Impact of Global Financial Crisis: Developed & Emerging Economies

Introduction

Globalization has made the economies of the world conglomerate into one singular and large unit. Economies of the world can therefore not be studied in isolation because of the interrelationship brought about by the advent of globalization. It is this interconnectedness of the global economy that is however posing the greatest risk in the event of a collapse. The fact that the economies have also been structured and developed around a few major economies that tends to control the activities of the rest further makes the risk more apparent. Currently, the state of affairs is such that any adverse changes affecting the status quo of either one or all of the economies of the G-8 world economies impact the rest of the world because these economies are the ones controlling the affairs of the globe. In order to appreciate the impact of the recent global economic crisis, it is important to understand what exactly is meant by the terms developed and emerging (developing) economies (Barbara 2009, p. 142).

The criteria used to determine the level of development of an economy have been the subject of fierce debate in recent times. It has however been generally agreed that among the elements that should form part of this criteria should be the national gross domestic product (GDP) whereby states with a high level of per capita GDP are considered developed and the level of industrialization whereby developed countries in these criteria are considered those whose industries are largely tertiary and not primary.

Recent studies in global development have also emerged with the human development index (HDI) criterion of determining a country’s level of economic development. The HDI considers a number of parameters both economic and social including national income, the level of education of the citizens and their life expectancy. The HDI rating, therefore, confirms whether a country ranks as developed or otherwise.

Former United Nations Secretary General Dr. Kofi Annan once defined a developed country as that which is capable of guaranteeing its citizens a livelihood characterized by freedom, safety and health (Berlatsky 2010, p. 57).

Proponents of the use of HDI in the determination of a country’s level of economic progress pose that it is not only important to consider national income but also consider how a country utilizes (transforms) its generated income into aspects such as health and education. According to the United Nations Development Program (UNDP) & the international monetary fund (IMF) all countries ranking with over 0.800 points have a high standard of human development (Bruno 2009, p.137).

In determining a developing country, the International Monetary Fund employs a less rigid system of classification that considers not only a country’s income per capita but also exports diversity. The export diversification criteria make countries that depend on only one export e.g. oil exporters not to have a necessarily high per capita income. The IMF also considers the extent of the country’s global financial integration; a developing economy has a gross national income of fewer than 975 dollars.

Impact of the crisis on the developed and developing economies

Both developed and emerging economies have suffered immensely from the effects of this crisis, the three major effects however include first, the reduction in global exports. Statistics provided by the IMF revealed that the volume of global exports reduced significantly by volume in the year 2008 by close to 5.5% from 9.3% in the year 2007. The effects of this decline though were more pronounced in the developed economies through a reduction in terms of trade. Developing economies being majorly primary economies producing non -processed or semi processed output for exports to be fully processed by the tertiary economies in the developed world; also suffered because of the projected decline in global commodity prices (apart from the price of oil) by one fifth (Desai 2003, p. 211).

Secondly, both the developed and emerging economies experienced a sharp reduction in investments. This was however more pronounced in the developed economies because they are the initial owners of massive means of production. The cost of interest rates associated with the acquisition of capital for investments increased thus discouraging developing countries from investing. Portfolio investments in these countries also reduced substantially as a result of limited foreign direct investments because affected countries now preferred to limit their capital with their borders.

Finally, there is also expected to be a general reduction in GDP in these economies as a result as meltdown. Many world economies experienced a decline in their Gross Domestic Products in the year 2009 when the crisis had reached fever pitch. Economies of major cities in the middle east notably Dubai shrunk by close to 4 percentage points. Developing on the strength of the individual country economies, a burst in the asset market bubble also resulted in a number of sectors like the financial and banking sectors to collapse (Goldstein et al 1999, p. 73).

The global picture created by this crisis makes it difficult to differentiate the extent of this crisis and identity the most affected economies as either being emerging or developed. This is because whereas the origin of the crisis is from the developed world, its effects are felt by the emerging economies regardless of the fact that they are minor players in global business. This is because world economies are inter-twinned by globalization. This research project therefore aims to investigate the question of how the global financial crisis of 2007-2009 affects these two sets of economies. Findings of this research would shed light on the most affected areas of these economies and provide the useful insights on key elements which are differentiating the impacts of the crisis.

