Crisis and 2008 Financial Crisis, Is Considered by Many Economists To Be The Worst

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008
CHAPTER: 1
INTRODUCTION
WHAT IS THE FINANCIAL CRISIS 2008?
The financial crisis of 20072008, also known as the global financial crisis and 2008 financial crisis, is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s.It resulted in the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many areas, the housing market also suffered, resulting in evictions, foreclosures and prolonged unemployment. The crisis played a significant role in the failure of key businesses, declines in consumer wealth estimated in trillions of US dollars, and a downturn in economic activity leading to the 20082012 global recession and contributing to the European sovereign-debt crisis. The active phase of the crisis, which manifested as a liquidity crisis, can be dated from August 7, 2007, when BNP Paribas terminated withdrawals from three hedge funds citing "a complete evaporation of liquidity". The bursting of the U.S. housing bubble, which peaked in 2006,caused the values of securities tied to U.S. real estate pricing to plummet, damaging financial institutions globally. The financial crisis was triggered by a complex interplay of policies that encouraged home ownership, providing easier access to loans for subprime borrowers, overvaluation of bundled sub-prime mortgages based on the theory that housing prices would continue to escalate, questionable trading practices on behalf of both buyers and sellers, compensation structures that prioritize short-term deal flow over long-term value creation, and a lack of adequate capital holdings from banks and insurance companies to back the financial commitments they were making. Questions regarding bank solvency, declines in credit availability and damaged investor confidence had an impact on global stock markets, where securities suffered large losses during 2008 and early 2009. Economies worldwide slowed during this period, as credit tightened and
1
international trade declined Governments and central banks responded with unprecedented fiscal stimulus, monetary policy expansion and institutional bailouts. In the U.S., Congress passed the American Recovery and Reinvestment Act of 2009. In the EU, the UK responded with austerity measures of spending cuts and tax increases without export growth and it has since slid into a double-dip recession. Many causes for the financial crisis have been suggested, with varying weight assigned by experts. The U.S. Senate's LevinCoburn Report asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." The 1999 repeal of the GlassSteagall Act effectively removed the separation between investment banks and depository banks in the United States. Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address 21st-century financial markets. Research into the causes of the financial crisis has also focused on the role of interest rate spreads. In the immediate aftermath of the financial crisis palliative fiscal and monetary policies were adopted to lessen the shock to the economy. In July 2010, the DoddFrank regulatory reforms were enacted to lessen the chance of a recurrence. He immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 20052006. Already-rising default rates on "subprime" and adjustable-rate mortgages (ARM) began to increase quickly thereafter. As banks began to give out more loans to potential home owners, housing prices began to rise. Easy availability of credit in the US, fueled by large inflows of foreign funds after the Russian debt crisis and Asian financial crisis of the 19971998 period, led to a housing construction boom and facilitated debt-financed consumer spending. Lax lending standards and rising real estate prices also contributed to the Real estate bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.
2
As part of the housing and credit booms, the number of financial agreements called mortgage-backed securities (MBS) and collateralized debt obligations (CDO), which derived their value from mortgage payments and housing prices, greatly increased.[ Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Falling prices also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues to drain wealth from consumers and erodes the financial strength of banking institutions. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.
Share in GDP of U.S. financial sector since 1860. While the housing and credit bubbles were building, a series of factors caused the financial system to both expand and become increasingly fragile, a process called
3
financialization. U.S. Government policy from the 1970s onward has emphasized deregulation to encourage business, which resulted in less oversight of activities and less disclosure of information about new activities undertaken by banks and other evolving financial institutions. Thus, policymakers did not immediately recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations. These institutions, as well as certain regulated banks, had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses. These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to provide funds to encourage lending and restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions and implemented economic stimulus programs, assuming significant additional financial commitments. The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserves failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels." During a period of intense competition between mortgage lenders for revenue and market share, and when the supply of creditworthy borrowers was limited, mortgage lenders relaxed underwriting standards and originated riskier mortgages to less creditworthy borrowers. In the view of some analysts, the relatively conservative Government Sponsored Enterprises (GSEs) policed mortgage
4
originators and maintained relatively high underwriting standards prior to 2003. However, as market power shifted from securitizers to originators and as intense competition from private securitizers undermined GSE power, mortgage standards declined and risky loans proliferated. The worst loans were originated in 2004 2007, the years of the most intense competition between securitizers and the lowest market share for the GSEs.
U.S. subprime lending expanded dramatically 20042006 As well as easy credit conditions, there is evidence that competitive pressures contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and government sponsored enterprises like Fannie Mae played an important role in the expansion of lending, with GSEs eventually relaxing their standards to try to catch up with the private banks. A contrarian view is that Fannie Mae and Freddie Mac led the way to
5
relaxed underwriting standards, starting in 1995, by advocating the use of easy-toqualify automated underwriting and appraisal systems, by designing the nodownpayment products issued by lenders, by the promotion of thousands of small mortgage brokers, and by their close relationship to subprime loan aggregators such as Countrywide. Depending on how subprime mortgages are defined, they remained below 10% of all mortgage originations until 2004, when they spiked to nearly 20% and remained there through the 20052006 peak of the United States housing bubble. Some scholars, like American Enterprise Institute fellow Peter J. Wallison, believe that the roots of the crisis can be traced directly to affordable housing policies initiated by HUD in the 1990s and to massive risky loan purchases by government sponsored entities Fannie Mae and Freddie Mac. Based upon information in the SEC's December 2011 securities fraud case against 6 ex-executives of Fannie and Freddie, Peter Wallison and Edward Pinto have estimated that, in 2008, Fannie and Freddie held 13 million substandard loans totaling over $2 trillion. The majority report of the Financial Crisis Inquiry Commission (written by the 6 Democratic appointees without Republican participation), studies by Federal Reserve economists, and the work of several independent scholars dispute Wallison's assertions. They note that GSE loans performed better than loans securitized by private investment banks, and performed better than some loans originated by institutions that held loans in their own portfolios. Paul Krugman has even claimed that the GSE never purchased subprime loans a claim that is widely disputed. On September 30, 1999, The New York Times reported that the Clinton Administration pushed for more lending to low and moderate income borrowers, while the mortgage industry sought guarantees for sub-prime loans: Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits. In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more
6
loans to so-called subprime borrowers... In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.[ In 2001, the independent research company, Graham Fisher & Company, stated that HUDs 1995 National Homeownership Strategy: Partners in the American Dream, a 100-page affordable housing advocacy document, promoted the relaxation of credit standards. In the early and mid-2000s (decade), the Bush administration called numerous timesfor investigation into the safety and soundness of the GSEs and their swelling portfolio of subprime mortgages. On September 10, 2003, the House Financial Services Committee held a hearing at the urging of the administration to assess safety and soundness issues and to review a recent report by the Office of Federal Housing Enterprise Oversight (OFHEO) that had uncovered accounting discrepancies within the two entities. The hearings never resulted in new legislation or formal investigation of Fannie Mae and Freddie Mac, as many of the committee members refused to accept the report and instead rebuked OFHEO for their attempt at regulation. Some believe this was an early warning to the systemic risk that the growing market in subprime mortgages posed to the U.S. financial system that went unheeded. A 2000 United States Department of the Treasury study of lending trends for 305 cities from 1993 to 1998 showed that $467 billion of mortgage lending was made by Community Reinvestment Act (CRA)-covered lenders into low and mid level income (LMI) borrowers and neighborhoods, representing 10% of all U.S. mortgage lending during the period. The majority of these were prime loans. Subprime loans made by CRA-covered institutions constituted a 3% market share of LMI loans in 1998, but in the run-up to the crisis, fully 25% of all sub-prime lending occurred at CRA-covered institutions and another 25% of sub-prime loans had some connection with CRA. In addition, an analysis by the Federal Reserve Bank of Dallas in 2009, however, concluded that the CRA was not responsible for the mortgage loan crisis, pointing out that CRA rules have been in place since 1995
7
whereas the poor lending emerged only a decade later. Furthermore, most subprime loans were not made to the LMI borrowers targeted by the CRA, especially in the years 20052006 leading up to the crisis. Nor did it find any evidence that lending under the CRA rules increased delinquency rates or that the CRA indirectly influenced independent mortgage lenders to ramp up sub-prime lending. To other analysts the delay between CRA rule changes (in 1995) and the explosion of subprime lending is not surprising, and does not exonerate the CRA. They contend that there were two, connected causes to the crisis: the relaxation of underwriting standards in 1995 and the ultra-low interest rates initiated by the Federal Reserve after the terrorist attack on September 11, 2001. Both causes had to be in place before the crisis could take place. Critics also point out that publicly announced CRA loan commitments were massive, totaling $4.5 trillion in the years between 1994 and 2007. They also argue that the Federal Reserves classification of CRA loans as prime is based on the faulty and self-serving assumption: that high-interest-rate loans (3 percentage points over average) equal subprime loans. Economist Paul Krugman argued in January 2010 that the simultaneous growth of the residential and commercial real estate pricing bubbles and the global nature of the crisis undermines the case made by those who argue that Fannie Mae, Freddie Mac, CRA, or predatory lending were primary causes of the crisis. In other words, bubbles in both markets developed even though only the residential market was affected by these potential causes. In his Dissent to the Financial Crisis Inquiry Commission, Peter J. Wallison wrote: "It is not true that every bubbleeven a large bubblehas the potential to cause a financial crisis when it deflates." Wallison notes that other developed countries had "large bubbles during the 1997 2007 period" but "the losses associated with mortgage delinquencies and defaults when these bubbles deflated were far lower than the losses suffered in the United States when the 19972007 [bubble] deflated." According to Wallison, the reason the U.S. residential housing bubble (as opposed to other types of bubbles) led to financial crisis was that it was supported by a huge number of substandard loans generally with low or no downpayments. Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in Portfolio Magazine, Michael Lewis spoke
8
with one trader who noted that "There werent enough Americans with [bad] credit taking out [bad loans] to satisfy investors' appetite for the end product." Essentially, investment banks and hedge funds used financial innovation to enable large wagers to be made, far beyond the actual value of the underlying mortgage loans, using derivatives called credit default swaps, collateralized debt obligations and synthetic CDOs. As of March 2011 the FDIC has had to pay out $9 billion to cover losses on bad loans at 165 failed financial institutions. The Congressional Budget Office estimated, in June 2011, that the bailout to Fannie Mae and Freddie Mac exceeds $300 billion (calculated by adding the fair value deficits of the entities to the direct bailout funds at the time).
CHAPTER: 2
CAUSES OF THE 2008 FINANCIAL CRISES

