The global economy has changed dramatically since September 2008. What began as a slump in the US real estate sector has now manifested as a global economic crisis, spreading both to rich and Poor economies. Many believe that this crisis may go down in history as the worst crisis since the Great Depression of the 1930s wiping out almost 10 trilion US dollars from the global financial markets. The most prevalent viewpoint among economists is that global economic imbalance that came about with the type of economic policies pursued by the US is at the root of the global economic crisis Mostly, the policies that led to excessive ‘consumption in the US economy contributed to the ‘growth of the rest of the world, in particular, that of Asia. When this consumption in the US economy {ellit impacted the rest of the world and manifested ‘as a global crisis. Thus we could trace the roots of the crisis to the US economic management during the last two decades or so. US Economic Management and Behaviour In the mid-1990s, during the Clinton era, the USA showed impressive factor productivity led growth. This economic growth led to various pressures from the banking sectors to further deregulate the financial sector for easy lending. One of the key victims of the financial deregulation exercise initiated by the Clinton administration was the Glass-Steagle Act which was a solid pillar of Franklin D. Roosevelt's ‘New Deal’. This Act was abolished in 1999 under the Financial Service Modernization Act and replaced with the Gramm-Laech-Billy Act. The new Act allowed investment banks to engage in Commercial Banking and vice versa. The Clinton led economic boom continued till 2000 and during these years there was a gradual erosion of the US traditional household prudence. US households used to save 8 per cent of th disposable income, but during the late 1990s the households went on a borrowing and spending Spree, and savings reduced to 2 per cent of {disposable income by the early 2000 and virtually feduced to zero by 2005/2006 (Table 1). In the year 2000 the world saw the dot.com crash and this was followed by the 9/11 terror attack in 2001 and both these events had an adverse impact ‘on the US economy. The economic uplifting of the newly elected Bush administration was based on further deregulating the economy, debt financing of ‘consumption and investment, and high leveraging Ofthe private sector. The deregulating exercise was {governed by the basic assumptions of: (a) financial markets are self-correcting, and b) tax cuts are self-financing. Growing US trade deficits during this period were financed by increasing trade surpluses of China, dapan, and other Asian countries that had accumulated large foreign-exchange reserves and were wiling to buy dollar denominated assets. Large capital inflows based on the strength of the Global Economic Crisis and Sri Lanka Dr. Saman Kelegama Executive Director institute of Policy Studies US dollar permitted the US government to maintain a low interest rate. The Governor of the Federal Reserve Bank, Alan Greenspan, permitted a relaxed monetary policy to support the low terest rates. Greenspan did not fear an westment bubble from excessive borrowing because he strongly believed in the information revolution created by the web that would keep investors informed of risky situations. Low interest rates meant that consumers needed other high return sources to put their savings and in this environment real estate became an attractive alternative. With increased investment in the real estate sector the price of real estate increased, encouraging further investments in the sector via mortgages. Sub-prime mortgages too saw a dramatic increase (sub-prime lending is the practice of giving loans to borrowers who do not qualify for market interest rates owing to various risk factors). Many young couples saw this as an opportunity and embarked on a borrowing spree. By mid-2007 real estate prices had risen by 70 per cent compared to 1995 and a speculative “bubble” was visible in the sector. With the 1999 new Act, banks created sophisticated mortgage-backed investment products by roping in other financial companies and sold these products to investors. The bubble created an estimated US $ 8 trillion in inflated new wealth, The financial deregulation together with a plethora of financial instruments and risk management techniques (bundling assets. and issuing asset-backed collateralized debt securities [CDS], mortgage-backed securities, credit default swaps, etc.) encouraged a massive accumulation of financial assets supported by growing levels of debt. inthe household, corporate and public sectors. This rapid expansion of debt was made possible by the