Economics Project

Global Economic Crises Introduction: Capitalism, an economic system whereby land, labor, production, pricing and distribution are all determined by the market, has a history of moving from extended periods relatively

of

rapid

growth

to

shorter

periods

of

contraction. The ongoing Global Financial Crisis 2008-09 actually has its roots in the closing years of the 20th century when U.S. housing

prices,

after

uninterrupted,

an

multi-year

escalation, began declining. By mid-2008, there was an almost striking

increase in mortgage

delinquencies. This increase in delinquencies was followed by an alarming loss in value of securities backed with housing mortgages. And, this alarming loss in value meant an equally alarming decline in the capital of America’s largest banks and trillion-dollar governmentbacked mortgage lenders (like Freddie Mac and Fannie Mae; the government-backed

mortgage

lenders

hold

some

$5

trillion

in

mortgage-backed securities). The $10 trillion mortgage market went into a state of severe turmoil. Outside of the U.S., the Bank of China and France’s BNP Paribas were the first international institutions to

declare substantial losses from subprime-related securities. Just underneath the U.S. subprime debacle was the European subprime catastrophe. Ireland, Portugal, Spain and Italy were the worst hit. The U.S. Federal Reserve, the European Central Bank, the Bank of Japan, the Reserve Bank of Australia and the Bank of Canada all began injecting huge chunks of liquidity into the banking system. France, Germany and the United Kingdom announced more than €163 billion ($222 billion) of new bank liquidity and €700 billion (nearly $1 trillion) in interbank loan guarantees. Towards the end of 2007, it had become quite clear that the subprime mortgage problems were truly global in nature. Of the $10 trillion around 50 percent belonged to Freddie Mac and Fannie Mae. By September 2008, the U.S. Department of Treasury was forced to place both Freddie and Fannie into federal conservatorship. On 15 September 2008, Lehman Brothers, one of America’s largest financial services entity, filed for bankruptcy. On September 16, American International Group (AIG), one of America’s largest insurer, saw its market value dwindle by 95 percent (AIG’s share fell to $1.25 from a 52-week high of $70). Germany, the fourth largest economy on the face of the planet, is economically, technologically and politically integrated with the world around it. With financial institutions going belly-up all around, credit institutions in Germany, investment firms, insurance companies and pension funds also came under severe financial stress. With bailout packages all around, Bundesministerium der Finanzen also managed to get its €480 billion bailout package approved through the Bundestag in record time. Germany’s answer to the Global Financial Crisis has been the Financial Market Stabilization Act. The Act creates a bailout

package to “stabilize financial markets, provide needed liquidity, restore the confidence of financial market players and prevent a further aggravation of the financial crisis (the Act has been enacted through federal legislation in less than a week’s time).” On 11 October 2008, finance ministers from the Group of Seven, G-7, Canada, France, Germany, Italy, Japan, the U.K. and the U.S. met in Washington but “failed to agree on a concrete plan to address the crisis.” On October 13, several European countries nationalized their banks in an attempt to increase liquidity. On November 14, leaders from twenty major economies gathered in Washington to design a joint effort towards regulating the global financial sector.

OPERATIONAL AND COMPLIANCE RISKS Operational risks associated with the global economic crisis are divided into financial and trading operational risks, while compliance risks are divided into debt compliance and reporting compliance and fraud. Operational Risks Because the global economic crisis was triggered by skyrocketing subprime mortgage foreclosures and subsequent bank lending limitations, financial risks are the primary focus of this subsection followed by a brief discussion of trading operational risks. Financial Risks: Financial risks are divided into the following risk

categories: capital costs, currency translation, liquidity, commodities, capital availability, and credit ratings. Following is a summary of the major events that have transpired under each financial risk category. Capital Costs: Because commercial banks are fearful of lending to high-

risk entities, U.S. junk bonds are now trading at more than 14 percentage points above comparable U.S. Treasury bonds relative to a spread of less than 6 percentage points in September 2008. Companies such as Texas-based El Paso Corp., one of the largest U.S. natural gas producers, were recently charged a 15.25 percent interest rate to borrow US $500 million for five years. As a result, delaying nearterm growth plans may be an appropriate strategy for companies with junk bond status given exorbitant capital costs. Capital Availability:

Except for GMAC and Chrysler Financial (the

financing arms of General Motors and Chrysler), which offer 0 percent

financing to near sub-prime U.S. consumers after receiving Troubled Asset Relief Fund Program (TARP) funds, only the highest creditworthy consumers and businesses are receiving loans. Obstacles to obtaining debt financing are compounded by declining consumer credit scores and business credit ratings. The challenge for financial institutions is to satisfy regulators who want to see more bailout monies lent out, while not making high-risk lending decisions that got them into the current crisis in the first place.15 Thus, credit markets have only partially thawed. Liquidity Risks: Participants at KPMG’s 2008 Audit Committee Round

tables III reported that liquidity risks were their top risk concern. This is especially true for commercial banks and insurance companies as stock sales satisfy about 20 percent of their liquidity needs. The remainder of their liquidity needs normally come from short-term borrowings and commercial paper, two options that are currently limited. The hedge fund industry also is facing a liquidity crisis that is forcing the selling of billions ofdollars in securities to meet investor withdrawal demands and lenders’ increased collateral requirements. As a result, many funds were liquidated in 2008, such as London-based Peloton Partners, which collapsed over bad bets on U.S. mortgages; Ospraie Management’s biggest commodity fund; and Citigroup’s Old Lane Partners. It is estimated that half of all hedge funds will either be liquidated or experience severe cash shortages in 2009

