GlobalFinancialCrisis: ImpactonBangladesh

Preparedby AnanyaRaihan ShahM.AhsanHabib

October22,2008 PresentedatSeminarorganizedbyEconomicReportersForum

GlobalFinancialCrisis:ImpactonBangladesh

Preamble:Theglobaleconomyisnowinadeepcrisis.Thecurrentcrisishastakenavery dangerousshapeandisbeingcalledthegreatestsincetheGreatDepression.Theeconomic crisisstartedin2007withshockingriseinfuelandcommodityprice. Thecrisisisnow overshadowed by global financial crisis, which started from a different origin. Now coincidingthetwocriseshavemadethingsworse.Originatedfromaspeculativebubblein therealestatesectorintheUSandbroughtseveredownturninglobaleconomies,thecurrent financialcrisisislikelytobejudgedastheharshestsincetheendofWorldWarII.1 Theeconomic crisis isnotnewinthecapitalist economic system.Interestingly,thepost BrettonWoodserawitnessedanunprecedentedwaveoffinancialcrises.Themagnitudeof thelossesincurredbytheeconomiesandbybanksduringthesecrisesisstaggering.Itisalso noteworthythatfinancialcrisesarenotuniquetoonlythepostBrettonWoodsera,historyis replete with financial crises, especially banking and exchange rate crises [IMF, 1998]. However,thefinancialcrisesinpostBrettonWoodseradifferinmanywaysfromthecrises beforethelaunchoftheBrettonWoodssystem.Theydifferinmagnitude,frequency,extent of devastation,failureofthelenderofthelastresort,contagioneffect,andinresonance throughouttheworld.However,duringtherecentcrisisofthecapitalismthegovernmentsin USA,UK,Finlandannouncenationalizationoftheprivatecompanies.Thus,thecurrentcrisis cannotbeconsideredonlyasacyclicalcrisisofthecapitalistsystem.Thetheoreticalbasisof financialcrisisandcapitalisteconomyprobablywouldberevisitedasoneoftheaftermaths ofthecrisis. Theobjectiveofthepaperistoinvestigatethecauseoftheglobalfinancialcrisisandpresent aquickanalysisofpossiblechannelsofcontagionontheBangladesheconomy.Itisdifficult to offer remedial and preparatory measures comprehensively within such a short time, howeveranattempthasbeenmadeforthataswell. 1.0TheSymptomsofCrisis 1.1 The source of current crisis is in the realestate business and investment banking, particularlyintheaggressiveuseoffinancialengineering.TheUSsubprimemortgagecrisis manifesteditselffirstthroughliquidityissuesinthebankingsystemowingtoasharpdecline in demand for assetbacked securities. Hardtovalue structured products and other instrumentscreatedduringaboomoffinancialinnovationhadtobeseverelymarkeddown duetothenewlyimplementedfairvalueaccountingandcreditratingdowngrades.Credit losses and asset write downs got worse with declining housing prices and accelerating mortgageforeclosureswhichincreasedinlate2006andworsenedfurtherin2007and2008. Anumberoffinancialinstitutionsfailed2,andprofitsatUSbanksdeclinedduetoprovisions
1

http://infoclickindia.com/article.php?art_id=1597 Themostnotablefailuressofar,havebeenthoseofthreemajorU.S.investmentbanks:BearStearns,Lehman Brothers,andMerrillLynch.BearStearnscollapsedonMarch16,2007,afterfacingmajorliquidityproblems, andwassoldtoJPMorganafterFederalReserveBankofNewYorkagreedtotakeoverBearStearnsUS$30 billionportfolioofmortgagebacksecurities.LehmanBrothersfilesforChapter11bankruptcyprotectionon September14th,2008,afterfailedattemptstosellthebanktoprivateparties.MerrillLynchwasacquiredby BankofAmericaonSeptember15th,2008.

2

forloanlosses.AsofAugust2008subprimerelatedandothercreditlossesorwritedownsby globalfinancialinstitutionsstoodatabout500billiondollars(Valenci,andLaeven,2008). Box1SymptomChronology 2007:Homesalescontinuetofall.Theplungeinexistinghomesalesisthesteepestsince 1989.InQ1/2007,S&P/CaseShillerhousepriceindexrecordsfirstyearoveryeardecline innationwidehousepricessince1991.Thesubprimemortgageindustrycollapses,anda surgeofforeclosureactivity(twiceasbadas2006)andrisinginterestratesthreatento depresspricesfurtherasproblemsinthesubprimemarketsspreadtothenearprimeand primemortgagemarkets.TheU.S.Treasurysecretarycallstheburstinghousingbubble "themostsignificantrisktooureconomy." 2008:Financialcrisisescalateswithcollapseofmajorlendersandinvestors March14,2008:BearStearnsgetsFedfundingassharesplummet. March16,2008:BearStearnsgetsacquiredfor$2asharebyJPMorganChaseinafire saleavoidingbankruptcy.ThedealisbackedbyFederalReserveprovidingupto$30Bto coverpossibleBearStearnlosses. May6,2008:UBSAGSwissbankannouncedplanstocut5,500jobsbythemiddleof 2009 September7,2008:FederaltakeoverofFannieMaeandFreddieMac September14,2008:MerrillLynchsoldtoBankofAmericaamidstfearsofaliquidity crisisandLehmanBrotherscollapse September15,2008:LehmanBrothersfilesforbankruptcyprotection September16,2008:Moody'sandStandardandPoor'sdowngraderatingsonAIG'scredit onconcernsovercontinuinglossestomortgagebackedsecurities,sendingthecompany intofearsofinsolvency. September17,2008:TheUSFederalReserveloans$85billiontoAmericanInternational Group(AIG)toavoidbankruptcy. September19,2008:Paulsonfinancialrescueplanunveiledafteravolatileweekinstock anddebtmarkets. September25,2008:WashingtonMutualwasseizedbytheFederalDepositInsurance Corporation,anditsbankingassetsweresoldtoJPMorganChasefor$1.9bn.

