Global Financial Crises: Causes, Context and Consequences
Global Financial Crisis
Financial crisis is a term that is applied widely to connote situations that are characterised by sudden loss of large part of the nominal value of financial assets. Most of the financial crises of between 19th and 21st-cennturies have been associated with crisis in the banking sector, and many recessions have coincided with these crises. The other notable causes of the past financial crisis include currency crisis, stock market crushes, property bubbles, and sovereign defaults (FSF, 2008). The 2008/2009 global financial crisis, which is the focus of this paper, began to show its signs many years before the actual burst of the bubble. As early as 2001, the world economy showed signs of a mild financial crisis, but timely measures were adopted and the economies were able to bounce back. The response to the 2008/2009 crisis, however, was different because when the initial signs manifested themselves, the Wall Street preached “no bail out” and this paved way for the second world’s major economic crisis after the 1930’s Great Depression (Frost, 2014). The real face of the problem was seen in 2007 when it became apparent that the U.S. property prices were turning decisively downwards. Massive default of mortgages followed soon as the crisis spread quickly to affect the financial sector, and eventually, the foreign financial markets (Frost, 2014). The key losers of the global financial crisis were the investment banks, mortgage lenders, commercial banks, insurance entities, and government-chartered banks involved in mortgage lending. Notably, the carnage of the crisis was not restricted to the financial sector, but also affected organizations that transact with financial institutions. Nevertheless, this paper would discuss the main causes of the 2008/2009 global financial crisis and how it affected the financial markets and global economies at that time. The discussion will then focus attention to the consequences that the global financial crisis had on the Gulf Cooperation Council (GCC) region and the main actions that the GCC nations have taken to mitigate the effect of the crisis.
The global financial crisis was deeply rooted on a series of events that took place in the U.S. economy between 2007 and 2008 (FSF, 2008). At their basic, these events can be placed under two broad categories: credit crunch in the banking sector and real estate property bubble. To a great extent, the greedy behaviours of banks and mortgage companies were responsible for the onset of the global financial crisis. The bankers and mortgage lenders deliberately engaged in manipulative practices to lure the mortgage investors and homeowners into the property business. As the banks advanced credit to the potential homeowners, they failed to assess their credit rating and securitization factors due to their greed. Similarly, the U.S. security-rating firms maliciously rated the mortgages in a manner that made them to appear to appear as very safe investments to lenders. This situation was jeopardised by failure of the nation’s lenders to conduct their own audit in order to authenticate the ratings made by the security-rating agencies (Frost, 2014). Amplifying the risk was the fact that the lending financial institutions held capital that was too little relative to the magnitude of the risks they were funding. A large proportion of the funding was advanced on short-term basis because the lenders assumed that the sector would remain prosperous and the borrowers will be in a position to pay back as soon as possible. Ideally, the combination of the short-term lending and the highly concentrated exposure to risk was the foundation of a crisis that would later affect the entire global financial systems. There are two distinct pathways through which the initial loss spread to affect the entire global financial systems. First, there were some big financial institutions that had multifaceted exposures to risk, meaning that a failure in one of the firms associated with them would lead to losses. In the second pathway, there was an effect of a common shock. As Crotty (2009) posits, when disconnected firms in the same industry make similar bad speculations, chances are high that they will fail for the same reasons and at the same span of time. Between September 2008 and June 2009, the U.S experienced successive failure of banks and mortgage firms, and this triggered a global-scale financial shock and panic. People lost trust and confidence in the financial systems and the stability of every big financial institution put in question. This would later result in a severely contracted global economy characterised by struggling firms. The use of sub-prime mortgages, which led to a bubble in property markets, was also a main cause of the global financial crisis. In the U.S., there was a marked shift towards the use of pooled mortgages to back up securities that were known as collateralized debt obligations (CDOs). The securities were then advanced to home owners in forms of subprime loans (FSF, 2008). However, the CDOs later turned to be underperforming when most borrowers proved to be unable to repay their mortgages, leading to massive defaults. The value of the homes also plummeted and the home owners had their assets auctioned to recover the loans. Ultimately, the collapse of the U.S. housing is considered one of the triggers of the 2008 global financial crisis.
