By Monica V

Edited by Kanika Lungani


A lot has been discussed about the 2008 Global Financial Crisis. However, it is very difficult to single out the most important factor responsible. This is due to immense inter-linkages in the financial markets. While the US financial markets were significantly impacted, Indian markets had remained quite resilient. So how did India survive the Global financial crisis?

The Indian GDP relies heavily on domestic demand than solely on exports unlike many of its Asian counterparts. Thus, the shortcomings in its trade integration had been a blessing in disguise. Furthermore, India has a fundamentally strong economy along with a diversified export base. The GDP of the US, Europe and Japan on the other hand have been slipping since 1990s due to slow growth in healthcare, lack of innovation and weak demographics respectively. Thus, the crisis only drew attention to the fundamental weaknesses that already existed in US, and exacerbated them further by reducing investor confidence. The relative strength of the Indian financial markets is further reaffirmed by its resilience to the Sovereign debt crisis in Greece, and the recent Chinese stock market crash which is being popularly called the China’s 1929.

As to the origin of the crisis in the US there is a non-exhaustive list. In this paper, I present a brief literature review of some of the main factors: Subprime mortgages, Securitisation, Credit Rating Agencies (CRAs), Over the Counter (OTC) market, and Efficient Market Hypothesis (EMH) and draw comparisons among various economies of the world.

Subprime Mortgages

The GDP of US had been slipping since 1990s, the housing crisis just brought this to light.

Post-2000s, subprime mortgages had increased drastically in the US due to two Government sponsored enterprises called Fannie Mae and Freddie Mac. “Subprime” mortgages are loans extended to people with low credit ratings, by taking their property (houses) as collateral. They were popularly known as “NINJA” loans i.e. No Income, No Job, No Assets. The loans were given at “teaser rates”, to attract investors, and later these interest rates were increased dramatically. The rationale was that even if the investors would default, the banks could sell the mortgages for high returns, considering that the value of these houses was appreciating due to high demand. However, when the interest rates became too high the demand for houses reduced, leading to the burst of the housing bubble in the year 2007. Furthermore, these loans were non-recourse borrowings, implying that even if the outstanding loan amount exceeds the value of the collateral, the borrower does not have any personal liability for the outstanding loan amount. Thus, when the housing bubble burst, the banks which held these mortgages suffered huge losses, while the borrowers were free to walk out of their house with no liability.

Many analysts are of the opinion that there is a risk of a property bubble forming in countries such as Brazil, China, Canada or Germany. Due to the huge availability of credit prices are going up, and buyers are not realising that these do not correspond to fundamental values. Will this lead to another housing bubble is a separate topic that requires much debate. However, India is not much exposed to the risk as private housing is not that big a part of our domestic economy.


Hull (2010) describes securitization as a way to transfer the credit risk of loans to an outside investor so that a bank is able to originate more loans without increasing its regulatory capital. He describes how loans were pooled and then divided into tranches called asset-backed securities (ABS) or mortgage-backed securities (MBS). The senior tranches had the highest credit rating, implying lowest risk of default, and low rate of return, while the equity (lowest) tranch had the lowest credit rating and highest rate of return. The MBSs were further divided into tranches called collateralised debt obligations (CDOs), making it all the more difficult to trace original loans, the collateral, and the performance of the individual tranches. Initially, these products were very popular when teaser rates were low, as borrowers were able to pay their interests, and the holders of MBSs were getting high returns. Thus, the markets got filled with MBSs and CDOs. Later when teaser rates became high, borrowers were no longer able to honour their payments, leading to banks defaulting on their payments to holders of MBSs. Since, securitisation had become a complex web, banks were no longer able to trace the actual loans to these MBSs. When the market realised this, even AAA rated MBSs became worthless overnight, leading to huge losses, and many financial institutions became bankrupt. However, many banks were bailed out, using tax payers money, to prevent a systemic failure.