1.2AlongsideUSA,alargenumberofglobalsophisticatedeconomiesandfinancialmarkets arefacingthetunesofthefinancialcrisis.TheeconomyoftheUnitedKingdomhasbeenhit byrisingoilpricesandthecreditcrisis,andTheErnst&YoungItemclubpredictedgrowth ofUKonly1.5percentin2008,slowingto1percentin2009.Standard&Poor'ssaidonJuly 30,2008that70,000homeownerswereinnegativeequityanditcouldriseto1.7millionor aboutoneinsixhomeownersintheUKbasedonanexpected17percentdeclineinto2009.3 AEuropeanCommissionforecastpredictedGermany,SpainandtheUKwouldallentera recessionbytheendoftheyearwhileFranceandItalywouldhaveflatgrowth.Finland, Denmark,Netherlands,Estonia,Ukraine,Greece,andLatviasaweconomiccontractionand

http://infoclickindia.com/article.php?art_id=1597

jobcuts.TheFinlandeconomywasannouncedbankrupt.HousingpricesinAustraliafellin thesecondquarterof2008forthefirsttimeinaboutthreeyears.InJapanexportsinJune declinedforthefirsttimeinaboutfiveyears;andexportstotheUSfell21.8percent,the biggestdeclineonrecord.Singapore'seconomysawit'sbiggestdropinfiveyearsinthe secondquarter.TheforeignexchangereservesofSouthKorea'scentralbankcontainedmany depreciating"Agencybonds"andthreateningacurrencycrisis,whileinChina,astruggleis underwaytoseewhowouldswallowthelossesonUSAgenciesandTreasuries. 1.4 Therewereseverallargedeclinesinstockmarketsworldwideduring2008.Thecrisis causedpanicinfinancialmarketsandencouragedinvestorstotaketheirmoneyoutofrisky mortgagebondsandshakyequities.BeginninginSummer2008,allthreemajorstockindices intheUnitedStates(theDowJonesIndustrialAverage,NASDAQ,andtheS&P500)entered abearmarket.On15September2008,aslewoffinancialconcernscausedtheindicestodrop bytheirsharpestamountssincethe2001.Thatday,themostnoteworthytriggerwasthe declaredbankruptcyofinvestmentbankLehmanBrothers.Additionally,MerrillLynchwas joined with Bankof America in a forced merger worth $50billion. Stock market drops occurredinvirtuallyeverymarketintheworld,withRussia,BrazilandKoreabeinghardhit. 2.TheorybehindtheCrisis 2.1Thecauseofcrisisisbeinganalyzedduringeverycrisisandafterthecrisisforawhile. Theneverybodyforgetsthelessonslearnt.Everytimetheeconomistsandpolicymakerstry todevelopanewtheory,becauseprevioustheoriescannotexplainfullythecauseofcrisis. As economic crisis is frequent, a large array of literature is already available on crisis [Williamson,1994].Anycrisishasimportantcountryspecificeconomic,socialandpolitical dimensions.Whatisperceivedasaseriouscrisisinonecountrymaynotbeanissueof concern in another. A financial crisis may be defined as a drastic disequilibrium in the economyoriginatingfromthefinancialsystem.However,notalltheresultingdisequilibrium involvesacrisis.Whetherwehaveacrisissituationdependsonthemagnitudeofimbalances andcredibilityofpoliciestocorrectimbalancesandachieve'softlanding".Threetypesof crisesoriginatefromthefinancialsystem:crisisinexchangeratemechanismorcurrency crisis,bankingcrisisstemmingeitherfromliabilitysideorfromassetsideofthebalance sheetsofthefinancialinstitutions,andsecuritymarketcrisis.Acurrencycrisisistooccur whenaspeculativeattackontheexchangerateofacurrencyresultsinalargedevaluationor depreciation of the currency, or the attack forces the national authorities to defend the currencybylargevolumesofinternationalreserveinterventionorbysharplyraisinginterest rates.Abankingcrisisreferstoasituationinwhichactualorpotentialbankrunsorfailures inducebankstosuspendtheinternalconvertibilityoftheirliabilitiesorwhichcompelsthe governmenttointervenetopreventrunsorfailurebyextendingassistanceonalargescale [IMF, 1998]. A security market crisis may erupt due to speculative attack on a certain portfolioofsecurities,whichcauseschangesinmarketexpectationandultimatelyresultin sharpfallinpriceindex,marketcapitalizationanddisinvestment.Financialcrisismaybe systemicornonsystemic.Asystemicfinancialcrisiscauseslargeadverseeffectsonthereal economythroughseverelydisruptingfinancialmarkets'abilityoffinancialintermediation. Sometimes, a banking crisis may be so extensive as to assume systemic proportion. A systemic financial crisis may involve a currency crisis, but a currency crisis does not necessarilyinvolveseriousdisruptionofthedomesticpaymentssystemandthusmaynot amounttoasystemicfinancialcrisis.Finally,anothertypeofcrisisistobementioned,which 5

