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Impact Of The Global Financial Crisis On Indian Economy

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Background of the Global Financial Crisis; What is it all about?
It all began with the one and all American dream, that every American should have a home. Regardless of who you are and what you do, if you are an American, you should have something called a home. Real Estate business was in a boom, and financial agents thought that there wasn’t a better time to give away loans. The Household sector was given a boost with increased monetary supply by commercial financial companies, and people were given loans regardless of the credit rating they received. It was never expected that the boom in the Real Estate business would come to such an abrupt end, and the prices would reach all time low. The US economy being a capitalist driven economy didn’t bother to indulge itself in the policies pursued by the then prominent financial giants. Gradually these financial giants in this business started feeling the heat as “sub-prime” clients started defaulting in their repayment of loans. The properties which were mortgaged by the clients weren’t even covering the principal amount of the loan, leave alone the interest commitments. The credit offered to the people in indiscriminate fashion, achieving short term goals and ignoring warnings from leading economists about long term sustainability of the policy, backfired completely and companies like Lehmann Brothers, Merill Lynch, Freddie Mac and Fannie Mae’s “bad assets” reached magnanimous proportions. An acute credit shortage was experienced in the economy, and simultaneous negative effects started occurring. The credit crunch meant that borrowing interest rates shot up in the market, companies slowed down their investment policies, production declined, lay offs increased, consumption decreased and the whole economy followed the downward spiral. The unemployment rate in the US reached an all time high of 6.1% and industrial growth saw its largest decline in the past three years and fell to 1.1%. The US governments realized the gravity of the situation, and started using monetary as well as fiscal policies to check the diminishing economy. Fiscal policy boost in the way that, an amount of around US$ 1 trillion was pumped into the economy to increase the liquidity scenario. The financial companies which filed for bankruptcy were nationalized, or there non-performing assets were accounted for by the government. The Federal Bank of US also lowered the monetary policy rates, like Statutory Liquidity Ratio (SLR), relating to the amount of money required to be deposited by commercial banks to the Federal bank, so as to have some check on the sky high interest rates.

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These policies which were targeted to cushion the huge credit shortage scenario has taken somewhat affect and the situation has stabilized a bit. But, as leading economists say, it is too early to comment on whether the trough of the graph has reached or not, or it is still the “tip of the iceberg” scenario. This fear is out there still because there is uncertainty over how many more “sub-prime” creditors are still there in the economy, and how many more companies will get affected by the fallacious policy, which was followed by short-sighted profit oriented companies.
Impact on the Indian Economy
The financial crisis in the US, slowly snowballed to an economic crisis, with growth in the economy stagnating. Efforts have been taken by the US authorities to restore the fully functional markets, but there’s an obvious time lag. Till then, the world economy has been affected by this deep economic crisis and India is no different. India being a net import driven economy, with exports (including the service sector) contributing 17% of GDP, is a little less vulnerable than other economies. Moreover we still have a socialistic pattern of economy where there is enough government intervention, which has somewhat checked the situation from becoming graver. At the present scenario it is a bit difficult to exactly quantify the implications of the global financial meltdown, but a few salient features are:-
• Indian IT companies have around 30% exposure to foreign financial services.
• Funding constraints would result in uncertainty in the real estate sector.
• While direct exposure for financial institutions is negligible, but there are a few firms which have impact on its margin.
• Foreign Direct Investment and Foreign Indirect Investment have decreased dramatically with the liquidity crunch, with companies selling their stakes in a hurry.
• The rupee has significantly depreciated due to the outflow of foreign reserve capital.
The Government of India and Reserve Bank of India accepted these challenges and took measures, discussed subsequently, to control the effects of the implications mentioned above. The holistic point of view is that it was imperative to improve the liquidity situation in the market as lack of liquidity led to the following effects:-
• Lack of lack of money available to commercial banks for offering credit.
• Borrowing interest rates went up.
• Industrial Sector deferred its investment plans.
• Decrease in Production.
• Appreciation in price of commodities.
• Inflationary trends.
• Consumption of Household Sector decreases.
• Government revenue in form of indirect taxes decreases.
• Fiscal deficit increases.
So we have a glimpse of the downward spiral that affects the economy as a whole, i.e. the household, industrial, government and the foreign trade sector, and hence realize the urgency of the government and the apex bank to apply the controlling measures.
Monetary Policy measures announced by the Reserve Bank of India and its implications
With the trickling of the economic depression in India from the US, the government took aggressive stance on the issue and started immediate control on the monetary policy measures. On consultation with the Ministry of Finance, Planning Commission, heads of other commercial banks, the Reserve Bank of India decided to implement these actions to maintain the liquidity scenario in the market and not to let the growth percentage come down:-
• Both repo rate and reverse-repo rate has been reduced to offer additional liquidity to the banking system. The repo rate was reduced to 6.5% and the reverse repo rate to 5%, effective from 08 Dec, 2008.
• Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) were also reduced to 5.5% and 24% respectively.
The cut in repo and reverse repo rates signifies that the amount lent to commercial banks by the apex bank comes at a cheaper rate, which signifies that the commercial banks in turn offer credit at a cheaper rate to the Industrial sector. The cut in CRR and SLR implies that the proportion of money the commercial banks have to deposit to the apex bank for security purposes have been decreased. This implies that there is greater money supply with the commercial banks, which increases the liquidity situation in the banking sector. The Industry sector thus receives easy available credit from commercial banks at affordable rates of borrowing. The investment is thus improved; production of goods and commodities takes place which in turn meets demand requirements and it adds to the GDP of the country.