shift from a traditional “buy-and-hold” banking model to a “securitization” trading model. The leverage ratios of some financial institutions went up as high as 30, well above the ceiling of 10 generally imposed on deposit banks. Real estate investment grew and financial experts felt that they had conquered risks. The investment boom permitted financial managers to reward their Senior Executives with multi-million dollar bonus packages. More than US $ 18 bn. was paid as bonuses to a few financial experts/CEOs in just over an year. All these deregulation led operations gave a false sense of security of economic dynamism in the country. Thus the US consumers had a boom time. The average US consumer had 3-5 credit cards and their consumption was ‘in line with the ‘Permanent Income Hypothesis’ articulated by Milton Friedman. In short, US growth was largely driven by consumer demand, stimulated by easy credit and underpinned by booming house prices as well as high rates of investment demand. Contd. Page 12Global Economic Crisis and Sri Lanka - Dr. Saman Kelegama Meanwhile, the US dollar started to depreciate to correct the increasing trade deficit. During 2002-2007, US dollar depreciated 38 per cent against the Euro, 30 per cent against the Sterling, and 39 per cent against the Canadian dollar. This led to gradual erosion of confidence on the US dollar. With the US doliar losing value, oil was seen as a future investment and speculative buying of ol grew, further increasing the price of oil (the rapid increase in demand for oil in India and China also contributed to the oil price increase since 2005). Finding alternative cheaper sources for oil started with bio-fuels becoming a key alternative. Bio-fuel production came at the cost of agriculture output. Thus, commodity prices faced upward pressure and this got aggravated with climate change induced decline in agriculture output (in countries, like Australia). Global inflation started to gather momentum with oil price increase and commodity price escalations. The dollar depreciation and creeping global inflation compelled US to increase the interest rates. This led the mortgage rates to go up and triggered a chain of events. First, mortgage holders could not afford to pay back their loans and. defaulted, and the ‘bubble’ burst; second, those who invested in CDSs lost; third, inter-bank lending frozened; fourth, people started withdrawing their deposits from banks as panic spread; and fifth, investment banks were unable to raise liquidity to cover the losses. All this led to the confidence on the financial market hitting rock bottom. Without any bailout helping hand extended by the US. government, the financial giant, Lehman Brothers collapsed on 15 September 2008 triggering the alarm bells. Table 2 provides on how the collapse of various banks/finance companies accelerated after the major events of Lehman Brothers collapse. Following the insolvency of a large number of banks and financial institutions in the US and Europe, financial conditions became much tighter and huge amounts of market capitalization evaporated. Banks became extra risk averse and virtually stopped giving loans. Production lines came to a standstill without credit. On the other hand, consumers became extra cautious with their spending and demand for products started dwindling. The crisis unfolded very quickly and spread to the rest of the world and demystified the notion of ‘decoupling’ (see Box). No one speaks of ‘decoupling’ now and six countries outside the main economic blocks; viz, Hungary, Ukraine, Pakistan, Iceland, Latvia, and Belarus have already gone to the IMF to bail them out of the crisis. Emerging Scenario The World Economic Outlook released by the IMF predicts that 2009 would show the lowest growth, since the second World War, of 0.5 per cent which ‘means that the global economy will practically stall; asserting that the “uncertainty surrounding the 12 outlook is unusually large”. But the IMF predicted 2.2 per cent global growth for 2009 in October 2008 and this shows that the gravity of the crisis is much deeper than initially predicted. The World Bank President has stated that the economic crisis has “already pushed an estimated 100 million people back to poverty”. As the crisis intensifies policy makers around the world are shifting to a more comprehensive and internationally coordinated form of crisis, management. The measures that are taken will re-shape the previously deregulated financial markets. Massive public spending has been made available to re-capitalize banks, taking partial or full ownership of failed financial institutions and providing government guarantees on bank deposits and other financial assets. Governments