HOW quickly the best of times became the worst of times, and the age of optimism became the age of self-doubt. If the epoch of growth yielded to the epoch of depression, the season of fat bonuses gave way to the season of job losses. The spring of hope naturally led to the winter of despair. We had everything before us, then we had nothing before us; we were all going direct to cities with streets paved with gold, we are all going direct the other way…With apologies to Dickens, ‘the superlative degree of comparison’ with another age tells it all.

Writing in Seminar’s annual number a year ago, I had noted that ‘There is the growing worry about what the western financial crisis will mean in 2008.’ Now we know. It has meant a global recession of the kind not seen for three-quarters of a century. And we do not know if we have plumbed the depths, or whether even more bad news is coming. When exports fall by 12 per cent, when auto-mobile sales collapse, when industrial production declines, the story is not about GDP growth being nine per cent, sorry eight, well 7.5, make that seven, no may be eight per cent that government spokesmen promise us, depending on their mood of the moment and how much they want to talk up markets that will not be talked up. Nor the fact that it might in fact be 6.5 and then six per cent. People don’t eat statistics.

The textile-garments industry has thrown lakhs of people out of work. Perhaps more than a million (which puts us in the American league, because the US lost one million jobs in October-November alone). But we also have the diamond cutting industry, the leather industry… all those labour-intensive export sectors which have found buyers overseas disappearing into the rubble of shattered banks.

We have our own shattered businesses. If there are no exports, what do ships carry? So ‘Cape size’ vessels that used to charter at $150,000 a few months ago are now available for $3,000 – or less than the cost of the fuel they have to use. Naturally, ships are being laid up – and seamen asked to go home.

Real estate prices have fallen 20 per cent, and office rentals by up to 50 per cent; still there are no takers – so the construction workers have gone home. Stock trading volumes have fallen by 60 per cent and more, so the brokers are idle. Airlines are quietly cancelling aircraft leases and cutting salaries after Jet’s Naresh Goyal found he couldn’t leave unwanted people at the roadside in their corporate livery, waiting for the airport shuttle that would never come. Car and truck companies are announcing factory closures one after the other, and then price cuts followed by repeat closures.

In a country with no social security system worth the name, the human cost of this downturn is massive. When we have lost it, we realize with hammer force the value and importance of rapid economic growth. So one question is answered: economic growth is worth striving for. If this is the difference between six per cent and nine per cent GDP growth, then who cares whether the cat is black or white, so long as it catches mice? There is no room for half-measures, or for dawdling over sterile debates about growth with/without jobs/ equity. The world is what it is, and whatever jobs and equity we got came from growth, nothing else. When the Soviet Union grew, it encouraged others to copy its systems. When it didn’t, it fell apart. Now that China has slowed down, there are questions there too: will the system hold?

 

It is going to get worse. The period till January-end will be full of financial results for the October-December quarter. That is the period, after the Lehman Brothers collapse of 15 September, when things fell apart, when slowdowns in industrial production and exports gave way to absolute declines, when some car companies stopped counting monthly sales in thousands and started talking in hundreds. So the scale of the carnage will be laid bare in sales and profit/loss numbers. It will not be a pretty sight.

That is not the end. Companies issued bonds overseas, and did so in the hope that they would be able to convert the bonds into equity at some crazy stock market valuation… and thus get finance on the cheap. Well, they now know the news: the stock market has crashed. And with that, all hopes of converting the bonds into equity. The dollar debt is now more than the value of some of the firms, many of them well-known ones. Default, possible bankruptcy or losing the company to the lenders are now the options. Except that the high risk of default has driven down the value of the bonds – by as much as a half – so you can buy them back on the cheap. But even that is beyond the capacity of some of the companies. The money involved is $20 billion (Rs 1,00,000 crore). Watch this play out over the coming months.

As I said, we don’t eat statistics. People and companies need jobs and cash, and both are not there for those who need them. And, of course, those who need them the most are all the people who borrowed to the hilt for a new home that they couldn’t really afford, or a new car, counting on payback with the help of the bonus they would get at the end of the year, or the new job they were negotiating – except that there is no bonus, and no job either. This is what a recession is all about.

