It is important that we focus on what it was that caused the financial crisis. Until 2007 we seemed to be living in a time of long- term, sustainable growth. Countries and individuals believed that the system would self-correct and continue to deliver increased wealth.
We all know that it all started here on Manhattan. The Financial crisis has its origin in the creation of financial products and financial institutions that escaped market regulation. Important factors where also a Washington driven lax interest rate policy that lead to over-confident borrowing and rising real-estate valuation. People were using their homes as ATM-machines.
The low interest rates inspired creativity in the financial sector. A period of origination and distribution became fashionable at the expense of traditional and unsophisticated but sound banking. Loopholes in regulations were clearly exploited, with financial sector executive remuneration and bonus systems as an underlying driver.
What started as crisis in the US subprime mortgages escalated and caused general dislocation and turmoil in US financial markets.
After the Lehman collapse, - banks could not trust their counterparties and what was until then a liquidity crisis in developed markets turned into a full blown credit crisis and a crisis of confidence with global repercussions.
Emerging market currencies collapsed 40%-50% with huge volatility. The stress in the markets exposed the weaknesses in a system which many assumed would simply continue to provide growth and stability indefinitely with minimal supervision.
We now know that leverage ratios were too steep to be sustainable (Total US Household and Business sector debt is 150% of GDP or ~ 19trn. When Financial Companies are included the ratio grows to 350% ! ) In emerging markets, previous crisis were driven by government over borrowing and low reserves. This time however EM debt /GDP ratios were low and reserves had been built up (Brazil has $300bn , China has $2trn ). The weakness was in the corporate sector. Mid sized and large corporations had expanded too quickly, taking on debt and making bets on currencies which in good times enhanced their revenues but which suddenly became huge losses and unsustainable debt.
Estimates of total emerging markets’ corporate debt is ~ $1trillion and total emerging market debt maturing in 2009 is ~ $2.5- $3 trillion.
It will be difficult to roll over this debt given capital is now flowing to developed nations and especially to the US to cover huge deficits and where risk reward is seen as more attractive.
The current stage of the crisis is employment. Developed countries have large social safety nets to help weather the bad times but emerging countries will be vulnerable due to the capital needs of the US government.
Developing and Emerging countries' governments have been quick to respond with monetary and fiscal policy action to help mitigate the crisis lowering rates, using reserves to stabilize their currencies, providing loans and credit lines to corporations, increase government spending, etc, but there is a limit to what can be done. The IMF also has helped by extending credit lines to Latin America and emerging market countries. But IMF resources are also running low.
Low income countries are especially at risk since most of their resources come from FDI and contributions from Word Bank and others which will not be sufficient given the extent of the losses.
The word faces an unprecedented challenge but also a great opportunity as it becomes increasingly clear that the only way out of the crisis is thru international cooperation and thru the strengthening of international institutions such as the IMF or WB. And this week we will explore further the role that UN itself can play.