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The Impact of the crisis on the Indian EconomyBy

Dr. T T Ram Mohan

Article Review by

Article Review by Group IV, 2009-12 Part Time IIFT, Kolkata

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Group IV Members

Ratnadeep Bhattacharjee (Roll

No. 29)

Ram kumar Ray (Roll No 27)

Sanjib Chatterjee (Roll No. 31)

Subhasish Bhandari (Roll No.

40)

Sukrit Dutt (Roll No. 43)


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Content Page

1. Objective 3

2. Group IV Analysis 4

3. Conclusion 12

4. References 13


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ObjectiveThe article is aimed at a post-mortem explanation of the 2007-2009 financial

crises in US economy in pre and post bankruptcy of Lehman Brothers and the

impact analysis on Indian economy. The whole write-up is tuned towards the

impact on the banking and financial industry. The effect has been severe than

initially forecasted. The various cascading effects had deepened the whole

situation.

India has been less affected because of the various regulations well in place and

adequate policy responses


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Group IV AnalysisOur analysis of the article is being divided in the same way as per the article by

Dr. T T Rammohan as per its various sections.

On US Economy Tried to explain the fall of Lehman Brothers and its effects on

US economy. We have agreed with the explanations provided by the author.

Though some of the economists felt that the failure of Lehman Brothers have

actually saved the world from greater crisis. That idea is missing from the article

by Dr. Rammohan.

On Emerging Economies Tried to explain the cascading effects of subprime

effects on Emerging markets. Disagreed with what Dr. T T Rammohan wants topromote the decoupling effect with emerging economy. We have tried to show

that the emerging economies were also affected might not be in the same way

as US but similarly affected and responded to US markets in a similar way.

On Indian Economy Tried to explain the why affects on the market and with

the help of IS-LM model tried to explain the effect of the changes monetary and

fiscal policies taken by Reserve Bank of India (RBI) and Government of India. We

agree with what Dr. T T Rammohan says in his article.

On Banking System- Explaining the difference in the nature of Economic

downturn with regard to Banking Systems in India and Developed economies, thelow credit off take in India adding fuel to the fire and the mysterious creditexpansion in the April-Oct period of 2009 without any realexpansion.

On US Economy-

The fall of Lehman Brothers in September 2009 has been marked as a major

cause for the sub-prime situation in US economy which has also affected

globally. The following figure shows the dealing of Lehman Brothers and the

effect of its fall on the market.


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1 A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes aseries of payments to the seller and, in exchange, receives a payoff if a credit instrument

(typically a bond or loan) goes into default (fails to pay) [1]. Less commonly, the creditevent that triggers the payoff can be a company undergoing restructuring, bankruptcy,or even just having its credit rating downgraded.

The above was what explained in the article. Lehman Brothers business

depended heavily on the various CDS contracts, short term debt and Re-

hypothecation. Financial institutions (such as banks) made subprime (low

quality) loan contracts to consumers with low creditworthiness that were

packaged into securities (like stocks and bonds) through a process known as

securitization. These bundles came to known as mortgage-backed securities

(MBS), and they are not inherently bad. Problems arose when the payments

rights to a loan in an MBS were used to guarantee other securities. Further

securitization with other debts morphed them into collateralized debt obligations

(CDO). Using a risky assetsuch as a loan with someone who is unlikely to pay it

backas collateral for another asset or security increases risk and spreads it to

everyone who holds a stake in the underlying asset through a phenomenon

called counterparty credit risk. This form of risk both inflates the value of the

security and makes it difficult to price. Couple that with leverageor borrowing

and firms risk magnifying their losses tens of times over (in the case of Lehman,

44 times over).

The crisis comes full circle when one considers that Fannie Mae and Freddie Mac

were two of the largest buyers and sellers of such toxic MBSs. Every firm on WallStreet had their fingers in CDOs, and the government was partially responsible

for regulatory failure. These instances of debt securitization far removed the

borrower of a loan from the initial lender; investors in foreign countries ended up

owning loans in US. Risk was spread so far out that Americas problem eventually

became the worlds problem. Lehmans fall was colossal because nobody

expected a company so large, and so connected to investors across the world,

would fail.

As per Dr. Rammohans article, the decision by Federal Government to let

Lehman Brother to fail was a blunder but according to some economist it was a


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blessing in disguise. According to the article (Lehman Brothers Failure May Have

Saved Us All) by Steven Pearlstein, there simply was no legal way they could

commit taxpayer money to bail out a firm that was so highly leveraged and so

deep into soured real estate investments that it had become insolvent.

But we do agree with Dr. T T Rammohans idea that it was because of faulty

regulations on US Federal part that led to the bankruptcy and faulty policies that

let to the massive economic downturn.

