INTRODUCTION

The main aim of doing this project as a dissertation was to analyze the condition of Indian I.T sector ,strength ,weakness ,opportunities and threat for Indian I.T sector, and the effect of U.S financial crisis on Indian I.T sector, so that some steps can be taken to improve the condition of Indian I.T sector

REPORT ON INDIAN ECONOMY:

GDP GROWTH IN 2005-06, 2006-07
The data released by CSO shows that Indian Economy grew by 9% during 2005-06 and 9.6% during 2006-07. In 2006-07 GDP growth was mainly fueled by Industry and services that grew at 10.9% and 11.0%. Although in 2005-06 the 9% growth rate of GDP was achieved due to a stronger performance by the agricultural sector. The agricultural sector (i.e. primary sector) grew at a rate of 6.1% in 2005-06 in comparison to a mere 3.8% in the following year i.e. 2006-07.Industrial and services sector respectively contributed 26.6% and 54.9 % to the total GDP growth in 06-07. On the other hand GDP growth in 2007-08 has been 9 %( Revised estimates by CSO) which is lower than the previous year. In the advance estimates GDP growth was expected at 8.7%. The upward revision in the GDP growth rate is mainly on account of the Revisions made in the estimated production of agricultural crops by the Department of Agriculture and Co-operation. The sectors which showed growth rates of 5 per cent or more, are manufacturing (8.8 Per cent), electricity, gas and water supply' (6.3 per cent), construction (9.8 per cent), 'trade, Hotels, transport and communication' (12.0 per cent), 'financing, insurance, real estate and Business services' (11.8 per cent), and 'community, social and personal services' (7.3 per cent). The growth could have been more but due to the rising inflation in the last 3 months of the fiscal (2007-08) the growth slowed down. The tight monetary policy of the RBI to control inflation and to check the credit growth in the economy has also been the reasons for this reduced rate of GDP. The industrial sector grew at a rate of 8.5% during the period. And the service sector growth rate has been 10.7%. Even this growth rate has been due to improved agricultural sector growth which was 4.5% during the period 2007-08.

ESTIMATES OF GDP IN FINANCIAL YEAR 2008-09

In the financial year 2008-09 the GDP Growth rate has been estimated at 7.6% while it has been estimated at 7.8% by CRISIL. The rising interest rates and the rising inflation etc. are the reasons for this slowdown in the GDP. Dr. Subir Gokarn, Chief Economist, Standard & Poor's Asia Pacific, said: "We expect the inflation rate to average 8.5% to 9.0% during 2008-09. Food price scenarios have improved somewhat, given comfortable levels of wheat stocks and expectations of a normal monsoon this year. However, high oil prices, strong input costs, and a depreciating rupee continue to exacerbate inflationary and other pressures. High interest rates, along with a slowing global economy, will trim GDP growth to 7.8% in 2008-09. On an average, the Indian GDP growth rate has been forecasted to be 7.5 % for the fiscal 2008-09. The main reason for this slow economic growth rate has been the continues rise in the inflation rate since last few months. The inflation rate even touched the 13 year high rate of 11.89 % once. The main reason for this high inflation rate has been the rising crude oil prices which are still approximately 50 % high than their levels one year ago. (The crude oil was trading at 70 $ per barrel during 2007-08 but now even after some correction, the crude oil was 107 $ per barrel as on 1st September, 2008.) The interest rates have been hiked by banks to control inflation but still inflation rates are very high @ 11.40 % for the week ended 16 th August 2008. In fact, the interest rate hike affected the GDP growth rate as loans for investors became costlier. As there looks to be no signs for inflation rate abatement, the chances of more stringent monetary policy is expected which may control inflation, but will surely make a dent into the GDP growth rate.

INDUSTRIAL GROWTH
Indian industry achieved an impressive growth in the last fiscal 2006-07. The overall Industrial production grew at 11.6% in 2006-07 as against the growth of 8.2% in the Previous fiscal. The industry growth rate in 2007-08 was 8.3%. Which is very low than 11.6% in the previous period. The manufacturing sector achieved a growth rate of 8.7 % during the period compared to 12.5 % IIP growth during 2006-07. Tight monetary policy resulting in high interest rates has been the major factor contributing to the decline in IIP growth. Capital goods production also came down to 16.9 % in 2007-08 when compared to a growth of 18.2% in 2006-07. The growth rate for consumer goods also fell down to 5.9 % from that of 10.1 % in the previous fiscal. The growth rate for basic goods also fell down to 7 % in 2007-08 from that of 10.3 % in the previous fiscal.

SIX CORE INFRASTRUCTURE INDUSTRIES

The Index of Six core-infrastructure industries having a combined weight of 26.7 per cent in the Index of Industrial Production (IIP) with base 1993-94. During the year 2006-07 the six core infrastructure industries grew at a high of 9.2% as compared to the 6.2% increase a year before. This growth arrived on account of better production numbers across the six core industries. The four infrastructure industries, crude petroleum, petroleum refinery, power and coal posted growths of 5.6%, 12.9%, 7.3% and 5.9% respectively exceeding the growths recorded in the previous fiscal, maintaining the overall infrastructure growth. However growth in the production of finished steel and cement slowed during the fiscal 2006-07. Production of finished steel was observed to speed-up in the last two months of 2006-07 compared to the corresponding months of 2005-06... The six core infrastructure industries registered a growth of 5.6 per cent during the Fiscal 2007-08 as compared to 9.2 per cent in corresponding period last year. The four infrastructure industries crude petroleum, petroleum refinery, power and coal posted less growth than the previous year with an exception in the electricity sector which achieved a negligible improvement in the growth rate than the last year. The growth of petroleum products took a plunge as it came down to just 6.5 % from 12.9 % in the previous fiscal. The steel and cement sector also showed less growth rates than the previous fiscal.

2008-09 ANNUAL INFLATION RATE PROJECTED BY S&P

The overall WPI based inflation for 2006-07, averaged at 5.4% as against the 4.4% in the 2005-06. The RBI employed monetary tightening measures to absorb the excess liquidity in the market impacting the prices of the manufactured items. The government regulated exports of some identified commodities addressing the supply crunch in various primary articles. For the fiscal 2007-08 RBI had kept the target inflation rate around 4.5% initially but then due to the rising crude oil prices, inflation has been on a continuous rise. Upto November 2007, the inflation rate was around 3 %. After November the WPI based inflation was around 4.56 % for the next 4 months of the fiscal 2007-08 i.e. December 2007 to march 2008. But still the Government was successful in keeping the annual inflation rate at the target level of 4.5 % for 2007-08. But after February 2008 the inflation has been on a rise. As it was 4.45 % at the end of February, 6.68 % at the end of march, 7.33 % at the end of April and finally at the end 10

of June 2008, the yoy inflation has touched its 13 years high at 11.42 %. The main reason For this sudden hike in inflation have been the rising rates of the crude oil in the International markets. This has been the biggest reason for the inflation to be so high Otherwise as the agricultural sector has showed a good growth rate of 4.5% there would not be such inflation. Although the reserve bank of India had taken some steps to reduce money supply in the previous fiscal. Like the CRR has been increased 5 times in the recent period to reduce money circulation in the economy and the crude oil prices also came down at the beginning of September 2008 to 107 $ from the levels of 144 $ per barrel, but still the inflation rate is high at 11.40 %

MONETARY INDICATORS
MONEY SUPPLY

11

The Broad money growth for the last fiscal 2006-07 stood at 21.5% and was slightly lower than the growth of M3 during the same period a year ago. Bank credit to the government rose substantially during the year-end 2007 compared to the same period of last year. We observed slowdown in the bank credit to the commercial sector. However, the net foreign exchange assets of the banks spiked by 28.9% as against 11.1% in the same period a year ago. Scale up in investments on government securities by 10% was also seen during the year. Impact of the hike in the rates of long term deposits was reflected in the numbers on aggregate deposits that went up by 23% in 2006-07 compared to 18% in the corresponding period of the previous year. Credit off take decelerated during the year compared to last year. Money supply (M3) increased by 20.7 per cent (Rs.6, 86,096 Crores) in 2007-08 as compared with 21.5 per cent (Rs.5,86,548 crore) in 2006-07. Aggregate deposits of SCBs (Scheduled commercial banks ) increased by 22.2 per cent (Rs.5, 80,208 crore) during 2007-08 as compared with 23.8 per cent (Rs.5, 02,885 crore) in the previous year. The average daily turnover in the foreign exchange market increased to US $ 57.3 billion at end-March 2008 from US $ 33.2 billion at end-March 2007. Commercial banks' investment in Government and other approved securities increased by 22.9 per cent (Rs.1, 81,222 crore) during 2007-08, significantly higher than 10.3 per cent (Rs.74, 062 crore) in 2006-07. Large inflows have led to swelling of net foreign exchange assets of the banks that grew by 16.9 percent against 10.3 percent in the last fiscal. This has increased M3 over the Aggregate deposits have picked up faster than the last year and this came after the RBI attached host of benefits to time deposits. Investments in the government and other approved securities have also shown higher increase compared to last years. Credit off take was seen to divert towards the non-food category. So the money supply in the economy continued in the period 2007-08. However for 2008-09, the total money supply is expected to grow at lesser rate than the previous year because of the rising cost of capital due to the CRR hikes of the RBI. Also as the stock market is volatile, this may also be a not so good choice for raising funds for Investments. This way both the GDP Growth rate and the inflation rate are expected to come down.