around the world have started to put together fiscal and monetary stimulus packages in order to prevent the global financial crisis from tuming into a worldwide disaster. While the fuller debate on causes of the crisis would perhaps require more time, it is evident that weak regulatory controls leading to astounding leveraging ratios and inadequate corporate governance structures are at the heart of the Present predicament. Ultimately, a global crisis requires a global solution. Aside from the immediate short term actions to stabilize finance, a longer term plan for reforming the regulatory and institutional framework for the world's financial systems is urgently required. This topic was discussed at length during the G 20 Summit end of, 2008. In early February 2009, Ministers from the World’s richest nations - G 7, met in Rome and pledged to stimulated their economies and avoid trade protectionism. Populist political temptation is to resort to trade protectionism at a time like this but the G-7 pledge was welcomed by all developing countries. There are still no indications as to how the crisis will progress and as to when it will bottom out, Global Economic Crisis and Sri Lanka Developing countries like Sri Lanka have already felt the impact of the crisis. Signs of the global economic crisis were visible from early 2008 with a gradual decline in demand in developed countries for imports from developing countries. This happened at a time when oil and food prices were escalating. Normally a foreign exchange crisis manifests at such a time, however Sri Lanka did not encounter this in the first half of 2008 due to: (a) favourable prices for leading exports like tea and rubber, (b) increase in remittances with the oil boom led prosperity in the Middle East, (c) commercial borrowing of US$ 500 mn. in September 2007 by the government, and (d) inflow of foreign funds to purchase Treasury Bonds and Bills by foreigners (this was an outcome of opening up 10 per cent of the total outstanding Treasury Bonds in November 2006, and 10 per cent of total outstanding Treasury Bills in November 2007 to foreigners) The foreign fund inflows till August 2008 exerted pressure on the exchange rate to appreciate, but with some interventions by the Central Bank Contd, Page 13Global Economic Crisis PS eye ann cry the exchange rate was kept at a relatively stable Position of Rs.107-108 per US Dollar till end- October 2008. However, the scenario changed after September 2008 when the US crisis aggravated with a number of US financial institutions going bust US $ 438 mn. worth of funds invested by foreigners in Treasury Bonds and Bills flowed out from Sri Lanka during the last 3 months of 2008 (CBSL, 2009). Moreover, high prices for tea and rubber suffered a set-back from August 2008 and this was manifested in tea/rubber exporters facing a difficult situation during the last quarter of 2008. An attempt to borrow US$ 300 mn. by the government in mid-2008 also did not materialize due to the Gradually creeping liquidity crunch in the global financial markets. Obviously, these developments made a dent ‘on the foreign reserves (which dropped close to US $ 1.7 bn. by end - 2008 - approximately 1.5 month worth of imports) and generated pressure ‘onthe exchange rate to depreciate. This is a normal market phenomenon to increase foreign exchange feserves when a depletion occurs. However, the Central Bank pursued a policy to defend the ‘currency at existing rates and as a result US $ 202.7 mn. in September 2008, US$ 587.5 mn. in October 2008, US$ 266 mn. in November 2008, and US$ 125 mn. in December 2008 was injected to the ‘market to maintain the Rupee at a pre-determined fate or defend a ‘soft peg’ with the US $, first at Rs, 108 and then at Rs. 110 (www.lbo.\k ) Exchange Rate Depreciation: Pros and Cons Itmay be pertinent to ask why more than US $ 1 bn was used to defend the currency in recent months when the exporters were complaining by October 2008 that they were finding it difficult to compete without a depreciating currency. In fact, if the behaviour of the exchange rate during 2008 is examined in the context of inflation for a sample of ‘countries, we can see the unrealistic position of the ii Lankan exchange rate vis-a-vis its competitors (Vide Table). While most countries that faced inflation much less than Sri Lanka have depreciated their currency more than 20 per cent (e.g., India, Pakistan, Korea, etc.), Sri Lanka has depreciated ‘only 4.25 per cent in 2008. If not for the relaxation ‘of restrictions by the Central Bank on the 30th of pee 2008 (Financial Review, The Island, 31 r 2008), the depreciation would have been {ess than 2 per cent. government of Sri Lanka has several