Subprime Crisis & its Implication on India


Manik Gursahani
Student of PGP-Finance
[Class of 2007-09]
Alliance Business School


Considering the lasting impact it has had on the world's leading financial institutions, 'subprime', has perhaps been the most dreaded, as well as the most oft-heard word in financial circles worldwide in the past six months or so. Ask a stock trader and he will have plenty of tales about how the 'subprime' demon took a toll on him as well as hundreds of other investors, big and small.

The root cause, as is the case in most of the market meltdowns, has been wide-scale euphoria. This time it pertained to mortgages. Post 2000, the US markets witnessed an environment of benign interest rates, which encouraged cheap borrowing and fueled housing prices. Things started assuming a bubble-like proportion as the lenders too joined the party with lenient lending covenants and 'innovative' loan products, which basically provided more convenient re-payment options at the start of the mortgage. These conditions prompted borrowers to buy homes far more expensive than their financial situation warranted. The originators re-financed these mortgages by financially re-packaging them into different types of products and selling them to other financial institutions. However, the scenario changed after a series of policy rate hike by the US Federal Reserve led to increased interest rates on floating housing loans and subsequently increasing defaults by borrowers. Some of the major financial conglomerates reported sub-prime related losses running into billions, repercussions of which were felt not only in the US financial markets but across the globe.

It seems that the direct effects of sub prime on the Indian markets are pretty limited. We have to look only at the collateral dimension, if there is any. Collateral damage can come in two forms; one is through a generalized slowdown in the global economy, more specifically in the US. If the US slows down, then the decoupling for emerging markets cannot be too far away. We are already facing a slowdown in the Indian economy as the GDP growth rate has declined to 7.9% by August 2008. The other channel is typically we are getting more financially integrated across the world. Capital market integration means that if there is a liquidity crisis coming out of the subprime crisis, then that can affect us in some fashion. The liquidity crisis has just begun in the foreign market which might reflect out the Indian markets too as the FII's inflows has started drying up all around the globe after 'Black Monday'.

The US will slow down significantly and the US investor is at risk. That is something, which is a serious problem. If you look at market behavior, over the last 10-15 years, whenever the Fed cut rates, it has normally been good for markets, provided that the US does not go into a recession. But at present the situation is quite adverse. The wiping of biggest investment banks in US has led to risk of employment for numerous employees of these companies in US & in other nations in which India also comprises. The employees of these firms are being converted into sales executives by domestic AMC's at half of their net salary.

As the slowdown in the India's Bull Run have its consequences on the FII's investments in India. The chief technical officers (CTO) of US-based companies, having their back-office operations in India, will be compelled to lower their budget, which will further have a cascading impact on Indian companies. The major chunk of FII investments from US would be negative as most of these investors will pull out money from the equity market, with European countries at a risk after the US crisis will restrict their investments in the domestic markets. This would lead to major FII's turning their back from the equity markets of India as on 16th September about $2.2 billion of the investments of FII's came into the debt market of India. Thus we can finally say that the bull run of the Indian equity market is over. 

There was a certain amount of FDI investments by Merrill Lynch in various India companies which would have a major effect on their future operations. Among them are two major real estate firms of India- 'DLF' & 'Unitech'. The net investments by Merrill Lynch which was wiped out turned out to be about $400 million.

Major sectors in India that would be affected out to a certain extent due to the current crisis are:

  • Banking Industry
  • IT & IT enabled services
  • Real Estate
  • Oil & Gas
  • FMCG

The good part of the story is that unlike China, which had an export oriented economy, the Indian economy was based on the domestic market. The India's trade theory is changing a lot as it is turning out to be more of a manufacturing export oriented country. The net trade of services done by India accounts to about just 22% just reflecting the risk on trade services is tried to be minimized. Also in the current scenario the trade practices of India with US has decreased and on the other hand has relatively increased with China reflecting out that the risk of US recession has been deflected.

A lot of experts being commenting that the India IT sector will have a major impact with effect to these banking crisis in US recently. The major Indian IT majors had all these companies as their major clients. So on a short term it will have its effect on these IT companies and also on its revenues in their future quarter results. Indian IT employees use to be mainly outsourced to US by various companies which would drastically reduce. The growth in the employment in the IT sector in the year 2008 was 44 % up till August 08 which will drop to about 28% net growth for this financial year. 

As US economy slowing down the US dollar is suppose to get weaken which it has started when compared to pound & has beaten seven year record but when compared with the Indian Rupee, which has turned up weak would reflect out to the India's GDP. Much more weakening of Indian Rupee beyond Rs 48 would lead RBI to take some monetary measures to support Indian Economy.

The Indian Banking Industry is not well known in the foreign market specially & there are no big players of India among the top world banks where as other developing countries like China has few banks among the top World Bank list. This gives a green signal to Indian banks like ICICI & SBI which are not much affected to the subprime crisis & thus can readily expand their services in the international markets. ICICI bank has faced a net loss of Rs 375 cr. in the current banking crisis. 

Learning from Sub Prime Crisis for India are:-

1. Sound banking practices:  The root cause of the sub prime mortgage (even prime mortgage loans are in trouble in US; e.g., trouble in Countrywide, America's biggest home loan lender) crisis is the unsound credit practices that emerged in the US market. Fake certification, which helps an ineligible person to raise a home loan, cannot be ruled out in India. Housing loan frauds are not uncommon in the cities of India and the aggressiveness with which housing loans are being sold by banks and financial companies in violation of sound credit practices cannot be ignored. Personal loans and overdue credit cards are the other sectors which the regulators and bankers should handle carefully because they have the potential to plunge the Indian banking sector into a crisis.

2. Controlled Derivatives market:  Derivatives are financial instruments, which can spread the default risk attaching to loans. All the same, indiscriminate use of such derivatives can lead to havoc as in US. Derivatives lead to such a chain reaction that it will be nearly impossible to quantify the risk of exposure to bad loans and advances subsequently. RBI and GOI should prohibit indiscriminate use of such derivatives if they intend to introduce such products in India.

3. Limited investment by Indian companies abroad:   Prudent investment abroad should be the order of the day. Reckless investment in the derivatives market abroad by banks and financial institutions has to be controlled.

In the recent crisis, BNP Paribas of France and Macquarie Bank of Australia have been affected because of such overseas investments. The exposure of Indian banks to the sub prime crisis of US is minimal.

4. Quality Inward Investment:  FDI should be given priority over FIIs as history has shown that flight of capital in case of FDI is low compared to that in respect of FIIs. Due to their stable nature, FDI can help in the growth of the country's infrastructure

Manik Gursahani
Student of PGP-Finance
[Class of 2007-09]
Alliance Business School

Source: E-mail September 20, 2008




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