Many factors directly and indirectly caused the ongoing 20072012 global financial crisis (which started with the US subprime mortgage crisis), with experts placing different weights upon particular causes. The crisis resulted from a combination of complex factors, including easy credit conditions during the 20022008 period that encouraged high-risk lending and borrowing practices; international trade imbalances; real-estate bubbles that have since burst; fiscal policy choices related to government revenues and expenses; and approaches used by nations to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses. One narrative describing the causes of the crisis begins with the significant increase in savings available for investment during the 2000 2007 period when the global pool of fixed-income securities increased from approximately $36 trillion in 2000 to $70 trillion by 2007. This "Giant Pool of Money" increased as savings from high-growth developing nations entered global capital markets. Investors searching for higher yields than those offered by U.S. Treasury bonds sought alternatives globally. The temptation offered by such readily available savings overwhelmed the policy and regulatory control mechanisms in country after country, as lenders and borrowers put these savings to use, generating bubble after bubble across the globe. While these bubbles have burst, causing asset prices (e.g., housing and commercial property) to decline, the liabilities owed to global investors remain at full price, generating
10
questions regarding the solvency of consumers, governments and banking systems. Struggling banks in the U.S. and Europe cut back lending causing a credit crunch. Consumers and some governments were no longer able to borrow and spend at pre-crisis levels. Businesses also cut back their investments as demand faltered and reduced their workforces. Higher unemployment due to the recession made it more difficult for consumers and countries to honor their obligations. This caused financial institution losses to surge, deepening the credit crunch, thereby creating an adverse feedback loop. The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserves failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels. Mortgage underwriting In addition to considering higher-risk borrowers, lenders offered increasingly risky loan options and borrowing incentives. Mortgage underwriting standards declined gradually during the boom period, particularly from 2004 to 2007. The use of automated loan approvals allowed loans to be made without appropriate review and documentation. In 2007, 40% of all subprime loans resulted from automated underwriting. The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers
11
could repay. Mortgage fraud by lenders and borrowers increased enormously.
Mortgage fraud In 2004, the Federal Bureau of Investigation warned of an "epidemic" in mortgage fraud, an important credit risk of non-prime mortgage lending, which, they said, could lead to "a problem that could have as much impact as the S&L crisis". Down payments and negative equity A down payment refers to the cash paid to the lender for the home and represents the initial homeowners equity or financial interest in the home. A low down payment means that a home represents a highly leveraged investment for the homeowner, with little equity relative to debt. In such circumstances, only small declines in the value of the home result in negative equity, a situation in which the value of the home is less than the mortgage amount owed. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever. By comparison, China has down payment requirements that exceed 20%, with higher amounts for nonprimary residences. homeowners with high credit scores at the time of entering a mortgage are 50% more likely to "strategically default" - abruptly and intentionally pull the plug and abandon the mortgage compared with lower-scoring borrowers. Such strategic defaults were heavily concentrated in markets with the highest price declines. An estimated 588,000 strategic defaults occurred nationwide during 2008, more than double the total in 2007. They represented 18% of all serious delinquencies that extended for more than 60 days in the fourth quarter of 2008.
12
Predatory lending Predatory lending refers to the practice of unscrupulous lenders, to enter into "unsafe" or "unsound" secured loans for inappropriate purposes. A classic bait-and-switch method was used by Countrywide, advertising low interest rates for home refinancing. Such loans were written into mind-numbingly detailed contracts and then swapped for more expensive loan products on the day of closing. Whereas the advertisement might have stated that 1% or 1.5% interest would be charged, the consumer would be put into an adjustable rate mortgage (ARM) in which the interest charged would be greater than the amount of interest paid. This created negative amortization, which the credit consumer might not notice until long after the loan transaction had been consummated. Risk-taking behavior In a June 2009 speech, U.S. President Barack Obama argued that a "culture of irresponsibility" was an important cause of the crisis. He criticized executive compensation that "rewarded recklessness rather than responsibility" and Americans who bought homes "without accepting the responsibilities." He continued that there "was far too much debt and not nearly enough capital in the system. And a growing economy bred complacency." A key theme of the crisis is that many large financial institutions did not have a sufficient financial cushion to absorb the losses they sustained or to support the commitments made to others. Using technical terms, these firms were highly leveraged (i.e., they maintained a high ratio of debt to equity) or had insufficient capital to post as collateral for their borrowing. A key to a stable financial system is that firms have the financial capacity to support their commitments Michael Lewis and David Einhorn argued: "The most critical role for regulation is to make sure that the sellers of risk have the capital to support their bets." Consumer and household borrowing
13
U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn.
USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. U.S. home mortgage debt relative to gross domestic product (GDP) increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion. In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.
Several economists and think tanks have argued that income inequality is one of the reasons for this over-leveraging. The New York Times reported in October 2012 that research by the Brookings Institution, the I.M.F. and dozens of economists at top research universities indicated that starting in the 1970s, earnings were squeezed for low- and middleincome households. They borrowed to improve their standards of living, buying bigger houses than they could afford and using those houses as piggy banks. Research by Raghuram Rajan indicated that: Starting in the early 1970s, advanced economies found it increasingly difficult to grow...the shortsighted political response to the anxieties of those falling behind was to ease their access to credit. Faced with little regulatory restraint, banks overdosed on risky loans." Home equity extraction This refers to homeowners borrowing and spending against the value of their homes, typically via a home equity loan or when selling the home. Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period, contributing to
14
economic growth worldwide. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.
Housing speculation Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market." Mortgage risks were underestimated by every institution in the chain from originator to investor by underweighting the possibility of falling housing prices given historical trends of rising prices. Misplaced confidence in innovation and excessive optimism led to miscalculations by both public and private institutions. Pro-cyclical human nature Keynesian economist Hyman Minsky described how speculative borrowing contributed to rising debt and an eventual collapse of asset values. Economist Paul McCulley described how Minsky's hypothesis translates to the current crisis, using Minsky's words: "...from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes, the economic system's reactions to a movement of the economy amplify the movement--inflation feeds upon inflation and debt-deflation feeds upon debt deflation." In other words, people are momentum investors by
15
nature, not value investors. People naturally take actions that expand the apex and nadir of cycles. One implication for policymakers and regulators is the implementation of counter-cyclical policies, such as contingent capital requirements for banks that increase during boom periods and are reduced during busts. Corporate risk-taking and leverage
Leverage Ratios of Significantly 200307
Investment
Banks
Increased
The former CEO of Citigroup Charles O. Prince said in November 2007: "As long as the music is playing, you've got to get up and dance." This metaphor summarized how financial institutions took advantage of easy credit conditions, by borrowing and investing large sums of money, a practice called leveraged lending. Debt taken on by financial institutions increased from 63.8% of U.S. gross domestic product in 1997 to 113.8% in 2007. Net capital rule A 2004 SEC decision related to the net capital rule allowed USA investment banks to issue substantially more debt, which was then used
16
to help fund the housing bubble through purchases of mortgage-backed securities. The change in regulation left the capital adequacy requirement at the same level but added a risk weighting that lowered capital requirements on AAA rated bonds and tranches. This led to a shift from first loss tranches to highly-rated less risky tranches and was seen as an improvement in risk management in the spirit of the European Basel accords. Financial market factors In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20 cited the following causes related to features of the modern financial markets: During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions. Financial product innovation
17
