Report on Indian Economy

7/28/2019 Report on Indian Economy

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INTRODUCTION

The main aim of doing this project as a dissertation was to analyze the condition of

Indian I.T sector ,strength ,weakness ,opportunities and threat for Indian I.T sector, and

the effect of U.S financial crisis on Indian I.T sector, so that some steps can be taken to

improve the condition of Indian I.T sector


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REPORT ON INDIAN ECONOMY:

GDP GROWTH IN 2005-06, 2006-07

The data released by CSO shows that Indian Economy grew by 9% during 2005-06 and

9.6% during 2006-07. In 2006-07 GDP growth was mainly fueled by Industry and

services that grew at 10.9% and 11.0%. Although in 2005-06 the 9% growth rate of GDP

was achieved due to a stronger performance by the agricultural sector. The agricultural

sector (i.e. primary sector) grew at a rate of 6.1% in 2005-06 in comparison to a mere

3.8% in the following year i.e. 2006-07.Industrial and services sector respectively

contributed 26.6% and 54.9 % to the total GDP growth in 06-07.

On the other hand GDP growth in 2007-08 has been 9 %( Revised estimates by CSO)

which is lower than the previous year. In the advance estimates GDP growth was

expected at 8.7%. The upward revision in the GDP growth rate is mainly on account of

the Revisions made in the estimated production of agricultural crops by the Department

of Agriculture and Co-operation. The sectors which showed growth rates of 5 per cent or

more, are manufacturing (8.8 Per cent), electricity, gas and water supply' (6.3 per

cent), construction (9.8 per cent), 'trade, Hotels, transport and communication' (12.0

per cent), 'financing, insurance, real estate and Business services' (11.8 per cent), and

'community, social and personal services' (7.3 per cent). The growth could have been

more but due to the rising inflation in the last 3 months of the fiscal (2007-08) the

growth slowed down. The tight monetary policy of the RBI to control inflation and to

check the credit growth in the economy has also been the reasons for this reduced rate ofGDP. The industrial sector grew at a rate of 8.5% during the period. And the service

sector growth rate has been 10.7%. Even this growth rate has been due to improved

agricultural sector growth which was 4.5% during the period 2007-08.

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ESTIMATES OF GDP IN FINANCIAL YEAR 2008-09

In the financial year 2008-09 the GDP Growth rate has been estimated at 7.6% while it

has been estimated at 7.8% by CRISIL. The rising interest rates and the rising inflation

etc. are the reasons for this slowdown in the GDP. Dr. Subir Gokarn, Chief Economist,

Standard & Poor's Asia Pacific, said: "We expect the inflation rate to average 8.5% to

9.0% during 2008-09. Food price scenarios have improved somewhat, given comfortable

levels of wheat stocks and expectations of a normal monsoon this year. However, high

oil prices, strong input costs, and a depreciating rupee continue to exacerbate inflationary

and other pressures. High interest rates, along with a slowing global economy, will trim

GDP growth to 7.8% in 2008-09. On an average, the Indian GDP growth rate has been

forecasted to be 7.5 % for the fiscal 2008-09. The main reason for this slow economic

growth rate has been the continues rise in the inflation rate since last few months. The

inflation rate even touched the 13 year high rate of 11.89 % once. The main reason for

this high inflation rate has been the rising crude oil prices which are still approximately

50 % high than their levels one year ago. (The crude oil was trading at 70 $ per barrel

during 2007-08 but now even after some correction, the crude oil was 107 $ per barrel as

on 1st September, 2008.) The interest rates have been hiked by banks to control inflation

but still inflation rates are very high @ 11.40 % for the week ended 16 th August 2008.

In fact, the interest rate hike affected the GDP growth rate as loans for investors became

costlier. As there looks to be no signs for inflation rate abatement, the chances of more

stringent monetary policy is expected which may control inflation, but will surely make

a dent into the GDP growth rate.

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INDUSTRIAL GROWTH

Indian industry achieved an impressive growth in the last fiscal 2006-07. The overall

Industrial production grew at 11.6% in 2006-07 as against the growth of 8.2% in the

Previous fiscal. The industry growth rate in 2007-08 was 8.3%. Which is very low than11.6% in the previous period. The manufacturing sector achieved a growth rate of 8.7 %

during the period compared to 12.5 % IIP growth during 2006-07. Tight monetary policy

resulting in high interest rates has been the major factor contributing to the decline in IIP

growth. Capital goods production also came down to 16.9 % in 2007-08 when compared

to a growth of 18.2% in 2006-07. The growth rate for consumer goods also fell down to

5.9 % from that of 10.1 % in the previous fiscal. The growth rate for basic goods also

fell down to 7 % in 2007-08 from that of 10.3 % in the previous fiscal.

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SIX CORE INFRASTRUCTURE INDUSTRIES

The Index of Six core-infrastructure industries having a combined weight of 26.7 per

cent

in the Index of Industrial Production (IIP) with base 1993-94. During the year 2006-07

the six core infrastructure industries grew at a high of 9.2% as compared to the 6.2%

increase a year before. This growth arrived on account of better production numbers

across the six core industries. The four infrastructure industries, crude petroleum,

petroleum refinery, power and coal posted growths of 5.6%, 12.9%, 7.3% and 5.9%

respectively exceeding the growths recorded in the previous fiscal, maintaining the

overall infrastructure growth. However growth in the production of finished steel andcement slowed during the fiscal 2006-07. Production of finished steel was observed to

speed-up in the last two months of 2006-07 compared to the corresponding months of

2005-06... The six core infrastructure industries registered a growth of 5.6 per cent

during the Fiscal 2007-08 as compared to 9.2 per cent in corresponding period last year.

The four infrastructure industries crude petroleum, petroleum refinery, power and coal

posted less growth than the previous year with an exception in the electricity sector

which achieved a negligible improvement in the growth rate than the last year. The

growth of petroleum products took a plunge as it came down to just 6.5 % from 12.9 %

in the previous fiscal. The steel and cement sector also showed less growth rates than the

previous fiscal.

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2008-09 ANNUAL INFLATION RATE PROJECTED BY S&P

The overall WPI based inflation for 2006-07, averaged at 5.4% as against the 4.4% in

the 2005-06. The RBI employed monetary tightening measures to absorb the excess

liquidity in the market impacting the prices of the manufactured items. The government

regulated

exports of some identified commodities addressing the supply crunch in various primary

articles. For the fiscal 2007-08 RBI had kept the target inflation rate around 4.5%

initially but then due to the rising crude oil prices, inflation has been on a continuous

rise. Upto November 2007, the inflation rate was around 3 %. After November the WPI

based inflation was around 4.56 % for the next 4 months of the fiscal 2007-08 i.e.

December 2007 to march 2008. But still the Government was successful in keeping the

annual inflation rate at the target level of 4.5 % for 2007-08.

But after February 2008 the inflation has been on a rise. As it was 4.45 % at the end

of February, 6.68 % at the end of march, 7.33 % at the end of April and finally at the end

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of June 2008, the yoy inflation has touched its 13 years high at 11.42 %. The main

reason

For this sudden hike in inflation have been the rising rates of the crude oil in the

International markets. This has been the biggest reason for the inflation to be so high

Otherwise as the agricultural sector has showed a good growth rate of 4.5% there would

not be such inflation. Although the reserve bank of India had taken some steps to reduce

money supply in the previous fiscal. Like the CRR has been increased 5 times in the

recent period to reduce money circulation in the economy and the crude oil prices also

came down at the beginning of September 2008 to 107 $ from the levels of 144 $ per

barrel, but still the inflation rate is high at 11.40 %

MONETARY INDICATORS

MONEY SUPPLY

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The Broad money growth for the last fiscal 2006-07 stood at 21.5% and was slightly

lower than the growth of M3 during the same period a year ago. Bank credit to the

government rose substantially during the year-end 2007 compared to the same period of

last year. We observed slowdown in the bank credit to the commercial sector. However,

the net foreign exchange assets of the banks spiked by 28.9% as against 11.1% in the

same period a year ago. Scale up in investments on government securities by 10% was

also seen during the year. Impact of the hike in the rates of long term deposits was

reflected in the numbers on aggregate deposits that went up by 23% in 2006-07

compared to 18% in the corresponding period of the previous year. Credit off take

decelerated during the year compared to last year. Money supply (M3) increased by 20.7

per cent (Rs.6, 86,096 Crores) in 2007-08 as compared with 21.5 per cent (Rs.5,86,548

crore) in 2006-07. Aggregate deposits of SCBs (Scheduled commercial banks )

increased by 22.2 per cent (Rs.5, 80,208 crore) during 2007-08 as compared with 23.8

per cent (Rs.5, 02,885 crore) in the previous year. The average daily turnover in the

foreign exchange market increased to US $ 57.3 billion at end-March 2008 from US $

