Recession to Recovery: A Road Map

S. S. Das

ssdas@nic.in
"A certain idea of globalisation is drawing to a close
with the end of a financial capitalism that had
imposed its logic on the whole economy and
contributed to perverting it. The idea of the
absolute power of the markets that should not
be constrained by any rule, by any political
intervention, was a mad idea. The idea that
markets are always right was a mad idea.”
Nicholas Sarkozy,
Outline of the Presentation
What is Recession?
Why Financial Crisis?
The Genesis of the current problem
Impact on world financial system and world
Economy
Global Response
Impact on India
India’s Response
Way Ahead
 What is Recession?

Recession is the economy shrinking for two

consecutive quarters with a decrease in the
GDP

If the recession continues for next quarter, (>6 months)

then the economy goes through “DEPRESSION”
 Recession Vs Depression

The joke that economists quote to explain the

Difference between “Recession & Depression”

RECESSION

= WHEN YOUR NEIGHBOR LOSES HIS JOB

DEPRESSION

= WHEN YOU LOSE YOUR JOB

Recession is nothing new
Recessions are something that cannot be avoided.
Even in a healthy economy there are periods of high
growth, slow growth and no growth.
In fact in order for the economy to be healthy there
needs to be some contraction and expansion.
But if the contraction lasts for more than 6 months
the economy is said to be in recession.
Causes of Recession
General consensus is that a recession is caused by numerous
factors and is the end result of several preceding events;
Actions taken to Control the Money Supply in the economy;
Financial Crisis;
Bad Investments by businesses;
 Stock Market crashes;
Factors that stunt short term growth in the economy,
such as a sharp increase in OIL PRICES;
Wars
Change in the nature of the business cycle due to
Globalization;
Current global recession is caused by a severe financial
crisis triggered in western developed economies.
What is a financial crisis?

The term financial crisis is applied broadly to a variety

of situations in which some financial institutions or
assets suddenly lose a large part of their value.
Why Financial Crisis Occurs??
“In the past financial crises have been generated by
combination of factors such as
overshooting of markets,
excessive leveraging of debt, and credit booms,
miscalculations of risk,
rapid outflows of capital from a country,
mismatches between asset types (e.g., short-term dollar
debt used to fund long-term local currency loans),
unsustainable macroeconomic policies,
inexperience with new financial instruments, and
deregulation without sufficient market monitoring and
oversight.
Genesis of Current Crisis….
The Current Financial Crisis is a combination of several
interrelated factors:

