How India avoided the economic crisis?

US and India were on the same boat during the real estate boom, but when the bubble burst, India was able to handle the downturn, while many of the US banks succumbed to it. What India did differently that saved its banks? NYtimes praises the former RBI governor for the effective measures that he took during his tenure, which eventually saved the Indian market. Before getting into the India story, lets briefly look at the incidents that brought down the US banks.

After the Internet bubble that burst during 2000-2001, the US stock market went down south and lost its lure as an investment platform. Many people were very reluctant to spend their money and the US was in the verge of a recession. So, to encourage spending among people and to infuse more liquidity, Fed reduced its interest rates. Eventually, the banks started giving more loans for the people to invest in houses. Those who were reluctant to invest money in the stock market, considered house as a safe-investment and invested in new houses; some bought their second house too. To attract the investors, the banks introduced the 'Adjustable Rate Mortgages' and people subscribed to it in huge numbers; loans were given to sub-prime borrowers . These were borrowers who were not eligible for the given loan amount and would default in their payment. So the loans accompanied high interest rates. Fueled by easy loans, the housing market grew rapidly over the period of time. This led to boom in the building industry which led to the over-supply. As over-supply always leads to lower prices, the housing prices started to reduce drastically followed by a few fore-closures.

So, to stabilize the market, the banks followed a different method to fund money. Here came Lehman and the other investment banks. All these mortgages were passed to these investment banks. Since these loans were generating some kind of money through high interest payments, those were considered as assets. The investment banks grouped these assets based on their Interest payment under the terms Mortgage Backed Securities (MBS) or Collateralized Debt Obligations (CDO). The CDOs were approved by credit rating agencies and were later insured by even AIG. So, these securities were sold to other investors around the world and the money generated out of those sales was shared by different parties involved in the transaction. So, these loans were generating good money. The greediness peaked here, and the investment banks needed more CDOs, which translated to more sub-prime loans to the customers. Remember, if the interest payment is high, the value of the CDO is also high. In this way, banks also benefited through these loans and it was money all over the wall street. Now, the market reached a point where the number of defaulters started to increase as the interest rates got higher and higher. This led to multiple foreclosures at a point as the loan value increased beyond the house value. This led to burst of the bubble and many banks failed as the borrowers were unable to pay the money. Now, the CDOs became worthless, so the Lehman and other investment banks too failed. Meanwhile, AIG which assured the CDOs were also in the verge of failure. It was later rescued by the government. The rest of the bad news were nothing but the domino effect.

Now coming to the India story, where did the Indian govt get it right?

• India didn't encourage the concept of sub-prime loans. Mortgages were issued based on just the borrower's income.
• When the land values were rising in India, then RBI governor Y.V.Reddy ordered the banks to stop issuing loans to raw lands.Without this ban, India would have got trapped in the bubble with its rising middle class income.
  
• Loan amount were released to the customers only after the development work was started.
  
• Indian banks were tempted heavily by the securitization method adopted by the US banks for funding money. But, the RBI governor was strict in rejecting the model. The Indian bankers who were critical of Reddy's tougher rules, later realized the reason behind the decisions. Meanwhile, the US equity firms funded the land purchases and got trapped into the bubble.
  
• Later, when the inflation increased, the governor increased the interest rates thus halting the housing frenzy.
  
• Apart from this, Indian regulators played a crucial in the stock market by bringing in tougher regulations. When the market was booming with voluminous funds from foreign investors, SEBI imposed tougher rules to limit and to regulate the funds.
  

Though, the Indian government adopted a mature approach during the real estate boom, the US crisis was felt in India and has affected the Indian industries. Globalization has its perils too!