33.2 billion at end-March 2007. Commercial banks' investment in Government and other

approved securities increased by 22.9 per cent (Rs.1, 81,222 crore) during 2007-08,

significantly higher than 10.3 per cent (Rs.74, 062 crore) in 2006-07. Large inflows have

led to swelling of net foreign exchange assets of the banks that grew by 16.9 percentagainst 10.3 percent in the last fiscal. This has increased M3 over the Aggregate deposits

have picked up faster than the last year and this came after the RBI attached host of

benefits to time deposits. Investments in the government and other approved securities

have also shown higher increase compared to last years. Credit off take was seen to

divert towards the non-food category. So the money supply in the economy continued in

the period 2007-08. However for 2008-09, the total money supply is expected to grow at

lesser rate than the previous year because of the rising cost of capital due to the CRR

hikes of the RBI. Also as the stock market is volatile, this may also be a not so good

choice for raising funds for

Investments. This way both the GDP Growth rate and the inflation rate are expected to

come down.

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CRR RATE HIKES

CRR has been increased by 50 basis points to 7.5% before October 2007. And after that

also once in January. And then due to the galloping inflation starting from February

onwards the CRR was again increased In May 2008, then again two times in July 2008.

And now it stands at 9.0 %. The SLR is still at 25 %. The Repo rate is now 9.0 %. All

these measures have been taken by the RBI to curtail inflation.

As raising both theserates will lead to higher cost of funds for commercial banks

that in turn will lead tohigher interest rates in the economy. This higher interest

rate will make cost of debt high for the corporate and households both. Thus it

discourages loan taking bypeople and RBI will be hoping that this increase in both

CRR and Repo rate willhelp reduce the money supply in the economy. And that

will in turn reduce demandand ultimately inflation.

Recently D Subbarao became the new RBI Governor. But he too is expected to continue

the stringent monetary policy adopted by the previous incumbent Dr. YV Reddy. So the

Growth may take a hit while targeting the inflation.

FISCAL MANAGEMENT

Gross tax revenue collections grew at a rate much higher in 2006-07 than the previous

year. Data up to March 2007 shows gross collections increased at 29.3% as against

the20% increase in the previous year. Corporation tax and Income tax both contributed

45% to the total tax collected and grew at 41% and 35.4% respectively and this was

much

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Higher than the increase in the tax collected a year ago. Among the indirect taxes we

saw collections from customs maintain the rise, growing at 32.7%, although collections

from the central excise was not as much as in the same period of previous year. In 2006-

07 the

Government was seen to achieve the targeted fiscal deficit. It touched a level of Rs

146348 Crores representing 100.10% of the targeted. Comparing the numbers of 2006-

07

With that of the previous years, we see numbers of 2006-07 close to the targeted figure.

For 2007-08, direct tax collection was Rs.3,144.68 billion. This represents an increase of

36.62 percent over the previous fiscal and 117.56 percent of the original budget

estimates. But it has already missed its revenue deficit target and expects it to be 1

percent of GDP in the year to end March 2009. "In four years, Direct tax collection has

been tripled - that is from Rs.1,050.88 billion to Rs.3,144.68 billion. This is a remarkable

achievement and I compliment the department for this extraordinary achievement," he

added. "The cost of collection has come down to 0.54 percent. For every Rs.100

collected, the department spends only 54 paisa. Now, this is the lowest in any

jurisdiction in the world." As per Mr. PC Chidambaram. For the first quarter of 2008-

09 the direct tax receipts jumped only 38.6 pct in the quarter to June from a year earlier.

The finance ministry said corporate taxes came in 32.7 percent higher at 345.66 billionrupees during the April-June period, while income tax receipts stood at 227.82 billion

rupees, 48.8 percent more than a year ago. Growth in tax collections in June slowed

from a scorching 71.3 percent growth in the April-May period as the government made a

hefty refund payout of 115.78 billion rupees. The government expects robust tax revenue

in the year to March 2009 to keep the fiscal deficit below a target of 2.5 percent of gross

domestic product (GDP) in 2008/09 compared to 2.8 percent of last year.

CENTERS FISCAL SITUATION: 2007-08

According to the Fiscal Responsibility and the Budget Management Act operationalised

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in 2004/05, the government must reduce its fiscal deficit to 3 pct of GDP and wipe out

its revenue deficit by 2008/09.The process of fiscal correction and consolidation under

the Fiscal Responsibility and Budget Management (FRBM) framework continued during

2007-08; the revised estimates for the year placed the revenue deficit and fiscal deficit

lower than budget estimates, both in absolute terms and relative to GDP. Revenue deficit

at Rs.63, 488 crore in 2007-08 was lower by Rs.7,990 crore than the budget estimates.

This reflected the significant increase in the tax and non-tax revenue which more than

offset the increase in the revenue expenditure on account of higher provision for interest

Payments and subsidies. The Gross fiscal deficit (GFD) at Rs.1,43,653 crore in 2007-08

was lower by Rs.7,295 crore than the budget estimates on account of the lower revenue

deficit coupled with a decline in capital expenditure. As a result, gross primary surplus

in the revised estimates at Rs.28,318 crore was significantly higher than the budget

estimates by Rs.20,271 crore. The reduction in GFD and revenue deficit by 0.4 per cent

and 0.5 per cent of GDP, respectively, during 2007-08 (RE) over 2006-07 met the

stipulated minimum threshold levels of 0.3 per cent and 0.5 per cent of GDP for GFD

and revenue deficit, respectively, under the FRBM Rules, 2004.

IMPACT OF BUDGET 2008-09

The cash-strapped government has pledged to spend billions of rupees on populist

schemes ahead of elections and has to foot a heft subsidy bills in order to keep fuel and

food prices low. For example in the budget for 2008-09 the government has given a

hefty loan waiver to farmers which will cost the exchequer a whopping 73000 crore

rupees. The government has not made it clear that from where it will arrange for this

much amount. So this loan waiver which has been given as a result of the vote bank

politics will surely effect the achievement of the fiscal target of 2.5 % in fiscal 2008-09.Although the government is thinking that the rising tax receipts and an average

growth rate of 40 % in tax receipts will be enough for achieving the fiscal targets. It does

not seem so. There have been other reasons also for this apprehension. Such as the oil

bonds issued by the government to cover their losses which are there because of the

rising crude oil prices and the governments subsidy policy on oil price. As is clear from

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the statement of the Former RBI Governor Mr. YV Reddy, India's fiscal deficit

continues to be among the highest in the world and underlying pressures are not entirely

showing up in headline fiscal numbers. India aims to bring down its fiscal deficit to 2.5

percent of GDP for the 2008/09 financial year, compared to 3.1 percent in 2007/08, but

analysts fear a $17 billion scheme to write off the debts of millions of small farmers and

tax cuts could trip up efforts.

FOREIGN TRADE

Indian trade numbers available for the year 2006-07 shows Indian exports growing at

20.9% as against the high growth of 24% in 2005-06 in US dollar terms.While in 2007-

08 On Bop basis, merchandise exports recorded an increase of 23.7 percent (21.8 per

cent in the previous year). Merchandise import payments, on Bop basis, showed a

growth of 29.9 per cent in 2007- 08 (21.8 per cent in 2006-07). The commodity-wise

data released by DGCI&S (April-February 2007-08) revealed a pick up in the growth of

primary products, while manufactured exports witnessed some moderation in growth.

Agriculture and allied products, engineering goods, gems and jeweler and petroleum

products were the mainstay of exports, as these items contributed about 72 per cent of

the export growth during April-February 2007-08.

