Social Aspects of

Development UNIT 28 GLOBAL ECONOMIC CRISIS

Structure

28.0 Objectives
28.1 Introduction
28.2 Origin of the crisis
28.2.1 Spread of the Crisis
28.3 Web of Crisis
28.4 Roots of the Crisis
28.5 Impact of the Crisis
28.6 What is to be Done
28.6.1 Need for Coordinated International Action
28.6.2 Need for a New International Financial Architecture
28.7 Impact on India
28.7.1 Policy Agenda for Future
28.7.2 What needs to be done?
28.8 Let us Sum up
28.9 Key Words
28.10 Answers/Hints to CYP Exercises

28.0 OBJECTIVES
After going through this unit you will be able to:
l trace the origins of the current global economic crisis;
l assess the impact of the crisis on developing economies like India;
l describe the measures that have been taken to deal with the crisis;
and
l articulate the elements of an international coordinated action
demanded by the crisis.

28.1 INTRODUCTION
The world economy is now mired in the most severe financial crisis
since the Great Depression of 1930s. In a little over a year, the mid-
2007 sub-prime mortgage debacle in the US developed into a global
financial crisis and began moving the global economy into a recession.
Aggressive monetary policy action in the US and massive liquidity
injection by the central banks of the major developed countries were
8 8 unable to avert this crisis. Several major financial institutions in the US
and Europe failed, and stock market and commodity prices collapsed Global Economic Crisis

and became highly volatile. Most developed economies entered into

recession during the second half of 2008, and the economic slowdown
spread to developing countries and the economies in transition.

28.2 ORIGIN OF THE CRISIS

Origin of the present global crisis can be traced to the sub-prime
mortgage market in the US. Sub-prime mortgages are residential loans
that do not conform to the criteria of ‘prime’ mortgages, and so have a
lower expected probability of full repayment. Because of their high risk
of default, sub-prime borrowers are charged higher interest rates than
prime borrowers. The sub-prime loans are securitised by which is meant
that they have been advanced without asset backed securities such as
collaterised debt obligations (CDOs). Institutional investors such as
hedge funds, pension funds and banks have been investing in such
securities.

The first sign of trouble in sub-prime lending in the US was associated

with high volume of ‘early payment deficits’ (or defaults) in which the
borrower misses one or two of the first three monthly payments, followed
by rising delinquency rates. Apart from the slowdown in the residential
property market, the adjustable interest rate loans offered by the lenders
was also a factor responsible for defaults and delinquencies. As interest
rates increased and house prices first flattened and then turned negative
in a number of regions, many borrowers were left with no option but to
default on repayment as refinancing options were not feasible with little
or no housing equity.

The crisis in sub-prime lending sent shock waves through other parts of
the financial system. Many of the structured credit and mortgaged market
products came under severe trade stress. Many investors facing margin
calls from worried counterparts were unable to sell holdings to raise
cash as there were no buyers forcing them to seek cash via the money
market. Hedge funds, who are investors in structured products, also
faced heavy withdrawals and margin calls. As a result, several banks
were hit by losses from risky property loans.

28.2.1 Spread of the Crisis

The crisis which had its origin in the sub-prime mortgage markets in the
US, took some time before problems in financial markets were
experienced in the real economies. By the second half of 2008, however,
most developed economies entered into recession with the effect of
economic slowdown spreading to developing countries and economies
in transition. Following this, vast majority of countries are experiencing
a sharp reversal in the robust growth registered during the period 2002-
2007. For instance, among the 160 economies in the world for which
data are available, the number of economies that had an annual growth 8 9
Social Aspects of in GDP per capita of 3 percent or higher is estimated to have dropped
Development
from 106 in 2007 to 83 in 2008, which is further feared to have declined
to 52 in 2009. Among the 107 developing countries, this number is
estimated to have dropped from 70 in 2007 to 57 in 2008, and to 29 in
2009. The trend suggests a significant set-back in the progress made
in poverty reduction in many developing countries over the past few
years.

