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Global Financial Crisis
Arvind Shrouti (Option Positive)
The global economic meltdown was shot in the arm for the world its intensity comparing
economic slowdown (recession) which was seen in the last century in 1929. Wall Street
remains at the centre of all the events undoubtedly. The former president of America Mr.
George W. Bush said “Wall Street was sloshed out it needs to be brought back in its
senses”. The president of France Mr. Nicolas Sarkozy said “Financial capitalism needs
morality more than anything else”. The president of Brazil Mr. Luiz Inácio Lula da Silva
said “This disaster is born out of gambling and needs to be fought back”. The statements
made by the leaders from all over world impel us to sense the seriousness of the issue.
Our Prime Minister and finance minister have also said that this economic slowdown will
hit India up to certain extent. Despite this Indians are living in fearful and dubious
environment.
On this platform we can endeavor to answer some questions like; why this financial crisis
has occurred? How this will affect global economy as well as Indian economy?
Why this has happened?
This financial crisis was initiated in American financial system by the burst of housing
loan bubble in august 2007. This burst of the bubble is now transformed into a financial
disaster and severely hit the global economy. Hence we need to understand the
background of this critical situation broke out of the burst of housing loan bubble in other
words sub-prime crisis.
Barring last 30 years all over world including America traditional banking system was a
popular practice. After strict credit underwriting loan were given to only borrowers worth
paying it back. Those loans were shown as assets on the balance sheet. These loans were
closely regulated by Federal Reserve Bank and central banks of other countries. For last
30 years this traditional banking system has undergone transformation and a new
financial system was born. This new financial system became popular mainly because of
three reasons.
1. De-regulation
2. Technological Innovation
3. Global financial capital
In this new financial system in order to avoid regulations of government bodies and
Federal Reserve Bank new financial instruments were innovated. The sudden growth in
the field of Information technology aided the efforts to recede the regulatory bodies.
Financial capital started roaming around the world freely. American and European
government liberalized and new financial system unleashed itself in deregulated
environment.
Before it was evident that this was exaggeration and not development, the overgrown
housing loan bubble was already busted in august 2007. Securitization was the centre
point of this new financial system. In this process loans were not only assets in the
balance sheet but also housing finance, car finance and similar loans were securitized.
These securities were sold to institutions like investment banks, money market funds and
hedge funds.
In 2001, the value of total securities issued by American banks exceeded the total amount
of loans were given, eventually in the next six years it exceeded in multiples of the loans.
Banks started giving loans without considering borrower’s credit or capacity to repay the
loan. Loans issued against housing property were converted into asset backed securities
and handed over to investment banks and other financial institutions. This enabled them
to provide housing loan to those borrowers who otherwise could not avail regular loans.
Hence it is called as sub-prime crisis.
Federal Reserve Bank of America deliberately kept interest rates moderate to encourage
financial institutions to lend more and more money. American citizens were provoked to
cross limits of consumerism and eventually faced bankruptcy. Till 1996 the amount of
loans given to American citizens constituted 80% of the National Income of that time. In
2000 it reached to 100% and till the mid of 2006 it touched 140%. Housing loan
constitutes the major part of this lending money business. Increase in demand of the
housing loan resulted into the increase in real estate prices. From 2000 to 2006 housing
prices doubled.
In 2006 Federal Reserve Bank of America decided to increase interest rates to regulate
the uncontrolled growth. This increase in interest rates resulted into increasing number of
defaults. By the time banks took the houses back housing prices were dropped by 20 to
30%. All this accumulated in substantial losses for banks and thousands of people ended
up losing their houses.
In the beginning of August 2007 the banks providing housing loans faced bankruptcy.
The investment banks and other financial institutions, who invested money in asset
backed securities, were severely hit. In the new banking system housing loans were
securitized and those securities were purchased by American and European investment
banks and financial institutions. Hence the not only banks provided housing loans faced
crisis but also investment banks and other financial institutions experienced the heat. The
cascading effect of building this structure was faster when it collapsed. It resulted in the
breach of trust and eventually liquidity crisis. This means sub-prime crisis resulted into
credit crunch triggered to Global financial crisis.
Remedies
To combat this economic slowdown International financial institutions and eminent
leaders from developed nations have joined hands. Bailout package of 700 billion dollars
was declared after three day long brainstorming discussions in American congress.
