GLOBAL FINANCIAL CRISIS AND IMPACT ON ECONOMY

1. EXECUTIVE SUMMARY

The world economy is engaged in a spiraled mortgage crisis, starting in the

United States, which is carving the route to the largest financial shock since

the Great Depression.

A loss of confidence by investors in the value of securitized mortgages in the

United States was the beginning of a financial crisis that swept the global

economy off its feet. The major financial crisis of the 21st century involves

esoteric instruments, unaware regulators, and nervous investors. Starting in

the summer of 2007, the United States experienced a startling contraction in

wealth, triggered by the subprime crisis, thereby leading to increase in

spreads, and decrease in credit market functioning. During boom years,

mortgage brokers, enticed by the lure of big commissions, talked buyers with

poor credit into accepting housing mortgages with little or no down payment

and without credit checks. Higher default levels, particularly among less

credit- worthy borrowers, magnified the impact of the crisis in the financial

sector.

The ability to raise cash, i.e. liquidity, is an essential component for the

markets and for the economy as a whole. The freezing liquidity has closed

shops of a large number of credit markets. Interest rates had been rising

across the world, even rates at which banks lend to each other. The freezing

up of the financial markets eventually lead to a severe reduction in the rate of

lending, followed by slow and drastically reduced business investments,

paving the way for a nasty recession in the overall economic state of the

globe.

A collapse of trust between market players has decreased the willingness of

lending institutions to risk money. The bursting of the housing bubble has

caused a lot of AAA labeled investments to turn out to be junk. Nervous

investors have been sending markets plunging down. Markets all over the

world including those of Britain, Germany, and Asia, had to confront all-

time low figures since the past couple of years or more.

Britain also witnessed the so-called ―bursting of the Brown Bubble‖, in the

form of the highest personal debt per capita in the G7, combined with an

unsustainable rise in housing prices. The longest period of expansion, which

Britain claimed to be undergoing, eventually revealed itself an illusion. The

illusion of rising to prosperity had been maintained by borrowing to spend,

often in the form of equity withdrawal from increasingly expensive houses.

The bubble ultimately burst, exposing Britain to the most serious financial

crisis since the 1920s. This brings a lot of misery to the home owners who

are set to see the cost of mortgages soar following the deepening of the

banking crisis and the Libor – the rate at which banks lend to each other.

The impact of the crisis is more vividly observable in the emerging markets

which are suffering from one of their biggest selloffs. Economies with

disproportionate offshore borrowings (like that of Australia) are adversely

affected by the western financial crunch. Globalization has ensured that none

of the economies of the world stay insulated from the financial crisis in the

developed economies.

Contrary to the ‗decoupling theory‘, emerging economies too have been hit

by the crisis. According to the decoupling theory, even if advanced

economies went into a downturn, emerging economies would remain

unscathed because of their substantial foreign exchange reserves, improved

policy framework, robust corporate balance sheets, and a relatively healthy

banking sector. In a rapidly globalizing world, the ‗decoupling theory‘ was

never totally persuasive.

The ‗decoupling theory‘ stands totally invalidated today in the face of

capital flow reversals, sharp widening of spreads on sovereign and corporate

debt and abrupt currency depreciations.

The Project:

In the subsequent parts of the project, several issues will be discussed which

will provide a detailed account of the origin of the crisis and the ripple effect

of economic downturn of the world‘s largest economy which engulfed even

the fast growing emerging economies into the crisis. The impact of the crisis

on the Indian economy will also be dealt with. The main aim of the study is

to find relevant answers to questions like why and how India has been hit by

the crisis and how the Indian economy and the Reserve Bank of India have

responded to the crisis. The recommendations include the outlook for the

Indian economy in the wake of the economic turmoil. The project concludes

with an analysis of Entrepreneurship in times of the financial crisis and a

swift overview of the various aspects of entrepreneurship which can help in

the revival of a plummeting economy.

2. INTRODUCTION

The Indian economy is experiencing a downturn after a long spell of

growth. Industrial growth is faltering, the current account deficit is

widening, foreign exchange reserves are depleting, and the rupee is

depreciating.

The crisis originated in the United States but the Indian government had

reasons to worry because there was a potential adverse impact of the

crisis on the Indian banks. Lehman Brothers and Merrill Lynch had

invested a substantial amount in Indian banks, who in turn had invested

the money in derivatives, leading to exposure of even the derivatives

market to these investment bankers.

Public Sector Unit (PSU) banks of India like Bank of Baroda had

significant exposure towards derivatives. ICICI faced the worst hit. With

Lehman Brothers having filed for bankruptcy in the US, ICICI (India‘s

largest private bank), survived a rumor during the crisis which argued that

the giant bank was slated to lose $80 million (Rs. 375 crores), invested in

Lehman‘s bonds through the bank‘s UK subsidiary. Even Axis Bank was

affected by the meltdown.

The real estate sector in India was also affected due to Lehman Brother‘s

real estate partner having given Rs 7.40 crores to Unitech Ltd., for its

mixed use development project in Santa Cruz. Lehman had also signed a

MoU with Peninsula Land Ltd, an Ashok Piramal real estate company, to

fund the latter‘s project amounting to Rs. 576 crores. DLF Assets, which

holds an investment worth $200 million, is another major real estate

organization whose valuations are affected by the Lehman Brothers

dissolution.

The impact of the crisis on the Indian economy has been studied here

forth and the study is chiefly focused on 4 major factors which affect the

Indian economy as a whole.

These are:

(i) Availability of global liquidity

(ii) Decreased consumer demand affecting exports

(iii) The Financial Crisis and the Indian IT Industry

(iv) The Financial Crisis and India‘s Financial Markets 9

Availability of Global Liquidity for India in times of Financial

Crisis:

The main source of Indian prosperity had been Foreign Direct Investment

(FDI). American and European companies were bringing in truck-loads of

dollars and Euros to get a piece of pie of Indian prosperity. Less inflow of

foreign investment will lead to a dilution of the element of GDP driven growth.

India is in no position to ever return this money because it has used the same in

subsidizing the petroleum products and building low quality infrastructure.

Liquidity is the major driving force of the stock market performances observed

in emerging markets. Markets such as those of India are especially dependent

on global liquidity and international risk appetite. The initial stage of the crisis

witnessed rising interest rates across global economies. Rising interest rates

tend to have a negative impact on global liquidity, and subsequently equity

prices, as funds may move into bonds or other money market instruments.