Root Causes of Crises It is not yet clear whether we stand at the start of a long fiscal crisis or one that will pass relatively quickly, like most other post-World War II recessions. The full extent will only become obvious in the years to come. But if we want to avoid future deep financial meltdowns of this or even greater magnitude, we must address the root causes. In my estimation two critical and related factors created the current crisis. First, profligate lending which allowed many people to buy overpriced properties that they could not, in reality, afford. Second, the existence of excessive land use regulation which helped drive prices up in many of the most impacted markets. Profligate lending all by itself would not likely have produced the financial crisis. It took a toxic connection with excessive land-use regulation. In some metropolitan markets, land use restrictions, such as urban growth boundaries, building moratoria and large areas made off-limits to development propelled house prices to unprecedented levels, leading to severely higher mortgage exposures. On the other hand, where land regulation was not so severe, in the traditionally regulated markets, such as in Texas, Georgia and much of the US Midwest and South there were only modest increases in relative house prices. If the increase in mortgage exposures around the country had been on the order of those sustained in traditionally regulated markets, the financial losses would have been far less. Here is a primer on the process:

The International Financial Crisis Started with Losses in the US Housing Market: There is general agreement that the US housing bubble was the proximate cause for the most severe financial crisis (in the US) since the Great Depression. This crisis has spread to other parts of the world, if for no other reason than the huge size of the American economy.

Root Cause #1 (Macro-Economic): Profligate Lending Led to Losses:

Profligate

lending,

a

macro-economic

factor,

occurred

throughout all markets in the United States. The greater availability of mortgage funding predictably led to greater demand for housing, as people who could not have previously qualified for credit received loans (“subprime” borrowers) and others qualified for loans far larger than they could have secured in the past (“prime” borrowers). When over-stretched, subprime and prime borrowers were unable to make their mortgage payments, the delinquency and foreclosure rates could not be absorbed by the lenders (and those which held or bought the "toxic" paper). This undermined the mortgage market, leading to the failures of firms like Bear Stearns and Lehman Brothers and the virtual failures of Fannie Mae and Freddie Mac. In this era of interconnected markets, this unprecedented reversal reverberated around the world.

Root

Cause

#2

(Micro-Economic):

Excessive

Land

Use

Regulation Exacerbated Losses: Profligate lending increased the demand for housing. This demand, however, produced far different results in different metropolitan areas, depending in large part upon the micro-economic factor of land use regulation. In some metropolitan markets, land use restrictions propelled prices and led to severely higher mortgage exposures. On the other hand, where land regulation was not so severe, in the traditionally regulated markets, there were only modest increases in relative house prices. If the increase in mortgage exposures around the country had been on the order of those sustained in traditionally regulated markets, the financial losses

would have been far less. This “two-Americas” nature of the housing bubble was noted by Nobel Laureate Paul Krugman more than three years

ago.

Krugman

noted

that

the

US

housing

bubble

was

concentrated in areas with stronger land use regulation. Indeed, the housing bubble is by no means pervasive. Krugman and others have identified the single identifiable difference. The bubble – the largest relative housing price increases – occurred in metropolitan markets that have strong restrictions on land use (called “smart growth,” “urban consolidation,” or “compact city” policy). Metropolitan markets that have the more liberal and traditional land use regulation experienced little relative increase in housing prices. Unlike the more strongly

regulated

markets,

the

traditionally

regulated

markets

permitted a normal supply response to the higher market demand created by the profligate lending. This disparate price performance is evidence of a well established principle of economics in operation – that shortages and rationing lead to higher prices. Among

the

50

metropolitan

areas

with

more

than

1,000,000

population, 25 have significant land use restrictions and 25 are more liberally regulated. The markets with liberal land use regulation were generally able to absorb from the excess of profligate lending at historic price norms (Median Multiple, or median house price divided by median household income, of 3.0 or less), while those with restrictive land use regulation were not. Moreover, the demand was greater in the more liberal markets, not the restrictive markets. Since 2000, population growth has been at least four times as high in the traditional metropolitan markets as in the more regulated markets. The ultimate examples are liberally regulated

Atlanta,

Dallas-Fort

Worth

and

Houston,

the

fastest

growing

metropolitan areas in the developed world with more than 5,000,000 population, where prices have remained within historic norms. Indeed, the more restrictive markets have seen a huge outflow of residents to the

markets

with

traditional

land

use

regulation

(see:

http://www.demographia.com/db-haffmigra.pdf).

