Stagnancy in Investment Cycle

The government’s Make in India initiative saw investment pledges worth Rs.15 lakh crore. While the government expects to convert 80-85% of this amount into serious business, it is important to note that according to a research no Indian state has had a conversion rate of more than 20%. Shocking. Making big promises and then not delivering upon those promises has been a trend in this country.

Let us understand the current scenario.

  • Consumer demand is low
  • Industrial output fell by 1.3% in December
  • The rupee is at a 30 month low
  • FIIs have pulled out $2 billion this FY
  • Cumulative gross NPAs of 24 listed Public Sector Banks stood at INR 3,93,035 crore (as on December 31, 2015)

The investors cannot only rely on the promises made by the government. There are a lot of factors that need due attention if the government wants to see the investment cycle in motion.

What does the Modi government need to focus on to clean up this mess?

  • Stalled Projects: 304 projects which involve investments worth INR 12,758,777 crore. When projects get stuck due to whatever reason there is always a fall in investments.
  • Fall in Private Investments—INR 0.50 lakh crore (approx.)
  • Fall in Government Investments—INR 2 lakh crore (approx.)
  • Fall in investment proposals—INR 1.20 lakh crore (approx.)
  • Low Capacity Utilisation: In most manufacturing sectors the capacity utilization is around 50-70% at best. This is one of the major issues that the government needs to focus upon. The capacity utilization needs to grow in core sectors like cement and steel where it is below 60%.
  • Poor Consumer Sentiment: This is one of the biggest reason why investments aren’t picking up. The job market is sluggish leading to lower demand levels. India adds about 23 million people to its workforce every year but has created only 7 million jobs annually over the past 30 years.
  • Growing NPAs: The whole NPA issue is taking a toll on the economic growth. In order to de-stress their balance sheets the Public Sector Banks are stuck in a situation where they are not willing to give loans or invest in stalled projects. As the gross amount of NPA’s totaled to almost INR 3.93 lakh crore, it will take some time for banks to settle down.

There are many other issues that demand the government’s attention but these are the major factors that are actually the main reasons for those issues.

Hopefully, Budget 2016 will be pro India and not pro subsidy and tax exemptions and will provide a platform to the Government to solve these problems and get the ball rolling again.

The NPA Scam

What are NPAs?

A Non-performing asset (NPA) is defined as a credit facility in respect of which the interest and/or installment of Bond finance principal has remained ‘past due’ for a specified period of time. NPA is used by financial institutions that refer to loans that are in jeopardy of default.

Current Situation…

Rs.1.14 lakh Crore worth of bad loans have been written off the books by PSU banks between 2013 and 2015. The Supreme Court has ordered the RBI to name all the defaulters who owe more than Rs. 500 Crores.

The cumulative amount of gross NPA of 24 Public Sector Banks stood at around INR 3.93 lakh crore as on December 2015

Why should we care?

Well, the answer is very simple. It is OUR money.

Why are NPAs in the limelight?

Whenever the PSU banks want fresh capital they ask the government and then the government provides them with this fresh capital. This process of investing fresh capital into the PSU banks by the government is called CAPITAL INFUSION.

But recently, instead of recapitalizing the banks, government has asked the PSU banks to clean up their balance sheets if they want to get recapitalized.

This made the banks write off such huge amounts of bad loans just to clean up their balance sheets so as to get fresh capital from the government.

Who to hold responsible for this mess?

  • The defaulters
  • The incompetent PSU banks
  • The irregularities shown by the RBI in maintaining a check over these banks
  • The deadly nexus between—The “Industrialist”—the “Babu”/”Neta”/”Politician” —the “Banks”

This NPA scam is being carried out right in front of our eyes and yet no charge sheet has been filed against those responsible.

Are we so blinded by the idea of a double digit economic growth that such scams are allowed to happen?

Is this a price that India a mixed economy has to pay to reap the benefits of both a capitalist and a socialist economy?

