29 March 2014
GLOBAL FINANCIAL CRISIS OF 2008-09.
Global Financial Crisis of 2008-09
· To find out the frame work of both the concepts of Global Recession and Indian economy.
· To analyze the implication of Recession occurred during the period 2007-2009.
· To analyze the causes and effects of Recession in India.
The global Financial Crisis of 2008 is the most severe financial crisis that the world has ever faced since the Great Depression of the 1930s. The ‘Financial Crisis of 2008’, also called the US Meltdown, has its origin in the United States housing sector back in 2001-02, but gradually extended over a period of time and eventually brought the entire world under its grip.
The financial crisis is characterized by contracted liquidity in the global credit and housing market, triggered by the failure of mortgage companies, investment banks, and government institutions which had heavily invested in subprime loans. Though the crisis started in 2005-06, but has become more visible during 2007-08, when many of the renowned Wall Street firms collapsed.
The Indian economy looked to be relatively insulated from the global financial crisis that started in August 2007 when the sub-prime mortgage crisis first surfaced in the United States (US). In fact, the Reserve Bank of India (RBI) was raising interest rates until August 2008 with the explicit objective of cooling the economy and bringing down the gross domestic product (GDP) growth rate, which visibly had moved above the rate of potential output growth and was contributing to the buildup of inflationary pressures in the economy. But when the collapse of Lehman Brothers on 23 September 2008 morphed the US financial meltdown into a global economic downturn, the impact on the Indian economy was almost immediate. External credit flows suddenly dried up and the overnight money market interest rate spiked to above 20% and remained high for the next month. It is perhaps judicious to assume that the impacts of the global economic downturn on the Indian economy are still unfolding. Against this backdrop, this paper attempts an analysis of the impact of the global financial crisis on the Indian economy and suggests some policy measures to put the economy back on track. Broadly, the paper has been divided into six sections.
It is difficult to pin down the exact cause of the financial crisis, but majority of the experts and economists are of the view that subprime loans in the housing sector was one of the most important cause of the financial crisis of 2008. The different causes of the crisis are specified below:
· Boom and bust in the housing market: The current crisis actually started with the bursting of housing “bubble” that began in 2001 and started growing at a rapid rate until it reached its peak in 2005. The housing bubble occurred due to rapid increase in the rate of the valuation of real property until the prices of the property reached the unsustainable level. The factors that led to the rapid increase in the demand for house price are-- low interest rate and the huge inflow of foreign capital from countries such as China, Japan U.K. Also, subprime loans added fuel to the fire, further increasing the demand for houses.
Also, the Federal Reserve Board cut the short-term interest rate from 6.5 percent in 2000-01 to 1 percent in 2003-04. A Greenspan, the Governor of Federal Reserve, accepted in 2007, the fact that housing bubble was “fundamentally endangered by the decline in real long-term interest rate”.
Because of above mentioned fact, the home ownership rate increased from 64 per cent in 1994 to an all time high peak of 69 per cent in 2004 This rise in demand pushed the prices of house by leaps and bounds. Between 1997 and 2006, American home prices increased by 124 per cent. Further, U.S. consumers lured by the increasing value of their homes went on borrowing spree. They started borrowing money for consumption by mortgaging their property
Also, Americans spent $800 billion per year more than they earned. Household debt grew from $680 billion in 1974 to $14 trillion in 2008. During 2008, the average U.S. household owned 13 credit cards, and 40 percent of them carried a balance up from 6 percent in 1970.
But overbuilding during the boom period and rise in interest rate led to the bursting of the bubble. Between 2004 and 2006 the Federal Reserve Board raised the interest rate by 17 times, up from 1 percent to 5.25 percent. Also, overbuilding during the boom eventually led to a surplus inventory of houses, causing home prices to decline, beginning in summer, 2006.
As a result foreclosure and default rate increased. About 8.8 million homeowners (10.8 per cent of total homeowners) had zero or negative equity as of March, 2008, meaning their houses are worth less than their mortgage. Sales of houses decreased by 26.4 per cent in 2007 compared with the previous year.
· Speculation: Another important cause of housing crisis is speculation in real estate. It was observed that investment in housing sector yield high return compared to other traditional investment avenues. As a result investment in housing sector increased. During 2006, 22 per cent of homes purchased (1.65 million units) were for investment purposes, with an additional 14 per cent (1.07 million units) purchased as vacation homes. Nearly 40 per cent of home purchases were not for primary residences. A hoping 85 percent of the houses purchased in Miami were for investment purposes.