cancontributetoorbeinfluencedbyfinancialcrisis,debtcrisis,definedasasituationin whichacountrycannotserviceitsforeigndebt,whethersovereignorprivate[IMF,1998]. If we consider economic crisis in a broader framework, origination of a crisis creating disequilibrium may beanywhere,both inmacroeconomic and microeconomic spheres of economicactivities.Aneconomiccrisismayoriginatelocallyoritmaybeasacontagion effectofacrisisoriginatingoutsidethenationalboundary. Itmaybeobservedthatataparticulartimeperiodeitheralltypesofcrisesnamelycurrency crisis,bankingcrisisanddebtcrisismaybepresentsimultaneously,or,onetypeofcrisismay precedeasleadingintoanotherformofcrisis.Forexample,theEastAsiancrisisin199697 and199495Mexicancrisisreflectsimultaneousoccurrenceofallformsofcrises,whereas 198182ArgentineandChileancrisesarethemanifestationofbankingcrisisprecedingthat ofdebtcrisis,andinthemid1990sTurkeyandVenezuelacrisesalso,bankingproblems haveprecededcurrencycrisis.Theconversehasalsohappened,thatis,debtandcurrency crises have precipitated the bankingcrisis, incaseof1980s Mexico, Uruguay, Peruand Columbiancrises.However,itmustbeconsideredthatonetypeofcrisisprecedinganother doesnotnecessarilyimplycausality(Choudhury&Raihan,2000). 2.2 Thefinancialcrisisbecomesglobalforseveralreasons:ifweplotallthecrisesonthe worldmapitwouldbedenselyspotted,i.e.,crisesbecomeepidemicbyaffectingboththe developinganddevelopedcountries.Besides,mostofthecrisescannotbecontainedwithin nationalboundaries.Ifweconsiderbothshortrunandlongruneffectsofanycrisis,the resonancereachesevenveryfarfromtheepicenterofthecrisis.Evenifacountryavoids shortruncontagioneffects,inthelongrunitfailstoprotecttheeconomyfromtherecession asaneffectofcrisisintheepicenterfarawayfromthecountry.Theterminology"global financial crisis" came in to the economic lexicon due to globalization of crisis through deregulation,imprudentuseoffinancialengineeringinventions,technologicalrevolution,and tradeandfinancialliberalization(Choudhury&Raihan,2000). 2.3 Financial crises can entail large costs in terms of lost output and welfare and distributional effects, which are substantially magnified in simultaneous occurrence of currencyandbankingcrises.Bankingcrisesexacerbatethenegativeimpactsontheeconomy throughareductioninthevolumeofloansandmisallocationoffinancialresources.The resolutioncostsforbankingcriseshaveinsomecasesreachedover40percentofGDP,while nonperformingloanshaveexceeded30percentoftotalloans[seeTable1].Ingeneral,the resolutioncostsofbankingcriseshavebeenhigherinemergingmarketcountriesthanin industrialcountries.Moreover,bankingcriseshavebeenfoundtobemoreprolongedand morecostlythancurrencycrises:onaverageitrequiresthree(3)yearsforbankingrecovery andaveragecumulativelossinoutputhasbeenaround11.5percent[seetable2]. In this background of huge financial costs and negative impacts on economy, an understandingofimplicationsofglobalfinancialcrisesbecomesverymuchimperativeforall thecountries,Bangladeshcannotbeanexceptiontoit.

2.4 Theunderlyingcausesmostlikelycanbeattributedtoacombinationoffactors.Asof now, development in US subprime mortgage lending market is the origin of the crisis. AccordingtotheIMF(2008)WorkingPaper,bothmacroandmicrofactorsareresponsible forthecrisis.Themacroeconomiccontextischaracterizedbyaprolongedperiodofexcess globalliquidityinducedinpartbyrelativelylowinterestratessetbytheFederalReserve BankandotherCentralBanksfollowingthe2001recessionintheUnitedStates.Theexcess liquidity fueled domestic demand and in particular residential investment, triggering a significantriseinhousingpriceswhichmorethandoubledinnominaltermsbetweenthe year2000andmid2006.

Table1.SelectedCrises:CostsofRestructuringFinancialSectorsandNonperformingLoans
Country Argentina Brazil Chile Colombia Finland Indonesia Japan6 Malaysia Mexico Norway Philippines Spain SriLanka Sweden Thailand Turkey UnitedStates Uruguay Venezuela Years 198082 1985 19941996 198185 198287 199193 1994 1990s 198588 199495 198892 198187 197785 198993 199193 198387 198285 198491 198184 198083 199495 FiscalandQuasiFiscalCosts4(%ofGDP) 1355 ... 410 1941 56 810 2 3 5 1215 4 34 1517 9 45 1 3 57 31 ... 17 NonperformingLoans5 9 30 9 16 25 9 ... 10 33 11 9 ... ... 35 11 15 ... 4 ... 15 ...

Source:IMF.1998.WorldEconomicOutlook,p.78.

However, microeconomic factors related to financial regulation (and lack thereof) and industrypracticesbyfinancialinstitutionsalsoappeartohaveplayedacrucialroleinthe buildupofthebubble.Theassetsecuritization7adoptedbymanyfinancialinstitutionsduring thisperiodseemstohaveexacerbatedtheproblemunderwhichbanksmadeloansprimarily tosellthemontootherfinancialinstitutionsthatinturnwouldpoolthemtoissueasset backedsecurities(Valenci,andLaeven,2008).

EstimatedinpercentofGDPduringtherestructuringperiod.Wherearangeisshown,thelowerestimateincludesonlycostsoffunds, credit,andbondsinjecteddirectlyintothebankingsystem,whilethehigherestimateincludesotherfiscalcosts,suchasexchangerate subsidies.

5

Estimateatpeakofnonperformingloansinpercentoftotalloans.measureisdependentoncountrydefinitionsofnonperformingloans.