American government is putting in huge money to save financial institutions from crisis
and heading for their partial nationalization also.
On 13 October 2008 American government declared that 250 billion dollars will be
utilized in 9 financial institutions including Goldman Sachs, J. P. Morgan, Bank of
America and Merrill Lynch, in the form of share capital. At the same time 15 countries
including France, Germany, Spain, Portuguese, have declared bailout package worth
1230 billion dollars. The consequences of these packages will be revealed in future only.
The current economic slowdown can be compared to financial debacle of 1929. At that
time also thousands of banks were collapsed, production declined by 33% and
unemployment reached 25%. The president of America of that time Mr. Roosevelt
restructured the boundaries between market and government. Most importantly
government had to take initiative to make appropriate changes in the financial system.
For last 30 years American government deregulated the economy to encourage private
sector growth. In current situation they are left with no option but to regulate economy.
American president Mr. Bush declared that this 700 billion dollars package is to save
market economy. But the fact is many people from private sector have melted money in
the disguise of bail out package. Many have drawn 8 digit salary and thick incentives
before escaping. The ordinary tax-payer’s money is now diverted to save rest of the
people who are at stake.
This whole roller coaster ride is the result of irrational greed for profit. The boundaries
between government and markets need to be redesigned. This does intend that
government should undertake all the sectors but regulation is desirable. Rational
interference of the government is the ultimate conclusion of the financial debacle.
A research group of IMF has come to conclusion that the rate of global financial growth
in the recent past was nearly 5% will drop to 3% in 2009. The most important fact is that
economies like India and China will grow at more than 7%, whereas developing nations
will have absolutely zero percent growth rates. But who is responsible for the global
economic meltdown?
Weather global economic slowdown exists or not is not at all the question. Rather we
have to accept financial crisis is the truth. The most important debate going on is about
how will be the process of healing the financial debacle. The economists all over world
are discussing will it be U, V or L shape. If it is U shape then won’t last long more than 6
to 8 months. If it is V shape intensity will be far severe might take one year to recover. If
it is L shape then will take even longer time to recover.
The accurate duration of complete recovery of financial debacle is not easy for anybody
to predict. Many economists have predicted the duration of at least 2 years. The effect of
this financial debacle on Indian economy is inevitable as a result of economic slowdown
in America and European nations.
Effect on Indian Economy
This financial debacle can affect Indian economy in three possible ways.
1. Indian banks having stake in securitization process of American banks are going to
face crisis for sure. Fortunately or by virtue of strict regulation of Reserve Bank of
India most of the Indian banks are not exposed as compared to their equity capital.
This will save them from bankruptcy although profit may decline.
2. In recent past foreign investments was hot cake in Indian market which may reduce in
volume for time being. Foreign investments are long term investments hence will face
temporary crisis as response to current scenario but will not be the same in long term.
3. Indian export sector will surely face crisis as American market solely constitutes 15%
and European market constitutes 23% of Indian export. All export driven sectors
including IT sector will face decline in growth.
So it is crystal clear that global economic slowdown will hit Indian economy inevitably.
But the impact will be less as compare to other countries. Also there is strength of India
of having substantial Foreign Reserves. In 1991 it was 1 billion dollars now in March
2008 it has reached to 309 billion dollars. After financial crisis it has stabilized on 265
billion dollars.
Presence of Foreign reserves in Indian treasury will surely help Indian economy to
retaliate global economic slowdown. If we would not have enough Foreign Reserves then
Indian rupee had collapsed way back eventually leading to uncontrolled inflation. In
current situation many developed countries are in the need of loan from international
financial institutions. India could save her face by virtue of substantial Foreign Reserves.
In spite of above optimistic scenario if we do not address internal issues we also might
face serious trouble. In market economy, production is dependent function of demand.
Presence of purchasing power makes demand different from needs and wants. Absence of
purchasing power in economic terms is not considered as demand. Out of the world
Population not having access to fresh drinking water India alone having 33% of them. It
constitutes 65 crore people. This huge population needs fresh drinking water but does not
add to the demand for mineral water as they can not afford it.
Situation remains the same in case of food, medicine and housing in along with other
basic needs of human being. For last two decades we have produced a class of people
drawing fat salaries and market fulfilling their demand for branded stuff, cosmetics,
beverages, vehicles, television, refrigerator, shopping malls, lavish hotels, water parks,
golf clubs, overseas tourism and luxurious residences.