Though the world had experienced a period of remarkable economic prosperity since 1990s, this would suddenly come to an end in 2007. The most severe economic impact was felt after the collapse of Lehman Brothers. Since this was a multinational financial institution, its collapse resulted in a significant ripple effect on the global banking industry. Though the initial impact was experienced by the U.S. and the economies in West Europe, the crisis spilled over unexpectedly to East and Central European nations that include Romania, Estonia, Poland, Slovakia, Czech Republic, Estonia, and Hungary (Frost, 2014). Each economy was affected to a different degree, but the most common effects were credit squeeze and borrowing conditions that were unfavourable to firms and households and that had adverse effects on consumption and investment rates. The economic downturn also affected the country’s exports and imports severely. There was also a massive loss of jobs as companies collapsed. As a result, most global economies recorded a significant drop of employment rates during the financial crisis. In fact, governments had to seek different forms of economic support to prevent their economies from further plummeting, but banks were unwilling to extend the much needed credit. Different financial markets segments in the European Union experienced remarkable economic difficulties. First, the exchange rate of the Euro suffered strongly. Secondly, the region’s stock markets recorded huge loses between 2007 and 2009. Third, risk index of government bonds increased to elevated levels and most governments could not access loans from the international financial institutions such as the World Bank, China Development Bank, and the IMF (FSF, 2008). These disruptions witnessed in the global financial markets, together with a plunge in the global flow of global commerce, worked to compromise economic growth and development of many countries, leading to severe recessions in most developed countries (Frost, 2014).The developing countries, on the other hand, were equally hit hard by the global financial crisis, but the impacts were somewhat delayed compared to the developed countries. Though each country’s economy was affected to a different degree, countries that are more interconnected to the world were hit hardest. In Africa and in parts of South America and Asia, the global financial crisis manifested itself in forms of shrinking per capita income, dwindling currency reserves, mounting trade deficits, higher indebtedness, souring budget deficits, currency devaluation, and increased inflation rates. For example, in third world countries like Brazil, India, China, and South Africa, the stock markets threshold fell by 23% within a week of the collapse of Lehman Brothers (Frost, 2014).
The GCC economies did not go unaffected by the 2008 global financial crisis. However, these countries recorded greater immunity and more resilience to the effect of the global financial crisis compared to their European counterparts. First, the oil boom in the GCC region has produced buoyant economic performance and investor confidence that worked to neutralize the effects of the global financial crisis. Secondly, the region’s banking sector has been less connected to the global financial institutions because it is dominated by Islamic banks that offer their products according to Islamic Sharia (Abdelbaki, 2010). As a result, the GCC financial institutions had limited exposure to sub-prime assets that had laid the foundation for the onset of the global financial crisis. The GCC banks focussed on mobilizing their lending and savings in the traditional ways while remaining less integrated to the global financial markets. No serious systemic consequences were recorded on most of the GCC banking sectors, except moderate decline in profitability and default by few. However, some GCC countries such as UAE, Bahrain, and Kuwait had banks that were more integrated to the global financial systems. Such banks engaged in real estate and construction lending and this exposed their balance sheets to the effects of the global financial crisis. At the corporate level, the boom in the real estate sector was associated with higher leverage, a factor that increased the vulnerability of the GCC economies. When the global financial crisis spread beyond Central and East Europe, the GCC region felt significant impact that came through financial and trade channels. First, the government finances and external positions of the GCC countries were directly affected by a sharp decline of oil prices and demand that were associated with the global financial crisis (Abdelbaki, 2010). At the same time, the GCC region experienced reversals of speculative inflow of capital between 2007 and 2008. Ideally, these are developments that worked to tighten conditions, and in the process, decrease the investor confidence. Imbalances were also witnessed in the GCC region’s financial sectors, mostly affecting the countries that had close links to the global credit and equity markets. There was a steep decline in the GCC region’s asset prices, increased rate of credit default, and widening of sovereign debt (Abdelbaki, 2010). Though a slight recovery was recorded in 2009, equity prices in most GCC countries remained low compared to the period before Lehman collapse.
GCC countries resorted to taking various steps in response to the global financial crisis and in order to bolster recovery effort and enhance their capacity to respond to future crisis. Generally, most GCC economies employed economic policies that were meant to mitigate the detrimental economic effects caused by crisis on financial and real-estate sectors. As part of this effort, central banks in the GCC region were given more oversight powers over the banking sector, including conducting tests to determine vulnerabilities and risk exposures among banks. In Kuwait, for instance, a law was passed in 2009 to allow provision of financial stability by government through Investment Equilibrium Fund (Abdelbaki, 2010). UAE, Saudi Arabia, and Bahrain, on the other hand, adopted a series of precautionary policies designed to allow pumping of liquidity during financial crisis. Ideally, the policy measures by the GCC governments have enhanced capital adequacy of banks and nonbank financial institutions through injection of private capital and public funds. In addition, the long-term measures by the GCC nations include adopting a forward-looking approach that would involve periodic reviews to monitor the capital adequacy and assets of banks (Abdelbaki, 2010). In the nonbank financial sector, Kuwait and UAE have put in place corrective-action frameworks with clear criteria of when the government intervention would be necessary. This is because in the light of the global financial crisis, fiscal stimuli to enhance liquidity and financial stability have been successful, both in the short and long-run. These fiscal stimuli have been designed to go hand in hand with policies that ensure enhanced corporate governance and transparency in the financial sector.
References
Abdelbaki, H. (2010). Accessing the Impact of Global Financial Crisis on GCC Countries: Journal of Business & Economics Research, 8(2): 139-153
Crotty, J., (2009). Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture, Cambridge journal of economics, 33(4), pp.563-580.
Financial Stability Forum (FSF) (2008). Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (Basel)
Frost, G., (2014). Understanding the crash: The financial crisis of 2008: causes, consequences, cures. Budapest: Danube Institute.