Costestimatesthrough1995only.Officialestimatesofthecosts,whichtakeintoaccountthecostsofsettlinghousingloancorporations "jusen',andofnonperformingloansare0.14percentand3percent,respectively.
6 7

Securitizationisastructuredfinanceprocessinwhichassets,receivablesorfinancialinstrumentsareacquired,classifiedintopools,and offeredascollateralforthirdpartyinvestment.Therearemanypartiesinvolved.Duetosecuritization,investorappetiteformortgage backedsecurities(MBS),andthetendencyofratingagenciestoassigninvestmentgraderatingstoMBS,loanswithahighriskofdefault couldbeoriginated,packagedandtheriskreadilytransferredtoothers.Assetsecuritizationbeganwiththestructuredfinancingofmortgage poolsinthe1970s.

Table2.CostsofCrisesinLostOutputRelativetoTrend Numb er of Crises Currency Crises Industrial Emerging Market Currency Crashes12 Industrial Emerging Market Banking Crashes Industrial Emerging Market Currency and Banking Crises Industrial Emerging
13

Average Recover y8 Time (inYears) 1.6 1.9 1.5 2.0 2.1 1.9 3.1 4.1 2.8

Cumulative Loss of Output per Crisis9 ( in percentage points) 4.3 3.1 4.8 7.1 5.0 7.9 11.6 10.2 12.1

Crises with Output Losses10 ( in percent) 61 55 64 71 62 74 82 67 86

Cumulative Loss of Output per Crisis with Output Loss11 ( in percentagepoints) 7.1 5.6 7.6 10.1 8.0 10.7 14.2 15.2 14.0

158 42 116 55 13 42 54 12 42

32 6 26

3.2 5.8 2.6

14.4 17.6 13.6

78 100 73

18.5 17.6 18.8

Market

Source:IMF.1998.WorldEconomicOutlook,p.78.

2.5Inalmostallavailableliterature,subprimelendingmarketboomandinterestfactorwere identified.Subprimeborrowingwasamajorcontributortoanincreaseinhomeownership ratesandthedemandforhousing. Acombinationoflowinterestratesandlargecapital inflowsfromoutsidetheUScreatedasurplusofloanablefundsandeasycreditformany yearsleadinguptothecrisis.Easycredit,combinedwiththeassumptionthathousingprices

8

AverageamountoftimeuntilGDPgrowthreturnedtotrend.BecauseGDPdataareavailableforallcountriesonlyonanannualbasis,by constructiontheminimumrecoverytimewasoneyear.
9

Calculatedbysummingthedifferencesbetweentrendgrowthandoutputgrowthafterthecrisisbeganuntilthetimewhenannualoutput growthreturnedtoitstrendandbyaveragingoverallcrises.
10 11

Percentofcrisesinwhichoutputwaslowerthantrendafterthecrisisbegan.

Calculatedbysummingthedifferencesbetweentrendgrowthandoutputgrowthafterthecrisisbeganuntilthetimewhenannualoutput growthreturnedtoitstrendandbyaveragingoverallcrisesthathadoutputlosses.
12

Currency"crashes"areidentifiedbycriseswherethecurrencycomponentoftheexchangemarketpressureindexaccountsfor75percent ormoreoftheindexwhentheindexsignalsacrisis.

13

Identifiedwhenabankingcrisisoccurredwithinayearofacurrencycrisis.

wouldcontinuetoappreciate,hadencouragedmanysubprimeborrowerstoobtainadjustable ratemortgages(ARMs)theycouldnotaffordaftertheinitialincentiveperiod.Increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices in the following period have significantly increased the supply ofhousing inventoryavailable. Thisexcesssupplyofhomeinventoryplacessignificantdownwardpressureonprices.As pricesdecline,morehomeownersareatriskofdefaultandforeclosure.Speculationinreal estatewasacontributingfactorinthecrisis.Whilehomeshadnottraditionallybeentreated asinvestmentslikestocks,thisbehaviorchangedduringthehousingboom. 2.6ExcessiveunderwritingandMortgagebrokersfailuretoexaminerepaymentcapacityof borrowerswerepointedoutbytheexpertsasresponsiblefactors.Underwritersdetermineif theriskoflendingtoaparticularborrowerundercertainparametersisacceptable.In2007, 40 percent of all subprime loans were generated by automated underwriting. Mortgage brokersdonotlendtheirownmoney.AccordingtoastudybyWholesaleAccessMortgage Research&ConsultingInc.,in2004Mortgagebrokersoriginated68%ofallresidentialloans in the US, with subprime and AltA loans accounting for 42.7% of brokerages' total production volume. The chairman of the Mortgage Bankers Association claimed brokers profitedfromahomeloanboombutdidn'tdoenoughtoexaminewhetherborrowerscould repay. 2.7 Credit rating agencies are now under scrutiny for giving investmentgrade ratings to securitizationtransactions basedonsubprimemortgageloans.Thesecuritizationofhome loansforpeoplewithpoorcreditnottheloansthemselveswastoblameforthecurrent globalcreditcrisis.Higherratingswerebelievedjustifiedbyvariouscreditenhancements includingovercollateralization(pledgingcollateralinexcessofdebtissued),creditdefault insurance,andequityinvestorswillingtobearthefirstlosses.Criticsclaimthatconflictsof interestwereinvolved,asratingagenciesarepaidbythefirmsthatorganizeandsellthedebt toinvestors,suchasinvestmentbanks. 2.8FailureoftheUSFederalReservecannotbedenied.Itwasnotfinancialliberalizationin theconventionalsense,butfinancialinnovationoffinancialinstrumentswhichthemarket and regulators failed to handle. Supported by these new financial products and asset securitization, mortgage credit markets expanded rapidly to virtually collapse in some segmentsasthefinancialcrisisunfolded.Zuberbhler(2008)observed,inrealestateboom times, the due diligence standards for the granting of loans were relaxed or just simply ignored.TheSwissbankingsectorsawthesamethinghappeningnottoolongago,whenthe lossesondomesticloansinthe1990sreachedbetween50and60billionfrancsasaresultof therealestatespeculationinthesecondhalfofthe1980s.IntheUS,however,theproblems were exacerbated by the fact that the majority of the subprime loans were granted or negotiatedbyunregulatedorhardlyregulatednonbanks(Zuberbhler,2008). 2.9 A mix of participants was involved in the crisis. These basically include: One, Homeownerseasytoobtainmortgages,combinedwiththeassumptionthathousingprices would continue to appreciate, encouraged many borrowers to obtain adjustable rate mortgages they could not afford after the initial incentive period; two, Housing market