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On Bop basis, with imports outpacing the growth in exports, trade deficit widened to US

$ 90.1 billion in 2007-08 (7.7 per cent of GDP) from US $ 63.2 billion (6.9 per cent of

GDP) in 2006-07. Invisible receipts, comprising services, current transfers and income,

rose by 26.2 per cent during 2007-08 (28.3 per cent in 2006-07) mainly due to the

momentum maintained in the growth of software services exports, travel, transportation,

along with the steady inflow of remittances from overseas Indians. Invisible payments

grew by 17.7 per cent in 2007-08 (29.3 per cent in 2006-07).The key components of invisible payments were travel payments, transportation,

business and management consultancy, engineering and other technical services,

dividend, profit and interest payments. The moderation in growth rate of invisible

payments during 2007-08 was mainly due to moderate payments relating to a number of

business and professional services. During 2007-08, the widening of the trade deficit

mainly led by imports resulted in a higher level of current account deficit which stood at

US $ 17.4 billion or 1.5 per cent of GDP (US $ 9.8 billion or 1.1 per cent of GDP in

2006-07) .

To sum up, the key features of Indias BoP that emerged in 2007-08 were:

(i) sharp rise in trade deficit (7.7 per cent of GDP in 2007-08 from 6.9 per cent in 2006-

07) mainly led by high imports, (ii) significant increase in invisible surplus led by

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remittances from overseas Indians and software services, (iii) higher current account

deficit at 1.5 per cent of GDP in 2007-08 as against 1.1 per cent in 2006-07 due to

widening of trade deficit, (iv) substantial increase in capital flows (net) which were 2.4

times than their level in 2006-07 and constituted 9.2 per cent of GDP (5.0 per cent of

GDP in 2006-07), (v) large accretion to reserves (excluding valuation) at US $ 92.2

billion (US $ 36.6 billion in 2006-07).

CAPITAL FLOWS

Capital Inflows for the period April-February 2006-07 have swept past the inflows

received during the entire 2005-06. Direct investment contributed USD 17.1 billion

during April- February period of 2006-07; this was much higher than USD 7.7 billion

received in the entire 2005-06. Portfolio investments however remained lower in 2006-

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07 than the investments in the previous year. During the year 2006-07, the amount raised

by

the Indian corporate through GDR and ADR route has been much higher ( USD 3.7

billion) than that was raised in the previous year (USD 2.5 billion ). Both capital inflows

to India and outflows from India remained large during 2007-08 reflecting the increased

liberalization of capital account, investors optimism and sustained growth momentum

of India. The gross capital inflows to India amounted to US $ 428.7 billion as against an

outflow of US $ 320.7 billion during 2007-08 . The net capital flows (inflows minus

outflows) at US $ 108.0 billion (9.2 per cent of GDP) in 2007-08 were 2.4 times than

that of 2006-07 (US $ 45.8 billion or 5.0 per cent of GDP) and 4.2 times of the net flows

of 2005-06 (US $ 25.5 billion or 3.1 per cent of GDP

Foreign direct investments (FDI) broadly comprise equity, reinvested earnings and

interoperate loans. Net FDI flows (net inward FDI minus net outward FDI) amounted to

US $ 15.5 billion in 2007-08 as against US $ 8.5 billion in 2006-07. Net inward FDI at

US $ 32.3 billion during 2007-08 (US $ 22.0 billion in 2006-07) reflected the continued

strength of sustained domestic activity and positive investment climate with inflows

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channelsing into construction, manufacturing, business and computer services. Net

Outward FDI stood at US $ 16.8 billion during 2007-08 (US $ 13.5 billion in 2006-07)

Reflecting the pace of global expansion by the Indian companies in terms of markets and

resources. As regards portfolio equity flows, foreign institutional investors (FIIs) made

net purchases in the Indian stock market throughout the year 2007-08 except during the

months of August, November, February and March. The large FII inflows (net) in 2007-

08 at US $ 20.3 billion as against US $ 3.2 billion in 2006-07 also reflected increased

participation of FIIs in primary markets as there were large resources mobilized by the

corporate through record level of 85 Initial Public Offerings (IPOs) and 7 Follow-on

Public Offers (FPO) together amounting to US $ 135.4 billion. Reflecting the buoyant

stock market, the resources mobilized by the Indian companies through their global

offerings of ADRs/GDRs abroad also remained large amounting to US $ 8.8 billion in

2007-08 (US $ 3.8 billion in 2006-07). As a result of large FII flows and resource

mobilization through ADRs/GDRs, the net portfolio investment was US $ 29.3 billion in

2007-08 as against US $ 7.1 billion in 2006-07. So the FDI and FII investors invested in

India in a big way in 2007-08 . and it shows that the foreign investors kept their faith in

India during the previous year.

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FOREIGN EXCHANGE RESERVES

Foreign exchange reserves crossed the USD 200 billion mark in the first week of April

2007. Forex reserves stood at USD 180 billion in December 2006 and since then a surgein the Forex was observed. The piling up of reserves is a strain for the central bank, as it

is seen that interest on securities exceeds the rate of return on reserves and therefore

some

steps need to be taken to ease the pressure due to forex buildup. Net accretion to foreign

exchange reserves on BoP basis (i.e., excluding valuation) at US $ 92.2 billion in 2007-

08 (US $ 36.6 billion in 2006-07) was led mainly by strong capital inflows. Taking into

account the valuation gain of US $ 18.3 billion (US $ 11.0 billion in 2006-07), foreign

exchange reserves recorded an increase of US $ 110.5 billion in 2007-08 (US $ 47.6

billion in 2006-07). At the end of March 2008, with outstanding foreign exchange

reserves at US $ 309.7 billion, India held the third largest stock of reserves among

the emerging market economies and fourth largest in the world

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TRENDS IN EXCHANGE RATE

Appreciation in Indian Rupee against the greenback started in March 2007. This rise in

Rupee value was on account of an inflow in the foreign capital, in the form of FDI, ECB

and Portfolio investments. To maintain the exchange rate within a range the central bank

has been buying dollars from the market but due to inflationary pressures, RBI slightly

distanced itself from the forex market. RBIs adoption of passive approach has made

Rupee appreciate to levels that are pro imports. Indian Rupee began to appreciate since

the middle of March 2007, it continued to slide below Rs 44.00 and slip to an alarming

below-forty one level towards the end of April 2007, It has been found that Indian Rupeeagainst the Euro too behaved similar to its movement vis--vis USD, Indian Rupee

attained a level of Rs 55-54 in June 2007 from 58-57 in March 2007, appreciating by

6.5%. But now from the beginning of the period 2008-09, the rupee has again started

Depreciating against the Dollar and it went to the level of 44 rupees per dollar at the end

of August 2008.

Rupees Per Unit of Foreign Currency

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POLITICAL SITUATION IN INDIA

The political system was stable in the economy for last 4 years as the UPA government

was running efficiently. Although the Left did stop a lot of reforms in these 4 years yet

the Government was doing fine as it can be seen with a growing economy from 2005-06

to 2007-08. But in the beginning of the year 2008-09 the government remained uncertain

The government had to prove its majority in the house after the Left parties withdrew

their support to the government on the nuclear deal issue. The government escaped after

the congress aligned with the Samajwadi party and some independents gave support to

Congress. Although the government is now safe but industry may not have reform

measures in Pension , Insurance and Banking Sector as the government on its own wouldnot be able to bring these reforms and BJP and left parties are against measures such as

increased limit of FDI in these sectors. So this uncertainty over issues will remain and

until the policy comes into effect, the foreign investors may not invest in insurance

sector.

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STOCK MARKET TRENDS IN 2006-07

The mood of the market was such that negative news triggers the adverse index

movements while the positives leave markets unchanged. We have seen that the attempt

of the central banks monetary tightening measures, hike in the CRR and the lending

rates to curb inflation rose concerns among the investor community. The fall in both the

indices BSE and NSE seen in the middle of March through April 2007 was in response

to the growing concern over the expensive funds. The BSE index plunged by 4.7

percentage points during March end 2007over the previous months close and NSE too

slipped by 4.9 percentage points. However the stock markets have shown resilience inMay 2007 and the host of corrective measures by the Central Bank resulted into bringing

inflation to

desired levels.