12

CRR RATE HIKES

CRR has been increased by 50 basis points to 7.5% before October 2007. And after that also once in January. And then due to the galloping inflation starting from February onwards the CRR was again increased In May 2008, then again two times in July 2008. And now it stands at 9.0 %. The SLR is still at 25 %. The Repo rate is now 9.0 %. All these measures have been taken by the RBI to curtail inflation. As raising both these rates will lead to higher cost of funds for commercial banks that in turn will lead to higher interest rates in the economy. This higher interest rate will make cost of debt high for the corporate and households both. Thus it discourages loan taking by people and RBI will be hoping that this increase in both CRR and Repo rate will help reduce the money supply in the economy. And that will in turn reduce demand and ultimately inflation. Recently D Subbarao became the new RBI Governor. But he too is expected to continue the stringent monetary policy adopted by the previous incumbent Dr. YV Reddy. So the Growth may take a hit while targeting the inflation.

FISCAL MANAGEMENT
Gross tax revenue collections grew at a rate much higher in 2006-07 than the previous year. Data up to March 2007 shows gross collections increased at 29.3% as against the20% increase in the previous year. Corporation tax and Income tax both contributed 45% to the total tax collected and grew at 41% and 35.4% respectively and this was much

13

Higher than the increase in the tax collected a year ago. Among the indirect taxes we saw collections from customs maintain the rise, growing at 32.7%, although collections from the central excise was not as much as in the same period of previous year. In 200607 the Government was seen to achieve the targeted fiscal deficit. It touched a level of Rs 146348 Crores representing 100.10% of the targeted. Comparing the numbers of 200607 With that of the previous years, we see numbers of 2006-07 close to the targeted figure. For 2007-08, direct tax collection was Rs.3,144.68 billion. This represents an increase of 36.62 percent over the previous fiscal and 117.56 percent of the original budget estimates. But it has already missed its revenue deficit target and expects it to be 1 percent of GDP in the year to end March 2009. "In four years, Direct tax collection has been tripled - that is from Rs.1,050.88 billion to Rs.3,144.68 billion. This is a remarkable achievement and I compliment the department for this extraordinary achievement," he added. "The cost of collection has come down to 0.54 percent. For every Rs.100 collected, the department spends only 54 paisa. Now, this is the lowest in any jurisdiction in the world." As per Mr. PC Chidambaram. For the first quarter of 200809 the direct tax receipts jumped only 38.6 pct in the quarter to June from a year earlier. The finance ministry said corporate taxes came in 32.7 percent higher at 345.66 billion rupees during the April-June period, while income tax receipts stood at 227.82 billion rupees, 48.8 percent more than a year ago. Growth in tax collections in June slowed from a scorching 71.3 percent growth in the April-May period as the government made a hefty refund payout of 115.78 billion rupees. The government expects robust tax revenue in the year to March 2009 to keep the fiscal deficit below a target of 2.5 percent of gross domestic product (GDP) in 2008/09 compared to 2.8 percent of last year.

CENTERS FISCAL SITUATION: 2007-08

According to the Fiscal Responsibility and the Budget Management Act operationalised

14

in 2004/05, the government must reduce its fiscal deficit to 3 pct of GDP and wipe out its revenue deficit by 2008/09.The process of fiscal correction and consolidation under the Fiscal Responsibility and Budget Management (FRBM) framework continued during 2007-08; the revised estimates for the year placed the revenue deficit and fiscal deficit lower than budget estimates, both in absolute terms and relative to GDP. Revenue deficit at Rs.63, 488 crore in 2007-08 was lower by Rs.7,990 crore than the budget estimates. This reflected the significant increase in the tax and non-tax revenue which more than offset the increase in the revenue expenditure on account of higher provision for interest Payments and subsidies. The Gross fiscal deficit (GFD) at Rs.1,43,653 crore in 2007-08 was lower by Rs.7,295 crore than the budget estimates on account of the lower revenue deficit coupled with a decline in capital expenditure. As a result, gross primary surplus in the revised estimates at Rs.28,318 crore was significantly higher than the budget estimates by Rs.20,271 crore. The reduction in GFD and revenue deficit by 0.4 per cent and 0.5 per cent of GDP, respectively, during 2007-08 (RE) over 2006-07 met the stipulated minimum threshold levels of 0.3 per cent and 0.5 per cent of GDP for GFD and revenue deficit, respectively, under the FRBM Rules, 2004.

IMPACT OF BUDGET 2008-09

The cash-strapped government has pledged to spend billions of rupees on populist schemes ahead of elections and has to foot a heft subsidy bills in order to keep fuel and food prices low. For example in the budget for 2008-09 the government has given a hefty loan waiver to farmers which will cost the exchequer a whopping 73000 crore rupees. The government has not made it clear that from where it will arrange for this much amount. So this loan waiver which has been given as a result of the vote bank politics will surely effect the achievement of the fiscal target of 2.5 % in fiscal 200809.Although the government is thinking that the rising tax receipts and an average growth rate of 40 % in tax receipts will be enough for achieving the fiscal targets. It does not seem so. There have been other reasons also for this apprehension. Such as the oil bonds issued by the government to cover their losses which are there because of the rising crude oil prices and the governments subsidy policy on oil price. As is clear from 15

the statement of the Former RBI Governor Mr. YV Reddy, India's fiscal deficit continues to be among the highest in the world and underlying pressures are not entirely showing up in headline fiscal numbers. India aims to bring down its fiscal deficit to 2.5 percent of GDP for the 2008/09 financial year, compared to 3.1 percent in 2007/08, but analysts fear a $17 billion scheme to write off the debts of millions of small farmers and tax cuts could trip up efforts.

FOREIGN TRADE
Indian trade numbers available for the year 2006-07 shows Indian exports growing at 20.9% as against the high growth of 24% in 2005-06 in US dollar terms.While in 200708 On Bop basis, merchandise exports recorded an increase of 23.7 percent (21.8 per cent in the previous year). Merchandise import payments, on Bop basis, showed a growth of 29.9 per cent in 2007- 08 (21.8 per cent in 2006-07). The commodity-wise data released by DGCI&S (April-February 2007-08) revealed a pick up in the growth of primary products, while manufactured exports witnessed some moderation in growth. Agriculture and allied products, engineering goods, gems and jeweler and petroleum products were the mainstay of exports, as these items contributed about 72 per cent of the export growth during April-February 2007-08.

16

On Bop basis, with imports outpacing the growth in exports, trade deficit widened to US $ 90.1 billion in 2007-08 (7.7 per cent of GDP) from US $ 63.2 billion (6.9 per cent of GDP) in 2006-07. Invisible receipts, comprising services, current transfers and income, rose by 26.2 per cent during 2007-08 (28.3 per cent in 2006-07) mainly due to the momentum maintained in the growth of software services exports, travel, transportation, along with the steady inflow of remittances from overseas Indians. Invisible payments grew by 17.7 per cent in 2007-08 (29.3 per cent in 2006-07). The key components of invisible payments were travel payments, transportation, business and management consultancy, engineering and other technical services, dividend, profit and interest payments. The moderation in growth rate of invisible payments during 2007-08 was mainly due to moderate payments relating to a number of business and professional services. During 2007-08, the widening of the trade deficit mainly led by imports resulted in a higher level of current account deficit which stood at US $ 17.4 billion or 1.5 per cent of GDP (US $ 9.8 billion or 1.1 per cent of GDP in 2006-07) . To sum up, the key features of Indias BoP that emerged in 2007-08 were: (i) sharp rise in trade deficit (7.7 per cent of GDP in 2007-08 from 6.9 per cent in 200607) mainly led by high imports, (ii) significant increase in invisible surplus led by

17

remittances from overseas Indians and software services, (iii) higher current account deficit at 1.5 per cent of GDP in 2007-08 as against 1.1 per cent in 2006-07 due to widening of trade deficit, (iv) substantial increase in capital flows (net) which were 2.4 times than their level in 2006-07 and constituted 9.2 per cent of GDP (5.0 per cent of GDP in 2006-07), (v) large accretion to reserves (excluding valuation) at US $ 92.2 billion (US $ 36.6 billion in 2006-07).

CAPITAL FLOWS
Capital Inflows for the period April-February 2006-07 have swept past the inflows received during the entire 2005-06. Direct investment contributed USD 17.1 billion during April- February period of 2006-07; this was much higher than USD 7.7 billion received in the entire 2005-06. Portfolio investments however remained lower in 2006-

18

07 than the investments in the previous year. During the year 2006-07, the amount raised by the Indian corporate through GDR and ADR route has been much higher ( USD 3.7 billion) than that was raised in the previous year (USD 2.5 billion ). Both capital inflows to India and outflows from India remained large during 2007-08 reflecting the increased liberalization of capital account, investors optimism and sustained growth momentum of India. The gross capital inflows to India amounted to US $ 428.7 billion as against an outflow of US $ 320.7 billion during 2007-08 . The net capital flows (inflows minus outflows) at US $ 108.0 billion (9.2 per cent of GDP) in 2007-08 were 2.4 times than that of 2006-07 (US $ 45.8 billion or 5.0 per cent of GDP) and 4.2 times of the net flows of 2005-06 (US $ 25.5 billion or 3.1 per cent of GDP

Foreign direct investments (FDI) broadly comprise equity, reinvested earnings and interoperate loans. Net FDI flows (net inward FDI minus net outward FDI) amounted to US $ 15.5 billion in 2007-08 as against US $ 8.5 billion in 2006-07. Net inward FDI at US $ 32.3 billion during 2007-08 (US $ 22.0 billion in 2006-07) reflected the continued strength of sustained domestic activity and positive investment climate with inflows 19

channelsing into construction, manufacturing, business and computer services. Net Outward FDI stood at US $ 16.8 billion during 2007-08 (US $ 13.5 billion in 2006-07) Reflecting the pace of global expansion by the Indian companies in terms of markets and resources. As regards portfolio equity flows, foreign institutional investors (FIIs) made net purchases in the Indian stock market throughout the year 2007-08 except during the months of August, November, February and March. The large FII inflows (net) in 200708 at US $ 20.3 billion as against US $ 3.2 billion in 2006-07 also reflected increased participation of FIIs in primary markets as there were large resources mobilized by the corporate through record level of 85 Initial Public Offerings (IPOs) and 7 Follow-on Public Offers (FPO) together amounting to US $ 135.4 billion. Reflecting the buoyant stock market, the resources mobilized by the Indian companies through their global offerings of ADRs/GDRs abroad also remained large amounting to US $ 8.8 billion in 2007-08 (US $ 3.8 billion in 2006-07). As a result of large FII flows and resource mobilization through ADRs/GDRs, the net portfolio investment was US $ 29.3 billion in 2007-08 as against US $ 7.1 billion in 2006-07. So the FDI and FII investors invested in India in a big way in 2007-08 . and it shows that the foreign investors kept their faith in India during the previous year.

