US financial meltdown and India .............

Read today in ET..........just pasting it here:

OCCASIONAL PAPER
US financial meltdown and India
MANOJ PANT
THE current financial meltdown shares one common link with the Great Depression of 1929 and the east-Asian crisis of 1997. In all cases the real sector precipitating the crisis has been real estate. The 1929 crisis also followed the bursting of the “South China Seas bubble” where unscrupulous middlemen sold non-existent real estate in the South China seas. In the east-Asian case, there were dubious real estate purchases by “friends” of bankers and politicians. Hence the title of “crony capitalism”. The current crisis has a similar real counterpart — the crash in the market for real estate in the US. All the crises also had a common financial counterpart in that excess liquidity with banks financed the sale of monetary assets linked to real assets like real estate. However, the level of coordination of banks during 1929 was somewhat different in that US banks then were largely small regional banks and the Federal Reserve bank played a dubious and delayed role in coordination. Finally, the east-Asian crisis was due to flow of excess liquidity from the west to the east (aided substantially by IMF actions) while the current crisis is financed by flow of excess savings from the east to the US. The main point of the above is the important link of this “financial crisis” to the real sector. Therein I think lie some lessons for India. But first a little recap of the current crisis. Readers may recall that during the period 2001-2003 or so, real rates of interest were zero or negative in most OECD countries. This led people to borrow money for returns of even 3% or so. Some of this money did find its way to the commercial real estate sector in India but this was limited because of the current restrictions on FII investments in real estate. Another portion of these funds found its way into the Indian stock market. Within the US also, the low interest regime led people to renegotiate their mortgages. This process essentially involved people borrowing from banks, paying off their mortgages and repurchasing them at lower rates of interest. The financial sector then “securitised” these mortgages thus making them tradeable monetary instruments. As long as rest of the world’s savings kept flowing in this process could continue. More importantly these mortgages then became part of the asset structure of investment banks. Speculation in mortgage values, however, is only sustainable if real estate prices rise. This in fact happened after 2002 and prices peaked in 2005. However, there were irrational expectations that such price rise would continue. Unfortunately, the demographics of the US population could not support such expectations. In the year 2005, only 27% of population was in the age group 0-19 and about 13% were aged 65 or more. Furthermore, the graying of the population is obvious given that by 2050 about 20% of population will be aged over sixty five. In other words, there was unlikely to be any sustained demand for real estate. Coupled with the undersaving by American households, it was clear that the mortgages could never really be encashed. The decline in the value of the homes led to a fall in the real wealth of most American households. This declining wealth effect was made worse when the financial meltdown fed into the stock market where most Americans have invested. This sudden decline in wealth led to cutbacks in expenditure which will accentuate demand contraction as time goes on and incomes also start falling. How would the Indian economy be impacted? For one, unlike the US there is a clear bottom to the present (welcome) correction in the real estate values in India. For the Indian demographics (50% of population aged around 25) ensures that at some lower value there will always be someone willing to invest in the Indian dream of owning a home. The exorbitant real estate values today are due to speculation much like in the US, but in India the demographics establish a floor to prices. Second, exports to the US now account for only about 16% of India’s total exports so the impact on domestic demand will be minimal. Third, the crashing Indian stock market generates little wealth effect. Finally, it must be remembered that cost-cutting by US firms and EU firms (mostly service exporters) may well lead to greater dependence on Indian IT services which are still low-cost and labour-intensive. The bottom line? The real impact on India will be minimal although financial variables like the exchange rate and equity prices will undergo correction as speculators exit. More important, the favourable demographics implies that the economy is unlikely to be severely demand constrained. Even more important, the regulatory systems in financial markets are well in place and large volume capital convertibility limited. Who needs to worry? The EU in particular.

• The east-Asian crisis was due to flow of excess liquidity from the west to the east, while the current crisis is financed by flow of excess savings from the east to the US
• The exorbitant real estate values today are due to speculation much like in the US, but in India the demographics establish a floor to prices
• The real impact on India will be minimal though variables like the exchange rate and equity prices will undergo correction........