The apparent robust growth pattern that had emerged from the early
2000s came with high risks. Growth was driven to a significant extent
by strong consumer demand in the US, stimulated by easy credit and by
very high rates of investment demand and strong export growth in some
developing countries, notably China. Growing US deficits in this period
were financed by increasing trade surpluses in China, Japan and other
countries accumulating large foreign exchange reserves and willing to
buy dollar denominated assets. At the same time, increasing financial
instruments and risk-management techniques encouraged a massive
accumulation of financial assets leading to growing levels of debt in the
household, corporate and public sectors. In some countries, both
developed and developing, since the early 1980s, domestic financial
debt had risen four to five fold as a share of national income. This rapid
explosion in debt was made possible by the shift from a traditional ‘buy-
and-hold’ banking model to a dynamic ‘originate-to-sell’ trading model
(called securitisation). Leverage ratios of some institutions went up to
as high as 30, well above the ceiling of 10 generally imposed on deposit
banks.

All parties seemed to benefit from the boom, particularly the major
financial players in the rich countries. The risks were conveniently
ignored, despite repeated warnings that mounting household, public sector
and financial sector indebtedness in the US and elsewhere would not be
sustainable over time. As strains in the US mortgage markets were
transmitted to the wider financial sector, fears of a meltdown escalated
and spread around the world.

In short, the origin and spread of the current global crisis can be traced
to:

i) excessive expansion of financial flows in blind pursuit of profit;

ii) failure of government supervision of the financial sector; and

iii) unsustainable model of development, characterised by prolonged low

savings and high consumption.

28.3 WEB OF CRISIS

The global crisis is an interwoven web of three crises:

9 0 First: The collapse of the consumer spending: American consumers

represent 70% of the economy. Traumatised by plunging home values Global Economic Crisis
and stock prices – which have shaved off an estimated $ 7 trillion worth
of personal wealth – they have curbed spending and increased saving.
This has directly led to a US recession and layoffs.

Second: The financial crisis: Lower lending deprives the economy of

the credit to finance businesses and costly consumer purchases (e.g.
cars, appliances).

Third: A trade crisis: Global spending and saving patterns are badly
askew. High saving Asian Countries relied on export-led growth which,
in turn, required American consumers to spend ever-larger shares of
their income. Huge trade imbalances have resulted in US deficits and
Asian surpluses plunging Asia too into recession.

Check Your Progress 1

1. What are sub-prime mortgages?

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

2. What are the two factors responsible for sub-prime borrowers to

default?

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

3. Mention the three high risk factors with which the robust growth
rates of early 2000s were accompanied in many developing
economies like India.

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

28.4 ROOTS OF THE CRISIS

The roots of the crisis lie in the interplay of several developments that
have fundamentally transformed the finance capitalism that existed in
the time period of Great Depression of 1929 or even just about there
decades ago. 9 1
Social Aspects of One, traditionally banks were careful to lend only to trusted clients
Development
carrying the debts on their books. In the new financial system, with
securitisation emerging as a major force, lenders pool the loans and
resell them as asset-backed securities. These securities are then
repackaged, leveraged and resold many times over.

Two, there have emerged highly sophisticated derivative products.

Especially important among these currently are the credit default swaps.
Taken together, asset-backed securities and derivatives widely spread the
risk. But they also breed complacency towards risk, laying the foundation
for quick contagion.

Three, there has emerged highly-leveraged investment banks.

Commercial bank leveraging is limited by stringent capital adequacy
norms. In contrast, investment banks could raise and invest funds up to
30 times their equity base, thus vastly increasing the fragility of the
system.

Four, there has been a globalisation of the financial system. One aspect
of this is a major imbalance between economic and political power.
China, India and other emerging economies in Asia and Middle East are
now the creditors of the west especially the US. Yet they have little say
in the design of the global financial architecture. Another aspect of this
is technological. Billions of dollars can now be transmitted
instantaneously across the globe. But so can market information and
market sentiments which can be on both the positive and negative sides
(on positive side exuberance and on negative side fear among investors).

