Support for the Sub Primary Market Finance Essay

The financial turmoil that engulfed the US during 2007-09 began in the mortgage lending markets. Indicators of the emerging problems came in early 2007 when, first, the Federal Home Loan Mortgage Corporation (commonly known as Freddie Mac or Freddie) announced it would no longer purchase high-risk mortgages and, second, New Century Financial Corporation - a leading mortgage lender to riskier customers - filed for bankruptcy. The crisis set in as house prices started to fall and the number of foreclosures rose dramatically. This in turn caused credit rating agencies to downgrade their risk assessments of asset-backed financial instruments in mid-2007. The increased risk restricted the ability of the issuers of these financial products to pay interest, and reflected the realisation that the bursting of the US housing and credit bubbles would entail unforeseen losses for asset-backed financial instruments. Between the third quarter of 2007 and the second quarter of 2008, $1.9tr of mortgage-backed curities received downgrades to reflect the reassessment of their risk. This represented an immediate and severe dislocation of the financial markets.The odds are only about 1 in 10,000 that a bond will go from the highest grade, AAA, to the low-quality CCC level during a calendar year. So imagine investors surprise on Aug. 21 when, in a single day, S&P slashed its ratings on two sets of AAA bonds backed by residential mortgage securities to CCC+ and CCC, instantly changing their status from top quality to pure junk. Amidst continuing tight credit markets, 5mortgage and financial firms received support from the Federal Reserve (Fed) through short-term lending facilities and auctions for the sale of mortgage-related financial products. However, such actions were unable to prevent rapid falls in asset prices as institutions sought to relieve themselves of these risky burdens and replenish their risk-weighted 6capital ratios. Mortgage lender Countrywide Financial was bought by Bank of America for $4bn in January 2008, while many other firms had their credit ratings downgraded [1] . It would have been hard, even a few months prior to the collapse of Lehman Brothers, to anticipate the impact that the global financial crisis would have on the Indian economy. This is because the Indian banking system did not have any direct exposure to subprime mortgage assets or any significant exposure to the failed institutions, and the recent growth had been driven predominantly by domestic consumption and investment. And yet, the extent to which the global crisis impacted India was dismaying, spreading through all channels - the financial channel, the real channel and the confidence channel. The reason why India was hit by the crisis was because of its rapid and growing integration into the global economy. [2]

CHAPTER 1

GLOBAL CRISIS; ITS ROOT CAUSES

The global economic crisis that began in 2007 was largely unexpected. Just before the crisis, the IMF in its bi-annual World Economic Outlook announced that risks to the global economy had become extremely low, given that capital inflows pushed up borrowing and asset prices, while reducing spreads on risky assets. 9 Also, since 2000, the world economy had continuously expanded at high rates. High growth of the world economy was spread across advanced, emerging and developing countries and allowed unemployment and poverty to decline (Figure 1). High demand from fast-growing developing and emerging markets led to high commodity prices that benefited growth in natural resource-rich countries. 1980-1999 200-2008 Here blue colour shows world, whereas red is for advanced economy and green is of emerging and developing economy. The Great Moderation was considered to be the result of several developments: for one, business and financial deregulation as well as financial innovation had created a more flexible and adaptable economic system. Financial assets were considered to be less risky than before, giving rise to higher levels of financial intermediation which in turn helped fuel growth as well as greater financial innovation, especially through hedge funds. Volatility of business cycles had also declined because the world experienced abundant liquidity-partly reflecting surplus savings in a number of emerging markets-giving the false sense that stability was due to some structural improvement in the financial system. Also, growing globalization and free trade, partly boosted by China's entry into the World Trade Organization in 2001, as well as the buoyant growth of China and other newly emerging economies was expected to keep inflation at bay even as global growth accelerated [3] .

Causes of the financial turmoil

The US housing market ; Creation of a housing bubble [4] US house prices rose dramatically from 1998 until late 2005, more than doubling over this period (see Chart 2), and far faster than average wages. Further support for the existence of a bubble came from the ratio of house prices to renting costs which rocketed upwards around 1999. Furthermore, Yale economist Robert Schiller found that inflation-adjusted house prices had remained relatively constant over the period 1899-1995. Pointing to the escalation in house prices and marked regional disparities. The rise in house prices reflected large increases in demand for housing and happened despite a rise in the supply of housing. The significant increase in the demand for housing is attributed to a number of factors. Low interest rate Sustained low interest rates from 1999 until 2004 made adjustable-rate mortgages (ARMs) appear very attractive to potential buyers. At least in part, low interest rates were driven by the large current account deficit run by the USA, mirrored by capital inflows from countries like China which avidly purchased US Treasury bonds , but also the decision (justified by a new economic paradigm) on the part of the Fed to keep interestrates lower than in similar previous scenarios. The Fed - and many of the world's other leading central banks - continued to pump liquidity into credit markets to ensure credit would continue to flow at low rates of interest.

Support for the sub primary market [5]

There is strong evidence to suggest that, in many parts of the US, it had become a lot easier, and cheaper, to receive a mortgage. A Federal Reserve study found that the gap between the interest rates facing the sub-prime and prime markets, America's most and least risky borrowers, fell dramatically from 2.8% in 2001 to 1.3% in 2007. Mortgage lenders who had previously sold their subprime loans on to Fannie and Freddie were threatening to bypass the middle-man and sell straight to the banks who sought to bundle up the loans into profitable securities. This activity posed a serious risk of moral hazard. As mortgage lenders became more profitable, selling riskier loans became more attractive as banks could sell on these mortgages. Empirically, this process of securitisation has been associated with a decline in credit quality. Accordingly, they devised 'teaser' schemes with initially low-interest rates or even interest-free mortgages to attract buyers who saw it as a chance to cast a 'bet' on the continuation of the inexorable rise in house prices. The initial lower rate period was also attractive for the banks as it gave them time to sell on mortgages before they defaulted. In addition, down payments were reduced, mortgages increasingly required little or no documentation or proof of income, and in some cases required no income, job or asset at all to qualify for a mortgage. In spite of its legal mandate to regulate abusive lending practices, the Fed failed to prevent such predatory lending. It is also likely that many of the mortgages were underpinned by fraudulent activity - perhaps up to 70% in the case of some lenders .

