Impact of Financial Crisis on UK Economy - Assignment Example

Page Impact of financial crisis on UK economy The UK economy has been experiencing tremendous growth since 1993. However, the subprime market collapse in the US and the ensuing global financial crisis have resulted in a growth slowdown in 2008-2009. The global credit crisis has been triggered by the sub-prime mortgage business. US banks gave way high-risk loans to borrowers with poor credit ratings. These loans along with other bonds or assets were bundled into portfolios, or, Collateralised Debt Obligations (CDOs) and sold to investors globally. When US interest rates were jacked up from 1% to 5.32% between 2004 and 2006, high risk housing loan borrowers defaulted on mortgage payments. Banks which had lent money to them, could not recover their assets and their capacity to lend too dried up. Consumer demand plummeted and this affected producers of goods and services. The result was a decline in the US economy accompanied by sharp increase in unemployment. The impact of the loan defaults were felt across the global financial system, as many of the mortgages had been bundled up and sold to banks and investors. Soon, the global financial system awash with junk mortgage securities started crumbling. The financial crisis became acute in July 2007. Loss of investors’ confidenc in the value of securitized mortgages in the United States resulted in a liquidity crisis that prompted substantial injection of capital into financial markets by the United States’ Federal Reserve, Bank of England and the European Central Bank. Across the world, banks and financial institutions were crumbling due to the liquidity crunch. In the US, some of them like New Century Financial filed for bankruptcy. Bear Stearns, and BNP Paribas, were unable to pay investors in their hedge funds. Bear Stearns was ultimately bought by J P Morgan Chase with backing from the US Central Bank. Lenders, Fannie May and Freddie Mac were bailed out by the US authorities. Lehmann Brothers collapsed and Merril Lynch was taken over by Bank of America. Insurance giant AIG had to be bailed out by the US government. Carmakers Ford, GM and Chrysler too had to take government support due to the credit squeeze. The global crisis affected Western Europes financial systems very badly because of their exposure to foreign financial assets with high levels of risk, particularly mortgage backed securities (MBS) in the US. Switzerland’s UBS, European bank Dexia, Germany’s Hypo Real Estate and Iceland’s Landsbanki had to be bailed out. In September 2007, UK’s Northern Rock sought funds from the Bank Of England as it felt the credit squeeze and could not carry on its sub-prime lending. Page 2 Customers lined up outside the bank branches seeking return of their hard earned savings. The bank was finally nationalised on February 17, 2008. HBOS faced a run on its shares and was taken over by Lloyds. Bradford & Bingley faced huge losses and has been nationalised. The UK economy that had witnessed unprecedented growth since 1993 was amongst the worst-hit in the crisis. This was mainly due to its bursting housing bubble, high household debt, a large government budget deficit and excessive dependence on the troubled financial sector. Since finance and real estate typically make up between a fifth and a third of GDP of Western European economies, losses and layoffs had a considerable impact on the regions economy. A severe credit crunch and falling home prices, pushed Britain back into recession in the latter half of 2008. Demand and investments were softening on account of the credit crisis. The damage to the real economy was phenomenal as growth started contracting. This prompted the Gordon Brown government to implement a slew of new measures to stimulate the economy and stabilize the financial markets; these included part-nationalizing the banking system, cutting taxes, suspending public sector borrowing rules, and bringing forward public spending on capital projects. UK took the lead to re-capitalise banks in order to prevent a financial meltdown. The Bank of England lowered interest rates from 5.0% in September 2008 to 2.0% in November 2008 and 1% in the first quarter of 2009. The British Government devised a plan to fight economic recession by pumping in £500 billion rescue packages, £37 billion bail-outs and, £75 billion in ‘quantitative easing’ (in effect, the printing of money), and £20 billion stimulus packages. Several banks including Northern Rock, RBS and Lloyds had to be bailed out. Despite these measures, economic projections are dismal. The IMF has warned of a decline in the economy to the extent of 4.1 % in 2009 and a continued contraction in 2010. Most banks are insolvent and are guzzling taxpayer funds at a rate that is intergenerational. Unemployment is soaring and national debt is exploding. Deflation is raging now, while the spectre of hyperinflation hovers, even as eroding financial fundamentals cripple the value of Britains currency. And the UK is also faced with a severe housing crisis. A former Chief Economist of Europe’s largest Bank HSBC, Roger Bootle, has said that the UK will remain in recession until at