US Recession

by hitesh sahnihttp://www.hiteshsahni.com

Introduction

• The fear of a recession looms over the United States.

• And as the cliche goes, whenever the US sneezes, the world catches a cold. This is evident from the way the Indian markets crashed taking a cue from a probable recession in the US and a global economic slowdown.

• Weakening of the American economy is bad news, not just for India, but for the rest of the world too.

What Is Recession ?• A recession is a contraction phase of the business cycle. • The official agency in charge of declaring that the economy

is in a state of recession is the National Bureau of Economic Research (NBER).

• They define recession as a "significant decline in economic activity lasting more than a few months“, which is normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

• For this reason, the official designation of recession may not come until after we are in a recession for six months or even longer.

• Some economists also suggest that a recession

occurs when the natural growth rate in GDP is less than the average of 2%. Typically, a normal economic recession lasts for approximately 1 year.

• American newspapers often quote the rule of thumb that a recession occurs when real gross domestic product (GDP) growth is negative for two or more consecutive quarters. This measure fails to register several official (NBER defined) US recessions

What Causes Recession ?

• An economy which grows over a period of time tends to slow down the growth as a part of the normal economic cycle.

• An economy typically expands for 6-10 years and tends to go into a recession for about six months to 2 years.

• A recession normally takes place when consumers lose confidence in the growth of the economy and spend less.

• This leads to a decreased demand for goods and services, which in turn leads to a decrease in production, lay-offs and a sharp rise in unemployment.

• Investors spend less as they fear stocks values will fall and thus stock markets fall on negative sentiment.

Recession Or Not ?

• According to numbers published by Bureau of Economic Analysis in May 2008, the GDP growth of the previous two quarters was positive. As one common definition of a recession is negative economic growth for at least two consecutive fiscal quarters, some analysts suggest this indicates that the U.S. economy was not in a recession at the time.

• However this estimate has been disputed by some analysts who argue that if inflation is taken into account, the GDP growth was negative for the past two quarters, making it a technical recession

• A study released by Moody's found two-thirds of the 381 largest metropolitan areas in the United States were in a recession.

• The study also said 28 states were in recession with 16 at risk. The findings were based on unemployment figures and industrial production data

Causes Of US Recession

• The general consensus is that a recession is primarily caused by the actions taken to control the money supply in the economy

• The Federal Reserve is responsible for maintaining an ideal balance between money supply, interest rates, and inflation.

• When the Fed loses balance in this equation, the economy can spiral out of control, forcing it to correct itself.

• Relaxed policies in lending practices making it easy to borrow money

• The economic activity became unsustainable resulting in the economy coming to a near halt.

• Recession can be caused by factors that stunt short term growth in the economy, such as spiking oil prices or war.

Crisis In The US

• The United States entered 2008 during a housing market correction, a subprime mortgage crisis and a declining dollar value

• In February, 63,000 jobs were lost, a 5-year record.• In September, 159,000 jobs were lost, bringing the

monthly average to 84,000 per month from January to September of 2008.

• On September 5, 2008, the United States Department of Labor issued a report that its unemployment rate rose to 6.1%, the highest in five years

• The defaults on sub-prime mortgages (homeloan defaults) have led to a major crisis in the US.

• Sub-prime is a high risk debt offered to people with poor credit worthiness or unstable incomes. Major banks have landed in trouble after people could not pay back loans.

• The housing market soared on the back of easy availability of loans.

• The realty sector boomed but could not sustain the momentum for long, and it collapsed under the gargantuan weight of crippling loan defaults

• Foreclosures spread like wildfire putting the US economy on shaky ground. This, coupled with rising oil prices at $100 a barrel, slowed down the growth of the economy.

Liquidity Crisis

• In early July, depositors at the Los Angeles offices of IndyMac Bank frantically lined up in the street to withdraw their money.

• On July 11, IndyMac - the largest mortgage lender in the US - was seized by federal regulators.

• The mortgage lender succumbed to the pressures of tighter credit, tumbling home prices and rising foreclosures.

