Financial Crisis

Wall Street is panic – struck.

The major financial crisis of the 21st century involves esoteric instruments, unaware regulators, and nervous investors. Starting in the summer of 2007, the United States experienced a startling contraction in wealth, triggered by the subprime crisis, thereby leading to increase in risk spreads, and decrease in credit market functioning. During boom years, mortgage brokers enticed by the lure of big commissions, talked buyers with poor credit into accepting housing mortgages with little or no down payment and without credit checks. Higher default levels, particularly among less credit-worthy borrowers, magnified the impact of the crisis on the financial sector.

 

The same financial crisis, which started last summer, is back with a vengeance. Paul Krugman describes the analogy between credit – lending between market players and the financial markets, and motor oil to car engines. The ability to raise cash on short notice, i.e. liquidity, is an essential lubricant for the markets and for the economy as a whole. The drying liquidity has closed shops of a large number of credit markets. Interest rates have been rising across the world, even rates at which banks lend to each other. The freezing up of the financial markets will ultimately lead to a severe reduction in the rate of lending, followed by slowed and drastically reduced business investments, leading to a recession, possibly a nasty one. A collapse of trust between market players has decreased the willingness of lending institutions to risk money. The major reason behind this lack of trust being the bursting of the housing bubble, which caused a lot of AAA labeled investments to turn out to be junk.

The IMF has warned the global economy of a spiraled mortgage crisis, starting in the United States, ultimately leading to the largest financial shock since the Great Depression. Since 1864, American Banking has been split into commercial banks and investment banks. But now that’s changing. Some of the biggest names on Wall Street, Bear Stearns, Lehman Brothers, and Merrill Lynch, have disappeared into thin air overnight. Goldman Sachs and Morgan Stanley are the only two giants left. Nervous investors have been sending markets plunging down. Even Morgan Stanley, one of the last two big independent investment banks on Wall Street, is struggling to survive at the exchange, though it insists that the company is still in solid shape. Markets all over the world are confronted by all-time low figures in the past couple of years or more, including those of Britain, Germany, and Asia.

In India, IT companies, with nearly half of their revenues coming from banking and financial service segments, are close monitors of the financial crisis across the world. The IT giants which had Lehman Brothers and Merrill Lynch as their clients are TCS, Wipro, Satyam, and Infosys Technologies. HCL escaped the los to a great extent because neither Lehman Brothers nor ML was its client.
The government has a reason to worry because the ongoing financial crisis may have an adverse impact on the banks. Lehman Brothers and Merrill Lynch had invested a substantial amount in the stocks of Indian Banks, which in turn had invested the money in derivatives, leading to the exposure of even the derivates market to these investment bankers.

PSU banks like Bank of India, Bank of Baroda have exposure towards derivates. ICICI has faced the worst hit. With Lehman Brothers filing for bankruptcy in the US, ICICI (India’s largest private bank) is expected to lose $80 million (Rs.375 crores), invested in Lehman’s bonds through the bank’s UK subsidiary. Even Axis bank is expected to be affected by the meltdown.

The real estate sector is also affected due to the same factor. Lehman Brothers’ real estate partner had given Rs. 7.40 crores to Unitech Ltd., for its mixed use development project in Santa Cruz. Lehman had also signed a MoU with Peninsula Land Ltd, an Ashok Piramal real estate company, to fund the latter’s project amounting to Rs. 576 crores. DLF Assets, which holds an investment worth $200 million, is another major real estate organization whose valuations are affected by the Lehman Brothers dissolution.

Britain has also witnessed the so called “bursting of the Brown bubble”, in the form of the highest personal debt per capita in the G7 combined with an unsustainable rise in housing prices. The longest period of expansion in the 21st century, which Britain claimed to be undergoing, eventually revealed itself of being an illusion. The illusion of rising to prosperity has been maintained by borrowing to spend, often in the form of equity withdrawal from increasing expensive houses. The bubble ultimately burst, exposing Britain to the most serious financial crisis since the 1920s. This brings a lot of misery for home owners who are set to see the cost of mortgages soar following the deepening of the banking crisis and the Libor – the rate at which banks lend to each other.

The impact of the crisis is more vividly observable in the emerging markets which are suffering from one of their biggest sell-offs.
“Everyone has exposure to everything…either directly or indirectly”, JP Morgan analyst, Brian Johnson Economies with disproportionate offshore borrowings (like that of Australia) are adversely affected by the western financial crunch. Globalization has ensured that none of the economies of the world stay insulated from the present financial crisis in the developed economies.
Analysis of the impact of the crisis on India can be on the basis of the following 3 criteria:
1. Availability of global liquidity
2. Demand for India investment and cost thereof
3. Decreased consumer demand affecting Indian exports

• The main source of Indian prosperity was Foreign Direct Investment (FDI). American and European companies were bringing in truck-loads of dollars and Euros to get a piece of the pie of Indian prosperity. Less inflow of foreign investment will result in the dilution of the element of GDP driven growth.
• Liquidity is a major driving force of the strong market performances we have seen in emerging markets. Markets such as those of India are especially dependent on global liquidity and international risk appetite. While interest rates in some countries are increasing, countries such as Brazil are decreasing interest rates. In general, rising interest rates tend to have a negative impact on global liquidity and subsequently equity prices as fund may move into bonds and other money markets.
• Indian companies which had access to foreign funds for financing their import and export will be worst hit
• Foreign funds will be available at huge premiums and will be limited only to the blue-chip companies, thus leading to:

1. Reduced capacity of expansion leading to supply – side pressure
2. Increased interest rates to affect corporate profitability
3. Increased demand for domestic liquidity will put interest rates under pressure

• Consumer demand will face a slow-down in developed economies leading to a reduced demand for Indian goods and services, thus affecting Indian exports

1. Export oriented units will be worst hit, thus impacting employment
2. Widening of the trade gap due to reduced exports, leading to pressure on the rupee exchange rate

• Impact on Financial Markets:

1. Equity market will continue to remain in bearish mood
2. Demand for domestic liquidity will push interest rates high and as a result will lead to rupee depreciation and depleted currency reserves.

“Every happy family is alike, but every unhappy family is unhappy in their own way.” – Leo Tolstoy. While each financial crisis is undoubtedly distinct, there are also striking similarities between them in growth patterns, debt accumulation, and in current account deficits.

 

Source: Institute of International Trade

Date: 17th Dec.,2009

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