Presentation on

BUSINESS ENVIRONMENT

GLOBAL
RECESSION
Prepared by:
Kesha M Tamakuwala
 CAUSES OF GLOBAL RECESSION :
These days the most talked about news is the
current financial crisis that has engulfed the
world economy. Every day the main headline of
all newspapers is about our falling share
markets, decreasing industrial growth and the
overall negative mood of the economy.  For
many people an economic depression has
already arrived whereas for some it is just
round the corner. In my opinion the depression
has already arrived and it has started showing
its effect on India.
So what has caused this major economic upheaval in the world? What
is the cause of falling share markets the world over and bankruptcy of major
banks? In this presentation, I shall try to explain the reasons for recent
economic depression for all those who find it difficult to understand the
complex economics ling and are looking for a simple explanation.
 Changing nature of systemic risk and
financial innovation
Before:”Originate-and-hold” model
Traditional Relationship between Borrower and Creditor

BANK
- Lends money - Pays interest and
- Manages delinquencies principal

BORROWER
 It all started in US…
In order to understand what is now happening in the world economy,
we need to go a little back in past and understand what was happening in the
housing sector of America for past many years. In US, a boom in the housing
sector was driving the economy to a new level.  A combination of low interest
rates and large inflows of foreign funds helped to create easy credit conditions
where it became quite easy for people to take home loans. As more and more
people took home loans, the demands for property increased and fueled the
home prices further. As there was enough money to lend to potential borrowers,
the loan agencies started to widen their loan disbursement reach and relaxed the
loan conditions.
The loan agents were asked to find more potential home buyers in
lieu of huge bonus and incentives. Since it was a good time and property prices
were soaring, the only aim of most lending institutions and mortgage firms was
to give loans to as many potential customers as possible. Since almost
everybody was driving by the greed factor during that housing boom period, the
common sense practice of checking the customer’s repaying capacity was also
ignored in many cases.
 As a result, many people with low income & bad
credit history or those who come under the NINJA (No Income, No Job, No
Assets) category were given housing loans in disregard to all principles of
financial prudence. These types of loans were known as sub-prime loans as
those were are not part of prime loan market (as the repaying capacity of the
borrowers was doubtful).
Since the demands for homes were at an all time high, many
homeowners used the increased property value to refinance their homes with
lower interest rates and take out second mortgages against the added value (of
home) to use the funds for consumer spending. The lending companies also
lured the borrowers with attractive loan conditions where for an initial period
the interest rates were low (known as adjustable rate mortgage (ARM).
However, despite knowing that the interest rates would increase after an initial
period, many sub-prime borrowers opted for them in the hope that as a result of
soaring housing prices they would be able to quickly refinance at more
favourable terms.
 Bubble that burst…
However, as the saying goes, “No
boom lasts forever”, the housing bubble was to
burst eventually. Overbuilding of houses during
the boom period finally led to a surplus
inventory of homes, causing home prices to
decline beginning from the summer of 2006.
Once housing prices started depreciating in
many parts of the U.S., refinancing became
more difficult. Home owners, who were
get a refinance on the basis of increased
expectinghome
to prices, found themselves unable
to re-finance and began to default on loans as their loans reset to higher interest
rates and payment amounts.
In the US, an estimated 8.8 million homeowners - nearly
10.8% of total homeowners - had zero or negative equity as of March 2008,
meaning their homes are worth less than their mortgage. This provided an
incentive to “walk away” from the home than to pay the mortgage.
 Foreclosures ( i.e. the legal proceedings initiated by a
creditor to repossess the property for loan that is in default ) accelerated in the
United States in late 2006. During 2007, nearly 1.3 million U.S. housing
properties were subject to foreclosure activity.  Increasing foreclosure rates
and unwillingness of many homeowners to sell their homes at reduced market
prices significantly increased the supply of housing inventory available. Sales
volume (units) of new homes dropped by 26.4% in 2007 as compare to 2006.
Further, a record nearly four million unsold existing homes were for sale
including nearly 2.9 million that were vacant. This excess supply of home
inventory placed significant downward pressure on prices. As prices declined,
more homeowners were at risk of default and foreclosure.
Now you must be wondering how this housing boom and its
subsequent decline is related to current economic depression? After all it
appears to be a local problem of America.
