disaster had struck without warning. No one could explain clearly what had gone wrong; no one could foretell how much worse conditions might become. These uncertainties produced a sense of helplessness and despair. The Great Depression left an indelible memory behind, particularly among the people of the United States. Fears that a similar economic collapse might overtake the world again still haunt millions of people even yet. It is important, therefore, to judge the Great Depression calmly in the perspective of history. It was a great misfortune, but it was neither so ominous nor as mysterious as some of the legends told about it suggest. What people in America and Europe noted most inescapably about the Depression was the reduction of their incomes. In addition to millions of wage earners who were thrown out of work entirely, millions more became part-time laborers. Even those who kept full-time jobs often had to accept a reduction in wages. In the United States the per capita income fell from Page | 6

about $700 in 1929 to some $400 in 1933. Most of the European people suffered in similar fashion. Only Soviet Russia, which had almost isolated itself from the rest of the world, escaped the effects of the Depression. But the Russian people, especially in the Ukraine, suffered severely for several years after 1929 from other causes. The forcible attempt to establish collective farms brought misery and death to millions of Russian farmers.

A second effect of the Depression which filled many people with apprehension was that international trade and manufacturing shrank rapidly. In 1929 the estimated value of United States imports and exports had reached almost ten billion dollars. By 1933 the value had dropped to three billion. Furthermore, American industrial output was cut in half. The world as a whole, however, weathered the storm somewhat better. Although prices dropped sharply and the "dollar value" of international trade fell more than 60 per cent, the actual decline in the cargoes shipped was about 25 per cent. World industrial output likewise suffered less sharply than that of the United States, falling about one-third in four years. It is important to realize the statistics on the decline of national income, of industrial production, and of international trade provided a gloomier picture from 1929 to 1933 than the actual world conditions warranted. The majority of the world's workers did not make their living from industry or trade; they supported themselves through agriculture. If the world food supply had dropped 60 or 50 or even 25 per cent between 1929 and 1933, mankind would have faced a much greater tragedy.

The dislocation of trade and industry, the falling prices, and the rising unemployment that came with the Depression forced statesmen and economists to seek remedies. But the experts could not agree in their diagnoses of what was wrong or what measures would prove most effective in restoring prosperity. Each nation sought to improve its own condition and some of the selfish measures adopted by individual governments made world conditions worse. Why this was so becomes clearer when the programs followed by the leading states are examined. On June 20, 1931, President Herbert Hoover proposed a moratorium, a suspension of payments on intergovernmental debts for one year. But the Depression had grown too serious and involved for any simple remedy, and Hoover's proposal failed to arrest the decline.

The spread of financial confusion, constricting the flow of world trade upon which Great Britain depended for prosperity, forced the British government to abandon the gold standard in September, 1931. The pound sterling immediately fell 20 to 30 per cent in value. For the British this result was not entirely a loss, for their debts could now be paid in devaluated pounds; and the reduction in wages made British manufactures relatively cheaper and therefore more welcome on the international market. Eighteen months later (April, 1933) the United States likewise abandoned the gold standard, although the major share of the world gold reserve was in this country. Soon the currencies of all the leading nations were unhinged from any fixed value, and the unpredictable fluctuations of the dollar, pound, franc, mark, or Page | 7

lira added a further hazard to discourage businessmen from the risks of international commerce. Without fixed policies, respect for contracts, and a stable unit of money with which to reckon costs and prices, traders could not negotiate or bankers calculate the prospects of a project or the worth of securities. All of these factors, which were at once causes and effects, increased the disastrous fall in world commerce after 1929. For that year the total international trade within Europe exceeded $11 billion (1929 dollar value). Trade between European and non-European countries reached $15 billion. Five years later foreign trade within Europe had shrunk to $4 billion (1929 dollar value), and European trade with the rest of the world to $5 billion.

