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International
Financial Crisis
What’s going on? What’s in store for us?
The
First Wave of Failure: It
is now more than one year since the financial system of the
United States of America went into deep trouble. This was
called the sub-prime credit crisis. American financial
institutions had for years been engaged on a lending spree,
financing the purchase of houses by a huge number of persons
who had no means to service their debt. Very low interest
rates imposed by the US central bank since 2001 had been
stoking up consumption backed by indebtedness and house
purchases supported by cheap loans. The credit boom that
followed inflated asset prices beyond measure. That was
before the asset price collapse and credit freeze a year
ago. There was hardly much value left now in the bad debts
that the banks and those who had joined them in extending
credit on such generous terms could obtain. Those
“assets” are still sitting on the books of the lender
banks.
Demand
for new houses soon started collapsing, sharply bringing
down a key engine of US economic growth. House prices are
even now continuing to slump. Confidence in the economy
started disappearing. Stock markets became volatile and went
on tumbling. Banks would not lend day-to-day money to each
other on fears and suspicions that they might not get repaid
by the other banks. Prohibitive interest rates emerged on
money markets, blocking the scope for further financial
transactions and, hence, economic growth. The US central
bank started pouring tons of money into banks that were on
the verge of collapse due to this situation. The public
sector thus started paying up for the serial misjudgements
of private sector lenders as well as for the US central bank
which had kept interest rates drastically depressed for
long. The contagion of the US sub-prime credit crisis spread
to the UK and to France where banks had to be salvaged by
the central banks as they threatened to bring down the whole
financial system. It is not difficult to imagine the state
of financial regulation in these countries.
The
Second Wave: It
was already difficult to fix the first crisis. Beginning
September 2008, the credit crisis intensified in the US.
This time, it is in the largely unregulated American
investment banks that the cracks started appearing. In fact,
they were deep fissures, not cracks. This has ushered a most
tumultuous and harrowing time for financial markets
worldwide. In the US, big names like Bear Sterns, Lehman
Brothers and Merrill Lynch have either failed or been taken
over. Two of the very large US house mortgage companies
called Freddie Mac and Fannie Mae were nationalised with a
huge injection of money ($85 billion) by the US government.
A global US insurance giant called AIG had to be bailed out
by the US central bank by injection of $90 billion because
its failure would not only have precipitated the failure of
other US financial institutions; it would also have extended
the contagion to several other key financial markets. To
save themselves from disaster, two of the top names in
American investment banking, Goldman Sachs and Morgan
Stanley, are currently seeking to convert to pure banking.
The
exploding financial crisis is threatening to spread to other
markets: UK, Japan, Canada, Switzerland, etc. Most European
economies are already registering negative economic growth.
The UK Chancellor, Alistair Darling, stated that the UK was
in deep economic crisis on a scale it has not seen over the
past 60 years. The US Treasury Secretary and the Chairman of
the US Federal Reserve Bank are at this very moment in front
the US Congress pleading to be allowed to pour $700 billion
of taxpayers’ money into the failing US financial system.
Congress will no doubt grant this request to buy up that
amount of non-performing debt held by US financial
institutions in a bid to shore up the banking system. The
alternative is to be prepared to see a generalisation of the
systemic financial sector crisis and a crumbling down of the
US economy. As the crisis unfolds, it is now becoming
clearer as to where the huge risks financial institutions
worldwide were taking on in years past, in the wake of the
credit boom, had been shelved away. If you take AIG alone,
its financial products division, a fairly small segment of
the giant insurance group, has written derivatives (credit
default swaps) amounting to $450 billion. It is in places
like this that banks expanding their credit portfolios
during the credit boom were supposedly hedging and shedding
away their risks. It is this division of AIG that has
contributed significantly to the collapse of AIG. There was
no real cover against the risks. AIG was not alone in that
business.
The
cheap money policy of the US administration over so many
years has made the entire system run out of liquidity. It is
being said, chiefly in the US, that once the liquidity
crisis is stemmed, things will turn for the better. Given
the utter loss of confidence of the public and investors in
the way financial institutions have been run, it will be
long before the investor public will think of replenishing
the cash shortage of the financial institutions in crisis.