Global mortgage boom and bust
 What complicated the matter?…
Unfortunately, this problem was not as straightforward as it
appears.  Had it remained a matter between the lenders (who disbursed risky
loans) and unreliable borrowers (who took loans and then got defaulted) then
probably it would remain a local problem of America. However, this was not
the case.  Let us understand what complicated the problem.
For original lenders these subprime loans were very lucrative
part of their investment portfolio as they were expected to yield a very high
return in view of the increasing home prices. Since, the interest rate charged on
subprime loans was about 2% higher than the interest on prime loans (owing to
their risky nature); lenders were confident that they would get a handsome
return on their investment. In case a sub-prime borrower continued to pay his
loans installment, the lender would get higher interest on the loans. And in case
a sub-prime borrower could not pay his loan and defaulted, the lender would
have the option to sell his home (on a high market price) and recovered his loan
amount. In both the situations the Sub-prime loans were excellent investment
options as long as the housing market was booming. Just at this point, the things
started complicating.
 With stock markets booming and the system flush with liquidity,
many big fund investors like hedge funds and mutual funds saw subprime loan
portfolios as attractive investment opportunities. Hence, they bought such
portfolios from the original lenders. This in turn meant the lenders had fresh
funds to lend. The subprime loan market thus became a fast growing segment. 
Major (American and European) investment banks and institutions heavily
bought these loans (known as Mortgage Backed Securities, MBS) to diversify
their investment portfolios. Most of these loans were brought as parts of CDOs
(Collateralized Debt Obligations). CDOs are just like mutual funds with two
significant differences. First unlike mutual funds, in CDOs all investors do not
assume the risk equally and each participatory group has different risk profiles.
Secondly, in contrast to mutual funds which normally buy shares and bonds,
CDOs usually buy securities that are backed by loans (just like the MBS of
subprime loans.)
Owing to heavy buying of Mortgage Backed Securities (MBS) of
subprime loans by major American and European Banks, the problem, which
was to remain within the confines of US propagated into the word’s financial
markets. Ideally, the MBS were a very attractive option as long as home prices
were soaring in US. However, when the home prices started declining, the
attractive investments in Subprime loans become risky and unprofitable.
 As the home prices started declining in the US, sub-prime
borrowers found themselves in a messy situation. Their house prices were
decreasing and the loan interest on these houses was soaring. As they could not
manage a second mortgage on their home, it became very difficult for them to
pay the higher interest rate. As a result many of them opted to default on their
home loans and vacated the house. However, as the home prices were falling
rapidly, the lending companies, which were hoping to sell them and recover the
loan amount, found them in a situation where loan amount exceeded the total
cost of the house. Eventually, there remained no option but to write off losses
on these loans.
The problem got worsened as the
Mortgage Backed Securities (MBS), which by that
time had become parts of CDOs of giant investments
banks of US & Europe, lost their value. Falling prices
of CDOs dented banks’ investment portfolios and
these losses destroyed banks’ capital. The complexity
of these instruments and their wide spread to major
International banks created a situation where no one
was too sure either about how big these losses were
or which banks had been hit the hardest.
 How it has affected India?
In the age of globalization, no country can remains isolated from
the fluctuations of world economy. Heavy losses suffered by major International
Banks is going to affect all countries of the world as these financial institutes
have their investment interest in almost all countries.
As of now India is facing heat on three grounds: (1) Our Share
Markets are falling everyday, (2) Rupee is weakening against dollars and (3) Our
banks are facing severe crash crunch resulting in shortage of liquidity in the
market. Actually all the above three problems are interconnected and have their
roots in the above-mentioned global crisis.
For the last two years, our stock market was
touching new heights thanks to heavy investments by Foreign Institutional
Investors (FIIs). However, when the parent companies of these investors (based
mainly in US and Europe) found themselves in a severe credit crunch as a result
of sub-prime mess, the only option left with these investors was to withdraw
their money from Indian Stock Markets to meet liabilities at home. FIIs were the
main buyers of Indian Stocks and their exit from the market is certain to wreak
havoc in the market.   FIIs who were on a buying spree last year, are now in the
mood of selling their stocks in India. As a result our Share Markets are touching
new lows everyday.
 Since, the money, which FIIs get after selling their stocks, needs
to be converted into dollars before they can sent it home, the demands for
dollars has suddenly increased. As more and more FIIs are buying dollars, the
rupee is loosing its strength against dollar. As long as demands for dollars
remain high, the rupee will keep loosing its strength against dollar.
