Research Paper (undergraduate), 2010
30 Pages, Grade: Grade1
2.0 The Genesis of the Recent Financial Crisis
3.0 How the Global crisis had a devastating toll on Low-Income Countries
3.1 Channels of Impact
3.2 Resource Implications and Policy Responses
3.4 Incremental spending accounts for relatively little of the deficit increase in LICs
4.0 Policy choices confronting the Global Economy
In months I have been writing this article I accumulated more debts than I can actually repay. This paper would be incomplete without thanking the following institutions and people, who have made my PhD studies a reality; first and foremost I would like to thank Chinese Scholarship Council (CSC) and Government Republic of Zambia for sponsoring my course, Bank of Zambia (BoZ), my employers, for giving me a paid study leave to come and pursue my studies here in China, and University of Xiamen for accepting me, my supervisor Professor Huang Meibo, for her tutorship and guidance and spending her time to review this script, whom I personally owe a lot. She is been very firm on me, but kind. Further I would like to thank Prof S Liao for further review of the paper and suggestions on how I should publish this article. To my wife and children, I say many thanks for being patient and understanding.
And lastly, all my lecturers, friends, WISE Institute and Economics Department staff whom I may not have a space to mention here individually. However, all the shortcomings of this Paper are entirely mine, and no person mentioned in here bears any responsibility for them.
It is now two years since the world economic crisis started and spread vigorously across nations. The financial crisis in 2008 originated in the advanced developed countries, but it spread quickly to become a world economic crisis affecting all countries, including the emerging economies and Less Developed Countries (LDCs). The LDCs or Low Income Countries (LICs) as they are called in other economic literatures were heavily affected by the crisis in real terms.
The crisis started in the USA due to the banks dealing in securitization on mortgages. At that time those mortgages were securitized, the buyers, in secondary market assumed that housing prices would ever be rising up, and therefore the payments were not very risky; however when housing prices began to fall, many more borrowers became delinquent than they had been expected. This lead to a bubble in an economy and particularly the mortgage market as value of most assets became eroded away. The other issue that contributed to the financial crisis was the credit default swaps (CDS). The financial crisis in the USA eroded the purchasing power of the people and this translated into reduced aggregate demand for real sector economy. Through pass through effects this further translated into global economic crisis. When the global economic crisis started, initial speculation by some scholars was that the limited integration of LICs into the global financial system might insulate them from the worst effects of the crisis. But as the crisis spread onto the real economy it impacted negatively on LICs. This was done through channels of the impact such as commodity prices, trade, capital markets, revenue pressures, remittances and migration, tourism and human development.
To counter the crisis both advanced and developing countries needed holistic and coordinated approaches for stimuli packages both fiscal and monetary easing policies to boost consumer confidence and revitalize the global economy. Once consumer confidence is restored in advanced countries aggregate demand on LDCs’ commodities is likely to rebound. Further LICs will need substantial additional funding to participate effectively in a global stimulus. Sources of funding for developing countries that could be activated quickly and not subject to inappropriate conditionality are necessary in this case. Developing Countries need more policy space and less conditionalities normally attached to official lending and support provided by international financial institutions. Lastly LICs need to diversify their economies from the reliance of commodities which are vulnerable to the effects of the global recession.
The outbreak of the financial crisis in 2008 originated in the advanced developed countries, but it spread quickly to become a world economic crisis affecting all countries, including the emerging economies and Less Developed Countries (LDCs). The LDCs or Low Income Countries (LICs), as they are called in other economic literatures, were heavily affected by this crisis in real terms.
To review the trend of the global financial crisis and explore ways and means how it affected the LICs, we will look at how the crisis in global financial markets started , how it affected the real economy and eventually its impact on the LICs, then we suggest the policy choices which confronted the LICs and the United States (US). Generally will also look at how other countries have been affected by the crisis due to the pass through effects of international trade.
Therefore, this paper presents an overview of the past recent economic recession and its trends, with some attention given to U.S. and the rest of the World, particularly the LICs which were not spared by this crisis.
As noted above, this financial crisis started in the USA due to the banks dealing in securitization on mortgages. We experienced a recession that was brought on by the bursting of a massive housing bubble, one that created some $8 trillion of illusory wealth before it began to burst in mid-2006. The problem is that at the time those mortgages were securitized, the buyers (in secondary market) assumed that housing prices would ever be rising up, and therefore the payments were not very risky; however when housing prices began to fall, many more borrowers became delinquent than had been expected. This lead to a bubble in an economy and particularly the mortgage market as value of most assets became eroded away.
The next problem is that, over the last two decades, most of US banks became giant proprietary trading rooms, meaning that they were buying and selling securities for profit. They bought some slices of mortgage pools, which paid them a higher interest rate than they were paying on their bonds they used for their capitalization. Suddenly they started making money hand over fist. But when housing prices started to fall, securitized subprime mortgages started plummeting in value, they started making loses. Since the value of their debt (in form of bonds) had not changed, they became technically insolvent at that point, because their losses exceeded their capital; put another way, the money coming in from their slices of mortgage pools was not enough to pay their bondholders.
The above, describes how a bank can become technically insolvent - that is, their assets becoming worth less than their liabilities. Financial institutions also faced liquidity runs, or bank runs, whether or not they were solvent.
The other issue that contributed to the financial crisis was the credit default swaps (CDS). A CDS is a form of insurance on a bond or a bond-like security. An instrument by which companies raise money in case the financial institution you buy bonds fails to honour it when it matures. CDS had the effect of amplifying and spreading uncertainty in ways that have reduced confidence in the financial sector in US. CDS became the tool of choice for betting on the likelihood of a company going bankrupt.
