Wednesday, March 26, 2008

Sub-prime crisis, dollar depreciation, Credit crunch, US recession, Nosedive of Indian indices, Fed rate cut, rising oil prices….what’s the connection

Currently the financial market through out the world is going through turmoil. It started with the sub-prime crisis. The US banks and financial institutions gave loans to credit unworthy borrowers at high rates. Rising housing prices in the US prompted the borrowers to assume mortgages, thinking that they can refinance at more favorable term later. But the housing bubble which began in 2001 and peaked in 2005 started deflating in 2006. As a result, the sub-prime borrowers defaulted in paying back the loan. They were either unable (as the interest rate was high) or unwilling to pay resulting in foreclosure (taking over of the property by the lender). The bank and other financial institutions, i.e. the mortgage lenders securitized the mortgage payments and credit/default risk and passed it to third party investors via Mortgage Back Securities (MBS) and Collateralized Debt Obligation (CDO) to corporate, individual and institutional investors spread across the globe. As the value of the mortgage assets declined, these investors faced significant losses. Major Banks and financial institutions around the world have reported losses of U.S. $170 billion as of February 2008. Bear Stearns, the Wall Street invest bank is one of the prominent examples.

As a result of this the banks in the US are suffering acute credit crunch. The companies are also finding it hard to acquire sort term loans (i.e. liquidity) by selling Commercial Papers pledging mortgage assets as collateral due to the investors' concern about the value of the collateral. Also the interest rates the investors are charging are substantially high above the historical levels.

Now as the US residents are finding it difficult to borrow (and banks and other financial institutions difficult to lend) the consumption has come down. As the consumption is the main driver of the US economy and its GDP growth, the US is heading for a recession. The GDP growth rate for US was only 2.2% in 2007.Decreasing US demand has also hurt the exporters to the US.

As the US market has become risky to invest in, the investors are looking to other countries causing the value of the dollar to depreciate and the other currencies like Rupees, Yen etc to appreciate substantially. This in turn has hurt the exporter of the countries like India, China etc.

The Indian benchmark index, the BSE SENSEX has plummeted close to 30% in the last two months. The investors fearing the US recessions and weak global markets indulged in panic selling brining down the index.

On the other hand, the bullion market is on a high. The price of gold crossed Rs. 13000 per 10 gram. As the stock prices tumble people are investing in the commodity derivatives more and more. This is the reason the price of the precious metal is skyrocketing.

The Fed in the US is trying to revive the US economy by cutting the over night lending rate. The interest rate is now brought down 2.25%. This will assist the banks to regain the liquidity. Also the Fed has announced $200 billion bail-out package for the banks and investment houses. Fed's move has shown some results. The indices across the globe have recovered a little after the Fed's latest move to cut the interest rate by 75 basis points to 2.25%.

In India the Reserve Bank of India has decided not to cut the REPO rate (the rate at which RBI lends money to commercial banks, currently at 7.75 per cent) as it will push up the inflation which is hovering above 5%. However, a cut in the REPO rate would translate into a cut in the retail lending rates by the banks which will boost the consumption and hence, growth. But as there is a difference between the rates in US and in India, Foreign Institutional Investors (FII) should again park their money in India. This will again put the SENSEX back on course. The rupee will also appreciate, though, to the nightmare of the exporters.

The sky-rocketing crude oil price which some days back was trading at $111 a barrel is the result of weakening dollar along with other reasons.
Oil analysts have said they expect oil's inverse relationship with the dollar to last until there are significant signs that underlying commodities demand is eroding because of the U.S. economic slowdown. There is heavy investment in commodities market with oil as underlying. Speculation and Hedging push the price of oil. Also we are having higher demand of oil from countries like US, China and India. The OPEC countries are pumping less oil into the market. There are supply disruption from IRAQ (due to decades of wars, sanctions and underinvestment), IRAN (locked in a dispute with the West over its nuclear program) and Nigeria.

As of 25th March, 2008 it seems the measures taken by the US Federal Reserve is working. The SENSEX rose around 900 points and crossed the 16000 mark. The other indices through out the world were also on the green. The commodity prices are also coming down as people are regaining confidence in the stock market. The gold price has also come down (Rs. 12300 per 10 gram for 24 carat).

Let's hope for the bullish market ahead!

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