Sudip Bandyopadhyay’s Blog

Why did we mostly get “it” so sensationally wrong? How did something that looks increasingly like the precursor of a slowdown or slump creep up on almost all of us last year? It is a pretty good question. It is a pretty embarrassing one, too. Perhaps this was more than could reasonably be expected. But we need to ask ourselves whether we could have done a better job of understanding the processes at work. The difficulty was that we all tend to look at just one bit of the clichéd elephant in the room. Monetary economists looked at monetary policy. Financial economists looked at risk management. International macroeconomists looked at global imbalances. Central bankers focused on inflation. Regulators looked at Basel capital ratios and then only inside the banking system. Politicians enjoyed the good times and did not ask too many questions. What of commentators? They tended to indulge in the fantasy that the above knew what they were talking about. One big lesson of the experience is that economics is too compartmentalized and so, too, are official institutions. To get a full sense of the risks, we needed to combine the worst Scenarios of each set of experts. Only then would we have had some sense of how the global imbalances, inflation targeting, the impact of asset price bubbles, financial innovation deregulation and risk management systems might interact.

Just as financial systems act as both lubricant and engines of market economies, we can also now see that today’s leveraged financial systems are inherently unstable. That is why the state needs to be involved in safeguarding systemic stability. The social costs of a systemic failure are otherwise too high. Yet clearly early warnings were not acted on and measures that might have mitigated disaster were not taken.Much is being written about the need for new regulations but this largely misses the point. What has been lacking is a framework for systemic scrutiny that “hard-wires” mechanisms for both sounding early warnings and providing the necessary architecture and instruments to produce a more effective response to the build-up of systemic pressures. At the root of the crisis is the huge increase in leverage in recent years – at the level of banks, asset managers and consumers, embedded within products and now, increasingly, used by governments. We have long known that once leverage reaches certain levels, the system can be vulnerable to shocks that cause a catastrophic loss of confidence. Once this point is reached, the result is panic and a dash for cash, creating the self-feeding vortex of reduced asset prices we see today. Historically most financial crises have during their course destroyed 15-25 per cent of a year’s national income of affected states. We risk this happening today on a global level, given the joined-up nature of the financial system in the liberalised and information technology enabled world. What should individual states do to prevent a recurrence? First, they should ensure the architecture exists both to help limit the build-up of leverage and to minimise the damage if instability ensues; and, second, create an effective range of policy tools to mitigate the build-up and its impact.

Indian Financial markets was shocked post uncovering of Satyam fraud which triggered heavy sell-off, resulting in benchmark indices nose-diving sharply and closing the week down by around 8% . Q3FY09 quarterly earnings result season is expected to start this week. This will be the first quarterly earnings season where one is expected to see the full impact of a slowdown in demand across sectors. More importantly a possible decline in IIP growth during the Oct-Dec 2008 quarter, rising asset quality problems for banks and a deceleration in exports are all potential negative trends which may get reflected in the corporate numbers. The slowdown in IIP growth may be due to the combined effect of the ongoing global crisis and global slowdown impacting demand resulting in cut in production levels coupled with tight liquidity conditions domestically leading to less availability of credit and increased interest costs for market players.

On the global markets front, news flows continued to remain disturbing. U.S. Auto sales plunged by 36% in December 08 led by outsized declines at Chrysler, Hyundai and Toyota, as the battered U.S. Auto industry closed out year 2008 as it’s weakest year since 1992. Weaker than-expected new orders received by U.S. factories in November and a seven-year low in pending home sales for the same month has ignited fresh concerns about mounting job losses and the deepening U.S. slowdown. Reflecting these trends U.S. private employers shed close to 700,000 jobs in December, far more than economists had earlier estimated. U.S. markets are now awaiting another mega fiscal package from the new U.S. President elect Barack Obama who assumes office from January 20 2009. According to indications the package will provide a fiscal boost to building infrastructure like Roads, Bridges, Education and Health care, along with tax cuts for the middle class and businesses and will entail a estimated outlay of $775 bn over the next two years. This will be in tune with the president elect Obama’s electoral promise of creating 3 mn new jobs in the U.S. To finance the deficit, the government will need to issue an unprecedented amount of debt — up to $2 trillion for fiscal 2009.