In India, securitisation is still in preliminary stages. Along with reconstruction Securitization and Reconstruction of Financial Assets & enforcement of Securities Interest Act, 2002 governs securitisation in India. The Act allows only banks and financial institutions to undertake securitization (trough a Special Purpose Vehicle (SPV)), unlike US and UK. In India, securitization is popular in Auto Loans and Infrastructure loans, and quite underdeveloped in housing (mortgages). However, India has a huge potential for growth in the latter, subject to amendments to the current Act. Having witnessed what happened in US, India will definitely be more cautious in expanding its MBSs market.

Role of Credit Rating Agencies (CRAs)

CRAs have attracted much criticism for their rating of Residential Mortgage Backed Securities (RMBSs). These securities had an AAA rating when they began to default. This questioned the capabilities and intentions of the CRAs. Several banks held huge portfolios of RMBSs, and when they were subgarded post the crisis as junk, the portfolios became worthless, leading to bankruptcies. But CRAS, on the other hand, escaped any legal liability for inaccurate ratings, under the protection of the First Amendment in US (Herring, 2009), and made huge profits even during the crisis.

The Big Three also received criticisms for rating sovereign bonds of countries such as Greece. However, what is interesting is that they were criticised both ways: once for not having downgraded the Greek bonds before they started defaulting, and then again when they finally downgraded the Greek bonds, claiming that the downgrade further increased the cost of debt for Greece, and worsened the situation. With respect to the crisis in Greece, India is not directly impacted by Greece. However, it could be indirectly impacted by rest of the European Union. For instance, if due to the Greece exit the interest rates in EU go up, there will be significant capital outflows from India. However in Indian context, RBI governor Raghuram Rajan said that the Indian economy’s robust forex reserves of $355 billion will cushion any possible impact of the crisis.

Until the financial crisis of 2008, the credit rating industry was self regulated; it was believed that the CRAs relied upon reputation for business, a belief, which post-crisis was proved incorrect. There were no incentives to maintain reputation. Unlike bonds, RMBS were limited and complex, which made detecting any errors difficult; plus, they offered huge profit margins.

From an alternative school of thought Boylan (2012) argues that the inaccurate ratings of RMBSs were due to unconscious bias created due to non-availability of information. There was no historical data that suggested the possibility of significant defaults in the US housing market. Also, the CRAs took the good past performance of the US housing market as representative of the future.

As per Fennell and Medvedev (2011), the references to ratings in regulations and in investment mandates created a demand for highly rated products even among investors. This pressure on CRAs to inflate ratings. Hence, this led to a compromise on the quality of the product, and the rating did not reflect its true risk. The issue was not just limited to the way ratings were produced. Investors did not treat CRA ratings just as inputs to their investment decision, but they based their investments entirely on them.

This affirms that the hardwiring of ratings in regulations and the negligent use of ratings that lead to the systemic breakdown in 2008, and not the inaccuracy of ratings by itself. Thus, it can be concluded that even if CRAs had been regulated it might not have prevented the crisis.

CRISIL, ICRA and CARE are the three largest CRAs in India. Unlike the Big Three, they have not attracted much criticism owing to good operational performance and rating accuracy. This is reflected in their share prices, with their share prices reaching record highs in April 2015. The relatively lower concern about the Indian CRAs ratings can also be attributed to the simplicity of financial securities traded in India. However, considering the high rate of innovation and growth of the Indian financial markets it’s imperative to assess risk accurately by reducing mechanistic reliance on CRAs, and regulatory hardwiring of CRAs in the financial system. In line with the global scenario, India as a member of Financial Stability Board (FSB) has been working on reducing the mechanistic reliance on ratings while encouraging market participants to develop strong internal credit risk assessment techniques.