On Emerging Markets

According to the author of the article, that prior to the current crisis many

emerging market countries had undertaken reforms that were designed to

insulate them from adverse shocks from the rest of the world. These policies

included substantial increases in reserve assets and substantial reductions in net

government debt. Moreover the currency exposure of EM governments was

reduced in some cases to long dollar positions, commercial bank net foreign

exchange borrowings were strictly limited and nonfinancial firms foreign

currency debt was monitored and, in many cases, strictly controlled. Finally,

emerging markets were generally experiencing current account and primary

fiscal surpluses. So according to the author, as the emerging markets were

decoupled, the effect was minimal.

But post Lehman Brothers collapse has shown severe impact on the emerging

markets as well specially transmission to the CDS 1 (Credit default Swap) spread

to the emerging economy.

According to transmission of the U.S. subprime crisis to emerging markets:evidence on the decoupling-recoupling hypothesis- by Michael P. Dooley,

Michael M. Hutchison they have shown with facts and figures how the emerging

economies have been affected. The transmission of news announcements to

these markets was rapid and there are several factors that affected CDS markets

almost uniformly. One event that was common to all emerging markets in our

sample was Lehman Brothers bankruptcy (LEHMAN) news and associated

announcements... Each LEHMAN announcement (on average) raised CDS

immediately by between 7 basis points (China) to over 100 basis points

(Argentina), with all countries being significantly affected. China and Chile were

the least affected, and Argentina and Russia were the most affected. Writedowns of equity (WD) in U.S. financial institutions, housing market developments

in the U.S. (HD) and the cancellation of the TARP plan to purchase mortgage-

related securities also were important factors that systemically raised CDS

spreads. Dr. T T Rammohans article also fails to substantiate the effect of the

sub-prime crisis on the equity market, credit market and exchange rates in the

emerging economies. All the indices of the equity and credit market seem to

follow the US market in a reasonably same manner showing a strong coupling

with the US economy. Exchange rates follow a similar general pattern to equity

prices in that they generally appreciated relative to the dollar, at times rapidly,

until fall of Lehman Brothers and then depreciated very sharply. EmergingArticle Review by Group IV, 2009-12 Part Time IIFT, Kolkata

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markets on balance appeared to be initially decoupled from the U.S. financial

crisis and then experienced large depreciations that greatly exceeded the initial

appreciations of their currencies.


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Following graph also shows how US assets are in the

hand of the emerging economies, and the practical

reason for decoupling-recoupling .


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On Indian Economy and explanation of the Policy responses:

Though many predicted that Indian economy was not so much dependent on its

US counterpart, the facts and the analysis of the article proved otherwise.

According to the article the Trade Channel which accounted for less than 15% of

GDP could have been bearable.

But the financial channel that had got a higher level of integration with US andglobal economy was severely impacted. For which after the fall of LehmanBrothers the following happened

Reduced Indian companies access to overseas finance,

lowered domestic liquidity

caused stock prices to fall

To counter 2nd and 3rd point, India implemented various monetary and fiscal

policies which are explained below. Due to the impact of both the policies the

confidence level of the investors (both domestic and foreign) on the Indianeconomy will arise which will improve the 1st point which takes a longer time to

recover. Moreover due to strong domestic market, the need to go for foreign

investments will be less compared to earlier.

The effect of the fiscal and monetary policies can be explained by the IS-LM*

model for the short run. The Fiscal policies of the government have been two

folds. One is through the sixth pay commission reduction of taxes and other is

through the various subsidies and additional allocations for National Rural

Employment Guarantee. This basically has made an increase in the Government

spending and the decrease in the taxes.

The following figure shows how a change in fiscal policy to implement increase in

government spending shifts the IS curve. With the government planned

expenditure on the rise because of the implementation of more funds through

NREG and various bonds , planned expenditure rises taking the equilibrium to

the right and hence the income rises from Y1 to Y2.


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As Indian Government has implemented both taxes cut as well as governmentpurchases the decrease of taxes, the effect on the economy has been manifoldwhich is being shown in the graph.


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1 The IS

Curve shifts

to the right

by


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The government-purchases multiplier in the Keynesian cross will tell that, at any

given interest rate, this change in fiscal policy raises the level of income by G/(1 MPC).

Therefore, as above shows, the IS curve shifts to the right by this amount. Theequilibrium of the economy moves from point A to point B. The increase in

government purchases raises both income and the interest rate.Again lowering of taxes will further shift the curve( IS) to the right of IS2 and thenew equilibrium is reached at where the new IS curve cuts the LM curve. The taxmultiplier in the Keynesian cross will tell that, at any given interest rate, this

change in policy raises the level of income by TMPC/(1 MPC).