Even though there are threats for the Indian economy due to the global liquidity

crunch, they are all oriented for the long term. Any short term liquidity concern

will be taken care of by the high rate of household and corporate savings in the

country. The Indian economy can certainly rely on its ‗piggy bank‘ to address

its short-term liquidity demands as the government is taking measures to

channelize large sums of household savings lying unused in physical assets into

the more productive financial sector. Thus, the Indian economy will be

relatively unaffected by the global liquidity crunch.

Indian companies which had access to foreign funds for financing their trading

activities are the worst hit. Foreign funds will be available at huge premiums but

will be limited to the blue-chip companies, thus leading to

Reduced capacity of expansion leading to supply pressure

Increased interest rates which will affect corporate profitability

Increased demand for domestic liquidity which will put interest rates

under pressure

Decreased consumer demand affecting exports:

Consumer demand has plummeted drastically in developed economies, leading

to a reduced demand for Indian goods and services, thus affecting Indian

exports.

Export oriented units are the worst hit; thus impacting employment

Trade gap has been widening due to the reduced exports, leading to

pressure on the rupee exchange rate

The Financial Crisis and Indian I.T. Industry

In India, IT companies, with nearly half of their revenues coming from

financial and banking service segments, are close monitors of the financial crisis

across the world. The IT giants which had Lehman Brothers and Merrill Lynch

(ML) as their clients are Tata Consultancy Services (TCS), Wipro, Satyam, and

Infosys Technologies. HCL escaped the loss to a great extent because neither

Lehman Brothers nor ML was its client.

Impact on Financial Markets:

The outflow of foreign institutional investment from the equity market has been

the most immediate effect of the crisis on India. Foreign Institutional Investors

(FIIs) have been major sellers in Indian markets as they need to retrench assets

in order to cover losses in their home countries, thus being forced to seek

havens of safety in an uncertain environment.

Given the importance of FII investment in driving Indian stock markets and the

fact the cumulative investment by FIIs stood at $66.5 billion at the beginning of

2008, the pullout of $11.1 billion during the first nine-and-a-half months of

2008 triggered a collapse in stock prices. The Sensex fell from its closing peak

of 20,873 on January 8, 2008, to less than 10,000 by October 17, 2008.

The withdrawal by FIIs also led to a sharp depreciation of the rupee. While this

depreciation may be good for the Indian exports which have been adversely

affected by the slowdown in global markets, it is not so good for those who

have accumulated foreign exchange payment commitments.

The financial crisis has reinstated the notion that in the globalized world, no

country can exist as an island, insulated from the twists and turns of the global

economy; growth prospects of emerging economies have been undermined by

the cascading financial crisis, though there certainly exist significant variations

across the countries.

UNDERSTANDING BUSINESS CYCLES

Business Cycle or Economic Cycle refers to economy-wide fluctuations in

production or economic activity over several months or years. These cycles are

characteristic features of market-oriented economies – whether in the form of

the alternating expansions and contractions which characterize a classic

business cycle, or the alternating speedups and slowdowns that mark cycles in

growth.

A recession occurs when a decline – however initiated or instigated – occurs in

some measure of aggregate economic activity and causes cascading declines in

the other key measures of activity. Thus, when a dip in sales causes a drop in

production, triggering declines in employment and income, which in turn feeds

back into a further fall in sales, a vicious cycle results and a recession ensues.

This domino effect of the transmission of the economic weakness, from sales to

output to employment to income, feeding back into further weakness in all of

these measures in turn, is what characterizes a recessionary downturn.

In the Keynesian view, business cycles reflect the possibility that the economy

may reach short- run equilibrium at levels below or above full employment. If

the economy is operating with less than full employment, i.e., with high

unemployment, then in theory monetary policy and fiscal policy can have a

positive role to play rather than simply causing inflation or diverting funds to

inefficient uses.

BACKGROUND OF THE CRISIS

A disorderly contraction in wealth and money supply in the market is the basic

cause of a financial crisis, also known as a credit crunch. The participants in an

economy lose confidence in having loans repaid by debtors, leading them to

limit further loans as well as recall existing loans.

Credit creation is the lifeblood of the financial/banking system. Credit is created

when debtors spend the money and which in turn is ‗banked‘ and loan to other

debtors. Due to this, a small contraction in lending can lead to a dramatic

contraction in money supply.

The present global meltdown is a culmination of several factors, the most

important being irrational and unsustainable consumption in the West

particularly in United States disproportionate to its income by consistent

borrowings fueled by savings and surpluses of the East particularly China and

Japan.

The second important factor is the greed of the investment bankers who induced

housing loans by uncontrolled leveraging on an optical illusion of increasing

prices in the housing sector.

The third important factor is the failure of the regulating agencies who ignored

the warning signals arising out of the ballooning debts, derivatives and financial

innovation on the assumption that the Collateral Debt Obligation (CDO), the

Credit Default Swapping (CDS) and Mortgaged Backed Securities (MBS)

would continue to remain safe with the mortgage guarantees provided by

Government Sponsored Enterprises (GSEs) namely Fannie Mae and Freddie

Mac which had enjoyed the political patronage since inception.

There are other several factors including shadow banking system, financial

leveraging by the investment bankers and lack of adequate disclosures in the

financial statements leading to fallacious ratings by the rating agencies.

The global financial crisis is the unwinding of the debt bubbles between 2007

and 2009. On December 1 2008, the National Bureau of Economic Research

(NBER) officially declared that the U.S. economy had entered recession in

December, 2007. The financial crisis has moved into an Industrial crisis now as

countries after countries are sharing negative results in their manufacturing and

services sectors.

CAUSE OF THE CRISIS: The Financial Crisis:

The current crisis has been linked to the sub- prime mortgage business, in which

US banks give high-risk loans to people with poor credit histories.

These and other loans, bonds, or assets are bundles into portfolios or

Collateralized Debt Obligations (CDOs) and sold to investors across the globe.

Falling housing prices and rising interest rates led to high numbers of people

who could not repay their mortgages. Investors suffered losses and hence

became reluctant to take on more CDOs. Credit markets froze and banks

became reluctant to lend to each other, not knowing how many bad loans and

non-performing assets could be on their rivals‘ books.