Toxic Mortgages are Concentrated Where there is Excessive Land Use Regulation: The overwhelming share of the excess increase in US house

prices and mortgage exposures relative to incomes has occurred in the restrictive land use markets. Our analysis of Federal Reserve and US Bureau of the Census data shows that these over-regulated markets accounted for upwards of 80% of “overhang” of an estimated $5.3 billion in overinflated mortgages.

Without Smart Growth, World Financial Losses Would Have Been Far Less: If supply markets had not been constrained by excessive land use regulation, the financial crisis would have been far less severe. Instead of a more than $5 Trillion housing bubble, a more likely scenario would have been at most a $0.5 Trillion housing bubble. Mortgage losses would have been at least that much less, something now defunct investors and the market probably could have handled. While the current financial crisis would not have occurred without the profligate lending that became pervasive in the United States, land use rationing policies of smart growth clearly intensified the problem and turned what may have been a relatively minor downturn into a global financial meltdown.

Bottom Line All of the analysts talk about whether we are “slipping into a recession” misses the point. For those whose retirement accounts have been wiped out, or stock in financial companies has been made worthless, those who have lost their jobs and homes, this might as well be another Great Depression. These people now have little prospect of restoring their former standard of living. Then there is the much larger number of people whose lives are more indirectly impacted – the many households and people toward the lower end of the economic ladder who have far less hope of achieving upward mobility. All of this leads to the bottom line. It is crucial that smart growth’s toxic land rationing policies be dismantled as quickly as possible. Otherwise, there could be further smart growth economic crises ahead, or, perhaps even worse, a further freezing of economic opportunity for future generations.

Case of South Asia I. Overview The global financial crisis is hitting South Asia at a time when it is already reeling from the adverse effects of a severe terms-of-trade shock. Countries have

responded

by

partially

adjusting

domestic

fuel

prices,

cutting

development spending and tightening monetary policy. The adverse effects of these terms of trade losses have been substantial, reflected in a slowdown of growth, worsening of macroeconomic balances and huge inflationary pressures.

The global financial crisis will likely worsen these trends, particularly on the growth and balance of payments front. Slowdown in global economy will adversely affect South Asian exports and could hurt income from remittances. Lower foreign capital flows and harder terms will reduce domestic investment. Both will lower growth prospects.

II. Terms of Trade Shocks: 2003-2008 Huge Terms of Trade Shock: Between January 2003 and May 2008 South Asia suffered a huge loss of income from a severe terms-of-trade shock owing to the surge in global commodity prices. While MENA, LAC and ECA gained from higher prices on a net basis, South Asia lost substantially from both higher food and petroleum prices. Within South Asia, losses range from 36 percent of GDP for the tiny Island country of Maldives to 8 percent for Bangladesh. Much of the loss came from higher petroleum prices, where all countries lost. On the food account, Bangladesh lost most, followed by Nepal and Sri Lanka. Pakistan and India

actually gained, being significant rice exporters. Although reliable data is not available for Afghanistan, losses from the oil and food price crisis are believed to be substantial.

Deterioration in external and fiscal balances: The large loss of income from the terms of trade shock was partially compensated by rising remittances. Nevertheless there has been a negative impact on the external balances of most South Asian countries Pakistan suffered the most rapid deterioration in the current account balance, which turned from a surplus of around 4 percent of GDP in 2003 to a deficit of over 8

percent in 2008. account deficit.

Sri Lanka similarly registered a sharp increase in current Even in India, the current account widened sharply from a

surplus of more than 2 percent of GDP in 2004 to a deficit of over 3 percent in 2008. The current balance in Nepal that was in surplus for a fairly long period finally turned into a deficit in 2008. Only Bangladesh continued to enjoy a surplus in its current balance. These differential effects reflect a number of factors including: the relative magnitude of terms of trade shocks, the differences in compensating growth of remittances, and policy responses Bangladesh in particular benefitted tremendously from the growth in remittances. Pakistan and Sri Lanka have been facing balance of payments pressures from expansionary fiscal and monetary policies; the terms of trade shocks accelerated the deterioration Concerning fiscal balance, all countries except Sri Lanka registered sharp deterioration

The fiscal deficit widened most for Pakistan, rising from 2.4 percent of GDP in 2004 to 7.4 percent in 2008. India

had

made

good

progress in reducing fiscal deficit between 2003 and 2007.

This progress was

reversed in 2008 as sharp increase in fuel subsidies (growing from 1 % of GDP in FY2007 to an estimated 4% of GDP in FY2009) threatens to wipe off the gains made so painfully over the past few years. Bangladesh also struggled quite a bit. Budget deficit widened to almost 4 percent in 2008 and is projected to grow further to over 5 percent, mostly due to increases in food and petroleum subsidies.

Nepal’s fiscal deficit has grown from its low level in 2004 owing

mainly due to fuel subsidy. Sri Lanka has long suffered from high fiscal deficits; as a result, it seceded to pass on the global price increases in petroleum to consumers.