In short, securitisation, derivatives, leveraging and globalisation

have made the global economy much more volatile and risky than the
world of 1929.

28.5 IMPACT OF THE CRISIS

Developed economies are leading the global slowdown. Meanwhile,
through international trade and finance channels, the weakness has spread
rapidly to developing countries with the following consequences.

1. The employment situation has deteriorated globally. Much of the

employment gains seen in the recent years due to a surge in exports in
developing economies like India is lost because of the global economic
slowdown.

2. World trade is grinding to a halt. This is a big worry because in the

post-war economic progress world economy has been built on the
premise that free trade between nations improves overall efficiency
and spreads wealth. However, many countries are now reporting sharp
declines in their exports since September 2008. These include all major
economies e.g. US, Germany, China, India, etc. The World Bank says
that global trade is likely to decline during 2009 for the first time
9 2 since many decades.
 At the micro level, a drop in the movement of goods across national Global Economic Crisis
borders will create huge pressures on the intricate web of global
supply chains that companies have built in recent decades. At the
macro level, recessions and slowdowns could lead to trade wars as
countries try to protect domestic manufacturers from imports. The
knee-jerk reaction is likely to be protectionist to mollify domestic
lobbies.

3. Financial markets will continue to be under stress with their troubles

pulling down growth in what the IMF describes as ‘a pernicious
feedback loop’. The recession is adding to bad loans and balance
sheet owes of global banks resulting in worsening financial crisis at
the global level.

4. The continuation of the financial crisis, as policies fail to dispel

uncertainty, has caused the asset values to fall sharply across advanced
and emerging economies. This has led to decreased household wealth
and the resultant downward pressure on consumer demand. In addition,
the associated high level of uncertainty has prompted household and
businesses to postpone expenditure, reducing demand for consumer
and capital goods. At the same time, widespread disruptions in credit
are constraining household spending which, in turn, is curtailing
production and trade.

5. A sharp drop in net capital inflows to the emerging economies is

also taking place. Globally, it is estimated that the net capital inflows
to emerging markets would drop to $ 165 billion in 2009, from
$ 466 billion in 2008 and $ 929 billion in 2007. Private financing
too for emerging Asia is expected to dip from $ 96 billion in 2008
to $ 65 billion in 2009 partly because FDI is expected to see a drop.

The current slump in net private capital inflows to emerging markets

is the worst compared with the two previous crisis episodes of 1981-
86 and 1996-2002. For instance, the net private inflows had fallen
from a peak of 3.5% of emerging market GDP in 1981 to a low of
0.3% of GDP in 1986. Again, during 1996-2002, it had fallen from
a peak of 5.7% of GDP in 1996 to a low of 2% in 2002. This time
around, however, the net inflows are expected to fall from a peak of
6.9% GDP in 2007 to about 1.1% of GDP in 2009.

6. A prolonged slowdown will mean that earnings could suffer hampering

the ability of companies to repay loans. This could lead to a rise in
bad loans with the units in the export-oriented sectors. The interest-
rate sensitive units would also experience greater stress.

With companies facing cash flow problems bankers fear that they
may resort to diverting funds from one business to another, hoping
they would be able to pay back when the situation improves. The
banks are getting increasingly concerned about such risks, especially
in case of companies with multiple accounts. 9 3
Social Aspects of The one silver lining right now is that the sharp downturn in the world
Development
economy and the fall in commodity prices has led to cooling down of
inflationary pressures, a far cry from the inflationary scare in the middle
of 2008.

28.6 WHAT IS TO BE DONE

There are two sets of responses.

One, to prevent a deeper financial crisis and the other to keep the real
economy of output and jobs as much on track as possible. The two
problems are linked as a further fall in growth will do more damage to
bank balance sheets which will worsen the credit crisis and lead to a
sharper fall in economic activity. Governments and central bank should
therefore move fast to put the financial sector back on its feet, even as
they increase public spending and money supply to support demand.

