US FINANCIAL CRISIS, ITS IMPACT ON INDIA AND GOVERNMENT INITIATIVES

University Degree Business and Administrative studies

TABLE OF CONTENTS

EXECUTIVE SUMMARY

The combined impact of the reversal of portfolio equity flows, the reduced availability of international capital both debt and equity, the perceived increase in the price of equity with lower equity valuations, and pressure on the exchange rate, growth in the Indian corporate sector is feeling some impact of the global financial turmoil. The monetary and fiscal package given by the Government and The RBI has given stimulus to maintain growth On the other hand, on a macro basis, with external savings utilisation having been low traditionally, between one to two percent of GDP, and the sustained high domestic savings rate, this impact can be expected to be at the margin. Moreover, the continued buoyancy of foreign direct investment suggests that confidence in Indian growth prospects remains healthy.

INTRODUCTION

The economy of each and every nation, whether big or small is facing the turmoil. Asia and Europe being most closely linked with US have faced the direct heat due to subprime crisis . The volatility of market and uncertainty which gripped the world around is surely going to have long lasting consequences. Whether its India, China, Singapore or any other Asian country, financial market of each and every economy has registered recession due to the US meltdown.

What is subprime crisis?

The subprime crisis is an ongoing financial crisis triggered by a dramatic rise in mortgage problems and foreclosures in the United States, with major adverse consequences for banks and financial markets around the globe. The crisis which has its root in the end of the 20th century, became apparent in 2007 and has exposed weakness in the financial industry regulation and the global finance system.

Many USA mortgages issued in recent years are subprime, meaning that little or no downpayment was made, and that they were issued to households with low incomes and assets, and with troubled credit histories. When USA house prices began to decline in 2006-07, mortgage default increased, 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.

How did it happen?

The crisis began with the bursting of the United States housing bubble and high default rates on "subprime" and adjustable rate mortgages (ARM), beginning in approximately 2005–2006. 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 borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favourable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 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 percent; from 2006.

Financial products called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors 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 in U.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 percent. Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine.

IMPACT OF THE CRISIS ON INDIA

In India, the adverse effects have been mainly in the equity markets because of reversal of portfolio equity flows, and the concomitant effects on the domestic forex market and liquidity conditions. But real estate, retail, IT/ITES, banking and export have also been affected. The macro effects have so far been muted due to the overall strength of domestic demand, the healthy balance sheets of the Indian corporate sector, and the predominant domestic financing of investment. As might be expected, the main impact of the global financial turmoil in India has emanated from the significant change experienced in the capital account in 2008-09. Total net capital flows fell from US$17.3 billion in April-June 2007 to US$13.2 billion in April-June 2008. Nonetheless, capital flows are expected to be more than sufficient to cover the current account deficit this year as well. While Foreign Direct Investment (FDI) inflows have continued to exhibit accelerated growth (US$ 16.7 billion during April-August 2008 as compared with US$ 8.5 billion in the corresponding period of 2007), portfolio investments by foreign institutional investors (FIIs) witnessed a net outflow of about US$ 6.4 billion in April-September 2008 as compared with a net inflow of US$ 15.5 billion in the corresponding period last year. Similarly, external commercial borrowings of the corporate sector declined from US$ 7.0 billion in April-June 2007 to US$ 1.6 billion in April-June 2008, partially in response to policy measures in the face of excess flows in 2007-08, but also due to the current turmoil in advanced economies. With the existence of a merchandise trade deficit of 7.7 per cent of GDP in 2007-08, and a current account deficit of 1.5 per cent, and change in perceptions with respect to capital flows, there has been significant pressure on the Indian exchange rate in recent months. Whereas the nominal exchange rate appreciated from US$1 = Rs. 46.12 in September 2006 to US$ 1 = Rs. 40.34 in September 2007, it has depreciated to a level of US $ 1 = Rs. 47.42 as on December 18, 2008.

With the volatility in portfolio flows having been large during 2007 and 2008, the impact of global financial turmoil has been felt particularly in the equity market. The BSE Sensex (1978-79=100) increased significantly from a level of 13,072 as at end-March 2007 to its peak of 20,873 on January 8, 2008 in the presence of heavy portfolio flows responding to the high growth performance of the Indian corporate sector. With portfolio flows reversing in 2008, partly because of the international market turmoil, the Sensex has now dropped to a level of 10076 on December 18, 2008, in line with ...

