S. S. Das

ssdas@nic.in

Recession to Recovery: A Road Map

"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 PresentationWhat is Recession?Why Financial Crisis?The Genesis of the current problemImpact on world financial system and

world EconomyGlobal ResponseImpact on IndiaIndia’s ResponseWay Ahead

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”

What is Recession?

RECESSION

= WHEN YOUR NEIGHBOR LOSES HIS JOB

The joke that economists quote to explain theDifference between “Recession & Depression”

Recession Vs Depression

DEPRESSION

= WHEN YOU LOSE YOUR JOB

Recession is nothing newRecessions 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 RecessionGeneral 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;WarsChange in the nature of the business cycle due to

Globalization;Current global recession is caused by a severe

financial crisis triggered in western developed economies.

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:

1. 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

2. 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 rates5. 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 asset- based

securities: Collateralized Debt Obligations (CDOs).6. Securities are repacked, leveraged, tranched, and resold

many times over camouflaging the underlying risks7. So called innovation of exotic products;

To cover the risk of defaults on mortgages, particularly subprime mortgages, the holders of CDOs (FIs) purchased Credit Default Swaps (CDSs).

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, they did not fall under insurance regulations requiring sufficient capital to pay claims.

Rise of CDS businessAs 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 trillionmore 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

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 base9. Globalization of the financial system

leading to large scale arbitrage of funds and flight of capitals

Collapse of Mortgage MarketCDSs 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 freezeInter bank lending almost stopsCrisis spread to other assets and institutionsFlight of capital leads to

Meltdown of the stock markets across the Globe

Exchange Rate Crisis

Impact of the CrisisCurrent crisis appears worse than even a

liquidation crisisLack of mark to market accounting creates

uncertainty as to who is solventGovernment rescue policies inconsistent

(Lehman was allowed to sink)Nobody knows who will survive and parties

refuse to lend to each otherFinancial system freezes!

Spread of the Crisis and ImpactMeltdown 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, BRICsMark to Market Accounting System to value that stock

according to market valuescapital 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 cashLead to rise in Demand for Dollar and fall in currency

value of other countries

Impact of the CrisisCollapse of Financial Institutions in several

parts of the worldLehman Brothers; AIG, Freddie Mac and

Fannie Mae etc. Central Banks in vulnerable countries such as

Iceland become BankruptInvestors across the globe lost huge amount

of their investmentsSevere Credit squeeze and Liquidity crunch

for the industryHousing; Automobiles; Retail; Services etc.

Impact of the Crisis….Crisis of confidence leads consumer

aversion to spendingFall in housing and real estate pricesFall in Demand for goods and servicesResorting to Trade Distorting

Protectionism Leads to drop in international trade in

commodities and servicesGets into a Vicious Cycle

Job cuts and serious unemployment problem followed

Onset of a recessionary spiral

Starting Point = Unwillingness to buy

Governments have 2 policy instruments

Fiscal Policies(By Govt.)

Monetary Policies(By Central Banks)

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 influence the economy by changing howThe Governments spend and collect money

Central Banks manipulate the available supply of money in the country

How to come out of recession

How to come out of recession?

Government influences the economy by changing how it (Government) spends and collects money

1] Tax cuts for businesses or for individuals

More moneyavailable forspending

Demand picksup; Market can recover;

2] More Spending by Govt. to create jobs

Individuals getsalary and spendmoney

3] Automatic fiscal policy; Unemployment Insurance

Some income tounemployed people to spend

Fiscal Policies

How to come out of recession?

1] Reduce reserve ratio

More moneyavailable for bankto give loans

Demand picksup; Market can recover;

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

It becomes anincome to Govt.to inject moneyinto the market

Central Bank manipulates the available supply of money in the country

MonetaryPolicies

2] Lower the interest rates

Individuals takemore loan

Global Response to the CrisisVaried Response and Intervention to protect

financial system and the tumbling economyShort 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 madeto 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 governmentFacilitation of mergers and acquisitions.Large Scale Government bailout packages for

affected industriesUS 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 economies

The second phase: 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 and services;

and Prevent collapse of industries and institutions

Road Ahead: Third phase of ResponseAction 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 macroeconomic

variables and prudential oversight, andhow financial rescue packages should be structured.

Road Ahead: G-20 initiativesIssue of misallocation of resources across the globeRole of the “Invisible Hand of the Market Forces”

and Government InterventionG-20 Initiatives

New Financial Architecture:Global coordination and oversight of Financial

MarketExecutive CompensationRegulation of Derivative Segments of Financial

MarketCall for restraints on protectionism

Fourth Phase of Global ResponseThe 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

DepressionFinancial capitalism brought enormous economic

and social benefits to hundreds of millions of peopleIt is possible that financial repression will

followwith nationalization of banks, severe control of

lending and trading, etcMore likely, will get more regulation

This might be a good ideaGood examples: securities and banking regulation

after the Great DepressionEmergence of new Global Financial Architecture???

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 lendingOver reaction to inflation during the first

half of 2008 and tightening of monetary policy

Impact on IndiaSignificant Currency devaluationDemand 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 IndiaExternal 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 InterventionBroad direction of the interventions on

monetary policy side has beento 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 InterventionEasing 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 InterventionDirected at stimulating demand for goods

and services through tax cutsCounter-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