A protester on Wall Street in the wake of the AIG bonus payments controversy is interviewed by news media.The term financial innovation refers to the ongoing development of financial products designed to achieve particular client objectives, such as offsetting a particular risk exposure (such as the default of a borrower) or to assist with obtaining financing. Examples pertinent to this crisis included: the adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities (MBS) or collateralized debt obligations (CDO) for sale to investors, a type of securitization; and a form of credit insurance called credit default swaps(CDS). The usage of these products expanded dramatically in the years leading up to the crisis. These products vary in complexity and the ease with which they can be valued on the books of financial institutions. Author Michael Lewis wrote that CDS enabled speculators to stack bets on the same mortgage bonds and CDO's. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as AIG) bet they would not. In addition, Chicago Public Radio and the Huffington Post reported in April 2010 that market participants, including a hedge fund called Magnetar Capital, encouraged the creation of CDO's containing low quality mortgages, so they could bet against them using CDS. NPR reported that Magnetar encouraged investors to purchase CDO's while simultaneously betting against them, without disclosing the latter bet.
18
Inaccurate credit ratings
MBS credit rating downgrades, by quarter. Credit rating agencies are now under scrutiny for having given investment-grade ratings to MBSs based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold to investors, thereby financing the housing boom. These ratings were believed justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. An estimated $3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or Alt-A mortgages) between 2002 and 2007. Economist Joseph Stiglitz stated: "I view the rating agencies as one of the key culprits...They were the party that performed the alchemy that converted the securities from F-rated to Arated. The banks could not have done what they did without the complicity of the rating agencies." Without the AAA ratings, demand for these securities would have been considerably less. Bank writedowns and losses on these investments totaled $523 billion as of September 2008.
19
Author Upton Sinclair (18781968) famously stated: "It is difficult to get a man to understand something when his job depends on not understanding it." From 2000-2006, structured finance (which includes CDO's) accounted for 40% of the revenues of the credit rating agencies. During that time, one major rating agency had its stock increase six-fold and its earnings grew by 900%. Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors.
Lack of transparency and independence in financial modeling The limitations of many, widely-used financial models also were not properly understood (see for example Li's Gaussian copula formula assumed that the price of CDS was correlated with and could predict the correct price of mortgage backed securities. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies. According to one wired.com article: "Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008 when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril... Li's Gaussian copula formula will go down in history as
20
instrumental in causing the unfathomable losses that brought the world financial system to its knees." As financial assets became more complex, less transparent, and harder and harder to value, investors were reassured by the fact that both the international bond rating agencies and bank regulators, who came to rely on them, accepted as valid some complex mathematical models which theoretically showed the risks were much smaller than they actually proved to be in practice. George Soros commented that "The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility." Off-balance sheet financing Complex financing structures called structured investment vehicles (SIV) or conduits enabled banks to move significant amounts of assets and liabilities, including unsold CDO's, off their books. This had the effect of helping the banks maintain regulatory minimum capital ratios. They were then able to lend anew, earning additional fees. Author Robin Blackburn explained how they worked: Institutional investors could be persuaded to buy the SIV's supposedly high-quality, short-term commercial paper, allowing the vehicles to acquire longer-term, lower quality assets, and generating a profit on the spread between the two. The latter included larger amounts of mortgages, credit-card debt, student loans and other receivables...For about five years those dealing in SIV's and conduits did very well by exploiting the spread...but
21
this disappeared in August 2007, and the banks were left holding a very distressed baby. Off balance sheet financing also made firms look less leveraged and enabled them to borrow at cheaper rates. Regulatory avoidance Certain financial innovation may also have the effect of circumventing regulations, such as off-balance sheet financing that affects the leverage or capital cushion reported by major banks. For example, Martin Wolf wrote in June 2009: "...an enormous part of what banks did in the early part of this decade the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself was to find a way round regulation." Financial sector concentration Niall Ferguson wrote that the financial sector became increasingly concentrated in the years leading up to the crisis, which made the stability of the financial system more reliant on just a few firms, which were also highly leveraged: Governmental policies
22
U.S. Subprime lending expanded dramatically 20042006.
Failure to regulate non-depository banking The Shadow banking system grew to exceed the size of the depository system, but was not subject to the same requirements and protections. Nobel laureate Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect." Affordable housing policies The Financial Crisis Inquiry Commission (majority report) stated that Fannie Mae and Freddie Mac, government affordable housing policies, and the Community Reinvestment Act were not primary causes of the crisis. Macroeconomic conditions Two important factors that contributed to the United states housing bubble were low U.S. interest rates and a large U.S. trade deficit. Low interest rates made bank lending more profitable, while trade deficits resulted in large capital inflows to the U.S. Both made funds for borrowing plentiful and relatively inexpensive.
23
Interest rates
Federal Funds Rate and Various Mortgage Rates From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation. The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest rate resets more expensive for homeowners.[ This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing. Globalization and Trade deficits
24
U.S. Current Account Deficit Globalization and trade imbalances contributed to enormous inflows of money into the U.S. from high savings countries, fueling debt-driven consumption and the housing bubble. The ratio of household debt to disposable income rose from 77% in 1990 to 127% by 2007. The steady entry into the world economy of new export-oriented economies began with Japan and the Asian tigers in the 1980s and peaked with China in the early 2000s, representing more than two billion newly employable workers. The integration of these high-savings, lower wage economies into the global economy, combined with dramatic productivity gains made possible by new information technologies and the globalization of corporate supply chains, decisively shifted the balance of global supply and demand. By 2000, the world economy was beset by excess supplies of labor, capital, and productive capacity relative to global demand. But the collapse of the consumer credit and housing price bubbles brought an end to this pattern of debt-financed economic growth and left the U.S. with the massive debt overhang. Boom and collapse of the shadow banking system Significance of the parallel banking system
25
Securitization markets were impaired during the crisis In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls. Further, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices. He described the significance of these entities: "In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion." He stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles." Run on the shadow banking system Nobel laureate and liberal political columnist Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures
26
should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect." Some researchers have suggested that competition between GSEs and the shadow banking system led to a deterioration in underwriting standards. For example, investment bank Bear Stearns was required to replenish much of its funding in overnight markets, making the firm vulnerable to credit market disruptions. Mortgage compensation model, executive pay and bonuses During the boom period, enormous fees were paid to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. Those originating loans were paid fees for selling them, regardless of how the loans performed. Default or credit risk was passed from mortgage originators to investors using various types of financial innovation.This became known as the "originate to distribute" model, as opposed to the traditional model where the bank originating the mortgage retained the credit risk. In effect, the mortgage originators were left with nothing which was at risk, giving rise to moral hazard in which behavior and consequence were separated. Regulation and Deregulation Critics have argued that the regulatory framework did not keep pace with financial innovation, such as the increasing importance of the shadow banking system, derivatives and off-balance sheet financing. In other cases, laws were changed or enforcement weakened in parts of the financial system. Several critics have argued that the most critical role for regulation is to make sure that financial institutions have the ability or capital to deliver on their commitments. Critics have also noted de facto deregulation through a shift in market share toward the least regulated portions of the mortgage market. Conflicts of interest and lobbying
27
A variety of conflicts of interest have been argued as contributing to this crisis:
Credit rating agencies are compensated for rating debt securities by those issuing the securities, who have an interest in seeing the most positive ratings applied. Further, changing the debt rating on a company that insures multiple debt securities such as AIG or MBIA, requires the re-rating of many other securities, creating significant costs. Despite taking on significantly more risk, AIG and MBIA retained the highest credit ratings until well into the crisis. There is a "revolving door" between major financial institutions, the Treasury Department, and Treasury bailout programs. For example, the former CEO of Goldman Sachs was Henry Paulson, who became President George W. Bush's Treasury Secretary. Although three of Goldman's key competitors either failed or were allowed to fail, it received $10 billion in Troubled Asset Relief Program (TARP) funds (which it has since paid back) and $12.9 billion in payments via AIG, while remaining highly profitable and paying enormous bonuses. The first two officials in charge of the TARP bailout program were also from Goldman.
28
CHAPTER: 3
THE FINANCIAL CRISIS 2008 AND ITS IMPACT ON DEVELOPING COUNTRIES