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The domestic investment is largely financed by domestic savings. However, the corporate sector has, in recent years, mobilized significant resources from global financial markets for funding, both debt and non-debt, their ambitious investment plans. The current risk aversion in the international financial markets to EMEs could,

therefore, have some impact on the Indian corporate sector’s ability to raise funds from international sources and thereby impede some investment growth. Such corporate would, therefore, have to rely relatively more on domestic sources of financing, including bank credit. This could, in turn, put some upward pressure on domestic interest rates. Moreover, domestic primary capital market issuances have suffered in the current fiscal year so far in view of the sluggish stock market conditions. Thus, one can expect more demand for bank credit, and non-food credit growth has indeed accelerated in the current year (26.2 per cent on a year-on-year basis as on September 12, 2008 as compared with 23.3 per cent a year ago).

Impact on the Indian Banking System

A detailed study undertaken by the RBI in September 2007 on the impact of the subprime episode on the Indian banks had revealed that none of the Indian banks or the foreign banks, with whom the discussions had been held, had any direct exposure to the sub-prime markets in the USA or other markets. However, a few Indian banks had invested in the collateralised debt obligations (CDOs) / bonds which had a few underlying entities with sub-prime exposures. Thus, no direct impact on account of direct exposure to the sub-prime market was in evidence. However, a few of these banks did suffer some losses on account of the mark-to-market losses caused by the widening of the credit spreads arising from the sub-prime episode on term liquidity in the market, even though the overnight markets remained stable.

Consequent upon filling of bankruptcy by Lehman Brothers, all banks were advised to report the details of their exposures to Lehman Brothers and related entities both in India and abroad. Out of 77 reporting banks, 14 reported exposures to Lehman Brothers and its related entities either in India or abroad. An analysis of the information reported by these banks revealed that majority of the exposures reported by the banks pertained to subsidiaries of Lehman Bros Holdings Inc. which are not covered by the bankruptcy proceedings. Overall, these banks’ exposure especially to Lehman Brothers Holding Inc. which has filed for bankruptcy is not significant and banks are reported to have made adequate provisions. In the aftermath of the turmoil caused by bankruptcy, the Reserve Bank has announced a series of measures to facilitate orderly operation of financial markets and to ensure financial stability which predominantly includes extension of additional liquidity support to banks.

Impact on foreign trade

Although foreign trade does help an economy, it also becomes vulnerable to external shocks as has happened with the US financial crisis which has now affected India's key sectors including information technology, banking and commodities. As foreign trade rises, more and more products are imported. Much of our value-added spices exported are based on raw spices imported into the country in large quantities. It is true that the government has always provides sops to boost the agricultures and allied businesses, but the major focus was sometimes on imports.

Exports fell by 12 percent in October and the government has cut its export target for the year to 175 billion US dollars from 200 billion.

Impact on manufacturing sector

India's industrial production contracted for the first time in 15 years in October. The index of industrial production shrank 0.4 percent in October, due in part to falling production of consumer goods. From April to October, the index grew by 4.1 percent versus 9.9 percent during the same period last year.

The weaker-than-expected data adds to growing skepticism that the government stimulus package announced over the weekend will prove effective.

More fresh evidence that India, while still growing faster than most economies, is not exempt from the global slowdown comes from its troubled auto sector. Many international carmakers have stormed into India as they try to counter falling sales in more developed markets.

Impact on automobile

Sales of passenger vehicles in India, which averaged 17.2 percent annual growth over the last five years, plunged 23.71 percent in November, according to the Society of Indian Automobile Manufacturers. Indian automakers slowed production by 6.11 percent in November, and many have slashed prices to attract more buyers.

Impact of Indian Outsourcing Industry

Analysts are predicting may miss target for the year 2009-2010.

Impact on IT sector

Approximately 61% of the Indian IT sector’s revenues are from US clients. If you just take the top five India players who account for 46% of the IT industry’s revenues, the revenue contribution from US clients is approximately 58%. About 30% of the industry revenues are estimated to be from financial services.