Impact on inflation: Rising food and fuel prices have been a major source of inflationary pressure in South

Asian

countries.

In

Afghanistan, Sri Lanka, Pakistan, Bangladesh and Nepal, food prices made a bigger impact on inflation than fuel.

In India, however, the

main surge to inflation came from fuel price increases. Afghanistan

saw the steepest increase in staple food prices between 2007 and August 2008, with wheat prices more than doubling, due to poor domestic production and export restrictions by Pakistan.

Other South Asian countries saw staple food price increases ranging from a low of only 12 percent for India to 83 percent for Sri Lanka. Prices of staple food have started to come down in all South Asian countries owing to good harvests in 2008 and falling global prices. The global oil prices have also come down sharply to around $70/barrel level as compared with the spike at $150/barrel. The combined effects of lower food and fuel prices along with demand management are reducing inflationary pressure in most South Asian countries except Pakistan.

III. Effects of the Emerging Global Financial Crisis As noted, the South Asia economies are already limping from the adverse effects of the huge terms of trade shocks of the past 6 years. The reduction in global petroleum and food prices observed over the past few months provides a silver lining for South Asia in an otherwise difficult external environment. Yet this silver lining is now heavily clouded by the emerging global financial crisis that poses tremendous downside risks to South Asia. These risks can transmit from both the financial sector in terms of volume and price of foreign capital flows as well as from the real sector based on adverse effects of a global slowdown on South Asian exports, possible downward pressure on remittances, and slowdown in private and public investment owing to higher interest rates as well as lower export demand.

(a) Financial sector effects: South Asia is fortunate to have a broadly resilient financial sector due to a combination of past financial sector reforms and capital controls that insulate these economies to a great extent from the risk of a financial crisis transmitted from abroad. However, individual country risks vary substantially as the macroeconomic performances, financial sector health and exposure to foreign capital markets differ considerably by countries. The largest economy, India, is relatively more exposed to the contagion effects of global financial markets through adverse effects on capital flows from portfolio and direct foreign investments, and also through exposure of domestic financial institutions to troubled international

financial

institutions

and

to

contracts—including

derivatives—that have undergone large value changes. The evidence so far shows significant losses in the stock market and a reduction in the flow of foreign capital. Yet these risks are countered by a fundamentally strong macro economy including prudent foreign debt management, high savings rate, solid

financial sector health, and a pro-active monetary policy management that will likely allow India to ride the crisis without destabilizing the financial sector. The Central Bank has already responded by letting the exchange rate depreciate to stem the outflow on the current account, by providing extra liquidity to the financial sector, and by raising the limit on private foreign borrowing. The nature and depth of the global financial crisis is still evolving and there is a significant downside risk of further slowing down of net capital flows and a hardening of terms. But these are countered by an overall healthy banking sector with low non-performing loans and a comfortable capital base and a pro-active monetary and exchange rate management. Foreign debt and debt service is low, and reserve cover ($274 billion) is still substantial. The high domestic saving rate (34 percent of GDP) provides added cushion. The main effects of the global financial crisis will be to reduce the availability of funds leading to higher interest rates and lower public and private investment that will hurt growth. The second largest economy, Pakistan, is much more fragile and faces the most vulnerability in the region. High fiscal and current account deficits, rapid inflation, low reserves, a weak currency, and a declining economy put Pakistan in a very difficult situation to face the global financial crisis. Efforts are now underway to arrest the decline of the macro economy through appropriate demand management including tightening of monetary and fiscal policies.

Pakistan's ability to borrow externally is already heavily

constrained and bond spreads are very high. The global financial crisis means that non-official foreign capital flows would be even more expensive than now. The contagion effects on domestic financial sector could be substantial, but stress tests suggest that the banking sector as a whole is likely to withstand the shocks. This is mainly due to the improved health of the financial sector based on past reforms. Sri Lanka suffers from high inflation and large current and fiscal

account deficits. To stem the deteriorating macro-balances Sri Lanka has started tightening monetary policy and is also trying to contain the fiscal deficit by passing on the energy price increases to consumers. The performance of the financial sector has improved over time, although there is a slight upward trend in Non-performing loans (NPL) in recent years.

The role of foreign

capital in Sri Lanka's domestic financial sector is limited. The main downside risk on the financial sector is a reduction in capital flows from outside, including for the government. There is already evidence of a rise in spreads for Sri Lanka bonds. Switching of demand to domestic financing in an environment of high inflation and further tightening of monetary policy would raise interest rates and slowdown economic activity. Financial difficulties in domestic firms could also adversely affect NPLs.

Overall, though, there is little risk of a financial

collapse. Bangladesh policies.

has

maintained

generally

prudent

macroeconomic

Balance of payments is in surplus owing to rapidly rising

remittances and prudent demand management. Inflation, which reached double digit, is now coming down due to falling food prices. Fiscal deficit has increased to 5-6 percent, but remains manageable in view of falling global oil and food prices from their global peaks last fiscal year. The financial sector is showing signs of improved health from past reforms and is mostly insulated from foreign markets because of very low private capital inflows.