The European Financial Tragedy

Following the trends of my previous posts, I will try to analyze the Eurozone Crisis.

The Eurozone Crisis is also known as the Sovereign Debt Crisis.

Let us first understand the meaning of Sovereign Debt. When a nation’s government issues bonds in a foreign currency to be sold to foreign investors in order to finance the issuing country’s growth, this debt raised by the government is known as Sovereign Debt.  Sovereign debt is a riskier investment when it comes from a developing nation and a safer investment when it comes from a developed country. The stability of the issuing government is an important factor to consider, when assessing the risk of investing in sovereign debt, and sovereign credit ratings help investors weigh this risk.

When a country fails to repay its debt it is known as Sovereign Default. Countries are often hesitant to default on their debts, since it will be difficult and expensive to borrow funds after a default event. However, sovereign countries are not subject to normal bankruptcy laws and have the potential to escape responsibility for debts without legal consequences. Sovereign defaults are relatively rare, and are often precipitated by an economic crisis affecting the defaulting nation. Investors in sovereign debt closely study the financial status and political temperament of sovereign borrowers in order to determine the risk of sovereign default.

Since the intensification of the financial crisis in September 2008 after the collapse of Lehman, long-term government bond yields relative to the German Bund have been rising after ten years of stability at very low levels. In the first phase, the associated global uncertainty and in the euro area the rescue of the largest Irish banks by the Irish government might have played a key role in the developments of the euro area sovereign spreads. The situation started to improve in the course of the spring and the summer 2009 as global uncertainty receded and after the announcement of stringent fiscal stabilization measures by the Irish government on 22 February 2009. On 16 October 2009, the Greek Prime Minister George Papandreou in his first parliamentary speech disclosed the country’s severe fiscal problems and immediately after on 5 November 2009 the Greek government revealed a revised budget deficit of 12.7% of GDP for 2009, which was the double of the previous estimate. Since then, the sovereign spreads rose sharply for most of the euro area countries, causing the biggest challenge for the European monetary union since its creation.

The Eurozone crisis resulted from a combination of complex factors,

  • the Globalization of finance;
  • easy credit conditions during the 2002–2008 period that encouraged high-risk lending and borrowing practices;
  • the financial crisis of 2007–08;
  • international trade imbalances;
  • real estate bubbles that have since burst;
  • the Great Recession of 2008–2012;
  • Fiscal policy choices related to government revenues and expenses;
  • Approaches used by states to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

In 1992, members of the European Union signed the Maastricht Treaty, under which they pledged to limit their deficit spending and debt levels. However, in the early 2000s, some EU member states were failing to stay within the confines of the Maastricht criteria and turned to securitizing future government revenues to reduce their debts and/or deficits, sidestepping best practice and ignoring international standards.

This allowed the sovereigns to mask their deficit and debt levels through a combination of techniques, including inconsistent accounting, off-balance-sheet transactions, and the use of complex currency and credit derivatives structures.

From late 2009 on, after Greece’s newly elected government stopped masking its true indebtedness and budget deficit, fears of sovereign defaults in certain European states developed in the public, and the government debt of several states was downgraded. The crisis subsequently spread to Ireland and Portugal, while raising concerns about Italy, Spain, and the European banking system, and more fundamental imbalances within the Eurozone.

The under-reporting was exposed through a revision of the forecast for the 2009 budget deficit from “6–8%” of GDP (no greater than 3% of GDP was a rule of the Maastricht Treaty) to 12.7%, almost immediately after PASOK won the October 2009 national elections. Large upwards revision of budget deficit forecasts due to the international financial crisis were not limited to Greece: for example, in the United States forecast for the 2009 budget deficit was raised from $407 billion projected in the 2009 fiscal year budget, to $1.4 trillion, while in the United Kingdom there was a final forecast more than 4 times higher than the original. In Greece the low (“6–8 %”) forecast was reported until very late in the year (September 2009), clearly not corresponding to the actual situation.

