Features: Magazine | Literary Review | Life | Metro Plus | Open Page | Education Plus | Book Review | Business | SciTech | NXg | Friday Review | Cinema Plus | Young World | Property Plus | Quest |

From U.S. sub-prime to global economic crisis financial scene

— PHOTO: AFP

ROOT CAUSE: Former Fannie Mae CEO Daniel Mudd (right) testifies along with former Freddie Mac CEO Richard Syron (left) before the House Oversight and the Government Reform Committee during a hearing on “The Role of Fannie and Freddie Mac in the Financial Crisis” on Capitol Hill last week.

Reserve Bank of India Governor Duvvuri Subbarao in a  recent speech* in Hyderabad enumerated five key learning experiences from the ongoing crisis that need to be debated further.

The Governor’s analysis of the crisis and the lessons therefrom are a lucid attempt at explaining the crisis dimensions to the lay person.

The sub-prime crisis starting in the U.S. housing mortgage sector has turned successively into a global banking crisis, global financial crisis and a global economic crisis. It is highly paradoxical that housing, a prime example of a ‘non-tradable’ good has triggered a crisis of global dimensions. No one is sure whether an end to the crisis is in sight.

The global outlook has been deteriorating sharply with the International Monetary Fund and the World Bank lowering their forecasts of growth in quick succession. The rich countries are officially in recession and their output is expected to contract next year. Emerging economies, including China and India, are expected to fare better but there is already enough empirical evidence that they too have been hit hard by the ongoing crisis. The once popular decoupling theory that broadly held that emerging economies would be able to chart their own course irrespective of the problems in the developed world has been proved wrong.

Massive capital flow reversals, sharp currency depreciations and a widening of spreads in bond and money markets are all manifestations of the contagion sweeping the global economy.

In India, although consumption and domestic investment have been the key drivers of recent economic growth, the impact of the global crisis has been felt. One obvious reason is that India’s integration with the rest of the world has been on the increase. India’s two way trade (merchandise exports plus imports) as a proportion of GDP has grown from 21.2 per cent in 1997-98 (the year of the Asian crisis) to 34.7 per cent in 2007-08.The ratio of gross current account and gross capital flows to GDP has increased from 46.8 per cent in 1997-98 to 117 per cent in 2007-08.

The present crisis shows that globalisation can cause pain. We, therefore, need to manage the downside ramifications of integrating with the rest of the world. India is experiencing the knock on effects through the monetary, financial and real channels. The financial, equity, money, forex and credit markets have come under pressure because of the ‘substitution effect’. Simply stated, credit channels from abroad have dried up leaving domestic institutions to take on the additional burden. The reversal of capital flows has put pressure on domestic forex markets leading to a sharp depreciation of the rupee.

There are at least five major learning lessons so far from the ongoing crisis.

The phenomenon of Asian savings going to fund the huge American deficits since the 1990s has contributed to the global imbalance.

Asia with a younger demographic profile and other advantages earned a competitive edge. Asian economies ran up huge trade surpluses which were mirrored by current account deficits of the U.S. This geographic savings — consumption imbalance — were inherently fragile but its consequences were not realised.

Accumulation of forex reserves to act as a buffer against financial crises has been followed by many Asian countries.

China and India too have built their reserves but with one important qualitative difference. In China, reserves have been built out of current account surpluses. In India, it is from capital flows. Hence, China’s reserves are unencumbered whereas in India reserves are encumbered by liabilities. Self-insurance has a price.

The ideal route of building up reserves is through current account surpluses. But such reliance on exports can become a liability if export demand shrinks, as it indeed has now. In short, self-insurance through aggressive exports offers protection against financial contagion but makes the economy vulnerable to trade contagion.

By far the most contentious and voluble debate in the ongoing crisis, reform of regulation calls for an understanding of the lacunae in the financial architecture and suggest solutions. Obviously complex financial products such as derivatives need to be made more transparent. However, there cannot be a new regulatory system that will be relevant for all countries.

Also, some regulations have been behind the curve. Regulation must keep pace with innovation but should not stifle innovation.

Under the nose of regulators grew an extensive and complex network of a shadow banking system comprising hedge funds, private equity funds and so on. These were loosely regulated.

The regulatory arbitrage encouraged loose practices and non-transparent and risky products. When the financial system began to unravel, it was realised that many of these institutions posed as much of a systemic risk as banks.

Regulators started believing that significant value could be created by financial engineering by, for instance, dicing and slicing mortgage securities. Recent financial history should have taught us that modern financial system with its deregulated markets, capital flows and highly leveraged entities was dangerously fragile.

Forgotten in the euphoria of financial alchemy is the basic tenet that the financial sector has no standing of its own. It derives its strength and resilience from the real economy. It is the real sector that should drive the financial sector, not the other way round.

Printer friendly page  
Send this article to Friends by E-Mail