As more than 75% of the people do not have purchasing power hence do not contribute to
the demand for above mentioned products. On the other hand market was also the least
bothered as remaining 25% middleclass and overseas market were the target segments for
them. Now this win-win situation is no longer in existence. The segment of people with
unfulfilled basic needs do not have ability to purchase and people capable of purchasing
are already saturated. So market has reached the stage where demand is lesser than
production. Indian business is in trouble as potential market of developed nations is also
in bad shape.
Considering technological advancement in today’s date and world is enough prosperous
to eradicate poverty from the world but the fruits of this progress are reaped by only
privileged class of the society. In a developed nation like America also the percentage of
people living below poverty line has gone up from 13% to 20%.
For last two decades rich and poor divide has only intensified. According to Paul
Krugman in the 80s almost 70% of the growth was enjoyed by 1% rich people. In the
90s, 42.2% of shares, 44.7% of bonds, 44.2% trusts and 71.4% of medium or large scale
industries were owned by only 1% people. Branko Milanovic is an economist from
World Bank said that only 1% upper class population of the world owns property equal to
56% of world population. Top 3 rich people from the world own property equal to sum of
National Income of 48 poor nations. The 225 richest people in the world earn more than
47% of the world population.
In a recent study done by ‘International Institute for Labor Studies’ i.e. ‘World of Work
Report 2008’ is published claiming from 1990 to 2007 the rich and poor divide has
considerably increased. The report also states that in America from 2003 to 2007 real pay
of top management has gone up by 45% and real pay of middle management has gone up
by 15% whereas basic pay of workers has gone up by 3% only. In the year 2007 the
average salary of management staff was 500 times more than average salary of ordinary
American employee. This ratio was 1:300 in the year 2003. Situation remains the same in
Germany, Australia, China and South Africa. In short at global level the divide between
rich & poor has increased steeply.
In India this situation is catching attention. From 1991 to 2007 the India’s average growth
was 6.23%. The proportion of poverty abolition has come down by 0.85% to 0.70%. Still
50% Indian children are victim of malnutrition and 50% females and 70% children are
victim of anemia. Infant mortality rate is one of the biggest issues in India because of all
above factors we stood 126th out of 175 countries in Human Development Index. The
regrettable fact is we are below than some of the poorer nations of Africa in ranking.
Although our 60% population is dependent on agriculture, it has apportioned only 17% of
total GDP. This is the reason why in this sector unemployment, suicidal tendency is seen
in large proportion.
Growth in different sectors failed to generate adequate growth in employment. Service
sector is the highest growing sector in India today. (Nearly 60% of the GDP) In the
sectors like IT, call centers, BPO, bank, insurance, tourism, hospitality and entertainment
only English speaking people formally dressed with tie are given preference.
Despite of these growing sectors rural and lower class urban people are yet starving for
jobs. These people are mostly employed as drivers, peon, carpenter, barber if self
employed then are in low cost low profit businesses like tea stall, wada-pao stall. In short
more than 90% working population is in unorganized sector and majority of them having
less income.
In the year 2004-2005 the ‘Arjun Sengupta’ states that in India more than 66% population
has per day per capita expenditure is only Rs 20. This ghastly picture is the truth
unfortunately. In a developing nation like India this report is not paid attention what it
deserves to be.
In brief the growth in India is benefited to only 20% upper class ignoring rest 80% of the
population. Even in the disguise of globalization it is inevitable to restructure our
financial system considering all above mentioned facts and figures.
If we address this issue religiously and with utter seriousness, we definitely will be able
to convert this challenge of economic slowdown into opportunity. In stead of using
recession as scapegoat we should encourage our efforts to conquer it with courage.
Government, management, labor unions and social organizations should join hands in
strategizing acknowledging their moral responsibility.
Instead of only analyzing complex equations of market forces, globalization needs to be
held accountable on humanitarian ground and encouraged to take some practical steps
then only my little understanding of Economics prove its worth.
Arvind Shrouti
Option Positive
Reference
1. Global Financial Crisis – Dr. Narendra Jadhav
2. Arth-Purna Viram- Mr. Achyut Godbole
3. World of Work Report- 2008, International Institute of Labour- ILO,
Geneva.
4. World Human Development Report- 2003.
5. Other Various National & International Reports, journals on labour
economics.
6. World Bank & IMF Reports