World Financial Crisis III

In this third and concluding part of the series on World Financial Crisis we will
discuss different scenarios we may experience in times to come. So far we have
Sensex 9,975 covered topics regarding mortgage bubble that started showing its ugly sign in early
2007 and blew up unprecedentedly later, bailout plans and anatomy of the financial
crisis. Here we will try to throw light on various possibilities that may take shape of
the reality in next few years. Experts are drawing parallel lines to compare today’s
scenario with what happened during great depression in 1930s or US financial crisis
in 1907. And they say history repeats itself. There are people who still claim that the
US will go in recession; some aver it is already in recession whereas some argue it’s
just a mild recession.

All about recession

We know that the US economy has suffered 10 recessions since the end of World
Nifty 3,074 War II. But what is recession after all? Before we explain you should remember that
one has to fall to rise and vice versa. An economy which grows over a period of time
tends to slow down the growth as a part of the normal economic cycle. An economy
typically expands for 6-10 years and tends to go into a recession for about six
months to 2 years. A recession is a decline in a country's gross domestic product
(GDP) growth for two or more consecutive quarters of a year. A recession is also
preceded by several quarters of slowing down. A recession normally takes place
when consumers lose confidence in the economic growth and spend less. This
culminates into a shrinking demand for goods and services, which in turn leads to a
decrease in production, lay-offs and a surge in unemployment. Investors spend less
as they fear stocks prices will fall and thus stock markets fall due to negative
sentiment. Now we can relate to such scenario because this is what we are
experiencing around us. By this definition we may deduce that the US is not in
recession yet because the real GDP grew by 2.8% in Q2 versus 0.9% in Q1 2008.
But there are enough reasons to expect that real GDP growth will slow sharply in
2009 thanks to the current housing market adjustment and the credit famine taking
their toll on country’s demand. Slowing growth in the developed world will also arrest
US export growth in 2009.

What happens in a recession?

 Shrinking demand for goods and services due to less consumer spending
 Significant decrease in output, more layoffs and surge in unemployment
 Steep fall in stock markets due to strong negative sentiments
 Weaker demand for commodities which will ease off inflation
 Significant decline in consumer spending
 Credit crises likely to affect economic growth in the US and Europe for at
least 2 years or so
 It will hit capex i.e. corporate expansion plans and consequently the
employment generation.
 State’s cash injection into the system will further fuel the inflation while
Deepak Tiwari deteriorating the fiscal deficit.
Research Analyst
 A high inflationary situation will mount pressure in the value of the country’s
deepakt@arthamoney.com currency.

T: + 91 22 4063 3032

October 18, 2008 For Private Circulation only 1

 US Economic Health O’meter: A snapshot

 The real GDP continuously grew by 2.8% in Q1 FY2008 against 0.9% in the
previous quarter. It is expected to sharply fall further down in 2009-10.

QoQ Real GDP Growth

6.0

5.0

4.0

3.0

2.0

1.0

0.0 II

II

II
IV

IV
I

I
III

III
-1.0 2006 2007 2008

 In the US payrolls have been chopped by 159,000, more than the 100,000 that
was expected which was the ninth straight month of job losses. It is expected this
trend will continue. The unemployment rate remained flat at 6.1%, as expected.
It’s pertinent to note that a staggering 760,000 jobs have disappeared so far this
year.

 The US September Retail Sales fell 1.2%, the largest drop since August 2005.
Retail sales have now fallen for three consecutive months. Even excluding the
struggling auto industry, sales fell 0.6%.
th
 Fed interest rate is already at the lowest level of 1.5% after a straight 8 cut and
it is expected that Fed will cut further by 50 bps as inflation recede.

 The US Consumer price inflation pegged at 4.9% down 0.1% in the month of
September 2008.

 US consumer confidence improved marginally for the third month in a row in

September since a recent low in June, but remained at a dismal level compared
with a year ago, according to The Conference Board Consumer Confidence
Survey.

 US housing starts fell more than expected in September to 817k representing a

month-over-month decrease of 6.3% against 6.2% in August pushing the number
of starts to its lowest level since 1991 and second lowest level on record.

 Q2 corporate profits fell 3.8% sequentially versus a fall of 1.1 % in the previous
quarter. Profits of domestic financial companies and net profits of US companies
earned abroad accounted for nearly all of the decline. Barring Q2 2007, corporate
profits have been declining since Q4 2006.

 Industrial production plunged a shock 2.8% in September, the steepest fall in

34 years, due to hurricanes in the Gulf of Mexico and a strike at Boeing. For the
Q3 as a whole, industrial production decreased at an annual rate of 6%.