Thus we can see that the Great Depression ushered in a time of great and grave uncertainty. We will see later how experts like Jahangir Aziz tell us that certainty is one of the first steps to providing liquidity. The Great Depression saw countless assets being devalued within moments, numerous investments losing all monetary credence, and a sudden but serious choke on the supply of loans for further investments. It took a protectionist yet revisionist New Deal by Roosevelt to loosen the screws and inject the world certainty and optimist that was the first step in bringing about a liquidity revival. So serious was the Great Depression, and so historic its impact, that already the current crisis is being called another Great Depression, that of liquidity. Rightly so? We will see…

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THE SITUATION TODAY: “The global economy today, is in a tough spot, caught between sharply slowing demand in many advanced economies and rising inflation everywhere, notably in emerging and developing economies. Global growth is expected to decelerate significantly in the second half of 2008, before recovering gradually in 2009. At the same time, rising energy and commodity prices have boosted inflationary pressure, particularly in emerging and developing economies. Against this background, the top priority for policymakers is to head off rising inflationary pressure, while keeping sight of risks to growth. In many emerging economies, tighter monetary policy and greater fiscal restraint are required, combined in some cases with more flexible exchange rate management. In the major advanced economies, the case for monetary tightening is less compelling, given that inflation expectations and labor costs are projected to remain well anchored while growth weakens noticeably, but inflationary pressures need to be monitored carefully.”

Global growth decelerated to 4½ percent in the first quarter of 2008 (measured over four quarters earlier), down from 5 percent in the third quarter of 2007, with activity slowing in both advanced and emerging economies. However, recent indicators suggest a further deceleration of activity in the second half of 2008. In advanced economies, business and consumer sentiment have continued to retreat, while industrial production has weakened further. There have also been signs of weakening business activity in emerging economies. Accordingly, global growth is projected to moderate from 5 percent in 2007 to 4.1 percent in 2008 and 3.9 percent in 2009 (see table). The picture is clearer on a fourth-quarteron-fourth quarter (q4/q4) basis: growth would decelerate from 4.8 percent in 2007 to 3.0 percent in 2008, before picking up to 4.3 percent in 2009.

• Growth for the United States in 2008 would moderate to 1.3 percent on an annual-average basis, an upward revision to reflect incoming data for the first half of the year. Nevertheless, the economy is projected to contract moderately during the second half of the year, as consumption would be dampened by rising oil and food prices and tight credit conditions, before starting to gradually recover in 2009. Growth projections for the euro area and Japan also show a slowdown in activity in the second half of 2008. • Expansions in emerging and developing economies are also expected to lose steam. Growth in these economies is projected to ease to around 7 percent in 2008–09, from 8 percent in 2007. In China, growth is now projected to moderate from near 12 percent in 2007 to around 10 percent in 2008–09. Risks to the global growth outlook are seen as balanced around the revised baseline. Financial risks remain elevated, as rising losses in the context of a global slowdown could add to strains on capital and exacerbate the squeeze on credit availability. Moreover, as discussed Page | 9

below, inflation is a rising concern and will constrain the policy response to slower growth. On the positive side, demand in advanced and emerging economies might be more resilient than projected to recent commodity price and financial shocks, as was the case during the first quarter of 2008.

Risks related to global imbalances also remain a concern. The continuing decline in the U.S. dollar and slower growth of the U.S. economy relative to its trading partners has put the current account deficit on a more sustainable trajectory. However, the pattern of exchange rate adjustments has borne little relationship to the pattern of current account balances, as the euro and other flexible currencies have carried the brunt of U.S. dollar adjustment and there has been less movement in currencies of several emerging economies recording large external surpluses. Moreover, rising international oil prices have raised projected current account surpluses of oil exporting countries.

Inflation Is Increasingly a Problem Inflation is mounting in both advanced and emerging economies, despite the global slowdown. In many countries, the driving force behind higher inflation is higher food and fuel prices. Oil prices have risen substantially above previous record highs in real terms, driven by supply concerns in the context of limited spare capacity and inelastic demand, while food prices have been boosted by poor weather conditions on top of continued strong growth in demand (including for biofuels).

In advanced economies, headline inflation rose to 3.5 percent in May 2008 (12-month change), and, while core inflation remained at 1.8 percent, central banks have expressed growing concern. The increase in inflation is more marked and broader in emerging and developing economies, where headline and core inflation have risen to 8.6 percent and 4.2 percent, respectively, the highest rates since around the beginning of the current decade. In these economies, food and fuel make up a larger share of consumption baskets and sustained strong growth has tightened capacity constraints.