The fact that the Greek debt exceeded $400 billion (over 120% of GDP) and France owned 10% of that debt, struck terror into investors at the word “default”. Although market reaction was rather slow—Greek 10-year government bond yield only exceeded 7% in April 2010—they coincided with a large number of negative articles, leading to arguments about the role of international news media and other actors fuelling the crisis.


In the early mid-2000s, Greece’s economy was one of the fastest growing in the eurozone and was associated with a large structural deficit. As the world economy was hit by the financial crisis of 2007–08, Greece was hit especially hard because its main industries—shipping and tourism—were especially sensitive to changes in the business cycle. The government spent heavily to keep the economy functioning and the country’s debt increased accordingly.

Despite the drastic upwards revision of the forecast for the 2009 budget deficit in October 2009, Greek borrowing rates initially rose rather slowly. By April 2010 it was apparent that the country was becoming unable to borrow from the markets; on 23 April 2010, the Greek government requested an initial loan of €45 billion from the EU and International Monetary Fund (IMF), to cover its financial needs for the remaining part of 2010. This eventually led to slashing of Greece’s sovereign debt rating by S&P.

As a counter measure to curb this growing crisis the Greek government announced a series of austerity measures. The third austerity package was announced to secure a 3 year 110 billion Euros loan. After this another bailout was agreed upon for Greece worth 130 billion Euros. Then, in March 2012, the Greek government did finally default on its debt, which was the largest default in history by a government, about twice as big as Russia’s 1918 default. Of all €252bn in bailouts between 2010 and 2015, just 10% has found its way into financing continued public deficit spending on the Greek government accounts. Much of the rest, went straight into refinancing the old stock of Greek government debt (originating mainly from the high general government deficits being ran in previous years), which was mainly held by private banks and hedge funds by the end of 2009.

So, basically as we can see the causes and consequences of the Eurozone Crisis were pretty similar to any of the previous crises. First there is a rapid increase in asset prices and the there is a credit boom which helps investors in investing in those assets and then the bubble bursts.

Same was the case with Ireland, Portugal, Spain and Cyprus.


The Irish sovereign debt crisis was not based on government over-spending, but from the state guaranteeing the six main Irish-based banks who had financed a property bubble.

Irish banks had lost an estimated 100 billion euros, much of it related to defaulted loans to property developers and homeowners made in the midst of the property bubble, which burst around 2007. The economy collapsed during 2008. Unemployment rose from 4% in 2006 to 14% by 2010, while the national budget went from a surplus in 2007 to a deficit of 32% GDP in 2010, the highest in the history of the Eurozone, despite austerity measures.

Similar to Greece Ireland was also bailed out by the EU and the IMF.


Portugal had allowed considerable slippage in state-managed public works and inflated top management and head officer bonuses and wages in the period between the Carnation Revolution in 1974 and 2010. Persistent and lasting recruitment policies boosted the number of redundant public servants. Risky credit, public debt creation, and European structural and cohesion funds were mismanaged across almost four decades. When the global crisis disrupted the markets and the world economy, together with the US subprime mortgage crisis and the Eurozone crisis, Portugal was one of the first and most affected economies to succumb.

During the crisis Portugal’s government debt increased from 93 to 139 percent of GDP.


Spain had a comparatively low debt level among advanced economies prior to the crisis. Its public debt relative to GDP in 2010 was only 60%, more than 20 points less than Germany, France or the US, and more than 60 points less than Italy, Ireland or Greece. Debt was largely avoided by the ballooning tax revenue from the housing bubble, which helped accommodate a decade of increased government spending without debt accumulation. When the bubble burst, Spain spent large amounts of money on bank bailouts. In May 2012, Bankia received a 19 billion euro bailout, on top of the previous 4.5 billion euros to prop up Bankia. Questionable accounting methods disguised bank losses. During September 2012, regulators indicated that Spanish banks required €59 billion (US$77 billion) in additional capital to offset losses from real estate investments.