The crisis began with the bursting of the United States housing bubble and high

default rates on sub- prime mortgages and adjustable rate mortgages (ARM).

The foreclosures exceeded 1.3 million during 2007 up 79% for 2006 which

increased to 2.3 million in 2008, an 81% increase over 2007.

Financial product called mortgaged backed securities (MBS) which in turn

derive their value from the mortgage installment payments and housing prices

had enabled financial institutions and investors around the world to invest in

U.S. housing markets. Major banks and financial institutions which had

invested in such MBS incurred losses of approximately US $ 435 billion as of

July 2008 which has mounted further and is now near to the value of US $ 1

trillion.

The owners of stock in US corporation alone has suffered loss of about US$ 8

trillion between 1 January and 11 October 2008 as the value of their holding

declined from US $ 20 trillion to US $ 12 trillion. The first catastrophe took

place when Bear Stearns was sold to JP Morgan at a throw away price in April

2008. The biggest adverse impact was on Fannie Mae (The Federal National

Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage

Corporation); the two Government Sponsored Enterprises (GSEs) were granted

a very quick bailout package by the US Treasury. A record breaking level of

mortgage foreclosures took place for the subprime mortgages. This led to a

sharp decline in the value of securities which were based on these mortgages.

Most of the investment bankers including Fannie Mae and Freddie Mac reached

to the brink of bankruptcy. When homeowners default, the payments received

by MBS and CDO investors decline and the perceived credit risk rises. This has

had a significant adverse effect on investors and the entire mortgage industry.

The effect is magnified by the high debt levels (financial leverage) households

and businesses have incurred in recent years. Finally, the risks associated with

American mortgage lending have global impacts, because a major consequence

of MBS and CDOs is a closer integration of the USA housing and mortgage

markets with global financial markets.

IMPACT OF THE CRISIS

The global financial crisis is already causing a considerable slowdown in most

developed countries. Governments around the world are trying to contain the

crisis, but many suggest the worst is not yet over. Stock markets are down more

than 40% from their recent highs. Investment banks have collapsed, rescue

packages are drawn up involving more than a trillion US dollars, and interest

rates have been cut around the world in what looks like a coordinated response.

Leading indicators of global economic activity, such as Rate of unemployment

shipping rates, are declining at alarming rates. hikes to 8.9% in the US: 539,000

jobs lost

The continuous development of the crisis had prompted fears of a global

economic collapse. Retail sales in the US have plunged to historic lows and

business and consumer US GDP shrinks by 8.1% confidence are at their lowest

levels. Most of the companies have reported steep decline in sales due to the

slackened in the first Quarter demand in the market. The rate of unemployment

in the United States has skyrocketed to 8.9% with the loss of a total of 539,000

jobs. US GDP shrunk 6.1% in the first US Foreclosures spike quarter; the fall in

GDP is recorded despite an increase in consumer spending in the economy

which is trying to 32% in April, 2009 recuperate from the crisis. The fourth

quarter of the previous year had recorded the highest contraction in GDP since

the past 25 years – the economy contracted by 6.3%. US Home Prices fall 14%

in first quarter

In the classical economics scheme of things, the free market economy is set to

correct itself when it verges away from full employment. This was proven to be

untrue in the 1930‘s Great Depression when up to a fourth of the workers in the

US were out of work.

Quoting US Economist Paul Krugman, as noted in New York Times column,

1. The bursting of the housing bubble has led to a surge in defaults and

foreclosures, which in turn has led to a plunge in mortgage-backed securities –

assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little

capital – too few assets compared with their debt. This problem is especially

severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they

haven‘t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling their

assets, including those mortgage-backed securities, but this drives asset prices

down and makes their financial condition even worse. This vicious cycle is

what some call the ‘paradox of deleveraging.’

On October 11, 2008, the head of the International Monetary Fund (IMF)

warned that the world financial system was teetering on the "brink of systemic

meltdown" The sequence of the event can be summarized as below for

understanding at a glance.

Bear Stearns was acquired by J.P. Morgan Chase in March 2008 for $1.2

billion. The sale was conditional on the Fed's lending Bear Sterns US$29 billion

on a nonrecourse basis.

The Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac

were both placed in conservatorship in September 2008. The two GSEs have

more than US$ 5 trillion in mortgage backed securities (MBS) and other debt

outstanding.

Merrill Lynch was acquired by Bank of America in September 2008 for $50

billion.

Scottish banking group HBOS agreed on 17 September 2008 to an emergency

acquisition by its UK rival Lloyds TSB, after a major decline in HBOS's share

price stemming from growing fears about its exposure to British and American

MBSs. The UK government made this takeover possible by agreeing to waive

its competition rules

Lehman Brothers declared bankruptcy on 15 September 2008, after the

Secretary of the Treasury Henry Paulson, citing moral hazard, refused to bail it

out.

AIG received an $85 billion emergency loan in September 2008 from the

Federal Reserve, which AIG is expected to repay by gradually selling off its

assets. In exchange, the Federal government acquired a 79.9% equity stake in

AIG.

Washington Mutual (WaMu) was seized in September 2008 by the USA Office

of Thrift Supervision (OTS). Most of WaMu's untroubled assets were to be sold

to J.P. Morgan Chase

British bank Bradford & Bingley was nationalized on bankruptcy in Q1 29

September 2008 by the UK government. The government assumed control of

the bank's £50 billion mortgage and loan portfolio, while its deposit and IMF:

Economic Crisis to branch network are to be sold to Spain's Grupo Santander.

In October 2008, the Australian government Germany sees GDP announced that

it would make AU$4 billion available plunge 3.8%, worst to nonbank lenders

unable to issue new loans. After drop in 40 years discussion with the industry,

this amount was increased to AU$8 billion.

In November 2008, the U.S. government announced by 1.6% it was purchasing

$27 billion of preferred stock in Citigroup, a USA bank with over $2 trillion in

assets, and warrants on 4.5% of its common stock. The preferred stock carries

an 8% dividend. This purchase follows an earlier purchase of $25 billion of the

same preferred stock using Troubled Asset Relief Program (TARP) funds.