Hence the total shift has been G/(1 MPC) x TMPC/(1 MPC)

With the implementation of the monetary policy, RBI has supplied more moneyinto the system by the following

Reduction in the repo rate from 9% to 5.5% and in the reverse repo ratefrom 6% to 4%;

Reduction in the cash reserve ratio from 9% to 5%; and

Reduction in the statutory liquidity ratio from 25% to 24%.

An increase in money supply leads to an increase in real money balances M/P,because the price level P is fixed in the short run. The theory of liquiditypreference shows that for any given level of income, an increase in real moneybalances leads to a lower interest rate. Therefore, the LM curve shifts downwardto LM2. The equilibrium moves to point C. The increase in the money supplylowers the interest rate and raises the level of income.When RBI increases the supply of money, people have more money than theywant to hold at the prevailing interest rate. As a result, they start depositing thisextra money in banks or use it to buy bonds. The interest rate rthen falls untilpeople are willing to hold all the extra money that the Fed has created; thisbrings the money market to a new equilibrium. The lower interest rate, in turn,has ramifications for the goods market. A lower interest rate stimulates plannedinvestment, which increases planned expenditure, production, and income. Thiswill help the economy come out of the bad times.

On Banking System


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1 The IS Curve

shifts to the

right by

TMPC/(1


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The effect on banking systems on account of this Economic downturn has

differed in India from the developed economies in Cause and Effect

relationship. Banking sector collapse has been the catalytic cause for the

downturn in advanced economies whereas in India, pressure on banking system

has to seen more as an effect of the downturn.

ECONOMIC SLOWDOWN IN DEVELOPED ECONOMIES BANKING

PERSPECTIVE

ECONOMIC SLOWDOWN IN INDIAN ECONOMY BANKING

PERSPECTIVE

Inadequate Credit Growth:

Credit off take in India has been a real cause of concern. There are three primary

reasons for that:

1. Poor market sentiments are preventing Corporates from funding new

projects by virtue of credit.

2. Due to a real & perceived increase in default rate; banks have become

conservative in their approach towards funding.

3. Under the current circumstances the return on government securities can

be in excess of 8%. This has let banks to increase their investments in

government securities dragging the supply of loan-able funds further

down.

Mysterious Credit Expansion:


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Huge

losses in

Banking/

Financial

sector

Collapse in

flow of

Credit

Lack of

confidence

in economy

Downward

shift in IS

curve

Leading to

collapse in

real

Economy

Reduction in Net Exports & Reduction in Inflow of

Capital

Shortage of investible funds in the

hands of corporates

Pressure on banking system stemming, from a real and

perceived increase in credit defaults


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The credit off take in the April-Oct period of 2009 had registered a growth of

almost 100%, spreading a belief that Banks are compensating for the capital

crunch of Indian Industry from abroad. In reality there was a miniscule growth

but rather a redistribution of financial entries that led to such high growth

figures. Corporates had procured derivatives from Banks and Corporates have

suffered mark-to-market losses on these derivatives. These derivatives weresettled but not carried forward. This led to a spur in the amount of receivables to

the Banks from corporates. These receivables which were actually losses

suffered by the corporates had taken the form of loan growth.


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ConclusionIn times of great uncertainty and stress, there is a temptation to wait and see.Maybe tomorrow there will be more clarity as to risks, maybe things will haveimproved and tough decisions can be delayed. It is necessary to recognize thatthe crunch has happened, and that its consequences will continue to emerge.Past actions can be regretted but they cannot be reversed.

The future, however, can be different and that is where management must focus.We believe that now is the time for leaders and management:

To quickly focus on cash and your exposure to the downturn. The greateryour liquidity, the greater your options and your prospects of success.Understand the impact on your clients and your suppliers. Seek to

understand the impact on your competitors. To seek to know your situation and your options.

To focus on the performance of your team and your assets. When marketsare tough and resources are scarce, this is the time to be ensuring thatyou are making both efficiency and effectiveness gains.

Finally, The Companies and Management may follow the simple suggestions toprotect themselves from the Global Recession.

