FINANCIAL CRISIS

Financial Crisis

Financial Crisis

Question 2

What were the major causes of the global financial crisis (“credit crunch”) starting in 2008? Examine the progress made by one country of your choice in its attempts to recover. Outline the nature of the measures it has taken, and provide statistical evidence of the extent to which it has recovered.

As is evident from the above statement made by the Governor of the Reserve Bank of India (RBI) in a speech delivered in Tokyo, the global financial crisis has had a profound impact on the Indian economy. The Indian economy, which was growing at an average annual rate of 8.8 per cent during the period 2003-04 to 2007-08, is expected to slow down sharply in 2009-10. This is in sharp contrast to the view that was promulgated for more than a year after the outbreak of the sub-prime crisis in the US that emerging Asian economies, especially India and China, would remain insulated from the crisis and play an important role in mitigating the world-wide slowdown. (World Bank 2009:21-25)

While the developed world had been in the grips of a financial crisis since August 2007, the effect was not immediately transmitted to the emerging economies. Even as the advanced economies began slowing down in the face of credit tightening by the middle of 2008, the emerging markets continue to grow at robust rates, compared to previous years.

As a result of these events, the solvency of several of the established financial institutions came to be questioned, and market volatility and demand for liquidity surged to new heights. It also resulted in flight of capital to safety and a complete freeze on wholesale funding, leading to disorderly deleveraging that cascaded across the rest of the financial system. Liquid assets were sold at heavy discounts and severe cutbacks took place in the credit lines to the leveraged financial intermediaries. High grade and high yield corporate bonds witnessed a sharp rise in the spreads and funds for trade finance and working capital were disrupted as banks tightened their lending standards. (World Bank 2008:47-52)

The financial markets of the emerging countries, including India, were severely impacted in the aftermath of the September 2008 events. Outflow of foreign investment hit the equity markets with equity prices falling sharply and issue of new equities coming to a virtual standstill. Bank related flows were heavily curtailed as risk aversion soared, leading to a rise in overnight rates. Foreign capital inflows were also curtailed due to failing health of the hedge funds, which were a major channel for such flows, an overwhelming desire for flight to safety and rising concerns about the emerging country economic prospects. The rising cost of borrowing, credit disruptions, heightened risk aversion on the part of lenders and recessionary pressures in the advanced economies impacted the emerging countries' growth prospects adversely, and industrial production and merchandise trade plunged in these countries in Q4 2008 and Ql1 2009. (Subbarao 2009:15-59)

With the above timeline of the spread of the financial crisis in mind we characterise ...