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Global Financial Meltdown and Its Impact on Saudi Arabia Report

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Updated: Nov 14th, 2021

Outline

The worldwide financial crisis is rearing its head since the middle of the year 2007 and has a full impact during the year 2008. Due to this economic crisis, the stock market around the world have tumbled, the world’s famous and large banks and financial institutions have filed bankruptcy petitions or merged and even the wealthiest nations faced the brunt as they have to come to rescue their banks and corporations with financial rescue packages mainly to bail out their economic structure. (IMF Report vi).

The fundamental reason for the present international financial meltdown can be ascribed to the subprime disaster which is the outcome of a national bubble in the residential housing market that started to burst in the USA in 2006 and has presently created shatters in many other economies across the world in the guise of the international credit crunch and financial failures. The impact of the financial rupture is that it has set in motion basic societal transformation – the change that will influence global consumer’s customs, relations with each other and our values. (Shiller 1).

Though, Saudi nations gained initially due to speculative zeal which pushed up the oil prices to unprecedented levels but later witnessed downtrends due to global financial crisis (Shiller, p. 5).

Commodity exporting nations like Saudi Arabia will witness a deep fall in oil prices which will put heavy pressure on its government finances and external accounts. Further, any future limits on OPEC productions could naturally assist to support oil prices. However, due to rising inventories and softening demand will prolong to weigh on the market in the shorter run (IMF Report, p. 12).

This research essay will focus on how the recent financial crisis has affected the economic system across the globe and its impact on Saudi Arabia’s economy in detail.

Introduction

The international economy is in the middle of a deep slump, influencing financial and real estate sectors which are having its impact both in advanced and in developing and emerging nations. All major developed economies are in a slump while economic activity both in developing and emerging economies is declining suddenly.

All nation’s economies are vulnerable to present international meltdown greatly than in earlier meltdowns since they are now more integrated than before with the global economy through foreign direct investment (FDI), trade and remittances. The current economic crisis has affected these nations through decreased requirements for their exports. Since a majority of these nations are exporters of merchandise and commodities, they are affected badly by the sharp downfall in demand for their merchandise. Due to global economic recession, many nations are affected by lower inward remittances and the flow of foreign direct investments and financial aid from the advanced economies is also under threat. It is to be noted that the increase in inward remittance was flat in the latter half of the year 2008 whereas it is anticipated to be negative in the year 2009. In the case of developing countries, a sharp decline in inward remittance is expected. Since many donor (advanced economies) nations are experiencing budgetary pressures, hopes for higher aid are rather eluding. (IMF Report vii).

Due to the present crisis, foreign lenders may become more unwilling or not able to roll over private and sovereign debt falling due. Domestic banks of many nations have been knocked by second–round impacts, as the economic slowdown increases the quantum of borrowers not capable of repaying their credits.

The international financial debacle will deteriorate the budgetary status of many countries. Since the economic activity slows down and due to a fall in merchandises prices, government revenues are anticipated to shrink. Developing nation’s budgets will witness serious budgetary deficits due to tighter economic scenarios and a fall in donor support. Further, many nations have to augment their spending mainly to safeguard the interest of the downtrodden people and extra spending pressure may come from rising interest rates, currency depreciation that could increase the debt service costs.

The present global financial meltdown is expected to have a serious impact on those nations which are heavily reliant on merchandise exports like oil exports. For the year 2009, the baseline projection predicts an aggregate of a balance of payment shock of US $166 billion. (IMF Report viii).

It is also predicted that developing nations may require a minimum of US$25 billion to counterbalance the effect of the shock on their global reserves.

This research essay will focus on how the recent financial crisis has affected the economic system across the globe and its impact on Saudi Arabia’s economy in detail.

Review of Literature Review and Analysis

During the Great Depression, the banking industry was worst affected due to speculation and bad loans. In the recent subprime mortgage crisis, discreet home loans were issued right and left to homeowners, and loans were sanctioned for investment in mortgage-supported securities.

In 1929, more than 5000 banks collapsed and ceased to lend to shun further losses. During the current subprime mortgage crisis, banks are lethargic in lending to shun further losses and credit markets have come to a virtual halt status.

The fundamental reason for the present international financial meltdown can be ascribed to the subprime disaster which is the outcome of a national bubble in the residential housing market that started to burst in the USA in 2006 and has presently created shatters in many other economies across the world in the guise of the international credit crunch and financial failures. The impact of the financial rupture is that it has set in motion basic societal transformation – the change that will influence global consumer’s customs, relations with each other and our values. (Shiller, p. 1).

Thus, the ultimate cause for the current global financial debacle is the psychology of the reality bubble which is analogous to the erstwhile stock market bubble that occurred internationally earlier. The fundamental cause for the reality bubble may be attributed to ever-growing deceitfulness among mortgage lenders, immorality practiced by rating agencies, hedge funds and securitisers. Housing loans were sanctioned especially in the USA to left and right to all of those who walked into the bank without assessing their financial background and ability to repay.

