Contagion of crisis

Print edition : August 07, 2015
While the volume is rich in material, insights and discussions on policies, the authors appear to be hesitant to enter into crucial matters relating to broader policy issues and their ramifications.

THIS volume authored by a former Governor of the Reserve Bank of India, a former civil servant and an economist formerly with the International Monetary Fund (IMF) will not be easy reading for the general reader. Even those who are fairly familiar with the global financial crisis of 2007-09 may not find the book particularly easy to follow. However, the book deals with an important but little understood aspect of the crisis that needs to be brought to the attention of the public at large. A statement from the preface puts it thus: “What started as a financial crisis is still running its course, transforming itself into an economic, if not a sociopolitical crisis.”

While the volume is technical, its attempt is not to trace the links between financial and fiscal policies in abstract terms. It deals with the real world examining in some detail what happened in the United States initially, how it soon impacted countries of the European Union (E.U.) almost simultaneously, and then became quite global. Because of the variety of problems faced by the European countries, including those that are not members of the E.U., a major part of the book is devoted to these issues. This review does not go into those details. Instead, its emphasis is to bring out the manner in which aggressively growing financial activities (those dealing with credit, and, therefore, of the banking systems under the guidance and supervision of the Central Bank) easily draw in countries across the globe, while measures to counter them (such as fiscal activities and primarily taxation) have to be designed by each country depending on its own specific situation. Matters are further complicated when inter-country economic relationships are involved and the global reserve currency happens to be the currency of a specific country, at present the U.S. dollar.

Ninja loans

A quick recap of the crisis, as it first manifested itself in the U.S. and soon spread to other countries, may be helpful. The 21st century opened on a recessionary note in the U.S. One of the counter-recessionary steps was to stimulate demand and encourage investment by making available credit to households to own houses. The initial response was so encouraging that credit from the banking sector started flowing at very low rates of interest and neglecting standard norms of credit-worthiness to such an extent that it came to be called “ninja loans”—no income, no jobs, no assets required to qualify for loans. In the meanwhile, investment banks that thrived on dealings in packaged collaterals were showing big profits and there was a large flow of liquid capital into what has come to be known as “collateralised debt obligations” (CDO). Indeed, the most profitable economic activity was in this arena of finance, certified by the soaring share markets. Monetary policy appeared to be on the right lines with the “market” leading the economy in the right direction. Growth started picking up (concealing the fact that the rapidly growing incomes and wealth were very much at the top, as shown later by considerable increase in inequalities). However, as it was essentially a speculative boom, it was short-lived. Borrowers started defaulting, adversely affecting the banks, smaller ones to begin with. In turn, it cast a shadow over many investment banks and insurance companies. The larger ones, which considered themselves “too big to fail”, held on for a while with credit being made available to them liberally. But by the fourth quarter of 2007, Citigroup, Merrill Lynch, Lehman Brothers and Bank of America were affected. Lehman Brothers, in particular, being outside the banking system, could not get official credit support and became insolvent, followed by AIG, the giant insurance firm. The Federal Reserve brought the interest rate close to zero. Even that could not save the situation. The Treasury had to step in followed by the government officially admitting by the third quarter of 2008 that the economy was in a recessionary phase. Production suffered and unemployment kept rising. Fiscal policies soon took over, with tax concessions, budgetary deficits, public borrowing, and so on. One of the consequences of these measures was to increase public debt with clear political overtones.

Because of the overreach of finance to other parts of the world with shares of companies registered in one country being held by citizens of other countries and the share markets thus becoming “global”, it is not surprising that recession starting in one country almost instantly spreads to other parts as well. As a result of the close economic links between the U.S. and Europe, especially with members of the E.U., they were the first to experience the contagion effect. Within the E.U., the specific measures to deal with the recession differed considerably because it is a currency union without political union. In countries such as Spain and Greece, there was the additional problem that public debt was denominated in foreign currencies, especially the dollar, so that mounting public debt took the form of sovereign debt also, that is, sovereign states being indebted to citizens of other countries.

Such were the circumstances under which policy measures had to be put into action, financial measures by the banking system led by the respective Central Banks and by the governments. Coordinating the financial and the fiscal was the main issue and continues to be so although, officially at least, the crisis is over.

Crisis spreads to India

How did India fare? Unlike the European countries, the Indian banking sector had near-zero exposure to the U.S. sub-prime mortgage market and so was largely insulated from the direct impact of the U.S. fiasco.

The authors, however, point out that given the globalisation of the Indian financial market and the role that the multinational corporations (MNCs) had come to play after the economy was “opened up” in the early 1990s, India was not completely protected either. The fall of Lehman Brothers in September 2008 caused ripples in India. The Reserve Bank of India, with Y.V. Reddy as the Governor, started taking corrective action immediately. Remedial measures included reduction of repo rates, the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR), all fairly conventional measures to increase liquidity in the system. The fact that the nationalised banking sector was largely under government’s supervision was an advantage. For instance, already in 2002 a programme of building up an investment fluctuation reserve had been started and restrictions were imposed on non-government securities. Even standard assets and loans were subject to pre-assigned limits. On the fiscal side, too, action was promptly taken, which included tax relief and increased expenditure on public projects to create employment and public assets.

Timely and effective interventions reduced the impact of the global recession on India. In 2009, the peak of the crisis, India posted a growth rate of 5.9 per cent, which was creditable indeed. Even so, the Indian economy was not totally immune to the global event because of its growing openness. In terms of exports and imports of goods as percentage of gross domestic product (GDP), openness increased from 20 per cent in the 1990s to close to 40 per cent in 2008-09 and if services are included the increase was from 23 per cent to over 53 per cent during the same period. Secondly, and more important from the point of view of volatility, a substantial share of foreign capital flow into the country was by foreign institutional investors (FIIs). Such capital flow reversals also played a prominent part during the crisis period.

As the authors put it: “The contagion of the crisis spread to India through all the channels—the financial channel, the real economy channel, and importantly, the confidence channel…”

While the volume is rich in material, insights and discussions on policies, the authors appear to be hesitant to enter into crucial matters relating to broader policy issues and their ramifications. For instance, in the context of recovery from a recessionary phase a much-debated issue is whether imposing austerity is the proper step to get out of a recession (a much-discussed topic in Greece, for instance). This is being debated in many parts of the globe as an economic as well as a socio-political theme. In turn, it is related to the whole problem of inequalities —finding expression in popular parlance as the 99 per cent versus the 1 per cent—bringing out the fact that the top income earners (and wealth holders) benefit both by prosperity and by recession. Similarly, while there is a sustained attempt in the volume to underline the adverse impact that recessions have on long-term growth of economies, the desired nature of that growth process is not touched upon at all. The neglect of these broader themes comes as an anti-climax, especially after raising expectations that there would be an unravelling of how what starts as a financial crisis transforms itself into a sociopolitical one.

Let it be noted, too, that responsible decision-makers have started warning that the global economy is slipping into “Great Depression-like problems of the 1930s”. If so, there is no way of hiding from the larger social and political calamities that an economic crisis can give rise to.

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