October 18, 2008 For Private Circulation only 2

 What we can expect in the US next?
 Nationalization of major financial institutions
 Cap on CEOs’ compensations
 Greater and stricter regulations
 Increased role and intervention of Govt. in business
 Return of an era of protectionist policies in US and the end of crony
capitalism

Can it lead to depression?

What's the difference between a recession and a depression? If the GDP of a

country drops by at least 10% then this can be classed as a depression. By these
standards, the last depression the US suffered was The Great Depression in the
1930's. By this definition we don’t expect this will lead to another depression in
existing circumstances. Yes growth is already slowing down and will continue to
slow down further but economy will bounce back in another 2 years.

Moreover, situation is not that bad. As during Great Depression US saw

unemployment rate of 25% which is 6.1% currently. During that time, thousand of
banks failed and it took three years for the Govt. to take action, but this time the
Govt. was quite active. This apart, this time we see coordinated efforts across the
globe by various governments and central banks taking every possible step to shore
up growth and stimulate respective economies. Current credit crises may recede in
few quarters but likely to take two years for the economies to stabilise. However, we
are yet to see ebb of European financial crises. There is risk that if the crisis in
Europe deepens further it may offset the positive effects of measures taken by the
US Govt. One wonders what will happen If this recession reaches Middle East or
other emerging markets?

How to deal with recession?

There are various steps a government takes to cope with recession. It includes tax
cuts, hiking government spending in order to create more jobs and helping private
sector through several measures to tide over such crisis. In the current case, the
Bush government had proposed a $150-billion bailout package in tax cuts in
January this year and likely to announce some more such incentives. Other steps
that the US Govt. and its regulatory authorities and its European counterparts have
taken so far are:

 Rate cuts
 SEC suggestions of relaxing on mark to market policy
 Fed to pay interest on reserves from October 1, 2008
 Tax incentives in the form of cuts
 FDIC deposit insurance limit raised from $100k to $250k

How will such steps going to help?

Recapitalization of banking financial system will encourage banks to begin lending

again. We see despite central banks pumping liquidity into the banking system still
banks are dithering to lend each other. Heightened risk aversion and cash hoarding
amongst banks are to be blamed for the widening spread between LIBOR and the
Overnight Index Swap (OIS) which is to unprecedented levels. Raising deposit
insurance limit will enable banks to attract large inflows of funds. Steps will restore
confidence of investors and depositors in banking system.

October 18, 2008 For Private Circulation only 3

 Are emerging market leaders de-coupled?
According to the IMF, in the past a 1% decline in US growth had led to a decline in
growth in emerging economies by between 0.5% and 1%, depending on trade and
financial links to the US. Now it’s needless to say that the proponents of the so called
de-coupled theory have gone absconding. Also because that often goods traded
among developing nations are eventually exported to the US or Europe.

As far as India’s trade and financial links to the US is concerned, India’s share of
exports of goods to the US has been consistently declining. In 2006 it was 16.8% of
total exports at $17.35 billion which fell down to 14.9% at $18.85 billion in 2007 which
further sagged to 12.7% at $ 20.71 billion. Contrary to this imports of goods from the
US have been on the rise. The share of India’s imports from the US increased to 6.3%
at $ 11.73 billion in 2007 to 8.4% at $ 21.02 billion in 2008. In other words, our trade
with the US is growing but mostly in imports of goods as the trade balance is
expanding sharply every year from just $ 14.3 billion in 2004 to $ 59.3 billion in 2007 to
$ 88.4 billion.

But India’s exports of services particularly IT and IT related services have been
growing exponentially. A major chunk of it comes from America followed by the
European countries. But such stream of revenues comes from BFSI segment which
has been hit the most in current financial turmoil.

October 18, 2008 For Private Circulation only 4

 Impact on India
The India economy may lose 1- 2 percentage points or even more in GDP growth in
this fiscal year. Indian IT firms and those having big export contracts in the US
would see their bottom-line and margins shrinking. Moreover, IT firms will be under
pressure and would not be allowed to bargain while renewing their expiring
contracts at favourable prices. Agencies are already engrossed in scaling down
India’s GDP growth forecasts. CMIE has revised its forecast for FY09 at 8.7% while
CLSA’s prognosis is 7.3%. CLSA’s GDP forecast for FY10 is 6.5%.

Some of the after effects of the US recession are:

 FIIs exodus
 Slowdown in FDIs
 US companies to cut IT spend will hit IT firms
 Pressure on Indian Govt. for reform in financial sector.
 India Inc may be compelled to diversify to other geographies like China,
Africa, West Asia and domestic markets.
 More bloodbath on the Dalal Street

Opportunities in disguise for IT firms

What could go in our favour?

