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Recession to Recovery: A Road Map

S. S. Das

ssdas@nic.in
"A certain idea of globalisation is drawing to
a close with the end of a financial
capitalism that had imposed its logic on the
whole economy and contributed to
perverting it. The idea of the absolute
power of the markets that should not
be constrained by any rule, by any
political intervention, was a mad idea.
The idea that markets are always right was
a mad idea.”
Nicholas Sarkozy,
Outline of the
Presentation
What is Recession?
Why Financial Crisis?
The Genesis of the current problem
Impact on world financial system and
world Economy
Global Response
Impact on India
India’s Response
Way Ahead
What is Recession?

Recession is the economy shrinking for two


consecutive quarters with a decrease in the
GDP

If the recession continues for next quarter, (>6 months)


then the economy goes through “DEPRESSION”
Recession Vs Depression

The joke that economists quote to explain


the
Difference between “Recession &
Depression” RECES SION

= WHEN YOUR NEIGHBOR LOSES HIS JOB

DEPRE SSION

= WHEN YOU LOSE YOUR JOB


Recession is nothing new
Recessions are something that cannot be
avoided.
Even in a healthy economy there are periods
of high growth, slow growth and no growth.
In fact in order for the economy to be healthy
there needs to be some contraction and
expansion.
But if the contraction lasts for more than 6
months the economy is said to be in
recession.
Causes of Recession
General consensus is that a recession is caused by
numerous factors and is the end result of several
preceding events;
Actions taken to Control the Money Supply in
the economy;
Financial Crisis;
Bad Investments by businesses;
 Stock Market crashes;
Factors that stunt short term growth in the
economy, such as a sharp increase in OIL
PRICES;
Wars
Change in the nature of the business cycle
due to Globalization;
What is a financial crisis?

The term financial crisis is applied broadly to


a variety of situations in which some financial
institutions or assets suddenly lose a
large part of their value.
Why Financial Crisis
Occurs??
“In the past financial crises have been
generated by combination of factors such as
overshooting of markets,
excessive leveraging of debt, and credit booms,
miscalculations of risk,
rapid outflows of capital from a country,
mismatches between asset types (e.g., short-
term dollar debt used to fund long-term local
currency loans),
unsustainable macroeconomic policies,
inexperience with new financial instruments, and
deregulation without sufficient market
monitoring and oversight.
Genesis of Current
Crisis….
The Current Financial Crisis is a combination of
several interrelated factors:

