Cause And Effect of US Economy Crash

stock.jpgThe stock market crash on Monday, January 21 was caused by the heavy selling by FII (Foreign Institutional Investors) and hedge funds. The historic crash is the hot word doing the rounds in the past two days. All the experts are ready to jump on to the bandwagon of tracing the crash to the economic slowdown in the United States. The plummet witnessed on Monday was merely a by product of the economic situation in the States. Following the argument of experts in the field, investors in the domestic market and the Reserve Bank of India will have to look at the conspicuous yet complex economic pan cakes being baked in the US economy.The bubble in the real estate sector burst in August 2007 and a cascade of trickling effects of the sub-prime crisis continues. It happened, when earlier, the US government increased the interest rates from 0.5% to around 5.5% within a span of two years.

As Eric Toussaint crisply puts forth the problem, “The mortgage lenders (like the banks) made long-term mortgage loans while borrowing for the short term (either from depositors, or on the inter-bank market at historically low interest rates, or by selling their mortgages to big banks and hedge funds). The ‘problem’ is that they made long-term loans to a sector of the population that was struggling to make repayments while the housing glut caused their property (which was the surety for their loan) to depreciate drastically. As the number of defaults increased, these mortgage lenders began to experience difficulties in repaying the short-term loans they had contracted with other banks. And the banks, to cover themselves, refused to grant them new loans or did so at much higher interest rates. In the United States, 84 mortgage lenders went bankrupt or partially ceased their activity between the beginning of the year and August 17, 2007, as opposed to only 17 being bankrupt for the whole of 2006. In Germany, the IKB bank and the public institute SachsenLB, both of whom had invested heavily in the US mortgage market, suffered immediate effects and were only saved by the skin of their teeth.”

This has had an obvious adverse impact on the households in the United States. Indebtedness in American households has reached an extraordinarily high level of 140% (in other words household debts amount to almost one and a half times their annual income). To add to this, a large number of employees have seen a real drop in income over the last few years. The rise in interest rates imposed by the Federal Reserve since June 2004 has exacerbated the mortgage repayments far too heavily when compared to the household income. In fact, the rise in payment defaults is not restricted to the real estate sector only but now it also concerns loans and credit cards. Hence, along with the sub-prime crises, there is speculation about a crisis in the credit market as well. As everybody has been borrowing from everybody else (an average American holds 9 credit cards and the rate of saving is -0.5%) one crisis trickle downs to lead to another and ironically, the economic slowdown is a result of the principles on which the American economy pushes itself.Gautam Chikermane explains insightfully (The Financial Express), “When money in the US economy shrinks, US investments in non-US economies are called back — yesterday, Hong Kong was down 5.5 per cent, Japan fell 3.9 per cent, UK 3.6 per cent — by investors who suddenly feel more at ease with US assets, all other markets being ‘riskier’. The reverse flow of money is also directed by bankers, who, despite falling interest rates, are unwilling or unable to lend simply because their books need to be beefed up with capital.” And hence the developed markets are trusted more than the riskier emerging markets to stabilise and secure funds when the home economy (US) is facing recession. Further, the heavy selling by the FIIs in the Indian market exhibited the fact beautifully with the historic crash. That is why, in a global economy, a young county like india needs to make sure that something like this doesn’t happen here since the Indian economy would be riddle with added unemployment.

It also demonstrated an important fact that Indian market is vulnerable and not insulated from the foreign money influence. It should be Kept in mind that India has to mould and, at the same time protect, and stabilise itself in face of such ups and downs. In fact, the recent cut in the interest rates by the Fed has reaffirmed the analysis.To stabilise the US economy and pull it out of the forthcoming recession the US Federal Reserve has slashed more than three fourth percentage points on January 22, 2008. It is the biggest cuts in past 23 years. It has come from the well founded fear that the recession in the US economy will pull down global markets along with it. “The committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth,” the Fed said in a statement. “While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labour markets,” the central bank said.It is a cause of deep concern for the Fed as the stock markets over this week have sold heavily and it has only added to the struggle under the deep housing slump and tight credit creations.Financial institutions are only looking forward to more interest rate cuts, at least by a quarter points when the Fed meets at the scheduled meeting on the 29-30 January.Market has to wait and watch for Fed policies and the US economy with ever increased vigilance. As far as Indian companies go, the fundamentals are intact and there is reason for solace as it is completely US economy driven crash and in the long run prospects are bright. As Gautam Chikermane puts it, “this seven session fall of almost 3,000 points or 14 per cent still leaves the Sensex 24 per cent higher than a year ago, 85 per cent higher than 2006 and 4.2 times what it was five years ago. In a market that has only seen ‘returns’ for the past five years, it’s time to meet ‘risk’.”

Himadri Agarwal