20

FOREIGN EXCHANGE RESERVES

Foreign exchange reserves crossed the USD 200 billion mark in the first week of April 2007. Forex reserves stood at USD 180 billion in December 2006 and since then a surge in the Forex was observed. The piling up of reserves is a strain for the central bank, as it is seen that interest on securities exceeds the rate of return on reserves and therefore some steps need to be taken to ease the pressure due to forex buildup. Net accretion to foreign exchange reserves on BoP basis (i.e., excluding valuation) at US $ 92.2 billion in 200708 (US $ 36.6 billion in 2006-07) was led mainly by strong capital inflows. Taking into account the valuation gain of US $ 18.3 billion (US $ 11.0 billion in 2006-07), foreign exchange reserves recorded an increase of US $ 110.5 billion in 2007-08 (US $ 47.6 billion in 2006-07). At the end of March 2008, with outstanding foreign exchange reserves at US $ 309.7 billion, India held the third largest stock of reserves among the emerging market economies and fourth largest in the world

21

TRENDS IN EXCHANGE RATE

Appreciation in Indian Rupee against the greenback started in March 2007. This rise in Rupee value was on account of an inflow in the foreign capital, in the form of FDI, ECB and Portfolio investments. To maintain the exchange rate within a range the central bank has been buying dollars from the market but due to inflationary pressures, RBI slightly distanced itself from the forex market. RBIs adoption of passive approach has made Rupee appreciate to levels that are pro imports. Indian Rupee began to appreciate since the middle of March 2007, it continued to slide below Rs 44.00 and slip to an alarming below-forty one level towards the end of April 2007, It has been found that Indian Rupee against the Euro too behaved similar to its movement vis--vis USD, Indian Rupee attained a level of Rs 55-54 in June 2007 from 58-57 in March 2007, appreciating by 6.5%. But now from the beginning of the period 2008-09, the rupee has again started Depreciating against the Dollar and it went to the level of 44 rupees per dollar at the end of August 2008.

Rupees Per Unit of Foreign Currency

22

POLITICAL SITUATION IN INDIA

The political system was stable in the economy for last 4 years as the UPA government was running efficiently. Although the Left did stop a lot of reforms in these 4 years yet the Government was doing fine as it can be seen with a growing economy from 2005-06 to 2007-08. But in the beginning of the year 2008-09 the government remained uncertain The government had to prove its majority in the house after the Left parties withdrew their support to the government on the nuclear deal issue. The government escaped after the congress aligned with the Samajwadi party and some independents gave support to Congress. Although the government is now safe but industry may not have reform measures in Pension , Insurance and Banking Sector as the government on its own would not be able to bring these reforms and BJP and left parties are against measures such as increased limit of FDI in these sectors. So this uncertainty over issues will remain and until the policy comes into effect, the foreign investors may not invest in insurance sector.

23

STOCK MARKET TRENDS IN 2006-07

The mood of the market was such that negative news triggers the adverse index movements while the positives leave markets unchanged. We have seen that the attempt of the central banks monetary tightening measures, hike in the CRR and the lending rates to curb inflation rose concerns among the investor community. The fall in both the indices BSE and NSE seen in the middle of March through April 2007 was in response to the growing concern over the expensive funds. The BSE index plunged by 4.7 percentage points during March end 2007over the previous months close and NSE too slipped by 4.9 percentage points. However the stock markets have shown resilience in May 2007 and the host of corrective measures by the Central Bank resulted into bringing inflation to desired levels.

STOCK MARKET TRENDS IN 2007-08 AND ONWARDS

Negative signals in some of the major markets have forced the foreign institutional investors to divert their funds in safe havens. Recently the Indian stock market has been Primarily pulled by the FII investments, partially fueled by domestic investments. From December 07 to January 22 2008, the Bull Run continued in the market. But on 23 rd January the market took a deep plunge of points. And from then the market has beengoing in the bear run. The main reason for the starting of this bear run was the sub prime crisis in USA. There was an ongoing talk about the US market going into recession because the Major US banks got big losses due to sub prime loans given to individuals. And as the banks provide liquidity to the economy, a funds problem in major banks may actually lead to credit crunch in the economy which in itself will lead to slow growth.

24

As India does a lot of trade with the US a slowdown in their economy also lead to volatility in the Indian market. And after that the rising crude oil prices which led to inflation rising up to 2 digits figure. To control inflation RBI also took stringent monetary policy such as increasing the repo rate in 2007-08. this rising rate of inflation also led to negative sentiments in the market. And also the earnings of the companies come down. All these factors lead to a market which was at 13000 levels. So due to all these factors the market has entered into a bear phase. Now the market has entered into a volatile phase and is gaining some momentum after being in a bear phase for long. 200809 The market, although still volatile, has achieved some stability in the last few months. The market has come to the levels of about 15000 from the level of 13000 two months ago.

WORLD ECONOMY SCENARIO

The USA economy is showing signs of Regression. All the major Investment banks like Merill lynch, Lehmann Brothers etc. have failed. The big five no more exist. Even Goldman Sachs and JP Morgan is leaving the investment banking. Due to these reasons the US economy has crumbled. The effects have been on India also. The cash starved FIIs have been selling for the past few days. The Indian financial sector will also be affected by this turbulence in USA as the bankrupt banks were also having stakes in the Indian companies. And the sentiments of investors have become negative. Other than USA , other countries, though showing some signs of slowdown, are still having near to normal conditions. And there are no signs of a world economy slowdown yet. If we talk about the BRIC countries then India seems to be ahead as it is expected that by 2015 , Indias GDP growth rate will be the highest in the BRIC countries as is clear from the following diagram

25

THE CURRENT SCENARIO IN INDIA Finally we can say that the Indian economy achieved very high growth rates in the last three fiscals (from 2005-06 to 2007-08). The GDP was approximately 9 % during these three years. But if we look at the current scenario the condition looks pretty dismal. The inflation rate has gone up to 11.89 % for the week ended 11th July 2008 before coming down to the level of 11.40 % at the end of 16 th August, 2008. The FIIs are moving away from the Indian equity market. The US is also facing recession signs thus in turn will affect the world economy along with the Indian economy. The crude oil rates are just going upwards with no signs of abatement. The only hope is the softening crude oil prices in the last month of August 2008. The crude has come to levels of 107 $ per barrel . but still it is very high than the rates of 70 $ per barrel in the fiscal 2006-07. The reason for this fall in crude oil prices has been the recession in the US and less demand for oil from other countries also along with increased supply from some oil producing countries The rupee is also weakening against the dollar. The corporate earnings have been affected by the inflation. In short , the year 2008-09 is going to be very hard for Indian economy. But the fundamentals of the Indian economy are still sound. India is still attracting a lot of FDI, FII etc. The corporate are still earning well and are doing a lot of mergers and acquisitions outside. The investment rate is also good. Although the near future may have some difficulties for India also but still the Indian economy is in a good 26

position in the long run and is expected to earn a GDP Growth rate of 7.6% which is second highest in the world after China.

INDUSTRY ANALYSIS IT SECTOR

According to the NASSCOMM , the Indian IT industry clocked an overall growth rate of 28% , registering revenues of USD 52 billion in 2007-08 up from USD 39.6 BILLION IN 2006-07. For 2008-09 , NASSCOMM has predicted the software industry to grow at 2124%.In FY 2007, the growth rate was 31 %. And the GDP contribution of the IT ITES stood at 5.2 %. The growth rate for the IT Exports was 33 %. For the June 2008 quarter , the industry clocked a growth rate of 27.8 % in revenues and it is expected to be at 27 % for the September 2008 quarter. While the growth in aggregate revenues was healthy, PAT grew by a mere 5.9 % in the June quarter. Forex losses incurred by software companies took a toll on earnings growth during the quarter. If the rupee remains at the current level or depreciates further, it could increase the forex losses of IT companies which have substantial amount outstanding in hedges.

SOFTWARE SECTOR
The software industry was on a high growth trajectory up to the year ended March 2007. However, the unabated rise in the rupee vis--vis the USD since April 2007 dampened the sales growth and dwindled the profits of the software companies which earn a majority of their billings in USD. Nevertheless, the industry managed to clock a healthy sales growth of over 20%. While growth in aggregate net sales was healthy, a higher 31% growth in aggregate total expenses restricted the growth in aggregate net profits to 11.8% during the March 2008 quarter. This was a lowest year on year growth in net profits in at least the last 17 quarters. A strong 21.8% growth in salary cost, the largest expense item of the software industry, and a substantial 42.9% growth in other expenses fuelled the growth in aggregate total expenses. As the growth in aggregated expenses in the March 2008 quarter outpaced aggregate income growth, it dented the profit margins. During the March 2008 quarter, PAT margin contracted by 240 basis points to 19.8%.