3. Misallocation of Resources
 Post Asian Crisis reaction: Self Insurance
 Accumulation of huge hard currency assets by
some countries (4.4 Trillion $) coupled with
huge US current account deficit;
 China alone has a Foreign Currency reserve of
US$ 2 Trillion
4. Huge Current Account surplus in these countries
supported by huge Current Account deficit by US
& UK
Genesis of Current
Crisis….
3. Diversion of some of these reserves into
Sovereign Wealth Funds
 Reserves mostly invested in US Treasury
Bonds puts pressure on bond yields and
interest rates;
 Lead to diversion of some Investments into
higher yielding assets than U.S. Treasury and
other government securities.
 Invested in High Tech Business till the collapse
of Dot Com Boom in 2000;
 After the dot-com bust, more “hot investment
capital” began to flow into housing markets —
in the United States and other countries of the
world.
Genesis of Current
Crisis….
4. Housing Boom in US encouraged by Govt.
Policies
 Lower long term interest rates
5. Housing boom coincided with greater popularity
of the Securitization of Loan Assets
 Particularly Mortgage debt (including subprime
mortgages)
 Pooling of Loans and reselling them as asset-
based securities: Collateralized Debt
Obligations (CDOs).
 Securities are repacked, leveraged, tranched,
and resold many times over camouflaging the
underlying risks
7. So called innovation of exotic products;
Rocket Scientists of the
Wall Street??
Thought that by slicing and dicing, structuring
and hedging, using sophisticated
mathematical models to understand and
manage risk, they can “create value” by
offering investors combination of risk and
return which are more attractive than those
available from direct purchase of underlying
credit exposures.
Credit Default Swaps
(CDS)
A type of insurance contract (a financial
derivative) that lenders purchase against
the possibility of credit event associated
with debt, a borrowing institution, or other
referenced entity.
A default on a debt obligation, bankruptcy,
restructuring, or credit rating downgrade.
As long as the credit events (defaults)
never occurred, issuers of CDSs could earn
huge amounts in fees relative to their
capital base.
Since CDSs were technically not insurance,
Rise of CDS business
As the risk of defaults rose, the cost of the
CDS protection rose.
Investors (mostly investment bankers)
could arbitrage between the lower and
higher risk CDSs and generate large
income streams with what was perceived
to be minimal risk.
In 2007, the notional value (face value of
underlying assets) of CDS had reached $62
trillion
more than the combined gross domestic
product of the entire world ($54 trillion),
Genesis of Current
Crisis…..
8. Emergence of highly Leveraged
Investment Banks
 Not subjected to capital adequacy norms
applicable to commercial banks
 Could raise and invest funds as high as
30 times their equity base
9. Globalization of the financial system
 leading to large scale arbitrage of funds
and flight of capitals
Collapse of Mortgage
Market
CDSs generated large profits for the
companies involved until the default rate,
particularly on subprime mortgages, and
the number of bankruptcies began to rise.
The leverage that generated outsized
profits began to generate outsized losses,
Defaults and declines in values of CDO’s
put big holes in balance sheets of financial
institutions;
By October 2008, the exposures became
too great for companies such as AIG.
The spread of the crisis
Banks around the world have similar
exposures to subprime and other declining
assets
Nearly universal uncertainty about bank
solvency
Crisis of Confidence and credit freeze
Inter bank lending almost stops
Crisis spread to other assets and institutions
Flight of capital leads to
Meltdown of the stock markets across the
Impact of the Crisis
Current crisis appears worse than even a
liquidation crisis
Lack of mark to market accounting creates
uncertainty as to who is solvent
Government rescue policies inconsistent
(Lehman was allowed to sink)
Nobody knows who will survive and parties
refuse to lend to each other
Financial system freezes!
Spread of the Crisis and
Impact
Meltdown of stock prices across the globe
 Market price of stock in Freddie Mac plummeted from
$63 on October 8, 2007 to $0.88 on October 28, 2008.
 reflected huge changes in expectations and lead to
flight of capital from assets in countries even with small
increases in risk.
 From Emerging Markets, BRICs
Mark to Market Accounting System to value that
stock according to market values
capital base of banks shrank and severely
curtailed their ability to make more loans : Lead
to Credit Freeze
Investors fled stocks and debt instruments for
the relative safety of cash
Lead to rise in Demand for Dollar and fall in
Impact of the Crisis
Collapse of Financial Institutions in several
parts of the world
Lehman Brothers; AIG, Freddie Mac and
Fannie Mae etc.
Central Banks in vulnerable countries such as
Iceland become Bankrupt
Investors across the globe lost huge amount
of their investments
Severe Credit squeeze and Liquidity crunch
for the industry
Housing; Automobiles; Retail; Services etc.
Impact of the Crisis….
Crisis of confidence leads consumer
aversion to spending
Fall in housing and real estate prices
Fall in Demand for goods and services
Resorting to Trade Distorting Protectionism
Leads to drop in international trade in
commodities and services
Gets into a Vicious Cycle
Job cuts and serious unemployment
problem followed
Onset of a recessionary spiral
tarting Point = Unwillingness to buy
How to come out of recession
Governments in Market economies do not have
direct control on Producers’ & the Consumers’
behavior; But, they can influence millions of Producers
& Consumers with Government’s policies;
Governments have 2 policy instruments

Fiscal Policies Monetary Policies


(By Govt.) (By Central Banks)

Central Banks manipulate


Governments influence the
economy by changing howthe available supply of
The Governments spend money in the country
and collect money
How to come out of recession?

FiscalGovernment influences the economy by changin


how it (Government) spends and collects money
Policies
1] Tax cuts for More money
businesses or available for
for individuals spending

2] More Spending Individuals get Demand picks


by Govt. to salary and spend up; Market
create jobs money
can recover;
3] Automatic
fiscal policy; Some income to
Unemployment unemployed
Insurance people to spend
How to come out of recession?

MonetaryCentral Bank manipulates the available supply


of money in the country
Policies
More money
1] Reduce reserve
available for bank
ratio
to give loans

Individuals take
Demand picks
2] Lower the
interest rates more loan up; Market
can recover;
3] Use its own It becomes an
reserved income to Govt.
money to buy to inject money
Govt. bonds into the market
Global Response to the
Crisis
Varied Response and Intervention to protect
financial system and the tumbling economy
 Short term Keynesian response to boost
demand for goods and services to revive the
economy by pumping in more money to the
system
 Structural adjustment to correct the
distortion in the financial system
 Long Term solution : Address the problem of
misallocation of resources
Global Response: First
phase of intervention
First and Immediate intervention by the
governments across the globe has been to
prevent collapse of the financial system.
Effort has been made
to stop the financial bleeding,
to coordinate interest rate cuts, and pursue
actions to restart and restore confidence in
credit markets.
rescue of financial institutions considered to be
“too big to fall,”
 Government take over of Banks and Financial
Institutions on the verge of Collapse to prevent the
financial system collapsing
 Freddie Mac and Fannie Mae; AIG etc.
First Phase…..
Injections of capital and government takeovers
of certain financial institutions,
Government guarantees of bank deposits and
money market funds, and government
Facilitation of mergers and acquisitions.
Large Scale Government bailout packages for
affected industries
 US Bailout package for affected Industries;

