Capitalism without bankruptcy is like Christianity without hell, or so goes the saying. The great financial crisis that many would like to, against all prudence, believe has past is that epitome, that proof of all that is perhaps wrong with capitalism. Without being a socialist or even trying to harp upon any of socialisms so called great tenets, the crash of 2007, if it may be called so, had sent some of the most revered names in the history of corporate America into the abyss of financial ruin and the rest seeking cover behind the covers and uncertainties of State planning and governmental intervention. The shock waves that emanated from the core of the sudden instability have been not restricted to the financial markets alone. Its effects could be felt throughout the sectors encompassing almost the entire world, doing justice to the proverb “When U.S. sneezes, the world catches cold”.
What is being called as the greatest financial crisis since the Great Depression of 1930 started with the liquidity shortfall in the U.S. banking system. The effects of this were felt throughout the world economy as large financial institutions collapsed and leading banks had to be bailed out by various national governments. The real estate sector collapsed as fast as a bubble bursts. Hundreds of thousands of people lost their homes and rentals and sale of real estate came to a grinding halt. The securities tied to the real estate sectors plummeted and issues regarding stability of the banking sector, credit availability etc. had a negative effect on stock markets throughout the globe. Stock markets collapsed as monies invested were pulled out due to lack of investor confidence. Businesses failed due to this and the expected loss of investor wealth can be safely attributed to billions of dollars. The economies of global behemoths as well as smaller developing nations slowed down due to the lack of easy availability of credit and related liquidity problems and international trade declined. Concerns were raised over lack of proper assessing of risks related to the sophisticated financial products that were available in the market; and regulators were severely criticized for not adopting their regulatory mechanism to the realities of the current financial innovations. State intervention was the rule of the day even in highly capitalisteconomies like the U.S. which witnessed a lack of economic activity and increased government spending. Governments and Centrals Banks responded to this burgeoning crisis by unprecedented fiscal stimulus, monetary policy expansion and institutional bailouts.
The principal cause that can be attributed to the sudden fallout of the crisis in 2007 can be traced back to the easy credit condition prevailing in the United States. The large inflow of foreign funds into the United States coupled with the steadily decreasing interest rates led to this easy availability of credit which lead to the soaring up of demand for housing and resulted in a construction boom supported by debt financed consumption, contributing to a large extent to the building up of a “bubble”. As the debt load on the individuals increased, financial innovation led to the creation of financial products like Mortgage Backed Securities (MBS) and Collaterized Debt Obligations (CDO), essentially derivative instruments which derived their value and were based on mortgage repayments and housing prices. Further, the increasing importance of unregulated financial institutions like hedge funds, investment banks, etc., being a part of the so called shadow banking segment of the United States, was not assessed properly by the markets or the regulators and law makers. These institutions had assumed significant exposure to these sub-prime MBS and CDOs without having the financial cushion to absorb large loan defaults and losses from derivative financial instruments. Thus, with the ever-increasing exposure of investors and financial institutions on these instruments, when the housing prices declined, major losses were suffered by those having exposure. The losses suffered from exposure to these securities led to a constraint in the availability of liquidity thereby impacting the businesses. The declining real estate prices led to an increase in foreclosure as the prices of the houses were considerably less than the value of the mortgage, thus, leading to a drop in income of the banks and financial institution and also removal of a lot of disposable income at the hands of the consumers of those real estates. Further, as the housing wealth disappeared, people cut their spending and the borrowings against their real estate. The draining away of considerable wealth from the hands of the consumers led to an increase in the default of other loans and advances and as the crisis which was confined to the real estate sector expanded rapidly to the other sectors of the economy, the losses incurred, too, jumped by leaps and bounds to trillions of U.S. dollars.
The year 2010 has seen a plethora of fundraising by banks. In my view, the global equity capital markets have remained somewhat subdued although the financial duress has receded. There are concerns over sovereign debt in Europe which still persist and are weighing heavily on investor sentiments, while private equity is viewed with skepticism by the public markets. The US economy turmoil showcased a sharp increase in unemployment, a widespread decline in asset prices, a fall in global industrial activity and the dismantling of institutions once thought to be indispensable to capital formation.
Due to the pressure on banks and financial institutions, there have been a further cutback in risk taking and the associated selling pressures in markets. Lingering effects and uncertainties about the credit cycle were reflected in a global sell-off in equity and debt-market valuations of global and regional financial institutions such as commercial and investment banks. Despite the adverse effects of deteriorating economic and financial conditions, an improvement in underlying profitability has enabled many European banks to maintain regulatory capital ratios at relatively comfortable levels. This situation reflects significant improvements in credit risk management, earning diversification and operating efficiency. In countries like Japan, the financial system’s risk-bearing capacity continues to be impaired by ongoing asset-price deflation and severe economic weakness, which have exacerbated the banks’ long standing problems related to the bubble period and led to the emergence of fresh non-performing loans.
