Global Financial Crisis: Comparative Study of the U.K and Developing Countries

Global Financial Crisis: comparative Study of the U.K and Developing Countries

  1. Introduction

The recent global financial crisis represents the first major financial crisis in the 21st century. According to Reinhart and Rogoff (2008:2) the crisis involves “esoteric instruments”, “unaware regulators” and “skittish investors”. The crisis began in the United States of America in the summer of 2007 when the U.S and global financial markets found themselves facing a financial crisis and the U.S Federal Reserve System – The Fed found itself in difficulties. (Cecchetti, 2008). Although the crisis began in the United States, virtually every country in the world has witnessed some share of the effects of the crisis as a result of the vast trade and economic relationship between the United States and the rest of the world. For example, a World Bank Working Paper by Ravillon (2008) suggests that the crisis could soon reach “deeply into the lives of many of the four fifths of humanity in developing countries”. However, it is not the interest of this paper to study how the crisis has affected every country of the world. This paper’s main objective is to understand how the crisis has affected the U.K’s economy highlighting the main industries that have been hard hit by the crisis. It should be noted that the U.K economy is highly correlated with the U.S economy which indicates that the least shock on the U.S economy is likely to have an equal shock on the U.K economy transmitted through contagion. As a result we expect the U.K economy to have been significantly affected by the crisis. The rest of the paper is organised as follows: section 2 looks at the main industry sectors in the U.K that have been affected by the crisis; section 3 provides suggestions on the course of action available in macroeconomy policy terms to U.K policy makers; section 4 highlights aspects of the crisis that suggest market failure; section 5 provides comparisons of the crisis in the U.K and two developing countries; section 6 looks at why developing countries are more vulnerable to the effects of the crisis as well as what can be done to reduce their vulnerability in the short- and long-run; and finally section 7 looks at how the IMF, World Bank, U.N and other similar institutions can help developing countries out of the crisis.

  1. Impact of the Financial Crisis on the U.K Economy.

As earlier mentioned above, the world witnessed significant crisis recently. The crisis have been mainly because of falling house prices. The main industries that have suffered from the crisis in the U.K include the Financial Services Industry, the Retail Industry and the Automobile Industry. To understand how the Financial Services Industry suffered, we would look at the case of Northern Rock and Bradford and Bingley, two Financial Institutions that were nationalised by the U.K government as a result of the crisis. Keasy and Veronesi (2008) suggest that NR has been the most obvious victim of the changes which have taken place in the financial system over the past 20 years. Northern Rock was one of the U.K highest Mortgage lender. It invested heavily on mortgages originated from the U.S. Northern suffered so much because it ran short of liquidity which came as a result of the fact that it had made a significant number of mortgage loans to borrowers who could not repay. On the contrary depositors needed repayment of their deposits. Northern Rock’s difficulties were exposed because it approached the Central Bank (the Bank of England for a Loan). As a result, many depositors began demanding their deposits from Northern Rock and the Bank witnessed a Bank Run. (Keasey and Veronesi, 2008; Hall, 2008). Keasey and Veronesi (2008) suggest that the risks faced by banks depend on the quality of the lending and whether they have retained sufficient funds to meet the demands of depositors. In the event where depositors have confidence in the bank, the bank does not need to retain enough funds to meet demand deposits. On the contrary in the event were depositors lose confidence in a bank, the bank may have to retain 100 percent of deposits in cash to meet the demands of depositors. This is exactly what happened to Northern Rock. Its inability to meet its liquidity requirements landed it into trouble. Like Northern Rock, Bradford and Bingley invested heavily in sub-prime mortgage loans with less hopes that the loans would ever be repaid. It was also unable to meet the demands of depositors and as such also witnessed a bank run. (Adams, 2008). The Retail Industry has also suffered because it has been unable to get credit from banks. Despite a bailout by the government, banks have become more and more afraid to provide credit to businesses. As a result the retail industry has been witnessing a liquidity squeeze. Retail Giants like Woolworths have been forced into administration as a result of the crisis. In Like manner the Automobile Industry has been unable to make sales because banks are no longer willing to provide car loans. Automobile plants such as those of Vauxhaul and Land Rover have been forced to suspend operations for some time. One can see that the international financial crisis is really having a significant impact on the U.K economy.

  1. Macroeconomic Tools Available

The macroeconomic tools available to policy makers in these circumstances include fiscal and monetary policy. As far as monetary policy is concerned, the government needs to devise means of increasing the supply of money in the economy so as to reduce the liquidity squeeze. The policy tools in this case include the purchase of bonds in the open market by the Bank of England, the provision of loans to banks by the Bank of England (in its function as a lender of last resort). Fiscal Policy measures include reducing taxes, increasing government spending, etc. The U.K government has already done much to increase liquidity in the economy. On the 9th of October 2008, the government announced a bailout package of £500billion to major banks in the U.K. (Winnett and Porter, 2008). In addition, the Bank of England on Thursday 8th January 2009 reduced the bank rate (the interbank lending rate) by 50 basis points from 2 percent to 1.5 percent in a bid to mitigate the recession. (Watts, 2009). There are also speculations that the central bank and British government may soon feel compelled to undertake a range of extraordinary measures such as figuratively printing money in an effort to stave off the threat of deflation. (Watts, 2009).

