Background: Experts know the reasons for every calamity and some, like in this case, even help create them. But ordinary mortals like us who have problem in comprehending the ramifications of such calamities have difficulties in findings reasons and logic for such occurrences. This article is not for such experts but for ordinary mortals like us who want to know the facts of life shorn of jargons and gibberish. This is for Dummies of the world to explore the complex world of economics without the help of the economists! Welcome you Layman for a study tour to understand the nuances of Lehman’s economics (pun, if any, is accidental) Calamities, especially the man-made variety, do happen but when they happen you will normally be able to identify and target the villains responsible for the catastrophe. When there are no identified targets to apportion the blame for any crisis there is this sense of frustration. And frustration it is in the financial markets now coupled with unprecedented uncertainties. For an ordinary man these are difficult things to comprehend and even more difficult to contend with. Let us make an attempt to look at the present crisis and see if some sense could be made out of the present financial meltdown in the world economy The Beginning of the crisis: Let us begin at the beginning. It is important to understand as to how a crisis of this nature happened in the first place before we look at how it will impact an emerging economy like India. There has been a reduction of spending on huge infrastructural projects by countries around the world and by big corporates on big industrial projects from the late nineties and the technology bubble of the early 2000 only made it worse. Many a country had surplus budgets and less than grand investment avenues leading to a savings glut. Banks and financial institutions were flush with funds and the specter of potential lender chasing an unwary customer was all there for everyone to see.A major portion of the excess money finally ended up in the US who had always been the custodian of all the money since the end of World War when the American economy had an intimidating 50% share of the world economy (since shrunk to about 25% now). Countries exporting to the US parked their excess funds in US itself enabling the Americans to indulge in excessive consumption, unmindful of any consequences like erosion of the value of the Dollar or the interest rates. It is nature’s law that human greed will ensure that money does not remain idle wherever it is and in whichever form it is. Excess liquidity, in the absence of productive investment avenues naturally found its way to the obvious sector – real estate. An unprecedented housing boom was in the works. Helped by innovative derivative products and driven by naked greed, investment banks which are subjected to nominal regulations and controls in America a housing bubble was in the making. A bubble, by definition, is bound to burst. So it did. The US financial system : In order to understand the situation clearly one has to be aware of how the housing mortgage system works in the US. You are given a loan to buy a house with the house itself as the mortgage by a Bank. The Bank does not hold on to the mortgage. They sell these portfolios to what are called the mortgage companies. They in turn convert these bought out assets into small bundles of Bonds which they sell in the market. These Bonds called Collatarised Debt Obligations (CDO for short – forget about the terminologies) fetched more interest than the treasury bonds and so was very attractive to the investors. With names like Freddie Mac and Fannie Mae, even countries started investing in them. Everything was hunky dory as long as the prices of the houses were going up as the security for the houses were the houses themselves. With liberal help from rating agencies and relatively lax regulations for financial institutions other than commercial banks, the prices of Bonds based on inflated housing prices reached untenable levels. In all this hoopla and euphoria there was this insurance giant AIG with another derivative product called Credit Default Swap (CDS for short – again, forget about the terminologies). Somewhere something had to give way beyond a point and it did. When the prices of real estate crashed people found that it was not worth honouring the mortgage commitments as they found that the loan amounts were lower than prices of the houses. Defaults rose and the intrinsic value of the Bonds (CDO) fell to an extent that they were not even worth the paper on which it was printed. Along with the Bonds the insurance companies derivatives also got into problem as AIG with its CDS had insured people against defaults. Everyone pulled everyone else down, all hurtling down at a speed the world had never seen before. No wonder the famous investor Warren Buffet called these derivative products financial weapons of mass destruction! The US Government initiatives : In all these, the US Government was a mute spectator. After all, the government of a capitalistic country cannot and is not supposed to do anything else. But no more. The collateral damages were too big to ignore. If companies like Freddie Mac and Fannie Mae were to fail, the investments made by foreign governments like the Chinese in the Bonds would have made it impossible for the US conduct trade with outer countries. The Government, therefore, bailed them out as a first step. The same logic was applied to AIG. When historians record the events of this Depression Ver. 2.0 the rescue of these companies along with Bear Stearns will be marked as the watershed when capitalism capitulated to human greed. From here on the world and more particularly the US felt the after-effects of the crisis. Investment Bankers like Lehman Brothers, a venerable institution once upon a time, had borrowed to the tune of thirty times their equity (economic experts call it leveraging). These institutions had no option but to sell off whatever properties they had to shore up their Balance Sheets. Effect – further depression in the market with this additional supply and further erosion in the value of securities of CDOs. George Bush could have attacked Iraq with CDOs than conventional bombs. He would not have been in this sorry mess. Amen. The US Congress after huffing and puffing for a couple of days did the inevitable. They approved a bailout package of the order $700 billion. For the benefit of Dummies like us this represents something like Rs. 35,000Crores! What is more, an additional $250 billion (Rs. 12,500 Crores) bailout is on the way. All these are in addition to the amounts pumped in in the formof temporary loans and advances into the system by the American Central Bank, the exact quantum of which is known only to the Fed Chief. God helpAmerica.
