NECF PAPER ON THE FINANCIAL CRISIS.

WHAT LESSONS FOR ZIMBABWE AND HOW DO WE MOVE FORWARD

BY NECF SECRETARIAT DECEMBER 2008

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HISTORY OF RECURRENT CRISES IN THE WORLD 1929: Wall Street collapse which was compounded by massive policy failure, monetary contraction and protectionism. 1987: Wall Street collapse again which was corrected through monetary expansion. 1997: Asian crisis which was preceded by the construction boom in Thailand. 2000: there was the Dot.com collapse which had limited impact on world markets. 2008: Sub prime loan debacle in United States. Where will it lead? Is it a repeat from 1929? No. SUBPRIME LOAN CRISIS SOURCE OF CRISIS The Banks in the United States were selling mortgages to people with no jobs, no incomes, no money to put down, no means of paying back. Banks convinced subprime customers that they could pay higher interest on their mortgage after a short grace period because house prices would rise, but prices fell. This exposed fundamental asymmetry of information, leading to grave moral hazard. Dealers developed vested private interest in many socially destructive deals, because the most they could lose was their jobs. The most they could win was astronomical wealth. One is then left to figure out the average of those two options.

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WHAT ARE THE LESSONS FROM THIS DEBACLE? LESSON I

There is need for legal protection against predatory lending. In some cases, it was out right corruption where bank cheques were issued which were not backed by money in the corresponding accounts for use on the stock markets. What it means is bank customers require protection from bankers especially in complicated financial deals. Subprime assets and stocks of dubious values were packaged into complete financial instruments of equally dubious values that few understood. Locally, the Old Mutual implied rate comes to mind. These same sub prime assets and stocks were given top ratings by rating agencies paid by dealers and some banks that pushed these instruments. LESSON II

Never or dont allow rating agencies to be paid by banks and dealers as clearly there is fundamental conflict of interest. In the 1930s in USA, they were laws that separated commercial banking from investments banking. These laws were weakened in the 1990s permitting banks again to blend the two types of banking. What it amounted to was like merging an electricity utility and a casino, making it possible for the casino, if it goes bust, to bring down the utility. The strange thing though is that in good times, the casino can support the utility, meaning this is very controversial, hence the need for strict regulations. LESSON III
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Put in place more and better regulatory mechanisms for banks and other financial institutions using best practices to protect the customers, public and maintain stability in the financial sector. LESSON IV

Each country through the Central Banks must at all times read the warning signals e.g. Two stories in the world come to mind, e.g. Iceland 2007, Count the Cranes in Bangkok in 1996. Always apply the Ratio of reserves to short-term debt known as the Guidetti-Greenspan Rule. Never allow gross foreign reserves held by Central Banks to fall below the short-term foreign debts of commercial banks. Failure to respect the rule amounts to an open invitation to speculators to stage an attack on the currency e.g. In Iceland, the Central Bank foreign reserves dropped from 100% of short-term debt to 6% in 2008 while bank assets rose to 9 times GDP. There was no strategy at all behind this rapid growth but just last for profit. Any similarities with Zimbabwe? Keynes famously said, A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined , is ruined in a conventional way along with his fellows, so that no one can really blame him JM Keynes In Iceland, banks copied each others business models: it was good when the going was good, but became terrible when the sea got rough. Again any similarities with Zimbabwean financial sector? LESSON V
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Never allow banks to outgrow the Central Banks ability to stand behind them as lender or borrower of last resort. At the same time, do not allow banks to operate branches abroad rather than subsidiaries, thus exposing domestic deposit insurance schemes to foreign obligations. It is easy to find about 300 000 Zimbabweans for example being held responsible for moneys kept in a Zimbabwean bank by a similar 300 000 South African depositors and more in Botswana. LESSON VI

Over valuation of currencies always lead to disaster. If at any time you find your currency per capita GDP having risen to 50% above the US per capita GDP, then its a clear sign that a correction is overdue. What normally happens is instead, many corporates and households borrow cheap foreign currencies at low interest even if all their earnings were in domestic currency. You find that senior banks and even ministers partaking in this in a clear sign of wide spread euphoria. The unmistakable signs coming through manifest themselves in huge current account deficits and escalating foreign indebtedness. LESSON VII