Speculations [6]

The upward rise in house prices was accentuated by property speculation. "In some markets, 10% to 15% of buyers were speculators. Speculative activity was exacerbated by the US's comparatively generous foreclosure rules: unlike in the UK, where foreclosure is likely to result in personal bankruptcy, homeowners in the US can generally just walk away from their home and mortgage.

Consequences

Together, these factors created a huge housing bubble. By 2005-06, the value of subprime mortgages relative to total new mortgages was estimated at 20% - as opposed to less than 7% in 2001. Subprime mortgage lending rose from $180bn in 2001 to $625bn in 2005. New Alt-A mortgages, the risk level between subprime and prime, had risen from 2% in 2001 to 14% by 2006. Dean Baker, co-director of the Center for Economic and Policy Research, valued the housing bubble at $8 trillion.

The collapse of the bubble

By 2006 a number of factors had conspired to burst the bubble. First, average hourly wages in the US had remained stagnant or declined since 2002 until 2009; in real terms this represented a decline. Consequently, prices could not continue to rise as housing became increasingly unaffordable. Second, growth in housing supply tracked price rises. 5While prices were able to withstand this downward pressure until 2005, once demand had subsided excess supply exacerbated the sharp fall in prices. Third, as interest rates rose to a peak of 5.25%, ARMs became less attractive and effectively removed many non-prime prospective buyers from the market - in the first half of 2006, the Mortgage Bankers Association found the value, and total number, of subprime mortgages to be down 30% on the second half of 2005. Fourth, as personal saving from disposable income fell below zero, fewer households had the requisite finance to support increases in debtThe collapse in house prices affected the ability, and the willingness, of mortgage owners to meet their payments. In some cases, house-owners with ARMs simply could not face the rise in their payments resulting from the steep rise in the Fed funds rate. As house prices fell, the options of either selling the property or re-financing the mortgage also diminished. This unfortunate position was exacerbated by the decline in the net savings rate, which meant homeowners had fewer financial reserves to help themselves. In other cases, there existed an incentive to voluntarily foreclose where the value of the house (and future gains associated with a stronger credit rating) was smaller than the value of the outstanding mortgage because of generous foreclosure legislation The rise in interest rates and fall in property values had a particularly damaging impact on those with ARMs. Consequently, 2007 and 2008 saw significant rises in delinquency and foreclosures. Serious mortgage delinquency rates rose in both the prime and subprime markets, although the latter's rise from just over 6% in 2006 to 18% in 2008 was particularly salient. The number of properties subject to foreclosure filings rose by 79% in 2006 to reach 1.3m in 2007, and increased by a further 81% to 2.3m in 2008 (a 225% increase on 2006). The expansion of credit to risky borrowers in the US extended beyond the housing market. Although mortgages were the largest single component, the value of non-mortgage asset-backed loans also grew considerably; accordingly, the issuance of asset-backed securities. (ABSs) quadrupled from 2001 to reach $1.3tr in 2006. These ABSs had gone through the same securitisation process as mortgage-backed securities (see below) and were thus equally vulnerable to collapses in the value of their underlying assets [7] .

The role of the financial industry

The web of financial instruments

The problems that arose from the housing bubble multiplied exponentially because of the manner in which they were re-packaged and distributed to the global financial markets. Complex innovations designed to maximise efficiency and profits by allocating risk to those happiest to bear it revolutionised finance in the mid 1990s. 67 The genesis of mortgage loans generally followed an intricate process where the initial loans were passed through a number of agents, and ended up scattered across financial markets [8] .

The securitization process

At the first stage in the process a household buys a mortgage from a mortgage lender. A rate of interest, fixed or variable, is agreed to be paid to the mortgage lender over a given period of time. The long-term interest rate is assessed on the basis of their credit history and score, and is greater where the risk of default is believed to be higher. At stage 2, the mortgage lender relieves himself of the risk of default by selling the mortgage on to a mortgage banker. Traditionally, mortgage bankers like Fannie and Freddie would issue bonds to purchase mortgages and sell the loans in parcels to the market. However, the innovative new financial process saw the mortgage banker in turn sell the mortgage on for a profit to an investment banker. This third stage may not occur where a mortgage bank also served the function of an investment bank - as was the case with Fannie and Freddie. Diagram 1 provides an overview of the process. Overview of the financial process

Household mortgage-----------Stage 1

Mortgage Lender--------------Stage 2

Mortgage Banker------------Stage 3

InvestmentBanker/Underwriter-------Stage 4

Credit Rating Agency--------------Stage 5

Investor---------------- Insurer-------------- Stage 6

At the fourth stage, the investment banker collects a large number of mortgages (or structured mortgage-based financial products) that it underwrites for the purpose of creating a security it can sell to investors. Using complicated financial instruments, investment bankers would pool together a large number (usually between 1,000 and 25,000) of mortgages into a security known as a mortgage-backed security (MBS) or a collateralised debt obligation (CDO) where the security could contain different types of assets including mortgages as collateral. By pooling together large numbers of assets, these securities dramatically reduced the risk of total default although maintained the same expected return (and risk-neutral credit spread ). Even where defaults occurred the owner would still receive returns from the acquired collateral (usually the house itself). A host of more complicated synthetic products such as CDO-squared were backed by the original securities, and were sold in a similar manner. The MBSs and CDOs varied in composition and form but yielded returns - either cash flows over time or market value - depending upon their risk profiles It is at stage 5 where the risk profile was generally calculated: credit rating agencies (CRAs) would make their risk assessment of these assets and their different tranches, and this would 'price' the security offered to the market by the investment banks but would also serve to inform risk-weighted capital requirements under the Basel II capital framework. Given that 80% of subprime MBSs were rated AAA (the highest credit rating level) and 95% at a least grade A, the securities appeared to be highly attractive investments, liable to offer generous returns which could be marked as low-risk assets on a firm's balance sheet. Once rated, the securities were either kept by investment banks - as investments or collateral - or parcelled off and purchased by investors including other banks, hedge funds and pension funds, as part of their asset portfolios [9] . The issuer would also receive a fee for managing the asset. Economist Markus Brunnermeier finds that pension funds generally purchased the safest tranches, hedge funds purchased riskier portions and the issuer retained the riskiest tranches for monitoring purposes. Selling such a security can benefit the issuer by providing cheap and diverse financing and removing risky assets from the balance sheet.