In 2003-2007, the developing world experienced an impressive economic boom, growing at a rate of 7per cent per year. The boom was fueled by a mix of four ingredients prevailing in global markets: exceptional financing, high commodity prices and, for a significant number of countries, large flows of remittances. The first two conditions had coincided for the last time in the 1970s, while the mix of the three had never been experienced before. The rise of an alternative
29
Asian engine, with China at the center, is a fourth element, which has had a strong influence on world trade and commodity prices. These conditions have been replaced since mid-2008, particularly since September 2008, by the effects of financial turmoil that erupted in mid-2007 in the U.S. which has now become the worst global financial crisis and the worst recession since the Great Depression. For a year since the crisis erupted, commodity prices continued to boom. This factor, together with high foreign exchange reserves, helped to attract capital to emerging markets even after the outburst of the subprime crisis. However, both have now joined the downturn. There are signs that remittances, the third source of the boom, have experienced a significant slowdown or are even falling. We will see in the immediate future whether the Asian and particularly the Chinese growth engine can serve as the basis for world economic growth, but recent data for the fourth quarter of 2008 are not very promising in this regard. More broadly, these events indicate that the view espoused by the IMF in 2007 that the developing world would decouple from weak economic conditions in industrial countries was essentially flawed.
CHANNELS OF TRANSMISSION OF THE CRISIS