INDIA AND THE FINANCIAL CRISIS

The global financial crisis has not left India unscathed. Over the last seven

months, growth has slipped dramatically - to 5.3% in the last quarter of calendar

year 2008 - from over 9% in the previous four years. The contagion of the crisis

has spread to India through all the channels – the financial channel, the real

channel, and importantly, as happens in all financial crises, the confidence

channel.

The slowdown is likely to have a large and immediate impact on employment

and poverty. Informal surveys suggest significant job losses. Job creation is

likely to remain a key concern as new entrants to the labor force - relatively

better educated and with higher aspirations - continue to put pressure on the job

market.

The country has the option of turning the crisis into an opportunity. The most

binding constraints to growth and inclusion will need to be addressed:

improving infrastructure, developing the small and medium enterprises sector,

building skills, and targeting social spending at the poor. Systemic

improvements in the design and governance of public programs are crucial to

get results from public spending. Improving the effectiveness of these programs

- that account for up to 8-10% of GDP - will therefore be an important part of

the challenge.

The impact of the crisis on the Indian economy has been studied here forth and

the study is chiefly focused on 4 major factors which affect the Indian economy

as a whole. These are:

(i) Availability of global liquidity

(ii) Decreased consumer demand affecting exports

(iii) The Financial Crisis and the Indian IT Industry

(iv) The Financial Crisis and India‘s Financial Markets 19

7.1. Global Liquidity Crunch and the Indian Economy

The Indian banking system was gauged as being relatively immune to the

factors that had lead to the turmoil in the global banking industry. The problems

of the global banks arose mainly due to the sub-prime mortgage lending and

investments in complex collateralized debt obligations (CDOs) whose values

were sharply eroded. Confidence-related issues had also affected banks across

the globe due to the freeze in the inter-bank lending market. Indian banks had

limited vulnerability on both counts.

The reasons for tight liquidity conditions in the Indian markets during the earlier

stages of the crisis were quite different from the factors driving the global

liquidity crisis. Large selling by foreign institutional investors (FIIs) and the

subsequent interventions by the Reserve Bank of India (RBI) in the foreign

currency market, continuing growth in advances, and earlier increases in the

Cash Reserve Ratio (CRR) to contain inflation are some of the reasons that

accelerated the Indian liquidity crunch.

Thousands of investors, big and small, have been hurt by the India’s Household

and downward plunge of the Indian stock market. It will also Corporate Savings

will have broader implications for India‘s financial system and fuel the

domestic the future savings and investment patterns.

Cautious investors had started to diversify away from bank when the global

deposits and cash over the past few years, and had moved to liquidity crunch is

equities, mutual funds and insurance products. The current market turmoil is

driving them back to the safety of bank- aggravating the deposits, reducing the

amount of capital available to other economic downturn in instruments and

possibly retarding the growth of the other parts of the financial-services industry

as a whole.

India's high savings rate has been a crucial driver of its economic boom,

providing productive capital and helping to fuel a virtuous cycle of higher

growth, higher income and higher savings. Since the 1990s, the gross domestic

savings rate has risen steadily from an average of 23% to an estimated high of

35% in the 2006/07 fiscal year (April-March). The latter rate compares very

favorably not only with developed economies (the US and the UK have savings

rates of around 14%), but also with other emerging economies—with a few

exceptions such as Malaysia (38%) and Chile (35%).

Yet India's household sector (including some small businesses) continues to

account for the lion's share—some 70%—of savings. The last five years have

seen a surge in corporate savings as companies became more competitive and

increased their profitability. That has been accompanied by a rise in public-

sector savings on the back of increased fiscal prudence. However, the current

economic situation is putting pressure on both corporate profitability and the

public finances, ensuring that savings in these two sectors are unlikely to grow

as rapidly as in the past. Household savings will therefore remain crucial to

sustaining a strong savings rate.

India will be relatively unaffected by the global liquidity crisis because the

large fund of India‘s household savings which stood at Rs9.85trn (US$192bn)

in 2006/07, will remain available to fuel domestic growth. At an aggregate

level, households in India had net savings of Rs 9, 53,212 crore in financial and

physical assets in 2007-08 or 19.9% of the GDP, estimated at current market

prices.

In the preceding year, it was Rs 8, 24,493 crore, or 20.2% of the GDP. Thus, as

GDP rose 14.4% at current market prices, net savings of the households grew

15.6%.The Indian government is trying to hasten the shift of India‘s physical

savings, still locked up in unproductive physical assets such as houses, durables,

and jewellery, into financial assets. The household savings can be channelized

into the country‘s debt, equity, and infrastructure finance markets. This would

not only deepen and stabilize the financial markets but also reduce the

government‘s social-security burden.

It is evident from the graph shown alongside that the ratio of gross domestic

savings to the GDP of the country has been increasing over the years.

Influx of these household savings into the country‘s debt, equity, and

infrastructure finance markets will certainly help in the deepening and

stabilization financial markets.

Gross National Savings also include all foreign remittances into India which

add to the domestic savings. A positive trend in the ratio further strengthens the

fact that India is self- sufficient in the short-term with regard to any immediate

liquidity demand.

India's savings rate at present is higher than all other regions of the world,

except developing Asia and Middle East. The country's investment rate showed

sharp acceleration during the period FY02-07 to surpass the average of all major

regions of the world in FY07.

However, according to a report5, factors which could weigh down the rate of

domestic savings to a moderate 33.0% and further to 32.8% during FY09 and

FY10 respectively from around 37.7% in FY08 are:

Lower corporate profitability

Significant widening of fiscal deficit

Erosion in value of financial and physical assets

Most Asian economies have been models of prudence. While American and

European households were borrowing up to the hilt, Asian ones were tucking

away their savings. While rich-country banks were piling into ever-riskier

assets, Asian banks kept their holdings of such assets small. And while America

and Britain were sucking up the world‘s savings, Asian governments piled up

vast stocks of foreign reserves.

The long-term trends in the savings of the country are a clear indicator of the

fact that even if India’s savings and investment rates undergo a cyclical

reduction in FY09, by next fiscal (FY10) these rates should still be around 30%,

with 6% growth in the second half of FY10.

7.2. Decreased Consumer demand affecting exports

Some of the sharpest declines in output during the global recession have been

suffered by the strongest economies of Asia. It is feared that due to their heavy

dependence on exports, some of these economies may not see the face of

recovery until demand rebounds in America and Europe.