Erect walls between banking and politics. Government must provide restraint on the growth of banks through taxes while the Central Banks should do so through reserve requirements. More importantly, Financial Supervision Regulatory must apply more stringent stress tests at regular intervals to maintain stability in the financial sector. All banks in problems must be exposed without any cover ups with clear accountability being upheld.
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LESSON VIII When things go wrong, hold people accountable by law or at least uncover the truth, do not at all try to cover up as this usually blows up in your faces. This will help avoid a repeat of the same. LESSON IX When banks collapse and assets are wiped out, there is need to protect the real economy by a massive monetary or fiscal stimulus. There is need to think outside the box which means putting the old religion about monetary restraints and fiscal prudence on hold, e.g. American bail out of General Motors, French Renault etc. This is simply done to avoid the repeat of 1929. It must be noted that a financial crisis, painful though it may be, typically wipes out only a small fraction of national wealth, e.g. physical capital 3 4 times GDP direct financial capital typically less than GDP and human capital 5-6 times physical capital. LESSON X Never jump to conclusions and do not throw out the baby with the bath water. Since the collapse of communism, a mixed market economy has been the only game in town. To many, the current financial crises had dealt a severe blow to the prestige of free markets, with banks having to be propped up temporarily by governments and in some instances, nationalized e.g. Western Rock in United Kingdom. However, it remains true that governments are not well suited to own and operate banks, so banks will need to be re-privatized in due course. Banking and politics have never been a good mix for obvious reasons. What is critical is to ensure that private banks need proper
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regulation because of their ability to inflict damage on innocent by standers. 4. IMPACT OF THE CRISIS ON ZIMBABWE The Zimbabwe financial sector is not as big as in the developed world. As such their rise and fall can cause a large bleep on the radar screens. The problem of the Zimbabwean financial sector has been spurred by a fatal cocktail of greed, hubris and the folly of overstretch. Many of the financial institutions were happy to make astronomical profits in manipulated and junk stocks, miscalculated positioning and underhand dealings. What is critical now is for monetary authorities to be equal to the task and keep under check the financial contagion so that the economy can rebound quickly. It would be tragic if regulatory authorities appear helpless. It should be made clear that banks in trouble should not expect automatic forbearance. Speculative exuberance must be kept in check at all times even if interest rates can be at an all time low and asset prices spiraling out of control. What is emerging in the Zimbabwean financial sector is the reality that high finance has become so complex in the digital age with several instruments being structured using acane language of quantum physics. Typically, this is not the sort of thing that your traditional Central Banker can understand, let alone track down and regulate. Even regulators in advanced economies are having a nightmare. Overally, the impact of the world financial crisis is the reduction of net capital flows, low raw material and mineral prices leading to pressures on export earnings and national budget resources. The full blown impact will not be felt that much but what should be avoided is to carry out policies that will bring down the engine

room of private entrepreneurship through a combination of euphoria, greed and folly. For Zimbabwe, the world financial crisis could have come at a worse time, especially when the country has been facing a capital market meltdown for some years now. The current crisis calls for the highest qualities of prudence and economic statecraft. The local stock market crisis has more to do with internal institutional defects which should be dealt with squarely. From a global perspective, what Zimbabwe as an economy faces today transcends mere partisan politics. There is need for a new historic consensus to rebuild the country and to restore hope in a time of turmoil. The restoration of economic and financial integrity requires retracting moral bearings and forging of a new coalition for the reconstruction of the internal economic order. Zimbabwe needs to re-invent itself and adapt to new realities. The country stands in need of vision and statesmanship to effectively confront systematic challenges such as economic collapse, financial and stock market turbulence, spread of infectious diseases and the nightmare of poverty. What is of critical importance is for all political formations to come together and implement a new framework for a national economic and political governance to propel the country forward based on solidarity and hope. NECF Secretariat