It is my firm belief that capitalism relies on four pillars of confidence, economic behavior, risk, and measures of value. Global debts and equity markets continue to experience turbulence as various governments have implemented strategies to help stabilizing the markets. I believe that the challenges are daunting, but, they can only be overcome through efforts of the public and private sectors working together.
India is a growing economy and in terms of its total market capitalization, the Indian equity market is considered large, relative to the country’s stage of economic development. In my view, over the last few years, SEBI has announced several far-reaching reforms to promote the capital market and protect investor interests. The regulatory structure has been overhauled with most of the powers for regulating the capital market vested with SEBI.
The Indian capital market has experienced a process of structural transformation with operations conducted to standard equivalent to those in the developed markets. Even though the foreign institutional investors (FIIs) were encouraged but many problems, including lack of confidence in stock investments, institutional overlaps and other governance issues remain as obstacles to the improvement of Indian capital market efficiency. If the financial sector is unable to provide funds in more or less the same proportion as required by the demand, the possibility is that there could simultaneously exist excess demand and excess supply in different segments of the financial market. I believe that, the excess supply of funds in one segment of the financial sector carries the danger that such funds may be used for speculative purposes in foreign exchange, real estate or commodities, which create their own problems in economic management. The net result can be an economy which is performing well below its potential and with high levels of systemic risk. Generally, the foreign capital is freely available and unpredictable too, therefore, the FIIs are always on the lookout for profits. The FIIs frequently move investments, and those swings can be expected to bring severe price fluctuations resulting in increased volatility. The increased investment from overseas has resulted in shift of control of domestic firms to foreign hands. This has showed us how the Indian market has been influenced by global markets like U.S., Europe and other Asian markets. In the present scenario, a number of policy and institutional changes have led to the creation of a fairly efficient and robust equity capital market in India, though clearly, there is a long way to go before it transforms and evolves into a market that is not only global in reach and access, but also in standardization and efficiency.
The crisis in US rapidly engulfed most of the economies around the world and the shock waves seemingly severely crippled the global faith in the financing sectors. One of the major fallouts of the crisis in 2010, was the sovereign debt crisis that engulfed some of the prime economies of Europe. The Euro Crisis developed primarily amongst certain members of the European Union, comprising of Portugal, Ireland, Italy, Greece, Spain, (affectionately known as the PIIGS) and Belgium. The outfall was that there was a severe crisis of lack of confidence as well as the widening of bond yield spreads and risk insurance on credit default swaps between these countries and other EU members, most importantly Germany. The over leveraging by certain PIIGS countries, to support governmental spending over prolonged period of time, resulted in huge deficits and set the alarm bells ringing in the financial markets as concerns were raised about their debt levels throughout the world. The downgrading of the European sovereign debts added fuel to the fire. The hardest hit amongst the PIIGS countries was Greece which at the time of the crisis was already suffering from the associated problems of bad governance. The credit rating agencies zeroed down upon Greece to be the recent eras “sick man of Europe”. There was a growing concern that Greece’s debt situation would result in a liquidity crisis for Greece as lenders may stop lending money to it which in turn may result in Greece defaulting on its sovereign debt obligation. Speculation was rife that any such default on the part of Greece would invariably result in a complete halt over the inflow of debt into the other PIIGS countries, which too, would have resulted in a failure on the part of these countries in repaying their sovereign debt. A sovereign default on the part of these countries would have lead to losses by most major banks throughout Europe. The situation seemed to be escalating almost similar to a critical nuclear reactor rapidly going out of control. To prevent an explosion which may have had as far reaching consequences as the disaster at Chernobyl, control rods were immediately infused in the form of a massive multi-billion dollar bailout package to Greece by the IMF and several other Eurozone countries to cool down the situation and control the reaction. As a further confidence building measure, the European Financial Stability Facility was set up with huge amounts at its disposal for securing the stability of the Eurozone economies.
Another significant crisis that threatened to dismantle the Eurozone was faced by Ireland, the Celtic tiger. The issuance of guarantee by the Irish Government on the debts of the Irish Banks in 2008 resulted in passing off the burden of the folly of the Irish financial sector to the taxpayers. Passing of this burden amounted to the debts of the Irish republic becoming significantly higher, thus forcing the government to borrow money at significantly higher interest rates as the government’s ability to repay was under the microscope. The measure taken by the Irish government was lowering of its deficit and thus cuttingexpenditure by slashing of wages and curbing expenses on social services. These measures were insufficient and did not address the concern of the market and the costs increased significantly. The European Central Bank had to step in to prevent an imminent collapse of the Irish economy with a huge bailout package. This package, in addition to stopping the impending collapse also prevented any collapse from affecting the banking sector of powerhouse economies like France and Germany. German and French banks had a significant expose to Irish debts and any default would have had a severe impact and could have snowballed into another crisis as the Eurozone economies are significantly interlinked and a crisis in one country has the potential of setting off a crisis in another economy.
