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Slide 1: The Sub Prime Financial Crisis and India Alok Sheel Secretary Economic Advisory Council to the Prime Minister
Slide 2: 2007 – The ‘INDIA’ Growth Story ж ж ж ж ж 9% growth rate 5-7% WPI inflation Tsunami of capital inflows Favourable external environment Muted inflationary expectations (productivity gains due to greater global integration) But………………….. Central Bank was battling on two interrelated fronts җ җ Rupee appreciation Sterilizing the reserves to manage money supply
Slide 3: India : Growth story India: Macroeconomic Fundamentals 2003/04 - 2007/08 10 9 8 7 6 5 4 GDP WPI_infl Res_accretion X_rate 2003/04 8.5 4.6 107.4 45.95 2004/05 7.5 5.1 26.2 44.932 2005/06 9.4 4.1 15.1 44.273 2006/07 9.6 6.7 36.6 45.28 2007/08 9 7.7 92.2 40.24 105 95 85 75 65 55 45 35 25 15
Slide 4: Benign External Environment Global Growth and Inflation : 1990 - 2007 (IMF data) 9 8 7 6 5 4 3 2 1 0 Av. 9099 2000 2001 2002 2003 2004 2005 2006 2007 20 18 16 14 12 10 8 6 4 2 0 World_gr Advanced_infl Advanced_gr Developing_infl Developing_gr
Slide 5: 2007 – The silent storm Meanwhile, a silent storm brewed in international financial markets with origins in the US housing market  Housing market • • • • • Mainstay of household demand in OECD countries including US Unprecedented boom since 2001 Fed on excess liquidity generated by global imbalances and financial innovation Real interest rates in US were negative High levels of leverage The boom was led by rising housing prices, low interest rates and exacerbated by financial innovation
Slide 6: Feeding the Housing Boom  Current Account Balance of Emerging Markets and US Graph CAB 700 600 500 400 300 200 100 1998 2002 2006 1996 1997 1999 2000 2001 2003 2004 2005 2007 2008 0 -100 -200 Real_IR 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% Real Interest Rates (Fed Funds Rate minus US CPI-Urban)
Slide 7: Financial Innovation Housing Loans Sub prime borrowers Complex Structured Derivatives Housing loans offered at back loaded teaser interest rates  Assuming that borrowers could refinance the sub prime loans through gains in home equity But loan originating banks were smart……………………………….. 
Slide 8: What did the banks do? Offloaded the sub prime loans from their balance sheet through Instruments like Collateralized Debt Obligations Modus Operandi of banks (loan originators)     Pool together mortgages, including sub prime loans, into CDOS Get top notch credit ratings for senior tranches Retain the highly rated senior derivatives through SIVS Repackage the lower rated derivatives to transform them into synthetic CDOs Investors : Hedge funds, money market and pension funds High Risk High Return in a low interest rate environment Was the mantra which drove these investments
Slide 9: How did the investors buy?  Hedge/money market/equity funds Accessed short term funds through ‘carry trade’ Pension and insurance funds invested because of top notch ratings Investment funds and investment banks invested their own funds through high leverage by recycling capital several times over on a thin capital base   Sharp rise in derivatives CDO and CDS issuance CDO 2004 - $25 billion 2007 - $186 billion Derivatives Industry 2002 - $ 103 trillion (3 X Global GDP) 2007 - $ 450 trillion (9 X Global GDP)
Slide 10: The boom begins to unravel from …. 2004    US Fed reacts to rising consumer and asset prices by monetary tightening from second half of 2004 Housing prices begin to fall by end of 2006 Rising interest rates and falling housing prices lead to Rise in subprime mortgage delinquencies & foreclosures US mortgages are non recourse Difficulty in refinancing
Slide 11: 220 210 200 190 180 170 160 150 140 130 120 110 100 Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Schillers Housing Index FFR (Intended) 0 1 2 3 4 5 6 7 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 The crisis deepens US CPI Urban - Case Shillers Housing Index (US Dept. of Labor, US Fed and S&P) US CPI Urban ………. 2007