27

For the June 2008 quarter , PAT and PBDIT both declined from the previous quarters and the main reason was the rupee appreciation

ITES SECTOR REPORTS LOSSES IN JUNE 2008

The ITES industry posted a robust growth in revenues in the two quarters ended December 2007 and it continued to maintain its high income growth even in the March 2008 quarter. The aggregate net sales of ITES companies grew by 27 % in June 2008 which was led by healthy performances of allied digital services (37.6 %) , HTMT Global Solutions (27.3 per cent ) and First source Solutions . (16.3 percent ). This healthy top line growth did not translate into corresponding growth in earnings and the PAT for June 2008 quarter showed losses as 5 out of a sample size of 10 ITES Companies reported losses for the June 2008 quarter. The growth in expenses was fuelled by a 29.5 % growth in wage cost. And a 132.6 % growth in other expenses. Wage costs accounted for 40 % of the total expenditure

28

GOVERNMENT POLICY TOWARDS IT SECTOR

The Department of Information Technology (DIT) in the Ministry of Communications and Information Technology is inter-alia responsible for formulation, implementation and review of national policies in the field of Information Technology. All policy matters relating to silicon facility, computer based information technology and processing including hardware and software, standardization of procedures and matters relating to international bodies, promotion of knowledge based enterprises, internet, eCommerce and information technology education and development of electronics and coordination amongst its various users are also addressed by the Department.

Industrial Approval Policy

Industrial Licensing has been virtually abolished in the Information Technology sector. Electronics and Information Technology industry can be set up anywhere in the country, subject to clearance from the authorities responsible for control of environmental pollution and local zoning and land use regulations.

29

Foreign Investment Policy

A foreign company can start operations in India by registration of its company under the Indian Companies Act 1956. Foreign equity in such Indian companies can be up to 100%. At the time of registration it is necessary to have project details, local partner (if any), structure of the company, its management structure and shareholding pattern. Registration is a kind of formality and it takes about two weeks. Foreign technology induction is encouraged both through FDI and through foreign technology collaboration agreement. Foreign Direct Investment and Foreign technology collaboration agreements can be approved either through the automatic route under powers delegated to the Reserve Bank of India (RBI) or otherwise by the Government automatic approval. FDI up to 100% is allowed under the automatic route from foreign/NRI investor without prior approval in most of the sectors including the services sector. FDI in sectors/activities under automatic route does not require any prior approval either by the Government or RBI

Foreign Trade Policy

In general, all IT products are freely importable, with the exception of some defense related items. All Electronics and IT products, in general, are freely exportable. Second hand capital goods are freely importable. Export Promotion Capital Goods scheme (EPCG) allows import of capital goods on payment of 5% customs duty. The export obligation under EPCG Scheme can also be fulfilled by the supply of Information Technology Agreement (ITA-1) items to the DTA provided the realization is in free foreign exchange. Special Economic Zones (SEZs) are being set up to enable hassle free manufacturing and trading for export purposes.

Export Promotion Schemes

30

The government has established many STPIs(Software technology park of India) and EOUs(Export oriented units ) for the development of the IT and ITES sectors in India. EOU/EHTP/STP units may import and/or procure from the DTA or bonded warehouses in DTA, without payment of duty, all types of goods, including capital goods, required for its activities, provided they are not prohibited items of import in the ITC(HS). The units shall also be permitted to import goods including capital goods required for the approved activity, free of cost or on loan/lease from clients. The government has also allowed for a lot of SEZs for the IT sector. Special Economic Zone (SEZ) is a specifically delineated duty free enclave and shall be deemed to be foreign territory for the purposes of trade operations and duties and tariffs. Goods and services going into the SEZ area from DTA shall be treated as exports and goods and services coming from the SEZ area into DTA shall be treated as if these are being imported. SEZ units may be set up for manufacture of goods and rendering of services. SEZ unit may import/procure from the DTA without payment of duty all types of goods and services, including capital goods, whether new or second hand, required by it for its activities or in connection therewith, provided they are not prohibited items of imports in the ITC(HS). The units shall also be permitted to import goods required for the approved activity, including capital goods, free of cost or on loan from clients. From 2010, the STPI Scheme is being abolished but the government has allowed the conversion of the existing STPIs into SEZs thus the software companies would continue to have benefits from the government policy and it will help them to grow further. So in general, the government has a very favorable policy for the IT sector. The policy for any foreign company coming into India is also attractive . so the market can expand in the near future. And the sector looks attractive to invest as the government policies are both stable and attractive.

SWOT ANALYSIS OF INDIAN IT INDUSTRY

31

STRENGTHS Highly skilled human resource :

The Indian IT sector boasts of highly skilled human resource available at low wages.

Quality of work Initiatives taken by the Government

(Setting up Hi-Tech Parks and implementation of e-governance projects) Following Quality Standards such as ISO 9000, SEI CMM etc. Cost competitiveness Quality telecommunications infrastructure Indian time zone (24 x 7 services to the global customers): Time difference between India and America is approximately 12 hours, which is beneficial for outsourcing of work. As the USA companies can get their work done during the time they sleep. So in a way the US companies work will be executing for all 24 hours of a day.

WEAKNESSES
Dearth of suitable candidates Less Research and Development:

32

Basically the Indian companies are doing a lot of outsourced work which is not very technical. The work of research etc. has not been done by the Indian companies on a large scale. The total expenditure on R&D is less. Due to the rising inflation since a very long time the employee salaries in IT sector are increasing tremendously. Low wages benefit will soon come to an end. And if this happens then it will be hard to maintain the customers in the Indian IT sector.

OPPORTUNITIES
High quality IT education market : The education market for IT is very good in
India .This can be substantiated by the fact that even the Chinese people are studying from NIIT , China centers.

Increasing number of working age people : Indias average work population is

25 years while it is above 50 for the USA . so India is having a tremendous advantage for getting more work from the foreign countries in future.

Upcoming International Players in the market : This will increase the IT

market in India. So overall it is good for the sector.

The slowdown in USA economy will force the US companies to cut their costs
and for this , off shoring will be the natural choice as the total work through off shoring costs very less in comparison to the work done in the USA. So the slowdown may prove to be a blessing in disguise.

THREATS
33

 Lack of data security systems Countries like China and Philippines with qualified workforce making efforts to overcome the English language barrier IT development concentrated in a few cities only Obama policies towards off shoring in the USA The USA Democratic presidential candidate Barack Obama is against the off\ shoring of work. So if he becomes the USA president, then the Indian IT industry may have problems in getting new business from USA, if Obama brings policies against off shoring.

5 FORCES IN THE INDUSTRY

THREAT OF NEW ENTRANTS

As the government policies are favorable towards the IT sector, the threat of new entrants is there in the sector. But if we talk about the big software and hardware companies in India such as Infosys and TCS etc. , they are not going to get much effected by the new companies as they have built a very strong client base till now. But still easy entry for the foreign players is not a good thing for the Indian IT majors. The BPO sector is already having a lot of competition already so it wont make much difference if some more BPOs come into the sector.

34

BARGAINING POWER OF BUYERS

With so many brands available in the industry, it is clear that consumers have a wide range of options. Therefore to attract new customers, every computer firm must offer something of value which is hard to ignore. The same is true about the Software industry as there is tough competition between TCS, Infosys, Satyam etc. so the customer is having much bargaining power. The current slow-down in the industry has given consumers even more power than they had before. They are now in demand, more than ever before and they can certainly cash in on this.

BARGAINING POWER OF SUPPLIERS

As the companies in the Indian IT software sector are service companies and their major resource is the Human power. The Indian IT industry will require about 2.3 million people up to 2010 as per a study done by NASSCOMM. And the skilled people are less in supply . This is the reason due to which the IT companies had to raise the wages in the near future. So for attracting and retaining the skilled manpower, the IT companies will be having less bargaining power in comparison to the employees.

THREAT OF SUBSTITUTES
Indian companies do work being outsourced by the USA , UK , Europe companies. Their substitute is either no off shoring by these companies or off shoring to other countries than India. No off shoring will lead to cost increase for these companies. And if they offshore work to other countries than Indias main competition will be with China. But still, in services like software development and maintenance, India is still ahead from other countries. But the rising competition from Philippines, China, Thailand etc. is a matter of concern for Indian IT sector.

35

RIVALRY AMONG COMPETITORS

The rivalry among the existing competitors is very intense. The competition will only get Tougher as some of the international players such as Microsoft and adobe have set shop in India.

CONCLUSION ON INDIAN IT SECTOR

The overall scenario of the Indian IT sector does not look attractive for now due to a lot of reasons like US Slowdown, High competition etc. But still the foundation of the Indian IT industry is strong. As India is having more expertise in software development than the other countries in the world doing off shoring For example, China and Philippines. So in the long term the sector will be able to maintain a steady growth .This can be proved by the following points. 1. Although there is a point of worry as the US economy is in a slowdown phase but this may be a blessing in disguise. Due to this slowdown in the US economy, the demand in USA is reducing which has led to decline in profits of USA companies. Thats why these companies will have to take steps for cost cutting. And off shoring work to low cost countries such as India will be an automatic choice for these companies. So the current US slowdown may increase the bottom-line of the Indian IT companies. 2. The big Indian IT companies are already having a lot of orders in pipeline. This factor will also play a role in at least a normal growth rate for Indian IT companies. 3. It is expected that the Indian IT companies may go on a spree of mergers and acquisitions in countries other than USA so as to reduce their dependency on USA for getting business. For example, recently HCL and Infosys were trying to acquire Axon of UK . This acquisition will give the bidding company an entry into UK and the company also got the research abilities of Axon. (Axon is a big player of providing SAP services in the UK).This acquisition may lead to other companies also doing the same to diversify

36

their risk by operating in various countries and it will also help them to move to higher point in value chain.