  1. Aspects of the Crisis that Suggest Market Failure.

The aspects of the crisis that suggest market failure are numerous. Firstly, banks were unable to determine that the mortgage loans will not perform well. Moreover, credit rating agencies seem to have rated most of the mortgaged backed securities (MBS) as being of high credit rating and thus made it difficult for banks to detect the inherent default in them. In addition, the regulators failed to regulate the Financial Services Industry properly to ensure that firms in the industry do not involve in too much risk taking. Even when there were signs of a crisis, the Bank of England and the FSA failed to act fast enough to bail Northern Rock out. They allowed the matter to escalate to a point were the bank had to witness a bank run. As earlier mentioned in the introduction Reinhart and Rogoff (2008:2) the crisis involves “esoteric instruments”, “unaware regulators” and “skittish investors”. Esoteric here indicates that complex financial instruments were created. The risk of these instruments was difficult o determine. Regulators were also unaware of the risks inherent in these instruments and investors lose confidence in the market.

  1. Comparison of the Crisis in The U.K and Cameroon/Zambia.

The main impact of the crisis on Cameroon is the fact that the demand for exports has began to drop. Cameroon depends a lot on the export of raw materials including timber, rubber, banana etc. There are reports that the timber sector in Cameroon is already facing difficulties. Many contracts to supply timber to a number of European countries have been cancelled and approximately 10,000 workers have been temporarily sent on technical leave. (Nyuylime, 2008). The main difference between Cameroon and the U.K is that Cameroon is still practicing traditional banking policies. Loans are only provided to borrowers who can pay. In addition, the banking system as well as the financial system still remains underdeveloped. So-called esoteric securities are not yet present in the system. Thus, banks in Cameroon are not exposed to the same type of risks that financial institutions in the U.K are exposed to. However, because of Cameroon’s dependence on exports of raw materials to European countries that currently face significant financial problems; it could not be left out of the crisis completely. The direct impact of the crisis on Zambia have also be limited. Zambia relies mostly on domestic funding and it has a limited exposure to external lines of credit. Like Cameroon, the main impact has been on exports. Global copper prices have dropped sharply and because copper accounts for a high portion of Zambia’s exports, Zambia’s currency has witnessed a significant deterioration of its currency. (Revilla, 2008). The government’s fiscal position has weakened because it depends heavily on increased tax revenues. (Revilla, 2008).

  1. How developing Countries can Limit Their exposure to Crisis.

Developing countries can reduce their exposure to such crisis in the future by reducing their dependence on the export of raw materials. What developing countries can do is to encourage inward foreign direct investment (FDI) into its manufacturing sector that will enable them transform their raw materials themselves. Developing continue to export raw materials at very cheap prices and buy capital goods from Europe at far more expensive rates. By so doing, they will be able to reduce their exposure to external shocks in both the short- and long-run.

  1. The Role of the IMF, World Bank and U.N.

The IMF and the World Bank can help developing countries by providing them with loans that will help improve on their manufacturing sector. In addition, they need to help developing countries improve on their infrastructure, transport networks and education. They can also help developing countries improve on their financial systems and macroeconomic policies. These are the factors that help in attracting foreign direct investment to the manufacturing sector in particular. By so doing, developing countries can reduce their dependence on export of raw materials. They will rather be transforming the raw materials themselves and their European counterparts will have less power to determine prices for them. This is because falling supply of raw materials will bid up prices. Another problem with developing countries is that they are characterised with a lot of conflicts that need to be resolved. In Africa for example, there is no democracy and the few countries that claim to be practicing democracy are still far from embracing true democracy. The lack of good political structures is hampering the development of sound macroeconomic policies. The U.N needs to play a more influential role to reduce conflicts in developing countries and to install concrete democratic structures in these countries.

BIBLIOGRAPHY

Adams, M. (2008). What Bradford & Bingley Will Cost Us. Available online at: https://money.sky.com/money/recession/bradford_bingley_public_cost.html

Cecchetti, S. G. (2008). Crisis And Responses: The Federal Reserve And The Financial Crisis Of 2007-2008. Working Paper 14134, NATIONAL BUREAU OF ECONOMIC RESEARCH, 1050 Massachusetts Avenue Cambridge, MA 02138 https://www.nber.org/papers/w14134

Keasey, K., Veronesi G. (2008). Lessons from the Northern Rock affair Journal of Financial Regulation and Compliance; Volume: 16; Issue: 1

Hall, M. J.B. (2008)The sub-prime crisis, the credit queeze and Northern Rock: the lessons to be learned Journal of Financial Regulation and Compliance; Volume: 16; Issue: 1;

Nyuylime, L. P. (2008). Cameroon: Global Financial Crisis – Cameroon. Available online at: https://allafrica.com/stories/200810210847.html

Ravallion, M. (2008). Bailing out the World’s Poorest. Policy Research Working Paper No. 4763. The World Bank Development Research Group.

Reinhart, C. M., Rogoff, K. S. (2008). Is the 2007 U.S. Sub-prime financial crisis so different? An International Historical comparison. Working Paper 13761 National Bureau Of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138: https://www.nber.org/papers/w13761

Revilla, J. (2008). Impact of the Global Financial Crisis on Zambia. Available online at: https://africacan.worldbank.org/impact-of-the-global-financial-crisis-on-zambia.

Watts, W. (2009). Key British interest rate cut to all-time low. Available online at: https://www.marketwatch.com/News/Story/Story.aspx?guid=%7BF64C219E%2D1B59%2D43D9%2D954C%2D4303F2645C30%7D

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