The use of credit derivatives

Banks needed to manage their risk and to meet their Basel capital requirements. Consequently, they sought protection against the riskiest securities issued in stage. This came in the form of a financial derivative called a credit default swap (CDS) which, in return for a fraction of the potentially large return, insured the holder of the MBS or CDO against the risk of default. The existence of 'naked' CDSs - CDS contracts where neither party actually held the underlying asset - created fertile ground for speculation on a firm's future creditworthiness as well as risk management. Insurance firms like AIG could make as many CDSs as they wished given that the market was unregulated. The Commodity Futures Modernization Act of 2000 specified that CDSs were not defined as insurance, securities or futures contracts (and therefore went unregulated). As long as the insurer remained AAA-rated, they did not need to put up any collateral; moreover, CDSs could be posted as profits immediately using default probabilities based on recent experience. Given that the CDS market contained considerable speculation upon the outcomes of the insurance/swap contracts, this ensured that derivatives traders across the world spread risks across an even broader spectrum of investors. Broadening the appeal of the process The process quickly grew in popularity as it promised significant profits at each stage. It is pertinent to note that throughout this chain each actor is betting on the same favourable outcome. Opportunities for involvement were magnified by a number of factors. In April 2004, a ruling by the Securities and Exchange Commission (SEC) permitted large investment banks to borrow more, and thereby allowing them to purchase and sell on more of the MBSs which were believed to offer excellent low-risk returns. This saw the investment banks raise their leverage ratios from the traditional level of approximately 12 dollars ofdebt for every 1 dollar of equity as high as 40 to 1. In conjunction, investors began adopting a more complacent approach to risk, having seen the Fed respond to previous asset bubbles by supporting liquidity injections. In the words of then President Bush, "Wall Street got drunk". Riskier prospects were particularly attractive at a time when bond yields had been driven down by low interest rates and the significant investment by China, among others, in US Treasury bonds. Moreover, mortgage brokers knew that the issuers of securities could sell almost any mortgage on the market, and accordingly this encouraged lenders to provide more loans. Lehman Brothers, for example, appeared to encourage generous lending standards and fraudulent activity at the mortgage lending firms (such as First Alliance) it had acquired. This cycle ensured that the market in MBSs, CDOs and CDSs reached vast proportions by 2007 MBSs valued at more than $2tr were issued into the bond market; CDOs were issued to the value of $521bn; although 90% of the CDS market was based on speculative bets, its notional value 88 soared to $62tr by December 2007.

The housing crash and the finance industry [10]

As the bubble burst, two key features endangered the returns from mortgage-backed assets: first, default meant that a large cash flow was halted; second, the housing collateral on which this was based saw a significant depreciation. Although the collapse of the subprime market cost the economy more than $1tr, the damage was greatly magnified by the web of financial instruments constructed around it - or the "chain reaction" as US Treasury Secretary Henry Paulson described it. Underpinning the complex financial instruments were a number of problems that broadened the collapse of the housing market to the financial sector as a whole. First, the formal and informal risk analysis underpinning the actions of each of the actors in Diagram 1 failed to accommodate the collapse of the housing bubble. Many models failed to integrate common shocks, and paid too little attention to unlikely but highlycostly "tail risks". Moreover, the formal statistical models used in the banks, CRAs, insurance firms and regulators made predictions which relied upon historical housing data generally only going back as far as two decades and which failed to reflect the relaxation of credit standards. Second, the credit ratings recommended by the CRAs may have suffered from inadequate risk analysis, conflicts of interests and a lack of competition. Third, the regulatory bodies failed to effectively oversee such activity and detect risks to the system. Many large, and systemically important, institutions had substantially increased their leverage both on and off their balance sheets. As leverage ratios reached50 in some cases, the potential losses associated with even a small fall in asset values increased dramatically. The new dynamic was particularly marked among the five large US investment banks following the SEC's 2004 rule change, and especially so at Bear Stearns where its leverage ratio reached 40 to 1 [11] . The financial crisis quickly spread to affect the US and world's real economy. Whether or not financial losses and uncertainty induced an irrational fear of further defaults (or hysteresis, in economic terminology), suspicion of financial firms ensured that interbank lending rates soared. In addition, banks and hedge funds experienced runs from depositors seeking to redeem their investments; this, in turn, required financial institutions to de-leverage further. Banks, without knowing the value of their assets, became uncertain of their lending capacities and became increasingly reluctant to make loans to institutions of uncertain creditworthiness. Firms that had used MBSs and CDOs as collateral for asset-backed commercial paper - essentially a short-term loan agreement engaged in by banks and corporations - could no longer receive the necessary loans as interest rate spreads spiked. Following the failure of the seemingly impregnable Lehman and AIG, money markets became highly conservative in their short-term lending. Consequently, a credit crisis developed which damaged firms in the real sector which relied upon loans for credit as well as financial firms needing large loans to increase their liquidity [12] .