U.S FINANCIAL CRISIS

In fact, it really does look as if the foundations of US capitalism have shattered. Since 1864, American banking has been split into commercial banks and investment banks. But now that's changing. Bear Stearns, Lehman Brothers, Merrill Lynch -- overnight, some of the biggest names on Wall Street have disappeared into thin air. Goldman Sachs and Morgan Stanley are the only giants left standing. Despite tolerable quarterly results, even they have been hurt by mysterious slumps in prices and -- at least in Morgan Stanley's case -- have prepared themselves for the end. "Nothing will be like it was before," said James Allroy, a broker who was brooding over his chai latte at a Starbucks on Wall Street. "The world as we know it is going down."Many are drawing comparisons with the Great Depression, the national trauma that has been the benchmark for everything since. "I think it has the chance to be the worst period of time since 1929," financing legend Donald Trump told CNN. And the Wall Street Journal seconds that opinion, giving one story the title: "Worst Crisis Since '30s, With No End Yet in Sight." But what's really happening? Experts have so far been unable to agree on any conclusions. Is this the beginning of the end? Or is it just a painful, but normal cycle correcting the excesses of recent years? Does responsibility lie with the ratings agencies, which have been overvaluing financial institutions for a long time? Or did dubious short sellers manipulate stock prices -- after all, they were suspected of having caused the last stock market crisis in July. The only thing that is certain is that the era of the unbridled free-market economy in the US has passed -- at least for now. The near nationalization of AIG, America's largest insurance company, with an $85 billion cash infusion -- a bill footed by taxpayers -- was

37

a staggering move. The sum is three times as high as the guarantee provided by the Federal Reserve when Bear Stearns was sold to JPMorgan Chase in March. The most breathtaking aspect about this week's crisis, though, is that the life raft -- which Washington had only previously used to bail out the mortgage giants Fannie Mae and Freddie Mac -- is being handed out by a government whose party usually fights against any form of government intervention. The policy is anchored in its party platform. "I fear the government has passed the point of no return," financial historian Ron Chernow told the New York Times. "We have the irony of a free-market administration doing things that the most liberal Democratic administration would never have been doing in its wildest dreams."

Subprime mortgage crisis

The subprime mortgage crisis is an ongoing financial crisis triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States, with major adverse consequences for banks and financial markets around the globe. The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 and has exposed pervasive weaknesses in financial industry regulation and the global financial system. Many U.S. mortgages issued in recent years were made to sub prime borrowers, defined as those with lesser ability to repay the loan based on various criteria. When U.S. house prices began to decline in 2006-07, mortgage delinquencies soared, and securities backed with subprime mortgages, widely held by financial firms, lost most of their value. The result has been a large decline in the capital of many banks and USA government sponsored enterprises, tightening credit around the world. The crisis began with the bursting of the United States housing bubble and high default rates on "sub prime" and adjustable rate mortgages (ARM), beginning in approximately 20052006. Government policies and competitive pressures for several years prior to the crisis encouraged higher risk lending practices. Further, an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged

38

borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 20062007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006. Financial products called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors around the world to invest in the U.S. housing market. Major banks and financial institutions had borrowed and invested heavily in MBS and reported losses of approximately US$435 billion as of 17 July 2008. The liquidity and solvency concerns regarding key financial institutions drove central banks to take action to provide funds to banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments. The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. These actions were designed to stimulate economic growth and inspire confidence in the financial markets. Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%.Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine. Leaders of the larger developed

39

and emerging nations met in November 2008 to formulate strategies for addressing the crisis.[ .Sub prime lending is the practice of lending, mainly in the form of mortgages for the purchase of residences, to borrowers who do not meet the usual criteria for borrowing at the lowest prevailing market interest rate. These criteria pertain to the borrower's credit score, credit history and other factors. If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender can take possession of the residence acquired using the proceeds from the mortgage, in a process called foreclosure. The value of USA sub prime mortgages was estimated at $1.3 trillion as of March 2007,
[

with over 7.5 million first-lien sub prime mortgages outstanding. Between 2004-2006

the share of sub prime mortgages relative to total originations ranged from 18%-21%, versus less than 10% in 2001-2003 and during 2007. In the third quarter of 2007, sub prime ARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of the foreclosures which began during that quarter. By October 2007, approximately 16% of sub prime adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005. By January 2008, the delinquency rate had risen to 21%. and by May 2008 it was 25%. The value of all outstanding residential mortgages, owed by USA households to purchase residences housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6 trillion as of midyear 2008.During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007.As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure. Between August 2007 and October 2008, 936,439 USA residences completed foreclosure.

40

leverage.
Credit risk arises because a borrower has the option of defaulting on the loan he/she owes. Traditionally, lenders (who were primarily thrifts) bore the credit risk on the mortgages they issued. Over the past 60 years, a variety of financial innovations have gradually made it possible for lenders to sell the right to receive the payments on the mortgages they issue, through a process called securitization. The resulting securities are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). Most American mortgages are now held by mortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4 trillion by traditional depository institutions. This "originate to distribute" model means that investors holding MBS and CDOs also bear several types of risks, and this has a variety of consequences. There are four primary types of risk:

Name Credit risk Asset risk Liquidity risk

Description the risk that the homeowner or borrower will be unable or unwilling to pay back the loan financial losses, markdowns and possibly margin calls the risk that a business entity will be unable to obtain financing, such as from the commercial paper market the risk that a party to a contract will be unable or unwilling to uphold their obligations.

price the risk that assets (MBS in this case) will depreciate in value, resulting in

Counterparty risk The aggregate effect of these and other risks has recently been called systemic risk, which refers to when formerly uncorrelated risks shift and become highly correlated, damaging the entire financial system

41

When homeowners default, the payments received by MBS and CDO investors decline and the perceived credit risk rises. This has had a significant adverse effect on investors and the entire mortgage industry. The effect is magnified by the high debt levels (financial leverage) households and businesses have incurred in recent years. Finally, the risks associated with American mortgage lending have global impacts, because a major consequence of MBS and CDOs is a closer integration of the USA housing and mortgage markets with global financial markets. Investors in MBS and CDOs can insure against credit risk by buying credit defaults swaps (CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their counterparties increased. This created uncertainty across the system, as investors wondered if CDS issuers would honor their commitments

Causes
The reasons proposed for this crisis is varied and complex. The crisis can be attributed to a number of factors pervasive in both housing and credit markets, factors which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments, poor judgment by borrowers and/or lenders, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, monetary policy, international trade imbalances, and government regulation (or the lack thereof).[31] Ultimately, though, moral hazard lay at the core of many of the causes.[32] In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20 cited the following causes: During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, 42

weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

Boom and bust in the housing market

Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom and encouraging debt-financed consumption. The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004. Sub prime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher. Between 1997 and 2006, the price of the typical American house increased by 124% During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004 and 4.6 in 2006. This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. While housing prices were increasing, consumers were saving less and both borrowing and spending more. A culture of consumerism is a factor "in an economy based on immediate gratification." Starting in 2005, American households have spent more than 99.5% of their disposable personal income on consumption or interest payments. If imputations mostly pertaining to owner-occupied housing are removed from these calculations, American households have spent more than their disposable personal income in every year starting in 1999. Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and

43

finally to $14.5 trillion in midyear 2008, 134% of disposable personal income. During 2008, the typical USA household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970. This credit and house price explosion led to a building boom and eventually to a surplus of unsold homes, which caused U.S. housing prices to peak and begin declining in mid2006.Easy credit, and a belief that house prices would continue to appreciate, had encouraged many sub prime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default. As more borrowers stop paying their mortgage payments, foreclosures and the supply of homes for sale increase. This places downward pressure on housing prices, which further lowers homeowners' equity. The decline in mortgage payments also reduces the value of mortgage-backed securities, which erodes the net worth and financial health of banks. This vicious cycle is at the heart of the crisis. By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. This major and unexpected decline in house prices means that many borrowers have zero or negative equity in their homes, meaning their homes were worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers 10.8% of all homeowners had negative equity in their homes, a number that is believed to have risen to 12 million by November 2008. Borrowers in this situation have an incentive to "walk away" from their mortgages and abandon their homes, even though doing so will damage their credit rating for a number of years. Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding year. By

44

January 2008, the inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest value of this ratio since 1981. Furthermore, nearly four million existing homes were for sale, of which almost 2.9 million were vacant. This overhang of unsold homes lowered house prices. As prices declined, more homeowners were at risk of default or foreclosure. House prices are expected to continue declining until this inventory of unsold homes (an instance of excess supply) declines to normal levels Economist Nouriel Roubini wrote in January 2009 that sub prime mortgage defaults triggered the broader global credit crisis, but were just one symptom of multiple debt bubble collapses: "This crisis is not merely the result of the U.S. housing bubbles bursting or the collapse of the United States sub prime mortgage sector. The credit excesses that created this disaster were global. There were many bubbles, and they extended beyond housing in many countries to commercial real estate mortgages and loans, to credit cards, auto loans, and student loans. There were bubbles for the securitized products that converted these loans and mortgages into complex, toxic, and destructive financial instruments. And there were still more bubbles for local government borrowing, leveraged buyouts, hedge funds, commercial and industrial loans, corporate bonds, commodities, and credit-default swaps..." It is the bursting of the many bubbles that he believes are causing this crisis to spread globally and magnify its impact.

Speculation
Speculation in residential real estate has been a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."

45

Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. For example, one company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties. Nicole Gelinas of the Manhattan Institute described the consequences of failing to respond to the shifting treatment of a home from conservative inflation hedge to speculative investment. For example, individuals investing in equities have margin (borrowing) restrictions and receive warnings regarding the risk to principal; there are no such requirements for home buyers. While stock brokers are prohibited from telling an investor that a stock or bond investment cannot lose money, it was not illegal for mortgage brokers to do so. Equity investors are well-aware of the need to diversify their financial holdings, but for many homeowners the home represented both a leveraged and concentrated risk. Further, in the U.S. capital gains on stocks are taxed more aggressively than housing appreciation, which has large exemptions. These factors all enabled speculative behavior. Economist Robert Shiller argues that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming." Keynesian economist Hyman Minsky described three types of speculative borrowing that contribute to rising debt and an eventual collapse of asset values:

The "hedge borrower," who expects to make debt payments from cash flows from other investments;

46

The "speculative borrower," who borrows believing that he can service the interest on his loan, but who must continually roll over the principal into new investments;

The "borrower," who relies on the appreciation of the value of his assets to refinance or pay off his debt, while being unable to repay the original loan.

