Expect nothing, live frugally on surprise.

Thursday, November 13, 2008

Economic Crisis: How to get out of the squeeze

Will the world come to a spectacular and disastrous financial end? Credit markets across the globe, which were flush with liquidity not too long ago, are in a limbo as inter-bank borrowing stands frozen after a series of prominent write-downs, insolvencies and collapses.Suddenly, it’s clear that everyone and everything is connected. This connection is due to the frictionless flow of capital across the globe. But while a crisis in leading economies can spill over to the rest of the world, the bubble itself cannot be attributed to this ‘connectedness’. What the bubble truly needed to ‘inflate’ beyond all expectations was the age-old artificial booster of purchasing power: leverage. And it is this leverage that lies at the root of most of the evils that threaten to disrupt the global financial system.In many ways, India presented the globally leveraged punters with a near-perfect investment story. Here was a nation of a billion people. A nation that was always brimming with talent but had somehow not managed to find its place in the sun. A cheap and seemingly unlimited supply of talented labour, a huge hinterland and mega-cities hungry for the creation of physical and digital infrastructure. A consuming class larger than the population of the United States.Income expansion, capital expenditure, infrastructure creation and the resultant consumption boost were the themes driving the ‘India story’ over 2003-7. Mutual funds garnered record inflows, even as the FDIs and portfolio investments by foreign investors soared. The result wasn’t difficult to predict: an overvalued stock market, which, by January 2008, was assuming several years of future growth as if it was assured.The only saving grace is that India’s economy, as well as its financial markets, are not as hopelessly overleveraged as those of the West. Capital adequacies at most banks are in double digits, and many leading corporates are actually cash rich rather than debt burdened. The ones that are ‘leveraged’ (prime examples would be debt-heavy real estate companies, or investors with ‘naked’ derivative positions in the stock market) would, of course, be susceptible to disproportionate losses in any downturn.While there is no denying the fact that an unprecedented phase of economic growth has been initiated, stock markets can take a long time to recover from the shock of largescale selling by FIIs and hedge funds. This is because Indian stock markets have, for some time now, relied more on foreign investors than on local institutions for emotional anchoring. The ‘main street’ might continue to struggle forward somehow, but the ‘financial street’ will find the going tough as overseas risk appetite refuses to reappear.The BSE Sensex has crashed through the psychologically important 10,000 floor and is down more than 55% from its January 2008 peak. Corporate earnings are being downgraded almost on a daily basis, while sustained FII outflows take the wind out of every rebound. Worse, GDP growth downgrades are beginning to happen almost every week now. Interest rates are refusing to fall back, reducing the consumers’ appetite to buy assets such as homes, vehicles and appliances. Capital spending by companies and development spending by government is slowing down and the job market is awash with supply.So, who exactly are these overleveraged players? Start with the sub-prime American home-owner, who ‘leveraged’ by taking on a mort-gage that he could not normally service, in the hope of home prices rising forever. Investment banks then packaged these mortgages into collateralised debt obligations (CDOs) bundles and helped banks trade them out, so they could go back and create even more mortgages. In turn, this drove up the bank leverage and home prices in a self-fulfilling virtuous cycle.The smarter investment bankers set up hedge funds and leveraged their funds using cheap yen loans to buy (and re-sell) more CDOs. Even smarter bankers then created contracts (credit default swaps—CDS— another sophisticated example of the leveraging effect of derivatives) that would guarantee such loans so that buyers could buy and sell them even more recklessly. Result: the CDS market is over $50 trillion today, which is over 3.5 times the annual US economic output and roughly equal to the global economy.American householders, already on steroids with seemingly perpetual home-price surges, merrily increased consumption by taking on more and more credit. The goods and services they consumed were provided by the factories of China, India and other Asian tigers. In turn, these economies experienced a multi-factor boom.


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