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Frenetic efforts fail to stop market panic

— PHOTO: AP

JITTERY NUMBERS: The electronic board of a securities firm in Tokyo indicating the downturn of stocks in global markets last week.

If the week ended October 10 witnessed the lowest point in the ongoing financial crisis the following week has not been any much better. In fact, benchmark indices ended below some psychologically important marks on Friday. But it was during the October 6-10 week when the plummeting stock prices and the panic in all financial markets forced coordinated action by governments around the world.

Stock markets everywhere had a free fall. The U.S. markets had their worst week since the Great Depression of the 1930s. In India, the Sensex lost 2000 points over the week and last Friday closed at half its highest ever level reached in early January this year. In other developed as well as emerging markets, the story was pretty much the same. In Britain, banking and other financial sector stocks were repeatedly pounded.

Investor confidence in banks had declined to dangerously low levels in the West. The crisis manifested itself acutely in other areas. Credit markets were frozen and banks stopped lending to one another in the (essentially) short-term inter-bank market. There was a severe liquidity crunch.

It was not as if governments were sitting idly watching the problems take monstrous proportions, threatening to lead their economies into deep and prolonged recessions. The U.S. government finally succeeded in getting its $700 billion package through the Congress. In the U.K., a 50-billion pound package was announced. Governments in Germany and some other European countries guaranteed the safety of money deposited in savings accounts.

However, even such massive rescue packages involving huge amounts of tax payers’ money failed to calm the markets. In short, the picture could not have been bleaker. Very much like the irrational exuberance that drove up stock prices to record levels until nine months ago, the present panic is based on psychological factors. That is why no amount of official intervention and ‘talking to’ seem to help.

However, out of the severity of the crisis some good seems to have emerged. Governments around the world were jolted into taking tough, unprecedented policy measures which at the beginning of the new week (October 13) seemed to be working. Panic that had gripped the financial markets around the world for nearly three weeks appeared to be subsiding.

On October 9, political leaders of G-7 countries meeting in Washington declared that “they would do whatever it takes” to end the panic. The markets were initially not convinced: after all, such official rhetoric was not uncommon. But this time around the politicians backed up their pronouncements with some bold initiatives and, equally significantly, reached a consensus on what needs to be done.

Coordinated action to contain the crisis was seen before, notably in the synchronised interest rate cuts effected by the central banks of leading countries and emerging markets. Even earlier, the U.S. Federal Reserve, the Bank of England and the European Central Bank were pumping in record sums of money.

If despite these the problems in the financial sector were spinning out of control, it was also because there was no consensus among policy makers on how to administer the various rescue packages involving tax payers’ money in order to obtain the best results under admittedly trying circumstances.

Very broadly, the evolving consensus has been over two interdependent lines of action. To unlock the frozen short-term inter-bank market governments agreed to guarantee short-term loans between banks. Banks had become wary of lending to one another. Since they started hoarding liquidity, they lent less, if at all.

The second course of action was to recapitalise banks by buying their preference shares and other forms of equity. Over the past 18 months banks in developing countries were reporting losses in successive quarters. Their capital was written down to dangerously low levels. Recapitalising them, injecting capital directly into the leading banks, it was agreed, was the most efficacious way of keeping the banking system afloat. The governments’ commitment — after all the net effect of the packages was to nationalise the assisted banks — would provide the necessary confidence to investors. The U.K. model of injecting capital into banks to shore up confidence differed from the plan proposed earlier in the U.S. That had involved buying the ‘toxic assets’ from failed institutions holding them at a price slightly higher than what they were worth. It was hoped that as asset prices improved, banks would start regaining financial muscle.

The U.S. plan was complex, to say the least, and involved setting up of an elaborate machinery to implement it. In contrast, the U.K. package proposed by Prime Minister Gordon Brown had the major advantage of being able to address market concerns over weak and failing banks.

Recapitalisation of banks is not new to India. All nationalised banks have received dollops of money from the government and strengthened their balance sheets. There were other reform packages too aimed at sprucing up their balance sheets through the adoption of prudential norms and so on. All of them prospered after that and had their shares listed. Most of them have or are in a position to return the capital to the government.

But the important difference is that the majority of Indian banks have always been owned by the government. The question of government providing capital to private sector banks has not arisen so far. However, the government and the Reserve Bank of India have nudged faltering private banks towards mergers with stronger banks.

The two pronged strategy of guaranteeing the short-term inter-bank loans and infusing capital into the banking system promised to end the panic that has gripped stock markets as well as other financial markets. However, by Wednesday, the markets were back on the downhill path. There has been high volatility.

The Sensex recovered 700 points on Thursday after threatening to fall below the 10000 level.

On Friday the index closed below 10,000 for the first time since July 2006.

Late on Wednesday, the RBI effected another one percentage point reduction in the CRR to release Rs. 40, 000 crore of impounded funds. The government for its part released another Rs. 25,000 crore to banks under the farm loan waiver scheme. The Indian strategy seems to focus on infusing liquidity and simultaneously reassuring investors.

However, going by the stock market behaviour, panic has not subsided.

A saving grace in India is that, unlike in developed markets, investors are not concerned about the solvency of financial institutions. It is the real prospect of a deep recession that is working on investor sentiment.

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