10

housingpricecorrectionsince2006anddefaultsandforeclosureactivitycreatedanexcess inventory of homes further contributing to the downturn in the housing market; three, Financialinstituitionslendersofferedanincreasingarrayofhigherriskloanstohigherrisk borrowers and the securitized share of subprime mortgages increased significantly; four, Mortgagebrokersenjoyedbigfinancialincentivesforsellingriskierloanssincetheyearn higher commissions; five, Mortgage underwriters determine if the risk of lending to a particular borrowerisacceptable.In2007,40%ofallsubprimeloansweregeneratedby automatedunderwriting;six,Creditratingagenciesbasedontheirratings,mortgagedassets weresecuritized.(IFSL,2008). 3.ImplicationsofGlobalEconomicCrisisforBangladesh 3.1Apartfrominflictingseverefinancialcostonthecrisishitcountriesaswellasreducing worldoutputgrowth,theglobalfinancialcriseshavesofarexposedseveralweaknessesof thedevelopinganddevelopedcountriesalike.Majoramongthemarefragilitiesindomestic financialsystems,shortcomingsinmacroeconomicpolicies,imperfections ininternational capitalmarkets,andweaknessesintheinternationalfinancialarchitectureforpreventingand dealingwithcrises.Inordertounderstandtheimplicationsoffinancialcrises,oneshould visitthepoliciesalreadytakenoraretobedesignedtodealwiththeweaknesses(crises)once theyhavebeenexposedandalsowaysofpreventingthosecrisesinfuture. Figure1presentedbyChoudhuryandRaihan(2000)tirestodemonstratelinkagebetween causes,symptomsandoutcomesofafinancialcrisis.Thecausesofcurrentglobalcrisisare highlighted in the Figure 1: lack of transparency and market discipline, lax prudential regulationandsupervisionandpoorriskmanagementintheFIs.Thesymptomsare:moral hazardprobleminformofexcessiverisktakingbyFIs(locallyandinternationally),high inflation,highinterestrate,andfailureindesirableoutcomeofpolicyreforms.Theshortterm outcomesofthecrisisare:insolventfinancialinstitutions(bankingcrisis),liquiditycrisis, fiscalinsolvencyofgovernmentforbailingoutFIs.Thelongtermoutcomesasidentifiedby Choudhury and Raihan (2000) are: growth crisis and development crisis. The diagram developedin2000perfectlyfitsinunderstandingthecausesandoutcomeofthecrisis. ItistruethattheBangladesheconomywasnotaffectedimmediatelyformtheglobalfinancial crisis.Although,thecountryisalreadyinacrisissituationmainlyduetohikeinfuelprice andcommoditypriceintheglobalmarket.Itisquestion,whyitdidnothappen.Theprimary reasonisthatBangladeshseconomyisnotdependentoninternationalcapitalandthereis insignificantvolumeofforeigninvestmentinBangladeshscapitalmarket.Thus,withdrawal ofinvestment,asaherdingbehaviour,didnotaffectourfinancialsystem.Atthesametime, there is virtually no Bangladeshi investment in international capital market and banking system(exceptsovereigninvestment).So,fallingindexesofglobalcapitalmarketcouldnot affectimmediatelyeither.However,thisdoesnotmeanthatBangladesheconomywillremain immuneinthelongruneither.Thus,thenegativeimplications,asacontagioneffect,may arisefromanumberofsources,whichmightbeexplainedformtheFigure1again.The possiblecontagionfactormaybe(dashedline): a. externalsectorvulnerabilityinformofexportpriceexpectation; b. Fallingforeignaidflowduetofailureineconomicreformanddiversionoffundto newimportantdestination; 11

c. ImprudentimpositionbyInternationalorganizationsandIMFbailoutpolicy: d. Poorriskmanagementinfinancialinstitutions.

12

Figure1.GeneralizationofCauses,SymptomsandOutcomesof Figure1.GeneralizationofCauses,SymptomsandOutcomesofFinancialCrisis a. FinancialCrisis

Causes Causes
Implicitgovernment guarantee Externalsector vulnerabilityinformof exportpriceexpectation failure Fallingforeignaidflow duetofailurein economicreformand diversionofaidfundto newmoreimportant destination. Tradeliberalizationin formofdrasticremoval oftariffbarriers. Halfhearted/unprepared/ illsequencedexternal Illsequencedexternal financialliberalization ImprudentPolicy Impositionby International organizationsandIMF bailoutpolicy LackofTransparency (disclosurenorms)and Marketdisciplinein corporategovernance Laxprudential Regulationand Supervision PoorRiskManagement inFIs ExcessiveGovernment Expenditure FiscalGap PoliticalInterferencein FIs/CB