· High risk loans and lending practices: The subprime loans were highly risky, as these loans were offered to the high risk borrowers-- illegal immigrants, person without any job, any assets and any income. The repayment from these borrowers was hardly expected. The share of subprime mortgages to total originations increased from 5 per cent ($35 billion) in 1994 to 20 per cent ($600 billion) in 2006. Again the difference between the prime loan and subprime loan declined from 2.8 per cent in 2001 to 1.3 per cent in 2007. This resulted in the increase in demand for subprime loans. Another example of high risk loans is the Adjustable Rate Mortgages (ARM). Under ARMs borrowers had to pay the only the interest (not principal) during the initial period. An estimated one-third of ARMs originated between 2004 and 2006 had ‘teaser’ rates below 4 percent.
· Securitization: Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, pooled together as collateral for the third party investments (Investment banks). Due to securitization, Mortgage Backed Securities (MBS) is created/ originated and distributed by the investment firms/banks. Initially Freddie Mae and Fannie Mac (quasi government agency) use to issue MBS but later private agencies also started issuing MBS on subprime loans. During 2003 to 2006, the agencies share of MBS fell from 76 per cent to 43 per cent while Wall Street’s share climbed up from 24 per cent to 57 per cent during the same period. The securitized share of subprime mortgages (MBs on subprime) increased from 54 per cent in 2001 to 75 per cent in 2006.
· Inaccurate credit rating: Under new system of securitization, investment firms/banks repackaged mortgages securities (MBS) into innovative financial products called CDOs (Collateral Debt Obligation), that promised to boost the return for investors. These CDOs were further divided into small financial units called ‘tranches’. These tranches were rated on the basis of risk involved. The safest portion of the tranches received the highest rating of AAA/aaa, while riskier tranches received the medium quality BBB/bbb rating, just above the junk bonds. It has been observed that MBS and CDOs originated from subprime mortgages were distributed by the investment firms. Credit rating agencies are under scanner for giving investment-grade rating to securitization transactions based on subprime loans.
· Government Policies: To provide house at affordable price to all the people was the priority of both the Clinton and Bush administration. In 1974, President Carter passed the Community Reinvestment Act. This Act made mandatory for all the banks and saving institution to provide home loans to the lower income people in broad outlying areas where they had branch.
· Central bank policies: The Federal Reserve’s primarily concern was to manage the monetary policy and was least bothered about the housing bubble and dot-com bubble. Once the bubble burst, the Central Bank tried to control the spread of the crisis on other sectors. A contributing factor to the rise in home prices was the lowering of the interest rate earlier in the decade by the Federal Reserve lowered by the funds rate target from 6.5 per cent to 1 per cent. Further Greenspan has been criticized for flourishing subprime loans.
India has been hit by the global meltdown; it is clearly due to India’s rapid and growing integration into the global economy. The strategy to counter these effects of the global crisis on the Indian economy. The strategy to counter these effects of the global crisis on the Indian economy and prevent the latter from any further collapse would require an effective departure from the dominant economic philosophy of the neo-liberalism. The first such departure should be a return to Food first doctrine, not only to ensure food security of the large population but also due to the fact the food production will be more profitable given the current signs of a shrinking market for export oriented commercial crops. The other important initiatives that needs to be adopted is the building of institution based on the principle of cooperation that will provide an alternative frame work of livelihood generation in the rural economy as opposed to the dominant logic of markets under capitalism. Institutions like cooperative markets and credit cooperative can go a long way in addressing the lack of economically viable producer prices primary sector. Such an alternative for economic activities in the primary sector. Such an alternative policy to tackle the consequences of the financial crisis will require effective Keynesian policies in the form of increased public expenditure at the rural and urban infrastructure. To sum up we can say that the global financial recession which started off as a a sub-prime crisis of USA has brought all nations including India into its fold. The GDP growth rate which was around none percent over the last four year has slowed since the last quarter of 2008 owing to deceleration in employment export, import tax GDP ratio reduction in capital inflows and significant outflows due to economic slowdown. The demand for bank credit is also slackening despite comfortable liquidity in the system. Once calm and confidence are restore in the global markets, economic activity in India will recover sharply. Yet there will be a period of painful adjustment which is inevitable.
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