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 2008-09 actually
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 America’s 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 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 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 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. 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. 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 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 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 the
benefits of a strong
agriculture 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 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 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 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.