Mumbai: As we start 2008, the global financial system is facing an unprecedented crisis, a crisis that threatens to down the shutters at mortgage firms and banks, and leave others badly bruised, saddled with billions of dollars of bad debts.
The problem started with the US housing market, where a lot of imprudent loans had been given to borrowers who couldn’t afford to repay them. When interest rates started climbing and house prices started falling, the bubble burst.
Thanks to financial innovations such as securitization, banks that made these faulty loans sliced them up, mixed them with good loans, got them rated by rating agencies and sold them to other banks all over the world. And because money was plentiful and interest rates were low, banks lapped up these “assets”. Also, because the bad loans were mixed with good ones and given a high credit rating (on the premise that only a percentage of the “subprime” loans went into default) many banks, insurance firms, pension funds, state governments and other buyers went the whole hog and bought them.
The result? Slices of these bad loans ended up in the portfolios of financial institutions across the globe and nobody has a clear idea of how much of this toxic paper is held by whom. Add to that the proliferation of derivatives on these loans which, too, are now affected by the meltdown in the values of the underlying assets and we have a situation of tremendous uncertainty in the financial markets.
The upshot of all this has been a series of write-downs by banks as they try to spot their bad assets and mark them to market. But, the problem has been exacerbated by the fact that the market in many of these instruments has disappeared because of the panic. Banks are, therefore, not willing to lend to each other and interbank lending rates, seen from rates such as Libor (London interbank offered rate), have shot up. And, if banks stop lending to each other, they can collapse. That’s why central banks across the world have stepped in and pledged to provide additional liquidity to banks.
The risks to the global economy are now fourfold.
One, a housing slump sends the US into a recession and, since the US is the main engine of world economic growth, this could slow the global economy. Former US Federal Reserve chairman Alan Greenspan recently warned that the US has a 50% chance of a recession.
Two, the bad-loan problem has led to many banks having to rescue some of their beleaguered funds by taking them onto their balance sheets. Citigroup, for instance, took $4.9 billion (Rs19,306 crore) of assets from its structured investment vehicles. This will constrain the ability of these banks to lend further. In any case, after getting their fingers so badly burnt by their exposure to subprime loans and derivatives, banks are likely to significantly tighten their lending standards. This means that although central banks may cut rates to boost demand, banks may be unwilling to lend.
Three, a lot of the market liquidity was being supplied by the explosion of credit derivatives. That is likely to come down significantly after the crisis and lending to hedge funds, too, is likely to come under the scanner. Again, the net effect will be lower liquidity. Since liquidity has been behind the stock market boom of the last few years, once it dips it could impact the prices. Corporations will no longer have the ability to obtain unlimited quantities of funding from these markets and, as a result, their growth plans could falter. Already, international bond issuance in the third quarter of the year has been just one-third of the amounts raised in the second quarter.
The fourth risk to global growth is the most problematic of all, as it raises the possibility of stagflation, or a mixture of stagnation and inflation, that was characteristic of the1970s. The worry is that although the US might slow, emerging nations such as China and India will continue to grow, as a result of which commodity prices would remain high. Food?prices,?for?instance,?have?spiralled while?oil?prices,?too,?continue?to?be?high. Also, the falling dollar makes imports more expensive, adding to inflation in the US. The Fed may not, therefore, find it easy to reduce interest rates to tackle the credit crisis, because it would risk stoking inflation even further.
For all these reasons, the International Monetary Fund (IMF) has said global growth will slow in 2008 to 4.8%, down from 5.2% this year, and IMF could revise it even further.
What will be the impact on India? Speaking at the meeting of the National Development Council to approve the 11th Plan, Prime Minister Manmohan Singh said: “There are worries that growth of the US and other leading economies may slow down and some may even go into a recession. This may impact both our exports as well as capital flows.” He was quite candid in his admission that Indian economy is now increasingly integrated into the global economy with the external sector now accounting for almost 40% of gross domestic product (GDP) and hence, “we cannot be fully immune to international developments.”
Foreign institutional investors (FIIs), the main driver of the Indian stock market, have been selling stocks. Since September-end, net FII investments have come down from a record $17.8 billion to $17.2 billion. Apart from a slowdown, the FIIs’ worst fear is tightening measures that Indian financial sector regulators may flow to rein in the capital flow.