The crisis can be seen as being driven by the reversal of the three positive shocks that developing countries experienced during the recent boom: rapid growth of remittances, capital flows and trade. We start with a short
30
look at remittances, where the information is not abundant. Then we deal more extensively with capital flows and trade.
REMITTANCES
For some regions, there is strong evidence of reduced dynamism of remittances. In the case of Latin America, in particular, remittances grew very slowly both in 2007 and 2008, falling as a proportion of GDP in both years, in sharp contrast with the rapid growth earlier in the decade. The direct sensitivity of migrant incomes to construction activity, which has been falling for three years now, seems to be an important explanation for the absolute reduction of remittances from the U.S. to Mexico in 2008, but absolute reductions are still an exception. Remittances from Europe may be experiencing a similar pattern of either a strong reduction in the growth rate or absolute reduction (see, for example, the case of Spain, one of the economies hit the hardest by a construction crisis). In contrast, other areas of destinations of migrants, particularly the Gulf countries, continued to boom until the third quarter of 2008, and have experienced no significant slowdown in remittances yet. This effect seems to have prevailed so far, but is likely to change as a result of the steep fall in oil prices. Overall, the World Bank has
31
estimated that remittances (7per cent in 2008 vs. 16per cent in 2007). However, in 2009 they will face a reduction either small (-1per cent) or large (-6per cent) (Ratha et al., 2008). Overall, remittances are likely to show resilience and are, therefore, unlikely to be a major channel of transmission of the crisis. However, should the recession become deep and prolonged, the effects on remittances could deepen. to the developing world experienced a lower, but still positive and fairly strong growth in 2008 CAPITAL FLOWS In contrast, one of the key channels for transmission of the crisis from developed to developing countries is via private capital flows. The effects take place both through volumes and associated costs of such flows. Vulnerability of developing countries to rapid deterioration in capital flows has been diminished by the fact that, as a result of their good policies, many of these countries have far higher levels of foreign exchange reserves and lower levels of external debt than in the past. As we will see below, they can help to cushion countries from a deteriorating international environment, but the space it provides for counter-cyclical macroeconomic policies remains to be seen. Emerging market investors (both public and private) have also become an important source of capital flows to developing countries. At the same time, new sources of vulnerability have opened up, such as the volatility of portfolio investments made into the growing domestic capital markets of developing countries and the rapid unwinding of carry
32
trade3 (this trade was mainly done using instruments from the rapidly growing derivative markets). Also, increased foreign ownership of developing country banks has not proven to be a source of strength, and in some cases may turned out to be a source of fragility, as these banks have withdrawn lending to their subsidiaries in developing and transition countries in order to strengthen their very weak positions in developed countries. As regards volumes of flows, foreign direct investment continued to grow through 2008. Private financial flows peaked from mid-2006 to mid-2007. After a short weakening during the third quarter of 2007 due to the sub-prime crisis, they recovered and boomed again during the first semester of 2008 but dropped very sharply since the third quarter of 2008 and became negative in some cases during the last quarter of the year. Emissions in bond markets came to a halt, bank lending was severely hit, and there was a sharp reversal of flows from mutual funds and an unwinding of the carry trade (further details below). On annual terms, financial flows peaked in 2007 and fell in 2008. They are widely expected (e.g. by the IMF, the United Nations and the Institute of International Finance - IIF) to fall further in 2009.In terms ofthe cost offinancing, although spreadsfor emergingmarket bonds have beenincreasing sincemid 2007,this effect waslargely counteracted by the reduction ofreference interestrates(generally the 10yearU.S. Treasury bond),so that yields did notshow a strong upward trend. It was only in June 2008 that
33
yieldsincreased substantially and exploded after the globalfinancialmeltdown ofmidSeptember 2008. This behavior ofthe quantity and price offinancialflows has been amajormechanism transmittingmovementsin stockmarketsfromindustrialto developing countries.On average, whenmeasured in dollarterms,stockmarkets have experienced a stronger contraction in emergingmarketssince their peak in lateOctober earlyNovember 2007 than stockmarkets in industrial countries. Thisimpact ofthe globalfinancial crisis has beenmore severe for emergingmarketsthan forlow income countries, which are lessintegrated into international private capitalmarkets. Indeed, capitalflowsto lowincome Africa relatively limited. Itis unfortunate, have been
nonetheless,thatthe bond issuance thatsome Sub Saharan African countries had begun to make has also stopped.Hardest hit were the transition economies of Central and Eastern Europe, where the combination of adverse expectations generated by large current account deficits, high vulnerability ofthe domestic financialsystem, or both, led to rapid withdrawals of private capitalflows. The reversal of portfolio flowsin East and South Asia waslarge and even surprising in several cases. For South Korea,for example,the Institute ofInternational Finance estimatesthatforeign investors withdrew amassive net $45 billion in 2008. Countrieslike India and Taiwan (PRC) also saw negative portfolio investmentflows. In Latin America, Brazil and Mexico
34
were hit by lossesin derivativemarkets and, in the first case, by the unwinding of the carry trade. South Africa was also severely hit.Concerning categories of private flows, amajorsource of problemsin late 2008 was the interruption of bond issuesin international capitalmarkets(some were done,though in limited quantities, in early 2009) and the severe slump in inter bank lending, both phenomena being part of a worldwide freeze in financing. Trade credit has been an important casualty ofthis drop. Some countries, like Brazil, have been able to puttheirforeign exchange reservesto good use by supporting exportersthat have no accessto international private trade crediIIF and othersrightly fearthat net bank lending to emergingmarkets willremain lowerforsome time, as bank capital willrestrain banks ability and willingnessto lend. According to IIF figures,bank lending to emergingmarketsfellfroma peak of $410 billion in 2007 to $167 billion in 2008. Evenmore worrisome, itis projected by the IIF to falltominus $60 b billion in 2009.A second source of problems is the high level of aggregate amortizations due by private sector borrowers, which are projected to reach $130 billion in the first half of 2009 and $250 billion for the whole of 2009, if both loans and syndicated bonds are added. More significantly, some emerging countries greatly increased their short-term borrowing in 2007 and 2008, which seems to leave them very vulnerable to a reversal of these short-term flows. South Korea and
35
Russia had particularly large short-term inflows, and their reversal has been a source of serious problem for their economies. The other category of highly problematic capital flows is net flows from non-bank sources such as mutual and hedge funds. Withdrawals from mutual funds in industrial countries and the unwinding of carry trade since July 2008 led to a massive reversal of currency positions out of high-yielding assets in emerging economies into developed countries currency. This phenomenon has had a major negative impact on exchange rates of developing countries, even in countries with significant current account surpluses. It also shows how some categories of private firms are almost totally driven by internationally-determined factors, such as the global risk aversion, and far less by the economic fundamentals of countries. The IIF estimates that short-term speculative carry trade positions are much reduced (in contrast to bank exposures that remain substantial) and, for this reason, it projects nonbank private debt flows to rebound in 2009. However, the transparency of these positions and firms is quite limited, as most of these transactions do not operate over the exchangeshave no or limited reporting requirements (see, for example, Griffith-Jones and Dodd, 2008).
36
CHAPTER: 4 IMPACT OF CRISIS ON INDIAN ECONOMY