Slide 12: The crisis deepens ж ж ж ………. 2007 Subprime loans at $1.2 trillion - only 13% of total housing mortgages but The complex structuring and repackaging created uncertainty Market could not pin point the delinquencies Heightened perception of counter party risk ж ж ж Price of & market for derivatives fell sharply because of fire sales Credit markets froze: ‘Ted’ and ‘CDS’ spreads symptomatic Banks forced to take back illiquid assets on their balance sheets and book losses of $ 500 billion to date [IMF’s estimate of total losses close to $ 1 Trillion)
Slide 13: The contagion spreads…..   US Fed serially lowered interest rates, opened credit window to exposed investment banks and bailed out stressed FIs like Bears Stearns and more recently Fannie Mae and Freddie Mac. Lehman Bros. on verge of collapse. US Treasury provided fiscal stimulus of $ 150 billion tax rebates to sustain demand. however In the US the housing prices and sales continue to plummet and foreclosures to rise after brief rallies following each intervention Ten US banks have failed – FDIC has put over 100 US banks on watchlist !! Contagion spreads to both OECD countries and emerging markets The financial tsunami combined with a boom in commodity prices to coalesce into a ‘perfect (stagflationary) storm’ that has left central banks confused whether to tighten (Europe) or loosen (US) monetary policy.    
Slide 14: Credit Crisis – Commodity link The link between the financial crisis and commodity prices (oil)  Commodity prices rising steadily from 2002 on account of above trend global GDP growth, especially in China and emerging markets  Sharp depreciation of the ‘$’   US $, already under pressure due to widening US trade deficit, plummeted as US Fed dramatically lowered interest rates while rest of the world was tightening monetary policy $ is the currency in which oil is traded - as $ depreciates oil prices rise (subsequent decline in commodity prices was accompanied by a recovery in US $ )  Plummeting real estate, stock and financial asset prices redirected excess liquidity towards commodities and oil – intensifying price rise after August 2007 (speculation in futures markets and shorting of financial stock to invest in commodities worsened the price rise)
Slide 15: Relative Asset Price Movement Q2/08 Q1/08 Q4/07 Q3/07 Q2/07 Q1/07 Q4/06 Q3/06 Q2/06 Q1/06 Q4/05 Q3/05 Q2/05 Q1/05 Q4/04 Q3/04 Q2/04 Q1/04 Q4/03 Q3/03 Q2/03 Q1/03 Q4/02 Q3/02 Q2/02 Q1/02 Q4/01 Q3/01 Q2/01 Q1/01 Q4/00 Q3/00 Q2/00 Q1/00 S&P Housing Composite 20 Feds Fund Intended Rogers Commodity Index 45 0 40 0 US-Euro DJIA 35 0 30 0 25 0 20 0 15 0 10 0 50 0 Quarter
Slide 17: Impact of Sub Prime crisis on India No direct impact: Structured finance undeveloped No deleveraging On the contrary India and China were seen as saviours of a ‘decoupling’ global economy Result capital influx, currency appreciation, stock market boom
Slide 18: Impact on India – second round The second round effect of Sub Prime + spike in oil prices was devastating for Asian countries, including India But for the macroeconomic cushion of low external debt Ratio and fiscal deficits and comfortable reserves this had the ingredients of a classic currency crisis
Slide 19: The devastation  Oil shock – worsening current account balance   India’s merchandise trade deficit in April-July 2008 increased by 50% BRIC may split – prospects of Brazil/Russia brightened& that of India/China darkened  Sharp increase in inflation – food & oil the culprits     Governments could no longer fully insulate consumers from increase in retail oil prices Spike in food prices through biofuels link Higher weightage of food and oil in the consumption basket of developing world July 2008- CPI at 9.41% and WPI at 12%+  Increase in fiscal deficit    Government absorbed part of the increase in oil and food prices – lower savings EAC’s estimate of off balance sheet deficit on account of rising food and oil prices – 4.5% of GDP Threat of credit downgrade  Decline in Capital flows   Sharp decline in stock market capitalization and bearish markets Rupee under pressure – feeds inflation  Decline in Growth [EAC’s estimate for 2007-08 : 7.7%]   Rising interest rates hurt consumption and investment Rise in fiscal deficit and decline in corporate profits result in fall in savings