In October 2008, India registered its first every year-over-year decline in

exports (of 15%), following growth of 35% in the previous five months. Indian

shipments declined 33.3% in March from a year earlier, the biggest fall since

the last 14 years.

Goods exports dropped 33% from a year earlier to $11.5 billion in April 2009.

This was the biggest fall since April 1995. Exports slid 21.7% in February.

India‘s exports, which account for 15% of the economy, grew 3.4% to $168.7

billion in the fiscal year ended March 31, missing a $200 billion target set by

the government, before the collapse of the Lehman Brothers Holding Inc.

accelerated the world financial and economic slump. The government expects

exports to total to $170 billion in the year that started April 1.

According to estimates from the Federation of Indian Export Organizations,

falling overseas sales may cost India about 10 million jobs.

“Asia is A high fiscal deficit and a high current account deficit are a threat to

economic stability—which is the main reason why international suffering from

credit rating agencies have brought the country‘s debt close to junk two

recessions: status. a domestic one Asia‘s export driven economies had benefited

more than any other as well as an region from America‘s consumer boom, so its

manufacturers were external one.” bound to be hit hard by the sudden

downward lurch.

Asia is suffering from two recessions a domestic one as well as an external one.

Domestic demand had been expected to cushion the blow of weaker exports, but

instead it was hit by two forces. First, the surge in food and energy prices in the

first half of 2008 squeezed companies‘ profits and consumers‘ purchasing

power. Food and energy account for a larger portion of household budgets in

Asia than in most other regions. Second, in several countries, including China,

South Korea and Taiwan, tighter monetary policy intended to curb inflation

choked domestic spending further. With hindsight, it appears that China‘s credit

restrictions to cool its property sector worked rather too well.

Shipments of Indian natural pearls, precious and semi-precious 12% of India’s

stones, and pharmaceutical products, all recorded a decline causing Indian

exports to the US to drop by 22.63% to $5.22 billion in Q1 of total exports of

2009. According to data from the US International Trade Commission, Indian

exports to the US were $6.75 billion during Q1 of 2008.

The Indian Gems and Jewellery sector was significantly affected by the reduced

demand in the United States and Europe. Overseas sales of India‘s gem and

jewellery items expanded at a seven-year low rate of 1.45% and stood at $21

billion in 2008-09, as exports contracted sharply in the last six months of the

year. This lead to about 200,000 job losses in the sector, especially of artisans

engaged in polishing diamonds.

The fall in exports was caused by lowering of demand in overseas markets for

luxury items in the backdrop of the ongoing global recession.

Exports of cut and polished diamonds dipped 8.24% to $13.02 billion. This

pulled down the overall growth trade of the sector as diamonds accounts for 62

per cent of the overseas sales. The drop in expansion of gems and jewellery

exports in 2008-09 was cushioned by a 23.6% growth in gold jewellery, which

stood at $6.85 billion as against $5.54 billion in the year-ago period.

Dun & Bradstreet (D&B) expects exports to be around US$ 178 billion in

FY09, which is approximately US$ 22 billion lower than the Government's

target, owing to economic downturn witnessed in India's key export markets.

D&B, however, expects exports to witness some revival during the second half

of FY10, when the world economy begins to stabilize. D&B expects exports to

grow around 14% to US$ 203 billion during FY10.

India and the other Asian economies will have to brace themselves up for the

sharply reduced consumption in the United States over an extended period,

following the global financial crisis, and change the export-dependent structure

of its economies and create more regional demand to drive their growth. 7 rd

Business Standard, 23 April, 2009 8 Dun and Bradstreet’s India Economic

Outlook, 2009-10 24

7.3 The Financial Crisis and the Indian IT Industry

India‘s emergence as a globally competitive supplier of software and services

has attracted world-wide attention. The software and service sector not only

contributed significantly to export earnings and GDP but also emerges as a

major source of employment generation in the country. Besides, the information

technology (IT) sector has served as a fertile ground for the growth of new

entrepreneurial ideas with innovative corporate practices and has been

instrumental in reversing the brain drain, raising India‘s brand equity and

attracting foreign direct investment (FDI) leading to other associated benefits.

Economists have long noted that services in general are cheaper in developing

countries than in developed countries. An abundant supply of labor – the major

input in the production of services – in developing countries, leading to low

wages is the chief factor that accounts for the low cost of producing services.

With the recent emergence of business process outsourcing delivered over the

Internet, the so- called IT enabled services (ITES-BPOs) as a major source of

employment and foreign exchange, The impact of the global financial crisis,

rooted in the United States, on the Indian IT sector can be easily gauged from

the fact that approximately 61% of the Indian IT sector‘s revenue were from

clients in the US. 58% of the revenue contribution of the top five players who

account for 46% of the IT industry‘s revenues is from US clients.

The US financial services and insurance sector (BFSI – Banking, Financial

Services, and Insurance) was one of the earliest adopters of the trend of

outsourcing along with India‘s biggest IT-outsourcing firms. Large outsourcing

chunks were created by the US BFSI which made the Indian IT players learn

from their experience.

Indian companies were appreciated by the US clients for their flexibility, good

quality delivery and giving a key lever in managing their selling, general, and

administrative expenses (SG&A) and time to market by freeing up more critical

IT resources. Indian players were essentially partners in taking some of the

fixed costs out of their SG&A. Because there was no partnering of Indian firms

with the financial services entities at any closer level, like tying up of their

invoices with the client‘s business outcomes, the Indian players were saved

from a much worse impact of the crisis. The slowing US economy has seen

70% of firms negotiating lower rates with their suppliers and nearly 60% are

cutting back on contractors. Due to a squeezed budget, only about 40% of the

companies plan to increase their use of offshore vendors. The US financial

crisis has put the growth of the Indian It industry in the short-to-medium-term in

an uncertain position. Growth numbers of IT companies were revised down by

2-3% after sentiment started building up against the US financial sector at the

time of the Q1 results. A worse downward revision is expected this quarter as

well, though some larger players like TCS, and Satyam have denied any larger

impact of the crisis.

Some factors offsetting the revenue slowdown are:

Favourable Rupee-dollar exchange rate

Growth de-risking through Europe

Growth in non-financial verticals

Growth through counter-cyclical new business (countercyclical to US

slowdown)

New outsourcing opportunities will also be provided by merger activities as

newly-merged entities may have to look at additional or new providers to

support the integration work with a broader global presence – considering the

large size of combined business operations.