A recent study reveals that 43% of Western companies are cutting back their IT spend and nearly 30 percent are scrutinizing IT projects for better returns. Some of this can lead to offshoring, but the impact of overall reduction in discretionary IT spends, including offshore work, cannot be denied. The slowing U.S. economy has seen 70 percent of firms negotiating lower rates with suppliers and nearly 60 percent are cutting back on contractors. With budgets squeezed, just over 40 percent of companies plan to increase their use of offshore vendors.

Impact on Real estate

In the race to amass huge land reserves, companies were outdoing each other by bidding for the costliest land parcels. Financing was done through internal accruals, private equity funding and large-scale borrowings — through banks, as well as against promoter shares.

Hence, property prices started touching new highs virtually everyday. With interest rates hovering around 12-13 %, home loan offtake was the first to bear the brunt of the stock market crash. Absence of demand led to a severe cash crunch. As a result, property prices took a sudden U-turn and started plunging.

Impact on employment

Job growth is also slowing , it is expected that net employment in India would grow 19 percent next quarter down from 43 percent this quarter.

MEASURES TAKEN BY GOVERNMENT

Monetary measures

The monetary policy response by RBI (and government) has been prompt and substantial. In the sharpest reduction ever, the CRR has been cut from 9 percent to 5.5 percent, thus injecting almost Rs 150,000 crores of primary liquidity in less than a month. In addition, the SLR has been reduced, effectively, to 24 percent (from 25 percent), with 1.5 percent points of the reduction earmarked for liquidity support by banks to mutual funds and NBFCs (since some of these entities had been experiencing substantial liquidity stress over the past month). The Repo policy rate has been reduced from 9 percent to 6.5 percent its reverse repo rate, the rate at which it borrows overnight, to 5.0 percent.. The RBI has also announced a plethora of other measures to enhance liquidity, liberalise terms for NRI deposits and external commercial borrowing (ECB), augment export credit refinance and (somewhat dubiously) reduce banks' provisioning norms (tightened during the earlier upswing in the credit cycle) for loans for housing, real estate, personal loans, credit card receivables and capital market exposure.

To facilitate credit flow to small units, the Reserve Bank of India recently announced a refinance facility of Rs 7,000 crore for the Small Industries Development Bank of India. The government has also said it will issue an advisory to public sector enterprises to ensure prompt payment of these units’ bills.

Fiscal Policy

The following are the highlights of the fiscal stimulus package unveiled by the government Sunday to contain the impact of global financial crisis on the Indian economy:- Plan, non-plan expenditure of Rs.300,000 crore (Rs.3,000 billion/$60 billion) in four months

Parliament nod to be sought for Rs.20,000 crore more toward plan expenditure.
Across-the-board cut of four percent in the ad valorem central value-added tax.
Interest subvention of two percent on export credit for labour intensive sectors.
Additional allocations for export incentive schemes
Full refund of service tax paid by exporters to foreign agents
Incentives for loans on housing for up to Rs.500,000, and up to Rs.2 million
Limits under the credit guarantee scheme for small enterprises doubled
Lock-in period for loans to small firms under credit guarantee scheme reduced
India Infrastructure Finance Co allowed to raise Rs.100 billion through tax-free bonds
Norms for government departments to replace vehicles relaxed
Import duty on naphtha for use by the power sector is being reduced to zero
Export duty on iron ore fines eliminated
Export duty on lumps for steel industry reduced to five percent

Exchange Rate Policy

Since the downward pressure on the rupee started a few months ago, government and RBI have correctly permitted a controlled slide, backed by substantial RBI forex sales from time to time.

Defending a particular rupee/$ rate would invite swift and unwanted depletion of reserves. The costs of "overshooting" on the downside could be hideously high, both in economic and political terms. So, the only viable policy remains one of intervening selectively and avoiding excessively loose monetary policy.

IMPACT OF THE MEASURE TAKEN ON THE ECONOMY

Interest support for exporters

The measures for exporters, who saw a decline in shipments in October for the first time in five years, include an interest support of two percent for labour intensive sectors like textiles, handicraft and handloom.

