Market Recovery After The Historic CrisisSep 15, 2018(15:39)
The month of September 2008 seems like yesterday; the events of the month are vividly remembered. While the immediate impact is long gone, the legacy of Lehman crisis still affects us.
As compared to other major markets in Asia, the Indian export to Gross Domestic Product (GDP) ratio is low at 19%. Hence, we believe India is a domestically oriented economy and safe from a global crisis. Something is amiss with this assumption, as India runs a current account deficit (CAD), which essentially represents the gap between savings and investment. For the April-June quarter of 2018, CAD was 2.4% of GDP. This deficit needs to be funded by foreign capital flows, making India vulnerable to any change in the direction of global flows.
The Lehman crisis drove home this point, call rate in India was 9.9% on the day before Lehman and it rose to 15% within the next five days, a sign of lack of liquidity. Over the next few months, Sensex declined 42%. Turmoil in Indian markets came as a rude shock to many investors who unfortunately witnessed a sharp decline in wealth. Thus, we believe Indian investors need to watch the developments in the global economy as much as the domestic ones. Emerging economies, especially China, have a huge influence and we should pay close attention to these.
Coming to the lasting impact of the crisis, we believe that in advanced economies, stagnation in incomes has given rise to populism, trade wars being a consequence, threatening future growth and prosperity.
Back home, the government launched a stimulus program which resulted in the ballooning of the fiscal deficit. In FY 10, the general fiscal deficit touched 10% (central and state combined) of GDP. The increase in fiscal deficit had two impacts. Firstly, inflation became a problem in subsequent years. Consumer Price Index (CPI) averaged in double-digits, this occurred when GDP growth slowed down- a situation which limits policy options. Secondly, the CAD increased significantly. In the October-December quarter of 2012, the CAD was 5.1% of GDP. This hit the Indian assets hard during the taper tantrum in the summer of 2013. Since then, India has made progress, the current account deficit in the April-June quarter of 2018 was 2.4% of GDP. Similarly, the general fiscal deficit declined to 7.4% in FY17-18.
Similar to India, China also launched a massive stimulus, largely via bank credit. In 2017 credit (non-financial sector) to GDP ratio reached 257% of GDP, rising from 140% of GDP in 2008. This build-up in leverage, especially the rate at which it has increased, poses a risk not only to the Chinese economy but to the world at large. China is the largest contributor to world economic growth. Traditionally, we have always looked up to large advanced economies like the US for clues on global business cycle, but now China is important and many believe Chinese debt situation has the potential to tip the world into a recession.
According to the data from the National Bureau of Economic Research, the US economy peaked in December 2007 and the following recession ended in June 2009. However, the genesis of the financial crisis can be traced back to the aftermath of the dot-com bubble and the unfortunate terror attack in September 2001. The US Federal Reserve maintained an accommodative monetary policy. Also, to beef up foreign exchange, many nations were keen on buying US assets, thus retaining low rates and flushing the system's liquidity.
As a result of the accommodative policy, there was a misallocation of capital. Many loans were granted to borrowers with questionable credit history and potential problems in loan repayments. These were largely for home purchases. Banks packaged these loans and sold as securities to investment banks, hedge funds and other investors.
There were warnings, which were unheeded. Raghuram Rajan, then with associated IMF, in August 2005 warned about a potential crisis, other experts like Nouriel Roubini too warned, however, no action was taken. As a result, investors like John Paulson and Kyle Bass made profitable bets against the US housing market.
Housing prices in the US peaked in February 2007 and started declining by March-April 2007, signs of financial stress were quite evident. In August 2007, the Federal Reserve cut interest rates, by the end of 2007, the crisis became widespread. Steps taken by the Federal Reserve, the US government and other regulators failed to prevent the spread of the crisis. In March 2008, Bear Sterns, a prominent global investment bank, was in trouble and was taken over by JP Morgan.
On 10th September 2008, Lehman announced a loss of USD 3.9 bn, attempts to rescue Lehman were unsuccessful and on 15th September 2008 it filed for bankruptcy. This led to a significant deepening of the housing crisis which impacted financial institutions.
Following this, the US Federal Reserve Bank adopted unconventional measures; in November 2008 it announced Quantitative Easing under which balance sheet was expanded by buying securities. The balance sheet had assets of USD 925 bn before the Lehman crisis and stood at USD 4208 as on 3rd September 2018. The US delivered the first rate hike in December 2015. As the rates are hiked and the US balance sheet unwinds, the financial system too will have to readjust.
While the actions taken by regulators were successful in steering the global economy out of the deep recession, progress since then has been slow. For instance, real disposable household income in Italy in 2017 was 10% below the 2007 levels, whereas in the UK and France it has just about reached 2007 levels. In the US, it has grown by about 10%, over ten years. No wonder that people feel their incomes are stagnant.
Excessive leverage was detected as the cause behind the crisis. According to IMF, leverage of G-20 economies (barring financial sector) in 2016 stood at 235% of GDP, exceeding the pre-crisis level of 210%. While the financial sector and households have deleveraged, the government debt has increased, as a result of the accommodation provided. As central bankers withdraw monetary accommodation provided during the days of the financial crisis, the global economy could face headwinds. Nevertheless, the financial system is dominated by a few too big to fail banks.
However, not all is lost. Some progress has been made on a global basis to make the financial system safer. For instance, upcoming Basel III norms recommend a common equity tier 1 (CET1) ratio to be 7% of risk-weighted assets, including a capital conservation buffer. Regulatory oversight has improved and banks are subject to routine stress tests.
In 2008, the shock led to fear. Many bright individuals in the financial sector chose to pursue a career elsewhere, fearing instability. Also, many investors fled the market out of fear. However, bear markets don’t last forever and it is important for those in the financial world to handhold investors during such periods. It is said that bull markets are born in pessimism. Money invested in the Sensex in 2008 would have multiplied by 5.4 times including reinvested dividends.
Despite all the gloom, there are reasons to be optimistic. As of now, the Indian economy is accelerating. IMF forecasts a growth of 7.3% for FY 19e and 7.5% for FY 20e. IMF also forecasts the world economy to grow at 3.9% for both CY 18e and CY 19e. This represents a good opportunity for investors. There has been a trend of increase in financial savings of households which has been finding its way in equities both directly and indirectly i.e. via mutual funds, insurance, etc.
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