And we all fall down

Indian Express, 22 January 2008

Data on the US economy shows job losses and indicates that a recession may be on its way. A statement by Ben Bernanke, the Chairman of the US Federal Reserve Bank indicates that there may be further trouble in the US economy in 2008.

In coming weeks, the US Fed is expected to further cut rates sharply. Why have the markets reacted differently this time?

In the last few months when trouble in the US economy started it seemed that a Fed rate cut would save the US econmy and therefore when the US Fed cut rates at first investors were overjoyed thinking the Fed has come to the rescue and so there would be no recession. It seems that it has started dawning on the stock market that the Fed cuts rates because it is truly concerned about what was happening in the economy - which is not good news for the firms. US unemployment data suggests there is a good chance that a recession may commence, and there is extensive discussion in the US of what macro policy should do in response.

Did no one see the imbalances emerging in the US eocnomy?

For many years now, the US stock market has been faring well. Once the nervousness after the 9/11 attacks subsided, the S&P 500 index bounced back, and essentially doubled in five years. But macroeconomists diverged from the financial markets in warning that all is not well. They warned about the massive Chinese exchange rate manipulation (accompanied by other Asian countries on a lesser scale). They warned about the massive US current account deficit. They warned about the extent to which the perceptions of low risk and low interest rates were generating incentives in the financial sector to seek out high risk portfolios.

How did the imbalances affect the US dollar?

A slow decline of the US dollar commenced in January 2002. The US Fed computes a `major currencies index', which shows the value of the US dollar against all the major floating exchange rates of the world. The governments of these countries, and the US, do not trade in their own currency markets; hence these prices can be trusted. This index shows end-January 2002 as the high. From that point onwards, the dollar started a long-term secular decline.

This decline appeared to be working in terms of addressing the global imbalances. As the dollar got cheaper, slowly, US exports started rising and the US current account deficit started dropping. Some people started announcing victory for US macro policy, saying that a `soft landing' had been achieved in resolving the global imbalances

How did trouble on the housing market impact on this situation?

In mid-2007, difficulties broke out on the US housing market. Many households started defaulting on their home loans. Many financial firms started reporting large losses on their home loan portfolio. Credit rating agencies came under cloud for having used faulty methods for coming up with ratings, and the business model of rating agencies (taking money from the company getting rated) came under severe attack. Matters worsened because the market stopped trusting credit ratings and froze up.

Merrill Lynch and Citibank have reported portfolio losses of roughly $20 billion, and the total losses reported now exceed $110 billion. For a sense of scale, US GDP is roughly $14 trillion, so the reported losses are now nudging 1% of US GDP. In India, it would be like a group of financial firms reporting portfolio losses of Rs.40,000 crore which is 1% of GDP. This would be big news. It is rumoured that in late 2007, Citibank was under extreme stress.

What does this mean for India?

First, the strength of the rupee-dollar rate should be seen in the context of dollar weakness. If we try to hang on to Rs.39 a dollar when the dollar is dropping, this constitutes a forced devaluation of the rupee. Second, it is not surprising that India is getting a lot of capital - the macroeconomic outlook in India is better than that seen in many parts of the world. This has increased the pressure on the rupee to appreciate. Third, if the US goes into a recession, it will affect more Indian firms than we tend to think today. That is what explains the reaction of the Indian stock market to US markets last week.

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