This apart, additional allocation has been made towards various incentives for exporters, guarantee of export credit, full refund of service tax to foreign agents and refund of service tax under the duty drawback scheme.

Incentives for home loan borrowers

Instructions have also been given to state-run banks to unveil a scheme under which borrowers for houses under two categories - up to Rs,500,000 and up to Rs.2 million - will get special incentives.

Cheaper Home loan would give a boost to the Real Estate sector which would drive the demand of steel and cement industry.

Credit guarantee limits for small units doubled

For small and micro enterprises, the limits under the credit guarantee scheme which gives access to working capital and other financial needs, have been doubled to Rs.10 million.
The lock in period for loans covered under the existing credit guarantee scheme is also being reduced from 24 to 18 months to encourage banks to extend more loans under the credit guarantee scheme, the statement said.

IIFCL to float $2bn tax free bonds

The government has also authorised the India Infrastructure Finance Co Ltd (IIFCL) to raise Rs.100 billion ($2 billion) through tax-free bonds to support financing of government-financed infrastructure projects. In a push to the automobile sector, government departments have been allowed to replace vehicles within the allowed budget, with a major relaxation in the time-consuming procedures.
This apart, import duty on naphtha for use by the power sector is being reduced to zero, while export duty on iron ore fines will be eliminated, and reduced to five percent for lumps.

The additional expenditure will further expand India's fiscal deficit, which widened 60 percent to 73 billion US dollars between April and October from the same period a year earlier.

The Fiscal Deficit would increase by 1.99% of GDP. This would also boost the aggregate demand.

Export incentives would make the credit cheaper and availability of debt will increase.
The Rs. 100 Billion tax free bonds will increase the spending on the government financed projects.

Expected Results (AD-AS Curve)

Both the fiscal and monetary measures taken by government will acts as complementary to each other and help the sliding economy to grow. This can be shown through the Aggregate demand-supply curve (AD-AS).

The above graph shows the AD-AS curve during the Indian economy slowdown and post monetary and fiscal policy measures.

Before the impact of US recession the economy was running as per planned, and the equilibrium point was at A on the LRAS0
The Government decreases its projection to LRAS1.
Due to the recession the various business sectors are affected, so the demand decreases and the AD curve shifts from AD0 to AD1.
Due to the decrease in demand and the tight measures being followed by in India like the high interest rates, supply also decreases and the AS curve shifts from AS0 to AS1.
Now due to these policy measures the demand will increase and the demand curve will shift from AD1 to AD2.
Due to the increased demand the supply will also increase in and the AS curve will go to AS2.

FUTURE IMPLICATION

From India’s perspective, there are many emerging silver linings that must be taken cognizance of. Firstly, the collapse of the bubble in global commodity prices including oil implies a return to equilibrium. Fortunately for India, the concurrent onset of recession in the world’s largest-consuming economies means that there will be stagnation or decline in demand for almost all major commodities — this will imply further easing of inflationary pressures on the Indian economy. The easing of inflationary pressure, especially in the backdrop of the forthcoming general elections, allows the government to become pro-growth once again should it choose to do so.

Secondly, a contraction in major global economies may turn out to a blessing for low-cost producers and exporters of numerous goods and services. With pressure on just about every business in the developed world to reduce cost and improve efficiency, and pressure from the consumers of the developed world on retailers and other goods and services providers to offer more value-priced options and solutions, India stands to gain sooner than later. The timing of such gains may vary from sector to sector but within the next 4-6 quarters months, just about every exporting sector from India should be in a position to benefit, provided the companies in such sectors are prepared for the same. Consumable products such as clothing, footwear, pharmaceuticals and chemicals should see an export-led recovery within the next 4-6 quarters, while automobiles and auto components, engineering goods and IT/ITES should see a return to “normalcy” in terms of business growth within the next 12 months. The IT, whose clients are mainly from USA, may benefit from more and more European firms looking for cost cutting solutions. The current contraction in exports can be easily explained by the fact that as the developed economies accept that they are in a recession, during the last six months or so, just about every business in such economies has been introspecting — this has led to drastic internal cost cutting and thinning down of inventories. While there may still be some room for further cost cutting and reduction of inventories in the entire supply chain, very shortly, the surviving businesses in the major economies will revert to focusing on running the businesses themselves. Further efficiency gains for such businesses will probably come from a more globalized supply chain, and restocking of retail shelves will necessarily imply the release of fresh purchase orders.