Looking forward, in advanced economies, inflationary pressures are likely to be countered by slowing demand and, with commodity prices projected to stabilize, the expected increase in inflation for 2008 is forecast to be reversed in 2009. In emerging and developing countries, inflationary pressures are mounting faster, fueled by soaring commodity prices, above-trend growth, and accommodative macroeconomic policies. Hence, inflation forecasts for these economies have been raised by more than 1.5 percentage points in both 2008 and 2009, to 9.1 percent and 7.4 percent, respectively.

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Food and Fuel Price Increases Have Pushed Some Countries to a Tipping Point Commodity prices, particularly those of fuel and foods, have surged. Inflationary pressures around the world have intensified; purchasing power in commodity-importing economies has been eroded; and some low- and middle-income countries face difficulties in ensuring adequate food supplies for their poorest citizens and are in danger of losing the gains in macroeconomic stability achieved in recent years.

Passing on the full price increases to consumers would encourage producers to increase supply and consumers to reduce demand. However, temporary and targeted social measures are also needed to help to cushion the impact of rising food and fuel prices. Furthermore, a multilateral effort is needed to address both the effects and the causes of the crisis. Some lowincome countries will need help from the international community to finance imports and social spending. Others will need help in designing policies to adjust to the shock. In addition, there is a need for multilateral efforts to promote better supply-demand balance in commodities markets, including stronger responses to higher prices.

Financial Market Turbulence Remains a Significant Downside Risk Financial market conditions remain difficult. Forceful policy responses to the financial turbulence and encouraging progress toward bank recapitalization seemed to have reduced concerns about a financial meltdown but, as events over the past week have underlined, markets remain fragile amid concerns about losses in the context of slowing economies. At the same time, extension of new credit will be constrained by the need to repair balance sheets. Accordingly, credit conditions in advanced economies are expected to remain tight in the coming quarters and efforts aimed at advancing balance sheet repair in financial sectors need to continue.

The world is at severe risk of a global systemic financial meltdown and a severe global depression The U.S. and advanced economies' financial systems are now headed towards a nearterm systemic financial meltdown as day after day stock markets are in free fall, money markets have shut down while their spreads are skyrocketing, and credit spreads are surging through the roof. There is now the beginning of a generalized run on the banking system of these economies; a collapse of the shadow banking system, i.e. those non-banks (broker dealers, nonbank mortgage lenders, SIV and conduits, hedge funds, money market funds, private equity firms) that, like banks, borrow short and liquid, are highly leveraged and lend and invest long and illiquid, and are thus at risk of a run on their short-term liabilities; and now a roll-off of the short term liabilities of the corporate sectors that may lead to widespread bankruptcies of solvent but illiquid financial and non-financial firms. Page | 11

On the real economic side, all the advanced economies representing 55% of global GDP (U.S.A, Eurozone, UK, other smaller European countries, Canada, Japan, Australia, New Zealand, Japan) entered a recession even before the massive financial shocks that started in the late summer made the liquidity and credit crunch even more virulent and will thus cause an even more severe recession than the one that started in the spring. So we have a severe recession, a severe financial crisis and a severe banking crisis in advanced economies.

There was no decoupling among advanced economies and there is no decoupling but rather re-coupling of the emerging market economies with the severe crisis of the advanced economies. By the third quarter of this year global economic growth will be in negative territory signaling a global recession. The re-coupling of emerging markets was initially limited to stock markets that fell even more than those of advanced economies as foreign investors pulled out of these markets; but then it spread to credit markets and money markets and currency markets bringing to the surface the vulnerabilities of many financial systems and corporate sectors that had experienced credit booms and that had borrowed short and in foreign currencies. Countries with large current account deficits and/or large fiscal deficits and with large short-term foreign currency liabilities and borrowings have been the most fragile. But even the better performing ones – like the BRICs club of Brazil, Russia, India and China – are now at risk of a hard landing. Trade and financial and currency and confidence channels are now leading to a massive slowdown of growth in emerging markets with many of them now at risk not only of a recession but also of a severe financial crisis.

The crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity where excessive leveraging and bubbles were not limited to housing in the U.S. but also to housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies: an housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression.

