Indian Economy | Global Financial Meltdown Download PDF
De Coupling Theory
On a number of occasions previously, we have made a passing reference to ‘The Global Crisis’ as a crisis first ever, in economic history, ever outshadowing the ‘Great Depression of 1929—1933’, in terms of the potential wide ranging impact and ability to destabilize the global economy. The great depression also resulted in contraction of US output and resultant global output, leading to the widespread global unemployment. However, it was confined to the US and Europe. The impact was little on Asian economies given their small size and most of them under the domain of the colonial rule, with little international stature, for any perceptible impact of the depression. Similarly, all the other crises were relatively confined to geographies and had brought forth the ‘decoupling theory’. That it was possible for economies to insulate themselves from adverse fall-outs in different parts of the world or ability of economies to remain ‘de-coupled’.The decoupling theory had worked during all the earlier crises but the theory was first tested during the ‘oil shock of the seventies’, which had affected most economies of the world.The global crisis has broken this myth, that in the present era of integration and globalization, it is not possible for economies to remain decoupled or insulated from adverse global developments. The degree of impact may vary but insulation is not possible.
Thus, it got its name as a global crisis, also known as the ‘global meltdown’ or the ‘sub-prime crisis’. It is first, a financial sector crisis, gradually seeping through to other sectors of various economies. Financial sector globally is seen as the backbone of an economy on which other sectors are heavily dependent for their financial needs. In its strength lies the ability of economies to grow. Any crisis in the financial sector cannot be insulated from the rest of the economy. In the earlier section on Global Integration, we had seen how financial integration had taken place and it was natural for the financial sector crisis to move across borders across different economies. The global financial institutions besides their spread across economies, over a period of time, had become complex, with new diversified risky products, operating on wafer thin margins, overleveraging and stretching the financial sector.
These institutions were not only spread wide but deep and so interwoven that it was impossible to track. A highly risky product of ‘derivatives’ or something deriving value on the strength of an underlying asset (bubble) which can either be exchange rates, bonds, equities or commodities.
It is not the credit derivative which is the issue, but for its exposure extending multiple times the balance sheet of institutions, was a sure recipe for disaster, just waiting to happen, and required only a trigger point. It may be interesting to note that just before the crisis the derivative market was over USD 600 trillion or 11 times the global output during 2007.
The top five banks of the US had combined assets of USD 4 trillion on a capital of USD 200 billion, a leveraging of twenty-one times. While the exposure to the derivative market was leveraged by over 90 times! This is what overleveraging like an inverted pyramid, which can never be stable and can collapse with the slightest of disturbance.
The trigger point was default by the sub-prime borrowers of mortgage loans in the US, against which mortgage backed securities (MBS) were sold after being diced and sliced multiple times by the banks, investment bankers and other institutions spread as tentacles, inter-woven across the global financial system. So much so, it was not possible to track them down not even by the banks which had issued these securities.
As a result, this set of a chain reaction leading to overnight collapse of well-known large financial institutions such as The Lehman Brothers, AIG, Bear & Stearns, General Motors and closure of many established banks, crashing the stock markets thus earning the name of global meltdown. It is the complete decimation of international financial giants and collapse of the stock market, referred as the meltdown.
It is important to understand that the US and European Governments got to know of the collapse ‘after’ the collapse and not ‘before’ the collapse and thus could not prevent the collapse ‘before’ the collapse. Since die beginning of the crisis as many as one hundred and fifty-seven banks have shut down in the US. It can be said that the crisis had its epicentre in the US but shivers went throughout the global economy.
Who are the sub-prime borrowers? It is that class of people who do not have the resources to service the loan taken or those borrowing for consumption purposes. But why lend to them? It was the US model of ‘consumption-driven growth. More the consumption, greater demand for goods and services and thus there would be greater production and output.
As a counter to the earlier slowdown of growth of their economy, US banks went for aggressive lending, reaching out to all, as they had the confidence that their financial sector would be able to balance it, by spreading the risk wide and through their complex range of products.
So what could be the reason(s) for the crisis? Can we say it was the global financial integration, or lending to sub-prime borrowers or aggressive lending or a combination of all, which led to the crisis. They may have contributed their share but there were five ‘excesses’. They are as follows:
(1) Excess overleveraging.
(2) Excess liquidity.
(3) Excess complex products.
(4) Excess confidence of the financial system.
(5) Excessive greed of the financial system.
First is the highly overleveraged financial system something like an inverted pyramid, which is structurally unstable. Secondly, free financial markets and absence of regulations on the overleveraging by financial institutions. Thirdly, overconfidence of international financial institutions of nothing can go wrong.
The sub-prime borrowers only precipitated the crisis, acted as a trigger point, but it was, like said earlier, a crisis only waiting to happen.
Global Crisis and India
The global crisis took its toll on the US and Europe leading to a contraction of their output, but did not enter the recessionary phase, which is continuous contraction of output more than two quarters. However, the fears of recession haunted both the US and Europe. More than the contraction of output, a greater concern was the increasing pace of the unemployment.
India had a higher degree of financial integration than trade integration with capital inflows both in current as well as capital account more than 100 per cent of the GDP. Let us also accept a fact that US is too large an economy to be ignored for their adverse fallouts by any economy. Being the biggest economy is the biggest driver of integration and coupling of economies.
The crisis did impact India as well as other Asian economies such as China with a ‘slowdown in their growth but not contraction of output, in all these economies. The impact was there but less intense than that experienced by the US and European economies. As said previously, this was a financial sector crisis and the Indian financial system was less affected, given dominance of the public sector banks, which are less exposed to complex risk products, not overleveraged, fairly risk averse and not much exposure to international markets and products.
What the crisis did to India was to push the domestic financial sector into a ‘cautious and wait and watch mode’, became averse to lending. It did impact some of the private and foreign banks in India but not to the same magnitude; as such exposures were limited and small in relation to their balance sheet size. This forced tightening of the liquidity by banks, self-imposed, in their own wisdom, dried up money with the industrial sector which in any case, had also gone in the cautious mode.
Both these resulted in build-up of inventories, longer production and repayment cycles and slowdown of industrial and overall growth of the Indian economy. It can be said the banking sector was on the verge of witnessing defaults and build-up of bad loan book, both which could have compounded the problem manifold and impact far greater.
The financial sector was fortunate to have a limited impact in the sense that no bank or any financial institution collapsed. However, it did dent exports, as for the first time, in over a decade or so, there was contraction of exports. But this contraction was not sufficient, to contract overall output, given the relative low share of exports to total output of the Indian economy.
So overall, the impact on India was that it put in the minds of people ‘fear and uncertainty’, resulting in a slowdown and definitely impacting exports for a short period of six months. The impact and fallout could have been greater and deeper both for the world economy and India, but for ‘timely’ and ‘collective’ government interventions both in India as well as other major economies of US, EU and Japan.