A

Report on

An Introduction to Subprime Crisis

& It’s impact on India

By

JHINUK ROY, Dept. of Economics,

Roll No.-3021-51-115, Registration No.- 012-1221-1650-12

A report submitted in fulfillment of the requirement of Term Paper

26th February, 2015

Asutosh College

Kolkata-700026

i

CERTIFICATE BY THE SUPERVISORS

Smt. Shumonika Gangoly Smt. Ena Chatterjee

Guest Lecturer, Dept. of Economics, Teacher-in-Charge,

Asutosh College, Asutosh College,

Kolkata Kolkata

Smt. Suparna Basu

Head of Department, Department of Economics,

Asutosh College,

Kolkata

This is to certify that the Term Paper entitled Subprime Crisis & It’s impact on India is a document of work done by Jhinuk Roy under our supervision during the period September 2014 to February 2015.

(Smt. Shumonika Gangoly) (Smt. Ena Chatterjee)

(Smt. Suparna. Basu)

ii

STATEMENT BY THE CANDIDATE

Jhinuk Roy

B.Sc Economics Honours

Dept. of Economics, Roll-3012-51-115

Asutosh College

I hereby state the Term Paper entitled Subprime Crisis & It’s impact on India has been prepared by me during the period September 2014 to February 2015.

(Jhinuk Roy)

iii

Acknowledgement

I deem it a pleasure to acknowledge my deep sense of gratitude to Guest Lecturer S.Gangoly

of Department of Economics of Asutosh College, who directed and guided me with her

timely advice and constant inspiration, which eased to task the completing the report.

Finally I must say that no height is ever achieved with some sacrifice made at some end

and it is here I owe my special debt to my parents and family members for showing their

love throughout this period of time.

TABLE OF CONTENTS

Certificate by Candidate…………………………………………………………………… (i)

Statement by candidate………………………………………………………………….… (ii)

Acknowledgement…………………………………………………………………...…..... (iii)

List of figures ……..……………………………………………………………………… (v)

Abstract ………………………………………………………………………………...… (vi)

Chapter-1 An Introduction to Subprime Crisis & Its impact 1-2

Introduction….…………………..…………………………………………………... 1

Literature Survey…………………………………………………………………….. 1

Chapter-2 Background of Subprime Crisis 3-6

Inflow of Huge Capital………………………………………………………………. 3

Factors playing major roles…………………………...……………………………... 5

Global impact of the crisis ……………………………………………….………….. 6

Chapter-3 Indian Economy 7-9

Introduction to Indian Economy……………………………………………………... 7

Impact..…………………………………………………………………………...….. 7

Policies undertaken to fight the crisis……………………………………………….. 8

Strength of Indian Economy…………………………………………………………. 8

Chapter-4 Comparative Study of Subprime Crisis of India 10-13

Comparison of India and Brazil in the global economic crisis……………………...10

Impacts of global crisis on India and Brazil………………………………………... 12

Analysis…………………………………………………………………………………….. 14

Conclusion………………………………………………………………………………….. 15

Bibliography………………………………………………………………………………... 16

v

LIST OF FIGURES

Figure 2.1: US Total Net Cash inflow……………………………………………………….. 3

Figure 4.1: Comparision table of real GDP growth rates of India and Brazil…………...….. 11

Figure 4.2: Comparision graph of real GDP growth rates of India and Brazil ……....…....... 11

vi

Abstract

This paper examines the causes of the crisis which took place in U.S. in 2007-2008 and

thereby the consequent impact of this crisis on the Indian economy. In particular, it

examines the emergence and collapse of the housing bubble. The financial crisis created

from the mortgage crisis coincided with the Great Recession in 2008 and thus the impact

became global. By comparing two developing countries, Brazil and India, it has been shown

that India unlike Brazil fought back the crisis successfully. It was realized that proper policy

measures are needed to protect the economy. The prompt decisions and actions taken by the

Indian government during the crisis was and will remain a remarkable instance for all other

economies in the world. Hence we proceed with our analysis and explanations on this topic

of discussion.