STOCK MARKET TRENDS IN 2007-08 AND ONWARDS

Negative signals in some of the major markets have forced the foreign institutional

investors to divert their funds in safe havens. Recently the Indian stock market has been

Primarily pulled by the FII investments, partially fueled by domestic investments. From

December 07 to January 22 2008, the Bull Run continued in the market. But on 23 rd

January the market took a deep plunge of points. And from then the market has

beengoing in the bear run. The main reason for the starting of this bear run was the sub

prime crisis in USA. There was an ongoing talk about the US market going into

recession because the Major US banks got big losses due to sub prime loans given toindividuals. And as the banks provide liquidity to the economy, a funds problem in

major banks may actually lead to credit crunch in the economy which in itself will lead

to slow growth.

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As India does a lot of trade with the US a slowdown in their economy also lead to

volatility in the Indian market. And after that the rising crude oil prices which led to

inflation rising up to 2 digits figure. To control inflation RBI also took stringent

monetary policy such as increasing the repo rate in 2007-08. this rising rate of inflation

also led to negative sentiments in the market. And also the earnings of the companies

come down. All these factors lead to a market which was at 13000 levels. So due to all

these factors the market has entered into a bear phase. Now the market has entered into a

volatile phase and is gaining some momentum after being in a bear phase for long. 2008-

09 The market, although still volatile, has achieved some stability in the last few months.

The market has come to the levels of about 15000 from the level of 13000 two months

ago.

WORLD ECONOMY SCENARIO

The USA economy is showing signs of Regression. All the major Investment banks like

Merill lynch, Lehmann Brothers etc. have failed. The big five no more exist. Even

Goldman Sachs and JP Morgan is leaving the investment banking. Due to these reasons

the US economy has crumbled. The effects have been on India also. The cash starved

FIIs have been selling for the past few days. The Indian financial sector will also be

affected by this turbulence in USA as the bankrupt banks were also having stakes in the

Indian companies. And the sentiments of investors have become negative. Other than

USA , other countries, though showing some signs of slowdown, are still having near to

normal conditions. And there are no signs of a world economy slowdown yet. If we talk

about the BRIC countries then India seems to be ahead as it is expected that by 2015 ,

Indias GDP growth rate will be the highest in the BRIC countries as is clear from the

following diagram

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THE CURRENT SCENARIO IN INDIA

Finally we can say that the Indian economy achieved very high growth rates in the last

three fiscals (from 2005-06 to 2007-08). The GDP was approximately 9 % during these

three years. But if we look at the current scenario the condition looks pretty dismal. The

inflation rate has gone up to 11.89 % for the week ended 11th July 2008 before coming

down to the level of 11.40 % at the end of 16 th August, 2008. The FIIs are moving

away from the Indian equity market. The US is also facing recession signs thus in turnwill affect the world economy along with the Indian economy. The crude oil rates are

just going upwards with no signs of abatement. The only hope is the softening crude oil

prices in the last month of August 2008. The crude has come to levels of 107 $ per barrel

. but still it is very high than the rates of 70 $ per barrel in the fiscal 2006-07. The reason

for this fall in crude oil prices has been the recession in the US and less demand for oil

from other countries also along with increased supply from some oil producing countries

The rupee is also weakening against the dollar. The corporate earnings have been

affected by the inflation. In short , the year 2008-09 is going to be very hard for Indian

economy. But the fundamentals of the Indian economy are still sound. India is still

attracting a lot of FDI, FII etc. The corporate are still earning well and are doing a lot of

mergers and acquisitions outside. The investment rate is also good. Although the near

future may have some difficulties for India also but still the Indian economy is in a good

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position in the long run and is expected to earn a GDP Growth rate of 7.6% which is

second highest in the world after China.

INDUSTRY ANALYSIS IT SECTORAccording to the NASSCOMM , the Indian IT industry clocked an overall growth rate of

28% , registering revenues of USD 52 billion in 2007-08 up from USD 39.6 BILLION

IN

2006-07. For 2008-09 , NASSCOMM has predicted the software industry to grow at 21-

24%.In FY 2007, the growth rate was 31 %. And the GDP contribution of the IT ITES

stood at 5.2 %. The growth rate for the IT Exports was 33 %. For the June 2008 quarter ,

the industry clocked a growth rate of 27.8 % in revenues and it is expected to be at 27 %

for the September 2008 quarter. While the growth in aggregate revenues was healthy,

PAT grew by a mere 5.9 % in the June quarter. Forex losses incurred by software

companies took a toll on earnings growth during the quarter. If the rupee remains at the

current level or depreciates further, it could increase the forex losses of IT companies

which have substantial amount outstanding in hedges.

SOFTWARE SECTOR

The software industry was on a high growth trajectory up to the year ended March 2007.

However, the unabated rise in the rupee vis--vis the USD since April 2007 dampened

the sales growth and dwindled the profits of the software companies which earn a

majority of their billings in USD. Nevertheless, the industry managed to clock a healthy

sales growth of over 20%. While growth in aggregate net sales was healthy, a higher

31% growth in aggregate total expenses restricted the growth in aggregate net profits to

11.8% during the March 2008 quarter. This was a lowest year on year growth in net

profits in at least the last 17 quarters. A strong 21.8% growth in salary cost, the largest

expense item of the software industry, and a substantial 42.9% growth in other expenses

fuelled the growth in aggregate total expenses. As the growth in aggregated expenses in

the March 2008 quarter outpaced aggregate income growth, it dented the profit margins.

During the March 2008 quarter, PAT margin contracted by 240 basis points to 19.8%.

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For the June 2008 quarter , PAT and PBDIT both declined from the previous quarters

and the main reason was the rupee appreciation

ITES SECTOR REPORTS LOSSES IN JUNE 2008

The ITES industry posted a robust growth in revenues in the two quarters ended

December 2007 and it continued to maintain its high income growth even in the March

2008 quarter. The aggregate net sales of ITES companies grew by 27 % in June 2008

which was led by healthy performances of allied digital services (37.6 %) , HTMT

Global Solutions (27.3 per cent ) and First source Solutions . (16.3 percent ). This

healthy top line growth did not translate into corresponding growth in earnings and the

PAT for June 2008 quarter showed losses as 5 out of a sample size of 10 ITES

Companies reported losses for the June 2008 quarter. The growth in expenses wasfuelled by a 29.5 % growth in wage cost. And a 132.6 % growth in other expenses.

Wage costs accounted for 40 % of the total expenditure

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GOVERNMENT POLICY TOWARDS IT SECTOR

The Department of Information Technology (DIT) in the Ministry of Communications

and Information Technology is inter-alia responsible for formulation, implementation

and review of national policies in the field of Information Technology. All policy

matters relating to silicon facility, computer based information technology and

processing including hardware and software, standardization of procedures and matters

relating to international bodies, promotion of knowledge based enterprises, internet, e-

Commerce and information technology education and development of electronics and

coordination amongst its various users are also addressed by the Department.

Industrial Approval Policy

Industrial Licensing has been virtually abolished in the Information Technology sector.

Electronics and Information Technology industry can be set up anywhere in the country,

subject to clearance from the authorities responsible for control of environmental

pollution and local zoning and land use regulations.

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Foreign Investment Policy

A foreign company can start operations in India by registration of its company under theIndian Companies Act 1956. Foreign equity in such Indian companies can be up to

100%. At the time of registration it is necessary to have project details, local partner (if

any), structure of the company, its management structure and shareholding pattern.

Registration is a kind of formality and it takes about two weeks. Foreign technology

induction is encouraged both through FDI and through foreign technology collaboration

agreement. Foreign Direct Investment and Foreign technology collaboration agreements

can be approved either through the automatic route under powers delegated to the

Reserve Bank of India (RBI) or otherwise by the Government automatic approval. FDI

up to 100% is allowed under the automatic route from foreign/NRI investor without

prior approval in most of the sectors including the services sector. FDI in

sectors/activities under automatic route does not require any prior approval either by the

Government or RBI

Foreign Trade Policy

In general, all IT products are freely importable, with the exception of some defense

related items. All Electronics and IT products, in general, are freely exportable. Second

hand capital goods are freely importable. Export Promotion Capital Goods scheme

(EPCG) allows import of capital goods on payment of 5% customs duty. The export

obligation under EPCG Scheme can also be fulfilled by the supply of Information

Technology Agreement (ITA-1) items to the DTA provided the realization is in free

foreign exchange. Special Economic Zones (SEZs) are being set up to enable hassle free

manufacturing and trading for export purposes.

