Mar 9 - 15, 2009

Severe problems in the USA's mortgage markets and increasing volatility in interest rates in emerging markets surfaced in mid of 2007 as early signs of emerging global financial turmoil. Despite massive liquidity injections and an increasingly loose monetary stance in USA, Japan and parts of Europe, the turmoil continued in 2008.

In September 2008, the financial turmoil intensified once again, this time turned into a global financial chaos characterized by a severe credit freeze, a precipitous sell-off in stock markets worldwide and the collapse of major financial institutions in the US and Europe. Several developed countries needed massive emergency loans from International Monetary Fund (IMF) to cope up with their financial problems.

The continued housing slump in the USA triggered the collapse of this financial house cards. Housing prices continued to decline in 2008 at an annual rate of about 17%. Mortgage delinquency ratio surged, particularly for sub-prime loans. No less than 40% of the sub-prime mortgages originated in 2006 were delinquent by the second half of 2008. As a result, the value of mortgage-related assets deteriorated significantly.

By the third quarter 2008, financial institutions worldwide had written down a total value of about $700 billion worth of asset-backed securities, of which major chunk belonged to commercial banks. This had actually led to erosion of capital base of many financial institutions and severely curtailed their ability to lend.

The credit crisis quickly spread to Europe, with a number of large European financial institutions courting collapse.

The contagion effects of the crisis also spread rapidly to emerging economies. Hungary was among the first of the emerging markets to have suffered. In Iceland, three major banks collapsed, dragging the country on the brink of bankruptcy as the total external liabilities of them accounted for five times Iceland's annual GDP.

Both Iceland and Hungary had to return to the IMF (and other sources) to alleviate the immediate financial market stresses, becoming the first two European countries to do so in over 30 years.

Ukraine also ran into acute liquidity problems, as its access to international capital markets was curtailed sharply, its currency was sold off, and the credit rating agencies downgraded the country's debt rating.

Initially the view was that the financial crisis that began in USA and then spread to Europe would not seriously affect the economies of the developing world. Most developing countries were not closely linked with the global financial system anchored in the US. However, in October 2008 many large developing countries saw record declines in their stock markets. The declines were registered in the sectors in which there were close connections with the developed world.

The drop in commodity prices hurt particulars exporters, but lower demand in the developed countries affected export growth throughout the developing world. Some emerging market economies faced with the severe curtailments in access to international trade.

The financial crisis that has spanned the globe has had an especially strong impact in countries beset by political uncertainty. Weak governments saddled with poorly performing economies are more vulnerable to social unrest. Pakistan is one of the most prominent examples of a nation where economic pressures are feeding unrest and threatening a wobbly government.

Growth has stalled in Pakistan while prices of food and fuel have been sky rocketing. Inflation, while down slightly from last year, still hovers at around 20%. There is unhappiness among the general population as food prices have gone up tremendously, gasoline is not available, electricity shortages are rampant. And, it doesn't seem that the government of Pakistan has solutions of all these problems.

The truth is that Pakistan's severe economic and financial problems, largely, are its own and not really connected with the financial turmoil in the US and Western Europe. With fast depleting international reserves, there was a growing fear that the country might be closing to default on its foreign loans obligations in future. Pakistan has the lowest credit rating in the developing world.

Pakistan could have actually reaped the benefits from the financial crisis in the developed world, at least in the short run. Pakistan's external account situation is a result, in part, of large increase in the import bill. This happened because of the unrelenting increase in the prices of oil and several agricultural commodities imported by the country. Both food and energy prices indices continued to increase through 2007-2008, with the oil prices increase outpacing the increase in the price rises of internationally traded agricultural products.

The financial crisis has suddenly reversed these trends. The prices of oil have declined by 50% in a couple of months while the prices of traded food crops have registered significant drops. This should have provided Pakistan with some relief and stop the rapid hemorrhaging in its foreign exchange reserves. Nevertheless, due to lack of inefficient regulations and negligence of our policy makers people keep facing the music.

Pakistan got a severe hit on its exports due to downturn in US and Europe. Millions of job losses in US resulted in declines in spending. Consumer spending is the main engine of growth in the United States. If it declines significantly, the economy goes into recession, and once an economy is in recession, there is a negative impact on imports. There had been large reduction in the American imports.

Of the developing world, the country affected most severely was China, which depended on exports to US to drive its trade-oriented economy. The effect on China was felt by a number of countries in its neighborhood that are exporters of raw materials to China.

Policy makers in Pakistan should make an effort to understand the nature of the economic and financial crisis in the west and adopt the policies that will arm it for both the short and the long-term.