Securing your present

Protecting your assets

Improving your performance

Reshaping your business Sustaining your future


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References

1. Impact of Crisis on the Indian Economy Authors (Rajiv Kumar, Pankaj

Vashisht) http://www.adbi.org/working-

paper/2009/11/12/3367.global.economic.crisis.india/impact.of.crisis.on.the

.indian.economy/

2. How US crisis impacts Indian economy Author(Ziad P S)

http://www.commodityonline.com/news/How-US-crisis-impacts-Indian-

economy-12040-3-1.html

3. The Positive Impacts of Financial Crisis on Indian Economy Authors (Ms.

Shradhanjali Panda Ms. Sanjukta Mishra) -

http://www.indianmba.com/Faculty_Column/FC1012/fc1012.html

4. Macroeconomics Author ( N. Gregory Manikew)

5. TRANSMISSION OF THE U.S. SUBPRIME CRISIS TO EMERGING MARKETS:EVIDENCE ON THE DECOUPLING-RECOUPLING HYPOTHESIS- Authors(Michael P. Dooley, Michael M. Hutchison)http://www.nipfp.org.in/nipfp-dea-program/PDF/10_5Pr_Hutchison_NBER_WP15120_June_2009_Emerging_Mr

kt_linkages.pdf

6. The Lehman Brothers Failure Was a Sham- Author (Pratik Desai )http://www.kevinwoghiren.com/2009/09/the-lehman-brothers-failure-was-a-sham/686

7. Lehman Brothers Failure May Have Saved Us All Author (StevenPearlstein) http://www.washingtonpost.com/wp-dyn/content/article/2009/09/03/AR2009090303584.html


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http://www.adbi.org/working-%20paper/2009/11/12/3367.global.economic.crisis.india/impact.of.crisis.on.the.indian.economy/http://www.adbi.org/working-%20paper/2009/11/12/3367.global.economic.crisis.india/impact.of.crisis.on.the.indian.economy/http://www.adbi.org/working-%20paper/2009/11/12/3367.global.economic.crisis.india/impact.of.crisis.on.the.indian.economy/http://www.commodityonline.com/news/How-US-crisis-impacts-Indian-economy-12040-3-1.htmlhttp://www.commodityonline.com/news/How-US-crisis-impacts-Indian-economy-12040-3-1.htmlhttp://www.indianmba.com/Faculty_Column/FC1012/fc1012.htmlhttp://www.nipfp.org.in/nipfp-dea-program/PDF/10_5Pr_Hutchison_NBER_WP15120_June_2009_Emerging_Mrkt_linkages.pdfhttp://www.nipfp.org.in/nipfp-dea-program/PDF/10_5Pr_Hutchison_NBER_WP15120_June_2009_Emerging_Mrkt_linkages.pdfhttp://www.nipfp.org.in/nipfp-dea-program/PDF/10_5Pr_Hutchison_NBER_WP15120_June_2009_Emerging_Mrkt_linkages.pdfhttp://www.kevinwoghiren.com/2009/09/the-lehman-brothers-failure-was-a-sham/686http://www.kevinwoghiren.com/2009/09/the-lehman-brothers-failure-was-a-sham/686http://www.washingtonpost.com/wp-dyn/content/article/2009/09/03/AR2009090303584.htmlhttp://www.washingtonpost.com/wp-dyn/content/article/2009/09/03/AR2009090303584.htmlhttp://www.adbi.org/working-%20paper/2009/11/12/3367.global.economic.crisis.india/impact.of.crisis.on.the.indian.economy/http://www.adbi.org/working-%20paper/2009/11/12/3367.global.economic.crisis.india/impact.of.crisis.on.the.indian.economy/http://www.adbi.org/working-%20paper/2009/11/12/3367.global.economic.crisis.india/impact.of.crisis.on.the.indian.economy/http://www.commodityonline.com/news/How-US-crisis-impacts-Indian-economy-12040-3-1.htmlhttp://www.commodityonline.com/news/How-US-crisis-impacts-Indian-economy-12040-3-1.htmlhttp://www.indianmba.com/Faculty_Column/FC1012/fc1012.htmlhttp://www.nipfp.org.in/nipfp-dea-program/PDF/10_5Pr_Hutchison_NBER_WP15120_June_2009_Emerging_Mrkt_linkages.pdfhttp://www.nipfp.org.in/nipfp-dea-program/PDF/10_5Pr_Hutchison_NBER_WP15120_June_2009_Emerging_Mrkt_linkages.pdfhttp://www.nipfp.org.in/nipfp-dea-program/PDF/10_5Pr_Hutchison_NBER_WP15120_June_2009_Emerging_Mrkt_linkages.pdfhttp://www.kevinwoghiren.com/2009/09/the-lehman-brothers-failure-was-a-sham/686http://www.kevinwoghiren.com/2009/09/the-lehman-brothers-failure-was-a-sham/686http://www.washingtonpost.com/wp-dyn/content/article/2009/09/03/AR2009090303584.htmlhttp://www.washingtonpost.com/wp-dyn/content/article/2009/09/03/AR2009090303584.html


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