Its not economics, stupid!

I am not sure if there is any one among the common people who understands what this world financial crisis is all about and how exactly is it going to affect them but I am quite convinced the experts don’t get it. Right up to the time when some of the strongest pillars of American capitalism were going bankrupt or were bailed out with unprecedented infusion of funds the experts were confidently reassuring the common people that all was well with the financial markets and the banks. Now when the party is over; the housing bubble caused mainly by aggressive sub prime lending has burst destroying trillions of dollars of investor’s wealth across the world, the experts are back, saying it was inevitable; as if they always knew this was coming.
The ‘bust’ has exploded many a myth. One of them being banks and insurance companies never fail and that people’s money in safe deposit with them, especially the bigger banks, is absolutely safe. The credit crisis has claimed retail banks like Washington Mutual Inc. which closed down and investment banks like Bear Sterns which was taken over by J P Morgan with dollops of help from the Federal Reserve. Filing for bankruptcy by Lehman Brothers, investment bankers that defined US financial systems for over a century, sent shock waves around the world leading to a global turmoil. American International Group, one of the most venerable insurers in the world, had to be taken over by the government for about $85 billion. It compelled Allen Greenspan, former chairman of the US Federal Reserve, who presided over much of the excess lending and expansion of the sub prime mortgage market that prompted the current global economic crisis, to say that he is in a state of “shocked disbelief”. He said, "This crisis has turned out to be much broader than anything I could have imagined. The world is going through a once in a century "credit tsunami". If Greenspan could not understand what hit the economy can you blame common people if they are wondering whether their deposits in the bank are safe or if the good old stocking is a more secure option to keep their money in? If the Banks in the US of A can fail how well equipped or capitalized are they in India to cope with a similar situation? Will the ‘$ 800 billion bailout package’ prove to be enough to tide over a $3 trillion crises without damaging the confidence of the banks, the financial institutions and above all the ordinary people not only in the USA but also in countries that are either directly affected because they funded the sub prime lending or others like India whose direct exposure is perhaps limited but where the signs of the impact of the ripple effect are now becoming ominously visible?
The experts were out again and were telling us that the Indian economy was insulated from whatever is happening in the US and Europe. The Indian banking system, they said, was very robust and the Banks were adequately capitalized and well equipped to face any challenges. The government and the Reserve bank of India, they opine, are on top of the situation and will do everything necessary to insure that the common man is not too affected by the ripple effect of the world financial crisis. The question is not whether the experts in the government and the RBI are willing to something or not. The question is do they know what to do? Will monetary measures taken by the government be enough when the problem is only partly economic and more psychological? Yet it is necessary to know how the Indian economy could be impacted and more importantly how the psyche of the Indian investor can be affected. Above all what is the opportunity side of this crisis.
It is naïve to think that India is so insulated from the world economy that it will remain completely unaffected by the momentous events in the USA and Europe. Indian economy is bound to be impacted since most US companies do business with companies in India. After all despite the tremendous progress made by the Asian tigers the USA and Europe still make up over 60% of the world economy. The whole world, let alone India, is expected to reel under the effect of the current financial crises considered as the worst since the Great Depression of 1929. That is the bad news. The good news is that India will, in all likelihood come out stronger if the government and the people recognize the opportunity to build infrastructure, invest in human capital and build social security safety nets.
At the macro level what we can see is that the Sensex has gone well below the psychologically important 10000 mark and sunk even breached 8000 a day before Diwali on black Monday the 27^th of October, 2008. It has eroding more than half of shareholder’s wealth in less than nine months. The Rupee is reeling at all time low and breached fifty to a dollar. Industrial production is growing at less than 5 percent against nearly 10 percent a couple of years ago. The trade deficit at $ 63.17 billion compares very unfavourably with the 12.6 billion deficit in 2006. Fiscal deficit today is at 1,16,890 crore against 77,740 crore in 2006. So fast has been the slide that people are reeling under the impact. Investors and speculators are still trying to figure out what hit them while TV news channels are leaving no stone unturned in fanning the fire and creating a Gloom and Doom situation. The good news about three bumper back to back harvests does not seem to mean anything to the media. Suffice it to say that the media is focused on less than ten million families or forty million people affected by the ups and downs of the stock markets and not concerned about the rest of the 960 million people who also live in India. They are not exactly rolling in luxury but are celebrating a happier Diwali than they have in years.
While it is true that the economic impact of the global financial crisis on India may not be as much as it will be on some of the countries whose banks funded the sub prime lending in the US the psychological impact could be tremendous. Some of the policy decisions the government took in the past have helped prevent a full blown impact on Indian banking and financial system. For example the conservative stance on total globalization and reluctance to go ahead with capital account convertibility shielded India to an extent while some other more integrated countries are finding it very hard to bear the onslaught of a Tsunami of a financial crisis. Yet companies like Lehman Brothers, Merrill Lynch, AIG and Morgan Stanley and many others have their captive research units, brokerage arms, investment banking arms in India employing several hundred thousand people in what is popularly known as BPOs (Business Process Outsourcing) and KPOs (Knowledge Process Outsourcing). Some of these jobs could be in jeopardy. For example Lehman Brothers’ Powai unit alone employed over 2,000 people most of whom will be rendered unemployed unless some other company buys out Lehman’s India operations and keeps the wheels running like TCS has bought out Citigroup Global Services Limited. Otherwise these companies will have to downsize their workforce to remain profitable and to cut costs. Goldman Sachs has already announced it will cut 10% of its global strength. That means 200 people in their India operations will lose their jobs. A lot of US companies have also outsourced their technology-related jobs to Indian companies like Satyam Computers, TCS, and Infosys which might be affected in the near future. However this might even turn out to be an opportunity for these companies as many more US banks and companies may want to outsource work to Indian companies to reduce costs.