Trading derivatives in the Over the Counter (OTC) markets

Derivatives, primarily those that were traded in the Over the Counter (OTC) market, have been blamed as the primary reason for the financial crisis in 2008. Business Insider (online) highlights that there are roughly $604.6 trillion in OTC derivative contracts which is more than ten times the world GDP ($57.53 trillion). This makes the OTC derivatives bubble much larger than the US housing bubble.

During the financial crisis, the risk of trading derivatives in the OTC markets became apparent. OTC markets are largely unregulated, and pose high counterparty credit risk; as transactions in the OTC markets are netted only bilaterally, they have very little collateral requirements, and the collateral may not be adjusted daily based on the market movement (mark to market). IMF (online) explains that bilateral netting led to proliferation of redundant overlapping contracts which increased the interconnections in the financial system. Thus, when one party to a contract defaulted, the other party to the same contract was unable to honour his obligations to another contract. Due to several such interconnections, there was a domino effect where a single default led to several defaults, affecting all the participants in the market. Also, OTC derivatives such as credit default swaps (CDS), were bought based on grounds of speculation rather than on hedging which led to huge losses to the buyers, and to bankruptcies of the issuers.

Post the crisis, in 2009, as per the recommendation of the G20 leaders, regulations across the world, including India, are trying to move most standardised OTC derivatives to be exchange traded and centrally cleared through a Central Counterparty (CCP ) which would take over the credit risk of a default of the parties to a financial transaction, whereby reducing systemic risk. I agree with this as it would bring more stability to the financial system. However, OTC markets will continue to exist as large institutions require customised contracts which are illiquid, and thus, cannot be exchange traded. Thus, apart from the focus on CCPs, regulators should be proactive in overseeing the OTC markets as well. The size of the OTC market in India is very small compared to that in US, but it has high growth prospects considering the growth of securitisation. Thus, the increased focus on the OTC markets is a positive factor in assuring the safety of the expand- ing OTC markets.

Blind Faith in Efficient Market Hypothesis (EMH)

EMH states that stock prices reflect all available information that is relevant to its value. Thus, its direct implication is that it is impossible to make abnormal returns, at least consistently, as any deviations from equilibrium do not last for long (The Economist, online).

According to The Economist (online) a blind faith on EMH was one of the major causes for the 2008 financial crisis. It explains that the believers in EMH did not doubt that the valuation of stocks could have such a large deviation from their true value over such a long time. They also argue that humans are extremely over confident about their abilities which contributes to creation of bubbles, and are irrationally risk averse after they make losses which further exaggerates losses. Thus, as against the assumption of the EMH, investors behaved irrationally during the boom that preceded the crisis which led to the stock market crash in 2008.

A possible contradiction to the EMH is the Chinese stock market crash in August 2015. The investors’ “panic sentiment” caused the Chinese stocks to continue to dive despite several support measures taken from Beijing. This led to India’s benchmark index, Sensex, seeing it’s biggest ever intra-day fall in absolute terms on 24th August 2015. However, the Indian stock markets soon stabilised, indicating the validity of the EMH. The equity markets in India draw a lot of direction from the US markets, so the Yuan devaluation will have only a temporary negative impact on the rupee. In fact, a slowdown in the Chinese economy isn’t a terrible event if you consider that Mr. Modi is trying to attract manufacturers with his Make-in-India initiative. In fact, Several Chinese companies have opened their factories in India because of favourable demographics and Government subsidies. This will contribute positively to India’s GDP, and India could become the fastest growing BRICS economy, considering that China is transitioning to a mature economy with a declining growth rate.

Several papers have found strong empirical evidence in support of EMH. Hence, the ocurrence of the global financial crisis is insufficient in ruling out the validity of the EMH. Furthermore, an alternative school of thought that explains the stock price movements has to be developed, before the EMH can be rejected.