CHAPTER 2

POLICY RESPONSE FOR FINANACIAL CRISIS

Severity of the 2008-2009 Recession

The 2008-2009 recession was long and deep, and according to several indicators was the most severe economic contraction since the 1930s (but still much less severe than the Great Depression) . The slowdown of economic activity was moderate through the first half of 2008, but at that point the weakening economy was overtaken by a major financial crisis that would exacerbate the economic weakness and accelerate the decline. When the fall of economic activity finally bottomed out in the second half of 2009, real gross domestic product (GDP) had contracted by approximately 5.1%, or by about $680 billion. At this point the output gap-the difference between what the economy could produce and what it actually produced-widened to an estimated 8.1%. The decline in economic activity was much sharper than in the nine previous post-war recessions, in which the fall of real GDP averaged about 2.0% and the output gap increased to near 4.0%. However, the recent decline falls well short of the experience during the Great Depression, when real GDP decreased by 30% and the output gap probably exceeded 40%. As output decreased the unemployment rate increased, rising from 4.6% in 2007 to a peak of 10.1% in October 2009, and remaining only slightly below that high into 2011. The U.S. unemployment rate has not been at this level since 1982, when in the aftermath of the 1981 recession it reached 10.8%, the highest rate of the post-war period. (During the Great epression the unemployment rate reached 25%.) This rise in the unemployment rate translates to about 7 million persons put out of work during the recession. Another 8.5 million workers have been pushed involuntarily into part-time employment. The recession was intertwined with a major financial crisis that exacerbated the negative effects on the economy. Falling stock and house prices led to a large decline in household wealth (net worth), which plummeted by more than $12 trillion or about 20% during 2008 and 2009. In addition, the financial panic led to an explosion of risk premiums (i.e., compensation to investors for accepting extra risk over relatively risk-free investments such as U.S. Treasury securities) that froze the flow of credit to the economy, crimping credit-supported spending by consumers, such as for automobiles, as well as business spending on new plant and equipment. The negative shocks the economy received in 2008 and 2009 were, arguably, more severe than what occurred in 1929. However, unlike in 1929, the severe negative impulses did not turn a recession into a depression, arguably because timely and sizable policy responses by the government helped to support aggregate spending and stabilize the financial system.6 That stimulative economic policies would have this beneficial effect on a collapsing economy is consistent with standard macroeconomic theory, but without the counterfactual of the economy's path in the absence of these policies, it is difficult to establish with precision how effective these policies were [13] .

Policy Responses to the Financial Crisis and Recession

Both monetary and fiscal policies as well as some extraordinary measures were applied to counter the economic decline. This policy response is thought to have forestalled a more severe economic contraction, helping to turn the economy into the incipient economic recovery by mid-2009. These policies are likely continuing to stimulate economic activity into 2014

Monetary Policy Actions

To bolster the liquidity of the financial system and stimulate the economy, during 2008 and 2009 the Federal Reserve (Fed) aggressively applied conventional monetary stimulus by lowering the federal funds rate to near zero and boldly expanding its "lender of last resort" role, creating new lending programs to better channel needed liquidity to the financial system and induce greater confidence among lenders. Following the worsening of the financial crisis in September 2008, the Fed grew its balance sheet by lending to the financial system. Between September and November 2008, the Fed's balance sheet more than doubled, increasing from under $1 trillion to more than $2 trillion. By the beginning of 2009, demand for loans from the Fed was falling as financial conditions normalized. Had the Fed done nothing to offset the fall in lending, the balance sheet would have shrunk by a commensurate amount, and the stimulus that it had added to the economy would have been withdrawn. In the spring of 2009, the Fed judged that the economy, which remained in a recession, still needed stimulus. On March 18, 2009, the Fed announced a commitment to purchase $300 billion of Treasury securities, $200 billion of Agency debt (later revised to $175 billion), and $1.25 trillion of Agency mortgage-backed securities. The Fed's planned purchases of Treasury securities were completed by the fall of 2009 and planned Agency purchases were completed by the spring of 2010. At this point, the Fed's balance sheet stood at just above [14] .

Fiscal Policy Actions

Congress and the Bush Administration enacted the Economic Stimulus Act of 2008 (P.L. 110-185). This act was a $120 billion package that provided tax rebates to households and accelerated depreciation rules for business. Congress and the Obama Administration passed the American Recovery and Reinvestment Act of 2009 (ARRA; P.L. 111-5). This was a $787 billion package with $286 billion of tax cuts and $501 billion of spending increases that relative to what would have happened without ARRA is estimated to have raised real GDP between 1.5% and 4.2% in 2010 but will increase real GDP by a smaller amount in 2011 and an even smaller amount in 2012. In terms of extraordinary measures, Congress and the Bush Administration passed the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), creating the Troubled Asset Relief Program (TARP). TARP authorized the Treasury to use up to $700 billion to directly bolster the capital position of banks or to remove troubled assets from bank balance sheets. Congress was an active participant in the emergence of these policy responses and has an ongoing interest in macroeconomic conditions. Current macroeconomic concerns include whether the economy is in a sustained recovery, rapidly reducing unemployment, speeding a return to normal output and employment growth, and addressing government's long-term debt problem [15] .

Is Sustained Economic Recovery Underway?

