Financial Crisis and India: Who Pays the Price?

On November 3, the Prime Minister of India, Dr. Manmohan Singh urged the Indian industries, not to cut jobs. He said, “While every effort needs to be made to cut cost and raise productivity, I hope there will be no knee-jerk reaction such as large scale layoffs, which may lead to a negative spiral.” Things are however not turning out as advised by the economist PM.

Job loss in the Indian Economy

Already, we have seen that the performance of the Indian corporate sector has been adversely affected. The results of the second quarter for this fiscal year show that the aggregate profit growth for the corporate sector as a whole has come down. The main reasons for such decline in profits being rise in interest costs and raw material prices. In the wake of such decline in profits, the Indian corporate sector had to cut down on costs. In this regard, retrenchment of workers was thought to be an effective way of cutting costs. The move by Jet Airways to retrench 800 workers was done primarily on the basis of the above thinking on the part of the Jet management. However, due to much public outcry and political pressure, the Jet management had to withdraw its decision. This was however only the beginning of the story. Almost all the sectors of the economy have resorted to job cuts or a cut back in the production in order to cope with the economic crisis. We give some of the major decisions of job cuts or production cuts on the part of the Indian corporate sector in the wake of the financial crisis.

• India’s leading truck maker, Tata Motors, announced the shutdown of its Pune unit for six days in November, which will follow a three-day closure of its Jamshedpur plant.
• Ashok Leyland, the second largest producer of trucks, drove in tandem, slashing its weekly working days to three.
• JSW Steel opted for a 20-per cent cut in output this month.
• Another steel maker Essar also has decided to reduce capacity utilization.
• Tata Steel’s UK subsidiary, Corus, has also affected a similar cut in capacity utilization. It has also decided to axe 400 jobs.
• DBS has decided to cut 900 jobs
• Cement manufacturers have reduced capacity utilization to about 85% because of a sharp fall in demand from the realty sector, which consumes about 55% of the total production of 200 million tonnes.

(The above data is taken from: More Companies Opt to Trim Man Hours, Cut Production, Business Line, 8 November 2008)

• Nearly 150 trained pilots and hundreds of trained airhostesses have been rendered jobless as the economic turbulence is forcing airline companies to ground a significant part of their staff. (150 Airhostesses, Pilots Get Grounded, The Economic Times, 8 November 2008).
• Even in the Finance or the IT sector, the threat of job loss is looming large. For example, Fidelity National Information Services (FIS) has given pink-slips to over 100 employees at its Chennai operations, which constitutes more than 10% of its staff in the metro. (Over 100 FIS staff get pink-slips, The Economic Times, 8 November 2008).
• L&T Infotech, the wholly-owned subsidiary of the country’s largest engineering company Larsen &Toubro (L&T), is trimming down its staff by asking some employees to resign. It is estimated that the number of forced resignations till now is around 100. (L&T IT Arm Starts Trimming, The Economic Times, 8 November 2008).
• At the same time, the international banks’ offices in India are significantly down sizing their work force. Goldman Sachs slashed its workforce by close to a dozen in its Mumbai office. Credit Suisse, another recent entrant in India, has also slashed some jobs in the country. (These Are Mean Cruel Times, Indian Arms of I-Banks in Lay-off Mode, The Economic Times, 8 November 2008).
• The most severe job cut however has been witnessed in the textile sector. It is estimated that over the last six months there have been 7 lakh job losses in the textile sector. The textile sector is particularly important because it provides employment to more than 3.5 crore workers. It is also projected that this number can increase to 12 lakhs in the next three months. (Textile Cuts 7 lakh Jobs in Six Months, The Economic Times, 8 November 2008).

Why Such Job loss?

The question that naturally arises is what accounts for such across the board and massive lay-offs in the Indian economy? There are several reasons for this. Firstly, as has been already mentioned, job cuts is a way of reducing costs to the companies, which they are resorting to in the wake of rising interest and raw material costs. However, the malaise goes deeper than this. This is evident from the fact that not only has there been a job cut, but many companies have been forced to suspend or reduce production in the recent times. This points to the fact that the companies are trying to reduce their capacities. Such reduction in capacity utilization is symptomatic of the fact that there is not enough demand in the economy. For example, for the auto manufacturers like TATA Motors or Ashok Leyland, there is just not enough buyers to buy their products. In this context, to carry on production will only result in accumulation of inventories, which these companies do not want- hence the decision to suspend production in their plants. As far as the steel sector is concerned, the biggest demand from steel in India comes from the construction and the real estate sector. Now, in the wake of the financial crisis, the realty sector has been substantially adversely affected. As a result the demand for steel in the country has been hit. Moreover, since the crisis is global in nature, there is not even enough external demand for steel, which can compensate for the drop in the domestic demand. In the absence of demand for steel, the companies have been forced to cut back on production.