Literature Review

One will ask what is the “financial crisis” itself. This can be described as a steep weakening of financial indicators groups which includes asset prices and interest rates of short term, which are accompanied by a potential financial institution failure. As a result, these financial institutions as well as assets abruptly lose a significant part of their value. A lot of financial crisis are associated with banking panics where vast recessions concur with these panics. These financial crises are caused when a given nation’s bank emphasis on liquidity or give its assets more value than necessary. However, apart from bank crisis there are other institutions where the crisis occurs such as stock market crashes and financial currency crises among others. Nevertheless, financial crises have no direct impact on the changes in the real economy unless they are accompanied by depression or recession, but they have a direct impact to the paper wealth loss. As a result, many financial institutions throughout the world come stumbling down with closure of stock markets globally. This for example happened when the United State banking System experienced a financial crisis in 2007. House market suffered and there was eviction and closure of many houses. This emerged as the most horrible crisis globally ever since the incidence of Great Depression 1n 1930s. The crisis caused downfall of important businesses, caused consumer wealth decline equivalent to trillions of U.S. dollars, made the government to incur substantial financial commitment, and contributed to significant economic activity decline (Hussain et al 1998, p. 175).

As a result of global housing falling, the values of securities associated to the real estate pricing were forced to fall, significantly affecting global financial institutions negatively. In addition, the availability of credit felled interfering with the confidence of investor an aspect that affected global stock market significantly leading to vast losses. In addition, due to deterioration of international trade and credit tightening, the global economy was slowed down. One major contributor of this deterioration as argued by economists was the error introduced by investors in setting risk prices of mortgage financial products as well as mundane regulatory practices that failed to agree with 21st century financial market.

As mentioned earlier, financial crisis can occur in several faces. The first face of financial crisis is the banking crisis. A banking panic may result when banks experience massive withdrawals on customer deposits in what is called a bank run. When customers withdraw their deposits en masse, the banks having lent out most of it will have nothing to give them upon demand. This may quickly translate into bankruptcy and majority of the depositors are likely to lose their monies unless such deposits are sufficiently cushioned by a comprehensive insurance cover. What is commonly known as a credit crunch arises when the banks in possession of customer deposits do not necessarily run bankrupt but are in a state of fear to release all the customer deposits being withdrawn en masse for fear of running “broke.” The insufficient availability of funds in the banking sector does more to accelerate an economic crisis. Bank runs were experienced in the United States in the early 1930s as well as in the early 90s.

Secondly, Stock market crash is another face of financial crisis. The financial assets for example stock creates optimism when its present value of the future income, which includes dividends or interest, is exceeded by its price to be received by permanently possessing the asset. Here, many investors buy the asset with a perception that it will fetch them more when income on selling it. This results to existence of a bubble, which means that a risk of a crash in asset prices is present. This make the investors to compete in buying assets such that when time come to sell them they are faced by low price making them to suffer a significant loss. According to International Monetary Fund (2009), “the Wall Street Crash of 1929, Dutch tulip mania, the United State housing bubble, and the crash of the dot-com bubble in 2000-2001” among others are good examples of crashes in stock prices.

The third face of financial crisis is the currency crisis or balance of payments crisis. This occurs when a country with a set exchange rate is required to suddenly lower the value of its currency as a result of a tentative attack. Additionally, this involves sovereign default brought about by failure of a country in paying back its sovereign dept. According to WEFA Group (1987) “the default and devaluation can be both the voluntary government decisions as well as the involuntary outcomes of a change in the sentiment of the investors which contributes to abrupt stop in inflow of capital or a sudden increase of ‘capital flight.’” (International Monetary Fund 2009, p. 42).

The fourth financial crisis face is the recession and depression of economics. Recession is the negative GDP growth which last for two or more quarters. If this recession is however prolonged, it is no longer called recession but it becomes a depression. However, because this factor does not affect financial systems only, they are sometime not included when dealing with financial crisis. Despite this, financial crises have in various ways witnessed in causing recessions. For example according to International Monetary Fund (2009) “the busting of real estates bubble around the world and the subprime mortgage crisis resulted to recession in several countries in late 2008 and early 2009. Moreover, financial crisis have been argued to result or to be caused by recessions and not the other way round. Also where the financial crisis becomes the initial shock for recession, it does not prolong the recession process but it is other factors that play this role.” The decline in economic for instance related with 1929 crash and 1930s bank panics would not have contributed to a prolonged depression if mistakes of monetary policy on Federal Reserve part did not bring in reinforcement.