This means that it will be mostly funds obtained from the
governments and central banks that will be employed to turn
the situation around. For now, people are putting their
money and confidence in gold and Treasury securities rather
than in the strongholds of capitalism that the world’s big
financial institutions really are. Somehow, the carnage
wrought by those who have been running the failing financial
institutions should be dealt with in priority. Side by side,
the economy has been sinking and it is difficult to manage
both the financial and economic crises at the same time. The
market for consumption goods, just like the housing market,
has dipped sharply in one capitalist economy after the other
despite the socialisation of financial institutions being
increasingly undertaken over there.
All
this is the result of greed. Such was the pace of expansion
of the US finance industry lately that the share of the
American finance industry in corporate profits has shot up
from a level of 10% in the 1980s to 40% last year.
Shareholders have been pocketing huge benefits both
from soaring company profits and from the sharp increase in
share prices provoked by the cheap US interest rate policy
since at least 2001. When it comes to bailing out the failed
institutions today, it is the public in the US and those in
the rest of the interconnected global financial markets that
will bear the brunt. How many hundreds of billions or even
trillions of dollars have the shareholders and company
executives personally accumulated all these past years and
why are they not being held to account through criminal
proceedings? There is hardly any provision in the capitalist
system to bring such persons to book and they know it in
advance. Can this be called “walking away with crime”?
What
are the risks we face?
No
matter what, the world business climate will not be the same
after this shock. The scale of economic activity in our
principal export markets will come down before picking up
again. The longer it takes for those economies to pick up
the more extended will be the time taken for our economic
adjustment. It could be painful. Already, the rupee has been
depreciated. From around Rs 26 to the US dollar only
recently, it is now close to Rs 30; from Rs 40 per Euro, it
is now near Rs 44; from around Rs 51 per pound sterling, it
is heading towards Rs 55. This means the expected benefits
from a less depreciated rupee are being surreptitiously
eaten away. Should exporters successfully lobby further
rupee depreciation, the pain from resulting inflation will
intensify and purchasing power will be severely eroded once
again. Less well off people will suffer more than others.
As
external markets shrink, not because the rupee’s exchange
rate has anything to do with it, there will be inevitable
loss of jobs unless we succeed to compensate by linking up
with other emerging markets that do not bear the full brunt
of the global economic crisis. This should have been our
strategy since long, but who cares? Short liquidity on
global markets means that it will become more difficult to
come across capital inflows (IRS, portfolio investment) to
shore up our foreign exchange reserves. Another chance for
the currency hawks to depreciate the rupee with its sequel
of second round inflation? People who are busy cutting down
on their current restaurant bills in foreign countries will
not necessarily transform themselves into a swarm of
tourists to our shores. Hotel and air tariffs will have to
take care of this problem in part. Those hit by the economic
crisis in our export markets will even buy less of the
textiles we could possibly export.
All
of this is bad foreboding about the state of affairs at home
if the financial market depression combines with a prolonged
economic downturn in the West. Should emerging markets fold
back on themselves to parry against the gales of the
financial crisis lurching into a new destructive force, we
will find it tougher to weather the storm. Fortunately, an
economic downturn may keep oil prices from shooting up due
to lower demand. This should help. If food production
remained steady because of better harvests than last year,
we should expect some soothing effects from this front given
our extreme dependence on imports.
The
more tricky part will be the effect on the financial sector.
Superficially, one can say that we are not exposed to the
products of the failing financial institutions and are
therefore insulated against damage. But what about the
offshore sector if shortage of liquidity on global markets
dries up the flow of capital to the external markets we
serve? If those markets are still perceived as safe havens,
what will not go to the shaky financial institutions in the
West may find its way through us to those external markets.
We have to watch out as many jobs will be at stake in
Mauritius in the event of a reverse flow or stoppage of
liquidity flows on global markets. In sum, we should not
become prophets of doom; it all depends how long the
authorities in the West take to fix all the damage done by
their failed policies.
M.K.
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