17602300 Economics Project

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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 of rapid growth to

relatively shorter periods of contraction. The

ongoing Global Financial Crisis 2008-09actually has its roots in the closing years of

the 20th century when U.S. housing prices,

after an uninterrupted, 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

Americas largest banks and trillion-dollar government-backed 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 Frances 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 Americas largest financial services entity, filed for

bankruptcy. On September 16, American International Group (AIG), one of Americas

largest insurer, saw its market value dwindle by 95 percent (AIGs 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. Germanys 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 weeks 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 sub-prime 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 near-term 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 KPMGs 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 Managements biggest commodity fund; and Citigroups 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 wit h Losses in t he 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 t here 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.

Wit hout Smart Growt h, 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 infinancial 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 growths 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. Sri Lanka similarly registered a sharp increase in current account deficit. 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. Nepals 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. Eff ects 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 difficultexternal 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 eff ects: 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 eff ects of globalfinancial markets through adverse eff ects on capital flows from portfolio and direct foreign

investments, and also through exposure of domestic financial institutions to troubled

international financial institutions and to contractsincluding derivativesthat 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 thecrisis 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 suff ers 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 has maintained generally prudent macroeconomic policies. 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 eff ects 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 eff ects: 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 doneremarkably 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 thesame 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 Asias 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 thebenefits of a strong agriculture

recovery. The onset of the

global financial crisis suggests

a significant slowdown in

South Asias growth prospects

for 2009-10. The slowdown

will be particularly notable for

India and Pakistan. Indias

prospects will be hurt by the reduction in capital flows and possible slowdown in the growth of

exports. Pakistans 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 f ertilizer 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 Pakistanwhich 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 Asias growth benefitted from prudent macroeconomic management and

both structural and institutional reforms. Refocusing policy attention to the next phase of



structural and institutional reformswill also help growth to recover.

Pakistans Dilemma

Pakistans 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, Pakistans 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.

Pakistans 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.



Pakistans Banking Sector

Pakistans 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 Pakistans (SBP) Financial Stability Review 2007-08,

Pakistans 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, Pakistans banking sector hasnt 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 owesand 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 LCs 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 LCs

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. IPPs like HUBCO and KAPCO are also having difficulty purchasing oil

and continuing operations.



The Karachi Stock Exchange (KSE)

The Karachi Stock Exchange (KSE) is Pakistans 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 & Poors cut its outlook for Pakistans credit rating to

stable from positive on concern that security was deteriorating. On 5 November

2007, Moodys Investors Service announced that Pakistans 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 Pakistans

Textile IndustrySignificance of Textile Industry for PakistanPakistan 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 one-fifth.

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 textileproducing 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.

Pakistans Textile Industry and Global Financial Crises

Surprisingly, Pakistans 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 Pakistans

textile industry to provide basic good quality textile low priced textiles to Europe and the United Stateswhere 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

Pakistans 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 industrys 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 t he 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 onfinance 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.'

Governments 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 Pakistans 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 value- chain 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.

17602300 Economics Project

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Transcript of 17602300 Economics Project