At this point the recession train has left the station; the financial and banking crisis train has left the station. The delusion that the U.S. and advanced economies contraction would be short and shallow – a V-shaped six month recession – has been replaced by the certainty that this will be a long and protracted U-shaped recession that may last at least two years in the U.S. and close to two years in most of the rest of the world. And given the rising risk of a global systemic financial meltdown, the probability that the outcome could become a decade long Lshaped recession – like the one experienced by Japan after the bursting of its real estate and equity bubble – cannot be ruled out. Page | 12

And in a world where there is a glut and excess capacity of goods while aggregate demand is falling, soon enough we will start to worry about deflation, debt deflation, liquidity traps and what monetary policy makers should do to fight deflation when policy rates get dangerously close to zero.

At this point the risk of an imminent stock market crash – like the one-day collapse of 20% plus in U.S. stock prices in 1987 – cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown.

This disconnect between more and more aggressive policy actions and easings, and greater and greater strains in the financial market is scary. When Bear Stearns' creditors were bailed out to the tune of $30 bn in March, the rally in equity, money and credit markets lasted eight weeks; when in July the U.S. Treasury announced legislation to bail out the mortgage giants Fannie and Freddie, the rally lasted four weeks; when the actual $200 billion rescue of these firms was undertaken and their $6 trillion liabilities taken over by the U.S. government, the rally lasted one day, and by the next day the panic had moved to Lehman's collapse; when AIG was bailed out to the tune of $85 billion, the market did not even rally for a day and instead fell 5%. Next when the $700 billion U.S. rescue package was passed by the U.S. Senate and House, markets fell another 7% in two days as there was no confidence in this flawed plan and the authorities. Next, as authorities in the U.S. and abroad took even more radical policy actions between October 6th and October 9th (payment of interest on reserves, doubling of the liquidity support of banks, extension of credit to the seized corporate sector, guarantees of bank deposits, plans to recapitalize banks, coordinated monetary policy easing, etc.), the stock markets and the credit markets and the money markets fell further and further and at accelerated rates day after day all week, including another 7% fall in U.S. equities today.

When in markets that are clearly way oversold, even the most radical policy actions don't provide rallies or relief to market participants. You know that you are one step away from a market crash and a systemic financial sector and corporate sector collapse. A vicious circle of deleveraging, asset collapses, margin calls, and cascading falls in asset prices well below falling fundamentals, and panic is now underway.

At this point anything short of these radical and coordinated actions may lead to a market crash, a global systemic financial meltdown and to a global depression. The time to act is now.

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THE CHALLENGES BEING POSED: All that we have seen till yet is only the tip of the iceberg, more is yet to come. We have heard and seen the liquidity crunch, but now the time is to feel it and face it. We bring out the problems arising out of the this crunch

Consequences of liquidity tightness In the best of times, banks are highly leveraged and thus highly fragile. Relatively small shocks can drive a bank into bankruptcy. Banking systems are inherently unable to absorb such stress on liquidity for an extended period.

For this reason, the liquidity crisis needs to be resolved in days and not weeks. In particular, banks who were using money market financing either in rupees or in dollars have faced increased costs and quantity risk in achieving this financing. This has led to acute stress for some banks. Under these conditions, some depositors might have fears about the soundness of a bank and exit, thus exacerbating the problem. A worrisome scenario is one where under the acute pressure of a liquidity crisis, technical failures in settlement take place at one or two banks. Given the prevalence of OTC transacting by banks, and given the low quality of IT systems at most banks, such a scenario cannot be ruled out.

If the newspapers carry stories about settlement failure by one or more banks, it would send out a very bad image to the domestic and international community, of an India engulfed in a banking crisis, even though the failure in settlement might only be a small technical problem involving a few crore rupees. When external shocks interacted with the existing operating procedures for monetary policy, this gave acute instability in the money market, the bond market, the equity market, corporate treasuries of Indian multinationals, and banks. This upsurge of financial instability reflects deeper structural problems of monetary policy and the bond market, and needs to be comprehensively addressed.