Global Integration of Indian Economy
In response to its balance of payments (BOP) crisis in the early 1990s, India implemented a series of trade, industry, and investment reforms. These reforms effectively liberalized the economy, ending a long period of relative isolation from global markets and financial and technology flows. Since then the Indian economy has become increasingly integrated with the world economy.Consequently, current account flows (receipts and payments of merchandise and invisibles) as a
37
proportion of GDP increased from 20% in FY19901991 to 53% in FY20072008.However, the most significant change can be witnessed in the capital account. Due to the rationalization of procedures and conditions for foreign investment, India has emerged as an attractive investment destination. This is reflected as an increase in foreign portfolio investment inflows from US$2 billion in FY20012002 to US$29 billion in FY20072008. Foreign direct investment (FDI) inflows have also gone up significantly in recent years, having risen to US$34.3 billion in FY20072008 from US$6.1 billion in FY2001 2002. At the same time, Indian corporations have also entered the global market for mergers and acquisitions, resulting in some capital account outflow from India. As a result, two-way flows of portfolio and direct foreign capital have gone up from a mere 12% of GDP in FY1990 1991, to 64% of the GDP in FY20072008, registering a fivefold increase. Interestingly, these ratios are significantly higher than those in the US, for which trade in goods and services constituted only 41% of GDP in 2007 and capital flows another 25% in the same year. Transmission of the Crisis to the Indian Economy With India's increased linkage with the world economy, India could not be expected to remain immune to the global crisis or be decoupled from the global economy. While it is true that the Indian banking sector remained largely unaffected because of its very limited operations outside India or exposure to sub-prime lending by foreign
38
investment banks, the global crisis has affected India through three distinct channels. These channels are financial markets, trade flows, and exchange rates. The financial sector includes the banking sector, equity markets (which are directly affected by foreign institutional investment [FII] flows), external commercial borrowings (ECBs) that drive corporate investments, FDI, and remittances. The global crisis had a differentiated impact on these various sub-sectors of the financial sector. Given prudent regulations and a proactive regulator,7 the Indian banking sector has remained more or less unaffected, at least directly, by the global crisis. The imposition by the RBI of a higher provisioning requirement on commercial bank lending to the real estate sector helped to curb the growth of a real estate price bubble. This is one of the few global examples of a countercyclical capital provisioning requirement by any central bank. In general, Indian banks were not overly exposed to sub-prime lending. Only one of the larger private sector banks, ICICI Bank, was partly exposed but it managed to thwart a crisis because of its strong balance sheet and timely action by the government, which virtually guaranteed its deposits. The banking sector as a whole has maintained a healthy balance sheet. In fact, during the third quarter of FY2008, which was a nightmare for many big financial institutions around the world, banks in India announced encouraging results. Against an absolute decline in the profitability of
39
non-financial corporate enterprises, the banking sector witnessed a jump of 43% in its profitability. A ban on complex structures like synthetic securitization coupled with a close monitoring of appropriate lending norms by RBI also ensured a better quality of banking assets. The non-performing assets as a ratio to gross advances have remained well within prudential norms.Further, with an average capital risk weighted assets ratio (CRAR) of 13%, Indian banks are well capitalized and better placed to weather the economic downturn. However, the indirect impacts of the crisis have affected Indian banks quite badly. The liquidity squeeze in global markets following the collapse of Lehman Brothers compelled Indian banks and corporations to shift their credit demand from external sources to the domestic banking sector. This move exerted a lot of pressure on liquidity in the domestic market and consequently shortterm lending rates shot up abnormally. The inter-bank call money rate spiked to 20% in October 2008 and remained high for the next month This credit crunch, coupled with the loss of confidence that followed the Lehman Brothers episode, increased the risk aversion of Indian banks and eventually hurt credit expansion in the domestic market. Contrary to the trend, non-food credit expansion started declining in November 2008 and became negative in January 2009.The magnitude of the impact of the crisis can be understood from the fact that non-food credit
40
expansion during last five months of FY20082009 has declined by more than 68% as compared with the same period in previous financial year. After an impressive performance for nearly five years, foreign capital inflows lost their momentum in the second half of 2008. The most significant change was observed in the case of FIIs, which saw a strong reversal of flows. Against a net inflow of US$20.3 billion in FY20072008, there was a net outflow of US$15 billion from Indian markets during FY20082009 as foreign portfolio investors sought safety and mobilized resources to strengthen the balance sheet of their parent companies. This massive outflow of FII created panic in the stock markets. Consequently, equity markets lost more than 60% of their index value and about US$1.3 trillion of market capitalization from an index peak of about 21,000 in January 2008 to 8,867 by 20 March 2009. This bad run at Dalal Street wiped out the primary market completely, which had been flourishing before the onset of the crisis. Between FY20072008 and FY20082009, fund collection through the primary market declined by 63%. In 2007, 106 initial public offerings (IPO) were issued and raised a total amount of about US$11 billion. In contrast, only 38 IPOs were issued in 2008 and resulted in accumulations of only US$3.8 billion. Given the presence of unutilized liquidity in the global market, and India being one of the few countries with positive growth, FIIs have once again started flowing back
41
to India.During the first two months of the current financial year (April and May 2009), Indian equity markets received net FII inflows of more than US$5 billion. Consequently, equity markets have partially gained their lost value. However, owing to prevailing uncertainties, the primary market has still not shown any sign of recovery. Most of the companies have put their IPOs on hold and only one IPO has been issued so far in 2009. Market Capitalization Percent to GDP he economic boom in India from FY20042005 to FY2007 2008 has also been accompanied by a substantial increase in the inflows of FDI and external commercial borrowings. The inflows of FDI increased from US$6 billion in FY20042005 to US$34.3 billion in FY20072008.The surge in FDI not only improved the domestic rate of capital formation but also helped many industries improve in a technological capacity due to the technology inflows that accompanied these FDI inflows. Like FDI, the inflows of ECBs also went up from US$9 billion in FY2004 2005 to US$30.3 billion in FY20072008, registering a threefold increase over four years. The spurt in ECBs benefited Indian entrepreneurs in two different ways. First, it supported them in their overseas mergers and acquisitions, making it easier for them to gain a market presence in target countries. Secondly, the influx of ECBs allowed Indian firms to finance their domestic capacity expansion at relatively lower capital costs. Both FDI inflows and ECB volumes have been adversely affected by the turmoil in the financial markets in
42
advanced economies. Given the credit crunch in the global markets since September 2008, Indian corporates managed to raise only US$18 billion in FY20082009 as commercial credit from the overseas market, which is 41% less than the amount raised in the previous year. The fall was rather phenomenal during the second half of FY20082009,when ECB approvals9declined from US$3 billion in September 2008 to less than US$0.5 billion in February 2009. Likewise, though not to the same extent, FDI inflows have also taken a hit. For the first time in last six years, FDI inflows witnessed a negative growth of 2% in FY20082009. Remittances are another source of inward foreign capital flows that in the past have helped to balance India's large trade account deficit and keep the current account deficit at a reasonable level. The remittances from overseas Indians started feeling the impact of the global crisis during the third quarter of FY20082009 when, on a yearon-year basis, they declined by 0.5%. The impact becomes more evident in the fourth quarter of FY20082009 when the inflow of remittances declined by more then 29% as compared to the same period in previous year. With the poor economic outlook for oil producing economies in the Gulf and West Asia, coupled with rising pressure against immigration in advanced countries, it is expected that remittances will further decline in the coming quarters.
43
The sluggishness of the inflows of FDI, ECBs, and remittances combined with the massive outflow of FII has resulted in the significant deterioration of India's capital account in FY20082009. From its peak in September 2007, the capital account surplus as percent of GDP started to decline and disappeared completely by December 2008.This is the first time after a long period that the capital account component of India's BOP has been negative. The second transmission of the global downturn to the Indian economy has been through the steep decline in demand for India's exports in its major markets. Gems and jewelry was the first sector to feel pressure at the very beginning of the global meltdown. In November 2008, it witnessed a sharp decline in export orders from the US and Europe, which resulted in a retrenchment of more than 300,000 workers. Since then, the negative impact has expanded to other export-oriented sectors such as garments and textiles, leather, handicrafts, marine products, and auto components. Merchandise exports have registered a negative average growth of 17% from October 2008 to May 2009. The decline in exports has been accelerating, falling by 29.2% in May 2009 as compared to the same month in 2008.In all likelihood, it seems difficult for merchandise exports to recover within this calendar year. Like merchandise, exports of services are also facing a rather steep downturn. During the third quarter of FY20082009, growth in service exports declined to a
44
mere 5.9% as compared to 34.0% in the corresponding period a year back. The earnings from travel, transportation, insurances, and banking services have contracted, while the growth rate of software exports has declined by more than 21 percentage points. The real shock came in the fourth quarter of FY20082009 when service exports witnessed a contraction of 6.6% as compared to the same period in the previous year. Though exports of both goods and services still account for only about 22% of the Indian GDP, their multiplier effect for economic activity is quite large as the import content is not high, unlike Chinese exports. This is reflected in the manufacturing sector output experiencing a sharp slowdown in recent months, during which exports have also shown a decline. The index of manufacturing sector output (Manufacturing IIP), which had grown at 9.6% during FY20072008 and by 5.3% in the first half of FY20082009, slowed down to 0.5% in the third quarter and further to -0.16% in the fourth quarter of FY2008 2009. Therefore, the export slump is expected to have a significant impact on GDP growth in the coming period. The third transmission channel is the exchange rate. With the outflow of portfolio investments and higher foreign exchange demand by Indian entrepreneurs who are seeking to replace external commercial borrowing by domestic financing, the Indian rupee has come under pressure. During last 12 months (from April 2008 to
45
March 2009) the Indian rupee has tumbled by 27% vis-vis the US dollar. At the same time, foreign exchange reserves have also fallen by US$60 billion. However, with foreign exchange reserves remaining at 110% of total external debt at the end of December 2008, investment sentiments should not be unduly affected in the near term. The nearly 25% depreciation in the Indian rupee's exchange rate has partially nullified the benefits from the decline in global oil and gas prices and has increased the cost of commercial borrowings. The weaker Indian rupee should, however, encourage exporters and it is possible that with imports declining as sharply as exports that the country's trade deficit may actually improve in the short run. Additionally, the external sector balance may remain stable and not pose any major policy issue. The timing of the external shock arising from the global economic downturn has been rather unfortunate. The Indian economy was already in the middle of a policyinduced slowdown and the crisis has further aggravated it. The impact of the global crisis on the real economy became evident in the third quarter of FY20082009, belying the optimistic official pronouncements and expectations of some economists, when the Indian economy registered a modest growth rate of 5.3%,1 significantly lower than 8.9% achieved in the corresponding period in FY20072008, and after having
46
achieved a 7.8% growth in GDP in the first half of FY20082009. At the sectoral level, robust growth in community, social, and personal services (22.5%) and financial, real estate, and business services (8.3%) enabled the services sector to maintain healthy growth despite the sharp decline in trade, hotel, transportation, and communication services. The secondary sector in general and the manufacturing sector in particular performed extremely badly. In the wake of a decline in domestic and export demand, the manufacturing sector witnessed a moderate growth of 0.9%, while growth in construction slowed down significantly from 9.7% to 4.2%. However, estimates for economic growth in the final quarter of FY20082009 (from January to March 2009) have pegged the growth at 5.8% and the full year's GDP growth at 6.7%. These is sharply lower than the average GDP growth of 8.9% during the previous four years (from FY20042005 to FY20072008) and also lower than 7.1%, which was the official estimate announced at the time of the interim budget in February 2009. The key question is whether the 5.8% growth in the fourth quarter of FY2008 2009 already reflects a turnaround in the economy, which may be expected to achieve a higher GDP growth in FY20092010
47
CHAPTER: 4
SOLUTIONS TO GLOBAL FINANCIAL CRISIS

