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Global Financial Crises

Class: MEF After PGD

SUBMITTED TO PROF. DR. SHAFIQ-UR-REHMAN UNIVERSITY OF KARACHI October 10, 2011 Submitted by: Muhammad Atif Khan (EP-101124) Muhammad Anwer (EP-101135) Usama Bin Tariq (EP-101168) Najeeb Siddiqui (EP-101140)

the bursting of the housing bubbles in the US and in other large economies. Towards the end of October 2008. and stock market volatility. soaring commodity prices. Its underlying causes had been reported following the subprime mortgage crisis. Others were bought out by their competition at low prices and in other cases. Therefore. The failures of large financial institutions in the United States rapidly evolved into a global crisis resulting in European bank failures. “Fallout from the collapse of the US mortgage market and the reversal of the housing boom in various important countries has turned out to be more profound and persistent than expected in 2007 and beginning of 2008. which were doing well before the ongoing financial crisis. The downturn after four years of fast growth is due to the global fallout from the financial crisis in the United States. the Bank of England said the world’s financial firms had now lost £1.Global Financial Crises Report Introduction:The global financial crisis of 2008 was the worst of its kind since the Great Depression of the 1930s. Following a period of economic boom. The problem was so severe that some of the world’s largest financial institutions collapsed. and significant reductions in the market-value of equities and commodities worldwide. increasingly restrictive monetary policies in a number of countries. As a result.8 trillion ($2. It surfaced to notice in September 2008 with the failure of several large United States based financial firms. The paper aims at highlighting the salient aspects of the global financial crisis. the financial crisis carries many pertinent lessons for the economies of countries like Pakistan. its impact on developing countries and drawing lessons for Pakistan. that as things started to unravel. which further accelerated the liquidity crisis. we are 10 Global Financial Crises | 10/10/2011 . the financial bubble has burst. the governments of the wealthiest nations in the world had to resort to extensive bailout and rescue packages for the remaining large banks and financial institutions.8 trillion) as a result of the continuing credit crisis. The collapse of the US sub-prime mortgage market and the reversal of the housing boom in other industrialized economies had ripple effects around the world. International Monetary Fund’s and World Bank’s Structural Adjustment Programmes have returned to countries. Some financial products and instruments have become so complex and twisted. says the United Nation’s Conference on Trade and Development in its Trade and Development Report 2008 as summarized by the Third World Network: The global economy is teetering on the brink of recession. including Pakistan. As more and more evidence is gathered and as the lag effects are showing up. The crisis led to liquidity problems and the de-leveraging of financial institutions especially in the United States and Europe. Other weaknesses in the global financial system have also surfaced. World political leaders and central bank directors coordinated their efforts to reduce fears but the crisis progressed into a currency crisis with investors transferring vast capital resources into stronger currencies leading many emergent economies to seek aid from the International Monetary Fund. declines in various stock indexes. trust in the whole system started to fail.