Fiscal Policy measures announced by the Government of India and its implications
With the inflation somewhat under controllable limits of around 6.84% (the drastic drop in price of crude being one of the major reasons) and growth also maintaining levels of 7.5%, the government decided to supplement its monetary policy with additional fiscal policy measures. The strategy obviously is to have instant effect on the economy, as the monetary policy takes some time to effect the changes, called the inside and outside lags. Monetary policies are governed by regulations, and firstly it’s through that the government tried to control the situation, but when it comes to immediate effect scenario, fiscal policy on the basis of discretion is applied. The upcoming election also being one of the major concerns for the government for immediate results, the announced fiscal measures was imminent and expected.
The fiscal boost of three hundred thousand crores in the form of planned and non-planned expenditure was announced by the government on 7 Dec, 2008. The salient features of the policy are given below:-
• Parliament nod to be sought for Rs.20000 crore more toward plan expenditure.
• Across the board cut of 4% in ad-valorem central value added tax.
• Interest subvention of 2% on export credit for labour intensive sectors.
• Additional allocations for export incentive schemes.
• Full refund of service tax paid by exporters to foreign agents.
• Incentives for loans on housing for upto Rs.500000 and upto 2 million.
• Limits under the credit guarantee scheme for SME doubled.
• Lock-in period for loans to small firms under credit guarantee scheme reduced.
• India Infrastructure Finance Co allowed raising Rs.100 billion through tax free bonds.
• Norms for government departments to replace vehicles relaxed.
• Import duty on naphtha for use by the power sector is being reduced to 0.
• Export duty on iron ore fines eliminated.
• Export duty on lumps for steel industry reduced to 5%.
The government went to the fiscal expansion mode by reducing tax rates, providing tax holidays and increasing expenditure in the forms of credit given to SMEs and Real Estate sectors. The government ignored the fiscal deficit, which increases due to more government expenditure and lesser accumulation of government revenue in the form of indirect taxes, but, boosts the industry sector to invests and increase the overall production levels. This in turn solidifies the foreign trade sector, as with increased production levels, exports increase.

The government has complemented its fiscal expansion efforts with a second stimulus package on 15 Dec, 2008. The salient features in this package are:-
• Increase limit for low-interest housing loans from Rs 20 lakhs to Rs 30 lakhs.
• Raise tax rebate on home loans from Rs 1.5 lakhs to Rs 2.5 lakhs per annum.
• Reduce car and two-wheeler loan rates by 2%, from current levels of 10-12%.
Further reduction in tax rates and loan rates confirms the government’s impetus to reduce the inflationary trend as well as put a thrust to the growth scenario of the country. These tax exemptions will lead to greater production from the Industry sector, and as prices will be less due to lesser excise duties, the aggregate demand will start increasing.

Aggregate Demand-Aggregate Supply Curve Scenario

Here, after economic recession, the equilibrium (pt. O) shifts from y0 to y1. Supply decreases considerably and prices of goods and commodities increases drastically (pt. A). After the government decides to give monetary thrust to the economy through the apex bank, money supply in the household sector increases. This leads to an increase in demand but the supply curve remains the same (pt. B). After sometime, which is after the inside and outside lags of the measures are over, the investment by the Industry sector increases which leads to an increase in supply curve and hence prices reduces to a stable p2 and output also increases to y2 (pt. C). Thus we see the effects of the economic recession on the Short Run Aggregate Supply Curve and the Aggregate Demand Curve.