As discussed above, it was an interplay of many factors that led to the crisis. The exponential growth of subprime mortgages, the borrowings were non-recourse, securitisation, inaccurate high credit ratings, OTC all together lead to the financial crisis. The crisis definitely raises questions on the validity of the EMH, which however cannot be rejected. The crisis led to several changes in the regulatory framework of the financial industry, such as, through the introduction of the Dodd-Frank Act in the US and the European Markets Infrastructure Regulation (EMIR) in Europe. According to me, though this was a necessary and positive move, the regulations are so elaborate that many argue that they have introduced new complications.

Despite all this, the strength of the Indian economy can be seen in its resilience to the Global financial crisis, the Greece sovereign crisis, and even to the recent Chinese stock market crash. Thus, even though so much has been discussed, analysed, and written about the crisis, wouldn’t we be to prevent such a crisis from occurring in the future?


Amtenbrink, F. and Haan, J.D., (2009), ‘Regulating Credit Rating Agencies in the European Union: A Critical First Assessment of the European Commission Proposal’. Available at: http:/ /papers.ssrn.com/sol3/papers.cfm?abstract_id=1394332&download=yes (Accessed: 15 August 2015)

Boylan, S.J., (2012), ‘Will credit rating agency reforms be effective?’, Journal of Financial Regulation and Compliance, Vol. 20, Iss. 4, pp. 356-366. Available at: http:// http://www.emeraldinsight.com/doi/pdfplus/10.1108/13581981211279327 (Accessed: 15 August 2015)

Business Insider, May 2010, ‘Forget About Housing, The The Real Cause Of The Crisis Was OTC Derivatives’, Available at: http://www.businessinsider.com/bubble- derivatives-otc-2010-5?IR=T (Accessed: 31 August 2015)

Fennell, D. and Medvedev, A., (2011), ‘An economic analysis of credit rating agency business models and ratings accuracy’, Financial Services Authority Occasional Paper 41 Available at: http://www.fsa.gov.uk/static/pubs/occpapers/op41.pdf (Accessed: 15 August 2015)

Hull, J., (2010), ‘Credit Ratings and the Securitization of Subprime Mortgages’, University of Toronto, Available at: http://citeseerx.ist.psu.edu/viewdoc/ download?doi= (Accessed: 15 August 2015)

IMF, ‘Making Over The Counter Derivatives Safer: The Role of Central

Counterparties’, Available at: https://www.imf.org/external/pubs/ft/gfsr/2010/01/ pdf/chap3.pdf (Accessed: 20 August 2015)

The Economist, July 2009, ‘Efficiency and beyond’, Available at: http:// http://www.economist.com/node/14030296 (Accessed: 20 August 2015)

Utzig, S., (2010), ‘The Financial Crisis and the Regulation of Credit Rating Agencies: A European Banking Perspective January’, ADBI Working paper No. 188. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1592834 (Accessed: 20 August 2015)

Veron, N., (2011), ‘What Can and Cannot Be Done about Rating Agencies’, Peterson Institute for International Economics Policy Briefs 11-21. Available at: http://www.iie.com/ publications/pb/pb11-21.pdf (Accessed: 15 August 2015)

White, L.J., (2010), ‘Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs Is a Better Response’, Journal of international banking law, Vol. 25, Iss. 4. Available at: http://web-docs.stern.nyu.edu/old_web/economics/docs/workingpapers/2010/ White_Credit%20Rating%20Agencies%20for%20JIBLR.pdf (Accessed: 20 August 2015)

mon_tjefAbout the author:

The author is a Banking and Financial Service student of batch 2015-2017 at TAPMI. Her area of interest is economics research, capital market, and fund management. She is the managing editor of TJEF and also co-convenor of Finance Forum. You can contact her at monica.bkfs17@tapmi.edu.in



By Vinit Intoliya

Edited by Shulin VK Satoskar


The end of Quantitative Easing (QE) policy and tightening of monetary policy (ending the zero rate policy) by US Federal Reserves has added fuel to the grow- ing fear in emerging economies’ debt and equity capital markets. During the period 2009 to 2013, the emerging economies received large foreign investments, Fed alleviated the losses caused by the subprime crisis. Now the tables have turned and die is being rolled by US Fed as its economy has almost recovered. The fall of Chinese stock market has also forced Chairperson of Federal Reserves to hike interest rates. The brunt of this huge pile-up of trillions of dollar as debt will decrease the local currency value of emerging countries, which will further make servicing of these debts costlier and create volatility.