The Downturn Spreads In the last few months, the downturn has widened to the rest of the world economy as growing financial turmoil and a darkening outlook have caused households and businesses to prepare for a long and deep slump by retrenching. Retail sales have fallen in each of the previous months. But the Census Bureau measures Page | 14

sales in cash terms rather than by volume, so the headline numbers tend to be distorted by changes in the price of gasoline, as well as financing programmes and deep discounting designed to shift auto inventories. A better guide to the underlying strength of the consumer sector is "core sales" of items other than autos and gasoline. Core sales fell in both August and September, the largest cumulative decline since the immediate aftermath of the attacks on the World Trade Centre and Pentagon, the first consecutive monthly decline in more than a decade. Core sales have risen on average just -0.12 percent in each of the last 12 months. Since even core inflation has been running faster than this, sales volumes have been flat or falling for a year. But the pace of decline has accelerated sharply in recent weeks. Slowing consumer spending and business investment is now working through to falling output. Manufacturing production slumped in September (-2.7 percent) and for the first time losses were concentrated outside motor manufacturing (-3.0 percent) as producers responded to falling orders by slashing output to prevent a buildup of unsold inventory. ISM reports that 46 percent of survey respondents reduced production and 40 percent cut employment last month. Even so, 52 per cent of manufacturers reported a fall in new orders and 50 percent reported shrinking order books. The pace of job losses picked up sharply in September, with private-sector employers eliminating 168,000 positions (net basis) and most of the job cuts coming from industries other than construction and autos (-115,000). The market is braced for a further big fall in nonfarm employment when data for Oct is published on Friday. The downturn is now spreading internationally. Purchasing surveys show declines in output, orders and employment in all three of the major euro zone economies last month. The European Commission has already accepted that the euro zone economy is in recession.

In the United Kingdom, with its construction and financial-services dependent economy, real gross domestic product fell 0.5 percent during Q3. Japan's economy was already shrinking in Q2 and the slide looks set to intensify during Q3, with the purchasing index falling further and further into negative territory. The main bright spot in an otherwise gloomy picture is continued growth in China and some of the other emerging economies of Asia and the Middle East. But even here, there are signs that export-led economies are slowing as the recession hits their main customer-base in North America and Western Europe. Page | 15

IT Companies Bear the Brunt For IT companies, there seems to be a slowdown on the revenue front. Sequential revenue growth in the last three quarters of top Indian IT companies such as Infosys, Wipro, Satyam, HCL Tech has been erratic.

After hitting growth rates of 5-9% for January-March quarter, revenues have grown at a moderate pace of 2-5% in the latest July-September quarter, an analysis shows. Cognizant has been the lone warrior as it has maintained a steady rate, moving in the narrow band of 6-7% aided by surprising and above-average growth in the troubled financial services segment. TCS, the country's largest software company, has been slow to get off the mark but sequential revenue growth rate has picked up in the recently concluded quarter, off a lowerbase. "Results for services mark a new low point. Appetite for offshore services remains well below trend, and we remain cautious on the space, with both TCS and Wipro," Sarah Friar of Goldman Sachs Global Investment Research said. She estimates revenue growth of Indian IT services to fall to 12% in 2009, from 29% in 2008. year with a 9% sequential growth in the January-March quarter, has seen revenue growth (measured quarter on quarter) slump to 3.9% in April-June and then 2.3% in the just concluded July-September quarter.

Likewise, HCL Technologies has seen sequential revenue growth unable to sustain the 5.2% rate in the three months ending January-March. It reported a mere 0.14% growth in revenues sequentially for the latest quarter.

Analysts paint a gloomy picture for Indian IT companies whose performance is intrinsically linked to US consumer spending (which is predicted to decline in OctoberDecember quarter).

"It is almost certain, if not already so, that consumer spending in the US is sharply decelerating into the fourth quarter of the calendar year. It is being generally predicted that consumer spending will decline in the current quarter, (October - December), by far the strongest quarter of spending in the US on account of the holiday season," Edelweiss Securities IT analyst Viju George says.

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He projects nominal earnings per share (EPS) growth of 3-6% in FY10 for TCS, Infy, Satyam, Wipro and HCL Tech as IT budget discussions (when decided, could lead to more work for Indian IT companies) at major clients are not only likely to get delayed, but also reduced.