Speculative borrowing has been cited as a contributing factor to the sub prime mortgage crisis.

High-risk mortgage loans and lending/borrowing practices

Lenders began to offer more and more loans to higher-risk borrowers, including illegal immigrants. Sub prime mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999, and $600 billion (20%) in 2006. A study by the Federal Reserve found that the average difference between sub prime and prime mortgage interest rates (the "sub prime markup") declined from 280 basis points in 2001, to 130 basis points in 2007. In other words, the risk premium required by lenders to offer a sub prime loan declined. This occurred even though the credit ratings of sub prime borrowers, and the characteristics of sub prime loans, both declined during the 2001 2006 period, which should have had the opposite effect. The combination of declining risk premia and credit standards is common to classic boom and bust credit cycles. In addition to considering higher-risk borrowers, lenders have offered increasingly risky loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever.By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences. Growth in mortgage loan fraud based upon US Department of the Treasury Suspicious Activity Report Analysis One high-risk option was the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans. Another example is the interest-only adjustable-rate mortgage 47

(ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. An estimated onethird of ARMs originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment. Mortgage underwriting practices have also been criticized, including automated loan approvals that critics argued were not subjected to appropriate review and documentation In 2007, 40% of all sub prime loans resulted from automated underwriting. The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay.Mortgage fraud by borrowers increased.

Securitization practices

Securitization, a form of structured finance, involves the pooling of financial assets, especially those for which there is no ready secondary market, such as mortgages, credit card receivables, student loans. The pooled assets serve as collateral for new financial assets issued by the entity (mostly GSEs and investment banks) owning the underlying assets. The diagram at left shows how there are many parties involved. Securitization, combined with investor appetite for mortgage-backed securities (MBS), and the high ratings formerly granted to MBSs by rating agencies, meant that mortgages with a high risk of default could be originated almost at will, with the risk shifted from the mortgage issuer to investors at large. Securitization meant that issuers could repeatedly relend a given sum, greatly increasing their fee income. Since issuers no longer carried any default risk, they had every incentive to lower their underwriting standards to increase their loan volume and total profit.

48

The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and retaining the credit (default) risk. With the advent of securitization, the traditional model has given way to the "originate to distribute" model, in which the credit risk is transferred (distributed) to investors through MBS and CDOs. Securitization created a secondary market for mortgages, and meant that those issuing mortgages were no longer required to hold them to maturity. Asset securitization began with the creation of private mortgage pools in the 1970s. Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of sub prime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006. Alan Greenspan has stated that the current global credit crisis cannot be blamed on mortgages being issued to households with poor credit, but rather on the securitization of such mortgages. American homeowners, consumers, and corporations owed roughly $25 trillion during 2008. American banks retained about $8 trillion of that total directly as traditional mortgage loans. Bondholders and other traditional lenders provided another $7 trillion. The remaining $10 trillion came from the securitization markets. The securitization markets started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds Investment banks sometimes placed the MBS they originated or purchased into offbalance sheet entities called structured investment vehicles or special purpose entities. Moving the debt "off the books" enabled large financial institutions to circumvent capital requirements, thereby increasing profits but augmenting risk. Investment banks and offbalance sheet financing vehicles are sometimes referred to as the shadow banking system and are not subject to the same capital requirements and central bank support as depository banks. Some believe that mortgage standards became lax because securitization gave rise to a form of moral hazard, whereby each link in the mortgage chain made a profit while passing any associated credit risk to the next link in the chain. At the same time, some financial firms retained significant amounts of the MBS they originated, thereby

49

retaining significant amounts of credit risk and so were less guilty of moral hazard. Some argue this was not a flaw in the securitization concept per se, but in its implementation According to Nobel laureate Dr. A. Michael Spence, "systemic risk escalates in the financial system when formerly uncorrelated risks shift and become highly correlated. When that happens, then insurance and diversification models fail. There are two striking aspects of the current crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability."

Government policies
Both government action and inaction has contributed to the crisis. Some are of the opinion that the current American regulatory framework is outdated. Then President George W. Bush stated in September 2008: "Once this crisis is resolved, there will be time to update our financial regulatory structures. Our 21st century global economy remains regulated largely by outdated 20th century laws. The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis. Increasing home ownership was a goal of the Clinton and Bush administrations There is evidence that the Federal government leaned on the mortgage industry, including Fannie Mae and Freddie Mac (the GSE), to lower lending standards. Also, the U.S. Department of Housing and Urban Development's (HUD) mortgage policies fueled the trend towards issuing risky loans. In 1995, the GSEs began receiving government incentive payments for purchasing mortgage backed securities which included loans to low income borrowers. Thus began the involvement of the GSE with the sub prime market Sub prime mortgage originations rose by 25% per year between 1994 and 2003, resulting in a nearly ten-fold increase in the volume of sub prime mortgages in just nine years. The relatively high yields on these 50

securities, in a time of low interest rates, were very attractive to Wall Street, and while Fannie and Freddie generally bought only the least risky sub prime mortgages, these purchases encouraged the entire sub prime market. In 1996, HUD directed the GSE that at least 42% of the mortgages they purchased should have been issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005. From 2002 to 2006 Fannie Mae and Freddie Mac combined purchases of sub prime securities rose from $38 billion to around $175 billion per year before dropping to $90 billion, thus fulfilling their government mandate to help make home buying more affordable. During this time, the total market for sub prime securities rose from $172 billion to nearly $500 billion only to fall back down to $450 billion. By 2008, the GSE owned, either directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the amount outstanding The GSE have always been SShighly leveraged, their net worth as of 30 June 2008 being a mere US$114 billion. When concerns arose in September 2008 regarding the ability of the GSE to make good on their guarantees, the Federal government was forced to place the companies into a conservator ship, effectively nationalizing them at the taxpayers' expense. Liberal economist Robert Kuttner has suggested that the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 may have contributed to the sub prime meltdown, but this is controversial.[113][114] The Federal government bailout of thrifts during the savings and loan crisis of the late 1980s may have encouraged other lenders to make risky loans, and thus given rise to moral hazard.[115] [116] Economists have also debated the possible effects of the Community Reinvestment Act (CRA), with detractors claiming that the Act encouraged lending to uncredit worthy borrowers. and defenders claiming a thirty year history of lending without increased risk. Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of mortgages issued to otherwise unqualified low-income borrowers, and allowed the securitization of CRA-regulated mortgages, even though a fair number of them were sub prime.

51

Impact in the U.S.

Between June 2007 and November 2008, Americans lost more than a quarter of their net worth. By early November 2008, a broad U.S. stock index, the S&P 500, was down 45 percent from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion.

Financial market impacts, 2007

The crisis began to affect the financial sector in February 2007, when HSBC, the world's largest (2008) bank, wrote down its holdings of sub prime-related MBS by $10.5 billion, the first major sub prime related loss to be reported. during 2007, at least 100 mortgage companies either shut down, suspended operations or were sold.[150] Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week of each other in late 2007. As the crisis deepened, more and more financial firms either merged, or announced that they were negotiating seeking merger partners.[152] During 2007, the crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of value". Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a "commodities super-cycle." Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds, some of which has been invested into food and raw materials. Mortgage defaults

52

and provisions for future defaults caused profits at the 8533 USA depository institutions insured by the FDIC to decline from $35.2 billion in 2006 Q4 billion to $646 million in the same quarter a year later, a decline of 98%. 2007 Q4 saw the worst bank and thrift quarterly performance since 1990. In all of 2007, insured depository institutions earned approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of 46%.

Financial market impacts, 2008

The TED spread an indicator of credit risk increased dramatically during September 2008. As of August 2008, financial firms around the globe have written down their holdings of sub prime related securities by US$501 billion. The IMF estimates that financial institutions around the globe will eventually have to write off $1.5 trillion of their holdings of sub prime MBSs. About $750 billion in such losses had been recognized as of November 2008. These losses have wiped out much of the capital of the world banking system. Banks headquartered in nations that have signed the Basel Accords must have so many cents of capital for every dollar of credit extended to consumers and businesses. Thus the massive reduction in bank capital just described has reduced the credit available to businesses and households. When Lehman Brothers and other important financial institutions failed in September 2008, the crisis hit a key point. During a two day period in September 2008, $150 billion were withdrawn from USA money funds. The average two day outflow had been $5 billion. In effect, the money market was subject to a bank run. The money market had been a key source of credit for banks (CDs) and no financial firms (commercial paper). The TED spread a measure of the risk of inter bank lending, quadrupled shortly after the Lehman failure. This credit freeze brought the global financial system to the brink of collapse. The response of the USA Federal Reserve, the European Central Bank, and other central banks was immediate and dramatic. During the last quarter of 2008, these central banks purchased US$2.5 trillion of government debt and troubled private assets 53

from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The governments of European nations and the USA also raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issued preferred stock in their major banks.