Export Promotion Schemes

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The government has established many STPIs(Software technology park of India) and

EOUs(Export oriented units ) for the development of the IT and ITES sectors in India.

EOU/EHTP/STP units may import and/or procure from the DTA or bonded warehouses

in DTA, without payment of duty, all types of goods, including capital goods, required

for its activities, provided they are not prohibited items of import in the ITC(HS). The

units shall also be permitted to import goods including capital goods required for the

approved activity, free of cost or on loan/lease from clients. The government has also

allowed for a lot of SEZs for the IT sector. Special Economic Zone (SEZ) is a

specifically delineated duty free enclave and shall be deemed to be foreign territory for

the purposes of trade operations and duties and tariffs. Goods and services going into the

SEZ area from DTA shall be treated as exports and goods and services coming from the

SEZ area into DTA shall be treated as if these are being imported. SEZ units may be set

up for manufacture of goods and rendering of services. SEZ unit may import/procure

from the DTA without payment of duty all types of goods and services, including capital

goods, whether new or second hand, required by it for its activities or in connection

therewith, provided they are not prohibited items of imports in the ITC(HS). The units

shall also be permitted to import goods required for the approved activity, including

capital goods, free of cost or on loan from clients. From 2010, the STPI Scheme is being

abolished but the government has allowed the conversion of the existing STPIs intoSEZs thus the software companies would continue to have benefits from the

government policy and it will help them to grow further.

So in general, the government has a very favorable policy for the IT sector. The

policy for any foreign company coming into India is also attractive . so the market

can expand in the near future. And the sector looks attractive to invest as the

government policies are both stable and attractive.

SWOT ANALYSIS OF INDIAN IT INDUSTRY

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STRENGTHS

Highly skilled human resource :

The Indian IT sector boasts of highly skilled human resource available at low wages.

Quality of work

Initiatives taken by the Government

(Setting up Hi-Tech Parks and implementation of e-governance projects)

Following Quality Standards such as ISO 9000, SEI CMM etc.

Cost competitiveness

Quality telecommunications infrastructure

Indian time zone (24 x 7 services to the global customers):

Time difference between India and America is approximately 12 hours, which is

beneficial for outsourcing of work. As the USA companies can get their work done

during the time they sleep. So in a way the US companies work will be executing for all

24 hours of a day.

WEAKNESSES

Dearth of suitable candidates

Less Research and Development:

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Basically the Indian companies are doing a lot of outsourced work which is not very

technical. The work of research etc. has not been done by the Indian companies on a

large scale. The total expenditure on R&D is less.

Due to the rising inflation since a very long time the employee salaries in IT sector are

increasing tremendously. Low wages benefit will soon come to an end. And if this

happens then it will be hard to maintain the customers in the Indian IT sector.

OPPORTUNITIES

High quality IT education market: The education market for IT is very good inIndia .This can be substantiated by the fact that even the Chinese people are studying

from NIIT , China centers.

Increasing number of working age people : Indias average work population is

25 years while it is above 50 for the USA . so India is having a tremendous advantage

for getting more work from the foreign countries in future.

Upcoming International Players in the market : This will increase the IT

market in India. So overall it is good for the sector.

The slowdown in USA economy will force the US companies to cut their costs

and for this , off shoring will be the natural choice as the total work through off shoring

costs very less in comparison to the work done in the USA. So the slowdown may prove

to be a blessing in disguise.

THREATS

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Lack of data security systems

Countries like China and Philippines with qualified workforce making efforts to

overcome the English language barrier

IT development concentrated in a few cities only

Obama policies towards off shoring in the USA

The USA Democratic presidential candidate Barack Obama is against the off\ shoring of

work. So if he becomes the USA president, then the Indian IT industry may have

problems in getting new business from USA, if Obama brings policies against off

shoring.

5 FORCES IN THE INDUSTRY

THREAT OF NEW ENTRANTS

As the government policies are favorable towards the IT sector, the threat of new

entrants

is there in the sector. But if we talk about the big software and hardware companies in

India such as Infosys and TCS etc. , they are not going to get much effected by the new

companies as they have built a very strong client base till now. But still easy entry for

theforeign players is not a good thing for the Indian IT majors. The BPO sector is already

having a lot of competition already so it wont make much difference if some more

BPOs come into the sector.

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BARGAINING POWER OF BUYERS

With so many brands available in the industry, it is clear that consumers have a wide

range of options. Therefore to attract new customers, every computer firm must offer

something of value which is hard to ignore. The same is true about the Software industry

as there is tough competition between TCS, Infosys, Satyam etc. so the customer is

having much bargaining power. The current slow-down in the industry has given

consumers even more power than they had before. They are now in demand, more than

ever before and they can certainly cash in on this.

BARGAINING POWER OF SUPPLIERSAs the companies in the Indian IT software sector are service companies and their major

resource is the Human power. The Indian IT industry will require about 2.3 million

people up to 2010 as per a study done by NASSCOMM. And the skilled people are less

in supply . This is the reason due to which the IT companies had to raise the wages in the

near future. So for attracting and retaining the skilled manpower, the IT companies will

be having less bargaining power in comparison to the employees.

THREAT OF SUBSTITUTES

Indian companies do work being outsourced by the USA , UK , Europe companies.

Their substitute is either no off shoring by these companies or off shoring to other

countries than India. No off shoring will lead to cost increase for these companies. And

if they offshore work to other countries than Indias main competition will be with

China. But still, in services like software development and maintenance, India is still

ahead from other countries. But the rising competition from Philippines, China, Thailand

etc. is a matter of concern for Indian IT sector.

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RIVALRY AMONG COMPETITORS

The rivalry among the existing competitors is very intense. The competition will only

get

Tougher as some of the international players such as Microsoft and adobe have set shopin India.

CONCLUSION ON INDIAN IT SECTOR

The overall scenario of the Indian IT sector does not look attractive for now due to a lot

of reasons like US Slowdown, High competition etc. But still the foundation of the

Indian IT industry is strong. As India is having more expertise in software development

than the other countries in the world doing off shoring For example, China and

Philippines. So in the long term the sector will be able to maintain a steady growth .This

can be proved by the following points.

1. Although there is a point of worry as the US economy is in a slowdown phase but this

may be a blessing in disguise. Due to this slowdown in the US economy, the demand in

USA is reducing which has led to decline in profits of USA companies. Thats why these

companies will have to take steps for cost cutting. And off shoring work to low costcountries such as India will be an automatic choice for these companies. So the current

US slowdown may increase the bottom-line of the Indian IT companies.

2. The big Indian IT companies are already having a lot of orders in pipeline. This factor

will also play a role in at least a normal growth rate for Indian IT companies.

3. It is expected that the Indian IT companies may go on a spree of mergers and

acquisitions in countries other than USA so as to reduce their dependency on USA for

getting business. For example, recently HCL and Infosys were trying to acquire Axon of

UK . This acquisition will give the bidding company an entry into UK and the company

also got the research abilities of Axon. (Axon is a big player of providing SAP services

in the UK).This acquisition may lead to other companies also doing the same to diversify

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their risk by operating in various countries and it will also help them to move to higher

point in value chain.

U.S FINANCIAL CRISIS

In fact, it really does look as if the foundations of US capitalism have shattered. Since

1864, American banking has been split into commercial banks and investment banks.

But now that's changing. Bear Stearns, Lehman Brothers, Merrill Lynch -- overnight,

some of the biggest names on Wall Street have disappeared into thin air. Goldman Sachs

and Morgan Stanley are the only giants left standing. Despite tolerable quarterly results,

even they have been hurt by mysterious slumps in prices and -- at least in Morgan

Stanley's case -- have prepared themselves for the end.