Again we can see a similar pattern of the bursting of the bubble leading to a crisis.


The economy of the small island of Cyprus with 840,000 people was hit by several huge blows in and around 2012 including, amongst other things, the €22 billion exposure of Cypriot banks to the Greek debt haircut, the downgrading of the Cypriot economy into junk status by international rating agencies and the inability of the government to refund its state expenses

So all these European countries were involved in the Sovereign Debt Crisis either because of the very similar reasons that lead to a financial crisis or because of the fact that they are dependent on each other and failure of one of them means failure of all of them.


The time when the bubble burst

In my previous post I talked about financial crisis, their causes and consequences. Now, I will try to analyze why did the Subprime Crisis or the Housing Bubble Crisis took place.

Observers and analysts have attributed the reasons for the 2001–2006 housing bubble and its 2007–10 collapse in the United States to the following:

  • Home buyers
  • Wall Street
  • Mortgage Brokers
  • Mortgage Underwriters
  • Investment Banks
  • Rating Agencies
  • Investors
  • Low mortgage interest rates
  • Low short-term interest rates
  • Relaxed standards for mortgage loans
  • Irrational exuberance
  • Alan Greenspan

But the four primary causes for the bursting of the housing bubble were:

  1. Low mortgage interest rates
  2. Low short-term interest rates
  3. Relaxed standards for mortgage loans
  4. Irrational exuberance


In the wake of the dot-com crash and the subsequent 2001–2002 recession the Federal Reserve dramatically lowered interest rates to historically low levels, from about 6.5% to just 1%. This spurred easy credit for banks to make loans. By 2006 the rates had moved up to 5.25% which lowered the demand and increased the monthly payments for adjustable rate mortgages. The resulting foreclosures increased supply, dropping housing prices further. Former Federal Reserve Board Chairman Alan Greenspan admitted that the housing bubble was “fundamentally engendered by the decline in real long-term interest rates.

Mortgages had been bundled together and sold on Wall Street to investors and other countries looking for a higher return than the 1% offered by Federal Reserve. The percentage of risky mortgages was increased while rating companies claimed they were all top-rated. Instead of the limited regions suffering the housing drop, it was felt around the world. The Congressmen who had pushed to create subprime loans now cited Wall Street and their rating companies for misleading these investors.

Low interest rates, high home prices, and flipping (or reselling homes to make a profit), effectively created an almost risk-free environment for lenders because risky or defaulted loans could be paid back by flipping homes.

Private lenders pushed subprime mortgages to capitalize on this, aided by greater market power for mortgage originators and less market power for mortgage securitizers, Subprime mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999 and $600 billion (20%) in 2006.

In March 2007, the United States’ subprime mortgage industry collapsed due to higher-than-expected home foreclosure rates (no verifying source), with more than 25 subprime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale.

The first notable event signaling a possible financial crisis occurred in the United Kingdom on August 9, 2007, when BNP Paribas, citing “a complete evaporation of liquidity”, blocked withdrawals from three hedge funds. The significance of this event was not immediately recognized but soon led to a panic as investors and savers attempted to liquidate assets deposited in highly leveraged financial institutions.

The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007 to 2010.

In September 2008, the crisis hit its most critical stage. There was the equivalent of a bank run on the money market funds, which frequently invest in commercial paper issued by corporations to fund their operations and payrolls. Withdrawal from money markets were $144.5 billion during one week, versus $7.1 billion the week prior. This interrupted the ability of corporations to rollover (replace) their short-term debt. The U.S. government responded by extending insurance for money market accounts analogous to bank deposit insurance via a temporary guarantee  and with Federal Reserve programs to purchase commercial paper. The TED spread, an indicator of perceived credit risk in the general economy, spiked up in July 2007, remained volatile for a year, then spiked even higher in September 2008, reaching a record 4.65% on October 10, 2008.