External

debt is low and reserves are comfortable. In this environment, the effect of the global financial crisis on the financial sector is likely to be negligible. Bangladesh is relatively more exposed from the real economy effects of a possible slowdown in exports, especially garments, and from remittances. Nepal is emerging from a conflict situation with low growth and the adverse effects of a global food and fuel crisis. Inflation is showing signs of deceleration due to reduction in international food and fuel prices.

Its

domestic financial sector is very weak in terms of financial indicators with large non-performing loans and low capital adequacy. However, the financial sector

is pretty much insulated from global finances due to the negligible amount of foreign private capital flows. The risks to the macro economy come from a potential expansionary budget in an environment of a deteriorating global economy.

(b) The real sector effects:

The possible downside effects of the

financial sector crisis are much more direct and substantial from the real economy implications.

These will work through trade, remittances and

investments. Exports:

Based on progress on trade reforms, South Asian economies have

become much better integrated with the global economy than in the early 1990s. Exports are now over 20 percent of GDP and are a major source of growth stimulus. The recession in OECD countries will almost certainly lower the export prospects for all South Asian countries, but especially India that has done remarkably well in the services sector and now faces a sharp slowdown in demand. South Asia is also a major exporter of textiles and garments that are vulnerable to the recession in the OECD economies. Depending on the magnitude and the period of this recession, the adverse effects on exports can be large. Imports: One redeeming feature emerging from the import side is the observed

downward trend in commodity prices, especially food and fuel. The import bills on these accounts, especially fuel, are already coming. The recession in OECD countries will likely cause a further reduction in commodity prices with positive effects for South Asia. Remittances: Foreign remittances have grown rapidly in South Asia over the

past few years. These have not only provided an offsetting cushion on the balance of payments, but more importantly they have been a huge source of income and safety net for a large number of poor households in South Asia, especially in the poor countries of Afghanistan, Bangladesh and Nepal. Much of these remittances come from low-skilled workers engaged in the oil-rich

countries of the Middle East. These earnings do not face an immediate risk as these economies have huge earnings and reserves from the oil price boom and oil prices are still substantially higher than in 2002 in real terms. However, remittances from OECD countries can be adversely affected. India and Pakistan are particularly exposed to this slowdown. On balance the downside risk of substantial lower earnings from remittances appear low. Investment: The main risk to growth comes from the likely adverse effects on

investment of the combined effects of a slowdown of foreign funding and a possible increase in non-performing assets of domestic banks owing to lower profitability of firms producing for export markets. At the same time, higher inflation has required tightening of monetary policy. All of these factors will reduce the availability of domestic financing of private investment.

Public

investment is already constrained by rising fiscal deficits. Overall, there is likely to be a slowdown in the rate of domestic investment. Improvements in saving rates in South Asian economies have been an important cushion.

But

inadequate adjustment to the losses from terms of trade, combined with a possible slowdown of exports earnings and foreign capital flows will almost certainly reduce investment and growth.

(c) Impact on macroeconomic balances: As noted South Asia’s macroeconomic balances had already worsened considerably owing to the term of trade shocks. The falling commodity prices of the past few months from their peak levels were providing some relief in FY09. Inflation also has been coming down in most South Asian countries. The global financial crisis could offset some of these improvements. A slowdown in earnings from exports and remittances would tend to hurt the current account, while lower growth of important demand and falling commodity prices would tend to improve. The fiscal picture will improve from lower subsidies due to falling prices, but revenue earnings can decline from lower growth. On balance, though, we expect inflation to fall and much of the impact will be absorbed by lower growth.

IV. Growth Prospects Since 1980, South Asia has been on a rising growth path, reaching a peak of 9 percent in 2006. Growth has been on a declining trend since then. In particular, the adjustment to the terms of trade shock brought about a slowdown in growth in 2008 for all South

countries,

notwithstanding benefits

of

agriculture

a

the strong

recovery.

The onset of the global financial crisis suggests a significant slowdown in South Asia’s growth prospects for 2009-10. The slowdown will be particularly notable for India and Pakistan. India‘s prospects will be hurt by the reduction in capital flows and possible slowdown in the growth of exports.

Pakistan’s economy is already

facing difficulties; the financial crisis will aggravate it.

IV. Policy Issues and Challenges Moving Forward Growing fiscal deficits due to food and fuel subsidies and rising inflation suggest that South Asian countries have basically run out of fiscal space and do not have the option of riding out further shocks with expansionary fiscal and monetary policies. So, in the near term growth will need to fall to absorb the shock from the financial crisis. Indeed, as noted, all South Asian countries have responded with some degree of monetary tightening and cutbacks in development spending, and have also adjusted domestic fuel and fertilizer prices in varying degrees to stem the widening of the fiscal deficit. The policy option of full pass through of fuel and fertilizer prices to consumers is not a politically viable option, although further reduction of the gap between domestic and international prices and better targeting of open-ended subsidies are possible options especially

in

Pakistan

which

faces

the

largest

macroeconomic

imbalances. Falling global prices also provide some relief.