Evidence indicates that the economy, as measured by real GDP growth, began to recover in mid-2009. However, the pace of growth has been slow and uneven with a pronounced deceleration evident during 2011. During 2009 and 2010, growth had been sustained by transitory factors, such as fiscal stimulus and the rebuilding of inventories by business. Economic growth in 2010 showed signs of being generated by more sustainable forces, but the strength of those forces continues to be uneven, and a slowing of growth during 2011 prompted concern about the recovery's sustainability. The economy began to recover in mid-2009. For the remainder of 2009 and through 2010, real GDP (i.e., GDP adjusted for inflation) increased at an annualized rate of 3.0%. However, during 2011 growth slowed to 1.6% and in the first quarter of 2012 that pace improved only slightly to 2.2%. In comparison to previous economic recoveries, growth at 3.0% is relatively weak, but is fast enough to at least make slow progress at reducing the large output gap and at reducing unemployment. However, growth at less than a 2% annual rate may not be fast enough to close the output gap and keep the unemployment rate from rising. Through 2010, much of the economy's upward momentum was sustained by the transitory factors of inventory increases and fiscal stimulus. Sustainable recovery would depend on more enduring sources of demand, such as consumers spending and businesses reviving, and providing momentum to the recovery. While business investment spending has been relatively brisk during the recovery, consumer spending was relatively tepid in 2011. Weak consumer spending along with the rapidly fading effects of fiscal stimulus and weaker growth in Europe raises concern about the sustainability of U.S. economic recovery in 2012 [16] . Credit conditions have improved, making getting loans easier for consumers and businesses, loosening a constraint on many types of credit supported expenditures. The Fed's survey of senior loan officers indicates that, on net, bank lending standards and terms continued to ease during 2011 and that the demand for commercial and industrial loans had increased. Manufacturing activity is increasing. Through March 2012, output had increased 3.8% over a year earlier and capacity utilization has risen from a low of 65% in mid-2009 to 77.8%. (A capacity utilization rate of 80% - 85% would be typical for a fully recovered economy.) Since mid-2009, non-farm payroll employment has increased by about 3.1 million jobs. Monthly gains have been consistently positive since late 2010, but often not at a scale characteristic of a strong recovery. Recent months have seen employment gains steadily falling, down from 275,000 workers in January 2012 to 115,000 workers in April 2012. The stock market has rebounded and interest rate spreads on corporate bonds have narrowed. The Dow Jones stock index had plunged to near 6500 in March 2009 but through April 2012 had regained about 90% of its lost capitalization. Spreads on investment grade corporate bonds, a measure of the lenders' perception of risk and creditworthiness of borrowers, have fallen from a high of 600 basis points in December 2008 to less than 100 basis points in 2012. China, Asia's other emerging economies, and Latin America are growing rapidly, which is transmitting a positive growth impulse to the United States by boosting demand for U.S. exports. Also the dollar is very competitive from a historical perspective, adding support to U.S. exports [17] . On the other hand, significant economic weakness remains evident. In the third quarter of 2011, the economy had regained its prerecession level of output. But it took 15 quarters to accomplish this as compared to 5 quarters on average in previous post-war recoveries. However, since potential GDP has also continued to grow, the output gap over this time period has only narrowed from about 8.1% to 6.1%. Consumer spending, the usual engine of a strong economic recovery, remains tepid, generally slowed by households' ongoing need to rebuild substantial net worth lost during the housing crisis and the recession, continued high unemployment and underemployment, and a surge in energy prices in the first half of 2012. Employment conditions remain weak. The unemployment rate, which had peaked at 10.1% in October of 2009, has only fallen to 8.1% in April 2012. However, much of this improvement occurred during 2010, with essentially no net improvement during 2011, because economic growth in 2011 was only just fast enough to keep the unemployment rate from rising. This high rate of unemployment after more than two years of economic recovery is unusual and a source of concern. Also some of the fall of the unemployment rate does not reflect people finding jobs, rather it is caused by discouraged workers leaving the labor force. Another measure of labor market conditions, the employment to population ratio, which is not affected by changes in labor force participation, shows a labor market that is essentially "treading water." During the recession that ratio fell from 63% to 58%, and it has remained near that low through nearly three years of economic recovery. The housing market remains depressed. Mortgage loan foreclosures continue to rise, house prices are still falling in many regions, and millions of mortgage holders are "under-water," with the market value of their house below the amount of their mortgage. Beyond the direct effect on economic activity through lower rates of new construction, housing market weakness has a strong negative indirect effect on the balance sheets of households and banks. The sharp fall in household net worth caused by the fall of house prices has been an important factor dampening current consumer spending and the pace of overall economic recovery. Growth in the Euro area has been weak and fiscal austerity measures to stem the growth of public debt have likely pushed the region back into recession, slowing growth there further. Slower growth in Europe, a major U.S. export market, will likely transmit a contractionary impulse to the United States, which could slow the pace of the U.S. recovery [18] .

The Shape of Economic Recovery

In the typical post-war business cycle, lower than normal growth of aggregate demand during the recession is quickly followed by a recovery period with above normal growth of spending, perhaps spurred by some degree of monetary and fiscal stimulus. The degree of acceleration of growth in the first two to three years of recovery has varied across post-war business cycles, but has been at an annual pace in a range of 4% to 8%.This above normal growth brings the economy back more quickly to the pre-recession growth path and speeds up the reentry of the unemployed to the workforce. Once the level of aggregate demand approaches the level of potential GDP (or full employment), the economy returns to its pre-recession growth path, where the growth of aggregate spending is slower because it is constrained by the growth of aggregate supply, which in recent years is estimated to have been at an annual pace of near 3.0%. (A subsequent section of the report looks more closely at aggregate supply.) There is concern, however, that this time the U.S. economy, without supporting stimulus from policy actions, will either not return to its pre-recession growth path, perhaps remain permanently below it, or return to the pre-crisis path but at a slower than normal pace, or worse, dip into a second recession. Below normal growth would almost certainly translate into below normal recovery of employment, whereas a second round of recession could increase the already high unemployment rate. The next sections of this report discuss problems on the supply side and the demand side of the economy that could lead to a weaker than normal recovery [19] . CHAPTER3