A number of examples of financial crisis will clearly describe how they took place in the past decades. These examples include:

The Latin American Debt Crisis (1960s & 70s)

In the years before 1970, there was an impressive boom in the economies of many Latin American countries, countries like Brazil, Argentina and Mexico were expanding their economies at a relatively faster rate, because of the increased productivity and boom, and there was greater need for expansion of infrastructure and creation of industries. These countries therefore experienced a deficiency of capital and this caused them to seek money in the form of foreign loans from international lending organizations. This was never going to be hard to acquire because the lenders were more than convinced these money will be repaid, their justification being the impressive economic record witnessed. The creditors having been satisfied with economic conditions, increased lending to a record 20%, the level of external borrowing for these three countries notably increased to more than four times. The world economic recession witnessed in the 1970s worsened the situation as the interest rates for loans in the United States went up; the oil prices became more expensive and the countries that had a high debt margin found it hard to honor their debt margin (Institute of Southern Asian Studies 2009, p. 173).

The effects of the crisis though limited to Latin America were adverse increasing the levels of unemployment. Because of the unemployment there was a massive drop in peoples’ disposable incomes, this coupled with the high levels of inflation, meant that the currencies of these economies lost value tremendously and so was the purchasing power of the currency. Middle class societies were hard hit with the slump in the level of economic growth. The depreciated levels of exchange rates called for a change of strategy from an ISI (Import Substitution Industrialization) to a more expanded export oriented industrialization approach. On a positive note however, pundits say that the collapse of autocratic military regimes in Brazil and Argentina were as a result of this crisis, so then the crisis is credited for the current expansion of democratic space in the region (with the exception of Cuba under Fidel Castro). Important lessons were however learnt on the admissible levels of lending to the developing countries by especially the United States and major world donors, they are given more than they can chew and end up choking in debt (International Monetary Fund 1999, p. 64).

The Asian economic crisis (1996-98)

This crisis also caused a series of major turbulence in the region. The problem was mainly blamed on a skewed economic policy adopted and followed by the Japanese economy to peg the value of the japans’ yen against the dollar in global economic transactions. In the years immediately preceding and up to 1995, the value of the United States dollar improved its value this meant that the vale of the yen particularly alongside that of neighboring currencies had to go up. This was however against the fundamentals in the economy viewed with respect to third parties. There was an immediate increase in the country’s deficits as regards their current accounts therefore the competitiveness of their exports slumped. Having pegged their currency against the dollar and the subsequent appreciation in value of the dollar meant that their exports were now more expensive. The entire region was forced to devalue currencies as was witnessed in 1977 by the likes of Singapore, Indonesia, Korea and Thailand. Public finances reduced and this forced the International Monetary Fund to inject in close to 112 billion dollars as a mitigating control (Nanto 2009, p. 159).

The underlying causes that triggered the crisis have been the subject of much debate with the Japanese government coming up strongly to defend its position. There was however a general unstable current account deficit seen in a number of economies just before the crisis a factor that is likely to have spurred the obnoxious turn of events. Any deficit beyond five percent of the country’s GDP is considered unfavorable when some countries like Thailand, Indonesia and Hong Kong had deficits exceeding this percentage limit. The presence of such huge deficits is not good for international business and points at some of the probable fault lines that may have resulted in the crisis (Reddy 2010, p. 217).

The other likely cause was the fact that a number of economies in this region were observed to be heavily dependent on the availability of short term funding from overseas lending authorities. Majority of local commercial banks within the region were blinded by prospects of making quick profits and expanding business operations to serve a larger clientele; a fact that made then opt for short term financing from overseas lenders because they wanted to expand but lacked the required capital to do so. Domestic banks were mistaken to assume that it would be easy for them to take advantage of the fixed exchange rates that was in application at that time to lower the cost of acquiring loans but this was not to happen because of what the IMF considered a weak structure on which their overall economies were pegged. Such a foreign exchange regime was not sustainable and was subject to fluctuations and adjustments as the economies in the region tried to establish an appropriate balance between fixed and fluctuating foreign exchange regimes on which to operate (Read 2009, p. 271).

The financial times also reported that there was a poor regulatory framework on the economies of South East Asia at the times preceding this crisis. Instances of corruption and even the total absence of banking ethics were noted. One was for instance more likely to find a bank in Thailand with several divisions taking money from one division and lending it to its other divisions. Some of the investments noted were of questionable nature bordering on corrupt tendencies. The governments were unable to correct malpractices in commercial banks because most of the officials in government had interests in the activities of these banks. Loans were issued to customers under unsynchronized standards and the activities of directors and bank managers were of questionable integrity. Transparency was obstructed because the government meddled in the affairs of banks not in a good sense but with an intention to cover up fraud, some banks were known to operate below the required levels of equity as guaranteed by their balance sheets. Risky lending was done with impunity (Soros 2008, p. 67).