The case of the textile sector is particularly worrying. This is because this sector employs a very large number of people. Moreover, the people who are particularly losing their jobs in the textile sector are those workers who are daily wage earners. The question is why such severe job cuts are being witnessed in the textile sector. One of the major sources of demand for the textile sector is the external demand. In other words, there is a strong export demand for the Indian textile sector. In 2006-07, the textile exports comprised of 12.9% of the total exports from India. (Economic Survey, 2007-08, Chapter on External Sector). Now, with the global financial crisis and the impending recession in the advanced capitalist countries, there has been a slow down in the export demand for Indian textile sector. With such decline in the demand for the Indian textile sector, there have been severe job losses.

Lessons for the Prime Minister

The economist Prime Minster needs to learn proper lessons from this. His argument to industry not to retrench workers is nothing short of a hogwash. This is because, as the Finance Minister and now the Prime Minister of the country, Dr. Singh has presided over a systematic entrenchment of the Indian economy into the logic of the market. Today, the organized sector employment growth rate has reached minimal level, with the employment in the Public sector turning negative. (Economic Survey, 2007-08). On top of this, there is the new mantra of labour market flexibility supposedly to increase the efficiency of the Indian industries. These are nothing but euphemism for doing away with whatever little social security that the workers have in this country. Now, when the workers have been subjected to the tyranny of globalization, Dr. Singh is now paying lip service to them, on the eve of the elections.

This impasse has been created by the votaries of neo-liberal reforms in the country. Over the last few years, the Government has self-imposed strict limits to fiscal expenditure as a result of following the policies of globalization, the FRBM Act being one example. Instead of ensuring proper expenditure on the part of the Government aimed at uplifting the conditions of the poor what has been done is providing sops to the corporate sector, in the form of tax exemptions. This has allowed the corporate sector to rise to dominance in the Indian economy. At the same time, the demand for the products, primarily high end, of the corporate sector has been provided by the debt financed consumption of the middle class and the rich. Now, with the financial crisis, the banks are becoming less forthcoming in providing such easy debts to the middle classes. That is why there has been consistent demand on the part of the press as well as other stakeholders to reduce the interest rates on housing and other loans, in order to again stimulate the debt financed consumption. In fact, the Finance Minister compelled the Public Sector Banks to reduce their rates. This route of stimulating demand is however problematic because of the following reason. What is essentially done through this lowering of interest rate is to neglect putting more purchasing power to the majority of the people and lure the middle class to consume, thereby keep the demand in the economy afloat. What is missed is the fact that such soft loans in return may give rise to sub-prime loans in the Indian economy, which can cause serious problems for the banks. Already it has been seen that the largest credit card issuer, ICICI Bank has shown flat profits and significantly enhanced loan loss provisions. The second largest credit card issuer, the State Bank of India’s SBI Cards, posted net losses in the past two quarters. On December 31, 2007, its non-performing assets, or credit card debt that could not be collected by the company, stood at 16.28 per cent. This is likely to have grown since then. (Now, the Credit Card Crunch, Jayati Ghosh, Frontline, November 8-21, 2008).

Who Pays the Price?

In this context one of the most important issue is the asymmetry in the impact of the boom and the bust. When India was growing at a very high speed riding the boom, lakhs of farmers committed suicide in the country, the employment rate declined, the rate of decrease in the poverty rates, even according to official estimates declined, children remained malnourished and millions died of curable diseases. At the same time however, India produced the largest number of billionaires, shopping malls and luxury hotels for the rich, high profile jobs for the English speaking elites. In other words, during the boom in India, the rich got richer while the poor got poorer.

Now, the signs of the impending slow down in the Indian economy are global in origin. It is the speculators in the Wall Street who have manufactured this global crisis riding on greed and free market ideology. And who suffers the consequences of this in India? We have already seen that 7 lakh people have already lost their jobs in the textile sector alone, majority of them being wage earners. Factories of TATA are being shut down, investment projects are being postponed, production is being cut-the sufferers in all this are the working people, whose jobs are at stake, whose salaries, job security and other benefits are at stake.

One might actually argue that the riches are also losing out. It is reported that the collective wealth of India’s wealthiest have fallen by $212 billion. Still, the net worth of Ambani is $20.8 billions in a country where 77% of the people live on less than Rs 20 per day. Moreover, this loss in the wealth that is being reported in the financial press is more of a notional loss than any original erosion in their asset position. This is because this loss is based on the valuation of the paper assets (stocks) of the industrialists, which have indeed decreased in the market.