areas in ‘when considering the currency depreciation. |. when public debt at 88 per cent of GDP has 40 per cent GDP as foreign debt, the ication of depreciation on debt payment mes an issue. This is because the iment has to use more domestic currency to foreign currency to repay the debt and jently, the debt payments can aggravate budget deficit and reduce space for meeting 13 other expenditure requirements. Second, the cost of imports will increase with depreciation thus applying brakes on the gradually reducing inflation. Cost of living could be an important issue if the government is contemplating on calling a General Election in 2009. Third, the government may want to give an assurance to some foreign investors on the stability of the currency and above alll feel that the new methods, as announced in the Road Map to Monetary Policy 2009, to raise foreign exchange via the Sri Lankan diaspora may be diluted by a frequently changing exchange rate. Normally the exchange rate should compensate for the high cost of production and provide a reasonable return to exporters and give adequate protection for import substitution industries to move forward with reasonable competitive pressure from imports. This is not the case in Sri Lanka at present. The World Bank (2008: 9) shows that the Sri Lankan basket-based real effective exchange rate has appreciated by 25 per cent since early 2004. The IPS (2008: 26) pointed out that real effective exchange rate calculated against a basket of 24 countries appreciated by 6.5 per cent in 2007 and by further 8.3 per cent between December 2007 and May 2008. In such an environment, the exporters and import substitution industrialists will find it difficult to compete and some may even go out of production. But the government may think that imports are less costlier with the current exchange rate, and with the ‘stimulus package’ {announced on 30th December 2008) the cost of production has come down for less value added exporters (that account for the bulk of Sri Lankan exports) to retain some profit margin. For import substitution industries, the government may argue that although competition from cheaper imports has intensified, the cost of production has declined with the overall reduction of inflation in recent months. Arguments to defend the status-quo can be made (note that ‘stimulus packages’ are also offered by competitor countries and inflation is coming down more rapidly in competitor countries) but only time will indicate the adverse results of delaying the required depreciation of currency. Sri Lanka’s Strategy Sri Lanka's latest strategy to boost the foreign exchange reserve is not based on an exchange rate policy but based on three policies: (1) engage swap arrangements (rupees for dollars) with friendly Central Banks; (2) opening up the Treasury Bonds and Bills market to the Sri Lankan diaspora; and (3) introducing a bonus interest rate on NRFC and RFC accounts to attract more non-rupee savings. The government is __ expecting approximately US $ 500 mn. from this exercise in 2009. While the strategy may work to boost the foreign reserves, it would not assist the economy, in particular, the production base, to make the necessary adjustments to the global changes and give the much needed comfort to the industrialists. Delayed adjustment of the exchange rate may prove to be costly in terms of industrial closure and employment losses. Contd. Page 14Global Economic Crisis TORR Ut ee Soon after the East Asian crisis in 1997, Sri Lanka required a devaluation to match the global changes. However, devaluation was not under- ‘taken when there was clear evidence in favour of it due to the Presidential Election in 1999 and General Election in 2000. Eventually, in end-2000 with escalating oil prices and defence expenditure the foreign reserves got depleted and the government had no option but to go for a costly stand-by-package with the IMF in early 2001 The free float of the Rupee was implanted with a 20 per cent devaluation and imposing a 40 per cent surcharge on all non-essential imports. The government did not have the intention of calling the IMF for economic rescue but the circumstances compelled it to do so (Kelegama, 2006: Chapter 6). The alternative to the IMF was imposing exchange controls and reversing the open economy for a temporary period until the foreign exchange situation improves. But this alternative would have given adverse signals to the private sector and FDI inflows and created many other problems for economic management. The current strategy will assist the government to postpone the required adjustments of the exchange rate but it is by no means a substitute to the required strategy for the economy. The