Business

Monday March 30, 2009

Effects of global financial crisis


Reforms of rules and regulation can avert similar crisis in future

THE roots of the current global financial crisis can be traced back to the fallout in the US subprime mortgage lending, which started in early 2007. It spread to other markets and economies via a combination of market failures and regulatory weaknesses.

In general, markets failed because of poor corporate governance and incompatible executive remuneration structures. The lack of transparency in trading procedures, financial instruments, and balance sheet positions of major financial institutions also exacerbated market failures.

Most countries have weak idiosyncratic rules pertaining to the operation of trading instruments and financial conglomerates. Poor capital regulation and accounting rules contributed to excessive risk-taking by banks. In addition, some rating agencies were also not subjected to the jurisdiction of the national regulators.

The international financial sector temporarily went into rigor mortis following mutual distrust between financial market participants in September 2008. This in turn led to a complete breakdown of short-term financial transactions in leading advanced and emerging market economies, and subsequently, a meltdown in global securities exchanges.

With the freezing of interbank lending and money markets, capital could not be channelled to economic agents operating across the entire production chain.

Policy actions

To resolve this problem, monetary authorities and governments took numerous policy actions to prevent the crisis from spreading further. The main priority was to restore confidence in the global financial system.

This was followed by the need to recapitalise financial intermediaries either through direct capital injections or merger and acquisition plans. Furthermore, active global coordination programmes were also implemented to minimise cross-border contagion effects.

The general consensus is that the current blockage in short-term financial market operations will be resolved in a relatively short time. Of course, certain researchers may expect a much longer time to defrost the global financial markets as well as to revive short-term lending.

In this case, the real sector may have to suffer a prolonged recession. In contrast, the process of deleveraging and recapitalisation of financial intermediaries, and the restoration of market confidence will entail a much longer period. Consequently, global financial markets will remain restrictive in the medium term, and possibly leading to poor allocation of credit as well as higher cost of funds.

On the other hand, both macroeconomic and microeconomic policies may also play their roles in negating the adverse effects of the financial crisis. As economies slow along with falling price levels, central banks may lower their official policy rates.

At the same time, monetary authorities may also opt to loosen their administrative procedures, such as the reserve requirement ratios, ceiling or floor caps, among others. Fiscal stimulus – for example, infrastructure spending, tax holiday, and direct funding to low-income groups – may also be useful to prevent an otherwise hard landing in the economic activity of each country.

The large-scale financial system deleveraging since October last year has brought about massive capital outflows from emerging market economies. Volatile capital flows has also led to wild exchange-rate fluctuations across the world.

What are the relative success and costs of these macroeconomic policies?

First, monetary easing may only be effective provided that inflation and inflation expectations are anticipated to fall in the medium term. The strengths and characteristics of the financial sector as well as the transmission process are other important factors determining the success of monetary policy.

Periodic monitoring

Although the efficacy of other administrative tools may be small, their use in addition to policy rate changes may be useful. Large and persistent cuts in official interest rates may tend to accelerate inflation in the long run.

Consequently, there is a trade-off between successfully resuscitating economic performance in the short to medium term from monetary laxity, and episodes of rapidly rising inflation in the long run. Hence, periodic monitoring of both economic and financial indicators may be a necessary task of the monetary regulator.

Similarly, large infrastructure spending may involve unknown budgetary costs to governments. It is routine for governments to fund such projects through fixed income securities. Accordingly, a large, liquid, and deep bond market may be necessary. Moreover, having a high rating of sovereign debt is important. The success of this tool also depends on the existence of a current account surplus to avoid the twin deficit problem.

It is well known that a reduction in taxes to boost consumption and investment will be compensated through much higher taxation in the future. Ongoing fiscal stimulus may generate large budget deficit in the long run with negative consequences in the event of a protracted recession. Thus, it is necessary to maintain an optimal size of fiscal package and fiscal sustainability measures to circumvent future debt crisis.

In terms of microeconomic policies, individual governments may implement special credit management or evaluation policies for sectors badly affected by the global financial turmoil.

Finally, to prevent a similar financial crisis in the future, it is useful to implement reforms on part of rules and regulation governing the operation of financial markets, market participants, and trading instruments.

Higher degree of disclosure and transparency by all financial institutions may be relevant, in addition to having better, harmonious, and unified law for financial conglomerates. Reforms should also mitigate asymmetric information between financial market participants and other economic agents. Having better crisis management procedures and active participation by all countries in the world are also equally important.

  • Dr Kee-Kuan Foong is senior research fellow at the Malaysian Institute of Economic Research


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