As far as the middle classes are concerned, yes there have been losses for this section of the population. The option of high consumption on the basis of soft loans has also dried out to a significant extent. This however might be transitory since the banks are already easing out different rates. A section of the white collared people has also lost their jobs. What is noteworthy however is the response of the media as well as the establishment to this problem of the middle class. Only 1900 people were sacked by Jet Airways, which was indeed a terrible thing, and the entire media cried foul over it. Today 7 lakhs poor people have lost their jobs in the textile sector only. The media is silent on their plight. Thus, it is seen that it is the working people of the country who are mostly paying the price in the aftermath of the financial crisis and its impact on India.

What Can be Done?

What can be done is however very simple. The Indian economy is riddled with large scale poverty and misery particularly in the rural areas. What is needed is Government expenditure in a big way in the economy, putting purchasing power in the hands of the people whose increased consumption can then be a very important source of demand in the economy. This can be done by providing employment to the masses, which will also help in eradicating poverty to a significant degree in India. One step in this regard is to implement the NREGA effectively in rural areas and expand to urban areas. Moreover, government investment should be forthcoming in major infrastructure areas like building roads, railways, hospitals, schools, colleges etc. This will not only generate employment for the masses but act as major social assets in the future. Today, China is already doing it.

The financing for these projects is not an impossible task if one sees it outside the prism of the ideology of neo-liberalism. What is first required in this regard is to do away with the FRBM Act and ensure more Government expenditure by enlarging the fiscal deficit. What is needed is a political will to implement policies for the upliftment of the poor and not merely directed at filling the coffers of the rich.

The Crisis in the US Financial Markets

The international financial market is currently in a crisis the intensity of which is unprecedented since the Great Depression of 1929-30. Within a week we have witnessed the serial closing down of the biggest investment banks in the USA and the world, some of which, like the Lehman Brothers, survived the aftermath of the Great Depression. In order to put breaks to this slide, the US Government has been forced to intervene in the market in a big way. Even then, nobody is sure whether this crisis will end or not; nobody is even sure whether we have witnessed the worst phase of the crisis or more is yet to come. In this context the following questions are being raised:

How severe is the crisis?

It is argued by certain sections of the media that ultimately, the world has witnessed such crises in the past. In 1997-98 there was the East Asian financial crisis. So the present crisis is no different. This argument is way off the mark because of the following. To be sure, the East Asian financial crisis was very serious and affected a large number of countries, including Brazil and Russia. But it originated and caused problems for countries which were in the periphery of capitalism. Ultimately, the origin of the crisis and its effect were largely limited to developing countries, with limited impact on developed countries. Even India and China, although so close to the East Asian theatre were not affected by it. But the present crisis has taken place in the heart of modern capitalism, the USA. This alone points to the fact that this crisis is of a qualitatively different nature.

In contrast to this, it is also being argued that this is not the first financial crisis that the USA has faced. Even in the recent past, during the late ‘90s and early part of this century, the USA economy witnessed similar problems following a period of relatively better economic performance. Thus, this crisis will not pose serious problems for the US too. What is missed in this type of analysis is the fact that the present crisis engulfs not only the financial sector of the US economy but has serious repercussions for the real sector of the economy also. While this will be taken up later, it suffices here to point out that the biggest investment banks in the USA have collapsed and the government has come out with the biggest bail out plan in the history to save the financial sector in the USA and the world. At least, the US Government knows how serious the crisis is. According to renowned economist Paul Krugman, the broadest measure of unemployment in the USA, has risen from 8.3 percent to 10.3 percent over the past year, roughly matching its high point five years ago.

How did it all go so wrong?

Let us first look into the functioning of banks. If the banks are giving loans to the public they have an expectation and assessment regarding the public’s credibility to pay back the loans. This expectation is backed by the collateral of the loan or the valuation of the project for which the loan is claimed. As long as the banks have correct estimations regarding the valuation of the mortgage or the project, its expectation will be realized. If due to some reason, the value of the mortgage or the project suffers drastic decline, then the possibility of the banker getting back the loan reduces greatly. Now, loans given by banks are assets to them. In case of defaults, this financial asset for the banks becomes essentially valueless. On the other hand, based on these assets, banks take credit from other agents for various purposes. Now, if the asset position of banks weaken then there exists a risk that the Bank will not be able to pay back to its creditors. If this happens in a large enough scale then the bank has to go bankrupt.

Let us now see what happened in the US markets. Firstly, it should be noted that the economic growth in the USA is largely consumption driven, with housing forming a very important part of consumption demand. Owning a house in the USA is a matter of social prestige and security. But every individual who is investing in housing does not necessarily build it in order to stay but sell it at a future date to gain profit. There was huge housing price inflation in the USA, which was largely based on speculations and higher demand for houses. As a result of this high price of houses, many more individuals started to invest in housing.