Banks and FIs exceeds 1 trillion US$


 Major economies such as European nations,
Japan, Russia, China come out with huge
bailout packages and stimulus packages to
bail out institutions and kick start their
Keynesian path to global
recovery
In the second phase of intervention
Governments have turned to traditional
monetary and fiscal policies to deal with
recessionary economic conditions, declining tax
revenues, and rising unemployment,
Several countries have turned to funding from
the IMF, World Bank, and capital surplus
countries.
Effort is to
 Improve liquidity in the system by infusion of
cash into the system;
 Restart credit flow by building confidence in the
system;
 Stimulate investment and demand for goods
Road Ahead: Third phase of
Response
Action is being coordinated to decide what
changes may be needed in the financial
system to prevent future crises;
Some issues being addressed are:
weakness in fundamental underwriting
principles,
the build-up of massive risk concentrations in
firms,
the originator-to-distributor model of
mortgage lending,
insufficient bank liquidity and capital
buffers,
overall regulatory structure for banks,
brokerages, insurance, and futures,
lack of a regulatory ties between
Road Ahead: G-20
initiatives
Issue of misallocation of resources across the
globe
Role of the “Invisible Hand of the Market
Forces” and Government Intervention
G-20 Initiatives
New Financial Architecture:
Global coordination and oversight of Financial
Market
Executive Compensation
Regulation of Derivative Segments of Financial
Market
Fourth Phase of Global
Response
The fourth phase of the process will be
dealing with political and social effects of
the financial turmoil.
The questions that have been raised are:
Will the financial crisis work to diminish the
influence of the United States and its Dollar in
financial circles relative to Europe and its
Euro/pound?
Growing influence of the newly emerging
economies (India, China, Brazil) in addressing
global financial issues.
Is this the end?
Not likely,
Given that US Capitalism survived the Great
Depression
Financial capitalism brought enormous economic
and social benefits to hundreds of millions of
people
It is possible that financial repression will
follow
with nationalization of banks, severe control of
lending and trading, etc
More likely, will get more regulation
This might be a good idea
Good examples: securities and banking
Financial Crisis and Impact on India
Subprime Lending is not a major issue in
India
Limited exposure of Indian banks to
overseas mortgage and derivative products
One of the bystanders affected by
development elsewhere??
Major problem is the liquidity crunch and
crisis of confidence of banks for lending
Over reaction to inflation during the first
half of 2008 and tightening of monetary
policy
Impact on India
Significant Currency devaluation
Demand side problem
Drying up of external demand for goods
and services due to major problems in
US and Europe: India’s major trading
partners
Lower domestic demand due to buyers
hesitation to spend
Exports down by about 20%
Year on Year export growth remains negative
Major affected sectors are: Real Estate; Auto
Industry, Textiles; Gem and Jewelry; Chemicals
and Allied Products; Iron and Steel; Capital Goods
etc.
Impact on India
External dependant service sectors shows sign of
stress.
However, India is not likely to face recessionary
trend.
GDP Growth likely to remain above 6% in spite of
recession and negative growth in the developed
economies.
Still has a sizeable Foreign Currency reserve.
It is felt that India and China, with their robust
domestic demands and savings, would lead the
recovery of world economy.
India’s Response: Monetary
Policy Intervention
Broad direction of the interventions on
monetary policy side has been
to increase liquidity; reduce interest
rates; restore confidence in the banking
system; restore banker’s confidence for
lending; and stimulate domestic demand
Easing of liquidity in the market by
reduction of CRR; SLR
Lowering Bench Mark interest rates by
lowering Repo and Reverse Repo rates;
Making special arrangements/windows for
lending to vulnerable sectors;
Monetary Policy
Intervention
Easing External Commercial Borrowing
norms for providing access to cheaper
funds abroad;

Interest subvention for exports credits for


certain labour intensive sectors and longer
tenure of export credit at concessional
rates;

Increasing liquidity to NBFCs for lending to


affected sectors such as Auto and Housing
at affordable rates to stimulate demand;
India’s Response: Fiscal
Policy Intervention
Directed at stimulating demand for goods
and services through tax cuts
Counter-cyclical pump-priming the
economy though higher and accelerated
government spending
Additional spending on large infrastructure
projects like Roads, Ports etc. to kick start
the economy

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