The 1997 crash caused devastation in countries like Indonesia and Thailand. New Delhi. “It is not the first time that the global financial system has suffered a crisis. we are seeing more and more countries around the world being affected by these rather profound and 11 . The lowering of interest rates in the US to overcome the recession led to liberal lending for mortgages and building. The magnitude of this transfer is unprecedented in recent history and probably cannot be sustained indefinitely.” Arvind Gupta. As more and more evidence is gathered and as the lag effects are showing up. 2008.” Daily Times (Islamabad).” Institute of Defence Studies and Analyses. “Global Inequity Must End. “Global Financial Crisis: Is There a Way Out?. A Deloitte Research Study. (November 5. or Are Things Better Than we Thought?”. This is the big imbalance in the global economy. “Fallout from the collapse of the US mortgage market and the reversal of the housing boom in various important countries has turned out to be more profound and persistent than expected in 2007 and beginning of 2008. It involves a massive flow of capital to the US from the rest of the world. The housing bubble finally burst in 2007 inspiring the subprime crisis. “The US invests far more than it saves (its current account deficit) and the rest of the world saves far more than it invests (a current account surplus). when it ends.” Global Financial Crises | 10/10/2011 Global Economic Outlook 2007: Is A Crisis Imminent. The bursting of the IT bubble in 2000 led to a recession in the US in 2001. 2008. October 26. Therefore.” The News(Islamabad). “The international financial system has failed to deliver on two accounts. (i) preventing instability and crises and (ii) transferring resources from richer to poorer economies. its impact on developing countries and drawing lessons for Pakistan. Review the Literature:“The financial crisis carries many pertinent lessons for the economies of countries like Pakistan.” Jayati Ghosh. if only because of the shifting of gears. “Is Capitalism ‘at bay’?. November 9. The paper aims at highlighting the salient aspects of the global financial crisis.” Huzaima Bukhari and Dr Ikram ul Haq. The innovative financial engineering concealed and dispersed the risk attached to bad lending practices of the lending institutions.seeing more and more countries around the world being affected by these rather profound and persistent negative effects from the reversal of housing booms in various countries. 2008). it could have a destabilizing effect on the global economy.

” Emergency Economic Stabilisation Act of 2008”. http://www. Not only is it occurring in a world of unprecedented financial globalization.e.advfn. “Economic Outlook Gloomy.” Tom Barkley. but it is also an imported Brazil.” Kanaga Raja.” Third World Network. October 30.htm. with origins outside the developing world. it is the poor and the disempowered whose lives are most thrown off balance and are the slowest to recover. World Bank.” The New School. September 4.” Silicon Investor. New York. 2008. when crisis strikes. “Of historically unprecedented magnitude and scope. “IMF Slashes World Growth Forecasts http://siliconinvestor.persistent negative effects from the reversal of housing booms in various countries.twnside. this crisis has serious implications for people. Risks to South: Say UNCTAD. well below the 3 per cent level the fund traditionally considers the threshold for a world recession. http://en.” . “The Human Impact of the Financial Crisis on Poor and Disempowered People and Countries. “Opponents of the rescue plan argued that since the problems of the American economy were created by excess credit and debt. The World Bank Report on “Global Financial Crisis and Implications for Developing Countries” described the impact of financial crisis in following broad terms. a massive infusion of credit and debt into the economy would only exacerbate the problems with the economy. Sao Paulo. “Global Financial Crisisand Implications for Developing Countries”. 2008.2 per cent in” 10 Global Financial Crises | 10/10/2011 “In fact.worldbank. “The IMF foresaw the global economy's growth slowing to 3.pdf “The challenges faced by developing countries earlier are now compounded by the pressures emanating from the global financial crisis.. For vulnerabilities in emerging and developing countries. G-20 Finance Ministers’ November 8. http://www. They asked for better alternatives to resolve the crisis. particularly for poor people in poor countries.aspx?msgid=25152632 Again.wikipedia. whether it is an economic meltdown like what South Korea experienced in 1998 or a natural disaster in rich countries such as Katrina in the United States in 2005 or the Kobe earthquake in 1998 in Japan. 2008. the economic impacts could also The crisis also comes on the heels of a major global shock from high food and fuel” Sakiko Fukuda. i.7 per cent in 2008 and 2. while the effects will vary from country to country. where the financial sector plays a historically large role in economic activity.

