The Hindu Business Line : A crisis of confidence

“USA becomes USSR,” screams a Washington report. The past few weeks have seen active intervention by the world’s capitalist leader and role model, the US.

The American Government took charge of two giant mortgage agencies, Fannie Mae and Freddie Mac. It bailed out Bear Stearns. It stepped in to save insurance giant AIG from collapse with an 85$ billion loan. American taxpayers will have to bear the brunt of what amounts to practical nationalisation by the Federal Government.

Reverberations around the world

Simultaneously, financial institutions in Europe are in trouble. The British Government helped mortgage lender Halifax Bank of Scotland to merge with Lloyds TSB. The Russian Government ordered crucial Government support for the financial system. The European Central Bank brought in a €25 billion packet to stave off the financial crisis. Japan, Sweden and Canada followed suit.

Lehman Brothers simply shut shop. Stock market indices plunged across the globe: USby 25 per cent Europe by 30 per cent, Russia by 50 per cent and China by 60 per cent. The question has been posed whether the situation can be described as the onset of recession in the West.

The West has seen the biggest drop in growth relative to potential. The Economist jocularly commented: “When your neighbour loses his job, it is called an economic slowdown. When you lose your job, it is a recession. But, when an economist loses his job, it becomes a depression.”

Should we bother about the stock market crash? Replies Alan Greenspan, “The price of equities worldwide will determine whether the international financial system can maintain a modicum of stability as it eases out of the credit crunch or falls back into another period of angst and turmoil: Lower global stock prices could impede the recapitalisation of banks and other financial institutions. Debt issuance would also be suppressed as it leverages off the level of equity.”

IMPACT ON INDIA

At least as far as India is concerned, it can be asserted that the steep decline in the stock market is not warranted by the robust growth in economy. America’s economy grew at 3 per cent and India’s at 8 per cent. The fall at 40 per cent in stock prices by mid-September 2008 in India and emerging markets can be attributed more to psychological factors and crisis of confidence.

Commenting on the risk factor in the 21st century, Mr Robert J. Shiller, Noble Laureate, pointed out how the theory of finance underwent a fundamental transformation starting around 1990 with the development of behavioural finance, the application of principles of psychology and insights from other social sciences to finance.

India ‘safe’

It is in this context we should applaud the initiative taken by the Finance Minister to assure Indian investors that the Indian financial market is safe, that the banking system in India is transparent and that the growth will not fall below 8 per cent in spite of the crisis.

Monetary policy is, no doubt, crucial. The hike in interest rates affected major companies in India. Interest coverage, representing the number of times profits cover interest costs, has come down to 2.2 times this quarter as against 2.8 times last year for the same quarter.

(The author is former Chief Commissioner of Income Tax. blfeedback@thehindu.co.in)