On the balance of

payments side, the flexibility of the exchange rate has been a positive factor, although this has happened only recently in Pakistan. Nevertheless, further tightening of demand, especially in Pakistan and Sri Lanka, will be necessary. Demand management will obviously need to focus on the right mix between fiscal and monetary policies with a view to ensuring that there is enough liquidity in the short-term to avoid a financial crunch while also ensuring that aggregate demand falls to reduce inflation and improve the macroeconomic balances. Over the medium term, there is substantial scope for domestic resource mobilization through the tax system that will play a key role to regain the growth momentum.

All South Asian countries can benefit

from it. In the short term, countries have tended to cut development spending to contain the rise in fiscal deficits, which is contributing to the growth

slowdown. So, better expenditure management is also a medium-term option for reconciling stabilization with growth objectives. Since

1980,

South

Asia’s

growth

benefitted

from

prudent

macroeconomic management and both structural and institutional reforms. Refocusing policy attention to the next phase of structural and institutional reforms will also help growth to recover.

Pakistan’s Dilemma Pakistan’s financial crisis predates the Global Financial Crisis. For the past several years, Pakistan has been running an unsustainable budgetary as well as trade deficits. The Government of Pakistan, with expected revenues of around $20 billion, routinely spends some $26 billion a year thus incurring a budget deficit of over 7 percent of GDP. On the trade front, accumulated exports hardly ever cross the $20 billion a year mark but imports end up exceeding $35 billion; a trade deficit in excess of $15 billion a year and a current account deficit of over $1 billion a month. In 2007-08, Pakistan’s balance of payment (BOP) crisis, as a consequence of $147 a barrel oil and a spike in commodity prices, meant a frightful depletion of foreign exchange reserves down to a less than 3-months import-cover. Inflation, in the meanwhile, shot up to over 24 percent and Pakistan stood caught in a vicious cycle of stagflation--economic stagnation plus high inflation. Pakistan’s BOP crisis had come at a time when the entire donor community including the U.S. and the Europeans were both engrossed in their own subprime disasters. Pakistan, desperate for a bailout package, pleaded the U.S., begged Saudi Arabia and urged China for a billion-dollar donation. The pleading, the begging and the urging was to

no avail. Finally, on 24 November 2008, the International Monetary Fund (IMF), reportedly allured by the United States Department of Defense, announced a 23-month, $7.6 billion, Stand-by Arrangement (SBA) of which the first tranche of $3.1 billion was released. As a consequence, foreign exchange reserves jumped from a low of $6 billion to over $9 billion.

Pakistan’s Banking Sector Pakistan’s banking sector is made up of 53 banks of which there are 30 commercial banks, four specialized banks, six Islamic banks, seven development financial institutions and six micro-finance banks. According to the State Bank of Pakistan’s (SBP) Financial Stability Review 2007-08, “Pakistan’s banking sector has remained remarkably strong

and

resilient,

despite

facing

pressures

emanating

from

weakening macroeconomic environment since late 2007.” According to Fitch

Ratings,

the

international

credit

rating

agency

dual-

headquartered in New York and London, “the Pakistani banking system has, over the last decade, gradually evolved from a weak state-owned system to a slightly healthier and active private sector driven system.” As of end-2008, data from the banking sector confirms a slowdown (after a multi-year growth pattern). As of October 2008, total deposits fell from Rs3.77 trillion in September to Rs3.67 trillion. Provisions for losses over the same period went up from Rs173 billion in September to Rs178.9 billion in October. In the meanwhile, the SBP has jacked up economy-wide rates of interest (the 3-month treasury bill auction has seen a jump from 9.09 percent in January 2008 to 14 percent as of January 2009 and bank lending rates are as high as 20 percent). Overall, Pakistan’s banking sector hasn’t been as prone to external shocks as have been banks in Europe. To be certain, liquidity is tight but that has little to do with the Global Financial Crisis and more to do with heavy government borrowing from the banking sector and thus tight liquidity and the ‘crowding out’ of the private sector.

Circular Debt On 26 January 2009, Raja Pervaiz Ashraf, Minister for Water and Power, told the Senate that the “federal government will settle half of the Rs400 billion circular debt by the end of January.” Circular debt arises when the Government of Pakistan owes—and is unable to pay--billions of rupees to Oil Marketing Companies (OMC) and to Independent Power Producers (IPPs). As a consequence, OMCs are unable to either import oil or supply oil to IPPs. In return, IPPs are unable to generate electricity and refineries are unable to open LC’s to import crude oil. According to BMA, a leading financial services entity, “The circular debt problem is seriously impacting the operations of the entire energy value chain. Due to low cash balances and liquidity as a result of the debt problem, the companies have to resort to short term financing at high interest rates. Refineries are having problems opening LC’s to import crude oil due to mounting payables and receivables. The same can be said about the OMC sector including the fact that financing costs in the entire energy sector have skyrocketed. IPP’s like HUBCO and KAPCO are also having difficulty purchasing oil and continuing operations.”