Australia. Continue vigorous efforts and take whatever further actions are necessary to stabilize the financial system. The world faces the severest credit crunch and recession since the Great Depression.independent. b. as appropriate. “The Global Financial Crisis and Developing Britain. and we welcome the recent introduction of new facilities by the World Bank in the areas of infrastructure and trade finance. Canada.” Overseas Development Institute (ODI). Mexico. In World Bank’s view. Italy. The 3. emerging and developing countries have a key role to play in improving the growth outlook. e. G-20 Declaration on Financial Crisis”. 2008. Russia. welcome its new short-term liquidity facility. of monetary policy support.Dirk Willem te Velde. Brazil. Developing countries’ growth prospects and access to external financing are subject to unusually large downside risks. and strengthening the international financial system. Recognize the importance appropriate to domestic conditions. South Korea. (accessed November 16. Encourage the World Bank and other multilateral development banks to use their full capacity in support of their development agenda.cnn. while maintaining a policy framework conducive to fiscal sustainability.600-word declaration mentioned the following actions to be taken: a. as deemed x. Help emerging and developing economies gain access to finance in current difficult financial conditions. India. UK. including through liquidity facilities and programme support. South Africa.” www. Germany. France. http://money. and urge the ongoing review of its instruments and facilities to ensure flexibility. November 15. European Union. 11 . essential for alleviating poverty. Turkey and United States was held at Washington on November 15. We stress the International Monetary Fund's (IMF) important role in crisis response. maintaining macroeconomic stability. are highly dependent on effective policy actions to restore confidence in the financial system and to counter falling international demand.htm “Ensure that the IMF. 2008). Global Financial Crises | 10/10/2011 “The prospects for an economic recovery. Saudi Arabia. While much of the responsibility for restoring global growth lies with policy makers in advanced economies. CNN-Money (Online). China. Indonesia. 2008. “Global economic summit of G-20 comprising Argentina. d. a. Use fiscal measures to stimulate domestic demand to rapid effect. World Bank and others have sufficient resources to continue playing their role in overcoming the crisis. (October 2008).

These countries had sufficient foreign exchange reserves and could afford stimulation package. which was supported by the International Monetary Fund (IMF). emerging. some may need to undertake fiscal consolidation. Pakistan was forced to cut back on its expenditure and could not afford stimulation packages like those of China and India. rapid inflation. and developing countries should take comprehensive action to resolve liquidity and solvency problems in the banking system and strengthen prudential supervision. Therefore. In November 2008. d. The contagion effects on domestic financial sector could be substantial. High fiscal and current account deficits. While transmission channels may differ. g.” Global Financial Crisis and its Impact on Developing Countries: Global Monitoring Report – 2009. Pakistan's ability to borrow externally is already heavily constrained and bond spreads are very high. 23. Economic policy responses should be adapted to country circumstances: countries with strong fundamentals may have room for monetary and fiscal stimulus. “This is mainly due to the improved health of the financial sector based on past reforms. It is crucial to maintain an open trade and exchange system.” Pakistan Country Overview 2009: Bank’s Assistance to Pakistan.” . Development aid must be increased to help countries cope with the crisis. low reserves. Pakistan could not do so due to weak foreign exchange position at the time of onset of the crisis. Global Financial Crisis: Implications for South Asia. and a fragile economy put Pakistan in a very difficult situation to face the global financial crisis. World Bank. to avoid a default on foreign debt payments. c. while those in weaker macroeconomic positions and with limited access to external financing will have less room for policy maneuver. Pakistan. Efforts are now underway to arrest the decline of the macro economy through demand management including tightening of monetary and fiscal policies. Pakistan developed a stabilization programme. Pakistan was also faced with political upheaval at that time. Advanced. a weak currency.b. but stress tests suggest that the banking sector as a whole is likely to withstand the shocks. China and India adopted stimulation packages and have recovered sooner than other countries. The global financial crisis means that non-official foreign capital flows will be even more expensive. e. the second largest economy. faces serious vulnerability in the region. Though originating in advanced countries. f. the crisis is hitting developing countries hard. both emerging market and lowincome countries will be severely impacted. 10 Global Financial Crises | 10/10/2011 “In South Asia. World Bank.