Corrective Measures
In response to the global financial crisis, governments and central banks took different measures to rectify the problems and put the financial markets and the economies back in the right path (Ramadhan 2008a). The most important of these measures are: Financial rescue plans: Since the credit crisis started in the United states, The American government arranged in Sept 2008, for an 800 Billion US$ rescue plan to save the financial market. The aim was to save the most important investment banks and insurance companies from bankruptcies to prevent further financial deterioration. Many central banks around the world presented similar rescue plans with different scoop. Central banks monetary policies: central banks around the world have resorted to all monetary policies to contain the financial crisis. The most critical of these policies was to lower the interest rate drastically. The objective is to minimize the cost of borrowing for private businesses and consumers in order to stimulate
48
commercial activities. Moreover, finance officials from the G20 nations appear to have achieved a preliminary consensus on a 24-point program intended to identify the growth of market bubbles and to insure that the world's banks operate more cautiously (Dixon 2009). Public stimulus packages: Governments around the world launched huge stimulus packages to pull their economies out of recession. As the financial crisis pushed the economies into deep recession, consumer spending has declined sharply due to fears and lack of confidence. As a result, industrial output declined and unemployment has been rising sharply around the world (expected job losses to be around 50 million jobs). Therefore, the stimulus packages aim to increase public spending on infrastructure projects. Public spending should create more jobs and stabilize consumers spending pattern. However, recovery from the current recession could be very sluggish. Production idle capacity and unemployment are on the rise. This makes it difficult for companies to hire workers which will keep demand at low levels and in turn increase idle capacity (Uchitelle, 2009).
Recommendations and Measures