1

CHAPTER-1

An Introduction to Subprime Crisis & It’s impact on India

Introduction:

Subprime mortgage crisis is an ongoing real estate crisis. It was a perfect storm. This is one

metaphor used to describe the present global crisis. The US housing market is seen by many

as the root cause of the financial crisis.

The said financial crisis started in the US housing market in 2007. The crisis spread across

the world and severely damaged the economies of many countries, including the US. The

term “subprime” is any loan that does not meet “prime” guidelines. A subprime borrower is

not 'prime' and a subprime lending, (also called B-paper, near-prime, or second chance

lending) is the practice of making loans to borrowers who do not qualify for the best market

interest rates because of their deficient credit history. Subprime lending is risky for both

lenders and borrowers due to the combination of high interest rates and poor credit history.

So Subprime Crisis is a situation that arose in 2008 and affected the mortgage industry

because borrowers were approved for loans they couldn't afford. As a result, many lending

institutions collapsed.

This crisis was felt globally and here we discuss the effects on the Indian economy and

how it fought back and improved in a proud manner.

Literature Survey:

i) David Lereah, Realtor’s chief economist at the time, stated that the 2006 decline in

investment buying was expected: "Speculators left the market in 2006, which caused

investment sales to fall much faster than the primary market."

ii) Thomas Friedman summarized the crisis through stages. According to him, when these

reckless mortgages eventually blew up, it led to a credit crisis and banks stopped lending,

that soon caused an equity crisis. The equity crisis made people feel poorer and this was

reflected on the consumption behaviour of the people which causes consumption crisis. Due

to this consumption crisis, purchases of cars, appliances, electronics, homes and clothing

have just fallen off a cliff. This in turn, has sparked more company defaults, exacerbated the

2

credit crisis and metastasized into an unemployment crisis, as companies rush to shed

workers.

iii) According to Alan Greenspan, as long as the uncertainty remains regarding housing

prices, mortgage-backed securities will continue to decline in value, placing the health of

banks at risk.

iv) Economist Nouriel Roubini wrote in January 2009 that Subprime Mortgage defaults

triggered the broader Global Credit Crisis, but were part of multiple credit bubble collapses.

It is the bursting of the many bubbles that he believes are causing this crisis to spread

globally and magnify its impact.

v) According to Robert J. Shiller and other economists, housing price increases beyond the

general inflation rate are not sustainable in the long term.

vi) Economist Stan Leibowitz argued in the Wall Street Journal that although only 12% of

homes had negative equity, they comprised 47% of foreclosures during the second half of

2008. He concluded that the extent of equity in the home was the key factor in foreclosure,

rather than the type of loan, credit worthiness of the borrower, or ability to pay.

vii) In a June 2008 speech, President of the NY Federal Reserve Bank Timothy Geithner,

who later became Secretary of the Treasury, placed significant blame for the freezing of

credit markets on a "run" on the entities in the "parallel" banking system, also called the

shadow banking system.

ix) Nobel laureate Pauk Krugman described the run on the shadow banking system as the

"core of what happened" to cause the crisis.

x) Economist Gary Gorton wrote in May 2009: "Unlike the historical banking panics of the

19th and early 20th centuries, the current banking panic is a wholesale panic, not a retail

panic.

xi) According to economist A. Michael Spence: "when formerly uncorrelated risks shift

and become highly correlated diversification models fail."

xii) Martin Wolf wrote in June 2009: "...an enormous part of what banks did in the early

part of this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking

system' itself – was to find a way round regulation."

3

CHAPTER-2

Background of Subprime Crisis

Inflow of huge capital:

In US, capital mobility was high and rising during the classical gold standard prior to

1914. An international capital market with its centre in London flourished during this first

period of globalization.

World War I interrupted international capital flows severely. By 1929 the international

capital market had not returned to the pre-war levels. The Great Depression in the 1930s

contributed to a decline in cross-border capital flows as countries took measures to reduce

capital outflows to protect their foreign reserves. Following the 1931 currency crisis,

Germany and Hungary for example banned capital outflows and imposed controls on

payments for imports. As a result, the International capital market collapsed during the Great

Depression. This was one channel through which the depression spread across the world.