The macro-economic terms used in the report are:-
a) Cash Reserve Ratio
b) Statutory Liquidity Ratio
c) Repo & Reverse Repo rates
d) Aggregate Demand
e) Aggregate Supply
f) Household Sector
g) Industrial Sector
h) Government Sector
i) Foreign Trade Sector
j) Gross Domestic Product
k) Fiscal Deficit
l) Excise Duty
m) Inflation
n) Foreign Exchange Rates

• Indian Economy: Wikipedia. (n.d.). Retrieved 12 18, 2008, from Wikipedia website: http://en.wikipedia.org/wiki/Indian_economy
• Speeches: RBI. (n.d.). Retrieved 12 18, 2008, from RBI Website: http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/87784.pdf
• Files: Worldbank. (n.d.). Retrieved 12 18, 2008, from Worldbank website: http://crisistalk.worldbank.org/files/Oct_31_JustinLin_KDI_remarks.pdf

The Effect of US Financial Crisis on India

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The Effect of US Financial Crisis on India

Lehman Brothers is no more. Merrill Lynch has gone down the Bank of America maw. AIG too could go belly up. With a doubt, these developments in America are the most shocking events to have hit global financial markets. So where did it all begin? And what does it mean for the Indian stock markets? Find out. . .
What is (or was) Lehman Brothers?
America's fourth-largest investment bank Lehman Brothers Holdings Inc has filed the biggest bankruptcy petition known to mankind.
The 158-year-old firm was founded by brothers Henry, Emanuel and Mayer Lehman, Jewish immigrants to the US from Germany, in 1850. Henry set up a general store in Alabama in 1844 and was later joined by his brothers. In 1850 they set up the merchant bank in New York after having made money in railway bonds. So what went wrong?
Compiled by Rediff Business Desk
Lehman Bros, which till June 2008 had not reported a quarterly loss even once, had earlier survived many an economic crises, like railroad bankruptcies of the 1800s, the Great Depression in the 1930s, and the collapse of Long-Term Capital Management in the 1990s.
Thus the collapse of the giant investment bank came as a major shock for the entire world markets that plunged after Lehman filed a Chapter 11 petition with US Bankruptcy Court in Manhattan.
The $613 billion (some estimates put the size at $639 billion) bankruptcy thus throws up the question: why did the Wall Street giant go bust? Here's why. . .
Why did Lehman Brothers go bankrupt?
The giant investment bank succumbed to the sub-prime mortgage crisis that has rocked the United States and the global economy. Lehman was strangled by a massive credit crisis and fast plummeting real estate prices.
The gargantuan $60 billion loss in bad real estate loans forced the bank to file for bankruptcy.
However, the fall of the 158-year-year institution that started cotton trade in US before the American Civil War and financed the railroad that built a nation, got hit by a large dose of bad luck, pride, arrogance and greed. Primarily, the pride of its chief executive office Richard Fuld.
But there were more reason. Check out what they were. . .
Lehman's collapse was also triggered by the refusal of other banks to do business with it because of its complex and, at times, opaque ways of trading.