But there is little clarity on how all this is to be done. We have already
seen policy response changes – from temporary liquidity pumped into
the global financial markets to direct purchases of government securities
by the US Federal Reserve, expensive plans to buy troubled assets and
semi-nationalisation of banks and financial institutions. But the financial
crisis has continued unabated.

Two, there have been announcements of lavish fiscal stimulus running

into several billions of dollars. These are attractive short-term
prescriptions with long-term ramifications. They are most likely going
to push government deficits and public debt. Meanwhile, the recession
has deepened.

Thus, the world economy is in more serious trouble than what these
time-tested solutions have proven to be effective. This brings us to the
option of the need for a coordinated international action.

28.6.1 Need for Coordinated International Action

The stabilisation of financial markets and stimulation of the global
economy will require a far greater policy coordination among the nations
of the world. Measures of individual nations can not match the benefits
of such a coordinated international action. These benefits can be stated
as follows.

One, there are real and psychological gains. Stimulus measures from
one country spill over to their trade partners, creating an additional
boost. Coordinated efforts help mitigate the volatility in currency and
bond markets which is usually the consequence of uncoordinated policies.

Two, coordination is an important defence against ‘beggar-thy-neighbour’

policies. Early forays into protectionism are already being made. There
has been a gradual creeping up of tariffs. Even within their WTO
9 4
commitments, there is scope for countries to raise tariffs. If all nations Global Economic Crisis
shore up tariffs to their bound rate (the highest rate consistent with their
WTO commitments), exporters from middle and high income countries
could face tariffs twice as high as current levels.

Three, international cooperation is essential because the crisis has

important implications for developing countries as they did not create
this crisis but have been badly damaged by it. The global recession in
advanced countries has weakened export opportunities for emerging
countries. In addition, the financial crisis has restricted credit flows
with crisis of debt to developing countries having widened significantly.

Four, the crisis presents an unprecedented opportunity to combine

shorter-term stimulus requirements to boost growth and employment
with the longer-term requirement to lift global productivity growth
accelerating the transformation to a lower-carbon economy.

In the immediate period, the developed and developing nations will need
to:

i. work out the quantum of stimulus necessary to offset the anticipated

contraction in the economy and the consequential impact on
employment;

ii. agree on the optimal content of stimulus policies to balance the

short and long-term economic needs;

iii. coordinate the implementation of these measures; and

iv. develop a medium–term exit strategy to ensure that surviving this

crisis does not shackle the world economy with a long-term inflation.

28.6.2 Need for a New International Financial Architecture

In today’s world of increased economic and political interdependence,
achieving a broad-based, rapid and sustained growth in income and
employment involves even more complex policy challenges than in the
past. The failure to create a truly inclusive system of global economic
governance – for effecting adequate counter-cyclical policies in the
short term and appropriate regulatory reform in the medium term – has
frustrated a coordinated, comprehensive and inclusive international
response to the current crisis. There is a growing need for a new
international financial architecture.

The new international financial architecture should address at least the

four core areas of reforms as follows.

i) Establishment of a credible and effective mechanism for international

policy coordination to guide a more inclusive process with adequate
participation and representation of developing countries in the process
of policy coordination and institution of global governance; 9 5
Social Aspects of ii) Fundamental reforms of existing systems of financial regulation and
Development
supervision leading to a new internationally coordinated framework
that can avoid the excesses of the past;

iii) Reform of the present international currency system, away from the
almost exclusive reliance on the US dollar, towards a multilaterally
backed multi-currency system which, perhaps, over time could evolve
into a single, world currency-backed system;

iv) Reforms of liquidity provisioning and compensatory financing

mechanisms – backed by, among other things, multilateral regional
pooling of national foreign-exchange reserves – which avoids the
onerous policy conditionality attached to existing mechanisms.

Check Your Progress 2

1. Mention, in brief, the four factors responsible for the current global
economic crisis.

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

2. Briefly mention the main consequences of the present global economic

crisis.