Symptom Symptom

Outcome
Outcome

Shortrun

Longrun

Moralhazardproblemin formofexcessiverisk takingbyFIs(locallyand internationally)

CADSustainabilityRisks CADSustainabilityRisks

Realexchangerate Realexchangerate appreciation appreciation Rising/highCAD Rising/highCAD Exportslowdowns Exportslowdowns

Institutions ShortRun BankingCrisis HighInflation

InsolventFinancial

HighinterestRate

Foreignexchange Scarcity CurrencyCrisis Exchangeratecrisis GrowthCrisis

Failureinhaving desirableoutcomeof policyreforms

Liquidity/Debtcrisis DevelopmentCrisis FiscalInsolvencyof governmentforbailing outFIs

Fallingovernment expenditureinsocial sector

HugeNPAandother HugeNPAandpoor poorfinancialratiosof otherfinancialratiosof FIs

NaturalCalamityinduced disruptioninproduction

Source:ChoudhuryandRaihan(2000)

13

The global recession caused by the global financial crisis may negatively impact either demandfororpriceofproductsexportedbyBangladesh.Suchimplicationmaycausefallin exportearnings,whichultimatelymaycreatepressureonbalanceofpaymentsituation.The readymadegarment(RMG)industry,themajorexportitemofBangladesh,heavilydepends on US and EU markets. There is growing concern that a prolonged recession in these economiesmayreduceconsumerspendingsignificantlyacrosstheboard,thusundermining thedemandforBangladeshiexports.AlthoughdemandforBangladesh'sexportsisnottoo sensitivetoincome,exportpricesmaydeclineandthiscouldhavesignificanteffectsonour exportearningsevenifexportvolumesremainlargelyunaffected. Itisproventhatintheperiodofcrisisandperiodfollowedbycrisis,theaidflowreducesto developing countries. Although, due to price shock crisis, developed countries pledged additionalsupporttodevelopingcountries,thesecondwaveofglobalfinancialcrisismight jeopardize that commitment. Such fall may contagion development crisis. Extraordinary bailoutpackagesannouncedbyUSandUKgovernmentscouldresourcesforaid.Thepolicy prescriptionofinternationalfinancialinstitutionsmightgoagainstmacroeconomicstability of countries like Bangladesh. The lending of commercial banks to importers may be excessively risky, as due to the fall of price of commodity in the world market, the commodityinthepipelinemightnotbesoldatapricedesiredbytheimporters.Thus,loan repaymentmaybeslower. Thesymptomsofcontagionmaybeasfollows: b. c. d. e. appreciationofrealexchangerateandexportslowdown; fallingovernmentexpenditureinthesocialsector; HugeNPAandotherpoorfinancialratiosoffinancialinstitutions; Fiscalgap.

Aprolongedcrisismaycauseinfallofexportofgoodsandremittanceearningsduetojob cuts in the counties of destinations of temporary workers. The bulk of Bangladesh's remittancescomefromtheMiddleEast,andlessthanonethirdcomefromtheUS,UKand Germany. Financial crisis is yet to affect the countrys remittance growth negatively. However,adeepandprotractedrecessioninUSandEUmayalsoaffectMiddleEastern economies.Especially,reductionoftheconsumptionofoilinUSA,EUandotherpartsofthe worldmayreduceexportearningsoftheMiddleEastandweakengrowthofthedevelopment activitiesandreducedemandforlaborclassBangladeshiremitters.Itcanbeobservedthat some stock markets in important MiddleEastern economies are already confronting the trouble.RemittancefromUSA,UKandEU,candirectlybeaffectedastheareeconomiesare undergoinghighdegreeofuncertaintyandemploymentcut. ForeignAidandothersupportmaybeaffectedinresponsetotheglobalfinancialcrisis. Governmentsinrichdonorcountriesarespendingmassiveamountstorescuetheirdomestic financialinstitutions.Theymaylookforsavingsfromothersourcestofinancethesebailouts. IMFandWorldBankhavealreadygivenaproposaltohelptheaffectedcountries.Ifthese countries agree to accept the loans from the said institutions, fund for the developing countriesmaynotbeavailable.Besides,aidforLDCincludingBangladeshmainlycomes fromUSA,EUandfromJapan,whicharenowaffectedbythefinancialcrisis.Sofundfor foreign aid may notbeeasilyavailable. The slowdowninaidflow maycauseincutof 14

expenditure insocialsectorandincreasefiscalgap.Bothgrowthcrisis anddevelopment crisismayoccurasaresultofcontagioninthelongrun. 3.2ThequestionisbeingaskednowwhetherBangladeshwillbeonlyloserfromthecrisis. Probably this is not the case. There are a few avenues, where we may also look for opportunities: a. b. c. d. e. taminginflation; inflowofsavingsfromnonresidentBangladeshis; reducingfiscaldeficit; shiftinginvestment; reducingpressureonbalanceofpayment.