1. Misallocation of Resources
 Post Asian Crisis reaction: Self Insurance
 Accumulation of huge hard currency assets by some
countries (4.4 Trillion $) coupled with huge US current
account deficit;
 China alone has a Foreign Currency reserve of US$ 2
Trillion
2. Huge Current Account surplus in these countries
supported by huge Current Account deficit by US & UK
Genesis of Current Crisis….
3. Diversion of some of these reserves into Sovereign
Wealth Funds
 Reserves mostly invested in US Treasury Bonds puts
pressure on bond yields and interest rates;
 Lead to diversion of some Investments into higher
yielding assets than U.S. Treasury and other
government securities.
 Invested in High Tech Business till the collapse of Dot
Com Boom in 2000;
 After the dot-com bust, more “hot investment capital”
began to flow into housing markets —in the United
States and other countries of the world.
Genesis of Current Crisis….
4. Housing Boom in US encouraged by Govt. Policies
 Lower long term interest rates
5. Housing boom coincided with greater popularity of the
Securitization of Loan Assets
 Particularly Mortgage debt (including subprime mortgages)
 Pooling of Loans and reselling them as asset- based
securities: Collateralized Debt Obligations (CDOs).
6. Securities are repacked, leveraged, tranched, and resold many
times over camouflaging the underlying risks
7. So called innovation of exotic products;
 To cover the risk of defaults on mortgages, particularly
subprime mortgages, the holders of CDOs (FIs) purchased
Credit Default Swaps (CDSs).
Rocket Scientists of the Wall
Street??
Thought that by slicing and dicing, structuring and
hedging, using sophisticated mathematical models to
understand and manage risk, they can “create value”
by offering investors combination of risk and return
which are more attractive than those available from
direct purchase of underlying credit exposures.
Credit Default Swaps (CDS)
A type of insurance contract (a financial
derivative) that lenders purchase against the
possibility of credit event associated with debt, a
borrowing institution, or other referenced entity.
A default on a debt obligation, bankruptcy,
restructuring, or credit rating downgrade.
As long as the credit events (defaults) never
occurred, issuers of CDSs could earn huge
amounts in fees relative to their capital base.
Since CDSs were technically not insurance, they
did not fall under insurance regulations requiring
sufficient capital to pay claims.
Rise of CDS business
As the risk of defaults rose, the cost of the CDS
protection rose.
Investors (mostly investment bankers) could
arbitrage between the lower and higher risk CDSs
and generate large income streams with what was
perceived to be minimal risk.
In 2007, the notional value (face value of underlying
assets) of CDS had reached $62 trillion
more than the combined gross domestic product of
the entire world ($54 trillion),
although the actual amount at risk was only a
fraction of that amount
Genesis of Current Crisis…..
8. Emergence of highly Leveraged Investment Banks
 Not subjected to capital adequacy norms
applicable to commercial banks
 Could raise and invest funds as high as 30 times
their equity base
9. Globalization of the financial system
 leading to large scale arbitrage of funds and
flight of capitals
Collapse of Mortgage Market
CDSs generated large profits for the companies
involved until the default rate, particularly on
subprime mortgages, and the number of
bankruptcies began to rise.
The leverage that generated outsized profits
began to generate outsized losses,
Defaults and declines in values of CDO’s put big
holes in balance sheets of financial institutions;
By October 2008, the exposures became too great
for companies such as AIG.
The spread of the crisis
Banks around the world have similar exposures to
subprime and other declining assets
Nearly universal uncertainty about bank solvency
Crisis of Confidence and credit freeze
Inter bank lending almost stops
Crisis spread to other assets and institutions
Flight of capital leads to
Meltdown of the stock markets across the Globe
Exchange Rate Crisis
Impact of the Crisis
Current crisis appears worse than even a liquidation
crisis
Lack of mark to market accounting creates
uncertainty as to who is solvent
Government rescue policies inconsistent (Lehman
was allowed to sink)
Nobody knows who will survive and parties refuse to
lend to each other
Financial system freezes!
Spread of the Crisis and Impact
Meltdown of stock prices across the globe
 Market price of stock in Freddie Mac plummeted from $63 on
October 8, 2007 to $0.88 on October 28, 2008.
 reflected huge changes in expectations and lead to f light of
capital from assets in countries even with small increases in risk.
 From Emerging Markets, BRICs
Mark to Market Accounting System to value that stock
according to market values
capital base of banks shrank and severely curtailed their
ability to make more loans : Lead to Credit Freeze
Investors fled stocks and debt instruments for the
relative safety of cash
Lead to rise in Demand for Dollar and fall in currency
value of other countries
Impact of the Crisis
Collapse of Financial Institutions in several parts of
the world
Lehman Brothers; AIG, Freddie Mac and Fannie
Mae etc.
Central Banks in vulnerable countries such as
Iceland become Bankrupt
Investors across the globe lost huge amount of their
investments
Severe Credit squeeze and Liquidity crunch for the
industry
Housing; Automobiles; Retail; Services etc.
Impact of the Crisis….
Crisis of confidence leads consumer aversion to
spending
Fall in housing and real estate prices
Fall in Demand for goods and services
Resorting to Trade Distorting Protectionism
Leads to drop in international trade in
commodities and services
Gets into a Vicious Cycle
Job cuts and serious unemployment problem
followed
 Onset of a recessionary spiral
Starting Point = Unwillingness to buy
 How to come out of recession
Governments in Market economies do not have direct control on
Producers’ & the Consumers’ behavior; But, they can influence
millions of Producers & Consumers with Government’s policies;
Governments have 2 policy instruments

Fiscal Policies Monetary Policies

(By Govt.) (By Central Banks)

Governments influence the Central Banks manipulate

economy by changing how the available supply of
The Governments spend money in the country
and collect money
 How to come out of recession?

Fiscal Government influences the economy by changing

Policies how it (Government) spends and collects money

1] Tax cuts for More money

businesses or available for
for individuals spending

2] More Spending Individuals get Demand picks

by Govt. to salary and spend up; Market
create jobs money
can recover;
3] Automatic
fiscal policy; Some income to
Unemployment unemployed
Insurance people to spend
 How to come out of recession?

Monetary Central Bank manipulates the available supply

Policies of money in the country

More money
1] Reduce reserve
available for bank
ratio
to give loans

Individuals take
Demand picks
2] Lower the
interest rates more loan up; Market
can recover;
3] Use its own It becomes an
reserved income to Govt.
money to buy to inject money
Govt. bonds into the market
Global Response to the Crisis
Varied Response and Intervention to protect financial
system and the tumbling economy
 Short term Keynesian response to boost demand for
goods and services to revive the economy by pumping
in more money to the system
 Structural adjustment to correct the distortion in the
financial system
 Long Term solution : Address the problem of
misallocation of resources
Global Response: First phase of
intervention
First and Immediate intervention by the governments
across the globe has been to prevent collapse of the
financial system.
Effort has been made
to stop the financial bleeding,
to coordinate interest rate cuts, and pursue actions to
restart and restore confidence in credit markets.
rescue of financial institutions considered to be “too big
to fall,”
 Government take over of Banks and Financial Institutions
on the verge of Collapse to prevent the financial system
collapsing
 Freddie Mac and Fannie Mae; AIG etc.
First Phase…..
Injections of capital and government takeovers of certain
financial institutions,
Government guarantees of bank deposits and money market
funds, and government
Facilitation of mergers and acquisitions.
Large Scale Government bailout packages for affected
industries
 US Bailout package for affected Industries; Banks and FIs