Based on the above analysis, this section will present a few recommendation and solutions that might help in correcting the mistakes that allowed for the financial crisis (Ramadhan 2008b). The following are some of these measures:
49
Reform of the WTO and global trade: The WTO should play more active role in balancing global trade. Countries such as China should not be allowed to dominate the world trade by adopting unfair activities. Many countries suffered because of decline in their exports'. Moreover, China has enjoyed high economic growth (over10% annually) over the last decades relative to the world. This has accelerated the rise in the oil and food prices leading to disasters in the developing world and great imbalance between poor and rich countries. The unwarranted economic growth in China has led to abundance of surpluses that were channeled back to the USA and played a role in the credit crisis (Economists 2009). G8 and G20 summits: These summits are usually conducted to serve the interest of the main industrial countries. The assumption is what good for the developed world is good for the world. This view should change and the perspectives and concerns of many developing countries should be considered and incorporated into common policies that serve the whole world. No country should dominate the agenda of the meeting anymore. This was requested from American president prior to the attendance of the G20 meeting to be held in England in April 2009. Government fiscal policies: Government fiscal spending and stimulus packages are very important during recession periods. However public spending should focus on infrastructure and construction activities that can lead to economic growth. Excessive spending on bailouts,
50
unemployment benefits, and subsidy programs, in order to increase spending will not have a long term impact. Short term objectives and spending will only worsen future growth. Market regulation and supervision: Governments and Central Banks around the world must be active in supervising and monitoring the activities of financial firms locally and international. Efforts in the short run must be directed to clean the balance sheet of financial firms from toxic assets. Credit lines should be provided for companies with good practices. A better process of monitoring the tax reports of financial companies is needed. It must be noted that, for many governments, the current financial system is very complicated to understand and control. Hence the expertise of financial specialists and central banks must be considered to formulate new policies and regulations. New global financial system: International Monetary Fund (IMF) should play a major role in regulating and auditing the global financial system. The IMF should both have more resources and play a broader role in the world economy than the past. New measures and regulations must be adopted to insure that the financial market mechanism will not permit for future collapses. Investment companies should be punished for conducting unfair practices in some countries (Tax Evasion) and financial practices must be consistent globally. China has proposed the creation of new global currency to replace
51
the US$. This proposal should be considered because the dependency of the world on US$ is a major cause of the crisis (Economist, 4/8/2009).
CHAPTER: 5
CONCLUSION
The global recession 2008 is the outcome of the financial crisis that has originated in the United States mortgages market and extended to the rest of the world. The financial crisis has forced the insolvency of many banks
52
and financial institutions in the U.S. and the world. Governments adopted different policies such as; financial saving plans, spending stimulus packages, and aggressive monetary policies to contain the crisis. However, the negative spread affect of the crisis has extended to other sectors and industries (e.g. Motor Industry). The financial credit crisis has moved the US and the global economy into deep recession. Bankruptcies and foreclosure of banks and firms has caused huge layoffs. Increased unemployment coupled with decline of wealth and income of consumers around the world has lowered demand for consumer and industrial products. As production output declines, this will cause factories to lay off more labor. The spiral effect will take a period of time until new equilibrium is reached. To summarize, lack of supervision of regulatory agencies over the financial market, expansion of financial derivatives beyond acceptable norms, imbalance in the world trade, and greed of Wall Street has led to this exceptional global financial and economic crisis.
BIBLIOGRAPHY
The Following Are A List Of Reference Books Which Have Been Referred For This Project :
53
THE FINANCIAL CRISES 2007-2008 FALSE PROFIT:RECOVERING FROM THE BUBBLE ECONOMY
WEBLIOGRAPHY
The Following Are A List Of The Websites Used For The Purpose Of This Project :
SOURCES: www.google.com www.yahoo.com www.wikipedia.com
54

Crisis and 2008 Financial Crisis, Is Considered by Many Economists To Be The Worst

Diunggah oleh

Informasi Dokumen

Judul Asli

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

Crisis and 2008 Financial Crisis, Is Considered by Many Economists To Be The Worst

Diunggah oleh

Hak Cipta:

Format Tersedia

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

CAUSES OF THE 2008 FINANCIAL CRISES

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

could repay. Mortgage fraud by lenders and borrowers increased enormously.

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

Leverage Ratios of Significantly 200307

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

Inaccurate credit ratings

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

U.S. Subprime lending expanded dramatically 20042006.

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

A variety of conflicts of interest have been argued as contributing to this crisis:

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

THE FINANCIAL CRISIS 2008 AND ITS IMPACT ON DEVELOPING COUNTRIES

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

CHANNELS OF TRANSMISSION OF THE CRISIS

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

CHAPTER: 4 IMPACT OF CRISIS ON INDIAN ECONOMY

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

SOLUTIONS TO GLOBAL FINANCIAL CRISIS

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

Recommendations and Measures

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008

ANALYTICAL STUDY ON GLOBAL ECONOMIC CRISIS 2008