 

The year didn’t start this way. Oil last January crossed $100 per barrel for the first time. It is now in the $40 range, after hitting $147 in July. Inflation in the first half ramped up sharply to 12 per cent, the highest in more than a decade; it is now headed for may be five per cent in a matter of weeks. The dollar was at Rs 40, and forecasters talked of it hitting Rs 35/$ before long. Instead, it is now at Rs 50. And, of course, the stock market has gone from a Sensex of 21,000 to 9,000. Does anyone understand what is happening? Or remember that, right up to July, the Reserve Bank was raising interest rates and tightening liquidity?

One man did understand exactly what was happening, with a clarity and accuracy that (with hindsight) is stunning: Peter Schiff, who works on Wall Street. He warned in the summer of 2005, two years before things began to fall apart with the onset of the sub-prime crisis, that the boom would not last, that the liquidity sloshing about would not always be there, that it would all go wrong because Americans were spending instead of saving and borrowing instead of investing. He even warned that the financial world was about to collapse, that the big financial firms were worth nothing because they would have no earnings to show… They were outrageous (and of course courageous) statements to make at the height of the go-go phase, and were treated as such.

And so Schiff earned his niche in history. On TV show after TV show, he would give his grim analysis and repeat his dire warnings; all the other experts scoffed at him, made their upbeat forecasts and continued to collect their bonuses. Arthur Laffer (of the Laffer curve) even took a bet with him. Other than that, no one paid heed. Not even when it all began to crumble. But Peter Schiff was right (you can watch him say it all on YouTube). And everything that he warned about, everything that he predicted, none of which anyone paid any attention to, has come to pass.

 

This is not the place to go into the underlying causes and the sequence of the financial crisis, and how it has ended up laying low the economy of much of the world, except to say three or four things. First, financial activity/innovation/speculation had simply become too big and too important; financial firms accounted for 40 per cent of all US corporate profits, more than double the level in some other developed markets. As the economist Keynes warned decades ago, speculation ‘could do no harm as bubbles on a steady stream of enterprise,’ but the situation ‘…is serious when enterprise becomes the bubble on a whirlpool of speculation.’

Second, in country after country, the banks and financial firms had become so big that they were bigger than their national economies. Iceland had a bank which was bigger than Iceland’s GDP, and so to save it the government had to look to Russia for help. Deutsche Bank had a market value that was 80 per cent of Germany’s GDP. The big four British banks had a value that was multiples of British GDP. These were not banks that were ‘too big to fail’, they were ‘too big to save’ – because governments did not have the financial power to bail them out.

Third, the big financial firms had either lobbied their way into getting poor or limited regulation, or evaded regulation through clever structuring and accounting. That helped them take bigger risks (excessive leverage, and/or complex trading strategies that even the firms’ chiefs did not understand); since the markets were buoyant, the reward was fat profits. But risk matches reward, and once the markets turned the risks weighed in – the result was quick bankruptcy.

Finally, in a high-risk situation fraught with excessive leverage, where the pricing of risk had to be accurate as well as sensitive, the massive failure of the credit rating agencies to understand and correctly rate complex financial derivatives (for just one of which the dense legalese could run into 7,500 pages) led to a massive mis-pricing of risk – so that the whole house of cards eventually came down.

 

You can learn what lessons you want from this, in terms of what kind of financial system and how much regulation you want (and, to his credit, the then governor of RBI, Y. Venugopal Reddy, did warn publicly about the mis-pricing of risk), but that is not the focus of this year-end assessment. The issue is how all this affected India. Straight off, it looked as if the linkages were few and the risk therefore quite small – if ICICI bank was exposed to the extent of a couple of hundred million dollars, it was neither here nor there. Then the fuller ramifications slowly became evident – because, after all, India had become more integrated with the world.

 

At the time of the Asian financial crisis of 1997-98, India’s exports (goods and services) accounted for about an eighth or ninth of GDP; now it is nearly a quarter. All current and capital account flows, in and out of the country, used to be equal to just under half of GDP; now it is much more than a year’s GDP. So what goes on in the rest of the world matters to the Indian economy – as we have seen this year, when the investments in Indian markets by foreign institutional investors accounted at one stage for $280 billion, and now total only $70 billion – in substantial part because share prices have crashed, but also because FIIs have been taking their money out.

Global prices matter too. The difference between oil at $50 and $150 is $50 billion in a year – i.e., an extra five per cent of our GDP gets shipped out to the Arabs. Add the impact of the sharply swinging prices of fertiliser, naphtha, steel, coal, aluminium, copper and also rubber, palm oil and pulses, and before you know it five per cent inflation becomes 12 per cent inflation and the commentariat is screaming blue murder.