Jobless ranks hit 10 million, most in 25 yrs Jobless ranks in US zoomed past 10 million last month, the most in a quarter-century, as piles of pink slips shut factory gates and office doors to 240,000 more Americans with the holidays nearing. Politicians and economists agreed on a painful bottom line: It's only going to get worse.

The unemployment rate soared to a 14-year high of 6.5 per cent, the government said Friday, up from 6.1 per cent just a month earlier. And there was more grim news from US automakers: Ford Motor Co. and General Motors Corp., American giants struggling to survive, each reported big losses and figured to be announcing even more job cuts before long.

Regulators, meanwhile, shut down Houston-based Franklin Bank and Security Pacific Bank in Los Angeles on Friday, bringing the number of failures of federally insured banks this year to 19.

The Federal Deposit Insurance Corp. was appointed receiver of Franklin Bank, which had $5.1 billion in assets and $3.7 billion in deposits as of Sept. 30, and of Security Pacific Bank, with $561.1 million in assets and $450.1 million in deposits as of Oct. 17. About 10.1 million people were unemployed in October, the most since the fall of 1983. More people have jobs now, since the population has grown, but it's still a staggering jobless figure. With employers slashing jobs every month so far this year, some 1.2 million positions have disappeared, over half in the past three months alone.

All the economy's woes — a housing collapse, mounting foreclosures, hard-to-get credit and financial market upheaval — will confront Obama when he assumes office in January. Unemployment is expected to keep rising during his first year in office, while record budget deficits will crimp his domestic agenda. October's jobless rate was the highest since March 1994 and now has surpassed the 6.3 per cent 2003 high after the most recent recession. The government also said job losses were Page | 17

worse than first reported for the preceding two months, 284,000 rather than 159,000 in September and 127,000 rather than 73,000 in August.

Many economists believe the unemployment rate will climb to 8 per cent or 8.5 per cent by the end of next year before slowly drifting downward. Some think unemployment could even hit 10 or 11 per cent — if an auto company should fail. In any case, the rate is likely to move higher even if the economy is on somewhat stronger footing by the middle of next year as some hope. That's because companies won't be inclined to ramp up hiring until they feel certain that a recovery has staying power. In the 1980-1982 recession- considered the worst since the Great Depression in terms of unemployment — the jobless rate rose as high as 10.8 percent in late 1982 just as the recession ended, before inching down. Factories, including auto makers, construction companies, especially home builders, retailers, mortgage bankers, securities firms, hotels and motels and educational services, all cut jobs. As did temporary help firms — a barometer of future hiring. All those losses more than swamped the few gains elsewhere, including in the government, health care and in accounting and bookkeeping. Private companies cut 263,000 jobs, the most since the country was beginning to emerge from the 2001 recession. It marked the 11th straight month of such reductions. The economy has lost its footing in just a few months. It contracted at a 0.3 per cent pace in the July-September quarter, signaling the onset of a likely recession. It was the worst showing since the 2001 recession, and reflected a massive pullback by consumers. As consumers watch jobs disappear, they'll probably retrench even further, spelling more trouble. Analysts say the economy is still shrinking in the current October-December quarter and will contract further in the first quarter of next year. All that more than fulfills a classic definition of a recession: two straight quarters of contracting economic activity.

UN agency links food crisis to meltdown The UN Food and Agriculture Organization(FAO) has cautioned that the impact of the current financial crisis on the agricultural sector could mean a surge in food prices in the coming year even as global cereal production is expected to hit a new record this year. Page | 18

In its bi-annual report 'Food Outlook', FAO noted that much of the boost in cereal production took place in developed countries, where farmers were in a better position to respond to high prices.

Developing countries, on the other hand, were largely limited in their capacity to respond to high prices by supply side constraints on their agricultural sectors.

For example, if the current price volatility and liquidity conditions prevail in 2008/09, plantings and output could be affected to such an extent that a new price surge might take place in 2009/10, unleashing even more severe food crises than those experienced recently.

FAO pointed out that the surge in food prices over the past year has increased the number of undernourished people in the world to an estimated 923 million, and this number could grow.

To feed a world population of more than nine billion people by 2050 (around six billion today), global food production must nearly double, according to FAO.