In addition to Mergers and Acquisitions, financial institutions will also be on

the look-out for ways to reduce their SG&A costs quickly which will opt for

outsourced solutions that affect the cause efficiently and effectively.

Efficiencies – Indian IT companies continue to be made of the same DNA as

during the dotcom days, and measures to shore up efficiencies are already

underway since we saw the exchange rate hit 39 to the Dollar. Some of those

gains are permanent since the processes have not been rolled back after the

Rupee started depreciating. Potential measures are voluntary salary cuts,

complete moratorium on salary raises, travel reduction, tightening of promotion

spends, just-in-time hiring, and hire-after-contract.

While we have looked mainly at IT, the ITES sector is joined at the hip with IT

industry, but with its own flavors. The impact in financial services operations

will be much larger, but, over the medium to long term, there will be a huge

gain for them from the increase in outsourcing and off-shoring in the financial

sector. However, short-term pain alongside the US slowdown is inevitable.

Financial Crisis and the Satyam Saga:

In the light of the debacle of the Satyam Computer Services, the current

financial crisis has brought the issue of audit committee effectiveness to the fore

in India.

Satyam, India‘s fourth largest computer software exporter, after years of vastly

inflated profits, was shattered and exhausted when the shocking reality of

Satyam‘s operating margin of 24% being false was brought to the forefront – its

operating margins were a meager 3%. Satyam worked with more than a third of

the Fortune 500, and claimed good financial health. Satyam has a remarkably

small promoter shareholding of 8.6%. They had 61.57% shareholding by

institutions of which 46.86% is made up of foreign institutional investors (FIIs).

The financial crisis also struck the company at a time when there were growing

suspicions related to the Maytas issue. Satyam was not able to maintain its

inflated figures in the wake of the crisis and hence, its majestic accounting fraud

was brought to the forefront.

Opportunities for India’s IT sector:

1. Make the growth vs. profitability tradeoff early on during the slowdown:

profitability levers are still available if growth is sacrificed when required, and

managed well

2. Utilize some of the unavoidable fixed costs for implementing investment

ideas that have been on the backburner and could not be done away with due to

high utilization

3. M&A opportunities exist in the US, both in financial sector and non-financial

sector

4. Intellectual Property (IP) and product related investments in the US should

be assessed and made

5. Operational efficiencies can be adhered to especially in an attractive labor

market and an environment of budget spend/uncertainty

7.4. The Financial Crisis and India’s Financial Markets:

Despite the vanishing foreign institutional investors (FIIs), the Indian markets

remained resilient and stayed afloat. Investors‘ sentiments have been

significantly impacted by the US financial crisis. The tendency of investors to

withdraw from risky markets has resulted in significant capital outflows that

have led to a liquidity crunch putting pressure on the Indian stock market.

The Indian economy continues to show good health because of the strength of

its domestic drivers, like infrastructure projects, SME Decline in RBI’s (small

and medium enterprises) sector exports and good yielding from the agricultural

sector.

The cause behind US economy debacle is that the US investment Depreciation

of banks are extremely over leveraged and solely dependent on whole the Rupee

sale finances. This led to their demise. But such is not the case with Indian

Banks. The common man‘s deposits are more in India and Decline in Stock they

have the trust on the Banks, because all most all the Banks are Market Indices

nationalized and the depositor‘s interest is highly protected by Government of

India.

In the US, the investment banks are dependent on institutional investor‘s funds.

These investments are highly volatile and always search for high returns on

their deposits. They look for Demand-based investments and not time-based

investments. Therefore, whenever the returns from one market start dipping,

they move their investment to re-invest in those markets which would offer a

better return, or take a defensive stance until the market regains momentum.

Domestic banking in India is generally secure, especially because nationalized

banking remains at the core of the system. Even so, there exist signs of fragility

and inadequacy within the banking sector. The effects of the global crisis have

directly impacted some important macroeconomic variables. Three such

indicators stand out in terms of their sudden deterioration since the middle of

last year:

(i) Decline in the foreign exchange reserves held by the Reserve Bank of

India

(ii) Fall in the external value of the rupee, especially vis-à-vis the US dollar

(iii) Decline in the stock market indices

Measures taken by the RBI to stop depreciation of the Rupee led to a steep

decline in its foreign exchange reserves. Factors which also contributed to the

decline were the revaluation in foreign currencies and large scale pullout by

foreign institutional investors.

8. BAIL-OUT PACKAGES AND RBI INITIATIVES

Financial markets in the United States and around the world are in a state of dire

emergency and they require urgent and decisive action. Some key parts of the

credit market were on the verge of a deadlock, resulting not just in the collapse

of major financial institutions but also in credit disruption that has been severely

weakening the long-term prospects of non-financial companies.

There was a need for swift action to deal with the ‗toxic‘ mortgage-backed

securities that had been causing credit markets to seize up. The Federal

government‘s effort to support the global financial system have resulted in

significant new financial commitments, with the U.S. government having

pledged more than $11.6 trillion on behalf of American taxpayers over the past

20 month, far in excess of the aggregate of the several bailout packages

announced or dolled out in the past, as may be evident.

The U.S. Treasury also added $200 billion to its support commitment for Fannie

Mae and Freddie Mac, the country‘s two largest mortgage-finance companies.

The Government of China had also announced a financial package of US$ 585

billion to pump prime the economy by making huge public investment and by

providing subsidies to protect domestic economy which is otherwise exposed to

external market and is likely to be severely affected because of the cuts in

imports by all the major importing countries.

8.1. India’s response to the Crisis

As the contagion of the financial system collapse across the world spread

towards India, and into it, the government and the Reserve Bank of India (RBI)

responded to the challenge in close coordination and consultation. The main

plank of the government‘s response was fiscal stimulus while the RBI‘s action

comprised monetary accommodation and counter cyclical regulatory

forbearance.