Slide 20: The devastating effect Consumer price inflation 16 14 12 10 8 6 4 2 0 Thailand India China South Korea Germany U.K. May/June Year ago Brazil Russia Soudi Arabia U.S
Slide 21: The devastating effect BSE Sensex and FII Equity Sensex Close 21000 20000 19000 18000 17000 16000 15000 14000 13000 12000 11000 November 2007 September 2007 December 2007 February 2007 February 2008 October 2007 January 2007 January 2008 March 2007 August 2007 March 2008 August 2008 June 2007 June 2008 May 2007 May 2008 July 2007 April 2007 April 2008 July 2008 FII Equity $M 7000.00 6000.00 5000.00 4000.00 3000.00 2000.00 1000.00 0.00 -1000.00 -2000.00 -3000.00 -4000.00 10000
Slide 22: 39 January 2007 February 2007 March 2007 April 2007 May 2007 June 2007 July 2007 August 2007 September 2007 October 2007 November 2007 December 2007 January 2008 February 2008 March 2008 April 2008 May 2008 June 2008 July 1 2008 August 1 2008 September 10 2008 US Dollar - Indian Rupee Exchange Rate (RBI) The devastating effect 40 41 42 43 44 45 46
Slide 23: The domino effect     Adjustments in financial sector immediate, in the real sector with a lag US growth negative in first quarter of 2008, Euro area and Japan little affected Second quarter low to negative growth in Euro area ignites fears of recession in Euro area and Japan because of contraction of US demand, high oil prices, delevering and tight monetary policy. Surprisingly robust annualized growth of 3.3 % in the US in the 2nd qtr because of loose monetary policy, export growth because of weak dollar [xports accounted for 3.1/3.3 % of growth] and fiscal stimulus. Unlikely to be sustained because of strengthening dollar, continued delevering, household demand destruction through negative housing equity and waning fiscal stimulus Emerging economies adversely impacted by demand destruction in ‘global consumer of the last resort’: US major trading partner for India (15% of exports), Brazil and China (20% of exports)
Slide 24: Crystal Ball Gazing ж Commodity prices: the canary in the gold mine falling since July 2008 ж ж A correction? Still 50% higher than January 2007 Pricking of a financial bubble? ж Credit crisis and Deleveraging persists, but the global imbalances that inflated the sub prime bubble intact ж ж Will they go into dollar assets [treasuries] because of global uncertainties? Or back to emerging Asia if commodity prices soften? ж Two canaries to watch in the gold mine ж ж commodity prices TED spreads
Slide 25: Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 2000 2500 3000 3500 4000 4500 5000 5500 6000 Rogers Inte rnational Commodity Index Commodity Prices
Slide 26: Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 TED Spreads 2000 2500 3000 3500 4000 4500 5000 5500 6000 Rogers International Commodity Index
Slide 27: Can India and China rescue the world? Emerging markets have borne the brunt of the second round impact and are themselves bearish
Slide 28: Lessons of the sub prime crisis for India  You cannot decouple from the world’s biggest economy in a fast integrating world Sophisticated structured finance products can become ‘weapons of mass destruction’ Moral hazard and financial sector liberalization RBI must rethink the concept of Universal Banking Focus on ‘Credit Discipline’ as a corrective to financial inclusion Reconsider basing monetary policy entirely on movements in consumer prices alone     
Slide 29: Thank You