Global Financial Crisis of 2008 and Indian Economy

 Introduction

The dot com bubble in the U.S. began in 1996 in which tech firms 'stock values grew too high and in 2002 this dot com bubble exploded, and these tech firms' stocks began to decline.

 At the same time around 2001, the banks ' interest rates were around 1 per cent so the investors did not want to keep their money in the banks.

Investors were searching for an asset class that could provide them with good yields, when the real-estate market was rising and the US government was encouraging the public to purchase homes.

It was very easy to take loans and buy a house because of very low interest rates so the investors in the U.S. moved to the real estate market. In the minds of investors, there was hope that the real estate prices would rise and they might benefit from it.

The US investment banks also saw it as an opportunity and decided to take advantage of it. Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley were some of the major investment banks involved. These investment banks also wanted to take benefit of the upward trending real estate market this idea connected investors and homeowners through Mortgages.

 These investment banks started purchasing the loans from the commercial banks and made a complexed derivative out of it called COD “Collateralized debt obligation”.

These CDOs were examined by the credit rating agencies which rated them with “AAA” rating which was considered the best and the safest rating given to any asset class.

The high rating by the credit rating agencies and good returns form the real estate market, investors started investing in these assets and soon the demand for the CDO was rising.

This led to investment bankers buying more loans from commercial banks.

 Before a housing loan is granted to any person, the credit score and background checks shall be carried out. Now banks have already given loans to individuals with a good credit background, now midst the growing demand for loans from investment bankers that commercial banks began to offer loans to individuals who do not have a good credit score and also to individuals without a permanent source of income.

These low-quality loans are known as “subprime” loans. And these subprime loans were sold to the investment bankers who further transformed it to CDOs and sold them to the investors.  These subprime loans were also given a AAA rating and the demand for CDOs kept on increasing.

Now here was a transfer of risk which was going on from-

                                                            

 

The quantity of the sub prime loans kept on increasing and hundreds of billion dollars of loan was granted to individuals with low credit ratings.

Commercial banks, investment banks and credit rating agencies made a lot of profits through this whole process.

Companies like AIG, which is one of the largest insurance companies, started providing insurance on these CDOs because the CDOs were rated very highly. They named it Credit Default Swap (CDS), and people started buying these insurances. Insurance companies also earned a lot of profit from these CDOs.

So, the subprime loans were issued at an adjustable interest rate, which is at the period that such loans were approved, the interest rates were very low, but over the period the adjustable interest started to increase and the subprime lenders were unable to keep up with the rising interest rates.

And it became difficult for subprime borrowers to repay the money at such high-interest rates, and they started defaulting.

In order to solve this situation, the banks began auctioning houses in order to get the money back. And with time, the defaulters were increasing, and the banks were trying to auction all these houses. As a result, the supply of houses increased. And in the second position, the interest rates were also raised by 5 per cent, because there were no buyers of these houses, and the prices of these houses fell dramatically. The subprime borrowers now have to pay the amount which was greater than the value of those houses. Therefore, most of the borrowers started defaulting and the value of CDOs too started decreasing very steadily. There also existed a lack of rules and regulation in the mortgage market which lead to the deterioration of the health of the financial system.

Investors now stopped buying the CDOs from the investment bankers and many investment banks filed bankruptcy. AIG which issued insurance for those CDO now was in a big loss.

Companies, investment banks and insurance firms have suffered tremendous losses, and now this situation was accompanied by a credit crunch, which has made it very difficult to access loans. More than 25 banks in the US have announced bankruptcies.

Small enterprises and other businesses were not getting capital to expand or operate efficiently, and US economic growth was completely halted.

Unemployment rates have risen up to 9.5%, global trade has been affected, and the global economy was in recession.

All these events gave rise to the financial crises in the United States, and this crisis was transferred to both exports driven developing nations and developed European nations which had invested in the US housing market.

 India and 2008 financial crisis

From 1991, the liberalization of the country's economic policies expanded India's contribution to the global economy. India's deepening with global economies probably made it vulnerable to the financial crisis.

According to the statics growth rate in India was 9.6% in 2006 and 9.2% in 2007. This remarkable growth rate was attributed to a booming stock market, growth in foreign direct investment and growth in foreign exchange reserves.

Around the same time, however, India's inflation rate was about 12.91 per cent. There was also a pre-economic crisis in India as a result of the tightening of monetary policy in 2004 and 2008-09, followed by a massive rise in commodity prices, especially metals, food and oil. The inflation rate was booming.

 Effects of the global crises in India

The first thing that occurred soon after the financial crisis was the exit of global intuitive investment from the stock market. The FIIs have withdrawn from the Indian market to offset their losses in their home countries. They were trying to get out of a highly volatile and dangerous environment.