During the present crisis there has hardly been any government intervention to arrest the

flow of capital across borders. However, the contraction of demand and output has brought

about a sharp decline in international capital flows.

Figure 2.1: US Total Net Cash Inflow

4

i) Crisis popped up in the housing sector of U.S: Since the late 1990s, house prices grew

rapidly in response to persistent low interest rates, over-generous lending and speculation.

The bursting of the housing bubble, in addition to simultaneous crashes in other asset

bubbles, triggered the credit crisis. The financial turmoil that engulfed the US during 2007-09

began in the mortgage lending markets. The crisis set in as house prices started to fall

dramatically. This represented an immediate and severe dislocation of the financial markets.

The Subprime loans were issued to those people who were discriminated against, people

having financial problems, young people who do not have enough money for down payment

, banks to earn more money by tapping the defaulting customers.

A massive amount of money flowed into the U.S from investors abroad. This large influx

of money to U.S. banks and financial institutions along with low interest rates, made it easier

for Americans to get credit. Easy credit combined with the faulty assumption that home

values would continue to rise which led to excesses and bad decisions. Optimism about

housing values also led to a boom in home construction. Eventually the number of new

houses exceeded the number of people willing to buy them. And with supply exceeding

demand, housing prices fell.

ii) Problems occurred: Borrowers with adjustable rate mortgages who had been planning to

sell or refinance their homes before the adjustments occurred were unable to refinance.

When subprime borrowers couldn't sell their houses at a higher price, they were forced to

default. Borrowers who bought more home than they could afford stopped paying the

mortgage. As a result, many mortgage holders began to default as the adjustments began. Of

course, to handle the problem, many also tried to increase income and decrease spending but

they were already on thin ice.

Once people started defaulting on loans in record numbers, the mortgage crisis really

heated up. Banks and investors began losing money. Financial institutions decided to reduce

their exposure to risk very quickly, and banks hesitated to lend to each other because they

didn’t know if they’d ever get paid back. Of course, banks and businesses need money to

flow in order to operate.

iii) Bank weakness caused bank failure: So the mortgage lenders faced problems as the

value of their collateral (or the assets used to secure the loans) fell. On 11 July 2008, Indy

5

Mac – the USA’s largest mortgage lender – collapsed and its assets were taken into federal

ownership.

Bear Stearns, a large American investment bank which had engaged heavily in mortgage-

backed securities, was severely damaged. Unable to recapitalise sufficiently to cover its

losses, it could not survive when its stock price collapsed in March 2008 and it was

ultimately acquired by Morgan Chase on 16 March 2008 in a government-assisted takeover.

In September and October 2008 the crisis hit the broader banking industry. On 15

September, investment bank Lehman Brothers filed for bankruptcy, having failed to raise the

necessary capital to underwrite its downgraded securities.

Most notably, investor confidence fell dramatically, which was reflected in the flight to

safer assets like gold, oil and the US dollar.

Thus, in 2007, the US economy entered a mortgage crisis that caused panic and financial

turmoil around the world. The mortgage crisis was a result of too much borrowing and

flawed financial modeling, largely based on the assumption that home prices only go up.

Greed and fraud also played important parts.

Factors playing major roles:

Eventually the collapse of the bubble occurred. By 2006 a number of factors had

conspired to burst the bubble.

First, average hourly wages in the US had remain stagnant or declined since 2002 until

2009 in real terms. Consequently, prices could not continue to rise as housing became

increasingly unaffordable.

Second, as interest rates rose to a peak of 5.25%, ARMs (Adjustable Rate Mortgages)

became less attractive and effectively removed many non-prime prospective buyers from the

market.

Global impact of the crisis:

There is little doubt that the US crisis has spilled over into other markets. Two major

advanced economies, Japan and Germany, have been singled out by the financial press as

being particularly hard-hit. Specifically, many countries in Europe and elsewhere (New

Zealand, for example) were having their own home-grown real estate bubbles. Also when

6

Bank of America was neck deep in trouble , governments everywhere were at their wit’s end

in dealing with the financial crisis, yet little of this storm has touched the Indian Banking

System. At the time of crisis, the Indian Banking System continues to show resilience. The

underlying fundamentals of the Indian economy would continue to underpin the robust

performance of the banking sector which remains profitable and well capitalized.