• During the weekend of September 13–14, Lehman Brothers declared bankruptcy after failing to find a buyer

• Bank of America agreed to purchase Merrill Lynch, the insurance company AIG sought a bridge loan from the Federal Reserve

• and a consortium of 10 banks created an emergency fund of at least $70 billion to deal with the effects of Lehman's closure

• The biggest bank failure in history occurred on September 25 when JP Morgan Chase agreed to purchase the banking assets of Washington Mutual

• The year 2008 as of September 17 has seen 81 public corporations file for bankruptcy in the United States, already higher than the 78 in 2007

• Lehman Brothers being the largest bankruptcy in U.S. history also makes 2008 a record year in terms of assets with Lehman's $691 billion in assets all past annual totals.

• The year also saw the ninth biggest bankruptcy with the failure of IndyMac Bank

• On September 29, Citigroup beat out Wells Fargo to acquire the ailing Wachovia's assets will pay $1 a share, or about $2.2 billion.

• In addition, the FDIC said that the agency would absorb the company's losses above $42 billion; in exchange they would receive $12 billion in preferred stock and warrants from Citigroup in return for assuming that risk

How The Government Tackles Recession

• Tax cuts are the first step that a government fighting recessionary trends or a full-fledged recession proposes to do.

• The government also hikes its spending to create more jobs and boost the manufacturing and services sectors and to prop up the economy.

• The government also takes steps to help the private sector come out of the crisis.

• In the current case, the Bush government has proposed a bailout package.

• Initial estimates of the cost of the Treasury bailout proposed by the Bush Administration's draft legislation (as of September 19, 2008) were in the range of $700 billion to $1 trillion U.S. dollars.

• President George W. Bush asked Congress on September 20, 2008 for the authority to spend as much as $700 billion to purchase troubled mortgage assets and contain the financial crisis.

• The crisis continued when the United States House of Representatives rejected the bill.

• The bill was eventually passed by the Senate and the House but the stock market continued to fall nevertheless

Impact On India

• A slowdown in the US economy is bad news for India.

• Indian companies have major outsourcing deals from the US.

• India's exports to the US have also grown substantially over the years.

• Indian companies with big tickets deals in the US are seeing their profit margins shrinking.

• More people have sold the shares in the indian share market than they bought in the recent weeks. This has added to the fall of sensex to lower points.

• One danger meanwhile is of a dip in the employment market. There is already anecdotal evidence of this in the IT and financial sectors, and reports of quiet downsizing in many other fields as companies cut costs.

• More than the downsizing itself, which may not involve large numbers, what this implies is a significant drop in new hiring -- and that will change the complexion of the job market.

• Many companies has laid off their staffs, the number of tourists inflow to india has come down, companies have cut down compensations and perks etc, government and other private companies are reluctant in starting new ventures and starting new projects etc.

• Projects that are halfway to completion, or companies that are stuck with cash flow issues on businesses that are yet to reach break even, will run out of cash.

• one of the casualties this time could be real estate, where building projects are half-done all over the country and in this tight liquidity situation developers find it difficult to raise finances.

• The only way out of the mess is for builders to drop prices, which had reached unrealistic levels and assumed the characteristics of a property bubble, so as to bring buyers back into the market, but there is not enough evidence of that happening.

• Consumers are also frozen in this sudden glare of the headlights.More expensive money means that floating rate loans begin to bite even more; even those not caught in such a pincer will decide that purchases of durables and cars are not desperately urgent.

• At the heart of the problem lie questions of liquidity and confidence.

• What the RBI needs to do, as events unfold, is to neutralise the outflow of FII money by unwinding the market stabilisation securities that it had used to sterilise the inflows when they happened.

• This will mean drawing down the dollar reserves, but that is the logical thing to do at such a time.

• If done sensibly, it would prevent a sudden

tightening of liquidity, and also not allow the credit market to overshoot by taking interest rates up too high.

• Meanwhile, there is an upside to be considered as well.

• The falling rupee (against the dollar, more than against other currencies) will mean that exporters who felt squeezed by the earlier rise of the currency can breathe easy again, though buyers overseas may now become more scarce.

• Overheated markets in general (stocks, real estate, employment-among others) will all have an element of sanity restored.

• And for importers, the oil price fall (and the general fall in commodity prices) will neutralise the impact of the dollar's decline against the rupee.

Thank You

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