This requires addressing a number of challenges related to agriculture, including land and water constraints, low investments in rural infrastructure and agricultural research, expensive agricultural inputs, and little adaptation to climate change.

It also requires more investments in agriculture, machinery, tractors and water pumps, as well as more skilled and better-trained farmers and more efficient supply chains.

Global crisis hits India where it hurts most: Dip in exports The global economic crisis hit India where it hurts the most as over a dozen job-oriented export sectors slipped into disarray showing up to 70 per cent negative growth last month over a year-ago period.

An alarming sharp decline in export value in tea (-20 per cent), handicrafts (-70 per cent), carpets (-32 per cent), oil meals (-50 per cent), man-made yarn (-17 per cent), cotton yarn (-19 per cent) and marine products (-19 per cent), was reported.

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At a high level meeting, convened by Commerce Secretary G K Pillai on October 24, it was pointed out that the government needs to 're-look' at all export restrictions. "The global financial crisis is significantly impacting Indian exports and the impact could be more in the coming days," said an official involved in the stock-taking exercise.

With several sectors putting up a dismal show, the overall export growth in September this fiscal plunged to a little over 10 per cent from 26.9 per cent in August. Exports for the AprilAugust period had shown a growth of 35.1 per cent.

The US and the 27-nation European Union bloc, two of the largest markets for Indian exports, are in the midst of the worst economic crisis since the Great Depression of the 1930s. The volume of decline in international trade is also reflected in the crash in shipping rates. Rates for bulk cargo have dropped by nearly 50 per cent.

Ironically, the dismal export performance in September -- figures for which are yet to be officially released -- has come about in the face of close to 25 per cent depreciation in rupee value. A declining rupee results in better realisations for the exporters.

Although apart from the these problems many more hav risen, need of the hour is not to merely talk and discuss these problems, but to formulate plans and implement them in order to restructure the economies world over and saving them from turning to another massive Great Depression.

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THE FIGHT BACK: According to Jahangir Aziz, the chief economist of JP Morgan Chase, India: “if there ever was a time when the government needed to overreact to a situation, it is now. The drying up of global liquidity after the bankruptcy of Lehman Brothers has hit financial markets across the board in India with astounding ferocity and speed. And with that, market uncertainty has spiked to unprecedented levels.” This and much more comes from Aziz’s article in the October 24th issue of the Times of India. Aziz admits that it is a fine job to determine policies that meet the liquidity needs of businesses in such uncertain times. This is because the reasons a business needs liquidity differ from business to business. Yet, he confesses a pleasant surprise that the government has made the right policy changes. Let us take his help to understand how the problem of liquidity crunch can be dealt with, and specifically how it is being dealt by the Indian government. The first solution, as pointed out in the above article as well, is a cut in the CRR- cash reserve ratio. By October 24th, the government had cut the CRR by 250 basis points, and on November 2nd, by another 50 basis points. The cutting of the CRR is one of the conventional methods to deal with a liquidity crunch. The CRR cut on 2nd November released Rs. 40,000 crores into the market through the medium of banks. By no means a small amount. The CRR cut is often accompanied by other measures such as a cut in the Repo rate. On 2 November this cut was of 50 basis points, aimed towards the eventual softening of deposit and lending rates. A cut in the SLR (special lending rate) means that banks can borrow from the central bank at a lower rate. At the time of Aziz’s article the cut in SLR was of 150 basis points. nd

However, Aziz points out that these measures seem more reactive than anything. He calls for a set of “standing liquidity-injecting facilities” that will assure liquidity in times of uncertainty. We will return to his set of proposals but first let us move on and take a look at a more domestic picture with Chandrajit Banerjee, the Director General of CII. Banerjee counts liquidity as one of the five issues that are driving every economic agent towards being “risk-averseness” in his article “Driving Growth in Turbulent Times” in the Economics Times. Like Jahangir Aziz, he too admits that the government initiatives like repo rate cut are good but need to be followed up by more measures. His first suggestion, to cut the repo rate further to 7.5% was indeed done by the 2nd of November as seen above. Also, he feels that the government should look to shield the most vulnerable units of our industry- the SMEs. Since they will be disproportionately hurt by the non-availability of credit in these times of liquidity crunch, he suggests the setting up of a corpus to lend to SMEs. Page | 21