7

CHAPTER-3

Indian Economy

Introduction to Indian Economy:

The ongoing global financial and economic crisis has significantly dented growth

prospects in India. Indian economy looked to be relatively insulated from the global

financial crisis that started in August 2007 when the sub-prime mortgage crisis first surfaced

in the US. But when the collapse of Lehman Brothers on 23 September 2008 morphed the

US financial meltdown into a global economic downturn, the impact on the Indian economy

was almost immediate.

Like other countries, India was hit by the spillover effects of the crisis due to its increased

integration into the global economy. The overall GDP growth rate almost halved, from a

peak of 10.6 per cent in the third quarter of 2006 to 5.8 per cent in the fourth quarter of

2008. Consequently, India was affected by the global crisis through both the trade and the

financial channel. India was already in the midst of a domestic downturn in September 2008

when the effects of the financial crisis began to take their toll. The situation on the eve of the

crisis was worsened by the adverse effects of a severe terms-of-trade shock that resulted

from a sharp rise in global food and oil prices.

Impacts:

The impact of the global crisis on India can broadly be divided into two parts:

A) the immediate or direct impact on its financial sector and

B) The indirect impact on economic activities.

Fortunately, India, like most of the emerging economies, was lucky to avoid the first round

of adverse effects because its banks were not overly exposed to sub-prime lending. Only

one of the larger private sector banks, the ICICI (formerly the Industrial Credit and

Investment Corporation of India), was partly exposed, but it also managed to avoid a crisis

because of its strong balance sheet and timely action by the government. The banking sector

as a whole remained financially sound. In fact, during the third quarter (Financial Year

2008–2009), which was a nightmare for many large global financial institutions, banks in

India announced encouraging results and witnessed an impressive jump in their profitability.

8

However, the indirect impact or the second round impact of the crisis affected India quite

significantly. The liquidity squeeze in global markets following the collapse of Lehman

Brothers had serious implications for India: it not only led to massive outflows of foreign

institutional investment (FII) but also compelled Indian banks and corporations to shift their

credit demand from external sources to the domestic banking sector. These events put

considerable pressure on liquidity in the domestic market and consequently provoked a

credit crunch. This credit crunch, coupled with a general loss of confidence, increased the

risk aversion of Indian banks, which eventually hurt credit expansion in the domestic

market.

Policies undertaken to fight the crisis:

The overall adverse impact of the global financial crisis was mitigated by a series of

proactive policy measures. While India’s monetary policy largely aimed at enhancing

domestic liquidity, which had shrunk considerably since the collapse of the United States

investment bank, Lehman Brothers, its fiscal policy sought to boost aggregate demand. All

these measures were able to curb the decline in the growth rate to a certain extent, and there

have been several signs of an incipient recovery since April 2009.

Strength of the economy:

India even at the time of crisis, continued to show resilience because:

1. The fundamentals of the Indian economy have been strong and continue to be strong.

2. The Indian banking system is sound, well capitalized and well regulated.

3. The forex and money markets have been functioning in an orderly manner.

4. As per information with RBI, Indian banks do not have any direct exposure to sub-prime

mortgages. The banking sector, through its overseas branches, has some exposure to

distressed financial instruments and troubled financial institutions. But this exposure is part

of the normal course of their business and is quite small relative to the size of their overall

business.

5. Whatever the Indian economy is witnessing today is indirect, knock-on effect of the

global financial situation. This is only a reflection of the uncertainty and anxiety in the

global financial markets.

9

6. RBI has taken action to inject liquidity into the system as warranted by the situation. The

situations were monitored on a continuous basis, and RBI stood ready to take appropriate

effective and swift action.

7. Once again, the Indian Banking system was stable and sound. There was no reason for

any anxiety or uncertainty.

Therefore we can conclude that the transmission of the global financial crisis to India has

clearly demonstrated that the country has become integrated into the global business cycle.