The RBI‘s policy response was to keep the domestic money and credit markets

functioning normally and see that the liquidity stress did not trigger solvency

cascades. RBI‘s targets can be classified into 3 prime directions: (Duvvuri

Subbarao, Governor)

(i) To maintain a comfortable rupee liquidity position

(ii) To augment foreign exchange liquidity

(iii) To maintain a policy framework that would keep credit delivery on track

so as to arrest the moderation in growth

The previous period has forced RBI to adopt tightened monetary policies in

response to heightened inflationary pressures. However, the RBI changed its

approach to handle the current scenario and eased monetary constraints in

response to easing inflationary pressures and moderation in growth in the

current cycle.

The following were the conventional measures of the RBI:

(i) Reduced the policy interest rates aggressively and rapidly

(ii) Reduced the quantum of bank reserves impounded by the central bank

(iii) Expanded and liberalized the refinance facilities for export credit

To manage Foreign Exchange, the RBI

(i) Made an upward adjustment on interest rate ceiling on the foreign

currency deposits by non-resident Indians

(ii) Substantially relaxed the External Commercial Borrowings (ECB)

regime for corporates

(iii) Allowed access to foreign borrowing to non-banking financial

companies and housing finance companies

RBI also took unconventional measures as a response to the liquidity scenario:

(i) Indian banks were given the rupee-dollar swap facility to give them comfort

in managing their short-term funding requirements

(ii) An exclusive refinance window, as also a special purpose vehicle, was

made available for supporting non-banking financial companies

(iii)The lendable resources available to apex finance institutions for refinancing

credit extended to small industries, housing and exports, was expanded

The Central Government‘s Fiscal Responsibility and Budget Management

(FRBM) Act, enacted to bring in fiscal discipline by imposing limits on fiscal

and revenue deficit, proved to be the road map to fiscal sustainability at the time

of the crisis. The emergency provisions of the FRBM Act were invokes by the

central government to seek relaxation from the fiscal targets and two fiscal

stimulus packages were launched in December 2008 and January 2009.

These fiscal stimulus packages, together amounting to about 3% of GDP,

included:

Additional public spending, particularly capital expenditure, government

guaranteed funds for infrastructure spending

Cuts in indirect taxes,

Expanded guarantee cover for credit to micro and small enterprises, and

Additional support to exporters.

These stimulus packages came on top of an already announced expanded safety-

net for rural poor, a farm loan waiver package and salary increases for

government staff, all of which too should stimulate demand.

The cumulative amount of primary liquidity potentially available to the

financial system through these measures is over US$ 75 billion or 7% of GDP.

Taking the signal from the policy rate cut, many of the big banks have reduced

their benchmark prime lending rates. Bank credit has expanded too, faster than

it did last year

OUTLOOK FOR THE INDIAN ECONOMY

India is witnessing a mixed result with respect to its growth prospects in the

wake of the global economic downturn. Real GDP growth has moderated to

6.6% and is projected to grow at the same rate in 2009-10.

The Services sector too, which accounts for 57% of India‘s GDP, and has been

the country‘s prime growth engine for the last five years, is slowing, mainly in

construction, transport and communication, trade, hotels and restaurants sub-

sectors.

According to recent data, demand for bank credit has been slackening despite

sufficient liquidity in the system. India‘s exports, which account for 15% of the

economy, grew 3.4% to $168.7 billion in the fiscal year ended March 31,

missing a $200 billion target set by the government.

Corporate margins have been dented due to higher input costs and dampened

demand; business confidence has been affected by the uncertainty around the

economic condition. The Index of Industrial production has been showing a

negative growth and the demand for investment is decelerating.

India, though, certainly has some advantages in addressing the fallout of the

crisis:

(i) Headline inflation, as measured by the wholesale price index, has

fallen sharply; inflation has declined faster than expected. Key factors

behind the disinflations have been commodity prices and a part of it is

contributed by slowing domestic demand.

(ii) Decline in inflation should prove to be positive for reviving consumer

demand and reducing input costs for corporates

(iii) Fiscal space will open up for infrastructure spending as the decline in

global crude prices and naphtha prices will reduce the amount of

subsidy given to the oil and fertilizer companies

(iv) Imports are expected to shrink more than exports; this will keep the

current account deficit at modest levels

(v) India‘s sound banking system has helped to sustain the financial

market stability to a large extent -well capitalized and prudently

regulated

(vi) Overseas investors are confident about the Indian economy due to

comfortable levels of foreign reserves

(vii) The negative impact of the wealth loss effect in the capital markets

that have plagued the advanced countries will not affect India because

majority of Indians stay away fro asset and equity markets

(viii) Institutional credit for agriculture will also remain unaffected because

of India‘s mandated priority sector lending

(ix) Agriculture sector of India will be further insulated from the crisis due

to the government‘s farm waiver package

(x) India‘s development of social safety programs over the years (e.g. the

rural employment guarantee program), will protect the poor and

migrant classes from the ill effects of the global crisis

Therefore, once the global economy begins to recover, India‘s turn around will

be sharper and swifter, backed by its strong financial system and regulatory

norms.

The present global crisis has taken the shape of the Great depression of 1929 at

least in US and Japan. The biggest losers will be US, Japan and China. The

biggest gainers may be India, Brazil and few other developing countries with

their own domestic savings and domestic market. The world will have to

undergo the impact in different forms, somewhere it will be economic

slowdown, somewhere recession and somewhere depression.

LIMITATIONS OF THE STUDY

The current project discusses key issues of the Indian economy that cropped up

as the global economy is swaying in its worst economic downturn. Though the

major factors have been discussed, yet there exist more issues which have not

been detailed due to time constraints.

As the economies across the globe try to protect themselves from the hazards of

the crisis, they are trying to maintain domestic demand and protect their

domestic industry from foreign invasions, lest their own economy might

destabilize. This has been giving rise to ‗Protectionism‘ and rising incidences of

countries resorting to protectionist measures have been recorded at the World

Trade Organization.

India has been recorded to initiate the maximum number of anti-dumping

investigations against goods exported into the country. America is propagating

its ‗Buy American‘ campaign in order to help itself become a more self-

sufficient economy. The Chinese economy is reeling from the global drop in

exports; China‘s economy is highly industrialized and a significant fraction of

its GDP is accounted for by its exports to the United States.

Therefore, apart from internal factors that have affected global economies,

there are critical external factors and trade behavior that dictate the nations

across the globe to resort to measures to help themselves. The discussion of

such issues in detail has not been made a part of the report at hand, though a

significant amount of information has been analyzed and studied for the same.