IMPACT ON INDIAN ECONOMY

Impact of the international crisis on the Indian financial system

It would have been hard, even a few months prior to the collapse of Lehman Brothers, to anticipate the impact that the global financial crisis would have on the Indian economy. This is because the Indian banking system did not have any direct exposure to sub prime mortgage assets or any significant exposure to the failed institutions, and the recent growth had been driven predominantly by domestic consumption and investment. And yet, the extent to which the global crisis impacted India was dismaying, spreading through all channels - the financial channel, the real channel and the confidence channel. The reason why India was hit by the crisis was because of its rapid and growing integration into the global economy. Under the impact of external demand shock, there was a moderation in growth in the second half of 2008-09 compared to the robust growth of 8.8% per annum in the preceding five years. The deceleration was more noticeable in the negative growth in industrial output in Q4 2008-09 - the first decline since the 1990s. The transmission of external demand shock was severe on export growth, which deteriorated from a peak rate of about 40% in Q2 2008-09 to (-)22 per cent in Q4, ie the first contraction since 2001-02. Simultaneously, domestic aggregate demand also moderated due to a sharp deceleration in the growth of private consumption demand [20] . With regard to financial markets, India witnessed a reversal of capital inflows following the collapse of Lehman Brothers. Due to a heavy sell-off by foreign institutional investors (FIIs) there was a significant downward movement in the domestic stock markets. The withdrawal by FIIs and the reduced access of Indian entities to external funds exerted significant pressure on dollar liquidity in the domestic foreign exchange (FX) market. This created adverse expectations on the balance of payments (BOP) outlook, leading to downward pressure on the Indian rupee and increased FX market volatility. While the banking system was sound and well capitalised, some segments of the financial system such as mutual funds (MFs) and non-banking financial companies (NBFCs) came under pressure due to reduced foreign funding and a subdued capital market. Moreover, the demand for bank credit increased due to the drying up of external sources. Against this backdrop, the Reserve Bank of India stepped in with liquidity-supplying measures - both in the rupee and in foreign currency - and the government implemented fiscal stimulus measures, a more detailed account of which is given below [21] . India's balance of payments in 2008-09 captured the spread of the global crisis to India (see Table 1). The current account deficit during 2008-09 shot up to 2.6 percent of GDP from 1.5 percent of GDP in 2007-08 (Table 1). And this is the highest level of current account deficit for India since 1990-91 (Chart 1). The capital account surplus dropped from a record high of 9.3 percent of GDP in 2007-08 to 0.9 percent of GDP. And this is lowest level of capital account surplus since 1981-82. The year ended with a decline in reserves of US$ 20.1 billion (inclusive of valuation changes) against a record rise in reserves of US$ 92.2 billion for 2007-08.

Impact of the global financial crisis on different markets

1. local money markets,

Although the direct impact of the sub prime crisis both on Indian banks and on the financial sector was almost negligible because of their limited exposure to the troubled assets, the prudential policies put in place by the Reserve Bank and the relatively low presence of foreign banks in the Indian banking sector, there was a sudden change in the external environment following the failure of Lehman Brothers in mid-September 2008. The knock-on effects of the global financial crisis manifested themselves not only as reversals in capital inflows but also in adverse market expectations, causing a sharp correction in asset prices on the back of sell-offs in the equity market by FIIs and exchange rate pressures [22] . The withdrawal of funds from the Indian equity markets, as in the case of other emerging market economies (EMEs) and the reduced access of Indian entities to international market funds exerted significant pressure on dollar liquidity in the domestic FX market. With a view to maintaining orderly conditions in the FX market which had become very volatile, the Reserve Bank scaled up its intervention operations, particularly in October 2008. However, the FX market remained orderly in 2009-10 with the rupee exhibiting a two-way movement against major currencies. Indian financial markets, particularly banks, have continued to function normally. However, the cumulative effect of the Reserve Bank's operations in the FX market as well as transient local factors such as the build-up in government balances following quarterly advance tax payments had an adverse impact on domestic liquidity conditions in September and October 2008. Consequently, in the money market the call money rate breached the upper bound of the informal Liquidity Adjustment Facility (LAF) corridor during mid-September-October 2008. However, as a result of the slew of measures initiated by the Reserve Bank (referred to in detail below) the money market rates declined and have remained below the upper bound of the LAF corridor since November 2008. In the current financial year, the call rate has thus far hovered around the lower bound of the informal LAF corridor. The indirect impact of the global financial turmoil was also evident in the activity in the certificate of deposit (CD) market. The outstanding amount of CDs issued by scheduled commercial banks (SCBs), after increasing between March and September 2008, declined thereafter until December 2008 as the global financial market turmoil intensified. With the easing of liquidity conditions, the CD volumes picked up in the last quarter of 2008-09. The weighted average discount rate (WADR) of CDs, which had increased with the tightening of liquidity conditions, started declining from December 2008 onwards. Commercial paper market developments were similar. As explained above, the rates in the unsecured (call) market went above the LAF corridor from mid-September to October 2008 as a consequence of the liquidity pressure in the domestic market. The rates in the collateralised money market - (Collateralised Borrowing and Lending Obligation (CBLO) and repo markets) - moved in tandem but remained below the call rate [23] .

2.Repo Market

The Indian repo markets were broadly unaffected by the global financial crisis. Currently, only government securities are permitted for repo and a select set of participants (regulated entities) is permitted to participate in repos. All repo transactions are novated by the Clearing Corporation of India and settled on a guaranteed basis. The interbank repo markets continued to function, without freezing, during the period of global financial turmoil. During the period June-October 2008, the repo volumes fell marginally but subsequently recovered. There was no incidence of settlement failure during the global financial crisis.

3.Money Market

The total volume in the money market segments decreased during September and October 2008. In October 2008, the decrease was more pronounced in the collateralised segment compared to the uncollateralised segment. The volume in the call market actually increased in October 2008. Moreover, the average daily amount of liquidity injected into the banking system through the LAF increased substantially during September and October 2008. The total money market average daily volume increased after December 2008 and was around Indian rupee (INR) 800 billion in March 2009 and around INR 900 billion in October 2009.

