Us and Them: On World Market & India Story

“So interwoven are all economies of the world that the sub-prime crisis in USA has affected not only the American economy but that of the world as a whole.”

What is this sub-prime crisis in USA? How is Indian economy tied up with that of the world? How will India be affected by this crisis? Will it have any impact what-so-ever on an average middle class household in India? Will ICICI Bank collapse!? Should I invest and buy more stocks now that the market is trading at such low levels? Should I wait and watch before buying gold? What will happen to the home loan EMI I am paying? Should I wait for a few months before buying any new land or house, so that real estate prices cool off? Will the diesel/petrol prices be revised further? Will LPG become dearer? Why is dollar increasing against rupee again?

Is there any connection between all these questions - apart from being the “Breaking News” on NDTV at different points of time?! Probably, a common thread called economics.

Ok. First things first – what is this sub-prime thing? Over the past few years, with affluence all around, the demand for homes in USA was very high. Everyone wanted a home, at any cost whatsoever. People needed home loans – banks provided those home loans, even when everyone knew that real estate was overpriced, even when the fact remained that most of the people could not afford to buy homes at such high prices. Banks did not check the credit worthiness correctly. There were mortgages and double mortgages taken against these homes so that people could buy another home! All these home loans and mortgages were then securitized by these banks.

But, what is this securitization? These home loans were pooled together, their worth combined and then divided into different classes or tranches based on the risk and payment analysis done by the banks. These classes or tranches were then sold as bonds in the market. Investment banks bought them, commercial banks bought them, hedge funds bought them, brokerage firms bought them, and probably a lot of high net worth individuals bought them as well.

Then what went wrong? Well, such high home prices were really not sustainable. Real estate prices started to nosedive. Suddenly, the assets for which people had spent their lives’ savings were worth nothing. Suddenly, they had no ways and means of paying back the annuities of exorbitant home loans they had taken! Their mortgage payments dried up, because the value of asset against which mortgage payments were being made had fallen as well. Why would I continue to pay you 5000 bucks a month for something which was worth 2 lakhs a year back and is not even worth a lakh now? I would find ways and means of renegotiating to get away with paying only 2000 bucks a month now! So, suddenly, all those home loan payments dried up. Banks did not have any means of making the payments due on account of those special bonds they had sold (tranches and classes!). They took ownership of homes for which loans were taken. But those homes were worth nothing really! Thus, the payments to investment banks, brokerage firms etc. dried up. So devalued were these bonds that nobody hoped to make any money out of it. Firms starting recording their value at current prices on their balance sheets, and this fall in asset values were formally “written off” by major banks – Merrill, Citigroup, Goldman Sachs, Lehman etc. A lot of them ultimately went bankrupt or were bought over.

Then how does this affect us, in India? Well, many lucrative jobs have dried up for sure! B-School placements are expected to suffer because many top notch recruiters do not exist anymore or have limited their operations so much that they really do not need any new people for the time being. What else? As trading/brokerage firms, many Indian companies also had bought some of these special bonds from the major US banks. Obviously, all those have been written off as losses. Many of our companies had trading obligations with these major banks. Now with these banks going bankrupt, there is a speculation that these trading obligations might not be honored and hence, top-line of major Indian financial firms might suffer. ICICI is one of these firms with some exposure to international markets. Hence, the volatility in its stock price in recent times.

Is that all? Not really. Here is where macroeconomics comes into picture. As discussed above, in the USA, banks do not have money to lend – they are short of funds. That is why the term – credit crunch. Every investor, whether an individual or an institutional one (banks, funds etc.), there is trying to get as many dollars as possible at the earliest and build a kind of “war-chest” for times to come. Hence, they are selling heavily whatever holdings they had in Indian markets. Due to this heavy selling, a downward pressure on the market is built. Why? Suppose everyone around you wants to sell the laptop they have and you are the only one willing to buy (more sellers, less buyers). Obviously, you will try and get the best bargain, i.e. minimum prices. Stock prices thus, fell (not to say this is the only reason, but one of the significant ones), and so did the Indian stock market.

Another issue – dollar being a major currency (acceptable worldwide for all kinds of transactions) - foreign investors are selling rupee heavily in the exchange market. As above, if everyone around you is selling rupee, the value of rupee is expected to fall and that of dollar is expected to rise- precisely the thing that is happening now. And how is RBI trying to support rupee and prevent its free fall? By trying and maximizing the amount of dollars it can lure foreign investors to invest in India – by measures like offering higher rates of interests to foreign nationals and NRIs if they invest in India etc.

With lower credit availability and lower spending by firms abroad, there is a speculation that the revenues of our export industry (primarily IT) might suffer. No new projects, no expansion plans etc. Obviously, those involved in financial services outsourcing would see a dip since many of their clients have gone bust, but what happens in general, remains to be seen.

So, what we see here is that Indian firms have lost money and clients. There are pressures to cut costs and boost bottom-lines. People have lost jobs. Imported goods cost more (increase in dollar value). Inflationary pressures, which existed in the Indian economy earlier (due to high money and credit supply), have resulted in higher costs all around. To cut this inflation (reduce money supply in the market), interest rates have been hiked. Thus, EMI rates have gone up. People prefer not to take loans; they prefer keeping money in bank deposits, earning the higher interest easily available. Foreign investors are pulling out money, as discussed above. It becomes difficult for domestic firms to raise capital and make further investments (no foreign investors and borrowing in local market is expensive due to high interest rates) in such a scenario. Without further investments, maintaining high growth rates is really not sustainable. Hence, the talk of downward revision in GDP growth estimates for India – from near 9% to around 7-8%.

What happens in future is really an issue of macroeconomic policy. India is an internal demand driven growth story. Yes, there are dependencies on world market as a whole, but our growth is not entirely due to a surge in exports or something. We have a huge consumer base, that is getting increasingly literate and well off. It remains to be seen how long such high interest rates continue – depends really on the time it takes for inflation to cool off, which in turn depends on oil (external) and food (internal). With a worldwide credit crunch, one can expect prices to cool off (lower demand, hence lower prices – demand/supply curve) in times to come. One can then expect interest rates to be lowered. One can then expect the Indian juggernaut to roll on further. How much time will all this take? Well, that remains to be seen and there is no point speculating!

People on Wall Street might be used to saying “Greed, for a lack of better word, is good”. However, experience shows that it is best to live within one’s means, strive to expand one’s means and once that is done expand one’s desires and that it is best to live by the motto “Deserve before you desire”

Rest, as they say, is one’s own choice.