"Nothing will be like it was before," said James Allroy, a broker who was brooding over

his chai latte at a Starbucks on Wall Street. "The world as we know it is going

down."Many are drawing comparisons with the Great Depression, the national trauma

that has been the benchmark for everything since. "I think it has the chance to be the

worst period of time since 1929," financing legend Donald Trump told CNN. And the

Wall Street Journalseconds that opinion, giving one story the title: "Worst Crisis Since

'30s, With No End Yet in Sight."

But what's really happening? Experts have so far been unable to agree on any

conclusions. Is this the beginning of the end? Or is it just a painful, but normal cycle

correcting the excesses of recent years? Does responsibility lie with the ratings agencies,

which have been overvaluing financial institutions for a long time? Or did dubious short

sellers manipulate stock prices -- after all, they were suspected of having caused the last

stock market crisis in July.

The only thing that is certain is that the era of the unbridled free-market economy in the

US has passed -- at least for now. The near nationalization of AIG, America's largest

insurance company, with an $85 billion cash infusion -- a bill footed by taxpayers -- was

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a staggering move. The sum is three times as high as the guarantee provided by the

Federal Reserve when Bear Stearns was sold to JPMorgan Chase in March.

The most breathtaking aspect about this week's crisis, though, is that the life raft -- which

Washington had only previously used to bail out the mortgage giants Fannie Mae and

Freddie Mac -- is being handed out by a government whose party usually fights against

any form of government intervention. The policy is anchored in its party platform.

"I fear the government has passed the point of no return," financial historian Ron

Chernow told the New York Times. "We have the irony of a free-market administration

doing things that the most liberal Democratic administration would never have been

doing in its wildest dreams."

Subprime mortgage crisis

The subprime mortgage crisis is an ongoing financial crisis triggered by a dramatic rise

in mortgage delinquencies and foreclosures in the United States, with major adverse

consequences for banks and financial markets around the globe. The crisis, which has its

roots in the closing years of the 20th century, became apparent in 2007 and has exposed

pervasive weaknesses in financial industry regulation and the global financial system.

Many U.S. mortgages issued in recent years were made to sub prime borrowers, defined

as those with lesser ability to repay the loan based on various criteria. When U.S. house

prices began to decline in 2006-07, mortgage delinquencies soared, and securities

backed with subprime mortgages, widely held by financial firms, lost most of their

value. The result has been a large decline in the capital of many banks and USA

government sponsored enterprises, tightening credit around the world.

The crisis began with the bursting of the United States housing bubble and high default

rates on "sub prime" and adjustable rate mortgages (ARM), beginning in approximately

20052006. Government policies and competitive pressures for several years prior to the

crisis encouraged higher risk lending practices. Further, an increase in loan incentives

such as easy initial terms and a long-term trend of rising housing prices had encouraged

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borrowers to assume difficult mortgages in the belief they would be able to quickly

refinance at more favorable terms. However, once interest rates began to rise and

housing prices started to drop moderately in 20062007 in many parts of the U.S.,

refinancing became more difficult. Defaults and foreclosure activity increased

dramatically as easy initial terms expired, home prices failed to go up as anticipated, and

ARM interest rates reset higher. Foreclosures accelerated in the United States in late

2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly

1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from

2006.

Financial products called mortgage-backed securities (MBS), which derive their value

from mortgage payments and housing prices, had enabled financial institutions andinvestors around the world to invest in the U.S. housing market. Major banks and

financial institutions had borrowed and invested heavily in MBS and reported losses of

approximately US$435 billion as of 17 July 2008. The liquidity and solvency concerns

regarding key financial institutions drove central banks to take action to provide funds to

banks to encourage lending to worthy borrowers and to restore faith in the commercial

paper markets, which are integral to funding business operations. Governments also

bailed out key financial institutions, assuming significant additional financial

commitments.

The risks to the broader economy created by the housing market downturn and

subsequent financial market crisis were primary factors in several decisions by central

banks around the world to cut interest rates and governments to implement economic

stimulus packages. These actions were designed to stimulate economic growth and

inspire confidence in the financial markets. Effects on global stock markets due to the

crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks inU.S. corporations had suffered about $8 trillion in losses, as their holdings declined in

value from $20 trillion to $12 trillion. Losses in other countries have averaged about

40%.Losses in the stock markets and housing value declines place further downward

pressure on consumer spending, a key economic engine. Leaders of the larger developed

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and emerging nations met in November 2008 to formulate strategies for addressing the

crisis.[

.Sub prime lending is the practice of lending, mainly in the form of mortgages for the

purchase of residences, to borrowers who do not meet the usual criteria for borrowing at

the lowest prevailing market interest rate. These criteria pertain to the borrower's credit

score, credit history and other factors. If a borrower is delinquent in making timely

mortgage payments to the loan servicer (a bank or other financial firm), the lender can

take possession of the residence acquired using the proceeds from the mortgage, in a

process called foreclosure.

The value of USA sub prime mortgages was estimated at $1.3 trillion as of March 2007,

[with over 7.5 million first-lien sub prime mortgages outstanding. Between 2004-2006

the share of sub prime mortgages relative to total originations ranged from 18%-21%,

versus less than 10% in 2001-2003 and during 2007. In the third quarter of 2007, sub

prime ARMs making up only 6.8% of USA mortgages outstanding also accounted for

43% of the foreclosures which began during that quarter. By October 2007,

approximately 16% of sub prime adjustable rate mortgages (ARM) were either 90-days

delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of

2005. By January 2008, the delinquency rate had risen to 21%. and by May 2008 it was

25%.

The value of all outstanding residential mortgages, owed by USA households to

purchase residences housing at most four families, was US$9.9 trillion as of year-end

2006, and US$10.6 trillion as of midyear 2008.During 2007, lenders had begun

foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This

increased to 2.3 million in 2008, an 81% increase vs. 2007.As of August 2008, 9.2% of

all mortgages outstanding were either delinquent or in foreclosure. Between August

2007 and October 2008, 936,439 USA residences completed foreclosure.

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leverage.

Credit risk arises because a borrower has the option of defaulting on the loan he/she

owes. Traditionally, lenders (who were primarily thrifts) bore the credit risk on the

mortgages they issued. Over the past 60 years, a variety of financial innovations have

gradually made it possible for lenders to sell the right to receive the payments on the

mortgages they issue, through a process called securitization. The resulting securities are

called mortgage backed securities (MBS) and collateralized debt obligations (CDO).

Most American mortgages are now held by mortgage pools, the generic term for MBS

and CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of midyear

2008, $6.6 trillion were held by mortgage pools, and $3.4 trillion by traditional

depository institutions.

This "originate to distribute" model means that investors holding MBS and CDOs also

bear several types of risks, and this has a variety of consequences. There are four

primary types of risk:

Name Description

Credit riskthe risk that the homeowner or borrower will be unable or unwilling to pay

back the loan

Asset price

risk

the risk that assets (MBS in this case) will depreciate in value, resulting in

financial losses, markdowns and possibly margin calls

Liquidity riskthe risk that a business entity will be unable to obtain financing, such as

from the commercial paper market

Counterparty

risk

the risk that a party to a contract will be unable or unwilling to uphold

their obligations.

The aggregate effect of these and other risks has recently been called

systemic risk, which refers to when formerly uncorrelated risks shift and

become highly correlated, damaging the entire financial system

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When homeowners default, the payments received by MBS and CDO investors decline

and the perceived credit risk rises. This has had a significant adverse effect on investors

and the entire mortgage industry. The effect is magnified by the high debt levels

(financial leverage) households and businesses have incurred in recent years. Finally, the

risks associated with American mortgage lending have global impacts, because a major

consequence of MBS and CDOs is a closer integration of the USA housing and

mortgage markets with global financial markets.