The Sensex, India’s bellwether equity index, has gained 45.41% in 2007 on top of 46.8% growth in 2006. The growth may not sustain and the most basic risk in the market is of valuation, say analysts. The current valuation of Indian stocks has factored in growth rate predictions for fiscal 2008. If there is a slowdown in corporate earnings, there could be some disappointment in Indian markets. “We expect little slowdown in the growth rate. If this happens, on the back of a global slowdown and rising inflation, market growth will be affected,” says Ramdeo Aggarwal, managing director of domestic brokerage Motilal Oswal Securities Ltd.
Brokerages are also keeping a close eye on national politics. “If the Left parties withdraw support from the coalition government, it could create panic in domestic market,” says Promod Kasat, director of global markets division at Deutsche Bank AG in India. According to him, the rhetoric of the Left parties in 2007 has made investors wary of the increasing political risk in India. Political risk, especially that of an early election, could slow decision making and hence impact corporate growth.
If demand slows in the US and Europe, the rate of growth of exports will slow. With Indian companies increasingly integrated with the global economy, the possibility of a global slowdown is the primary risk facing Indian firms in 2008. The proportion of exports in India’s GDP has risen considerably, led by exports of IT services. While export-oriented firms face the biggest threat of a global demand slowdown, even companies focused on sectors such as commodities could be hit. In fact, the expectation of a drop in demand has already hit prices of non-ferrous metals such as aluminium and zinc in 2007.
The global credit crunch, too, will hit Indian firms hard. According to Abheek Barua, chief economist at HDFC Bank Ltd, access to external funds will not be easy and it would be too simplistic to assume the credit needs of Indian companies would be met by Asian sovereign wealth funds. “I’m not too sure sovereign funds will ease the tight credit situation, since everyone is turning to them,” he says. “They may prefer picking up US assets at throwaway prices, rather than invest in riskier emerging market assets.”
To be sure, Asian and West Asian sovereign funds have committed funds worth nearly $25 billion in troubled international banks.
Adds Michael Gordon, head of investment strategy at Fidelity International: “Leverage, which has underpinned so much of the rise in all markets over the last couple of years, is no longer readily available on attractive terms. The era of easy credit is over.” Gordon’s advice is that it’s important for investors to move away from leveraged assets, considering that aftershocks of the credit squeeze in mid-2007 will continue to be felt in the banking system.
Indian firms that have resorted to high leverage to fund large global acquisition could face challenges in 2008. Besides, since overseas acquisitions by Indian companies reached new heights this year with mega transactions such as the purchase of Corus Group Plc. and Novelis Inc., 2008 would be the year when the spotlight will be on how successfully these will be integrated by their buyers. Experts, however, say the credit crunch and a possible slowdown could well turn out to be an opportunity for more Indian firms that are scouting for global acquisitions, as they would be able to buy assets relatively cheap without strong competition from private equity firms. According to Sanjay Sinha, chief investment officer at SBI Mutual Fund, the key risk facing Indian companies is that of execution. “Current estimates of growth in financial year 2008-09 are based on the assumption that the capacity expansion under way will come on stream in time,” he says. “Delayed execution would put growth at risk.”
Other risks facing companies include high oil prices, an even stronger rupee and political uncertainty. In his outlook for 2008, Tushar Poddar, an economist at Goldman Sachs, predicts that capital inflows are likely to remain strong, enticed by India’s growth story and this will put pressure on the rupee to continue appreciating, albeit at a lower rate compared with 2007.
Finally, the tight money policy of the Indian banking regulator is also being seen as a risk factor. The Reserve Bank of India has raised its policy rate twice, by a quarter percentage point each in 2007 to 7.75%, while the banks’ cash reserve kept with the apex bank has been raised by 1.5 percentage point to 7.5%, draining out liquidity from the financial system. As a result, the economy has started to decelerate.
The silver lining is that India’s dependence on domestic demand for growth insulates it to some extent from a global slowdown. That is why a Citigroup report recently said India is one of the best places to hide in a global downturn. That’s probably the main reason why, despite the many obvious downside risks ahead, few people talk of less than 8% growth for India’s GDP in 2008.
Mobis Philipose and Nesil Staney contributed to this story.