Indirect economic effects

The subprime crisis has had a number of adverse effects on the overall American economic situation. USA GDP was expected to contract at a 5.5% annual rate during Q4 2008. USA employers slashed 2.6 million jobs during 2008, the most since 1945. There have been significant job losses in the financial sector, with over 65,400 jobs lost in the USA as of September 2008. The unemployment rate climbed to 7.2% in December 2008, the highest level in 16 years. Declining house prices have reduced household wealth and the collateral for home equity loans, which is placing downward pressure on consumption. The tightening of credit has caused a major decline in the sale of motor vehicles. Between October 2007 and October 2008, Ford sales were down 33.8%, General Motors sales were down 15.6%, and Toyota sales had declined 32.3%.There is an ongoing global automobile industry crisis, and calls for some form of government intervention. Members of USA minority groups received a disproportionate number of sub prime mortgages, and so have experienced a disproportionate level of the resulting foreclosures. Minorities have also born the brunt of the dramatic reduction in sub prime lending. House-related crimes such as arson have increased Many renters became innocent victims, by being evicted from their residences without notice, because their landlords' property has been foreclosed. In October 2008, Tom Dart, the elected Sheriff of Cook County, Illinois, criticized mortgage lenders for the adverse consequences their actions had on tenants, and announced that he was suspending all foreclosure evictions

54

Responses
Various actions have been taken since the crisis became apparent in August 2007. In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis. To date, various government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending.

Federal Reserve Bank

The central bank of the USA, the Federal Reserve, in partnership with central banks around the world, has taken several steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve's response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy." The Fed has: Lowered the target for the Federal funds rate from 5.25% to 2%, and the discount rate from 5.75% to 2.25%. This took place in six steps occurring between 18 September 2007 and 30 April 2008; Undertaken, along with other central banks, open market operations to ensure member banks remain liquid. These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates (called the discount rate in the USA) they charge member banks for short-term loans Used the Term Auction Facility (TAF) to provide short-term loans (liquidity) to banks. The Fed increased the monthly amount of these auctions throughout the crisis, raising it to $300 billion by November 2008, up from $20 billion at inception. A total of $1.6 trillion in loans to banks were made for various types of collateral by November 2008. Finalized, in July 2008, new rules for mortgage lenders; In October 2008, the Fed expanded the collateral it will lend against to include commercial

55

paper, to help address continued liquidity concerns. By November 2008, the Fed had purchased $271 billion of such paper, out of a program limit of $1.4 trillion. In November 2008, the Fed announced the $200 billion Term Asset-Backed Securities Loan Facility (TALF). This program supported the issuance of asset-backed securities (ABS) collateralized by loans related to autos, credit cards, education, and small businesses. This step was taken to offset liquidity concerns. In November 2008, the Fed announced a $600 billion program to purchase the MBS of the GSE, to help lower mortgage rates

Regulation
Regulators and legislators have contemplated taking action with respect to lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders. Regulations or guidelines can influence the transparency and reporting required of lenders and the types of loans they choose to issue. Congressional committees are also conducting hearings to help identify solutions and apply pressure to the various parties involved. On 31 March 2008, a sweeping expansion of the Fed's regulatory powers was proposed, that would expand its jurisdiction over nonbank financial institutions, and its authority to intervene in market crises. Responding to concerns that lending was not properly regulated, the House and Senate are both considering bills to further regulate lending practices. Countrywide's VIP program has led ethics experts and key senators to recommend that members of Congress be required to disclose information about the mortgages they take out. Non depository banks (e.g., investment banks and mortgage companies) are not subject to the same capital requirements as depository banks. Many investment banks had limited capital to offset declines in their holdings of MBSs, or to support their side of credit default insurance contracts. Nobel prize winner Joseph Stiglitz has recommended that the USA adopt regulations restricting leverage, and preventing companies from becoming "too big to fail.

56

British Prime Minister Gordon Brown and Nobel laureate A. Michael Spence have argued for an "early warning system" to help detect a confluence of events leading to systemic risk.[187] Dr. Ram Charan has also argued for risk management early warning systems at the corporate board level On 18 September 2008, UK regulators announced a temporary ban on short-selling the stock of financial firms. The Australian government will invest AU$4 billion in mortgage backed securities issued by non bank lenders, in an attempt to maintain competition in the mortgage market. However this is considered a drop in the ocean in regards to total lending. SFed Chairman Ben Bernanke stated there is a need for "well-defined procedures and authorities for dealing with the potential failure of a systemically important non-bank financial institution." Alan Greenspan has called for banks to have a 14% capital ratio, rather than the historical 8-10%. Major U.S. banks had capital ratios of around 12% in December 2008 after the initial round of bailout funds. The minimum capital ratio is regulated. Economists Nouriel Roubini and Lasse Pederson recommended in January 2009 that capital requirements for financial institutions be proportional to the systemic risk they pose, based on an assessment by regulators. Further, each financial institution would pay an insurance premium to the government based on its systemic risk.

Economic Stimulus Act of 2008

On 13 February 2008, President Bush ssigned into law an economic stimulus package costing $168 billion, mainly taking the form of income tax rebate checks mailed directly to taxpayers. Checks were mailed starting the week of 28 April 2008. However, this rebate coincided with an unexpected jump in gasoline and food prices. This coincidence led some to wonder whether the stimulus package would have the intended effect, or whether consumers would simply spend their rebates to cover higher food and fuel prices. Some Congressmen even contemplated a second round of tax rebates to ensure that the American economy would indeed be stimulated. Secretary of the Treasury Henry Paulson strongly opposed such initiative.

Housing and Economic Recovery Act of 2008

The Housing and Economic Recovery Act of 2008 included six separate major acts intended to restore confidence in the American mortgage industry. The Act:\Insures $300 billion in mortgages, that will assist an estimated 400,000 borrowers; Creates a 57

new Federal regulator to ensure the safe and sound operation of the GSEs (Fannie Mae and Freddie Mac) and Federal Home Loan Banks; Raises the ceiling on the dollar value of the mortgages the government sponsored enterprises (GSEs) may purchase; Lends money to mortgage bankers to help them refinance the mortgages of owneroccupants at risk of foreclosure. The lender reduces the amount of the mortgage (typically taking a significant loss), in exchange for sharing in any future appreciation in the selling price of the house via the Federal Housing Administration. The refinancing must have fixed payments for a term of 30 years; Requires that lenders disclose more information about the products they offer and the deals they close; governments buy and renovate foreclosed properties. Helps local

Effect on the financial condition of USA governmental unit

Deficit and Debt Increases 20012008
The Federal government's efforts to support the global financial system have resulted in significant new financial commitments, totaling $7 trillion by November, 2008. These commitments can be characterized as investments, loans, and loan guarantees, rather than direct expenditures. In many cases, the government purchased financial assets such as commercial paper, mortgage-backed securities, or other types of asset-backed paper, to enhance liquidity in frozen markets. As the crisis has progressed, the Fed has expanded the collateral against which it is willing to lend to include higher-risk assets The extent to which the Federal government is at risk because of these investments and guarantees remains to be seen. The upshot has been a US$1 trillion increase in the national debt of the USA during FY 2008, compared to an average increase of US$550 billion during the previous five years. The total debt reached $10 trillion in September 2008. In addition, state and local government property tax collections are expected to decline because of an estimated $1.2 trillion reduction in housing prices, and a slowing of the

58

overall American economy this expectation is affecting the ability of state governments to finance their operations through bond sales. Finding themselves unable to borrow, the states of California and Massachusetts have requested that the Fed lend them the amounts they would have borrowed elsewhere under normal conditions

Expectations and forecasts

Several years before the crisis Prem Watsa warned: We have been concerned for some time about the risks in asset-backed bonds, particularly bonds that are backed by home equity loans, automobile loans or credit card debt (we own no asset-backed bonds). It seems to us that securitization (or the creation of these asset-backed bonds) eliminates the incentive for the originator of the loan to be credit sensitive... With securitization, the dealer (almost) does not care as these loans can be laid off through securitization. Thus, the loss experienced on these loans after securitization will no longer be comparable to that experienced prior to securitization... This is not a small problem. There is $1.0 trillion in asset-backed bonds outstanding as of December 31, 2003 in the U.S.... Who is buying these bonds? Insurance companies, money managers and banks in the main all reaching for yield given the excellent ratings for these bonds. What happens if we hit an air pocket? Stifel Nicolaus, writing in Market Watch, has claimed that the problem mortgages are not confined to the sub prime niche: "the rapidly increasing scope and depth of the problems in the mortgage market suggest that the entire sector has plunged into a downward spiral similar to the sub prime woes whereby each negative development feeds further deterioration," calling it a "vicious cycle" and adding that lenders "continue to believe conditions will get worse" On 19 May, 2008, Nouriel Roubini, a professor at New York University and head of Roubini Global Economics, was quoted as saying that if the economy slips into recession "then you have a systemic banking crisis like we haven't had since the 1930s

59

Because debt instruments backed by sub prime mortgages were purchased worldwide, the International Monetary Fund (IMF) "says that worldwide losses stemming from the USA sub prime mortgage crisis could run to $945 billion." As of February 2009, analysts were predicting that Alt-A loans, offered to those with good credit but less steady income than prime borrowers, represent the next wave of delinquencies and foreclosures. Rating agency Moody's expects the delinquency rate to increase to over 20%, compared with the historical average of below 1%. Analysts at Goldman Sachs estimate write-downs on the $1.3 trillion of total Alt-A debt at $600 billion, almost as much as expected sub prime losses. Add in option ARMs, many of which are essentially the same as Alt-A, and the potential impact climbs towards $1 trillion. Francis Fukuyama has argued that the crisis represents the end of Reaganism in the financial sector, which was characterized by lighter regulation, pared-back government, and lower taxes. Significant financial sector regulatory changes are expected as a result of the crisis Fareed Zakaria believes that the crisis may force Americans and their government to live within their means. Further, some of the best minds may be redeployed from financiall engineering to more valuable business activities, or to science and technology Roger Altman wrote that "the crash of 2008 has inflicted profound damage on [the U.S.] financial system, its economy, and its standing in the world; the crisis is an important geopolitical setback...the crisis has coincided with historical forces that were already shifting the world's focus away from the United States. Over the medium term, the United States will have to operate from a smaller global platform -- while others, especially China, will have a chance to rise faster." The crisis has cast doubt on the legacy of Alan Greenspan, the Chairman of the Federal Reserve System from 1986 to January 2006. Senator Chris Dodd claimed that Greenspan created the "perfect storm".[270] Greenspan has remarked that there is a one-in-three chance of recession from the fallout. When asked to comment on the crisis, Greenspan spoke as follows:[129]

60

The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgagebacked securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business

Why is the US financial services sector critical for Indian IT?