The current financial crisis has also started directly affecting
Indian Industries. For the past few years, the two most preferred method of
raising money by the companies were Stock Markets and external borrowings
on low interest rates. Stock Markets are bleeding everyday and it is not possible
to raise money there. Regarding external borrowing from world markets, this
option has also become difficult.
In the last fiscal year alone, India borrowed $29 billion from
foreign lenders and got $34 billion of foreign direct investment. A global
recession has hurt external demand. International lenders who have become
extremely risk aversive can limit access to international capital. If that happens,
both India’s financial markets and the real economy will be hurt in the process.
Suddenly, the 9% growth target does not seem that ‘doable’ any more; we
should be happy to clock 7% this fiscal year and the next.
 However, one positive point in favour of India is the
fact that Indian Banks are more or less secured from the ill-effects of sub-prime
mess. A glance at Indian banks’ balance sheets would show that their exposure
to complex instruments like CDOs is almost nil. In India, still the major
banking operations are in the hands of Public Sector Banks who exercise
extreme cautions in disbursing loans to needy people/companies. As a result,
we are not likely to see a repeat of sub-prime crisis in India. Though there have
been a presence of big US/European Banks in India and even some Indian
banks (like ICICI) have some foreign subsidiary with stake in the sub-prime
losses, there presence is miniscule as compare to the overall size of Indian
banking industry. So at least on this major front we need not worry much.
However, a global depression is likely to result in a fall
in demand of all types of consumer goods. In 2007-08, India sold 13.5% of its
goods to foreign buyers. A fall in demand is likely to affect the growth rate this
year. Our export may get affected badly.
A negative atmosphere, shortage of cash, fall in demands,
reducing growth rate and uncertainties in the market are some of the most
visible aspects of an economic depression. What started as a small matter of
sub-prime loan defaulters has now become a subject of global discussion and
has engulfed the global economy scenario.
Table 1: Rate of Growth at Factor Cost at 1999-2000 Prices(%)
2003- 2004- 2005- 2006- 2007- 2008-
04 05 06 07 08 09
Agriculture, forestry and 10 0 5.8 4 4.9 1.6
fishing.
Mining and Quarrying 3.1 8.2 4.9 8.8 3.3 3.6
Manufacturing 6.6 8.7 9.1 11.8 8.2 2.4
Electricity & gas and 4.8 7.9 5.1 5.3 5.3 3.4
water supply
Constructions 12 16.1 16.2 11.8 10.1 7.2
Trade, hotels 10.1 7.7 10.3 10.4 10.9 9
Transport and 15.3 15.6 14.9 16.3 15.5 9
communication
Finance, Insurance, Real 5.6 8.7 11.4 13.8 11.7 7.8
estate & business
services
Community, Social & 5.4 6.8 7.1 5.7 6.8 13.1
Personal services
Total GDP 8.5 7.5 9.5 9.7 9 6.7
Table 1: Rate of Growth at Factor Cost at 1999-2000 Prices(%)
2007-08 2008-09
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Agriculture, forestry 4.3 3.9 8.1 2.2 3 2.7 -0.8 2.7
and fishing.
Mining and Quarrying 0.1 3.8 4.2 4.7 4.6 3.7 4.9 1.6
Manufacturing 10 8.2 8.6 6.3 5.5 5.1 0.9 -1.4
Electricity & gas 6.9 5.9 3.8 4.6 2.7 3.8 3.5 3.6
and water supply
Constructions 11 13.4 9.7 6.9 8.4 9.6 4.2 6.8
Trade, hotels, 13.1 10.9 11.7 13.8 13 12.1 5.9 6.3
Transport and
communication
Finance, Insurance, 12.6 12.4 11.9 10.3 6.9 6.4 8.3 9.5
Real estate & business
services
Community, Social 4.5 7.1 5.5 9.5 8.2 9 22.5 12.5
& Personal services
Total GDP 9.2 9 9.3 8.6 7.8 7.7 5.8 5.8
 Global Financial Crisis (2)
Current Account Balance (per cent to GDP)
1995- 2000-
Country 1990-94 99 04 2005 2006 2007 2008
China 1.4 1.9 2.4 7.2 9.5 11.0 10.0
India -1.3 -1.3 0.5 -1.3 -1.1 -1.0 -2.8
Russia 0.9 3.5 11.2 11.0 9.5 5.9 6.1
Saudi Arabia -11.7 -2.4 10.6 28.7 27.9 25.1 28.9
United Arab
Emirates 8.3 4.6 9.9 18.0 22.6 16.1 15.8
United States -1.0 -2.1 -4.5 -5.9 -6.0 -5.3 -4.7
Memo:
Euro area n.a. 0.9 0.4 0.4 0.3 0.2 -0.7
Middle East -5.1 1.0 8.4 19.7 21.0 18.2 18.8
 positive effect on India….