Sectors like real estate, aviation, and information technology have already started downsizing their employee strength. Even though Subhash Goyal of Jet Air was arm twisted into taking back the 1900 employees, a day after they were sacked, there are newspaper reports about DLF and Kingfisher reducing their staff strength by 300 because of cash crunch and sluggish business. Technology companies like TCS and IBM had removed more than 500 people each citing poor performance long before the US woke up to the financial crisis. Tata Steel laid off 300. Young graduates and professionals who have been planning to take up jobs may have to wait longer and/or accept lower packages. In the absence of any significant safety net downsizing and lay offs could hit people who lose their jobs very hard. The Government needs to act and act fast. It must convert this crisis into an opportunity to institute safety nets for the urban and rural employees who could lose their jobs because of downsizing or else we might have an epidemic of suicides which may not be as severe as the farmers’ suicides of the last decade but could be a pretty serious matter. The gruesome killing by Karthik Rajaram, a 45-year-old Indian American, who lost his high-profile job to the global financial meltdown, of his wife, mother-in-law and three children before taking his own life, is both tragic and foreboding. It is critical to step up and recognize we are in some pretty troubled times.
Another trend, a consequence of the world economic crisis, which could hit the middle class in India is raising interest rates. In the last couple of years it was the inflation rate that spoilt the party for Indian borrowers of home loans, personal loans and credit card purchases. Now it seems rising cost of money, because of illiquidity caused by distrust between banks, among other factors, will send interest rates soaring north. Banks have become so distrustful and wary of each other that inter bank lending, so crucial to smooth running of the banking industry, have dried up. They refuse to lend t each other for fear of default. Fear psychosis has gripped the banking sector and this is the real problem. If Lehman Brothers can file for bankruptcy what is a small Indian bank in comparison? So much for the Indian banking system being insulated from the events in the US. So the interest rates are headed north for some time to come whether we like it or not. Though the government has acted swiftly and has infused over Rs.185,000 crore in the economy with some desperate measures that led to easing of inter bank lending rates for the time being; rising interest rates is a trend which will take its time before it reverses. There is nothing much the government can do about it in the short run but can certainly pursue policies which will insure lower interest rates once the trend has run its course.
Similarly RBI’s effort to stop the slide in the value of the Indian Rupee against the dollar has failed miserably. India’s foreign exchange reserves were $274 billion down from $316 billion in May. The pile of reserves has come down as the RBI’s has been aggressively selling dollars in the market in an effort to stem the slide of the rupee against the US dollar. Yet that effort could not stop the rupee from slumping to its lowest level ever. The truth is when economics and psychology clash it is normally the later that triumphs. There is no other way to explain the failure of such massive government efforts to stem the economic rot. The problem in India is not that there is any real danger of a major bank failing or the government going bankrupt (like Iceland); the problem is that of confidence. There does not seem to be any dearth of capital as the government and the Reserve Bank have amply demonstrated; the problem is that of credence. The inter bank credit dried up not because there is no cash. It dried up because the banks don’t trust each other. The American sub prime lending crisis was caused by overzealous bankers disbursing loans to people who did not have means to return them. It would not be surprising if the Banks go to the other extreme now and become extremely skeptical and use extreme caution in sanctioning loans leading to lower lending and higher interest rates. ‘Greed’ was the force behind sub prime lending ‘fear’ has griped the market now. The confidence that borrowers will repay the banks’ money with interest every month has been shattered in the US and Indian borrowers will have to bear the brunt of this lack of confidence in the days to come. Some banks have already started charging higher interest on your credit card dues. What can you and I do about it. Well, pay off your loans and credit card dues as soon as possible. At least make a systematic plan and pay them off in the next three to six months. Else brace up for higher interest rates for that is the trend. With due apologies to Victor Hugo; you can stop invading armies but you can’t stop a trend once it has gained momentum and taken control of people’s psyche. A trend will run its course and that takes time.
There is some good news though, for people who have been wondering whether they will ever be able to buy a house during their life time. Real estate prices in Indian towns and cities are likely to come down by 10-15 per cent in the next few months. If the trend catches on the real estate prices could fall very sharply as developers are going to be hard pressed for cash with banks becoming so paranoid with news of housing loans being at the epicentre of the world financial crisis. Once again it is the psychology taking precedence over hard headed economics. The outcome could be developers lowering rates to lure buyers to shore up cash flows. The looming recession in the USA and Europe has brought steel and cement prices down. That should be a good news for the housing and we could see the revival of the housing activity sooner than most people expect.
The best way to begin to deal with the situation is to recognize the situation for what it is. In India it is critical but not crippling. People in the government also needs to remember that at such times it is not economic measures alone that will work. The government needs to work on the psychological and social aspects. The least it can do is not panic and not be seen to panic and have a long term perspective. The flip side of crisis is opportunity. The government can seize the opportunity and step up pace of building infrastructure when the cost of building it is low so that we are ready for the boom that will certainly follow these critical times. Whatever the state of the stock markets, commodity markets or even the currency markets the real Indian economy is still very robust and poised for another round of super growth albeit after a breather.