Investors in MBS and CDOs can insure against credit risk by buying credit defaults

swaps (CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would

have to pay their counterparties increased. This created uncertainty across the system, as

investors wondered if CDS issuers would honor their commitments

Causes

The reasons proposed for this crisis is varied and complex. The crisis can be attributed

to a number of factors pervasive in both housing and credit markets, factors which

emerged over a number of years. Causes proposed include the inability of homeownersto make their mortgage payments, poor judgment by borrowers and/or lenders,

speculation and overbuilding during the boom period, risky mortgage products, high

personal and corporate debt levels, financial products that distributed and perhaps

concealed the risk of mortgage default, monetary policy, international trade imbalances,

and government regulation (or the lack thereof).[31] Ultimately, though, moral hazard lay

at the core of many of the causes.[32]

In its "Declaration of the Summit on Financial Markets and the World Economy," dated

15 November 2008, leaders of the Group of 20 cited the following causes:

During a period of strong global growth, growing capital flows, and prolonged stability

earlier this decade, market participants sought higher yields without an adequate

appreciation of the risks and failed to exercise proper due diligence. At the same time,

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weak underwriting standards, unsound risk management practices, increasingly complex

and opaque financial products, and consequent excessive leverage combined to create

vulnerabilities in the system. Policy-makers, regulators and supervisors, in some

advanced countries, did not adequately appreciate and address the risks building up in

financial markets, keep pace with financial innovation, or take into account the systemic

ramifications of domestic regulatory actions.

Boom and bust in the housing market

Low interest rates and large inflows of foreign funds created easy credit conditions for a

number of years prior to the crisis, fueling a housing market boom and encouraging

debt-financed consumption.

The USA home ownership rate increased from 64% in 1994(about where it had been since 1980) to an all-time high of 69.2% in 2004. Sub prime

lending was a major contributor to this increase in home ownership rates and in the

overall demand for housing, which drove prices higher.

Between 1997 and 2006, the price of the typical American house increased by 124%

During the two decades ending in 2001, the national median home price ranged from 2.9

to 3.1 times median household income. This ratio rose to 4.0 in 2004 and 4.6 in 2006.

This housing bubble resulted in quite a few homeowners refinancing their homes at

lower interest rates, or financing consumer spending by taking out second mortgages

secured by the price appreciation. USA household debt as a percentage of annual

disposable personal income was 127% at the end of 2007, versus 77% in 1990.

While housing prices were increasing, consumers were saving less and both borrowing

and spending more. A culture of consumerism is a factor "in an economy based on

immediate gratification." Starting in 2005, American households have spent more than

99.5% of their disposable personal income on consumption or interest payments. If

imputations mostly pertaining to owner-occupied housing are removed from these

calculations, American households have spent more than their disposable personal

income in every year starting in 1999. Household debt grew from $705 billion at year-

end 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and

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finally to $14.5 trillion in midyear 2008, 134% of disposable personal income. During

2008, the typical USA household owned 13 credit cards, with 40% of households

carrying a balance, up from 6% in 1970.

This credit and house price explosion led to a building boom and eventually to a surplus

of unsold homes, which caused U.S. housing prices to peak and begin declining in mid-

2006.Easy credit, and a belief that house prices would continue to appreciate, had

encouraged many sub prime borrowers to obtain adjustable-rate mortgages. These

mortgages enticed borrowers with a below market interest rate for some predetermined

period, followed by market interest rates for the remainder of the mortgage's term.

Borrowers who could not make the higher payments once the initial grace period ended

would try to refinance their mortgages. Refinancing became more difficult, once houseprices began to decline in many parts of the USA. Borrowers who found themselves

unable to escape higher monthly payments by refinancing began to default.

As more borrowers stop paying their mortgage payments, foreclosures and the supply of

homes for sale increase. This places downward pressure on housing prices, which further

lowers homeowners' equity. The decline in mortgage payments also reduces the value of

mortgage-backed securities, which erodes the net worth and financial health of banks.

This vicious cycle is at the heart of the crisis.

By September 2008, average U.S. housing prices had declined by over 20% from their

mid-2006 peak. This major and unexpected decline in house prices means that many

borrowers have zero or negative equity in their homes, meaning their homes were worth

less than their mortgages. As of March 2008, an estimated 8.8 million borrowers

10.8% of all homeowners had negative equity in their homes, a number that is

believed to have risen to 12 million by November 2008. Borrowers in this situation have

an incentive to "walk away" from their mortgages and abandon their homes, even though

doing so will damage their credit rating for a number of years.

Increasing foreclosure rates increases the inventory of houses offered for sale. The

number of new homes sold in 2007 was 26.4% less than in the preceding year. By

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January 2008, the inventory of unsold new homes was 9.8 times the December 2007

sales volume, the highest value of this ratio since 1981. Furthermore, nearly four million

existing homes were for sale, of which almost 2.9 million were vacant. This overhang of

unsold homes lowered house prices. As prices declined, more homeowners were at risk

of default or foreclosure. House prices are expected to continue declining until this

inventory of unsold homes (an instance of excess supply) declines to normal levels

Economist Nouriel Roubini wrote in January 2009 that sub prime mortgage defaults

triggered the broader global credit crisis, but were just one symptom of multiple debt

bubble collapses: "This crisis is not merely the result of the U.S. housing bubbles

bursting or the collapse of the United States sub prime mortgage sector. The credit

excesses that created this disaster were global. There were many bubbles, and theyextended beyond housing in many countries to commercial real estate mortgages and

loans, to credit cards, auto loans, and student loans. There were bubbles for the

securitized products that converted these loans and mortgages into complex, toxic, and

destructive financial instruments. And there were still more bubbles for local

government borrowing, leveraged buyouts, hedge funds, commercial and industrial

loans, corporate bonds, commodities, and credit-default swaps..." It is the bursting of the

many bubbles that he believes are causing this crisis to spread globally and magnify its

impact.

Speculation

Speculation in residential real estate has been a contributing factor. During 2006, 22% of

homes purchased (1.65 million units) were for investment purposes, with an additional

14% (1.07 million units) purchased as vacation homes. During 2005, these figures were

28% and 12%, respectively. In other words, a record level of nearly 40% of homespurchases were not intended as primary residences. David Lereah, NAR's chief

economist at the time, stated that the 2006 decline in investment buying was expected:

"Speculators left the market in 2006, which caused investment sales to fall much faster

than the primary market."

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Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the

historical appreciation at roughly the rate of inflation. While homes had not traditionally

been treated as investments subject to speculation, this behavior changed during the

housing boom. For example, one company estimated that as many as 85% of

condominium properties purchased in Miami were for investment purposes. Media

widely reported condominiums being purchased while under construction, then being

"flipped" (sold) for a profit without the seller ever having lived in them. Some mortgage

companies identified risks inherent in this activity as early as 2005, after identifying

investors assuming highly leveraged positions in multiple properties.

Nicole Gelinas of the Manhattan Institute described the consequences of failing to

respond to the shifting treatment of a home from conservative inflation hedge tospeculative investment. For example, individuals investing in equities have margin

(borrowing) restrictions and receive warnings regarding the risk to principal; there are no

such requirements for home buyers. While stock brokers are prohibited from telling an

investor that a stock or bond investment cannot lose money, it was not illegal for

mortgage brokers to do so. Equity investors are well-aware of the need to diversify their

financial holdings, but for many homeowners the home represented both a leveraged and

concentrated risk. Further, in the U.S. capital gains on stocks are taxed more

aggressively than housing appreciation, which has large exemptions. These factors all

enabled speculative behavior.

Economist Robert Shiller argues that speculative bubbles are fueled by "contagious

optimism, seemingly impervious to facts, that often takes hold when prices are rising.

Bubbles are primarily social phenomena; until we understand and address the

psychology that fuels them, they're going to keep forming." Keynesian economist

Hyman Minsky described three types of speculative borrowing that contribute to risingdebt and an eventual collapse of asset values:

The "hedge borrower," who expects to make debt payments from cash flows

from other investments;

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The "speculative borrower," who borrows believing that he can service the

interest on his loan, but who must continually roll over the principal into new

investments;

The "borrower," who relies on the appreciation of the value of his assets to

refinance or pay off his debt, while being unable to repay the original loan.

Speculative borrowing has been cited as a contributing factor to the sub prime mortgage

crisis.