The Karachi Stock Exchange (KSE) The Karachi Stock Exchange (KSE) is Pakistan’s largest and the most liquid exchange. It was the “Best Performing Stock Market of the World for the year 2002.”

As of the last trading day of December 2008, KSE had a total of 653 companies listed with an accumulated market capitalization of Rs1.85 trillion ($23 billion). On 26 December 2007, KSE, as represented by the KSE-100 Index, closed at 14,814 points, its highest close ever, with a market capitalization of Rs4.57 trillion ($58 billion). As of 23 January 2009, KSE-100 Index stood at 4,929 points with a market capitalization of Rs1.58 trillion ($20 billion), a loss of over 65 percent from its highest point ever. According to estimates of the State Bank of Pakistan (SBP), foreign investment into the KSE stands at around $500 million. Other estimates put foreign investment at around 20 percent of the total free float. During calendar 2006 as well as 2007 foreign investors were quite actively investing into KSE-listed securities.

In September 2007, Standard & Poor’s cut its outlook for Pakistan’s credit rating to “stable” from “positive” on concern that “security was deteriorating.” On 5 November 2007, Moody’s Investors Service announced that Pakistan’s credit rating had been placed “under review.”

Towards the end of 2007, the uncertainties of the upcoming general election, a troubling macroeconomic scenario, an active insurgency in the Federally Administered Tribal Areas (FATA), double-digit inflation, a ballooning trade deficit, an unsustainable budgetary deficit and a worrying depletion in foreign currency reserves had all brought dark, threatening clouds over the KSE.

Impacts over Exports of Pakistan’s Textile Industry Significance of Textile Industry for Pakistan Pakistan textile sector is by far the most important sector of the economy contributing 57% to export earnings and engaging 38% of labor force. At present it comprised of 521 textile units (50 composite units and 471 spinning units) with installed capacity of 10.0 million spindles and 114 thousand rotors. Pakistan has third largest spinning capacity in Asia with spinning capacity of 5% of the total world and 7.6% of the capacity in Asia. The entire value chain represents production of cotton,

ginning,

spinning,

weaving,

dyeing,

printing

and

finally

garments

manufacturing. Pakistan has emerged as one of the major cotton textile product suppliers in the world with a market share of about 28% in world yarn trade and 8% in cotton cloth. The value addition in the sector accounts for over 9% of GDP and its weight age in the quantum index of large-scale manufacturing are estimated at onefifth.

An overview of impacts over Asian Textile Industry The impact of the global recession has already reached the key supplier countries of textiles including China, India and Pakistan. China until recently was the unstoppable force perceived by all textile producing countries as a major threat. However, Chinese textile industry is now severely hit by the sluggish demand as well. Textile industry in China which had seen double digit growth made massive investments in plant and equipment in the last five years. The slowdown of the global economy has rendered these investments as redundant resulting in closing of huge textile units and unprecedented layoffs. To counter this adverse situation, the Chinese government has increased export subsidies to its textile industry by $10 billion, a 55% rise after giving firm assurances rejection of protectionism and pursuance of open market policies to the G20 Summit on Financial Markets and the

World Economy. Furthermore, China apparently wants to move out of the high labor intensive mass production of basic textiles. That is why other high tech industries are getting more attention of the policy makers. India has also provided certain relief to its textile industry by reduction of excise duties, funneling more funds in the Textile Up gradation Fund and interest subvention for certain labor intensive textile sectors like handlooms, handicrafts and carpets. Indian textile industry is now perceived to be producers of high quality textile products. The Indian textile industry which has made huge investments in textiles in the last few years as a result of generous incentives including the “Technology Upgradation Fund” is also suffering due to eroded global demand. Indian companies are now looking inward and the domestic markets are now in focusing on the textile manufacturers who are looking at tier 2 and tier 3 cities to tap the market which is largely untouched by the economic downturn.

Pakistan’s Textile Industry and Global Financial Crises Surprisingly, Pakistan’s textile industry in spite of all expectations and pessimism has proven to be quite resilient and the sectors such as bedwear, towels, knitwear and synthetic textiles according to the latest statistics have shown increased exports both in terms of quantities as well as value. However, the unit price is generally seen decreased across the board. This is apparently an opportunity for Pakistan’s textile industry to provide basic good quality textile low priced textiles to Europe and the United States where discount stores like Walmart are not only surviving but also thriving in the present crisis. Producing low priced, lower margin range of textiles was until recently perceived as a weakness of Pakistan’s textile industry. According to industry sources there is no dearth of orders for the textile industry. However, increased cost of utilities and chronic power breakdowns have crippled a large section of the textile industry which needs to run 24 hours to perform efficiently. This is the time of reckoning for the textile industry of Pakistan. The window of opportunity provided by the present global crisis can be cashed if the basic demands will be addressed immediately by the government. Mere rhetoric will not suffice and the industry needs concrete steps taken like restoration of 6% R & D facility and provision of adequate and uninterrupted power necessary to keep the industry running.