Dollar Carry Trade

Let us rewind the story a few years back when the financial crisis of 2007 struck with the burst of Housing bubble. The resulting crisis led to sharp cutbacks in consumer spending. The dual combination of financial market chaos and decrease in consumption led to collapse in business environment leading to contagion effect around the globe. US Federal Reserve resorted to various steps to boost the economy which includes the unconventional path called Quantitative Easing (QE). Three rounds of QE has raised the Federal Reserve’s balance sheet from around less than $1 trillion in 2007 to more than $4 trillion now. Along with QE, Federal Reserve used the most common approach to revive the economy by using zero interest rate policy (ZIRP). Both the steps were taken to increase investment and pump up more money into the economy.

From 2010 onwards, the yields had fallen drastically and investors were forced to search for higher yield financial instruments around the globe. The reason be- ing ZIRP and changes in bond buying behavior of Federal Reserve. At this time, many countries around the world have been impacted but emerging markets re- main financially intact i.e. overall financial position is good and are offering higher yields. This has created a situation of dollar carry trade i.e. a company in emerging economies issues US dollar denominated bonds which provides higher yield compared to US bonds. Hence, investors borrow money at zero interest rate and invest in emerging markets thus gaining higher yields. In turn, corporates of emerg- ing markets invest the proceeds from the sale of bonds into higher yielding instruments.

This whole scenario of global carry trade has been initiated due to large interest rate difference between emerging economies and U.S. This also led to the spiral of money supply growth which fueled economies and thus increased the demand for emerging markets bonds.

Why did Fed decide to increase interest rate?

From last year onwards, taper tantrum decision of Fed gives investors a hint that the honeymoon period of borrowing money at zero interest rate will be over soon. There were various reasons due to which Fed thinks that current US economy is in sweet spot to raise the interest rates.

– Controlling Mortgage and Unemployment rate

One of the intentions of US central bank behind the availability of easy money in the US economy was to bring the mortgage rate under control and once again individuals start investing fixed assets. From year 2008 to 2015, Fed was able to bring down the mortgage rate by around 200 percentage point. Currently, the US mortgage rate is hovering around 3.90%.

During the global crisis the unemployment rate jumped from 5% in December 2007 to 9% in June 2009 (as per National Bureau of Economic Research). The recession killed around 7.9 million jobs spreading bad sentiments across the na- tion. But now according to US labor department, the current unemployment rate has again reached 5% and private sectors has made highest hiring record. The Fed strongly believes that this improvement in employment rate will bring desired inflation and wages.



As consumer spending and wages have improved, the main agenda of Fed is to maintain the inflation which is persisting in the economy. In FY’15, in the first 6 months the country was experiencing negative inflation and in April’15, it touched -0.20% and currently in Aug’15 inflation is +0.20%. The Fed wants to maintain this inflation rate in the economy and to increase the cost of borrowings which will keep the economy on an even keel.


Fed Effect on Emerging Economies

With interest rate tweaks in any economy, there is higher probability of huge capital inflow and outflow from the economy. Whenever central bank increases the interest rate, it directly affects the currency of those countries. And when US hiked the interest rate, dollar will be strong and there will be a huge impact as it is rightly said by IMF Chief Christine Lagarde that it will create “spillover effect” and spread volatility in the financial markets. Impact on emerging economies can be seen in terms of reversal of capital flows and high US dollar denominated debt. These both factors are inter- dependent on each other.