High-risk mortgage loans and lending/borrowing practices

Lenders began to offer more and more loans to higher-risk borrowers, including illegal

immigrants. Sub prime mortgages amounted to $35 billion (5% of total originations) in

1994, 9% in 1996, $160 billion (13%) in 1999, and $600 billion (20%) in 2006. A study

by the Federal Reserve found that the average difference between sub prime and prime

mortgage interest rates (the "sub prime markup") declined from 280 basis points in 2001,

to 130 basis points in 2007. In other words, the risk premium required by lenders to offer

a sub prime loan declined. This occurred even though the credit ratings of sub prime

borrowers, and the characteristics of sub prime loans, both declined during the 2001

2006 period, which should have had the opposite effect. The combination of declining

risk premia and credit standards is common to classic boom and bust credit cycles.

In addition to considering higher-risk borrowers, lenders have offered increasingly risky

loan options and borrowing incentives. In 2005, the median down payment for first-time

home buyers was 2%, with 43% of those buyers making no down payment

whatsoever.By comparison, China has down payment requirements that exceed 20%,

with higher amounts for non-primary residences.

Growth in mortgage loan fraud based upon US Department of the Treasury Suspicious

Activity Report Analysis

One high-risk option was the "No Income, No Job and no Assets" loans, sometimes

referred to as Ninja loans. Another example is the interest-only adjustable-rate mortgage

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(ARM), which allows the homeowner to pay just the interest (not principal) during an

initial period. Still another is a "payment option" loan, in which the homeowner can pay

a variable amount, but any interest not paid is added to the principal. An estimated one-

third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%, which

then increased significantly after some initial period, as much as doubling the monthly

payment.

Mortgage underwriting practices have also been criticized, including automated loan

approvals that critics argued were not subjected to appropriate review and

documentation In 2007, 40% of all sub prime loans resulted from automated

underwriting. The chairman of the Mortgage Bankers Association claimed that mortgage

brokers, while profiting from the home loan boom, did not do enough to examinewhether borrowers could repay.Mortgage fraud by borrowers increased.

Securitization practices

Securitization, a form of structured finance, involves the pooling of financial assets,

especially those for which there is no ready secondary market, such as mortgages, creditcard receivables, student loans. The pooled assets serve as collateral for new financial

assets issued by the entity (mostly GSEs and investment banks) owning the underlying

assets. The diagram at left shows how there are many parties involved.

Securitization, combined with investor appetite formortgage-backed securities (MBS),

and the high ratings formerly granted to MBSs by rating agencies, meant that mortgages

with a high risk of default could be originated almost at will, with the risk shifted from

the mortgage issuer to investors at large. Securitization meant that issuers could

repeatedly relend a given sum, greatly increasing their fee income. Since issuers no

longer carried any default risk, they had every incentive to lower their underwriting

standards to increase their loan volume and total profit.

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The traditional mortgage model involved a bank originating a loan to the

borrower/homeowner and retaining the credit (default) risk. With the advent of

securitization, the traditional model has given way to the "originate to distribute" model,

in which the credit risk is transferred (distributed) to investors through MBS and CDOs.

Securitization created a secondary market for mortgages, and meant that those issuing

mortgages were no longer required to hold them to maturity.

Asset securitization began with the creation of private mortgage pools in the 1970s.

Securitization accelerated in the mid-1990s. The total amount of mortgage-backed

securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized

share of sub prime mortgages (i.e., those passed to third-party investors via MBS)

increased from 54% in 2001, to 75% in 2006. Alan Greenspan has stated that the current

global credit crisis cannot be blamed on mortgages being issued to households with poor

credit, but rather on the securitization of such mortgages.

American homeowners, consumers, and corporations owed roughly $25 trillion during

2008. American banks retained about $8 trillion of that total directly as traditional

mortgage loans. Bondholders and other traditional lenders provided another $7 trillion.

The remaining $10 trillion came from the securitization markets. The securitization

markets started to close down in the spring of 2007 and nearly shut-down in the fall of

2008. More than a third of the private credit markets thus became unavailable as a sourceof funds

Investment banks sometimes placed the MBS they originated or purchased into off-

balance sheet entities called structured investment vehiclesor special purpose entities.

Moving the debt "off the books" enabled large financial institutions to circumvent capital

requirements, thereby increasing profits but augmenting risk. Investment banks and off-

balance sheet financing vehicles are sometimes referred to as the shadow banking system

and are not subject to the same capital requirements and central bank support as

depository banks.

Some believe that mortgage standards became lax because securitization gave rise to a

form of moral hazard, whereby each link in the mortgage chain made a profit while

passing any associated credit risk to the next link in the chain. At the same time, some

financial firms retained significant amounts of the MBS they originated, thereby

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retaining significant amounts of credit risk and so were less guilty of moral hazard.

Some argue this was not a flaw in the securitization concept per se, but in its

implementation

According to Nobel laureate Dr. A. Michael Spence, "systemic risk escalates in the

financial system when formerly uncorrelated risks shift and become highly correlated.

When that happens, then insurance and diversification models fail. There are two

striking aspects of the current crisis and its origins. One is that systemic risk built

steadily in the system. The second is that this buildup went either unnoticed or was not

acted upon. That means that it was not perceived by the majority of participants until it

was too late. Financial innovation, intended to redistribute and reduce risk, appears

mainly to have hidden it from view. An important challenge going forward is to better

understand these dynamics as the analytical underpinning of an early warning system

with respect to financial instability."

Government policies

Both government action and inaction has contributed to the crisis. Some are of the

opinion that the current American regulatory framework is outdated. Then President

George W. Bush stated in September 2008: "Once this crisis is resolved, there will be

time to update our financial regulatory structures. Our 21st century global economy

remains regulated largely by outdated 20th century laws. The Securities and Exchange

Commission (SEC) has conceded that self-regulation of investment banks contributed to

the crisis.

Increasing home ownership was a goal of the Clinton and Bush administrations There is

evidence that the Federal government leaned on the mortgage industry, including Fannie

Mae and Freddie Mac (the GSE), to lower lending standards. Also, the U.S. Department

of Housing and Urban Development's (HUD) mortgage policies fueled the trend towards

issuing risky loans.In 1995, the GSEs began receiving government incentive payments for purchasing

mortgage backed securities which included loans to low income borrowers. Thus began

the involvement of the GSE with the sub prime market Sub prime mortgage originations

rose by 25% per year between 1994 and 2003, resulting in a nearly ten-fold increase in

the volume of sub prime mortgages in just nine years. The relatively high yields on these

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securities, in a time of low interest rates, were very attractive to Wall Street, and while

Fannie and Freddie generally bought only the least risky sub prime mortgages, these

purchases encouraged the entire sub prime market. In 1996, HUD directed the GSE that

at least 42% of the mortgages they purchased should have been issued to borrowers

whose household income was below the median in their area. This target was increased

to 50% in 2000 and 52% in 2005. From 2002 to 2006 Fannie Mae and Freddie Mac

combined purchases of sub prime securities rose from $38 billion to around $175 billion

per year before dropping to $90 billion, thus fulfilling their government mandate to help

make home buying more affordable. During this time, the total market for sub prime

securities rose from $172 billion to nearly $500 billion only to fall back down to $450

billion.

By 2008, the GSE owned, either directly or through mortgage pools they sponsored, $5.1

trillion in residential mortgages, about half the amount outstanding The GSE have

always been SShighly leveraged, their net worth as of 30 June 2008 being a mere

US$114 billion. When concerns arose in September 2008 regarding the ability of the

GSE to make good on their guarantees, the Federal government was forced to place the

companies into a conservator ship, effectively nationalizing them at the taxpayers'

expense.

Liberal economist Robert Kuttnerhas suggested that the repeal of the Glass-Steagall Actby the Gramm-Leach-Bliley Act of 1999 may have contributed to the sub prime

meltdown, but this is controversial.[113][114] The Federal government bailout of thrifts

during the savings and loan crisis of the late 1980s may have encouraged other lenders to

make risky loans, and thus given rise to moral hazard.[115][116]

Economists have also debated the possible effects of the Community Reinvestment Act

(CRA), with detractors claiming that the Act encouraged lending to uncredit worthy

borrowers. and defenders claiming a thirty year history of lending without increased risk.

Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount

of mortgages issued to otherwise unqualified low-income borrowers, and allowed the

securitization of CRA-regulated mortgages, even though a fair number of them were sub

prime.

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