In case of the US recession Indian rupee may strengthen against the greenback.
But experts say a weak dollar could bring more foreign money to Indian markets. Oil
may get cheaper brining down inflation. A recession could bring down oil prices to
$50. Moreover, in the aftermath of the fall of financial giants of Wall Street like
Lehman Brothers and Merrill Lynch, IT firms may find some interesting opportunities
as western institutions would be under pressure to cut their costs significantly. And
here our Indian companies see big opportunities there. We believe that after coping
with Y2K and dot com era, Indian IT firms will once again stand tall and emerge
stronger.

October 18, 2008 For Private Circulation only 5

 World Indices since January 2008

%
18-Jan 17-Oct Change
SENSEX 19,013.70 9,975.35 -47.5%
NIFTY 5,705.30 3,074.35 -46.1%
SHCOMP 5,180.51 1,909.94 -63.1%
NIKKEI 13,861.29 8,693.82 -37.3%
HSI 25,201.87 14,554.21 -42.2%
STRAITS 3,050.09 1,878.51 -38.4%
DJIA 12,099.30 8,852.22 -26.8%
NASDAQ 2,340.02 1,711.29 -26.9%
S&P 500 1,325.19 940.55 -29.0%
FTSE 5,901.70 4,063.00 -31.2%

Impact on Indian equities

The economy and the stock market are inextricably linked. We can see that Asian
indices have borne the brunt of the sub-prime mess most than that of developed
countries despite strong growth trajectory. The Indian bourses have lost close to
50% from the January 18, 2008 level. Interestingly the US and FTSE have lost the
least.

30,000.00

25,000.00

20,000.00

15,000.00
January Level
10,000.00
Current Level
5,000.00

0.00
NIKKEI

STRAITS
DJIA
NASDAQ
SENSEX

SHCOMP

HSI
NIFTY

S&P 500
FTSE

October 18, 2008 For Private Circulation only 6

 Major US Recessions so far and the Stock markets

The US has seen two longest recessions during mid-1940s until 2007. And it lasted for 16 months each, one extending from
November 1973 to March 1975, and the other from July 1981 to November 1982. In both of these cases there was a considerable
decline in real GDP.

Name Period Duration Causes How Dow Jones Fared?

Stock markets crashed worldwide, and a banking collapse took place Dow Jones lost 89.2% from its peak of
in the United States. This sparked a global downturn, including a 381 in March 1929 to low of 41 in July
1929– second, more minor recession in the United States, the Recession of 1932. Further, it recovered only 32%
Great Depression 1939 10 years 1937. until the end of 1939.
After a post-Korean War inflationary period, more funds were Dow Jones experienced a long term
transferred into national security. The Federal Reserve changed consolidation phase since early 1951
1953– monetary policy to be more restrictive in 1952 due to fears of further and started nothbound journey only in
Recession of 1953 1954 1 year inflation. 1954.
Monetary policy was tightened during the two years preceding 1957,
followed by an easing of policy at the end of 1957. The budget
balance resulted in a change in budget surplus of 0.8% of GDP in 1957 In this period too, Dow Jones struggled
1957– to a budget deficit of 0.6% of GDP in 1958, and then to 2.6% of GDP in and began to advance only in early
Recession of 1957 1958 1 year 1959. 1958.
During this period, Dow Jones lost
45.1% from its peak of 1,052 in
A quadrupling of oil prices by OPEC coupled with high government January 1973 to low of 474 in June
1973– spending due to the Vietnam War lead to stagflation in the United 1974. By the end of 1975, it retraced
1973 oil crisis 1975 2 year States. 58% of the loss in the period.

The Iranian Revolution sharply increased the price of oil around the
world in 1979, causing the 1979 energy crisis. This was caused by the
new regime in power in Iran, which exported oil at inconsistent
intervals and at a lower volume, forcing prices to go up. Tight
monetary policy in the United States to control inflation lead to During this period Dow Jones traded in
another recession. The changes were made largely because of the ballpark of 759- 1,071 and
1980– inflation that was carried over from the previous decade due to the remained lull before started surging in
Early 1980s recession 1982 2 year 1973 oil crisis and the 1979 energy crisis. 1983.
1990– Industrial production and manufacturing-trade sales decreased in Dow Jones remained range bound in
Early 1990s recession 1991 1 year early 1991. the range of 2,365 and 3,169.
The collapse of the dot-com bubble, the September 11th attacks, and During this period, Dow lost 35.7%
2001– accounting scandals contributed to a relatively mild contraction in the from its peak of 11,338 in 2001 to its
Early 2000s recession 2003 2 year North American economy. low of 7,286 in 2002.
Source: Wikipedia, Artha Money Research, yahoo finance