November 18.” Dawn (Online Edition). after losing 19. which came in 2007-08 and led to a balance of payments crisis. On November 17. but many suggest the worst is not yet over. Pakistan’s high economic growth in the earlier part of this decade was in part by heavy reliance on external financing and on expansionary fiscal stance.3 per cent in value against the US Dollar. “Pakistan’s vulnerability has been summarized by World Bank as under: a. Governments around the word are trying to contain the crisis. Italy. World Bank. and interest rates have been cut around the world in what looks like a coordinated response. security.” Economic Survey 2008-2009. rescue packages are drawn up involving more than a trillion US dollars. Ministry of Finance. China. The Rupee stabilized. 2008. Canada. Investment banks have collapsed. The forum agreed on a broad framework for cooperation with Pakistan in four major sectors including cooperation in the fields of development. And for how much longer can growth persist? What are the channels through which the crisis could spread to developing 11 . but forecasts have been downgraded substantially in the space of a few months. 2008. Leading indicators of global economic activity. Turkey. France. Stock markets are down more than 40% from their recent highs. Government of Pakistan. England. Islamabad. 2008. UAE.” 2009 Pakistan Economic Update.“Economic environment in Pakistan remained inhospitable for growth and investment during the first half of 2008-09. To reduce the economy’s vulnerability. c. UN and European Union was launched on September 26. US. Reliance on external financing left the economy vulnerable to external shocks. expanding domestic revenue mobilization would be critical. firm policy action to restore macroeconomic stability paid off dividends by December. are declining at alarming rates. and jeopardize development efforts by limiting resources available for planned investments in human and physical infrastructure. the Friends of Pakistan met at Abu Dhabi acknowledging that Pakistan is facing “formidable challenges and needs a well-coordinated international cooperation”. Australia. b. such as shipping rates. Failure to raise revenues in future would further intensify Pakistan’s vulnerability to external shocks. while revenues and savings remained stagnant. “Friends of Pakistan (now called Friends of Democratic Pakistan) forum comprising Saudi Arabia. What does the turmoil mean for developing countries? Many developing country economies are still growing strongly. energy and institution-building. Global Financial Crises | 10/10/2011 Collection of Data:Which countries are at risk and what can be done? The global financial crisis is already causing a considerable slowdown in most developed countries.

which countries might be most at risk. and which are most at risk? What is the role for development policy and what do developing country policy-makers need to know? This note discusses recent growth performance in developed and developing countries. Lagos is not Lehman. Growth performances vary substantially among developed and developing countries. The USA is going through the greatest financial crisis since the 1930s. the USA and other developed countries. and possible policy responses. and many African countries still gain significantly from this (they are growing at 67%). the channels through which the global crisis affects developing countries. held back by decades of economic mismanagement.countries and how are the effects being felt in developing countries? Which developing countries will be able to withstand the international macro economic challenges created by the downturn in developed economies. France. as the Financial Times has reported. Leaders in China suggest that they can help the world by offering growth rates of up to 10%. decoupling or delayed coupling? With a recession already underway in the UK. 10 Global Financial Crises | 10/10/2011 . is growing at nearly 9%. Germany. Yet this is today’s stark reality. African growth exceeds OECD growth by margins not seen for 25 years. Growth in developed and developing countries. it is quite startling to hear the Malawian finance minister argue that Malawi’s economy is projected to grow by more than 8% this year. but. East Asia’s growth is diverging as much as it did during the last significant global economic downturn in the early 1990s (see Figure 1). Nigeria.

