Global Financial Crisis: Causes, Consequences and Prospects

Global Financial Crisis
w  Deep and long global economic recession looms for all countries with high unemployment, shrinking tax receipts, lower exports and trade, gyration in value of currencies, decreasing tourism income, reduced consumption levels - and the specter of depression
w  Oil prices are in a steep fall, affecting the income of many oil-producing (developing) countries.
w  All these pressures reduce the ability of governments in industrialized and developing countries alike to steer their economies; budget deficits are rising.
w  Governments are forced to prune their budgets so as to reach as balanced a budget as possible, especially if they require IMF standby credits
w  Moral hazard: Need for more equity in policy-making and allocation of public funds
w  The global financial crisis has spread like wildfire across the world because one single model of globalization, i.e. liberalizing market economy without regard to diversity, different stages of development, needs etc. was pursued.
w  The deliberate pushing aside of alternative models and approaches points to a moral and ethical deficiency, which policy-makers would have to account for.
The Consequences
w  Developing countries, the most defenseless and often “innocent bystanders” - face a perfect storm and for them the crisis may translate into
w  lower government budget allocations to social and productive sectors;
w  More demand for official development assistance (ODA) and foreign direct investment (FDI) flows
w  More demand for multilateral and NGO/ foundation funds
w  For the private sector, this may translate into
w  Lower economic growth
w  Less trade with developing countries irrespective of trade barriers and custom levels
w  Lower levels of FDI flows
w  Less loans for investment and trade in developing countries
w  Lack of interest in new public-private partnerships requiring private sector funding
w  Overall, reduced confidence in market forces
The Multilateral Fallout
w  Global “collisions” and contradictions arise; difficult to resolve - e.g., lower budget allocations by developing countries makes them look towards UN agencies which by themselves may be hit by lower budgets - or promote trade while credit dries up
w  Doing more with less: demand by developing countries for assistance will increase while contributions to agencies are likely to decrease.
w  Proximate causes
w  Sub-prime lending
w  Originate and distribute model
w  Financial engineering, derivatives
w  Credit rating agencies
w  Tax regulations
w  Large global imbalances
Financial Crisis: Differences between US/Europe and Pakistan
  What has not happened here
      No subprime lending
      No toxic derivatives
      No bank losses threatening capital
      No bank credit crunch
      No mistrust between banks
  Our Problems
      Reduction in capital flows
  Pressure on Balance of Payment
  Stock markets performance
  Monetary and liquidity impact
  Impact on MFs/NBFCs
  Reduction in flow from non-banks
  Perceptions of credit crunch
Issues and Challenges
Fiscal Policy
  Fiscal deficit in Pakistan 
      Even before the recent setback: very high by international standards
      Contribute to the persistence of an interest rate differential with the rest of the world,
  constrains progress towards full capital account convertibility.
      Self imposed rule based fiscal correction needs to be consolidated and carried forward.
  Sustained interest rate differential also connected with the existence of a persistent inflation differential with the rest of the world.
      A key challenge is to further reduce inflation expectations toward international levels.
Monetary Policy
  A continuous need to adapt monetary management to the emerging needs of a fast growing and increasingly open economy.
  Financial deepening and increasing monetization.
      Expansion of monetary aggregates departs from their traditional relationship with real GDP growth.
      Task of monetary management: manage such growth without endangering price or financial stability.
  Further development of financial markets
  Large capital inflows in recent years
  Issues for monetary policy
      current account balance as a good guide to evaluation of the appropriate level of an exchange rate?
      to what extent should the capital account influence the exchange rate?
      implications of large current account deficits for the real economy?
  Optimal response to the large and volatile capital flows is based on
      sound macroeconomic policies
      prudent debt management
      exchange rate flexibility
      effective management of the capital account
      accumulation of appropriate levels of reserves as self-insurance and
      development of resilient domestic financial markets
      combination is country-specific; no “one size fits all”.
  Fundamentals to remain strong
      Financial sector robust
      Monetary policy – sufficient instruments, flexible
      Corporate sector not too leveraged – productivity gains
      Foreign direct investment buoyant
      Agriculture improving
      Growth domestically financed
      High growth rate
Approach to Manage Financial Stability
      Current account: Full, but gradual opening up
      Capital account and financial sector: More calibrated approach towards opening up. 
  Equity flows encouraged;
  debt flows subject to ceilings and some end-use restrictions.
  Capital outflows: progressively liberalized.
      Financial sector, especially banks, subject to prudential regulation
      both liquidity and capital. 
      prudential limits on banks’ inter-bank liabilities in relation to their net worth;
      asset-liability management guidelines take cognizance of both on and off balance sheet items
      Basel II framework: guidelines issued. 
      Dynamic provisioning
      NBFCs: regulation and supervision tightened - to reduce regulatory arbitrage.
Lessons from the Crisis
  Avoid high volatility in monetary policy
  Appropriate response of monetary policy to asset prices
  Manage capital flow volatility
  Look for signs of over leveraging
  Active dynamic financial regulation
      Capital buffers, dynamic provisioning
      Look for regulatory arbitrage incentives/ possibilities

 Lecture delivered by Dr. Babar Zaheer Butt to PhD and MS scholars at Iqra University Islamabad.