The current US financial crisis has been variously compared with the 1907 banking/credit crisis, the Great Depression and the dotcom bust. Its been quite a rollercoaster ride for the world economy with financial services dominating the headlines world over companies writing down losses, companies merging, acquiring, and going bust. The latest saga including Lehman, Merrill and AIG has unnerved the financial world and created serious concerns among their business partners, especially the Indian IT players. The current crisis parallels the 2001-2002 bust especially for Indias IT (export) sector. Approximately 61% of the Indian IT sectors revenues are from US clients. If you just take the top five India players who account for 46% of the IT industrys revenues, the revenue contribution from US clients is approximately 58%. About 30% of the industry revenues are estimated to be from financial services. In addition, from a qualitative standpoint, the tentacles of the financial sector business are quite well-entrenched and have significant structural impact as well. The size and maturity of the IT industry today are far ahead of the 2001 days, and the current model has signs of irreversibility and long-term competitive advantage. While GE invented the industry along with Indias biggest IT outsourcing firms, the US financial services and insurance sector (BFSI) was one of the earliest adopters of the outsourcing trend in a big way.

61

The US BFSI players created large outsourcing chunks, made Indian IT players learn from their experience, negotiated aggressively on pricing, pushed for service level commitments, and rewarded with more work to all who excelled in taking on their challenges. Between 1999 and 2008, the share of US financial services revenue as a % of total revenues for the Top 3 Indian players thus went up from 25% to 38%. In the minds of the BFSI US players, Indian companies were flexible, delivered good quality (resources), and gave a key lever in managing their SG&A and time to market by freeing up more critical IT resources. They were essentially partners in taking some of the fixed costs out of their SG&A. Partnering in the operating business areas was still far away and is a tad far even today. It is ironic that this crisis would have had a worse impact, if Indian firms had partnered with the financial services entities much more closely, tying up their invoices with the clients business outcomes.

Top Line Impact

A recent study by Forrester reveals that 43% of Western companies are cutting back their IT spend and nearly 30 percent are scrutinizing IT projects for better returns. Some of this can lead to off shoring, but the impact of overall reduction in discretionary IT spends, including offshore work, cannot be denied. The slowing U.S. economy has seen 70 percent of firms negotiating lower rates with suppliers and nearly 60 percent are cutting back on contractors. With budgets squeezed, just over 40 percent of companies plan to increase their use of offshore vendors. The US financial crisis puts a question mark on growth for Indian IT in the short-tomedium-term. At the time of Q1 results, we saw growth numbers that were revised down by 2-3% after sentiment started building up against the US financial sector. A worse downward revision is expected this quarter as well, though some larger players like TCS and Satyam have officially denied any possible impact on growth. Going by Infy numbers, a gloomy forecast can be expected.

62

However, there are some offsetting factors softening the revenue slowdown - favorable Rupee-Dollar exchange rate, growth de-risking through Europe, growth in non-financial verticals, and growth through countercyclical new business (countercyclical to US slowdown). There may still be some hope of revenue growth from new avenues, albeit resulting from the current crisis. Merger activity is going to provide new outsourcing opportunities(as Infy confirmed), as newly-merged entities may have to look at additional or new providers to support the integration work and a broader global presence - especially when you take into account the huge size of combined international operations. In addition to the M&A activity, financial institutions will be looking to reduce their SG&A costs quickly, which will opt for outsourced solutions that impact the bottom-line - i.e. F&A BPO and some ITO and possibly some HRO deals, where there is quick remediation of staff.

Bottom-Line Impact
It is very difficult to replace fixed costs with variable costs at short notice of say a month. Hence, the focus will have to move to across-the-board fixed cost-cutting since making the costs esp. overheads and support costs variable at short notice is impossible. Pricing has been difficult in this sector compared to other sectors: On an average, the US financial sector has driven bulk volumes through lower onsite pricing, higher offshoring and aggressive volume discounts. It is safe to infer that BFSI application business margins especially in the top companies are a few percentage points below the higher margin verticals like, say, energy. Hence, a replacement of financial services business with business from other verticals is likely to positively impact the bottom-line. A speedy replacement is however, easier said than done. Exchange Rate: The Rupee-Dollar exchange rate benefit for a company that would have done zero-hedging is in the range of 10-12%. However, if we analyze the top few firms, the median seems to be around an offset benefit of around 2-3% on the bottom-line,

63

assuming some hedging. The Rupee has depreciated since the last quarter by more than 10% which has had a positive effect on both top line and the bottom-line in Rupee terms. This is to an extent countered by the significant hedging done by the IT biggies, the ramifications of which translated into forex losses for them in the June quarter. This may bite them again this quarter. For example, TCS has hedged about US$ 2.2 billion for the year at Rs.45/US$. According to the June quarter results transcript, at Rs.45/US$, the mark-to-market loss on this would be about US$100 million. And, considering the Rupee has moved beyond Rs.47/US$ into the first week of October, this can be far worse. There is also another issue with this currency pantomime facing firms like Infosys, which derives 28% of its revenues from the Euro, British Pound and Australian Dollar. The US$ has also been appreciating against these currencies. These earnings translated into US$ will have a negative 2% impact on the companys numbers. Taking these factors in to consideration, the currency depreciation does not paint as rosy a picture as we can imagine.

Cost-Side Controls
Wages are stabilizing and overall will have a positive impact on profitability due to

lower attrition and hence lower recruitment costs. Wages as a % of top line also go down due to depreciation and labor market conditions. Similarly, pushing higher variability into wages can bring more benefits. And so will managing bench more aggressively and employee performance management programs.

Efficiencies Indian IT companies continue to be made of the same DNA as

during the dotcom days, and measures to shore up efficiencies are already underway since we saw the exchange rate hit 39 to the Dollar. Some of those gains are permanent

64

since the processes have not been rolled back after the Rupee started depreciating. Potential measures are voluntary salary cuts, complete moratorium on salary raises, travel reduction, tightening of promotion spends, just-in-time hiring, hire-after-contract, etc. While we have looked mainly at IT, the ITES sector is joined at the hip with IT industry, but with its own flavors. The impact in financial services operations will be much larger, but, over the medium to long term, there will be a huge gain for them from the increase in outsourcing and off shoring in the financial sector. However, short-term pain alongside the US slowdown is inevitable.

Conclusion and Opportunities for Indias IT Sector

While there are growth-related challenges in the short-to-medium term, there seem to be some opportunities for managing the bottom-line for the rest of the year. The macroeconomic environment is depressing and has impacted the overall confidence in the sector from a market perspective. A US recession has not started but if it does, in all probability, it will last through 2009 and more, making this period a challenging one for growth. Despite the foreboding current financial crisis, the opportunities are: Make the growth vs. profitability tradeoff early on during the slowdown (which is

now). Profitability levers are still available if growth is sacrificed where required, and managed well. Utilize some of the unavoidable fixed costs for implementing investment ideas that

have been on the backburner and could not be kicked off due to high utilization. Look for M&A opportunities in US, both in financial sector and non-financial sector,

especially where the option is to hold cash vs acquire.

65

1. Financial sector companies: Distressed assets in the mortgage and other financial services industry are available to be picked up by Indian cos the assets are laden with debt and a lack of good forecasts on future business. 2. IT companies to look for IP and product related investments especially in the US 3. BPOs, especially captives, with significant financial services exposure are available for investments for Indian players. Focus on operational efficiencies efficiencies that can help shore up the bottom line

especially in an attractive labor market and an environment of budget/spend uncertainty. All in all, the environment looks weakest in a long while, and yet there remain pockets of opportunity. These areas, if tapped intelligently, would enable the IT firms to ease the blow of this financial crisis and help them tide through the tough times. The crisis has now spread globally Finally we can come to a conclusion that the Indian IT sector , though having some difficulties in the form of US slowdown and competition from China, will still be growing at a good pace of 21-24 % in 2008-09. But if we see the near future then the sector is going to see a lot of problems. The near future will not be so smooth for the IT Companies due to the national and international developments which have led to credit crunch situation in both USA and to some extent, in India also. Due to this US slowdown the IT spent of companies will be going down and it will lead to less business for these companies leading to less returns. So the IT sector and the IT companies are not attractive for the point of view of investment. However, if we talk about the long term , then IT Sector is a good sector to invest. As companies will be diversifying their business both functionally and Geographically. The companies will try to move higher in the value chain by providing consulting services. This has been proved by the counter bid for Axon by HCL. This will serve both types of diversification motives. The US is also trying to pass the 700 Billion $ bailout package for the companies which have been affected by the slowdown. It will also help the US 66

clients of Indian companies to again become solvent and work normally doing their routine work outsourced. As India is still ahead from other countries in IT expertise and is having worlds youngest working population and a lot of talent for the future, in long term the IT sector will be good for investing

BIBLIOGRAPHY
1. http://rbi.org.in 2. http://mospi.nic.in 4. http://dipp.nic.in 6. http://timesofindia.indiatimes.com 7. http://www.indianexpress.com/story/254652.html 8. http://www.moneycontrol.com 9. http://www.rediff.com/money 10. http://economictimes.indiatimes.com
11. CMIE PROWESS and CMIE IAS

12. www.nse-india.com 13. www.dit.gov.in 14. www.assocham.org

67