FDI. According to the IMF World Economic Outlook report in April 2008. a decline in world growth of one percentage point would lead to a 0.5 percentage point drop in Africa’s GDP. African growth has 11 . so the effects of global turmoil on Africa (via trade. it was only 0.Global Financial Crises | 10/10/2011 The relationship between OECD GDP and Africa’s GDP has weakened as a result of the emergence of countries such as China. aid) would be quite high. as well as structural changes in African economies. but between 2000 and 2007. The correlation between African GDP and World GDP since 1980 is 0.5. As there have been significant structural changes (and a move into services that were able to withstand competition much better) as well as the rise of China.2.

but also India (-1. The IMF growth forecasts have been revised significantly. And there are also signs of a slowdown in Asia. Inflation has also doubled. Dominica. In the space of a couple of months. the Asian Development Bank has revised its forecast for Asian countries downwards by 1-2 percentage points. African countries such as Kenya. the decade in which several financial crises struck. Latin American countries are currently in a much better fiscal and external position compared to the 1990s. Trillion dollar rescue packages are launched around the world. Swaziland.5 percentage points to 9. the UK is already in a recession. Many developing and especially small and African countries are.3% respectively). Several Asian countries have built up healthy government reserves.9% real GDP growth). The terms of trade shock tend to be highest in small importing countries such as Fiji. The magnitude of the crisis will depend on the response of the USA and EU. However.3% and 6. and solid export performance has helped their strong current account position. especially for the UK (-1. Malawi. it was in deficit by 4% in 2007.1 percentage points down to 6. Tanzania are projected to have faced terms of trade shocks of greater than 5% of GDP (World Bank paper for the October 2008 Commonwealth Finance Ministers meeting). there are also several worrying signs.8 percentage points down from the last forecast for 2009). However. the engine of recent world growth. in a bad position to face yet another crisis. There is less scope for expansionary fiscal policy – in fact these rescue measures have increased public debt. The combination of high food prices and high oil prices has meant that. and China and Africa (both down by -0. 10 Global Financial Crises | 10/10/2011 . Its magnitude will depend. in part. but while the markets may eventually respond.temporarily decoupled from OECD GDP. with the recent interest rate cut a sure sign the authorities are concerned more about the financial crisis than recent inflationary pressures. therefore. while the current account of oil and food importers was in balance by 2003. on how accommodative monetary policy can be.

We have seen share prices tumble between 12 and 19% in the USA. which has led to greater exports and higher prices. there could be financial contagion and spillovers for stock markets in emerging markets. The channels of impact on developing countries include: • Trade and trade prices. First. oil and other natural resources. There will be fewer economic migrants coming to developed countries when they are in a recession. Growth in China and India has increased imports and pushed up the demand for copper. South Africa. Stock markets across the world – developed and developing – have all dropped substantially since May 2008. • Remittances. The Russian stock market had to stop trading twice. This includes stock markets in Brazil. India and China. which will have knock on effects on other poorer countries. Remittances to developing countries will decline. We need to better understand the nature of the financial linkages. Second. how they occur (as they do appear to occur) and whether anything can be done to minimise contagion. the India stock market dropped by 8% in one day at the same time as stock markets in the USA and Brazil plunged. so fewer remittances and also probably lower volumes of remittances per migrant. the economic downturn in developed countries may also have significant impact on developing countries. including from African countries.Impact of the current financial crisis on developing countries The current financial crisis affects developing countries in two possible ways. while the MSCI emerging market index fell 23%. UK and Japan in just one week. Global Financial Crises | 10/10/2011 11 . Eventually. growth in China and India is likely to slow down.