4.Security market

The Indian government securities markets have been broadly insulated from the global financial crisis. There has been no incidence of settlement failure or default. The muted impact of the global crisis on the Indian government securities markets can be attributed, nter alia, to the calibrated opening of the markets to foreign players. Internationally, it has been observed that capital flows to EMEs dried up during the crisis period on account of the "flight to safety", despite the interest rate differentials. In the Indian context, however, the investment limits for FIIs in the Indian government securities markets have been put in place to contain the volatility and are being revised in a calibrated manner, taking into consideration macroeconomic factors. Currently, the investment limit for FIIs is USD 5 billion and its utilisation is about 62.60% (as of 9 October 2009).The yields began to firm up in March 2008, tracking the policy rates in the wake of inflationary pressures and the benchmark 10-year yield reached a peak of 9.48% in mid-July 2008 (see the chart below). The failure of Lehman Brothers and the subsequent global developments followed by sharp reductions in policy rates (the repo rate was reduced from 9.00% to 4.75% during the period October 2008-April 2009 and the reverse repo rate was reduced from 6.00% to 3.25% during the period December 2008-April 2009) resulted in a softening of government security yields coupled with higher turnover in the secondary market. However, the increased borrowing requirements by the central and state governments on account of various countercyclical fiscal measures taken to stimulate the economy resulted in a huge supply of government securities impacting on the interest rates. The benchmark 10-year yield, which had touched a low of 5.27% on 31 December 2008, rose to around 7.41% during early September 2009 on account of concerns over excess supply and inflationary expectations [24] .

CHAPTER 4

INDIA'S TCTICS FOR FACING THIS CRISIS

The Reserve Bank subsequently employed a combination of measures involving monetary easing and the use of innovative debt management tools such as synchronising the Market Stabilisation Scheme (MSS) buyback auctions and open market purchases with the government's normal market borrowings and de-sequestering of MSS balances. By appropriately timing the release of liquidity to the financial system to coincide with the auctions of government securities, the Reserve Bank ensured a relatively smooth conduct of the government's market borrowing programme, resulting in a decline in the cost of borrowings during 2008-09 for the first time in five years [25] . In 2008-09, the Indian rupee, with significant intra year variation, generally depreciated against major currencies except the pound sterling on account of the widening of trade and current account deficits as well as capital outflows. The rupee exhibited greater two-way movements in 2008-09. For example, it moved between INR 39.89 and INR 52.09 per US dollar. The FX market remained orderly during 2009-10, with the rupee exhibiting a two-way movement against major currencies. In the current financial year, the rupee appreciated by 9.7% against the US dollar and 2.6% against the Japanese yen, whereas it depreciated by 5.7% against the pound sterling and 3.2% against the euro. In terms of the real exchange rate, the six-currency trade-based real effective exchange rate (REER) (1993-94 = 100) moved up from 96.3 at end-March 2009 to 104.2 by 23 October 2009 [26] . Following the intensification of the global financial crisis in September 2008, the Reserve Bank implemented both conventional and unconventional policy measures in order to proactively mitigate the adverse impact of the global financial crisis on the Indian economy [27] . The thrust of the various policy initiatives by the Reserve Bank since September 2008 has been on providing ample rupee liquidity, ensuring comfortable dollar liquidity and maintaining a market environment conducive to the continued flow of credit to productive sectors. For this purpose, the Reserve Bank used a variety of instruments at its command such as the repo and reverse repo rates, the cash reserve ratio (CRR), the statutory liquidity ratio (SLR), open market operations, including the liquidity adjustment facility (LAF), the MSS, special market operations and sector-specific liquidity facilities. In addition, the Reserve Bank used prudential tools to modulate the flow of credit to certain sectors consistent with financial stability. The availability of multiple instruments and the flexible use of those instruments in the implementation of monetary policy enabled the Reserve Bank to modulate the liquidity and interest rate conditions amid uncertain global macroeconomic conditions. When the global markets became dysfunctional in September 2008, the macro financial conditions remained exceptionally challenging from the standpoint of the implementation of the Reserve Bank's policies, as it had to respond to multiple challenges, from containing inflation in the second half of 2008 to containing the deceleration in growth, preserving the soundness of banks and financial institutions, ensuring the normal functioning of the credit market and maintaining orderly conditions in the financial markets in the first half of 2009. The Reserve Bank was able to restore normalcy in the financial markets over a short period of time through its liquidity operations in both domestic and foreign currency. The evolving policy stance was increasingly conditioned by the need to preserve financial stability while arresting the moderation in the growth momentum. The Reserve Bank acted aggressively and pre-emptively on monetary policy accommodation, both through interest rate cuts and a reduction in reserve requirements in terms of both magnitude and pace [28] . The policy repo rate under the liquidity adjustment facility (LAF) was reduced from 9.0% to 4.75%. The policy reverse repo rate under the LAF was reduced from 6.0% to 3.25%. With receding inflationary pressures and the possibility of the global crisis affecting India's growth prospects looming on the horizon, the Reserve Bank switched to an accommodative stance in mid-October 2008 when it reduced the CRR by 250 basis points from 9% to 6.5%. Between 11 October 2008 and 5 March 2009, the CRR was reduced by a cumulative 400 basis points to 5.0%. The statutory liquidity ratio (SLR), a legal obligation on banks to invest a certain proportion of their liabilities in specified financial assets including cash, gold and government securities (under Section 24 of the Banking Regulation Act 1949), was one of the instruments used during the crisis to modulate the liquidity conditions in the economy. Variation of the SLR has an impact on the growth of money and credit in the economy through the government debt market. Accordingly, on 1 November 2008, the SLR was reduced to 24% of net demand and time liabilities (NDTL) with Effect from the fortnight beginning 8 November 2008. The liquidity situation remained comfortable from mid-November 2008 onwards, as reflected in the daily surplus being placed by banks in the LAF window of the Reserve Bank. In view of this, the SLR was restored to 25% of NDTL with effect from the fortnight beginning 7 November 2009 [29] . The key policy initiatives taken by the Reserve Bank in response to the Developments after September 2008 to improve the availability of FX liquidity included the selling of US dollars in the market by the Reserve Bank, the opening of a new FX swap facility for banks and the raising of interest rate ceilings on non- resident repatriable deposits to attract larger inflows. A cumulative increase of 175 basis points in the interest rate ceilings on each of the aforesaid term deposits was affected between mid-September and November 2008. Banks were permitted to borrow funds from their overseas branches and Correspondent banks to a maximum of 50% of their unimpaired Tier 1 capital or US$ 10 million, whichever was higher. The systemically important non-deposit- taking non-banking financial companies (NBFC-ND-SI) and housing finance companies (HFCs) were permitted to raise short-term foreign currency borrowings. The ceiling rate on export credit in foreign currency was raised by 250 basis points to Libor+350 basis points on 5 February 2009. Correspondingly, the ceiling interest rate on the lines of credit from overseas banks was also increased by 75 basis points to six-month Libor/euro Libor/Euribor+150 basis points. The policy on the premature buyback of foreign currency convertible bonds (FCCBs) was liberalised in December 2008, recognising the benefits accruing to Indian companies as well as to the economy on account of the depressed global markets. Under this scheme, the buyback of FCCBs by Indian companies was allowed under both the approval and the automatic routes, provided that the buyback was financed by foreign currency resources held in India or abroad and/or by fresh external commercial borrowings (ECBs) raised in conformity with the extant ECB norms and by internal accruals. Considering the continuing tightness of credit spreads in the international markets, the all-in-cost ceilings for different maturities were increased in respect of ECBs (150 to 250 basis points) as well as trade credit (75 to 150 basis points).Furthermore, the all-in-cost ceiling for ECBs under the approval route was dispensed with, initially until 30 June 2009, and later extended until 31 December 2009 [30] . Measures were also initiated to safeguard the interests of India's export sector which was affected by the global economic recession. The period of realisation and repatriation to India of the amount representing the full export value of goods or software exported was enhanced from six months to 12 months from the date of export, subject to review after one year. Similarly, as a relief measure to importers, the limit for the direct receipt of import bills/documents from overseas suppliers was enhanced from US$ 100,000 to US$ 300,000 in the case of imports of rough diamonds and rough precious and semi-precious stones by non-status holder exporters, enabling them to reduce transaction costs [31] .