The impact of the integration through trade and capital flows is compounded by the financial linkages. When the global liquidity crunch means that Indian exporters stop getting suppliers’ credit, they turn to Indian banks for the money. When the international operations of Indian bank subsidiaries overseas get hampered because financial markets have frozen up in London and New York, dollars are sent from India. When the FIIs pull out in droves, more dollars go out.

When there is a surge of demand for dollars for being shipped out, the rupee can crash – instead of going from Rs 40/$ to Rs 50, as it did, it could easily become Rs 60 or worse – which could spell disaster if it becomes a free fall (remember Indonesia in 1997). The RBI therefore likes currency movements to be smooth and orderly, so it cushions the fall by selling dollars to finance the outflows. But that means taking in rupees in exchange, so domestic liquidity seizes up too – especially if Parliament is busy with trust votes on the nuclear deal and therefore does not do essential financial business, and the oil and fertiliser companies take from banks the subsidy rupees that the government was to give them but cannot because Parliament has not authorised it. All of which is why you couldn’t get money for love or usurious interest rates at one stage in September; it had already gone elsewhere.

 

You could argue (and many have done so) that the government and RBI messed it up, that they should have seen the turn of events and eased up on rupee liquidity and interest rates two or three months before they finally did, i.e. in July and not in October. If so, the shock and pain of those two or three months would not have been quite so bad, and the transition to a slower pace might have been managed better. But equally, if the world is being turned upside down, India is not going to remain immune, not when 2008 is so different from 1998.

In the fateful third quarter of 2008, when the whole economy seemed to swing around on a pin, the macro-economic context had changed in three fundamental ways. First, the deficit on trade had soared to dangerous levels because of the commodity price surge, and there was no panic only because RBI had a stash of dollars in its vaults. Second, the fiscal deficit also soared; by any accurate measure, it threatened to hit seven per cent of GDP this year, the highest in a decade. And third, the official inflation numbers went out of control.

But by the time the fourth quarter got under way, the new realities began to seep in. If you are looking ahead, and not in the rear view mirror, the outlook has changed quite dramatically yet again. Oil is back in the $40 price range, the same as four years ago – and if that level holds, there two huge pay-offs. First, the deficit on trade becomes very manageable again. Second, there is no oil burden on the exchequer because the oil subsidy disappears, which means the fisc too gets back into balance. Finally, the price curve has been flattening and inflation will cease to be an issue in a couple of months, if it has not already done so. So all three macro pressure points have eased. Voila, we can breathe easy again.

 

What this could mean is that the underlying strengths of the Indian economy start manifesting themselves again, even as the global economy takes time to recover. By all accounts, the recession in western markets will last through 2009, so the pressure on Indian exporters will continue. Since there is little or no money in global markets, no one should expect much of an inflow on the FII account or through the foreign direct investment route. In other words, the sources of growth must come from within.

Those forces are three-fold: retail demand, investment demand, and the savings/investment to fuel growth. Both kinds of demand will take time to return; consumers will hold back until they are sure about holding on to their jobs, and companies are not going to invest till they are sure about cash flow and resumption of growth. And with export demand in question, most observers see slow growth continuing through 2009. The macro-economy may be back on even keel, but the engines will not be firing away to achieve rapid growth.

 

One positive here is that rural demand could be strong – agricultural growth has been good for the past four-five years, the 2008 monsoon was good too, and the write-off of bank loans would have eased much of the pressure on farm household budgets. The second positive is that the government has now paid out the money flowing from the Pay Commission award; millions of government employees will therefore be spending more – and this will generate demand in many sectors.

Perhaps the real uptick will come when the stock market recovers, and investors stop counting their losses from the crash of 2008. For this, companies will have to start showing better results – and a low base effect could kick in around September-October of 2009. Looked at in totality, and assuming that the world as a whole (or just China) does not go belly up, it should be possible to see a slow change of mood in the second half of 2009.

The only reason to doubt such a happy turn of events is the general perception that the developed economies are going through their worst crisis in 80 years, and the expectation therefore that the crisis will be a prolonged one. But short of a cataclysm, it is hard to believe that, a year from now, the mood will not have changed significantly for the better.

For a lot of troubled enterprises and households, the point is to get from here to there.