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Global Financial Crisis: the root cause

The reason behind the global financial crisis is the subprime crisis, epicentre of which is
US. What happened was that many corporations awarded to loans to debtors classified as sub
prime. These investments appeared to be very lucrative as the returns expected were higher as
these were lend at higher rates. But the flip side of these was the high credit risk involved. Due to
their lucrative offers, these investments were made at a very big scale. The creditworthiness of
the debtors was ignored. For a number of years prior to the crisis, declining lending standards, an
increase in loan incentives such as easy initial terms, and a long-term trend of rising housing
prices had encouraged borrowers to assume difficult mortgages in the belief they would be able
to quickly refinance at more favourable terms. However, once interest rates began to rise and
housing prices started to drop moderately in 20062007 in many parts of the U.S., refinancing
became more difficult. This led to drastic increase in the number of defaulters leading to the
major financial crisis of the century.
I mpact on I ndia
Indian economy was also hit by Global Financial crisis but to a limited extent. Indices of
Stock Markets (Nifty, Sensex etc) plummeted but not because of loss of confidence of
domestic investors significantly. The major reason for downward trend in these indices is
the excessive outflow by FIIs as they are facing liquidity crunch in other countries as well
as they are hit by panic. Indian Stock Exchanges saw year to date (YTD) FII outflow of
$9.2 bn. With US bailout package in place, pressure on liquidity will ease and stability to
the Indian market.
Indian economy being a domestic consumption driven economy with exports constituting
a very small portion of GDP is insulated from global crisis to great extent. GDP is
expected to grow at 7-8%.
Barring domestic brokerages, this meltdown has not affected any domestic BFSI
(Banking, Financial Services & Insurance) business significantly. Public sector banks are
safe. Apart from reasonable exposure that some Indian private sector banks have, rest of
the business is as usual. Indian regulators (RBI & SEBI) have done a good job by putting
caps and regulations on foreign investments. RBI, for instance, had used ECB, Repo
Rates, CRR & LAF (Liquidity Adjustment Facility) to good effect.
Moreover, Indian economy is undergoing real economic growth (infrastructure, services
etc) unlike the developed countries experiencing financial growth (excessive lending
etc.). Hence, Indian economys growth is not so much impacted by the financial turmoil
when compared with countries like US and UK which are epicentres for this crisis.
. FIIs pulling out
The FIIs, who have been in exit mode since January, have liquidated shares worth Rs 8,739,
only in the first fortnight of September. The net sales, since the beginning of 2008 are estimated
at over Rs 37,000 crores. This means that corporates access to overseas funds will be limited
and more expensive going forward. Lenders will now look more closely at who is the counter-
party and make a careful assessment before taking on additional risks. This could mean a
tightening of liquidity with further rise in interest rates. And industry, which is already in a tight
spot, will be squeezed further. The concerted intervention by central banks of developed
countries in injecting liquidity is expected to reduce the unwinding of India investments held by
foreign entities, but fresh investment flows into India are in doubt.

Other areas where the Indian economy has been effected areas are as follows:-
1. Effect on Dalal Street
2. Effect on employment level
3. Effect on insurance sector
4. Impact on other sectors
6. Effect on Indian Banks

Macro-economical aspects
Impact of this financial turmoil on the macro-economic factors are summarized in the following
1. Borrowing costs up
RBI had announced measures to salvage the falling Rupee, which had crossed Rs48 to
the Dollar. It said it would continue to sell Dollars through agent banks or intervene
directly to meet any supply-demand gaps.
While the RBI steps did have a salutary affect on the sliding Rupees vis--vis the dollar,
it will be a while before credit starts flowing as before. Promoters of companies would be
hit by depreciation in value of their equity holdings, which are normally leveraged to
provide additional capital sought by way of preferential issues or for shoring up their
holdings in the company. Promoters who have already borrowed against their holdings
would have to meet the additional margin call requirements following the erosion in the
value of their assets and also pay higher risk premium in volatile time for additional
While big companies will be hit, it is the small and medium companies that will find it
extremely difficult to raise funds. During troubled times, quality lenders are loathe to take
exposure from small borrowers having inadequate collateral. The worst hit will be SMEs. While
issues form the big houses or PSUs divestments may still evoke a good response irrespective of
conditions, the market for mid-size companies is virtually dead.

2. Adverse effect on M&As
What would hurt companies even more will be their inability to grow through M&As despite the
fact that overseas assets are available at bargain rates. This inability to fund acquisitions from
overseas borrowings will slow down the overseas growth plans of Indian companies. Even
private investors who were otherwise gung-ho on funding these acquisitions will now turn wary.
Only respite is that times like this offer opportunities for private equity investors to acquire
assets which could be capable of providing super-normal profits.

Source: RBI website

3. Depreciation of Rupee
The Indian rupee has several negative factors - a current account deficit, high inflation and high
fiscal deficit, all of which tend to weaken the currency. The one positive factor is a still high
growth rate of 7-8% that attracts foreign funds and hence capital inflows. But these are fickle
since they depend on factors not in our control. Major factors for rupee fall are external
commercial borrowings (ECB) repayments and FII outflows from the equity market. Also, the
dollar has been strong against major currencies like the Euro, British Pound & Swiss Franc. As
oil futures started falling rapidly from May onwards, speculators turned to other asset classes
such as the Dollar and gold which resulted in the unwinding of oil futures into dollars.
Meanwhile, there is an upside to be considered as well. The falling rupee (against the dollar,
more than against other currencies) will mean that exporters who felt squeezed by the earlier rise
of the currency can breathe easy again, though buyers overseas may now become more scarce.

Indirect effect of other countries reform policy on India

As other countries plan to handle the current financial crisis by adopting various reforms and
policies the Indian economy may get affected because of that in the adverse manner possible.
CHINA one of the developing economies plan to spend $586 billion in order to get out of the
current recession the amount spent is much bigger than what INDIA can spent which may attract
the FII from every part of world as they are looking strong economies who can handle
themselves in the best manner possible, therefore the FII which were till now coming to INDIA
in context of investment in the stock market as a result of which the stock market had reached a
historical high of more than 20,000 points and Mr. Anil Ambani had become the richest man in
the world for a day may stop. The falling stock prices will reduce the liquidity and credit power
of the companies which till now because of the following factor were enjoying a good and
healthy stock positioning. The lack of FII wills surely effects the development of INDIAN
infrastructure up to a particular extends.

Today, there is a consensus that the FIIS will not return to emerging markets like India in
a hurry. That will probably see the markets remain in tight range band of 12000-16000. There
are, of course, a few naysayers who see a gloomier scenario, predicting that the markets could
even test even the 10000 levels before March 2008.
But financing the India growth story would not be that much of an issue given the
buoyancy in deposits, high savings and levers available with the RBI to inject liquidity. Recent
steps taken such as increasing the attractiveness of NRI deposits, and providing additional
liquidity support via the LAF window to alleviate the liquidity shortage are encouraging. The
immediate issue is how long will it take for the Indian markets to recover? Despite strong
fundamentals, some views are that it will not be before mid-2009, perhaps even 2010. But with
the emergence of desi players during the crisis periods, the Indian markets may chart out a new
course, independent of the global markets.
1. http://economictimes.indiatimes.com/ET_Debates/Will_financial_crisis_derail_Indias_ec
2. http://economictimes.indiatimes.com/articleshow/3574867.cms