As there is huge money outflow from the economy, it basically means For- eign Institutional Investors (FIIs) are taking out their money which they have invested in stock markets of the countries. It will create negative sentiments and there will be net sellers’ environment. Hence there will be dollar outflow from the economy and countries own currency will become weaker in terms of dollar. This directly impacts the trade of the country. From the below figure, it is clear that in last six months that the export and import of emerging economies are suffering a lot.


The huge impact has been largely faced by India and China. Six months before, export and current export has changed drastically. If at this time Fed in- creases the interest rate, there is higher chance of creating environment of “Twin Deficit” i.e. current account deficit and fiscal deficit of each country will increase and worsen the economy. The dwindling capital inflows will make countries in EM worse to pay their debts, spend on infrastructure and hence less corporate expansion.

The latest report by IMF says that the borrowings of emerging economy countries have been doubled in the last 5 years and reached to US$ 4.5 trillion. The foreign companies’ US dollar debt were increased from $6 trillion to $9 trillion. Since 2008, according to funds tracker EPFR, there is total outflow of US $9.3 bn during the 2nd week of June from emerging markets. In the past 7 years, emerging markets have seen biggest weekly outflows. Hence, own currency de- valuation and concurrent back flow of capital will make debt repayment difficult for emerging countries. Therefore, the strong dollar will create a ripple effect.

Is it really a matter of concern?

The continuous capital outflow has posed danger to the whole economy or this brunt will be faced by just equity traded funds market. It depends on each country on how to manage their monetary and fiscal policies and how it remains financially intact from external shock. In Feb’15, the Fed issued a list of countries calling “Fragile Five” which can be highly vulnerable to increase in interest rates. The list depends on each country’s external financial exposure. Brazil, Mexico and Turkey are in most threatening situations


It is believed that all countries that lie in EM category will not suffer badly. It rather depends on how fundamentally strong are the policies of each country. It can be seen that this whole outflow of money is not due to the fear that Fed is increasing interest rate but it is due to China stock market bubble crash and bad policies system which governs the economy.


For example, Brazil was once praised for its robust growth but now it is facing huge criticism due to massive public debt, corruption and continuous interest rate tapering leading to high inflation. This led S&P to downgrade the bond to junk category. Due to this, investors are thinking about parking funds elsewhere.

This behavior of ‘beggar thy neighbor’ policy creates upheaval at the macro level. At the same time, India is looking fundamentally very strong from a long term perspective. Currently, the reaction in Indian stock market is due to herd mentality. Basically it means that when there is panic at a global level, it will lead to high selloff. Equity market is more of a sentiment driven market. At this juncture, the main indicator which will quantify the strong position of economy will be debt to GDP ratio and other Foreign Exchange Reserves. Currently, all the countries in EM have decent amount of foreign reserves which makes them shock proof and able to survive for short run. But in the long run, central bank and government of each country need to work together and make policies financially viable rather than managing according to the impact of hiked rate in US.

Bottom Line

Current exodus of capital is more due to fundamental changes in an economy and not because of fear of increasing rates. The end to bond buying program of Fed reserves from 2013 has send clear indication that Fed will increase the rates in future but once it will be done the after effects will be transitory. The emerging economies are facing structural breakdown and this slowness is directly or indirectly related to China. The latest stock market crash of China and US Fed thinks of hiking interest rate are coinciding. On this hypothesis, we cannot create causation effect as this turbulence is due to the fear of interest rate hike. If in future also the US Fed is increasing interest rate, the most vulnerable countries would be the one that depends a lot on external financings and also who have low foreign reserves.


How Do U.S. Interest Rate Hikes Affect Emerging Markets – Article published by Owen Davis

Goldman Sachs sees limited impact of Fed rate hike on emerging markets – article published by Sue Chang

Stop Blaming China – Article published by Brian Kelly Fed rate Hike – Article published by Amit Mudgill

Fed rate Hike – Article published by Amit Mudgill