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Global Financial Crisis: Is there a Way Out?

Dr. Arvind Gupta was Director General at the Institute for Defence Studies and Analyses, New Delhi. Click here for detailed profile
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  • November 05, 2008

    President Bush will host the first ever financial summit of the G-20 on November 15, 2008 in Washington to discuss the current global financial crisis which threatens the economic and political stability through out the world. The crisis comes on the heels of an economic crisis in the global economy in the first half of 2008 which was characterised by a record level of oil prices, global food shortages, high inflation and rising inflation in most countries.

    The summit is likely to be attended by the top leaders of G-20 countries who account for over 80 percent of the world’s economy. The Summit will provide an opportunity to the world leaders to exchange views on the current crisis and also to explore the way out.

    The global financial meltdown, which began in the US with the sub-prime crisis in 2007 in the housing mortgage sector, has expanded to include financial, credit and currency markets. The unprecedented crisis in the global financial sector has led to the drying up of liquidity, which is the life line of the global economy. Stock markets have crashed all across the world by 40 to 80 percent of their peaks a few months ago. The world economy is teetering on the brink of recession. The oil prices have fallen to less than half of their all-time high just a few months ago.

    Unlike the 1997 economic crash which began in South East Asia but spared most of the world, the present crisis began in the developed countries and has spread to the rest of the world, touching the emerging economies like Russia, China, India and Brazil and East Europe. What is interesting to note is that the emerging economies are being hurt for no fault of theirs. The fault lies with the utterly irresponsible behaviour of the US financial system which has been characterised by doubtful innovation at the expense of common sense prudence. The emerging economies are affected because they are closely linked with the US and other developed countries through a myriad of pathways.

    The global response has been unprecedented too. The countries which have lectured the rest of the world on the benefits of deregulation and capitalism have rushed to save their banks and other flagship companies from collapsing by buying their tainted, toxic assets and by even taking them over through nationalisation. Major countries have come out with huge financial bailouts to save their banks and other financial institutions from collapsing. According to the Bank of England, global bailouts will amount to about 12 percent of global GDP of $60 trillion, i.e. about $7.2 trillion of taxpayers’ money. This will be spent on recapitalisation of banks, buying out their toxic assets, state guarantees and nationalisation.

    The US has worked out a $700 billion bailout package. Other countries are not far behind. The combined EU bailout packages are estimated to be about $2.3 trillion. UK’s bailout package amounts to about $692 billion; Germany has offered about $670 billion; France $490 billion; Ireland $545 billion and Spain $140 billion. Japan has announced $275 billion worth of bailout package. Several countries have coordinated their interest rate cuts to overcome liquidity problems. Despite these massive, unprecedented bailouts, the financial system remains risk prone and volatile. In a twist of irony, socialism, the dreaded word in the citadels of capitalist finance, is being bandied about freely. Karl Marx is once again in flavour.

    Despite these measures, the crisis continues unabated as reflected in the collapse of stock markets everywhere. The world is heading towards a recession. No one yet knows the depth of the crisis – how long will it continue and where is the world headed? About a dozen countries are in acute financial distress and require emergency aid.

    It is not the first time that the global financial system has suffered a crisis. The 1997 crash caused devastation in countries like Indonesia and Thailand. The bursting of the IT bubble in 2000 led to a recession in the US in 2001. The lowering of interest rates in the US to overcome the recession led to liberal lending through mortgages and the consequent building of the housing bubble which finally burst in 2007 in the shape of the sub-prime crisis. The innovative financial engineering concealed and dispersed the risk attached to bad lending practices of the lending institutions. Thus the roots of the present crisis lay in the previous crises.

    The current crisis will have unforeseen geopolitical consequences. The crisis may lead to the weakening of the US and the rewriting of new power equations in which the emerging economies will have a greater say, provided they weather the storm better than the developed countries.

    The crisis comes at a time when the US is bogged down in war in Iraq and Afghanistan without clear exit strategies. Winning these wars is important for the US and NATO. If the US goes into recession, will it be able to sustain the two ongoing wars simultaneously? Probably not. That will have a major follow-on effect on regional security. If the US withdraws from these wars prematurely without lasting settlements, it will be seen by its adversaries to have been defeated. That will raise serious doubts among allies about the US’ ability to fulfil its security commitments.

    Is this the moment China has been waiting for? China’s astronauts concluded a space walk mission in September 2008. Following the successful conclusion of the Olympics, China’s confidence is at an all-time high while there is doom and gloom in the US. China would be watching the US’ moves carefully.