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Housing loans made by the bank to people with little support made these loans very risky, and when interest rates rose, these borrowers could no more repay Lehman. This led to huge losses, the extent of which is not yet clear.
Thus other banks stopped trading with Lehman. This led to it losing almost all business and triggered its fall.
The final straw for Lehman was the fact that both Barclays Plc of the United Kingdom and Bank of America Corp pulled out of takeover talks. BofA bought out Merrill Lynch for $50 billion.
However, Barclays has now said that it is in discussions with Lehman Brothers about buying certain assets of the stricken US investment bank.
"Barclays confirms that it is discussing with Lehman Brothers the possible acquisition of certain Lehman Brothers assets on terms that would be attractive to Barclay's shareholders," Britain's third largest bank said in a statement.
When other banks do not want to buy Lehman, why is Barclays interested?
Barclays wanted to buy Lehman out at a discount, so to speak. But when Lehman CEO Fuld decided that his bank was worth much more than what Barclays had apparently offered, Barclays stepped back.
Now that Lehman has filed for bankruptcy, its assets are available fairly cheap. However, the biggest problem is to take on Lehman's enormous liabilities.
How far is the CEO of the company responsible for Lehman's fall?
Wall Street analysts believe that it was the 'hubris' of Richard Fuld, the 62-year-old CEO of Lehman, who did not take the telltale signs of impending doom very seriously. Fuld, nicknamed The Gorilla for his foul temper, intimidating presence and tough talk, rejected many bids to save Lehman because he thought that the sinking giant was much bigger than Wall Street was giving it credit for, and wanted to get more price for the sale of the company.
Analysts say if the bank was sold just a week before it went kaput, it could have been saved the ignominy of a bankruptcy, but Fuld was far too adamant to see reason. Result: the end of a 158-year-old financial giant.
Could the United States government helped, like it helped Bear Stearns in May this year, and Fannie Mae and Freddie Mac earlier this month?
The US government could have helped, but US Treasury Secretary Henry Paulson said that it would not use up any more taxpayer dollars to bail out Lehman Brothers as it would lead to investment banks getting away with their gambling ways. Paulson had bailed out Fannie Mae, Freddie Mac and Bear Stearns, saying that if the government had not done so, the US housing loan market would have collapsed leading to gigantic losses for hundreds of banks all over the globe that have invested in US property.
Paulson, however, believes that a brokerage major like Lehman, which does not have a direct connection with ordinary people who have taken on home loans, need not be bailed out as it would not cause any systemic damage to the US economy.
Will everyone in Lehman lose their jobs?
The bankruptcy administrators, PricewaterhouseCoopers, feels that as Lehman's operations were essentially centralized at New York, the folding up of the investment banker in the US will have a telling impact on all its operations globally.
Over 5,000 employees in the UK have already lost their jobs, while about 20,000 in the US might as well forget going back to their work stations. About 2,500 Lehman employees in India too face the axe.
Will the whole bank be liquidated?
Unlikely, at least for now. The US Chapter 11 that deals with bankruptcy says that PwC, the administrators, can go about taking its time to find good offers and buyers for Lehman's 'least affected businesses.'
The entire exercise can take months before all of Lehman's assets are sold, given the complexities linked to the bankruptcy
What about the Bank of America and Merrill Lynch deal?
Merrill Lynch's buy out by Bank of America is also a shocking development. ML, saw the writing on the wall once it guessed that Lehman was going bust, and decided to sell out before it actually has to file a bankruptcy petition..
What about the insurance giant AIG?
The world's largest insurer, American International Group, has been downgraded by credit rating agencies and is racing against time to find a multi billion dollar infusion to stay afloat. US Federal Reserve officials and two leading banks, JPMorgan Chase and Goldman Sachs, were negotiating to put together $75 billion package to save the insurance giant to stave off crisis.
AIG has sought $40 billion in bridge loan to stave off the crisis. But the Fed rebuffed the request. AIG's ills came to fore, when three leading credit rating agencies - Standard and Poor's Moody's and Fitch - lowered the company's credit scores.
Who could be the next to fall?
Some Wall Street analysts, reports The Guardian, name Washington Mutual as the next financial major to 'find itself in serious trouble.'
However, the even bigger worry is whether the world's largest securities firms, Goldman Sachs and Morgan Stanley, would be able to survive this brutal financial crisis. But many say that these two gaints will not melt down as they have 'done a better job of spreading their bets across world markets and are also more diversified, less leveraged and have managed such risks much better.'
What do Indian markets fear?
The fall of two global financial behemoths -- Lehman Brothers and Merrill Lynch -- is expected to dent India Inc's ability to raise resources via the equity route.
Experts feel that such events significantly increase the risk perception, which in turn will put all future investments by institutional investors such as pension or endowment funds, on the back burner.
While the public issue market has already dried up, the private equity funds are also becoming conservative in terms of pricing. This is resulting in either inordinate delays in concluding deals or transactions being called off.
There are many instances of private equity fund managers refusing to go ahead with deals after signing the term sheet. Sources said that a leading fund conducted due diligence on two companies in the last fortnight but did not close either deal primarily because of the developments in the US, their home country.
The crisis faced by Merrill Lynch and Lehman Brothers is expected to have a cascading effect on PE firms too.
Will it hit the Indian growth story?
The ongoing financial sector crisis in the United States and its repercussions on developed markets worldwide will result in lower capital inflows into emerging markets like India, economists and government officials said today.
At the same time, they called for the government to make it easier for Indian companies to borrow overseas by easing the restrictions that have been imposed in the past to reduce excessive liquidity in the system and control inflation.
This will, in turn, lead to a slowing in investment growth in the months ahead. As lending gets tighter and investment flows dry, corporate India will find it more difficult to raise both equity and debt.
Technology firms are shivering
Lehman Brothers' bankruptcy filing may well prove to be the last straw for Indian IT firms, which were expecting the second half of FY09 to be better. As a result of the US financial market crisis, analysts do not expect Indian IT firms to sign any significant contracts in the banking, financial services and insurance (BFSI) space in the months to come.
While IT firms do not disclose client-specific details, it's estimated that Lehman Brothers has outsourced deals amounting to anywhere between Rs 550 crore and Rs 700 crore (annually) to numerous IT firms, including majors like Tata Consultancy Services, Satyam Computer Services and Wipro. Lehman Brothers, say sources, works with 14 services providers in India - Wipro and TCS being the largest. It also has investments in a few IT firms. It's not clear if these holdings will be liquidated to raise funds.
Moreover, the sources add that Lehman Brothers' unit in India has issued termination letters to a majority of its 2,500 employees
What kind of investment does Lehman have in India?
Lehman does not have direct large holding in the Indian stock markets. These holdings are estimated at around $200 million, including Participatory Notes. This figure is not enough to cripple the Indian stock markets.
But Lehman has exposure to the Indian stock market through special purpose vehicles. This exposure to real estate stocks is said to be of about $1.5 billion, enough to shake up the markets.

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