The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock indexes, and large reductions in the market value of equities and commodities.

The severe recession that began in December of 2007 was caused by the bursting of the housing bubble and the resulting credit crisis. Each of the four primary causes played an important role in creating the housing bubble and the credit crisis. The combination of all four causes created a type of “perfect storm” causing the housing bubble to be extreme and the resulting credit crisis to be severe. Three of the causes, though they contributed to the housing bubble, were not essential to the development of the bubble. Low mortgage interest rates, low short-term interest rates, and relaxed mortgage lending standards all contributed to the housing bubble. But the absence of any of these three causes would not necessarily have prevented the housing bubble. For example, if mortgage interest rates had not been at historically low levels, a housing bubble still could have happened. A housing bubble occurred in the late 1980s at much higher mortgage interest rates.

The one essential cause of the housing bubble was irrational exuberance. The housing bubble would not have occurred without the widespread belief that home prices would continue to rise. Irrational exuberance contributed to the other three causes. Mortgage interest rates would not have been so low if foreign investors and credit rating agencies had not believed that U.S. home prices would keep rising. Low short-term interest rates would not have led to such extensive use of ARMs and such a high degree of leveraging without irrational exuberance. And relaxed standards for mortgage loans would not have led to such a large increase in subprime mortgages without irrational exuberance.

Financial Crisis: What is it?

The term financial crisis is used to describe a situation in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, financial crises were associated with banking panics and many recessions coincided with these panics. Situations like stock market crashes, bursting of financial bubbles, currency crises, and sovereign defaults are often referred to as financial crises.

There are many theories offered by several economists about how financial crises develop and how they could be prevented. But even today, the economists have not reached a consensus.

From time to time the world has witnessed a financial crisis. More recently two situations that have taken the form of financial crises are the Sovereign Debt Crisis and the 2008 Housing Bubble crisis.

There is a consensus among various economists that there are many similarities across crises episodes. Some of these similarities are rapid increase in asset prices; credit boom; a dramatic expansion in marginal loans; and failure in regulation and supervision of such developments. All these factors when combined increase the risk of a situation known as a financial crisis.

Rapid Increase in Asset Prices: This is a very common factor across most of the financial crises till date. Prior to the 2008 crisis there was a meteoric increase in the house prices in the US, UK, Iceland, Ireland, Spain, and all other markets that eventually faced the brunt of this crisis. Now this increase in prices was similar to previous banking crises in advanced economies. These booms in the prices are generally the result of rising credit.

Credit Boom: The rapid expansion of credit play a large role in the run-up to the crises. While historically not all credit booms end up in a crisis, but they only increase the probability of a crisis. Credit boom occurs because. There are various factors that can cause a credit boom. Financial reforms, surges in capital inflows, lagged GDP growth and other domestic factors are some of the triggers that can cause a credit boom.

Marginal Loans and Systematic Risk: Credit booms and rapid growth in financial markets are usually associated with a deterioration in lending standards. They lead to the creation of marginal assets which are good till the time economic conditions are favorable. The problem arises when the economic conditions start to become hostile rather than friendly.

Ineffective Regulation and Supervision: When reforms and financial liberalization are not properly regularized the probability of a crisis occurring is very high. If we look at all the crises till now there is a common trend of insufficient prevention and early intervention mechanisms.

Let us now understand the effects or consequences of a financial crisis.

Usually recessions are associated with financial crises. These recessions tend to be unusually severe and their recoveries are very slow. The recent crises have taken a very heavy toll on the world’s economy. These recessions result in much larger declines in real economic activity. Globally synchronized recessions are often long and deep, and recoveries from these recessions are generally weak.

So now that we understand what financial crises are, in my next few posts I will try to explain the causes for the 2008 Housing Bubble Crisis and the Sovereign Debt Crisis.