Further, CDS are not regulated in US, and in fact there was a measure inserted into an appropriations bill in December 2000 that blocked any agency from regulating them. Traditional insurance, by contrast, is highly regulated. The CDS market is not, so a bank could sell as many CDS as it wanted and invest the money in anything it wanted.
So, 2008 rolled around, and bonds started going bad. There were CDS not just for traditional corporate debt, but also for mortgage-backed securities. During the boom, when everyone was optimistic, CDS for these exotic products were cheap; when they started failing, the price of CDS shot up, and anyone who had sold these swaps was looking at losses on them. So CDS were one way that losses on subprime mortgages triggered write downs at other financial institutions. This only got worse as banks, such as Bear Stearns and Lehman, started failing, and people who had sold CDS on their debt faced even larger losses. So the most basic problem with CDS is that the insurers selling them (and many of the companies selling them were not insurance companies) sold them at excessively low prices, and now they were facing major losses.
The financial crisis in the USA eroded away the purchasing power of the people and this translated into reduced aggregate demand for real sector economy. It is said that one of the biggest market for the Chinese goods is the USA, as at 2007 about 20.1 percent of Chinese goods were exported to USA as a single market. China sells most of its final products to USA and buys most of its raw materials from Africa and other LDCs. So when there was a financial crisis which eroded people’s purchasing power in USA, the demand for Chinese products shrank tremendously leading to reduced mass production by China. With this reduced production of final goods by China, China also had to reduce demand on the raw materials procured from LDCs. This further translated into global economic crisis.
The years preceding the global crisis were banner ones for LICs. Per capita income, which fell during the 1980s and 1990s, grew by 3.2 percent annually from 2001 to 2007. Financing conditions were favorable, as net private capital flows grew from 1.2 to 7.4 percent of GDP between 2000 and 2007. With current account and fiscal balances more sound than in previous periods, conditions for LICs by 2007 were fairly sound.
LICs were first hit by an unprecedented surge in fuel and food prices from 2007 through mid-2008 . For many commodity-importing countries, high prices led to deteriorating external balances, rising inflation, weaker incomes and household spending as they used up much of the economic cushion that they had developed during the preceding years of strong growth. The impact was most severe for the poor, for whom expenditures on food and fuel often represent more than 50 percent of spending.
When the financial crisis hit in the autumn of 2008, its epicenter was in the financial sectors of advanced economies. This quickly spread throughout the highly globalized financial system, impacting negatively on emerging markets around the world, even those with sound macroeconomic fundamentals. As the crisis spread from the financial sector to the real economy, policymakers rushed to respond through a combination of monetary easing and fiscal stimulus. The G-20 played a key role in the coordinated global response at their summits in Washington and London held in September 2009, at which restoration of financial stability took center stage.
When the global economic crisis started, initial speculation by some was that the limited integration of LICs into the global financial system might insulate them from the worst effects of the crisis. But as the crisis spread onto the real economy, with falling global aggregate demand, commodity prices and employment, LICs-many already reeling in the wake of the food and fuel crises faced a deterioration in economic conditions, and initial hopes that the impact would be mild quickly dissipated. Research suggests that without a concerted effort to stimulate growth, recovery in LICs would lag recovery in the rest of the world. With most LICs lacking the means to undertake countercyclical fiscal policy, the resources necessary to return them to pre-crisis growth and poverty reduction trajectories would need to come from abroad.
The economic shock that hit LICs was not similar in patterns, differing substantially across countries and regions, reflecting different economic structures, initial conditions, and the relative significance of different channels of impact. These differences, together with a shortage of high frequency data, complicated efforts to assess the impact of the crisis on the poor. But available evidence—however partial—confirms that the impact was real and large, and points to a clear erosion of recent hard-fought gains toward achieving the Millennium Development Goals (MDGs) in many of these countries. Looking ahead, there was a risk that, without extraordinary efforts both domestically and by the international community, the achievements of recent years would be lost, with potentially long-term consequences for the economic and social development of LICs, and global security and prosperity, more broadly.
The initial financial crisis triggered a real-side crisis with surprising speed . Firms and individuals reacted to tighter borrowing conditions, rising borrowing costs (interest rates), and increased uncertainty by delaying spending on investment and consumer durables. Private capital outlays across the world plummeted, and global production and trade of capital goods and consumer durables slumped. GDP losses across high-income countries surged during late 2008 and early 2009, and emerging markets were hit as well—20 of 25 middle-income countries (MICs) experienced GDP declines during the final quarter of 2008 and 24 of 26 during the first quarter of 2009.
Developments at mid-2009 suggested that the global recession may be coming to an end, although the recovery of employment was expected to lag that of output . GDP declines had slowed or ended in many advanced countries, and looking ahead, growth was expected to strengthen, underpinned by substantial fiscal and monetary stimuli—notably in the US and China. High frequency data suggested that the slowdown in global production and trade could be over, and leading indicators pointed to a strengthening recovery in output over the next few quarters. The driving force for the increase was trade, which was emerging from its trough in early 2009. While these signs offered hope for a gradual revival of world economic activity, uncertainties regarding recovery remained, including the durability of the ―green shoots emerging in major economies and the health of the banking system across the OECD. Moreover, despite tentative signs of GDP growth recovery, the private-sector—hit by waves of uncertainty and constrained access to credit—was expected to resume hiring in earnest only with a lag, suggesting that unemployment and underemployment could rise further in the near term.
 See, US International Trade Commission, US Department of Commerce, and US Census Bureau, 2007
 See Stiglitz Joseph, 2008
 See World Bank Group, 2009
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