exceeds 1 trillion US$

 Major economies such as European nations, Japan, Russia,

China come out with huge bailout packages and stimulus

packages to bail out institutions and kick start their
economies
The second phase: Keynesian path
to global recovery
In the second phase of intervention
Governments have turned to traditional monetary and
fiscal policies to deal with recessionary economic conditions,
declining tax revenues, and rising unemployment,
Several countries have turned to funding from the IMF, World
Bank, and capital surplus countries.
Effort is to
 Improve liquidity in the system by infusion of cash into the
system;
 Restart credit flow by building confidence in the system;

 Stimulate investment and demand for goods and services; and

 Prevent collapse of industries and institutions

Road Ahead: Third phase of Response
Action is being coordinated to decide what changes may be
needed in the financial system to prevent future crises;
Some issues being addressed are:
weakness in fundamental underwriting principles,
the build-up of massive risk concentrations in firms,
the originator-to-distributor model of mortgage
lending,
insufficient bank liquidity and capital buffers,
overall regulatory structure for banks, brokerages,
insurance, and futures,
lack of a regulatory ties between macroeconomic variables
and prudential oversight, and
how financial rescue packages should be structured.
Road Ahead: G-20 initiatives
Issue of misallocation of resources across the globe
Role of the “Invisible Hand of the Market Forces” and
Government Intervention
G-20 Initiatives
New Financial Architecture:
Global coordination and oversight of Financial Market
Executive Compensation
Regulation of Derivative Segments of Financial Market
Call for restraints on protectionism
Fourth Phase of Global Response
The fourth phase of the process will be dealing
with political and social effects of the financial
turmoil.
The questions that have been raised are:
Will the financial crisis work to diminish the influence
of the United States and its Dollar in financial circles
relative to Europe and its Euro/pound?
Growing influence of the newly emerging economies
(India, China, Brazil) in addressing global financial
issues.
Is this the end?
Not likely,
Given that US Capitalism survived the Great Depression
Financial capitalism brought enormous economic and social
benefits to hundreds of millions of people
It is possible that financial repression will follow
with nationalization of banks, severe control of lending and
trading, etc
More likely, will get more regulation
This might be a good idea
Good examples: securities and banking regulation after the
Great Depression
Emergence of new Global Financial Architecture???
Financial Crisis and Impact on India
Subprime Lending is not a major issue in India
Limited exposure of Indian banks to overseas mortgage
and derivative products
One of the bystanders affected by development
elsewhere??
Major problem is the liquidity crunch and crisis of
confidence of banks for lending
Over reaction to inflation during the first half of
2008 and tightening of monetary policy
Impact on India
Significant Currency devaluation
Demand side problem
Drying up of external demand for goods and
services due to major problems in US and
Europe: India’s major trading partners
Lower domestic demand due to buyers
hesitation to spend
Exports down by about 20%
Year on Year export growth remains negative
Major affected sectors are: Real Estate; Auto Industry,
Textiles; Gem and Jewelry; Chemicals and Allied Products;
Iron and Steel; Capital Goods etc.
Impact on India
External dependant service sectors shows sign of stress.
However, India is not likely to face recessionary trend.
GDP Growth likely to remain above 6% in spite of recession
and negative growth in the developed economies.
Still has a sizeable Foreign Currency reserve.
It is felt that India and China, with their robust domestic
demands and savings, would lead the recovery of world
economy.
India’s Response: Monetary Policy
Intervention
Broad direction of the interventions on monetary
policy side has been
to increase liquidity; reduce interest rates; restore
confidence in the banking system; restore banker’s
confidence for lending; and stimulate domestic
demand
Easing of liquidity in the market by reduction of CRR;
SLR
Lowering Bench Mark interest rates by lowering Repo
and Reverse Repo rates;
Making special arrangements/windows for lending to
vulnerable sectors;
Monetary Policy Intervention
Easing External Commercial Borrowing norms for
providing access to cheaper funds abroad;

Interest subvention for exports credits for certain

labour intensive sectors and longer tenure of export
credit at concessional rates;

Increasing liquidity to NBFCs for lending to affected

sectors such as Auto and Housing at affordable rates
to stimulate demand;
India’s Response: Fiscal Policy
Intervention
Directed at stimulating demand for goods and
services through tax cuts
Counter-cyclical pump-priming the economy
though higher and accelerated government
spending
Additional spending on large infrastructure
projects like Roads, Ports etc. to kick start the
economy