Monday, October 20, 2008

Global financial crisis. Why did it hit India? What should it do?

Why did the current global financial crisis affect India? What could India do?

India did not lend in a great way to subprime borrowers within its borders. Nor did its banks and financial institutions invest in the subprime related assets (barring the ICICI Bank to a small extant; but which by no means can really pull it down) in the US. In spite of this, how come we are witnessing a downturn in our financial fortunes? Why are our markets collapsing? What could be the possible reasons? How can this be explained?

In a very well written article Arthur Okun, Professor of Yale University reels out the reasons and the possible course of action that India should take. Worth a read. Do so here. Some excerpts which I found are worth our filing in our library:

Actually, the similarity of market behaviour across countries is evidence that something else, deeper than the causes that are usually given for the subprime crisis in the US, is at work.

The most fundamental problem is found in the swings of overconfidence that was seen in many countries since the 1990s, overconfidence shared by millions, billions, of people. And this confidence has been very strong until recently.

In the US, consumer confidence rose to near-record levels at the time of the peak in the stock market around 2000. This high level of confidence, shared in many other countries as well, was related to the booming markets and booming economy of that time. The booming markets and economy were in turn substantially buoyed by the high confidence, in a feedback loop.

Recently, confidence has been fading. In the US, confidence has fallen sharply since 2006, now below the lowest levels reached in the 2001 recession. This decline in confidence is seen in other countries as well.

But economic confidence, the true state of mind that affects asset markets and the economy, is difficult to measure by any survey. The seizing up of credit markets, amidst the reports of a financial spectacle that is going on in the US that is reminiscent of the Great Depression, certainly changes people’s thinking all over the world.

When people expect good performance from their investment assets, they tend to bid up their prices. That is what was happening in many places around the world in the years leading up to the current crisis, until markets collapsed.

The subprime crisis in the US is only a symptom of this fundamental problem. The deterioration in mortgage lending standards in the US since the 1990s is not an exogenous cause of the crisis. It is, in substantial measure, a consequence of the overconfidence that is the real cause. Mortgage lending standards deteriorated because people thought that home prices can only go up, and so they thought there is little risk in writing mortgages with few protections.

Even the loose Fed monetary policy in the US is, in a way, derived from the overconfidence. The Fed was willing to have such loose monetary policy because, under Alan Greenspan, it was so unaware of the bubble in home prices, thought it was just another sign of spectacular economic growth, and so felt no concern about it.

India is part of world culture and is not invulnerable to changing patterns of thinking about investment. Much of what happens in speculative markets in India is just the same as in other countries. But India must rank as among the most vulnerable in the world to speculative turbulence, since she appears to be undergoing such a dramatic economic revolution, a revolution that, along with China’s, is the talk of the world, and that allows imaginations to run wild and confuses traditional and sober thinking.

So, India appears not at all invulnerable to the current crisis. She urgently needs to take many of the same actions that are called for in other countries. Some serious work needs to be done to improve the quality of the financial markets, both expanding regulation and consumer protection, but also expanding the scope integrity of the markets and their retail products. Work needs to be done now to democratise finance, to make enlightened risk management available to everyone, by subsidising financial advice and education.

PS: While discussing about the current financial crisis and its impact on India, it is very important that we keep ourselves abreast of the reflections of some great minds like KV Kamath and Vinod Dham. Kamath feels that we are affected by sentiments rather than fundamentals and that the current crisis will test the economy’s resilience and provide it with insights to build an even more robust framework for reforms. Vinod Dham feels that the current crisis offers a boon for the country.

1 Comment:

Renjith Nair said...

http://renjithmn.wordpress.com/2008/10/25/global-economic-downturn-and-indian-reality/