Causes Pakistan Textile Industry is facing an uncertain environment. Following few factors, increase in input cost of minimum wage by 50 percent, increasing interest rates, non-guaranteed energy supplies, lack of R&D and reduction in cotton production, put a negative impact on the industry’s competitiveness internationally. Because of the entire situation the companies are downsizing, production units are shutting down; around 500,000 of the workers have already lost their jobs. After surviving from the load-shedding scenario the industry has yet to survive the gas load shedding scenario as authorities have informed the industry that they would not be to supply power for the additional load and only the sanctioned load will be supplied during the times to come.

Banker in the Office of Finance Advisor The financial crisis in the textile sector is getting deeper with every passing day, particularly because of a dilly-dallying attitude of the government towards the relief calls from the sector. Presence of a banker in the office of advisor to prime minister on finance, said the industry circles, is not less than a stumbling block to an early financial relief to the industry. According to them, the banking industry is also comfortable and taking no pressure of the situation after having a banker with a capacity to call financial shots in the finance ministry. The industry circles sincerely believe that the situation would have been different if a political person is sitting in the finance ministry.

The US Aid However, those availing the opportunity of having the audience of the Prime Minister's advisor on finance in recent past are of the view that the government has pinned all its hopes on the release of aid package from the US. According to them, the finance advisor has categorically stated that nothing can be extended to the industry unless the government gets something from its friendly countries. Rather, a joke is becoming popular among textile circles that what the government would offer to the textile sector when it lacks sufficient funds to pay the Independent Power Producers (IPPs) in order to overcome the power shortage. Interestingly, Shaukat Aziz, the predecessor of Shaukat Tarin, was also a banker by profession and

remained hostile to the textile sector, particularly the basic one, throughout his tenure as finance minister of Pakistan.

Privatization of Leading Banks The privatization of all leading banks in the country has added salt to the injury, as it is only the National Bank of Pakistan (NBP) management that is ready to extend a patient hearing to the cries of textile sector. Rest of the banking industry, otherwise, is not ready to look at the situation through the lenses provided by the textile sector. The grim situation in textile industry is getting from bad to worse and many new entrants to the sector have already closed down their units. A good number of single spinning unit holders are on their way to closure. The weaving sector is breathing hard at the oxygen ventilator. The apparel sector is left in the lurch with the termination of 6 percent Research and Development (R&D) fund for 2008-09.

Scarcity of Funds & Mark-Up Rate A scarcity of funds in the government kitty is resulting into deferment of all promises by the financial advisor to the prime minister. For example, the industry has demanded an immediate revision of the mark up rate to single digit, extension of export refinance and reactivation of subsidized financing. The finance advisor is deferring the implementation while promising to fulfill these demands 'within days' and 'not weeks.'

Government’s Approach The government is stressing upon the industry for the consolidation of the sector through mergers & acquisitions in order to effectively face tough international trading environment, as the international and regional competitive pressures are going to further build up and it will be large

corporate that are more likely to

survive. To deal with this scenario government has approved the textile package, including different measures including relief in the interest rate for loan to spinning sector and Research and Development (R&D) support to textile and clothing industry.

Our Industry - Being Conventional Although the textile sector is the backbone of Pakistan’s economy, the Government as well as the textile industry has kept their focus on conventional textiles, ignoring technical textiles and knowledge-based products. In many industrialized countries,

technical textiles account for over 50% of the total textile activity, while this figure for China is 20%.

Suggestions In facing the present challenges and preparing for the future changes – the pictures of production and textile value – addition in Pakistan must be validated for the decades to come. 'Where we should stand' is the ideal command to explore new heights in the textile sector of world. These days textiles is no longer the trade of exporting fibers, bales of cotton or fabrics. It is an arena of marvelous fibrous materials and products that may bear many times higher value return. The valuechain of textile production has an origin in cotton crop. The cotton fibers obtained are used in producing a variety of textile products from fiber to fabric. The time has come to place higher priority for raising the standards in value – addition rather limiting or concentrating the approaches. 1. Continuation of R & D package for the textile sector, if government do not appraise it then the future of textile industry, and specially the most value added apparel sector, will further go into drastic stage. 2. Price of utilities which includes, electricity and gas, are also constantly going up, and there is an urgent need that it should be reduced for the textile industry and especially for the export oriented units. 3. Exporters have asked the State Bank to make certain modifications in Export Refinance Scheme to ensure more funds for the export trade presently on decline. Leaders of several exporters associations have drawn attention of SBP to the fact that the cost of financing borne by value-added textile sector under the scheme has rendered exports uncompetitive in the world market. 4. Cut in interest rates to bring at par with Regional Competitors. 5. Tax concessions, exemptions in levies, export permits for new and potential entrants. 6. Matching Incentives be given to textile exporters. 7. Technological advancements for firms to achieve added value – value chain.

8. Textile organization should hire professional CEOs and directors.