October 18, 2008 For Private Circulation only 7

 0
100
200
300
400
500
600
50

0
100
200
300
400
500
600
700
0
100
150
200
250
300
350
400
450
1/3/1956 1/2/1951 1/2/1929
3/2/1951 5/2/1929
3/3/1956 9/2/1929
5/2/1951

October 18, 2008

7/2/1951 1/2/1930
5/3/1956 5/2/1930
9/2/1951
9/2/1930
7/3/1956 11/2/1951
1/2/1931
1/2/1952 5/2/1931
9/3/1956 3/2/1952 9/2/1931
5/2/1952 1/2/1932
11/3/1956
7/2/1952 5/2/1932
1/3/1957 9/2/1952 9/2/1932
11/2/1952 1/2/1933
3/3/1957 5/2/1933
1/2/1953
9/2/1933
5/3/1957 3/2/1953
1/2/1934
5/2/1953
5/2/1934
7/3/1957 7/2/1953 9/2/1934
9/2/1953 1/2/1935
9/3/1957
11/2/1953 5/2/1935
How the Dow Jones fared during the US recessions

1/2/1954 9/2/1935
11/3/1957
Dow Jones during 1953-54

For Private Circulation only

3/2/1954 1/2/1936
5/2/1936

Dow Jones during 1957 recession

1/3/1958 5/2/1954
Dow Jones during Great Depression

9/2/1936
7/2/1954
3/3/1958 1/2/1937
9/2/1954
5/2/1937
5/3/1958 11/2/1954 9/2/1937
1/2/1955 1/2/1938
7/3/1958 3/2/1955 5/2/1938
5/2/1955 9/2/1938
9/3/1958 7/2/1955 1/2/1939
9/2/1955 5/2/1939
11/3/1958
9/2/1939
11/2/1955

8
 0
500
0
0

1000
1200
1400
200
400
600
800
1000
1200

1000
1500
2000
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3500
4000
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800
1/2/1990 1/2/1980 1/3/1972
3/2/1980 3/3/1972

October 18, 2008

3/2/1990
5/2/1980 5/3/1972
5/2/1990
7/2/1980 7/3/1972
7/2/1990 9/2/1980 9/3/1972
11/2/1980 11/3/1972
9/2/1990
1/2/1981 1/3/1973
11/2/1990 3/2/1981 3/3/1973

1/2/1991 5/2/1981 5/3/1973

7/2/1981 7/3/1973
3/2/1991
9/2/1981 9/3/1973
5/2/1991 11/2/1981 11/3/1973

7/2/1991 1/2/1982 1/3/1974

3/2/1982 3/3/1974
9/2/1991
5/2/1982 5/3/1974
Dow Jones 1973 oil crisis

Dow Jones during 1980-82

11/2/1991 7/2/1982 7/3/1974

For Private Circulation only

Dow Jones during 1990-91
9/2/1982 9/3/1974
1/2/1992
11/2/1982 11/3/1974
3/2/1992
1/2/1983 1/3/1975
5/2/1992 3/2/1983 3/3/1975
5/2/1983 5/3/1975
7/2/1992
7/2/1983 7/3/1975
9/2/1992
9/2/1983 9/3/1975

11/2/1992 11/2/1983 11/3/1975

9
 Dow Jones during dot com recession
14000
12000
10000
8000
6000
4000
2000
0
1/3/2000
3/3/2000
5/3/2000
7/3/2000
9/3/2000
11/3/2000
1/3/2001
3/3/2001
5/3/2001
7/3/2001
9/3/2001
11/3/2001
1/3/2002
3/3/2002
5/3/2002
7/3/2002
9/3/2002
11/3/2002
1/3/2003
3/3/2003
5/3/2003
7/3/2003
9/3/2003
11/3/2003
Dow Jones post sub-prime crsis
16000
14000
12000
10000
8000
6000
4000
2000
0
10/3/2007

11/3/2007

12/3/2007

10/3/2008
1/3/2007

2/3/2007
3/3/2007

4/3/2007

5/3/2007

6/3/2007

7/3/2007

8/3/2007

9/3/2007

1/3/2008

2/3/2008
3/3/2008

4/3/2008

5/3/2008

6/3/2008

7/3/2008

8/3/2008

9/3/2008

Sources and references:

Yahoo Finance
Wikipedia
Bureau of Economic Analysis, US Dept. Of Commerce
Artha Money Research.

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October 18, 2008 For Private Circulation only 10