Economic Recovery

From all accounts, except for the agricultural sector initially as noted above, economic recovery seems to be well underway. Economic growth stood at 8.6 percent during fiscal year 2010-11 per the advance estimates of CSO released on February 7, 2011. GDP growth for 2009-10 per quick estimates of January 31, 2011 was placed at 8 percent. The recovery in GDP growth for 2009-10, as indicated in the estimates, was broad based. Seven out of eight sectors/sub-sectors show a growth rate of 6.5 percent or higher. The exception, as anticipated, is agriculture and allied sectors where the growth rate needs to higher and sustainable over time. Sectors including mining and quarrying; manufacturing; and electricity, gas and water supply have significantly improved their growth rates at over 8 percent in comparison with 2008-09. When compared to countries across the world, India stands out as one of the best performing economies. Although there was a clear moderation in growth from 9 percent levels to 7+ percent soon after the crisis hit, in 2010-11, at 8.6 percent, GDP growth in nearing the pre-crisis levels and this pace makes India the fastest growing major economy after China. In order for India's growth to be much more inclusive than what it has been, much higher level of public spending is needed in sectors, such as health and education along with the implementation of sectoral reforms so as to ensure timely and efficient service delivery. Plan allocations for 2010-11 for the social sectors have been stepped up, as can be seen from the figures below, this process however needs to be strengthened and sustained over time. As expected, the measures undertaken by government of India to counter the effects of the global meltdown on the Indian economy have resulted in shortfall in revenues and substantial increases in government expenditures, leading to deviation from the fiscal consolidation path mandated under the Fiscal Responsibility and Budget Management (FRBM) Act. The gross tax to GDP ratio which increased to an all time high of 12 percent in 2007-08, thanks to the conomy riding on a high growth trajectory, has steadily declined to 10.9 percent in 2008-09 and 10.3 per cent in 2009-10 due to moderation in growth and reduction in tax/duty rates. At the same time, total expenditure as percentage of GDP has increased from 14.4 percent in 2007-08 to 15.9 percent in 2008-09 and 16.6 percent in 2009-10. The fiscal expansion in the last 2 years has resulted in higher fiscal deficit of 6 percent of GDP in 2008-09 and 6.7 percent in 2009-10. Moreover, the revenue deficit as percentage ofGDP has worsened to 4.5 percent and 5.3 percent in 2008-09 and 2009-10 respectively. The revenue deficit and fiscal deficit in 2009-2010 are higher than the targets set under the FRBM Act and Rules. the deviation from the mandate under FRBM Act and Rules was resorted to with the objective of keeping the economy on a high growth trajectory amidst global slowdown by creating demand through increased public expenditures in identified sectors. While the intent of the government, it says is to bring the fiscal deficit under control with institutional reform measures encompassing all aspects of fiscal management such as subsidies, taxes, disinvestment and other expenditures as indicated in the Budget 2009-10, there is unfortunately no movement on any of these fronts, Considering the current inflationary strains, the as yet excessive pre-emption of the community's savings by the government, the potential for crowding out the requirements of the enterprise sector, and rising interest payments on government debt, it is extremely essential to reduce the fiscal deficit, and more aggressively, mainly by lowering the revenue deficit. Correction of these deficits would, inter alia, require considerable refocusing and reduction of large hidden subsidies associated with under-pricing in crucial areas, such as power, irrigation, and urban transport. Food and fertilizer subsidies are other major areas of expenditure control. Be that as it may, the process of fiscal consolidation needs to be accelerated through more qualitative adjustments to reduce government dissavings and ameliorate price pressures. The step-up in India's growth rate over much of the last two decades was primarily due to the structural changes in industrial, trade and financial areas, among others, over the 1990s as the reforms in these sectors were wide and deep and hence contributed significantly to higher productivity of the economy. Indeed, there is potential for still higher growth on a sustained basis of 9+ percent in the years ahead, but among other things, this would require the following: Revival and a vigorous pursuit of economic reforms at the center and in the states; A major effort at raising the rate of domestic savings, especially by reducing government dissavings at the central and state levels through cuts in, and refocusing of, explicit and implicit subsidies, stricter control over non-developmental expenditures, improvements in the tax ratio through stronger tax enforcement, and strengthening incentives for savings; Larger investments in, and bett

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