macroeconomic fundamentals should be in place in an economy to encourage private sector led growth, and a realistic exchange rate is an important tool in this process. The US financial crisis has shown to the world that using innovative financial instruments such as derivatives to drive the economy are no substitutes to correcting economic fundamentals. ‘An exchange rate depreciation will also assist the government to bring down the interest rates. With inflation falling, interest rates have already been reduced but the reduction can be sustained only via an exchange rate depreciation which will cut import expenditure in the system. This will reduce the upward pressure on the prevailing interest rates, to cut expenditure in the system when that task is not performed via the existing overvalued exchange rate. With the prevailing exchange rate, reduction of interest rate will be difficult to sustain. ‘An. optimistic scenario visualized by some economists is that with the war coming to an end in Northern Sri Lanka, there can be, (a) more foreign aid inflows for reconstruction and rehabilitation of the North (similar to. the aid inflows after the devastating Tsunami), and (b) increase in business confidence in the economy and more foreign investors and tourists coming into the country. Under this’ scenario, with the gradual pick up of the global economy in late 2009, it is argued that the pressure on the exchange rate to depreciate will ease. While such a scenario is a possibility it must also be recognized that there are many outward payments due such as postponed oil payments, 14 US $ 400-700 mn. due payments from the Ceylon Petroleum Corporation for hedging (at present, temporarily halted under a Monetary Board directive), etc. Thus, it is always better to take the correct remedy without excessively relying on ‘quick‘fixes’ and permit the exchange rate to gradually depreciate and work out a compromise with the debt payments obligations and political economy imperatives and agree on a more realistic level of ‘soft peg’. An excessively overvalued currency should be avoided at any cost in an open economy. It will simply prove to be unsustainable. Table 1: United States household Savings and Indebtedness (percentage of disposable income) —____}1922] 1006 1908 [ 2000] 2002] 2003] 2008 2005] 2006 saings 7z| 40{ 43{ 2s] 2al 2a] 21] as] o4| lisbities [67.2] 950] 97.1] t0a7| 1121] 1202| 1268 194.4198 WWorigages [623] ea8| 649] 685] 704] 57] s22[s002|1031 Debt as per cert lofnet worth | 181] 173] 167] 179] 226| 223] 229] 23.6] 239] loa oa] 16] 25] 43] 44] 48] 55] ar] 22] Table 2: Crisis Spreads: Timeline of Events bas Counry [Bark stats oa-Feb|UK | Nortem feck | Natonalied- Bought bP Morean 21-Feb]USA | Baw Stearns chase o7—Sep] USA | Fannie mae Netonaizes o7-sep] USA | Freie Mac Natonaizes 15-Sop]USA | Lehman Bos cotapsed 15-Sop] USA | Meniltyren Taken oer i6-Sapfusa |aG Pat nationalized 17-Sop]UK. | Gottman Sass Group | Token oer 21-sop] USA ne Pot nator 1-Sap] USA. | MorganStaiey [Pat nator 25-Sap| USA | Wak Cotapsed and sot 28 Sap] Begum | Forts Nationale 29-Sep| UK. | Brad & Bingley | Naina’ 29-Sep| USA | Wachovia ake oer 29-Sop}uK. | Gti Nationale os cxt| Gemmany| Hypo RealEstate | Resevepacage 13-Oet} Ux. | Roya Bark ot Stand Part ratonalaed i3-oe}ux | voyss 758 Part natonalaed Box: Crisis Unfolds Sub-prime Crisis —+ Financial Crisis —» Crecit Crunch —» US Recession —> Asset Price Deflaio —» Less Investment —> Less Consumption —» Reduce demand for imports (2, for exports of others) — Prices and Output dectine —» Growth and Employment decine Contd Page 15Global Economic Crisis Ure) Sri Lanka - Dr. Saman Kelegama ale] Table 3: Exchange Rate and Inflation Behaviour during 2008 in a Selected Sample of Countries in 2008* 2008 Japan China Hong Kong Bangladesh*** Singapore*** Taiwan Euro Denmark Thailand Sri Lanka*** Malaysia Philippines*** Indonesia New Zealand Korea United Kingdom South Africa 15 Sources * Data obtained from The Economist, First edition of 2008 for 02.01.2008 data and First edition of 2009 for 29.12.2008 data. ** The Economist poll or Economist Intelligence Unit estimate/ forecast. *** Central Banks of the listed countries, 30.01.2009. References CBSL (2009), Road Map for Monetary and Financial Sector Policies for 2009 and Beyond, Central Bank of Sri Lanka. IPS (2008), Sri Lanka: State of the Economy - 2008, Institute of Policy Studies of Sri Lanka, Colombo. Kelegama, S. (2006), Development under Stress: Sri Lankan Economy in Transition, Sage Publications, Delhi. Lanka Business Online - www./bo./k World Bank (2008), Sri Lanka: Country Assistance Strategy 2009-2012, The World Bank in South Asia, Washington D.C. Websites on the Global Economic Crisis