    China may be able to weather the current financial crisis better than most countries because of its huge foreign currency reserves and healthy current account and budget surpluses. During the current crisis, its economy may slow down but still grow at 9 percent, an impressive growth by any standards. The Chinese economy may provide the anchor that the world needs badly in the time of current turbulence. If that happens, China’s prestige in the world will increase tremendously. The US may have to rely upon China to ride out the current storm. President Bush called President Hu Jintao at the height of the crisis and requested him not to withdraw Chinese investments from the US treasury bonds. China cooperated. China’s say in the management of the global financial institutions, dominated hitherto by the US, Europe and Japan, may grow.

    With some luck, India might be able to weather the storm and may also see its influence grow in the world. India’s economic growth is expected to slow down to 7 percent. India also has decent foreign exchange reserves. It has somewhat uncomfortable current account and budget deficits. It is heading towards general elections which might increase political stability. The Reserve Bank of India has taken some swift action to introduce liquidity in the system. The Indian banks have not been affected much by the subprime crisis as they had limited exposure to mortgage-backed securities in the US.

    Russia has been affected severely by the financial crisis. Its stock markets have crashed by over 80 percent in a few months and there has been flight of capital from the country. The steep fall in the price of oil will reduce government’s income. But the government has over $550 billion in reserves. This has helped the government to come out with a substantial bailout package for its own companies. The government has managed to stop the fall in the value of the rouble. The Russian leaders are confident that Russia will survive the storm. They have been at the forefront of demanding a total overhaul of the global financial system, multiple reserve currencies and the emergence of new global financial centres. Russia will see in the current crisis an opportunity for bolstering its international position which suffered following the war with Georgia in August.

    Europe is in bad shape. The European banks have been battered by the subprime crisis. The governments across Europe have come out with huge bail out packages to save their financial systems. Iceland, closely linked with Europe, is in dire need of money to save its economy. Poland and Hungary are also in serous trouble. The current financial crisis is going to increase the EU’s internal troubles which have divided it along many axes. The EU may have to patch up with Russia, which remains its most important supplier of energy and where a large amount of the EU’s investment is held up.

    Japan has also come up with a large bailout package. The rise in Yen carry-trade has adversely affected its exports. The rise in the prestige and status of China in the region will adversely impact Japan’s own standing.

    There will be other geopolitical consequences whose contours are not clear as yet. For instance, faced with global recession, the nations’ commitment to fight climate change may weaken as the priority would shift to economic recovery. It will be interesting to see whether there would be a reduction in global military expenditure as the governments’ revenues decline during the slowdown. An increase in unemployment due to world recession may increase youth violence and even terrorism. The achievement of the Millennium Development Goals may fall behind schedule. The FDI inflows may reduce, thereby hurting the developing economies. The fall in economic growth will reduce the capacity of various countries to undertake developmental measures. This will make the fight against poverty difficult. The response in each country will be different depending upon the depth and extent of recession.

    The G-20 summit is being held in the backdrop of above changes. What can it hope to achieve?

    1. The summit could take up the need for reform in the current global financial architecture. The innovative but highly risky financial engineering which profited from the risk associated with mortgage-backed securities through speculations has to be blamed for much of the present crisis. The summit may discuss ways and means of strengthening the oversight of financial institutions. Early warning systems and more regulation of the financial sector may be on the cards.
    2. The role of IMF and the World Bank may also come up for discussion. Many countries, particularly the emerging economies, may get more say in the running of these institutions. In the past, the IMF lending has been associated with strict conditionalities which have brought hardships to the recipient countries. The terms and conditions under which IMF should lend to the countries need to be discussed.
    3. International cooperation is needed to handle global instabilities which spread so fast. The present crisis has shown that countries can respond quickly in a coordinated fashion. This was evident when several countries cut their interest rates at the same time. This helped provide the liquidity to global markets. But this was a one-off action. What should be the nature of cooperation amongst the various countries and what should be the institutional mechanism to achieve this may be discussed at the Summit.
    4. Emerging economies, particularly those with cash rich sovereign funds, may be called upon to extend help to the developed countries

    Russia has proposed a radical reform of the financial system. Russian President Medvedev has called for several reserve currencies and multiple financial centres. Russia is pushing for Moscow to become a financial centre. Thus, Moscow’s solution is to push for multipolarity in the international financial system. Putin said at the SCO meeting of Prime Ministers in October 2008: “The present turmoil in the global economy and on the world financial markets points to tectonic shifts in the structure of international relations; the flawed nature of monopolism has been manifested clearly in world finances and in the policy of economic egoism….In these conditions the collective structures of global management will have to act as arbiters, ensuring compatibility of their economic strategies,” he stressed. China has called for international cooperation to tackle the crisis.

    The summit will need to come to grips with the root of the present financial crisis which lay essentially in excessive greed and irresponsible behaviour of the financial institutions. Greater prudence and better supervision, coupled with an effective early warning system may be required to ensure that such a crisis does not recur in future. Greater participation of the emerging economies in the management of global financial institutions should also be ensured. However, care must be taken that greater controls do not stifle the markets altogether.