Apart from these, there may be some technical flaws like:

(i) The accuracy and reliability of the data collected – data across different

sources may vary slightly

(ii) The measurability of the factors relating to the crisis across a global scale

may not be thorough – considering all the factors would not be a feasible

option.

(iii) Opinion biasness may also exist.

The study of the global financial crisis is inexhaustible, and it will continue as

long as the world economy does not become self-sustainable again. The

impacts of the crisis are a test of the financial market stabilities and regulations

across the global economy; the corrections that will be made have been long

overdue

ENTREPRENEURSHIP IN TIMES OF FINANCIAL CRISIS

Entrepreneurship can be technically defined as a process of starting new

organizations or revitalizing mature organizations, particularly new businesses,

generally in response to identified opportunities. Jean-Baptiste Say, a French

economist who first coined the word entrepreneur in about 1800, said: ―The

entrepreneur shifts economic resources out of an area of lower and into an area

of higher productivity and greater yield.

The dictionary definition of entrepreneur reads as ―a person who organizes and

manages any enterprise, esp. a business, usually with considerable initiative and

risk‖; and also ―an employer of productive labor; contractor‖. The propensity to

take risks and the desire to create wealth are some qualities possessed by

entrepreneurs that define their entrepreneurship.

Entrepreneurs are ruthlessly opportunistic; they would persevere with a business

plan at a time when others are chasing full-time employment opportunities. The

act of innovation holds prime importance; the size of the company is a

secondary aspect to that. Entrepreneurs have traditionally faced the shortage of

finance, not of ideas. Moreover, the human capital is also a critical aspect of an

organization. The growing industry of venture capitalists has greatly fostered

entrepreneurship across the globe. Talented people in an organization make the

core machinery of ideas and execution. To establish themselves, businesses

need to put forward substantial value propositions and a clear path to achieving

their set goals and objectives. Above all, intellectual capital is the chief

component of entrepreneurship; human capital and monetary capital fall after

that. The information age makes it even easier for ordinary people to start

business now.

Entrepreneurship is a stimulator of economic growth and social cohesiveness.

The globalization of entrepreneurship is raising the bar of competitiveness for

all the players. Once-closed economies like India and China have opened up to

enterprisers and entrepreneurs from all over the globe. Innovative entrepreneurs

carry more weight because of their ability to create more jobs.

The economic downturn has put the global economy in an awkward situation.

The motives of established entrepreneurs are being questioned and their

disastrous results are being scorned off at. In the wake of scandals over

established figures like Enron, and Satyam, things have become more difficult

for start-ups. Potential entrepreneurs are lured towards a safe and secure

government job and are becoming increasingly apprehensive of taking the risk

of venturing into an unknown territory. Risk, the lifeblood of the entrepreneurial

economy, is becoming something to be avoided.

However, the current financial crisis also brings with itself some unprecedented

opportunities that can prove to be a resource haven for the upcoming and new

entrepreneurs. Those who are planning to start and manage a new business will

now encounter a fresh set of values and a need to go back to the basics of

managing a business. Though the crisis does not put forth an appealing

landscape for entrepreneurs, yet those with rational expectations will face no

dearth of opportunities or ideas or innovations. The average life cycle of a start-

up from inception to exit will be much longer – over 5 years – chiefly due to

reduced mergers and acquisitions and late initial public offerings. Persistence

and commitment are the need of the hour and the willingness to wait with

patience before reaping the harvests of an endeavor is indispensable. Those who

are driven by the desire for a windfall should prepare themselves for

disappointment.

Aspiring entrepreneurs should realize that the receding economy offers them the

best time to start a company. The market is full of talented people looking for

new opportunities. The opportunity cost of letting go of an attractive and high-

paying job is very low as there is a general decline in employment opportunities

across the globe.

Moreover, the ordinary costs of doing a business are depressed. Space,

equipment, and any other resourceful asset were never available at such low

investments. Raising finance in times of the credit crunch is a tough task, but

what should be kept in mind is that competitive pressures are much lower

during downturns and it becomes relatively easier to establish one‘s company as

the leader. Advertising and other marketing expenditures are very low and it‘s

easy to make a mark when relatively few in the market are trying to do so.

Being the holder of a private company, the entrepreneur would not have to

worry about quarter-to-quarter performance and the investors would also have a

long term perspective. ‗

Time‘ is another critical aspect. A business, at its inception, needs to do a lot of

market research, research of potential customers, product designing and

building, and also look for investors and financing opportunities. What is not

expected from a start-up is the potential to start selling as soon as it is

conceived.

Therefore, the current slump in demand across global economies is a non-entity

with respect to a start-up. Moreover, any new business initially sells to the

‗early adopters‘ whose buying patterns are independent of the economic state of

the environment.

Therefore, the initial customer base is not susceptible to economic cycle

changes and the business can head off for a great start.

Poorly capitalized start-ups can cope with the grinding recession by

reallocating their existing financials and keeping non-essential activities out of

operations. Focus should be on the more important features and marketing costs

should be cut down to a minimum unless it is proven to give a positive return on

investment. Money from all payments which can be deferred should be put into

more productive areas of the business. Even well capitalized start-ups need to

keep themselves buckled up and cut costs wherever possible. However, it

should be borne in mind that ruthless slashing of marketing costs does a lot of

harm in the future when companies have to spend a lot more than they saved in

order to recover. Therefore, a balanced and judiciously thought out approach

should be followed.

Entrepreneurship has the potential to drive an economy out of the economic

turmoil. It creates new jobs, generates revenue, advances innovation, enhances

productivity, and improves business models and processes. Entrepreneurship

has never been as vital for an economy as it is today. The risks and rewards go

hand-in-hand. A company should keep its strategic thinking flexible enough to

manage uncertain times and should have the aptitude to look beyond the crisis.

History has demonstrated time and again that entrepreneurship and new

companies is the way to bolster a flagging economy. Giants like Microsoft,

Genentech, Gap, and The Limited were all founded during recessions.

Companies which started off in the Depression include Hewlett- Packard,

Geophysical Service (now Texas Instruments), United Technologies, Polaroid,

and Revlon. A plummeting economy helps initiators to develop a business

which has the tenacity to survive though difficult times and which is relatively

unaffected by a cycle of bankruptcies.