Global financial crisis II: the challenges for India

The economic analysts all over the world are almost convinced that the world is now heading for another financial crisis and a possible recession, three years after the one that started in 2008. Though the epicentre of the 2008 crisis was the United States, this time around it is the countries in Europe which are sending shivers.

It was the huge subprime crisis in the US that triggered the last recession and engulfed the world. The subprime crisis or the mortgage crisis, was actually the result of a financial adventurism where borrowers with lower creditworthiness were given generous home loans by banks at a rate of interest higher than the prime rates.

To expand the market further, these loan portfolios were sold again to other investors like private equity funds, hedge funds and non-banking finance companies through securitisation. But the artificial boom created with easy money went bust as financially weaker borrowers started defaulting and property prices crashed leading to further defaults and price crash.

As the mortgage crisis engulfed the entire financial system in the US and a part of Europe, large financial entities like Lehmann Brothers and many banks went bust and banks like American Express, Citi Bank, Morgan Stanley, UBS, Bear Sterns, etc had to write off large loans and needed government’s rescue package to survive.

Barely had the world economy recovered from the last crisis that trouble started brewing in Europe and to some extent in the US. Euro zone, a conglomeration of 17 European countries using the common currency Euro, is in trouble because some of its member countries like Greece, Spain, Italy, etc are unable to service their huge sovereign debts.

Then there are other countries like Portugal, Cyprus and Ireland which are already in trouble. Some of these troubled countries have already seen downgrading of their credit ratings while others are facing the impending threat.

Austerity measures
With great reluctance and after a lot of debate, though some of the stronger members of the EU, such as Germany and France, have worked out bailout packages, the stringent austerity conditions attached to them are facing stiff oppositions from the borrowers.

As the weaker countries are on the verge of defaulting on their debt commitments, there is an increasingly nagging fear that euro zone may soon collapse. Economists fear that Greece will soon default on its huge debt repayment and will be forced to pull out of Euro leading to further financial crisis in large European banks who have lent huge sums to Greece. Though the government in Italy has recently raised funds by issuing bonds, because of poor credit rating, it had to offer interest rates four times higher than the normal rates.  

Noticing the turn of events, World Bank President Robert Zoellick, last week, pronounced that the world had entered a new economic danger zone and Europe, Japan and the United States all needed to make hard decisions to avoid dragging down the global economy. His bluntly-worded address, last week, highlighted mounting fears among global policymakers about an escalating sovereign debt crisis in Europe, which has for now overshadowed investor concerns about public finances and reforms in the US and Japan.

“The time for muddling through is over,” Zoellick said. “If we do not get ahead of such events; if we do not adapt to change; if we do not rise above short-term political tactics or recognise, then we will drift in dangerous currents.” Things have turned so bad that some of the European countries now want China to bail them out by buying their sovereign bonds.

The fear of the euro zone breaking up became so real that US Treasury Secretary Timothy Geithner had to rush to Poland to attend a meeting of the EU finance ministers last Friday. His mission, apart from assuring dollar support, was to tell the bickering governments in euro zone to forget their differences and rise above the political agenda to stop a euro zone break-up.

Banks downgraded
The European financial crisis further aggravated as the credit rating agency Moody’s downgraded the long term debt ratings of two large French banks: Societe Generale SA and Credit Agricole SA have put BNP Paribas under review for downgrades. This in turn has seen huge pullout of funds from European banks by the US money market funds.

As a result, Euro sharply lost its value against dollar in the last one week. The situation reached such alarming proportions that the European Central was joined by four central banks, namely US Fed Reserve, Bank of England, Bank of Japan and Swiss National Bank, to make dollar available from their resources so that acute dollar shortage does not lead to a landslide fall Euro’s value.     

These developments have raised the most disturbing question: Will euro zone survive? While efforts are on to keep it intact, many believe that Greece may soon dropout from the club and, in turn, will trigger the dismantling of euro zone. According to a recent Bank of America Merrill Lynch survey of global fund managers showed that around 38 per cent of the managers are underweight on Europe, a level last seen at the time of 2008 financial crisis. The economic growth in the euro zone is expected to be near zero in 2011.

Things are equally gloomy on the other side of the Atlantic. The US economy is growing abysmally slow, unemployment rates are very high, the US President’s call for a fiscal stimulus package of $450 billion is facing stiff opposition and the debt-ridden government’s deficit is ballooning as US has spent around $4 trillion on Iraq and Afghanistan.

Impact on India
The crisis in the Europe and US is already affecting India in many ways. Firstly, it is affecting us through the monetary route as euro is losing value, dollar is becoming more expensive. This, in turn, means Indian currency  is losing value against dollar. Recently, when rupee touched 48.01 against dollar, it was the lowest level in the last two years.

Our large trade deficits, resulting from imports being far greater than exports, have made the things worse as the trade is funded with large buying of dollars. One of the main reasons for the last week’s petrol price hike was the fall in rupee making imports costlier. As expensive imports of petrol, diesel, cooking gas, fertilizer, etc, add to the general inflation, the Reserve Bank of India (RBI), as a counter inflationary measure, keeps raising interest rates.

Continuous hike in interest rates, the one last week was the 12th one in the last 18 months, has already jeopardised Indian industry and led to a slowdown in credit off takes from banks. The purpose of taming the rising inflation was not served but it lead to a further slowdown in investments and industrial growth.

“Even as RBI justifies this rate hike to dampen inflationary expectations, it is difficult to fathom that this will be achieved when a cumulative rate hike of 325 basis points since March 2010 could not achieve this objective,” Ficci Secretary General Rajiv Kumar said.

Growth in industrial production slipped to a 21-month low of 3.3 per cent in July. The country’s economic growth also moderated to 7.7 per cent during the April-June quarter this fiscal, the slowest growth in six quarters. The industry bodies are also worried that expensive loans will further contract demand for car and home buying.

“The market has already slowed down. This latest hike will further dampen the auto sector. It will dampen demand during the festive season. The RBI should have given a break, at least this time,” GM India VP P Balendran said.

When the economic growth slows down, a country also becomes unattractive for investment. No wonder the foreign direct investment (FDI) in the country has dropped significantly in the last few months and the stock markets are seeing flight of foreign capital as the FIIs are selling their holdings in hoards.