India and Global Financial Crisis

A year ago, people were questioning if the subprime crisis that began in the summer of 2007 in the United States would spread to India. It was pointed out that India has not been a major investor in U.S. subprime mortgages, and that the institutions of subprime lending, of piggy-back mortgages, of no-doc mortgages and of securitisation of mortgages are not prominent in India.

Moreover, the Reserve Bank of India did not follow the policy of the Federal Reserve in the U.S. of cutting interest rates to near zero levels at the height of a real estate boom.

In the U.S., the Federal Reserve kept policy so loose that short-term real (that is, inflation-corrected) interest rates were in negative territory for roughly three years, from late 2002 to well into 2005, the very height of the real estate boom in the U.S. In India, the Reserve Bank did no such thing, and Indian real three-month rates generally stayed in the (positive) 1% to 4% range for almost all of the period since 2002.

So, it might well seem that the situation in India is completely different. There have been many optimists who have questioned whether India would have any serious fallout from the economic explosion in the U.S.

Now, a year later, after a September 2008 which showed massive financial collapse in the U.S., we know India has been hit by the crisis. But it has not, so far, been a serious disruption. The seemingly inexorable rise in the Indian stock market has been clipped. The sensex rose about eight-fold from 2003 to the beginning of 2008, but now has had a correction, is down about 40% from its peak. It is only about 10% below what it was in the summer of 2007 though.

The markets for homes in major cities, which were booming in the summer of 2006, are now clearly in distress. The real estate markets in India have slowed and many home prices are falling sharply.

Even though the commonly-identified “causes” of the crisis in the U.S., the subprime mortgage revolution and the extremely loose monetary policy, were not in evidence in India, India is still seeing some of the same outcomes.

Should we be surprised? Actually, the similarity of market behaviour across countries is evidence that something else, deeper than the causes that are usually given for the subprime crisis in the U.S., is at work.

The most fundamental problem is found in the swings of overconfidence that was seen in many countries since the 1990s, overconfidence shared by millions, billions, of people. And this confidence has been very strong until recently.

In the U.S., consumer confidence rose to near-record levels at the time of the peak in the stock market around 2000. This high level of confidence, shared in many other countries as well, was related to the booming markets and booming economy of that time. The booming markets and economy were in turn substantially buoyed by the high confidence, in a feedback loop.

Recently, confidence has been fading. In the U.S., confidence has fallen sharply since 2006, now below the lowest levels reached in the 2001 recession. This decline in confidence is seen in other countries as well.

But economic confidence, the true state of mind that affects asset markets and the economy, is difficult to measure by any survey. The seizing up of credit markets, amidst the reports of a financial spectacle that is going on in the U.S. that is reminiscent of the Great Depression, certainly changes people’s thinking all over the world.

When people expect good performance from their investment assets, they tend to bid up their prices. That is what was happening in many places around the world in the years leading up to the current crisis, until markets collapsed.

The subprime crisis in the U.S. is only a symptom of this fundamental problem. The deterioration in mortgage lending standards in the U.S. since the 1990s is not an exogenous cause of the crisis. It is, in substantial measure, a consequence of the overconfidence that is the real cause. Mortgage lending standards deteriorated because people thought that home prices can only go up, and so they thought there is little risk in writing mortgages with few protections.

Even the loose Fed monetary policy in the U.S. is, in a way, derived from the overconfidence. The Fed was willing to have such loose monetary policy because, under Alan Greenspan, it was so unaware of the bubble in home prices, thought it was just another sign of spectacular economic growth, and so felt no concern about it.

We have to consider the epoch the world economy is in. It is a time of the unleashing of free market economics around the world as it has never been before, and it is creating spectacular economic growth, particularly in emerging countries like India and China.

That is a good thing. But people all over the world have noticed this, and it has led to some sometimes exaggerated expectations for investments.

Until the peak in the stock market in countries over much of the world in the year 2000, there was a growing belief in stocks as the “best investment” that outperforms all other investments. India saw a peak in their stock market at this time too, which, though now eclipsed by even more dramatic Indian stock market performance, was something of a sensation. The lacklustre performance since 2000 of the stock market in many countries (and in India this year) has tarnished this belief.

A strange idea that has grown dramatically after 2000 and is a sign of our recent times in much of the world today has been that investing in homes should yield spectacular capital gains on into the indefinite future. The idea that home prices can only go up became firmly entrenched in the early 2000s, and has influenced the great masses of small investors all over the world.

I have been expressing doubts about the inevitability of home price increases to people in various countries for some time. People in India will say, “Then explain why my neighbour got Rs 30 lakh last week for a house she bought for Rs 2 lakh 30 years back!” They did not seem to realise that consumer prices in India have risen ten-fold in the last 30 years, so most of this is just inflation, and much of the remainder might be explained by a bubble in home prices.

Now, with home prices falling in many places, the idea that homes are always a great investment is starting to be doubted. The most important single factor that has driven so many economies around the world over the last decade or more has been the changes in confidence in the economy and investments, including stocks, real estate, as well as energy and agricultural.

India is part of world culture and is not invulnerable to changing patterns of thinking about investment. Much of what happens in speculative markets in India is just the same as in other countries. But India must rank as among the most vulnerable in the world to speculative turbulence, since she appears to be undergoing such a dramatic economic revolution, a revolution that, along with China’s, is the talk of the world, and that allows imaginations to run wild and confuses traditional and sober thinking.

So, India appears not at all invulnerable to the current crisis. She urgently needs to take many of the same actions that are called for in other countries. Some serious work needs to be done to improve the quality of the financial markets, both expanding regulation and consumer protection, but also expanding the scope integrity of the markets and their retail products.

Work needs to be done now to democratise finance, to make enlightened risk management available to everyone, by subsidising financial advice and education.

The author is the Arthur M Okun professor of economics and professor of finance at Yale University.