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

3. What long term measures are needed to be taken to steer the economies
from the path of the present economic crisis?

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

4. What are the short term measures needed to be taken to cope with the
current global economic crisis?

....................................................................................................................
....................................................................................................................
....................................................................................................................
9 6 ....................................................................................................................
 Global Economic Crisis
28.7 IMPACT ON INDIA
It is difficult to comprehend the depth of the global crisis on a country
like India which can still record growth of 6 to 7 percent during 2008-
09 at a time when most developed countries are suffering from negative
growth. Some sectors like exports, real estate, textiles, IT and transport
equipment have been affected severely. But overall, the impact has
been limited, largely due to the prompt and sustained measures taken by
the RBI and the government.

The markets have stabilised and the decline of the rupee has been arrested.
There has been a marginal decline in the financial resources to the
commercial sector as resource mobilisation from capital markets and
ECBs had been affected.

However, the massive liquidity injected into the system as a part of

stimulus packages cannot translate into additional bank credit because
of both supply and demand side constraints. In the gloomy economic
scenario, instead of expanding commercial credit, banks prefer excessive
investments in government securities as well as secondary market
operations. They also tend to persist with high interest rates despite
steep reductions in the RBI’s benchmark rates. Following fiscal
compressions, the capacity of the administration to absorb higher
productive expenditure has suffered in recent years.

28.7.1 Policy Agenda For Future

While several issues relating to the future course of the economy arise,
two potential stress points deserve particular attention from policymakers.

The first is the fiscal situation, which, over the course of the crisis, has
gone from reasonably healthy to severely degraded state. The Prime
Minister’s Economic Advisory Council has estimated that the effective
combined fiscal deficit (including fuel and fertiliser subsidies) of the
centre and states would be around 8% of GDP in 2008-09. Many private
forecasters put the number significantly higher, pointing to not just a
sharp but a potentially irretrievable deviation from the fiscal responsibility
mandate of 6 per cent. The current state of global capital market does
not raise hopes of large capital inflows for sometime to come. This will
put pressure on the government to provide resources for many
investments (e.g. infrastructures) which were earlier expected to be
financed by foreign investors. At the same time, if the growth rate does
not return to the high levels of the past couple of years, revenue growth
will be subdued. We may just have the makings of a painful trade-off
between sustaining growth and fiscal discipline. It is quite clear that the
issue of fiscal management will regain central stage in the policy
formulation.

The second is the BOP scenario which is marked by threats to various

components of inflows and outflows. Invisibles, both remittances and 9 7
Social Aspects of service exports, face diminished prospectus, which, together with falling
Development
or stagnant merchandise exports, raise concerns of a widening current
account deficit. Of course, subdued energy and commodity prices will
help contain the pressure to an extent but capital flows are not going to
provide anywhere near the cushion they have been extending for the past
few years. Even optimistic observers of the global financial system do
not believe that the flow of funds into emerging markets will return
anywhere close to pre-crisis levels. Though the foreign exchange revenue
position remains reasonably healthy, the overall situation is a far cry
from the ‘problem of plenty’ that existed until 2007.

Overall, both the fiscal and BOP situation, while evolving in predictable
ways during the downturn, do pose significant risk to even a moderately
recovering economy. Their potential to inflict damage even as the
economy begins to turn around should not be ignored.

28.7.2 What Needs to be Done?

Policy needs are to re-inflate and re-ignite demand. Although the
monetary policy has been loosened considerably, it still has considerable
room left to ease. For instance, short-term policy rates are still too
high, because with prices set to fall further, real lending rates in India,
will still be among the highest in the region. Given the long lags in
transmitting policy rates to bank lending rates and then to overall activity,
there is merit in getting policy rates down as quickly as possible.

Monetary policy outlined above will, however, not be enough. Its

effectiveness is constrained due to rising credit risk, which is causing
a divergence between policy and bank lending rates. Therefore, cutting
policy rates is necessary but not sufficient to stimulate demand.