ThefallinglobalfoodpriceduetofallindemandisagoodnewsforBangladesh.The combinationofthisfallandgoodharvestinnextcropseasonwouldhavepositiveimpacton thedomesticfoodinflation.TheinsecuredepositofnonresidentBangladeshisinUS,UK andotherdevelopedcountriesmayfindmoreprofitableinvestmentinbanksinBangladesh. Thereducingfuelpricewouldhavepositiveimplicationsforthegovernmentintermsof reducingsubsidiesonfuel.Furthermore,anyreductioninfuelpricewouldhavemultiplier effectfortheeconomyasBangladeshiproductsmightbemorecompetitiveduetoreduction incostofproduction.Thefarmerswouldbeparticularlybenefitedfromreducedfuelprice andwouldreducecostofirrigation,whichultimatelywouldaffectdomesticfoodprice.The competitivenessofmanycompetitioncountrieswouldbereducedduetodownwardpressure on price of export products. If crisis lingers, then investment may shift to Bangladesh, howeverthatwouldlargelydependonexchangeratesituation. Duringrecentperiodimportpaymentofthecountryfallmainlyduetothefallinpricesof petroleumproducts,wheatandedibleoil.Thegainsonaccountofreducedimportpayments canimprovefurthertheforeignreservesituation. 4.0NobodyCaresEarlywarning 4.1Therewereindicationsandwarningsonthecurrentcrises.Unprecedentedrunupinhouse pricesbetween1997and2005hadanumberofwiderangingeffectsontheeconomyofthe UnitedStates.Onanationallevel,housingpricespeakedinearly2005,begandecliningin 2006andhavenotyetbottomed.Thepossibilityofaneconomiccrisiswassuggestedby severalimportantindicatorsofeconomicdownturnworldwidein2008.Theseincludedhigh oilprices,whichledtobothhighfoodprices.Thecommoditypricehikeof2008,notablyoil andfood,rosesohighastocausegenuineeconomicdamagethreateningstagflation. 4.2 InUSA,severalmarketsarefacingtheissuesofballooninginventories,fallingprices, andsharplyreducedsalesvolumes.InAugust2006,Barron'smagazinewarned,"ahousing crisisapproaches".Fortunemagazinelabelledmanypreviouslystronghousingmarketsas "DeadZones;"otherareasareclassifiedas"DangerZones"and"SafeHavens".Fortunealso dispelled"fourmythsaboutthefutureofhomeprices." InBoston,yearoveryearpricesare dropping,salesarefalling,inventoryisincreasing,foreclosuresareup,andthecorrectionin Massachusettshasbeencalleda"hardlanding".TheFinancialTimeswarnedoftheimpact 15

ontheU.S.economyofthe"hardedge"inthe"softlanding"scenario,saying"Aslowdown intheseredhotmarketsisinevitable. 4.3BasedonslumpingsalesandpricesinAugust2006,economistNourielRoubiniwarned thatthehousingsectorisin"freefall"andwillderailtherestoftheeconomy,causinga recessionin2007.JosephStiglitz,winneroftheNobelPrizeineconomicsin2001,agreed, sayingthattheU.S.mayenterarecessionashousepricesdecline.Theextenttowhichthe economicslowdown,orpossiblerecession,wouldlastdependsinlargepartontheresiliency oftheU.S.consumerspending. 4.4 Thesupervisoryauthoritiesandcentralbanksdidinfactissuemorethanonewarning about the speculative bubble on the financial markets, the too low risk premiums, the unpredictable conduct and feedback mechanism of complex financial instruments under stress,aswellastheconsequencesofasuddenshortageofliquidityonthecapitalmarkets. The BaselCommittee onBankingSupervisioncorrectly identified theweaknessesofthe "originatetodistribute" business model shortly before the crisis struck. However, it was already toolatetoreact,andundertheimpressionofthedebateonoverregulationsome regulatoryprojectsinitiatedearlierwererelativelyslow(Zuberbhler,2008). 5.0RevisitingTheoreticalFoundations? 5.1 Inresponsetotheongoingfinancialcrisis,variousstepshavebeentriedandareonto protectthefinancialsystemandeconomy.Thesemainlyincludepolicymeasurestoincrease liquidity,depositguaranteetopreventrunonbanks,governmentguaranteeforinterbank lending, injecting liquidity to crisistorn banks for real sector financing, recapitalization, interestratecutetc.Similartoalmostallpreviouscrises,bankingsystemhealthisbeing restoredthroughacombinationofbankrecapitalizations,mergersandacquisitions,andasset sales.Tomanyobservers,theannouncementofnationalizationofailingfinancialinstitutions was unprecedented. Many enthusiasts claim it as a failure of capitalism and revival of socialisteconomicapproach.However,nationalizationsarelastresortmeasurescommonly usedinpreviouscrises.However,theyhavebeenmorecommonindevelopingcountries whereitmaybehardtofindnewownersforfailedbanks.Indevelopedeconomiessuchas theUK,wherecapitalisabundant,nationalizationsarerareandgenerallyconsideredtobe avoided. Thenationalization stanceis rather canbecoinedasnationalization ofloss of privateimprudence,notnationalizationoftheeconomy.So,thereisnochanceforcelebrate thisstance. 5.2 However,thecurrentcrisiswouldpushtheglobaleconomicleadersandeconomiststo think abouttheroleofstateincapitalist economy,aboutwhichJosephStiglitz andPaul Krugmanhavebeentellingsincelong.Traditionalneoclassicaleconomicsliteratureassumes thatmarketsarealwaysefficientexceptforsomelimitedandwelldefinedmarketfailures; Stiglitz et al. more recent studies reverse that presumption: it is only under exceptional circumstancesthatmarketsareefficient.Stiglitz(andGreenwald(1986))haveshownthat "whenever markets are incomplete and /or information is imperfect (which are true in virtually all economies), even competitive market allocation is not constrained Pareto efficient".Inotherwords,therealmostalwaysexistsschemesofgovernmentintervention which can induce Pareto superior outcomes, thus making everyone better off Greenwald