While undoubtedly this opening up has helped India achieve robust growth rates in recent

years, it has also made the country prone to shocks originating in other parts of the world.

Consequently, there is a need to create policy space in good times that can be utilized during

periods of crisis. This would imply moving to a path of fiscal consolidation, regulating the

availability of liquidity in the economy and ensuring the availability of foreign exchange

liquidity through the accumulation of sufficient reserves.

10

CHAPTER-4

Comparative Study of Subprime Crisis of India

Comparison of India and Brazil in the global economic crisis:

In an economic environment in which depression, or the risk of depression, is global, the

timeliness and intensity of economic policy responses matter. In September 2008, when

Brazil and India faced the first adverse impacts of the global crisis through the financial

channels, it might have been expected that both countries would be negatively affected in

very similar ways. However, while the Brazilian economy fell into recession and registered a

real GDP contraction of -0.2 per cent in 2009, India’s real GDP grew by over 6 per cent

(with an estimated growth rate of 6.9 per cent for its fiscal year from April 2009 to March

2010). This remarkable performance meant that India was the second least adversely

affected country by the global crisis, after China.

Here we compares the impacts of the global economic crisis on the Brazilian and Indian

economies, as well as the economic policies that those countries immediately implemented

to restore the regular credit channels and reduce the negative effects of the crisis on

economic growth.

Reasons of comparison: Brazil and India are both developing countries, almost similar in

their area and population size.

There are several reasons to compare Brazil with India; a major one being that, although

the initial financial impacts occurred through similar transmission channels in both

countries, their different economic policy responses produced distinct effects on their real

economies.

In India, notwithstanding high real GDP growth rates prior to the eruption of the 2008 global

crisis (in figure 1), the economy had been decelerating since 2006 due to the priority given

by India’s central bank, the Reserve Bank of India (RBI), to reducing inflation. However,

since September 2008, the RBI has radically shifted its priority in order to safeguard India’s

economic growth. Thus, because of swifter and more intense monetary and fiscal policy

responses than Brazil between September 2008 and January 2009, Indian policymakers were

not only more successful at saving the economy from recession, but also at setting it on a

path of rapid recovery and growth.

11

Brazil and India : Real GDP growth rates, 2005–2009 (Per cent)

COUNTRY YEAR

2005 2006 2007 2008 2009

INDIA 9.2 9.8 9 7.3 6.9

BRAZIL 3 4 5.7 5.1 -0.2

Figure 4.1: Comparision table of real GDP growth rates of India and Brazil

9.29.8

9

7.36.9

3

4

5.75.1

-0.2

-2

0

2

4

6

8

10

12

2005 2006 2007 2008 2009

GDP GROW

TH

YEAR

INDIA

BRAZIL

Figure 4..2: Showing the quicker and more aggressive monetary and fiscal countercyclical response to the global crisis by policymakers in India than in Brazil which explains why the Indian economy was able to avoid a recession in 2009.

12

Impacts of global crisis on India and Brazil:

Brazil and India, much like most other developing countries, suffered the immediate

impacts of the global economic crisis. Since September and more intensely in October 2008,

both countries have suffered from a sudden stopping of foreign capital (especially short-term

capital and foreign capital for trade finance), nominal exchange rate depreciation and a

strong credit squeeze.

By comparing the behaviour of the nominal exchange rate depreciation between September

2008 and December 2008, it can be concluded that India was more successful than Brazil in

stabilizing its foreign exchange market. The Brazilian real depreciated to a much greater

extent than the Indian rupee. In December 2008, the Brazilian real reported a nominal

depreciation of 42.9 per cent compared with the August 2008 level, against a depreciation of

10.9 per cent for the Indian rupee.

There are two reasons why negative expectations were stabilized quicker in India than

in Brazil?

a) India is currently open to foreign capital inflows for direct investment and the stock

market, but it still imposes high restrictions on foreign investment in treasury bonds and fixed

income assets.

b) Although derivative transactions in India before the 2008 crisis were allowed, since April

2007 all derivative contracts (especially exchange rate and interest rate derivatives) have been

tightly regulated by the RBI. The RBI defines and manages the permissible derivative

instruments, risk management and eligibility criteria in order “to safeguard the interests of the

system as well as the players in the market”.

