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Global dimensions of the financial crisis

There are no signs yet that the major crisis that has engulfed the global financial markets is abating. The fact that it has spread to all financial markets as well as countries far removed from where it started suggests that its resolution will be complex and will involve several countries. In any case, no solution seems possible over the near term.

The most visible manifestation of the ongoing crisis is seen in the highly volatile stock market behaviour but the crisis has affected all financial markets including the credit markets (from where it began in the U.S.), exchange markets and money markets. The deleterious consequences outside the U.S. have however not been so conspicuous. In India, for instance, the benchmark indices, the Sensex and the Nifty, have plummeted amidst unprecedented volatility while other financial markets have reacted less dramatically.

However, the rupee has begun sliding after four months of appreciation. The obvious reason is the heavy stock selling by foreign institutional investors and the consequent demand for dollars for repatriation.

Ironically the U.S. remains a haven during this phase of uncertainty although the crisis had its origin there this time.

Since it is now a global phenomenon, monetary authorities of all countries will have to work in unison. While the contours of a plan of action are hazy two facets of the current global financial scenario are worth recapitulating.

(1) For quite some time now, central banks the world over, including the Reserve Bank of India, have been articulating the need for a concerted plan of action in the face of a possible unwinding of global imbalances between savings and investment. It is well known that Asian countries have been funding the twin deficits of the U.S., budgetary as well as current account. This scenario was not expected to be sustained indefinitely. The process of unwinding, if and when it happened, was expected to be painful and accompanied by a high degree of volatility among financial markets. Some see in the present crisis the start of the process but then no one is sure.

(2) The second factor that distinguishes the present crisis is that the complex financial instruments used to package risky home loans for absorption by investors have not been fully understood by those who invested in them and even by those who devised them. Much will be written about the need to better regulate the financial system to minimise the opaqueness of these instruments as well as the intermediaries.

Neither of these — the global level co-ordination or a vastly improved supervision of the financial system — is likely to happen soon

Meanwhile, on August 17, the U.S. Federal Reserve took the first few steps by (a) acknowledging that the problems of the financial sector have the potential to restrain economic growth and (b) in a move to shore up the confidence of investors, lowering the discount rate by 0.50 percentage point. The Fed lends directly to banks through the discount window and the latest move is meant to stall crisis-hit-mortgage companies from going under. The more widely watched Fed funds rate has not been tinkered with for now but there are indications that it will be lowered soon. The Fed funds rate is reduced to stimulate a flagging economy and raised to rein in inflation.

The recognition that the financial crisis can no longer be insulated from the economy is a welcome development. It is an acknowledgement that the damage to the economy can be large. Already, well-to-do families in the U.S. are reportedly finding it difficult to locate lenders to fund normal mortgages. Many of them have sold their equities, leading to a fall in stock markets. All these are happening despite the U.S. Fed and other leading central banks injecting massive liquidity, estimated at hundreds of billions of dollars.

What about India? After watching the stock market movements, no one can say that India is immune or will suffer much less pain than, say, the developed countries. Even before the latest crisis, Indian stock markets have been taking their cue from other markets, especially the emerging ones in Asia. Now that the contagion has spread, the first negative consequence is seen in the stock markets. The dominant foreign institutional investors are repricing the risks and India may soon have to pay a higher risk premium. Besides, the hedge funds and others which have been actively dealing in instruments based on sub-prime mortgages have been active in Indian stocks too. To recoup their losses elsewhere they may reduce their exposure on India.

Recently Indian companies were on an acquisition drive abroad. Even big names like the Tatas and the Aditya Birla group may find the cost of refinancing the takeovers going up.

Second, the cost of external commercial borrowings will go up and overseas lenders may become selective.

Third, a number of companies have floated their shares and debt instruments abroad. Thus the growing connection with the outside world, a welcome feature, may come under stress.

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