The responsibility will then have to fall on the fiscal policy. In particular,
there needs to be additional stimulus in the coming year. There is an
argument that there is no more fiscal space for further countercyclical
policy as it would lead to the crowding out of the private sector and
could lead to our debt burden becoming unsustainable. However, the
arguments cannot be sustained for the following reasons.

One, in the current abnormal environment, the private sector has already
been weakened as banks are not lending to them due to high credit risk.
What is of concern is that corporate bond yields are very high relative
to government bond yields. If monetary policy is further loosened,
government yields can fall further. Additional fiscal stimulus is thus not
part of the problem but part of the solution for corporates.

Two, although India’s debt burden will rise, what mattes more for the
long-term sustainability of debt is the differential between GDP growth
and interest rates. It would be much worse for our debt ratio if growth
rates were to be significantly lowered due to the negative shock. As long
9 8 as fiscal expansion is temporary and helps to boost growth, it will not
endanger sustainability. India’s favourable demographics will also help Global Economic Crisis
in bringing down the debt burden. However, the expansion should be
carefully calibrated with a medium-term commitment to bring down the
deficit when more favourable conditions return.

What form should a fiscal expansion take?

Increased spending by the government suffers from two problems – it

takes time to filter through, and there are serious problems in
implementation capacity. It is preferable to have a tax cut which is quick,
equitable, and can unleash domestic demand from liquidity-constrained
consumers.

To get back to 8 per cent growth, the long-term policy reform has to be
more structural reform. But in the short-term, where falling domestic
demand can affect India’s growth process, the response has to be
immediate counter-cyclical easing of both monetary and fiscal policy.

Despite the gloom on the economic growth front, once the global
recovery begins, India’s turnaround will be sharper and swifter due to its
strong fundamental and untapped potential.

Check Your Progress 3

1. How do you assess the impact of the present economic crisis on India?
Briefly outline in 50 words by identifying the sectors which have
suffered a set back due to the current crisis.

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

2. On the fiscal front, in what respects do you think there is scope for
providing stimulus to the Indian economy to help absorb the present
shock better?

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

28.8 LET US SUM UP

The global economy is caught in an unprecedented crisis. The developed
world is experiencing negative growth, while growth rates in developing
economies have considerably slowed down. The origin of the present
crisis can be traced to what has come to be known as the US sub-prime
9 9
Social Aspects of mortgage crisis. This soon spread to different financial markets. Once
Development
the financial world was caught in the grip of a severe crisis, it was never
going to be too long before the real economy got hurt. Most of the
developed world is currently in the grip of recession and is struggling
hard to prevent from slipping down into depression. As a part of the
increasingly globalising economy, India too could not remain immune
from the crisis, although the degree of damage suffered by India has
been relatively low. Also, the process of recovery in India may be
faster than in the rest of the world. To come out of the crisis, the world
needs a well-designed internationally-coordinated action.

28.9 KEY WORDS

Sub-prime mortgages : Residential loans advanced without
conforming to the criteria of ‘prime’
mortgages in terms of assured security.

Securitisation : A structured financial process involving

pooling and repackaging of cash flow
producing financial assets into securities that
are then sold to investors. The name
‘securitisation’ is derived from the fact that
the form of financial instruments used to
obtain funds from the investors are securities.

Leveraging : Investing with borrowed money as a way to

amplify potential gains (at the risk of greater
losses).

28.10 ANSWERS/HINTS TO CYP EXERCISES

Check Your Progress 1
1. See Section 28.2 and answer.
2. See Section 28.2 and answer.
3. See Section 28.2.1 and answer.
Check Your Progress 2
1. See Section 28.4 and answer.
2. See Section 28.5 and answer.
3. See Section 28.6 and answer.
4. See Section 28.6.1 and answer.
Check Your Progress 3
1. See Section 28.7 and answer.
100 2. See Section 28.7.2 and answer.