As the chart shows, India would have grown 7.5 per cent this year (a slowdown from 9 per cent in 2007-08), had the global crisis not occurred. The global crisis is likely to bring India’s growth rate to below 6 per cent in 2008-09. With the first half GDP growth rate already known, this implies a sharp slowdown in the next two quarters. In the first half of next year, the economy would have grown below 7 per cent in the absence of the external crisis. The global crisis may reduce Indian growth rate to as low as less than 4 per cent in 2009-10. (However, we have not calibrated the intensity of the different shocks and the impact on growth is treated similar far all shocks. If the current shock is more serious than the previous ones, the growth may fall even further.)

CONCLUSION

There is no denying the fact that the Indian economy is not contracting and in fact, is poised to grow at a relatively healthy real growth in the range of 5 to 7 per cent in the current fiscal and perhaps around 5 per cent next year.

India must now play to win. It must put an end to the mourning period it has been, perhaps rightly, observing in the last few months and usher 2009 with enthusiasm and positive energy. The government can give the best stimulus package to the economy by urgently undertaking bold policy reforms and creating a more conducive environment for the flow of international investment into India. The public and private industry can then recreate the growth momentum by prudent but determined action targeted towards winning rather than mere self-preservation.

GLOSSARY

GDP :- GDP is defined as the total of all and services produced within the country in a given period of time (usually a ).

Foreign Direct Investment :- Foreign Direct Investment (FDI) in its classic form is defined as a company from one country making a physical investment into building a factory in another country. Its definition can be extended to include investments made to acquire lasting interest in enterprises operating outside of the economy of the investor.

Mortgage-Backed Securities (MBS):- a Mortgage-Backed Security (MBS) is an whose cash flows are backed by the principal and interest payments of a set of . Payments are typically made monthly over the lifetime of the underlying loans.

Forex:- The foreign exchange (currency, forex or fx) market is where currency trading takes place. Forex transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another.

Exchange rate:- The exchange rates (also known as the foreign-exchange rate, forex rate or fx rate) between two specifies how much one currency is worth in terms of the other

BSE SENSEX:- THE BSE SENSEX or bombay Stock Exchange Sensitive Index is a composed of 30 stocks

Monetary policy:- Monetary policy is the process by which the , , or monetary authority of a country controls (i) the , (ii) availability of money, and (iii) cost of money or rate of , in order to attain a set of objectives oriented towards the growth and stability of the .

CRR:- These reserves are designed to satisfy withdrawal demands, and would normally be in the form of stored in a (vault cash), or with a .

SLR:- It is the amount which a bank has to maintain in the form of cash, gold or approved securities. The quantum is specified as some percentage of the total demand and time liabilities ( i.e. The liabilities of the bank which are payable on demand anytime, and those liabilities which are accruing in one months time due to maturity) of a bank.

Repo policy rate:- Repo rate is the rate at which the banks can borrow money from a central bank of the country in order to avoid scarcity of funds. for eg, whenever the banks have any shortage of funds they can borrow it from (RBI).

Reverse repo rate:- the rate at which bank lends to RBI

Fiscal policy:- Fiscal policy refers to government attempts to influence the direction of the economy through changes in government taxes, or through some spending

BIBLIOGRAPHY

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BUSINESS STANDARD. (2008, DECEMBER 17). Retrieved from http://www.business-standard.com/india/.

BUSINESS TODAY. (2008, DECEMBER 17). Retrieved from http://businesstoday.digitaltoday.in/index.php?option=com_magazine&opt=section&sectionid=22&issueid=45&Itemid=1.

BUSINESS WEEK. (2008, DECEMBER 17). Retrieved from http://www.businessweek.com/magazine/news/articles/business_news.htm.

BUSINESS WORLD. (2008, DECEMBER 17). Retrieved from http://www.businessworld.in/index.php/Economy/Economy.html.

FINANCIAL EXPRESS. (2008, DECEMBER 18). Retrieved from http://www.financialexpress.com/section/Economy/97/.

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