depending on policy responses. This would limit investment in such countries as Argentina. The impact on developing countries will vary. India has seen a devaluation as well as high inflation. will have less to remit. • Countries with a high current account deficit with pressures on exchange rates and inflation rates. While 2007 was a record year for FDI to developing countries. Pakistan and Ukraine.g. With fewer bonuses. • Aid. and the economic characteristics and policy responses. These will come under pressure. South Africa cannot afford to reduce interest rates as it needs to attract investment to address its current account deficit. • Countries exporting products whose prices are affected or products with high income elasticities. Each of these channels needs to be monitored. The proposed Xstrata takeover of a South African mining conglomerate was put on hold as the financing was harder due to the credit crunch. aid budgets are now likely to be under increased pressure.g. • Other official flows. • Commercial lending. Import values in other countries have already 10 Global Financial Crises | 10/10/2011 . There will be fewer migrants coming into the UK and other developed countries. Banks under pressure in developed countries may not be able to lend as much as they have done in the past. South Africa cannot afford to reduce its interest rate. Aid budgets are under pressure because of debt problems and weak fiscal positions. While the promises of increased aid at the Gleneagles summit in 2005 were already off track just three years later. Those countries that have done well by participating in the global economy may also lose out most.g. in developing countries. portfolio and DFI finance to address their current account problems (e.• Foreign direct investment (FDI) and equity investment. 2008. following the financial collapse of Iceland.g. There are several other examples e. Mexico is a good example. factoring in the risk of some emerging market countries defaulting on their debt. so there is scope for taking on more risks. However these have been relatively high recently. and the tourism sector in Caribbean and African countries will be hit. and this is not the time to reject globalisation but to better understand how to regulate and manage the globalisation processes for the benefit of developing countries. Iceland. as changes in these variables have direct consequences for growth and development (see e. It will depend on the response in developed countries to the financial crisis and the slowdown. equity finance is under pressure and corporate and project finance is already weakening. in India. Te Velde. increasingly. Capital adequacy ratios of development finance institutions will be under pressure. • Countries with sophisticated stock markets and banking sectors with weakly regulated markets for securities. where attitudes might harden and job opportunities become more scarce. for example. in the UK and other European countries and in the USA. on pro-poor globalisation). Which countries are at risk and how? The list of channels above suggest that the following types of countries are most likely to be at risk (this is a selection of indicators): • Countries with significant exports to crisis affected countries such as the USA and EU countries (either directly or indirectly). • Countries heavily dependent on FDI. Investors are. and it has already missed some important FDI deals). Indian workers in the city of London. e. • Countries dependent on remittances. Zambia would eventually be hit by lower copper prices.

counteracting reductions in other financial flows. how cross-border cooperation can help to provide the public good of international financial rules and systems. but development finance institutions may be able to take some risks and support investment flows to developing countries. There could also be social effects: • Lower growth translating into higher poverty. the economic impacts could include: • Weaker export revenues. loan losses higher and returns lower than they are at present. o Aid volumes will come under pressure. as they already need to address balance of payment problems in countries due to high food and oil prices? Global Financial Crises | 10/10/2011 11 . The EBRD argued in 2007 that is able to withstand the impact of a major shock with an impact equivalent to 3. • Lost employment. Do countries have room to use fiscal and monetary polices? • Developing countries need to understand the social outcomes and provide appropriate social protection schemes. India has a weak fiscal position which means that they cannot put schemes in place. without a need to call capital. and how should this be channelled? Are existing IMF and World Bank schemes sufficient for this. Should aid be provided to countries with high risks. and what the most appropriate rules are with respect to development. weaker health systems and even more difficulties meeting the Millennium Development Goals. • Developing countries will also need to manage the implications of the current economic slowdown – after a period of strong and continued growth in developing countries. For example.5 times the magnitude of the financial crisis in 1998.1 but there may also be implications for the composition of aid. While the effects will vary from country to country. for example by looking at what happened during the Asian financial crisis of the late 1990s. • Lower investment and growth rates. • There will also be implications for development policy: There will be limits to financial solutions if the problems lie in the real economy. • Countries dependent on aid. During this period DFI portfolios were riskier. • Countries with high government deficits. Possible policy responses The current macro economic and social challenges posed by the global financial crisis require a much better understanding of appropriate policy responses: • There needs to be a better understanding of what can provide financial stability.weakened the current account. Whether DFIs can take higher risks might be informed by past experience. • There needs to be an understanding of whether and how developing countries can minimise financial contagion. • Further pressures on current accounts and balance of payment. international macro economic management will now move up the policy agenda. And yet this poorer financial performance has not had an adverse affect on institutional credit ratings. which has promoted interest in structural factors of growth. • More crime.