Effect on other countries:
Now let us turn to what it means to others other than America. The UK is already in recession and Japan, the second largest economy in the world has just entered the august body. The Asian countries have already started to feel their ground slipping away from under their feet. However, it has affected different Asian tigers differently. Let us see how. All those Asian countries that have a substantial export component in their GDP are the worst hit. Take for example a country like Vietnam or Taiwan. They are so heavily dependent on exports that their economies have crated. China which had a policy of ‘Dollar at any cost’ is now paying a heavy price for those Dollars. China arguably has the biggest stake in keeping the US economy running at whatever speed it can, for they are dependent on the US for their exports and also to safeguard their accumulated sovereign wealth which is lying in some obscure corner in one of the mortgage companies. American economy with such predominant position in the global economy, it is unlikely that any other country would escape being affected adversely, unless you are talking about a country like Myanmar. India and the Crisis: Now let us turn our attention to India. A country expected to grow at the rate of 7% even in this downturn is not doing too bad, for a change. In fact it is creditable indeed. One reason is that the base itself is low compared to other countries like Japan or China. The other more important reason is that the country is still not an open economy and is insulated from the vicissitudes of global economic machinations. The feeling of safety comes primarily from the fact that there is no capital account convertibility for our currency. Let us look at some of the effects as we can foresee today. The list is not be exhaustive. 1. The first beneficiary of the crisis would be the Left. It is time to say déjà vu. They have already gone to the market to claim that but for them the economy would have been so widely opened, making our county vulnerable to the evil effects of capitalism. They may be partially true. Everything American will not necessarily be the best henceforth. 2. The policies followed by the Reserve Bank of India, especially with a bureaucracy firmly entrenched in the past always look forward to anything new with suspicion. For RBI the middle name has always been caution and rightly so. In times of crisis like this you cannot ask for more. That is the virtue of conservatism. Effect - future reforms will meet with stiff resistance. 3. Banking practices like keeping one-third of the deposits received by banks blocked and thereby increase the cost of capital is paying off. There may be no one who would envy the West for such low interest rates compared to India. That now looks like an investment for a rainy day. 4. FIIs have already taken away their money from the capital markets. Those who have not done so yet, will do so now depressing the market and its sentiments. Let us be practical. The financial institutions in the US need the money in their process to shore up their Balance Sheets by what is called ‘deleveraging’. Simply put, it is the process of converting all available assets of the company in to cash which they need desperately. 5. On the other hand FDIs are unlikely to resort to any knee-jerk reactions as their funds are normally tied to planned and committed long gestation projects. It may nevertheless slow down for sure. 6. As all the cash is needed in US from the sale proceeds with FIIs or others there is a strong demand for Dollars pushing up its exchange rate. This will benefit exports and adversely affect imports. 7. When money is sucked out from the system and the inflow becomes less there will be difficulties in finding liquid cash in the system in India. Economists call this the liquidity crunch. The Reserve Bank has already intervened to ease the situation by injecting additional liquidity by reducing the percentage funds the banks have to keep with the RBI. (They call it by fancy acronyms like SLR and CRR – forget the terminology – we are dummies) 8. It is also important to bear in mind that the mortgage lending pattern in India is quite different from the practice in the US where weightage is largely to the value of the property compared to the repayment capacity of the borrowers. Here we are conscious of our EMIs more than the value of the property. 9. In India when it comes to real estate lending (perhaps not applicable for large players) there is always a built-in safety margin in land against which the banks do not lend thereby increasing the intrinsic value of the property. We call it black money. Don’t we? 10. IT and ITES companies of all sizes and shapes are likely to be affected by the meltdown as a major chunk of the revenues come from export of services. The BPO culture is sure to get a break. 11. India cannot be insulated to what is happening around the world. Manufacturing industry may not lay off permanent workforce right away. The axe will fall on the so called hapless casual workers, contract employees and on ancillaries, suppliers and vendors. The latter because of their size may be wiped out if the recession turns out to be deep and long. 12. Service sectors like aviation, banking, retail, hospitality, etc. will pay the price for globalization. We had the cake till now we have to face the rough end of the cane. 13. Management salaries which had also reached unreasonable levels will plateau and drop. The losses on account of the fall in stock prices will affect the ESOPs of the high and mighty. They are seeing their book profits vanishing in front of their own eyes. What could be of more importance is the fact that many a manager will find it difficult to survive the meltdown as commitments of targeted numbers may not be forthcoming. At a micro level he may not be in a position to explain the shortfall by blaming what is happening in the United States of America. 14. With the slowdown in the economy and with a volatile stock market, market players who were making money with borrowed money may follow the footsteps of the Vidharb farmers. God forbid. 15. Promoters running their companies on the principles of their grandmothers that loan funds are poisonous will make a killing. Today cash is king. Conclusion: As of now no one can be sure how long the recession would last. It is likely that it will last for another two to three years. The resilience of man with adequate doses of hope and greed will ensure that things will change and change for the better. In the new world economic order one can be sure of one thing. The American hegemony as an economic super power will take a solid knock. Other countries will start looking for insulation from these kinds of disasters and may not be solely dependent on America. Once they shift their reserves from that country the cost of funds there will rise awakening the American to the virtues of thrift. It is time that he also realises that capitalism in the present form is dead. Financial socialism is already here. Otherwise why the bailout? America, if it has to save capitalism, it will need to put in place adequate regulations and safeguards in their financial system. That’s what my grandmother told me. But who will listen to us; after all we are Dummies.
Article by Mr. Ashok Nawal January Bulletin source www.icwai-wirc.org
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