16

( 1986). Empirical evidence on the pervasiveness of these market failures is lacking. Althoughtheseconclusions,andthepervasivenessofmarketfailures,donotatallwarrant thestateinterveningbroadlyinanyeconomy,itmakesclearthatthe"optimal" rangeof government recommendable interventions is definitely much larger than the traditional "marketfailure"schoolrecognizes(Wang,2002)ForStiglitzthereisnosuchthingasan "invisiblehand"(Stiglitz,2002). Iftheroleofstateisimportantfordevelopedeconomies,whytheleastdevelopedcountries likeBangladeshshouldgoforrampantprivatization?Theansweristobesoughtnow.Letus startrethinkinggovernmentsroleineconomy. 6.0PossibleMeasures Bangladesheconomyisincrisisduetoglobalfuelandcommoditypricehikeandvarious estimateshaveshownthatabout10millionpeoplewentbacktopovertyasaresultofthis crisis.Thereareothersymptomsofcrisis,whicharefullyoriginatedformdomesticsources. For example, failure in power generation and energy crisis is probably the most deadly syndromefortheBangladesheconomy,whichalonewoulddrageconomytothelowerlevel of equilibrium and growth trajectory, if no emergency stapes are taken. Moral hazard problemhasbeencreatedwithrelaxationofdriveagainstcorruption,whichwillhavelong termnegativeimpactontheeconomicfront.Mismanagementinagriculturesectorwould bearitfruitsoon.Thus,theglobalfinancialcrisisbringsadditionalriskstotheBangladesh economyinmediumandlongterm.Thus,precautionarymeasuresareessential.Afewof themmaybe: closewatchontheexchangerateandensuringmoderatedevaluationofcurrencyfor keepingexportablecompetitive.Asthespendingonfuelandfoodimportreduced, suchmoderatedevaluationwouldnotaffectthebalanceofpaymentnegatively; reductionoffuelpricetotheextentwhichwouldnotallowlossoftheBPC.This action would have multiplier effect on the economy and cost of production of exportablewouldbeatleastcontained. Introduction of deposit insurance may be considered. Such action may prohibit potentialbankrun. Cutting the development budget for reducing wasteful expenses and focusing on enhancingsafetynetperogrammestoprotecttheachievementinpovertyalleviation earnedbydecadesofpainfulintervention.Thegovernmentintransitionwouldnotbe ableimplementmanydevelopmentprojectsastheyarebusywithnationalelection anyway. Continuationoflobbyingforadditionalfinancialaidforrecoveryoftheeconomy fromshockoffoodandfuelpricehike. Undertakingmonetaryandfiscalpolicysuitablefortheeconomy,notfortheIFIs. ReductioninconsumerlendingforreducingriskofexcessiveNPAstemmingfrom fallingimportprice. Provisioningforcashsubsidyfortheexportorientedindustrysothatbuyerretention canbeachieved. CampaigningforattractinginvestmentfromnonresidentBangladeshis. CampaigningforrelocationofinvestmenttoBangladeshfromcompetingcountriesin exportsectors. 17

Reductionofgovernmentborrowingtoreducefiscalgap. Continuationofmoderateexpansionarymonetarypolicyforcontinuinggrowthpace.

References 1. BIS(2008),Thehousingmeltdown:WhydidithappenintheUnitedStates? BIS WorkingPapersNo259,MonetaryandEconomicDepartments,Basel,Switzerland 2. ChoudhuryandRaihan.2000.GlobalFinancialCrisis:ImplicationsfortheBanking SectorinBangladesh,SAARCFINANCE. 3. FinancialCrisis:LikelyimpactonBangladeshZahidHussain,TheDailyStar,2008 4. GREENWALD,BruceandSTIGLITZ,JosephE.1986ExternalitiesinEconomies withImperfectInformationandIncompleteMarkets,QuarterlyJournalofEconomics, no.90. 5. Himmelberg, Charles, Christopher Mayer and Todd Sinai (2005), Assessing High HousePrices:Bubbles,Fundamentals,andMisperceptionsFederalReserveBankof NewYorkStaffReportsStaffReportno.218,September2005 6. IFSL (2008) Participants of the Crisis: Causes of the subprime crisis, IFSL Banking,London,2008,Februray.www.ifsl.org.uk/research 7. IMF. 1998. World Economic Outlook, May, 1998. A Survey by the Staff of the InternationalMonetaryFund.WashingtonD.C.:IMF. 8. RMGinshadowsofglobalturmoilStarBusinessReport(October14,2008) 9. Savic,Ivan(2008)CopingwithToday'sFinancialCrisis:LessonsfromthePast,G20 ResearchGroup,VisitingResearchFellow,MunkCentreforInternationalStudies.

10.Stiglitz,JosephE. Thereisnoinvisiblehand. London:TheGuardianComment,

December20,2002. 11. Valenci,FabianandLucLaeven(2008)SystemicBankingCrises:ANewDatabase, IMFWorkingPaper,ResearchDepartment,IMF,WashingtonDC 12. Wang,Shaoguang2002.TheState,MarketEconomy,andTransition.Departmentof PoliticalScience,YaleUniversity. 13. Wiiliamson,John,ed.1994.ThePoliticalEconomyofPolicyReform.Washington, D.C.:InstituteofInternationalEconomics. 14. Zuberbhler, Daniel (2008) Global credit crisis consequences for banking supervision, APaperpresentedonAnnualmediaconference,1April2008Swiss FederalBankingCommission WebsitesVisited: http://groups.google.com.bd/group/ http://soc.culture.asian.american/browse_thread/thread/c088adf972a2dc3e http://infoclickindia.com/article.php?art_id=1595 http://soc.culture.asian.americanSeptember,2008 http://infoclickindia.com/article.php?Artid=1597 http://timesofindia.indiatimes.com/World/Europe_holds_financial_crisis_summit/articleshow /3561048.cms

18

19