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US FINANCIAL CRISIS
by WILFRED JOHN
11/07/08
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US FINANCIAL CRISIS


Governments and regulators across the world have been striving hard to contain the fallout of the U.S. financial sector crisis that has now acquired menacing proportions. The problem is particularly acute in the U.S. where early last week, the House of Representatives had voted out a rescue bill costing an astounding $700 billion.


The bill, crafted after some frenzied discussions in the two major political parties, hit political roadblocks. A large number of legislators are seeking re-elections while the Presidential elections are a month away. The rescue package was however salvaged subsequently after political leaders across the globe urged its passage — a clear admission that the pain emanating from the crisis is felt in many other countries. Besides, even though the rescue was politically unacceptable, there really was no alternative.

In retrospect the U.S. financial sector, for long considered the model of sophistication and occupying a pivotal place in the global financial system, has proved to be extremely brittle. Naturally other countries too are feeling the impact of the failures in the U.S. Across the Atlantic in the U.K. and the European continent, there have been many instances of banks coming under stress. Even as the governments rush in with their own versions of bailout, no one knows where the next failure would occur.


Extreme loss of confidence in the financial sector is now a common phenomenon in the West. That in turn has frozen credit markets. Banks have stopped lending to each other in the inter-bank market. There is a flight to safety from every market and country. Ironically, the U.S. at the centre of the crisis is attracting all the money from countries that are less affected. Investors including central banks have for long favoured American government securities for their safety though not for the return on them. In times of crisis, safety and liquidity considerations override all others.


As pointed out by Prime Minister Manmohan Singh, India is obviously not immune. Nor can it be kept insulated from global developments. The pull out by foreign institutional investors has been one of the principal causes for the low stock market valuations here. As the crisis intensifies their withdrawal from Indian markets has been going up. Stock markets around the world have demonstrated a high degree of interconnection. In India, global cues matter as much as domestic factors. FII holding of Indian stocks is still substantial around $150 billion. Obviously, the stock market is the place to watch for signs of trouble.
The rupee has been weakening rapidly falling below 47 to the dollar. RBI intervention to keep the rupee from going down drastically would mean drawing on forex reserves. Their level, though lower than it was at the start of this fiscal year, is still comfortable. However, in the context of the financial crisis no level of reserves can be considered high. All talk of deploying reserves more profitably should be shelved for now.


It is not just FII flows but even the more stable FDI (foreign direct investment) flows that will be affected in the wake of the crisis. A recent UNCTAD report estimates cross border FDI flows to be at least 10 per cent lower this year as compared to last year. Lower capital flows will automatically sound the alarm bells for the external sector.

Capital flows, till recently those from FIIs, have played a major role in bridging the deficit in the country’s balance of payments. There may not be any danger now but surely falling asset prices, a depreciating rupee and a widening current account deficit are ominous signs that policy makers cannot ignore any longer.


According to recent figures, merchandise trade deficit has surged to over $49 billion between April and August this year despite a substantial growth in exports. Exporters as a rule will welcome a cheaper rupee. However, a substantial portion of exports has imported components. Besides, it is stable exchange rates — a managed float pointing to a gradual depreciation of the rupee — that the RBI has been striving to achieve.



The other important foreign exchange earners, exporters of services, have also not benefited from a cheaper rupee. Major IT companies, facing a strong rupee last year, had complained of lower operating margins. It was then a question of not hedging their receivables. This time it seems to be a question of hedging too much. Of course, no body thought of the rupee falling below 47 to a dollar. Most of the forward contracts on behalf of the IT companies had apparently been booked in the expectation that the rupee would not fall so sharply as it did. In the present case it is more a question of opportunity loss.
Of course, IT companies have other major reasons to worry about. All the big ones have been concentrating on the financial sector, with U.S. banks giving them a substantial share of the IT business.


All the above developments cannot be viewed in isolation from the financial sector crisis. On Tuesday, the Finance Minister and the financial sector regulators did well to assuage investor concerns, specifically in the areas of payments, liquidity and stability and solvency of the financial sector. The widely publicised problem exposures of ICICI Bank to sub-prime assets seem manageable for now.
The RBI has asked all banks to disclose their outstanding exposures — both direct and indirect — to the failed global entities. Only then will the full extent of Indian banks’ involvement in the crisis be known.

© WJ
WILFRED JOHN
FREELANCE JOURNALIST
WRITER
POET
johnrwilfred2003@yahoo.com

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