UK Small Banks Crisis (1991-93)

The economy of Sweden is a developed mixed one with great supporters being iron core, timber, and hydropower, which represents the resources which facilitate the foreign trade economy. This has defined the nation’s main industries which are telecommunications, forestry, motor vehicles and pharmaceuticals. In the post-world War II, the country possessed a distinctive economic model characterized by a strong cooperation between the labour unions, government and corporations. As a result the nation’s economy had achieved universal and extensive social benefits which were boosted by high taxes, approximating 50% of GDP. In the 1980s, there was a formation of financial bubble and real estate which were contributed by rapid increase in lending. However, the reconstruction of the tax system aimed at emphasizing low inflation with incorporation with international economic slowdown in early 1990s resulted to bursting of the bubble (Shiller 2008, p. 471).

This resulted to fall of the GDP by 5% sky rocketing the unemployment rate between 1990 and 1993, something that caused the worst economic crisis in the country since 1930s. This shows that to a run on the currency in 1992 when the central bank jacked up interests to 500% with a determination of defending the currency’s fixed exchange rate was an effort that was futile. There was a decline of total employment by 10% during this crisis. The crisis also saw the real estate boom ending in a bust, with the government taking more than a quarter of the banking assets at a cost of about 4% of the countries GDP. As a result of GDP fall, large welfare payment and lower employment, the sustenance of the welfare system which had been growing quickly since 1970s could no longer be achieved. By 1994, the government experienced a budget deficit which exceeded 15% of GDP, which forced it to cut institute and spending aimed as a reform of improving the nation’s competitiveness (Scott 2009, p. 374).

Through the process of contagion, financial crises are eventually integrated to global crisis. This means that financial crises in one institution such as bank and crises like stock market are capable of integrating into other institutions either within a given nation or spreading to other nearby and far countries. As a result this has made contagion a common globalization factor. Moreover, technology has played a great part in enhancing contagion globally due to share of financial operating system similar within different nations. As a result, when something negative happens in one place, it spreads to other places regardless of any reason. For example, if people are in financial trouble, they are forced to sell some assets, a country with a devaluated currency puts pressure on other country’s currencies. When a situation happens in one place, there is a consideration of whether it can happen in other places (Committee on Capital Markets Regulation (U.S) 2009, p. 37).

This phenomenon can be explained by an example of an economic Crisis in Thailand that spread throughout the world. As the Thais recognized the advantage of borrowing capital from oversea which was accompanied by low interest rate in comparison to their country’s baht, foreign investor on the other hand feared that Thais might fail to repay them and they started moving their money from Thailand. As a result, the Thai central bank raised the baht/dollar interest rate to defend it currency value from the conversion of baht to dollar made by these investors. Raising the interest rate contributed to fall in price for stocks and lands. As a result, according to Velloso (2009) “huge problems cropped in Thai economy as trade deficit, huge foreign debt, and banking systems weakened from the heavy burden of unpaid loans” (Velloso 2009, p. 316).

Eventually, it was no longer possible for the Thai central bank to continue defending it currency value as it ran out of dollars making its currency value to drop alarmingly. This eventually emerged to be not only a problem of Thailand alone but also to other countries like Malaysia and Korea among others. In response to this threat, they quickly converted their currency into dollar something which resulted to decline in values of their currencies. This called for International Monetary Fund’s intervention to employ packages of emergency rescue to these nations, meant to saving the global market. However, by 1998, the crisis had spread to Brazil, Russia and many other nations. The IMF employed packages of $23 billion and $ 42 billion for Russia and Brazil consecutively making the rescue package for Asia, Russia, and Brazil to rack up some $184 billion in order to keep safe the world market (Woo et al 2000, p. 390).

2007-08 US Subprime Crisis

The crisis of the global economies can be traced to the events in the United States occasioned by a burst in the asset bubble. The US subprime mortgage crisis was as a result of problems in the real estate sector of the economy. This was caused by an unprecedented increase in mortgage delinquency ratio. The most affected sector was of course the banking sector and the subsequent vibrations had a global impact. A significant portion (more than three quarters) of all mortgages that were sold by commercial banks were those that had adjustable rates (Mathieson et al 2000, p. 247).

The mortgage cost had witnessed a boom in 2006 and later gradually began to reduce making the refinancing of the mortgage debt a difficult task. The mortgage rates shot up occasioning the subsequent loss of value of any form of securities held by commercial banks backing up the mortgages. All affected banks therefore reported shrinkage of capital (Organization for Economic Co-operation and Development 2010, p. 91).