Further, he suggests that if there was a time to relax the FDI caps, then that time is now. Loosening of the caps in sectors like insurance, he says, will help in the increased inflow of foreign exchange. He also suggests that the EXIM Bank be allowed to borrow foreign exchange from the RBI to assist exporters. Lastly, he suggests that a fund be set up to inject some buoyancy and depth in the Indian capital markets so that manufacturing companies looking to raise capital can do so effectively- taking the funds from RBI’s forex reserves. While naming these suggestions on the monetary side, he also asks the government to consider speedy release of government funds for various projects to ensure the timely implementation and generation of economic activity. Given the above context we can now return to Jahangir Aziz, who feels that foreign sources of liquidity are important. The reason for this, he says, lies in the funding models of Indian businesses, banks, and mutual funds, many of which rely on money markets abroad to fund their loans. Thus when the global interest rates shot up after September 15th, the cost of borrowing for these Indian institutions also rose up. They then turned to the Indian markets for their funds, bringing up the demand for domestic liquidity. This brings us back full circle to our definition of liquidity crunch as a situation where the supply of loans does not meet the demand of loans:

Aziz calls for the government to err now on the side of excess liquidity, for the current times call not only for liquidity but also for certainty. And the latter can come, he says, only when liquidity is provided in spades. Thus the government needs to step up liquidity injection. His suggestions to further cut the CRR were taken in by the 2nd of November as discussed. Page | 22

Further, he says that SLR needs to go down further to make oil and fertilizer bonds SLR eligible. To increase the dollar liquidity, which would then lessen the strain on our local loan markets, he argues for a weekly dollar-swap facility against the rupee denominated assets and for the investment of forex reserves in one year deposits in foreign branches of Indian banks. We get further solutions to solving the liquidity crunch by Jaideep Mishra in his 3rd November article in the Economic Times- Boosting Growth the Target. According to him it makes ample sense for the RBI to invite an NRI bond issue to bolster our holdings. He also approves of the RBI’s decision to engage in buy-back of government securities issued earlier as per the market stabilization scheme. While then the MSS bonds were intended for sterilizing the expansionary effects of large forex inflows, their buyback now would be another way of injecting liquidity. Thus the government and RBI can adopt various measures to tackle the liquidity crunch that we are facing. It is obvious that there is no single fool proof method, but a slew of complementary measures, many of which offset the side effects of each other. Cutting essential rates like CRR and SLR are necessary for a direct release of money and in enabling banks to create loans. This has a direct effect on supply of loans thereby increasing liquidity in the market. Yet we must look to two other parameters as well- certainty or stability as emphasized by Jahangir Aziz, and the larger growth story as emphasized by Banerjee and Mishra. Conventional monetary measures of CRR and repo control are to be accompanied by modes of protection for the more vulnerable sectors of our industry. Systems of fund generation and storage need to be created keeping in mind possible future crises. This forms part of what Jaideep Mishra calls the larger picture- a policy objective with overall growth first and foremost in mind.

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REFERENCES: Liquidity and Goldilocks, Mythili Bhusnurmath, Economic Times, October 20 Massacre on World Street, Rajiv Dogra, Pioneer, October 21 Time to Overreact, Jahangir Aziz, Times of India, October 24 Driving Growth in Turbulent Times, Chandrajit Banerjee, Economic Times, date NA Boom, Bust and Recovery, Jeffrey D Sachs, Economic Times, date NA Newspiece: RBI CUTS CRR & SLR BY 1% EACH, Economic Times, November 2 Boosting Growth the Target, Jaideep Mishra, Economic Times, November 3 NUMEROUS UNARCHIVED/UNRECORDED ARTICLES WWW.WIKIPEDIA.COM WWW.GOOGLE.COM http://mars.wnec.edu/~grempel/courses/world/lectures/depressionresults.html Other unarchived sources The current liquidity crunch in India: Diagnosis and policy response, Jahangir Aziz, Ila Patnaik, Ajay Shah, October 20

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VARIOUS ARTICLES THAT WE TOOK HELP FROM:

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