least 2011 and predicts the housing market will continue to struggle with rising repossessions, growing negative equity and poor access to finance. Speaking at the Chartered Institute of Housing South East’s Annual Conference and Exhibition in Brighton on March 3, 2009, Mr Bootle, suggested that round 3.5 million households will fall into arrears – twice the level of the early 1990s - and mortgage repossessions could rise as high as 90,000 this year. Predicting that house prices would continue to fall throughout 2009, he warned that the country is in the biggest housing bubble ever seen and there was a long way to go before the market stabilized completely. The British Chambers of Commerce (BCC) on January 23, 2009 released a Page 3 survey result of 6000 firms (employing 6,80,000 people). The report said that the situation is the worst since the survey began in 1989 and pointed to plunging domestic demand and falling exports. Economic activity is slowing in all key sectors of the economy, business confidence is waning and falling house prices and tight credit conditions have dented consumer spending. And the coming months hold more gloom, as, the UKs proud record of 63 consecutive quarters of economic growth takes a bad mauling. The Paris-based think tank, Organization for Economic Cooperation and Development (OECD) in its Economy Outlook report released in June 2009 said that the UK economy which is in the throes of a severe recession would shrink by 4.3% this year, its fastest pace of decline since the Second World War, and stagnate in 2010. The fiscal deficit is expected to rise to 14% of economic output in 2010, compared with an average of 8.75% across the OECD groups 30 members. The report said that the financial crisis had caused a serious credit crunch and house prices had fallen sharply, thus restraining business and household spending. Unemployment is likely to be exacerbated and the large rise in the government deficit is providing support to demand, but, the debt-to-GDP ratio will increase substantially. By the end of 2008, estimated public debt had already risen to 42 per cent, and could rise to 70 per cent of GDP by 2010, meaning that the Sustainable Investment Rule has been broken. The justification is that a severe recession needs Keynesian stimulus to revive it, and that balancing the books should only be sought once the economic recovery begins. GDP growth, unemployment and the current budget balance Source: OECD (2009); OECD Economic Outlook 85 database and ONS. With cuts in interest rates, inflation is easing to the benefit of consumers as the world economy slows down, yet the risk of deflation (a decrease in price levels) is a growing concern. Deflation could have a negative impact on the economy. When prices fall, consumers defer purchases in the hope of cheaper prices; similarly, businesses and investors hoard money rather than spend or invest it. This in turn reduces demand, causing prices to fall further and aggravating the recession. Page 4 Even as the impact of the financial crisis on the global North has been much analyzed in the media and academic journals, the crisis could lead to debilitating macro-economic melt down for those most in need, the developing world, says a new report by Neil McCullock, for the Institute of Development Studies. The real economies of poorer countries have been hammered despite the fact that poor developing countries have played no role in creating the current crisis A new financial architecture is needed to reduce the vulnerability of developing countries to macro-economic shocks. A fall in crucial investment, a decline in demand for exports and plummeting commodity prices will mean that growth in some of the poorest countries in the world will be severely stunted. The current crisis may be the worst to hit the developed countries in 80 years, but, such situations are quite common in developing countries. As the recession in the West deepens and endures, the real impact of the financial crisis will be felt severely by countries in the developing world. This would manifest in the form of fall in crucial investment, a decline in demand for exports and plummeting commodity prices. Pointers are that growth in some of the poorest countries in the world will be severely stunted. In the last ten years, major financial crises have affected Argentina, Brazil, Russia, and the East Asian countries, to name only a few. There is a need for regulation in the financial sector and better prevention of the accumulation of large and unsustainable macroeconomic imbalances that give rise to crises. A new system of international financial governance that creates a mechanism for hearing the voices of poor countries, as well as larger and more ‘systemically important’ nations, is needed. The G20 grouping, although broader than the G8, includes only one country from Africa (South Africa) and no low income country. Ndulo, Mudenda, Ingombe and Muchimba in their study published in May 2009 on the impact of the financial crisis on Zambia, say that the global financial crisis has spawned macro-economic imbalances affecting trade, foreign direct investment (FDI), development assistance and