In my view, there is a considerable pressure in Europe to promote equity capital formation. The increasing pressure to develop equity capital is driving Europe’s equity markets to develop more efficient structures. Generally speaking, there are economies of scale when capital investment increases and because of this the local exchanges are under economic pressure to combine to form larger entities providing international services.
Equity markets are most successful when their participants realise that their most important duty is to provide service to investors. As such, the competition is promoted by enlightened regulatory policy and market structures designed to promote investor confidence, rather than to serve entrenched interests. The time has come for the European equity markets to develop and the differences between national legal and regulatory system in the European Union member states must be removed, as this will restrict the development of the panEuropean equity securities market.
While comparing the situation with the emerging Asian markets, the region’s resilient economies should help them recover as the global crisis ebbs and the investor’s appetite returns. I believe that the turmoil in the Asian markets was a result of the close interconnection between the markets and economies around the world and urges the need for the governments and financial sector globally to continuously improve regulation, oversight and risk management process. Nevertheless, the road to recovery for the region’s equity markets will be long and hard given persistent uncertainty about the length and severity of the recent economic downturn.
A positive impact of the Irish crisis may be that it managed to deliver to Europe a much weaker currency. The Euro has weakened considerably against the dollar. However, a weaker currency may be a silver lining against the dark clouds that are rapidly gathering over the other economies of Europe. Yields on Spanish and Portuguese debt are still rising and Spanish banks are also facing higher financing costs. The rearranging of the card game that is being played currently may have the fore bearings of an even large crisis at hand. It is being said in economic circles that the measures that were taken to bail-out the countries embroiled in the financial crisis had led to the fiscal crisis which may eventually lead to a currency crisis. The U.S. and the U.K. are considering the possibility of having weak currencies as it is considered by many that the only source of growth in a recession hit scenario is to have a weak currency. In this background and much to the anguish of the economists, a new currency war has erupted between the United States and China. As an immediate measure of internal fiscal and economic adjustment, devaluation of currency is being considered as a panacea for all ills by the U.S., at least for the moment, as a quick fix solution to the larger problem. This would also correct the huge trade imbalance between the developed and the developing world, especially the U.S. and China. To that extent, the U.S. is pressing for the revaluation of the dollar pegged Chinese Yuan, a measure being desperately resisted by China as it does not wish to part ways with the benefits it is deriving from its under valued pegged currency.
In world economic stage today, any major crisis in the economic powerhouses, is bound to have an impact on the other major world economies which are in some way or the other inter linked with each other. But, it will definitely not be an exaggeration to state that in the face of the global economic upheavals when two of the ‘economic role models’ of the world (the United States and European Union) were reeling from grave economic and financial distress, the Indian economy has performed exceptionally well. India remained the second fastestgrowing economy in the world. When most other major countries were either in recession or were suffering from negative growth over the last two years or so, India’s economy has grown at impressive rates. Undoubtedly, when the U.S. was reeling from the outbreak of the crisis and the bursting of the bubble, the Indian bourses tanked as foreign capital took flight. However, within less than a couple of years, investors have once more invested back in the Indian stock markets and the equities markets are again on a roll and it has managed to regain the lost heights of 2008-2009.
Experts have attributed India’s good performance to it being not only less vulnerable to the global crisis, but because of its lower exposure to trade, India is much less dependent on global flow of trade and capital. Roughly speaking, only one-fifth of India’s economy relies on foreign trade and the rest is internal consumption. Though, export of its commodities and goods had suffered during the economic crisis elsewhere, the huge internal consumption of its huge and ever increasing population kept its economy rolling, and the money flowing. The services sector, mostly IT and ITES segments, remained robust and continued to perform well throughout. The remittances from Indians abroad were plentiful and did not dry down to a trickle. When the whole world was going in for sophisticated financial instruments, the Indian banking and financial sector conservatively placed their bets on robust instruments and did not take much exposure to mortgage-supported securities and credit-default swaps that sent several western financial institutions hurting down the financial abyss all the way to bankruptcy. Moreover, the Government of India adopted a pro-active but conservative fiscal policy and rolled out two rounds of stimulus packages for the economy. In addition, the authorities pursued pro-growth policies, including lower interest rates, expanded credit, and a reduction in excise duties. However, a powerful series of counter-measures by the major economies worldwide should also not be over looked as these arrested the financial meltdown and stimulated global demand. Had this not been the case, India may not have been as resilient in the face of the global financial turmoil and may have had eventually fallen prey to it’s hobnobs. Even so, as the global situation is still in doldrums and quite fragile in itself, together with the high risk that is still subsisting in the global economies, it will be prudent for the Indian government not to let down its guard and work towards further strengthening its now famed economic resilience.
However, in the event of a currency war and major dollar depreciation, key export and growth sectors like IT, ITES, textiles etc. may get severely affected. Even in such a scenario, it can be reasonably expected that the strong domestic consumption and ever increasing population would probably keep India’s economy rolling and the money flowing. It can be said that the purpose of population is not ultimately peopling earth; it is also to fuel the economy.
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