In contrast, in Brazil the existence of a large foreign exchange market, as well as equity and

credit derivative markets connected to domestic and global markets, was not only responsible

for deeply worsening the financial health of banks and companies, but also caused a sudden

and lengthened halt to both interbank lending and final credit.

Therefore we can conclude that In September 2008, when Brazil and India faced the first

effects of the global crisis through the financial channels, they might have been expected to

experience similar adverse impacts, especially in terms of a downturn of economic activity.

However, India turned out to be one of the few countries in the world that escaped the

recession in the middle of the global “storm”. Although the Indian economy decelerated in

the immediate aftermath of the global crisis (in the last quarter of 2008), in early 2009 it

13

showed signs of a rapid recovery. India’s real GDP growth rate was over 6 per cent in the

2009 calendar year (and was estimated at 6.9 per cent for the April 2009 to March 2010 fiscal

year), which was a remarkable performance and enough to lead to the conclusion that the

Indian economy was much less adversely affected than the Brazilian economy which fell into

recession in the same year. However, one could cynically point out that a more (initially)

conservative response of both monetary and fiscal policy could have put Brazil onto a more

sustainable recovery and growth path than India. Unlike Brazil, which fell into recession in

2009, India was the second least adversely affected country by the global crisis, after China.

14

ANALYSIS:

Subprime crisis has demonstrated the importance of a coordinated framework for the

management and prevention of the crisis.

i) Crisis prevention: It is essential to prevent the re-occurrence of the crisis in the future.

ii) Crisis control and mitigation: This is to minimize the damage by preventing systemic

defaults of banks and easing the social hardship stemming from recession. Thus, it’s

main objective is to stabilize the financial system and the real economy in the short run.

iii) Crisis resolution: It is needed to bring the crisis to a lasting close by securing

consumer protection and minimizing competitive distortions in the internal market. The

beginnings of such a framework are emerging gradually.

The following are some major lessons that developing countries can learn from the crisis:

a) Economic , and, particularly , financial globalization, can make developing countries

more vulnerable and thus hinders the growth. Countries should be able to shield against

negative exogenous shocks from financial markets. The roles of business and the state need

to be rebalanced and globalization requires enhanced “global governance”.

b) Developing countries need more policy space for macroeconomic policy- making, for

monetary as well as fiscal and exchange rate policy. Beyond the strategies taken by the

Washington Consensus for ensuring price stability and budgetary discipline, the

macroeconomic and development strategies of developing countries need to be better

tailored to their specific needs.

Many countries have adopted narrow, constantly tight macroeconomic policies, along with

liberalization of trade and privatization programmes, which have tended to yield little

success in terms of growth and employment creation. While there is still major uncertainity

regarding the pace of economic recovery, now it is essential to design exit strategies of crisis

control policies and commit it. This is necessary both to secure macroeconomic stability and

to ensure the effectiveness of the actions taken.

15

CONCLUSION:

We can conclude that the ultimate causes of the crisis reside in the functioning of financial

markets as well as macroeconomic developments. Particularly the collapse of Lehman

Brothers in September, risk loving banks and investors around the world and due to the

complexity of the mortgage-backed securities resulted to a rapidly deteriorating US housing

sector.

Governments in both advanced and developing countries reacted aggressively by injecting

massive amounts of credit into financial markets and nationalizing banks and swift cut in

interest rates. This response helped to avoid a disastrous depression in many countries

though the effectiveness of policies has varied depending on the magnitude of the response

and vulnerabilities of the domestic economy.

Although there are signs that banks are starting to make profits again and risk spreads have

generally returned to pre-September levels, government policies have failed to arrest rises in

unemployment and contractions in output.

This paper has navigated a wide and diverse terrain. It stresses on the range of complex

and interlinked factors behind the emergence of the global financial crisis in 2007.This paper

also summarizes how economies around the world have been affected, resulting in millions

of job losses.

16

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