remittances, which are the major transmission mechanisms of the crisis to the country. With interest rates spiralling and stock prices crumbling, foreign portfolio flows have been adversely affected and the Kwacha has depreciated against the major currencies. Prospects for Zambia, as a commodity exporter depend significantly on the price of copper. If the price of copper does not fall below US$3000 per tonne, the economy is likely to weather the crisis, provided it pursues optimal policy responses, and the crisis is over by 2011. Mines have scaled down investments, production and employment, and some mining units have been closed, with about 8100 jobs lost. Secondary industries supporting the mines in the copper belt and tourism sector have been affected. The government needs to address the issue through fiscal monetary and exchange rate policies, bu,t for policies to be effective they must be accompanied by growth-enhancing structural policy measures. These include economic diversification and improvement of the business environment. Other requirements are governance reforms in the mining sector, social protection and a package of austerity measures. To address the crisis and maintain macroeconomic stability, Zambia should pursue a limited expansionary policy that restricts the budget deficit to no more than 3% of GDP in the long run. The expansionary stimuli should be targeted at investments in infrastructure and investments in health and education. The financial crisis wiped $50 trillion off the value of financial assets across the globe last year, according to an Asian Development Bank (ADB) on March 9, 2009. Nearly $10 trillion of those losses were in developing countries of Asia, excluding Japan. The downturn has hit Asia more than other emerging economies because of the recent phase of fast growth. The bank predicted Asia would be one of the first to emerge from recession. India, one of the fastest growing emerging economies, initially registered a robust growth of 9 per cent in 2007-2008, despite the impact of the sub-prime crisis on the US and other major economies. This, was mainly due to the fact that Indian banking had no direct exposure to the sub-prime mortgage crisis, and the country’s growth is largely based on domestic consumption and investment. Indian financial markets are still relatively insulated from global financial markets. India has a healthy external balance, with high foreign exchange reserves, low ratio of short term external debt to GDP and less than complete capital account convertibility. Professor Jha Raghbendra who spoke at the India Update, held on the 6th and 7th of November 2008 at the Australian National University says: “Indian banks have strong balance sheets, are well-capitalised and well regulated. The capital adequacy ratio of every Indian bank is well above Basel norms and those stipulated by the RBI. Not one Indian bank has had to be rescued in the aftermath of the crisis. India has a long history of working with public sector banks and in engineering bank rescues”. Nevertheless, there is a liquidity crunch and exports were badly hit in 2008-2009 due to the lack of external demand. Also key stock indices have crashed since foreign institutional investors have withdrawn from Indian stock markets. Indian policy makers have responded with measures to enhance liquidity – primarily by reducing the cash reserve ratio and the repo rate – and enhancing confidence. Bank guarantees, beyond those that already exist, have been deemed unnecessary. However, with the nascent recovery across the world, India’s external trade which declined by 25-30 per cent through late 2008 and the first half of 2009, is likely to improve. Despite the growing integration of India’s financial markets with global financial markets, Indian banks and lending institutions have developed a risk aversion after the collapse of Lehmann brothers and hence, it would take time for matters to reach normalcy. As the global economy inches its way to a recovery, the world has earmarked a staggering $11.9 trillion to wriggle out of the financial crisis, the sum which is enough to finance a £1,779 handout for every person living on the planet, according to the International Monetary Fund. The whopping total cost of the crisis is equivalent to around a fifth of the entire globes annual economic output and includes capital injections pumped into banks in order to prevent them from collapse, the cost of soaking up so-called toxic assets, guarantees over debt and liquidity support from central banks. The financial tsunami then, has caused nations to take a relook at their macro-economic policies and also drawn attention to the lack of adequate supervision and regulation of the financial sector. Reference OECD Economic Outlook No. 85, June 2009, Economic Survey of the United Kingdom 2009,  www.oecd.org/eco/surveys/uk Manenga Ndulo, Dale Mudenda, Lutangu Ingombe and Lillian Muchimba in Global Financial Discussion Series on Zambia for Overseas Development Institute http://www.odi.org.uk/resources/download/3311.pdf Jha Raghabendra lecture at Australian National University, June 16, 2009 http://rspas.anu.edu.au/asarc/reviews.php . Read More