The financial crisis triggered a credit crunch on the Indian economy. The lack of money supply and the exit of the FIIs from the Indian economy has caused the Indian currency to devalue the Indian rupee from about 47 rupees per dollar to 40 rupees per dollar.

Following the withdrawal of the FIIs from the Indian stock market, the Sensex dropped to 10,000 in December 2008, from about 21,000 in early 2008.

 

Indian exports dropped due to the crisis in the developed economies and industrial performance was also adversely affected. There was almost  33 per cent decline in Indian exports. Steel, automobile, banking and financial service were adversely affected. Food prices also increased affecting the household budgets.

Unemployment rates marked a level of 10.7%

  Policy measures

During quarter 4 of 2008 and 1^st quarter of 2009-10 there were large changes in policy measures. Here we will concentrate on the monetary policy measure the RBI took to counteract the consequences of the financial crises.

There was a credit crunch on the Indian economy as a result of the withdrawal of foreign direct investment from the capital markets and a decline in exports in the 2nd quarter of 2008-09. Consequently, the RBI's main purpose at the time was to adjust monetary policy in such a way that the money supply rises in the economy so that the domestic companies can work properly.

RBI had to-

 1) Provide adequate liquidity on domestic markets to ensure that the domestic companies     run efficiently;

2) To help those sectors that were productive and had a large share of exports.

some policy measures taken by Reserve Bank of India are as follows-

1)    The repo rate was reduced by 9% to 4.75% in 2008.

2)    Reverse Repo rate was reduced by 6% to 3.25 per cent.

3)    Cash reserve ratio was reduced by 8.25% to 5%.

In the time of the 2008 financial crisis, the repo rate, the reverse repo rate and CRR were decreased to raise the money supply on the market so that the economy could recover from the downturn.

As a result, these RBI initiatives increased the money supply in the economy and commercial banks were given an opportunity to increase the amount of loans they provided.

The decline in the cash reserve ratio from 8.25 per cent to 5 per cent in 2008, lead banks to keep low reserves with themselves and they could grant extra loans that increased their credit power by the multiplier effect.

 The value of Indian rupee was also decreasing, in order to shield the rupee from further depreciation, RBI reacted by aggressively selling its foreign reserves. The foreign reserve declined in November 2008 from $315 billion in May 2008 to $246 billion.

  IS-LM Framework

 Sharp decline in the exports from India and a decline in the domestic aggregate demand lead to the shift in the IS curve.

The shift in the IS curve takes place from IS0 to IS1 that is the IS curve shift leftward.

 Now the change in the monetary policy was to increase the money supply in the market.

For the same the interest rates were decreased which lead to the increasing domestic aggregate demand.

The shift in the LM curve takes place from LM0 to LM1.

 The output (Y) rises from Y0 to Y1.            

  

A  small decrease in the rate of interest causes a great increase in the output (LM curve shifts from LM0 to LM1 and output increases from Y0 to Y1).

 Conclusion

The repercussions of the 2008 financial recession have been very severe and have almost affected the entire world. The financial crisis erupted in India when the Indian economy was already plagued by inflationary pressure, currency depreciation and high unemployment. This financial crisis further aggravated the situation by causing a recession in aggregate demand, a decrease in exports, a spike in unemployment and volatility in the stock market. Still, India was one of the few countries that quickly recovered from all the financial crises that had occurred, credit for this can be given to sound Indian monetary and fiscal policies, yet another thing to be apricated is that the Indian banking and finance sector was tightly regulated and enabled India to get back on track. 

References

Joseph, M. (n.d.). Global Financial Crisis: How was India Impacted? Retrieved from https://www.die-gdi.de/fileadmin/_migrated/content_uploads/Global_Financial_Crisis_and_Impact_on_India_Berlin030909.pdf

Mohan, R. (2009, 04 23). Global Financial Crisis: Causes, Impact, Policy Responses and Lessons. Retrieved from https://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/IIBISSApril212009.pdf

Mohanty, D. (2009, 11 12). Global Financial Crisis and Monetary Policy Response in India. Retrieved from https://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=446

Singh, S. (n.d.). The Indian response to the Global financial crisis. Retrieved from https://www.researchgate.net/publication/277754521_The_Indian_response_to_the_global_financial_crisis

Viswanathan, K. G. (2010). The Global Financial Crisis and its Impact on India. Retrieved from https://scholarlycommons.law.hofstra.edu/cgi/viewcontent.cgi?article=1112&context=jibl#:~:text=The%20unemployment%20rates%20among%20EMEs,10.7%25%20between%202008%20and%202009.