More local reasons for the boost range from the need for mutual funds to window-dress their net asset values at the end of the quarter, market-boosting action by insurers and fear from short-sellers about being caught on the wrong foot if rate cuts or the bailout package materialize soon. Short-selling is a technique used by investors who try to profit from the falling price of a stock.

Emerging markets, including India, are a side show compared with the grand deleveraging spectacle taking place in developed markets. Until the financial system in the West is back on a stable footing, it’s futile to talk of stability in the emerging markets.

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A recent research note by Citigroup Inc. economist Yiping Huang says, “Asset prices are likely to tumble further, until the US risks stabilize. Despite the fact that the US is the centre of the crisis, every time the crisis escalates, capital leaves emerging Asia." At the time of writing, money market rates in Europe had climbed records, indicating that although the stock markets were stable, credit markets remained pulverized.

Liquidity strains have already started appearing in the economy. The Reserve Bank of India, however, has enough leeway to enhance liquidity. Sachchidanand Shukla, economist with Enam Securities Pvt. Ltd, writes, “While in the short term, India will be impacted if the credit crunch worsens due to its equity market linkages that benefited through money supply-driven growth lately, we believe that the government of India and RBI have enough ammunition to fight the credit crunch, which could be far severe in FY 2010. If the crisis is limited to the next 6-12 months, India is in a far better shape to scrape through with minimum damage provided policy impetus is provided to attract inflows."

What could be the extent of the deleveraging? A report by George Magnus, senior economic adviser with UBS AG, pointed out that “the main conclusion is that favourable factors aside, banks will have to raise more capital over the coming 18 months and shrink their balance sheets". And further, for US banks, “risk-weighted assets would have to shrink by roughly $646 billion (Rs30.3 trillion)—or by 10%, from $6.36 trillion to $5.72 trillion. For global banks covered, the percent decline is comparable, from $34.1 trillion to $30.6 trillion." That’s $3.5 trillion worth of unwinding.

And if things get really bad and the US goes the Japanese way, then “Japan’s experience over the last 30 years shows what can happen when deleveraging gets deep and protracted.

The long boom of the 1980s gave way to a 20-year period—still running—in which bank claims on the private sector have stagnated in yen terms. In the process, they dropped by about 35% of GDP between about 1989 and 1998, since when the ratio has marked time."

How long have economies taken to recover from banking crises? A World Bank research paper, Controlling Fiscal Costs of Banking Crises, by Patrick Honohan and Daniela Klingebiel (2000) has a table (extracts reproduced here) indicating the time it took for countries to recover from banking crises.

Interestingly, the authors asked the question whether countries that used large bailouts recovered faster. Their research found no obvious trade-off between fiscal costs and subsequent economic growth.

Countries that used policies such as liquidity support and blanket guarantees and regulatory forbearance did not recover faster. Rather, liquidity support appears to make recovery from a crisis longer and output losses larger.

It can be argued that the current crisis is deeper and more widespread than many of the others on the list, especially among industrial countries, although the Japanese crisis may have been worse. One reason is the Japanese authorities dithered too long in enacting comprehensive bailout legislation.

What happens to the world economy if the US goes into a recession for the next two years? During the 1980-82 US recession, precipitated by record oil prices and a tumbling dollar, the global economy had growth rates of 1.99% in 1980, 2.17% in 1981 and 0.88% in 1982.

True, the world has changed dramatically in the last 20 years and we now have multiple engines of growth. But even if global growth slows to the 2.22% recorded in 2001—the last global downturn—that will be a huge fall from the 4.94% global GDP growth recorded in 2007.

And things could get much worse if a comprehensive plan to recapitalize the dysfunctional financial system in the West is not adopted speedily.

What if nothing is done and they wait for the market to purge its own excesses? That’s exactly the view that US treasury secretary Andrew Mellon advocated in the early 1930s. Then US president Herbert Hoover said of him: “He held that even a panic was not altogether a bad thing."

Mellon had said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people." What followed was the Great Depression.

While that’s unlikely to happen, this bear market is not going to go away any time soon.

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