Now, in order to invest, the investors needed loans from the banks, which were provided against a mortgage. Since there was a housing price inflation, many borrowers managed to pay back the loans between 2000 and 2003. This increased the expectation of the banks that giving loans for the housing sector is actually profitable, since in the past loans were recovered based on the housing price inflation. Moreover, with the housing price inflation continuing, the banks estimated that by selling the houses, in case of default, the loan could be reclaimed. This reduced the bank’s scrutiny of the mortgages and resulted in giving more loans to borrowers whose creditworthiness was low, which are essentially the sub-prime loans. In 2006, 20.1% of all mortgage backed loans were sub-prime.

This did not cause any alarm, as long as the housing price inflation continued. But this could not continue for long due to a simple economic factor. With the housing price inflation a large number of investors invested in the housing market which resulted in a steep increase in the supply of houses. At the same time the demand for houses could not increase more since there was a slow down in the growth rate of GDP and increase in unemployment between 2001 and 2005. Both these factors had to bring the price of houses down which started to decline sharply from December 2005. This resulted in problems for the banks through two routes. Firstly, the valuation of the project (houses) for which the loans were taken declined. Secondly, loans were issued against mortgages of lower valuations to begin with. This resulted in a situation where the banks could not recover their loans and suffered losses.

The above discussion raises two issues. Firstly, why were such sub-prime loans given in the first place? Secondly, how did the problem in the housing market and the sub-prime mortgage market become such an all encompassing problem for the financial sector?

The answer to the first question lies in two facts. One is that there have been substantial de-regulations in the USA following the decline in the earnings of commercial banks in the United States in the 1980s. Secondly, the unbridled quest for profits is also responsible. Every bank is thinking that if I do not give the loans somebody else will give and earn profits. Hence, in the end, every bank starts to provide these sub-prime loans.

On top of this, the banks engaged in myriad forms of financial innovations which resulted in contagion of the problem in the housing and the sub-prime mortgage markets to other financial segments. What was essentially been done is the following. Suppose person A takes a sub-prime loan from a bank. Now for the bank this is an asset, since this will generate a future stream of income. Subsequently, the Bank floats another subsidiary or the Special Purpose Vehicle (SPV) to which it sells this asset. With the selling off of this asset the risk associated with it is also transferred by the bank. The SPV issues papers called securities to sell in the market and mobilize funds to buy the asset. The return to these papers is linked with the performance of the original asset. Moreover, these papers are itself assets to its holders against which loans can be taken. (This process is called securitization. It is estimated that 80.5% of the sub-prime loans were securitized in 2006.)

Now, if the person A defaults in his payment commitment to the bank, then there is no income flow that is coming from the loan as an asset. If the mortgage is not securitized then the initial bank from which the loan is taken suffers loss. On the other hand, if it is securitized, all those who are holding securities on this asset do not get any return. As a result with the initial asset becoming valueless, a chain of assets become valueless. This results in problems for large section of the players in meeting their payment commitments. More financial instruments such as these were produced in the US market which resulted in the contagion of the problem of the housing and sub-prime mortgage markets to the entire financial architecture resulting in bankruptcies as has been mentioned above.

In short the financial de-regulation of the financial sector along with the banks’ profligacy in providing sub-prime loans, based on wrong assessment, along with the innovations of various financial instruments led to the massive crisis in the financial sector in USA.

This crisis essentially has resulted in a loss of confidence in the financial sector, resulting from massive defaults, where people are not sure whether they will get back the money that they are lending. As a result people who are willing to borrow money from the market are not being able to get it. This is harming investment prospects in the economy. Moreover, massive job cut in the financial sector is also causing a decline in the aggregate demand in the economy. Both of these are slowing down the US economy.

What does the crisis signify?

There is a theory in economics which says that the Government is inefficient and can never be a solution to economic problems. In fact it was believed that the Government is a problem and not a solution as far as working of markets is concerned. The first casualty of this crisis, apart from the US economy and the banks, is this orthodox belief in the ultimate efficacy of the market mechanism. This economic myth was proved wrong during the Great Depression and again has been proved wrong today. The crisis proves that unbridled free market orthodoxy results in massive crises. Now, it is the US Government which has to step in with a massive bailout plan of $700 billion to save the private banks and other players in the financial market.

Secondly, the invincibility of American capitalism has been questioned like never before, at least not since the Second World War. For all those, who are talking about how good the US economic system is, please hold your breath and look at the mess that the US is in right now. The present crisis should also be a wake up call for all those who want to mould the Indian economy like that of the USA.

Thirdly, for Indian Government this is a wake up call against the policies of financial liberalization that it wants to pursue. Clearly, the model of unbridled financial liberalization has failed in the USA. It is high time that our Government drops the idea of putting us voluntarily into the possibility of a crisis that the USA is currently faced with.