The crisis was caused by a combination of variables on interplay taking up different phases. There was a debt crisis in the economy of the United States because initially banks would lend money to a number of high risk investors and borrowers, a number of which were immigrants with questionable citizenship status (illegal immigrants). A study by the United States Federal Reserve Bank indicated that by the year 2009, the total value of lending had reached a record high of 600 billion dollars up from only 35 billion dollars in the year 1994. The existing laxity in lending regulations made it possible for banks to issue loans without any proof that the borrower had an income; all that was needed was a way to show that the individual borrower had money in the bank. This was the beginning of the use of the No Income Verified Assets (NIVA) to give loans (WEFA Group 1987, p. 74).

The creation of the famous NINA (No income No Assets) loans meant that loaning requirements had become extensively slack to an extent that individuals could be allowed to borrow money without proving ownership of assets. For one to receive loans, it was only necessary to have a simple credit in their rating score.

The loans standards for qualification to acquire financing was responsible for the increased levels of borrowing and the resultant loans glut paralyzed the activity of banks when there was a mass failure of the loans. This was essentially the debt crisis that was the trigger of the financial crisis (Hussain et al 1998, p. 65).

The anatomy of the global financial crisis that originated from the United States of America was centered basically around home owner speculation, the sudden boom and eventual collapse of shadow banking systems and the arguably skewed government policy adopted by the federal government. The speculation surrounding home ownership had occurred when a record 1.6 million housing units were bought not because they were meant for residential purposes but because buyers had intended to sell them off in order to make profits. The cost of purchasing houses doubled and this was a totally different trend from previous years. The level of financial risk (leverage) associated with such a tendency was clearly high and when the mortgage rates increased there was a sorry collapse in the commercial banks capital from the speculation (Goldstein et al 1999, p. 561).

A number of government policies instituted by the federal government have had a direct hand in the crisis. At the time when commercial banks had slackened their lending regulations the federal government failed to regulate the activities of commercial banks. A number of other minor financial crises had taken place in the united states in earlier times notably in the mid 90s and the federal government instituted a stimulus package to revive the affected banks. This was absolutely justified considering the fact that the affected banks were strategic in the financial sector both in terms of creating employment opportunities and investments, had such a stimulus been ignored and the banks allowed to collapse, many would have lost their jobs and a number of major individual and institutional investments would go to waste. This policy to revive ailing financial institutions was however heavily criticized by a number of economic analysts saying that it created a bad culture of recklessness and impunity on the banks. Because the banks are assured of perpetual state protection any time there is a meltdown, they end up engaging in risky investments tendencies including issuing loans without adequate security. Such policies of protectionism and lack of a regulation mechanism and goodwill to regulate the activities of commercial banks also resulted in the crisis in the eyes of many analysts (Desai 2003, 87).

The increased loan packaging, incentives which included easy initial terms, marketing and a considerable term for raising prices of housing made borrowers to ignore mortgages by believing that they will be able raise more money and repay their loans. However, as the loan terms become altered with increase in interest rates accompanied by fall of housing price refinancing, it turned out to be difficult. Despite this crisis affecting the individuals within the country, other major financial institutions which had borrowed and invested in subprime mortgage-backed securities recorded massive losses. The price decline contributed to home value declining below mortgage loans which provided a financial incentive in interring foreclosure. The foreclosure brought about negative impact as it drained customer’s wealth as well as eroded the banking institutions’ financial strength (Bruno 2009, p. 120).

Conclusion

The research has shown how global financial crisis have and still affect the economy of the developed and the developing nation. The financial crisis as it is, from domestic to global have different magnitude impact toward the two type of economy depending by the face that the crisis present. For instance the research enables one to identify the difference in the impact towards these markets by a common crisis. In many instances the developed economy has shown greater sensitivity to the crisis as it acts as the initials propagator of the economic operation. Due to the massive means of production conducted in this economy, being the active trader in importing raw materials and exporting finished product, as well as holding the powerful investing system, occurrence of crisis causes more pronounced impact on it. On the other hand the developing economy suffers price drop on trading raw materials and in investment the raise of interest rates associated with acquisition of capital discourages it in investing more (Committee on Capital Markets Regulation (U.S) 2009, p. 313).

Financial crisis has resulted to crumble of powerful financial institutions in different countries bringing the GDP of the country down with decline of employment and fall of welfare systems. In addition the financial crisis has shown to contain great potential in spreading and transforming into global crisis. Through mismanagement of financial institutions such as banks and stock of one nation, globalization and technology that have enabled these systems in different nations to function under similar or connected operation hence, are spreading the crisis to other countries. In addition, some measures that a nation takes to defend its economy from crisis impact have contributed to spread of the crisis instead to other nations due to slight miscalculations. Understanding the core cause of domestic crisis is the major concept that any government should employ to be able to prevent the occurrence of the crisis within the nation which will see to reduction of global financial crisis.

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