First positive effect of this Depression is that the Indian stock
market is again returning to core fundamentals. For the last few months the
market was soaring at such a high pace that it defied any business logic or
commonsense. People were not ready to listen the same advice and everybody
was ready to ride this bandwagon of a super bullish environment. The pace in
the market was primarily due to heavy buying from big investors (FIIs to be
precise). However, this buying was so huge that an imaginary atmosphere of
ever increasing Sensex was developed.
It is common knowledge that Share prices should be determined
on the basis of the performance of the companies in their respective fields.
However, the stocks of these companies were telling an entirely different
stories. The stocks which used to sell on a price range of 15 to 20 Price by
Earning ratio (P/E) were being sold for a P/E ratio of 45-50 . This price was
simply an inflated price with no solid logic behind it. However, people were in
a rush to buy shares even on these price on the belief that the prices will soar
more and they will be able to make some serious cash.
 The recent fall in the stock market has helped in cooling
off the heated share prices and has brought a common sense in the market. The
prices have come down to their realistic value and this in fact is a very positive
development for the Indian economy. The fall in prices has given a buying
opportunity to those investors who wanted to buy stocks of companies but
could not do so owing to their exorbitant prices. In the long run, this price
correction will greatly help the Indian companies as only long term and serious
investors will be able to get the real profit. The short term and non-serious
investors will slowly move away and a stability will come in the market.
The second positive development of this US depression
will come in the form of a fall in the global prices of Oil. A US depression
clearly means a fall in the demand of oil. The lowering of demand will result
in the fall of oil prices. This fall in oil prices will help India and China the
most as these economies are having the fastest growth rate and a decrease in
oil prices will keep deflation in control .The end result : more demand and
more production.
There is one scenario, however, which may spoil the party.
If the OPEC countries (the group of Oil exporters countries) decide to lower
their oil production in view of fall in demand from America, there will again
be a increase in the global oil prices. It is, however, believed that OPEC can be
persuaded for not doing this.
 The third and final benefit from a US depression for India
is that soon we may see a fall in the interest rate here. As US federal bank is
regularly lowering interest rates to control the economy, the investment in US is
becoming less and less attractive. As a result, the big investors are heading
towards other profitable markets like India. This has resulted into a big dollar
inflow into India making our currency rupee very strong which is pinching the
exporters. Further, as interest rates are at their peak at the moment, this, along
with a strong rupee has made many Indian companies postpone their investment
plans for future. This situation, however, cannot last for long as doing so will
hamper the growth rate. The only solution available is to decrease the interest
rate which will make lending easy and spur the growth in many sectors. This
will increase the inflow of money into the economy and give a boost to the
demands. Further, a lower interest rate will also put a break on dollar inflow as
the investment in India will become less profitable. Though, today, the Reserve
Bank of India has not announced any decrease in interest rate and has asked the
Banks to take a decision on their own, it is certain that sooner or later a
reduction in interest rate is inevitable. Since India’s economy is not heavily
dependent on US Economy and it has its own huge domestic market, a lower
interest will give a boost to the production and help the economy.
 conclusion….
So these were the three main benefits of a US depression for
India. Though I know that depression is not good for any country and it comes
with lots of pain and disappointment, in my opinion, this depression will not be
a dreaded one for the US too. For the first time in the history of a depression in
America, the world has a counterbalance in the economies of India and China
which will keep driving the world’s economic engine even in tried and tested
times.
The world is fast becoming a global village. We all have
become interconnected with each others. What happens to one affects the other.
There was never such a time in the history when we get to see so direct and
interconnected effects of worlds events as we are witnessing today. Let us hope
that we all get through the difficult times successfully