These mortgage loans were later securitised and sold and resold to investors around the world including commercial banks around the world. (Shiller, p. 3).

Due to massive scale default in mortgage repayments, many major US-based banks sustained heavy financial losses and most famous banks like Morgan Stanley, Bear Stearns, Merrill –Lynch, Fannie Mae, AIG, Freddie Mac, Citibank, Lehman Brothers and Merrill Lynch were in the red. Morgan-Stanley and Goldman Sachs were transformed as holding companies which perhaps acted as the end of investment banking in the U.S.A. The financial crisis enveloped other economical sectors as there were defaults in automobile loan and housing credit card sectors also. Both the state and local government finance was affected badly as credit ratings of municipal bond insurers were downgraded. The corporate loan sector was also affected due to severe setbacks suffered by the market for commercial paper.

Since mortgage loan securities of the USA has been sold and resold to many financial institutions around the world, the sudden debacle in the US housing market has created rumble in many parts of the global economy as there were failures of WestLB, SachsenLB and Deutsche Industriebank and BayernLB in Germany, the failure of BNP Paribas in France and the bankruptcy of Northern Rock Building Society in the United Kingdom (Shiller, p. 4).

Failures of many banks across the world have in fact had a reverberation on the U.S economy ad it had manifested in a declining dollar, failure of the U.S investment bank Bear Sterns and many more financial failures.

Speculative passion in fact assisted to result in an international energy crisis and an international food crisis. Though, Saudi nations gained initially due to speculative zeal which pushed up the oil prices to unprecedented levels but later witnessed downtrends due to global financial crisis (Shiller, p. 5).

International economic growth is expected to deteriorate significantly. Economic activity on the international level is anticipated to slow down from 3.5 % in the year 2008 to just 0.5 % in the year 2009 before venturing on slow recovery in the year 2010. (IMF Report, p. 11).

Even the developed economies as a cluster are witnessing their worst ever post-war economic abbreviation. Japan and the EU have been worst affected due to a downfall in external demand, while in the USA, the vagueness about the path of the economy is weakening both in business investment and consumption. Economic activities in the above-mentioned nations are anticipated to reduce by two percent in 2009 accompanied by a modest recovery in 2010.

Saudi Arabia’s national economy is robust and is able to meet the international economic confronts and global changes. However, Saudi Arabia’s economic growth is predominantly dependent on its oil exports and any constant fluctuations in oil prices will no doubt have an impact on its national economy. Any unexpected downfall in oil price due to the global economic crisis would hamper Saudi’s economic development as it may badly affect government spending. The relationship between the ruling al Saud family and Wahhabi Religious authority is deeply cemented. However, Wahhabi often raises their concerns about the ruling family involvement in the global economy. Any future fatwa by Wahhabi may hamper Saudi’s future economy. (Ali, p. 32). Many Saudi Arabian enterprises which include government holding have foreign assets worth $ 237 billion as of 2006 and any global economic crisis will no doubt have an impact on the values of foreign assets held by Saudi companies and its economy ( Ali, p. 29).

Commodity exporting nations like Saudi Arabia will witness a deep fall in oil prices which will put heavy pressure on its government finances and external accounts. Further, any future limits on OPEC productions could naturally assist to support oil prices. However, due to rising inventories and softening demand will prolong to weigh on the market in the shorter run (IMF Report, p. 12).

The Earlier Financial Crisis

During the earlier financial crises which occurred in the 1990s, many developing nations particularly in Asia introduced some significant changes in their macroeconomic position. Many of these nations, prior to these financial crises, had meek current account deficits and trade. These nations had invested higher than their savings and they funded their investment by resorting to borrowing from the rich nations of the world. For fast-developing economies, this borrowing has some hidden advantages. These nations will have become strong economies in the future as they are able to maintain the consumption with the help of their borrowing and at the same time, they invested in the infrastructure projects like new manufacturing units and new highways.

For varied underlying reasons, these nations underwent a chain of a financial debacle in the 1990s as detailed in the following table:

Year Name of the Country
1994 Mexico
1997-1998 Asia
1998 Russia
1999 Brazil
2002 Argentina

The outcome of the financial crisis was a steep decline in lending from the strong economies, a tumult decline in the value of their stock markets and currencies and deep recessions. After the financial crisis was over, these nations significantly increased their savings, restricted their external borrowings, and later these nations have become leading lenders to the other nations particularly to the USA. In 1996, the developing nations borrowed $88 billion from other nations and in fact, these nations saved a net amount of $205 million into the global stock market later.

This reversal has generated an international saving glut. In advanced nations, capital markets were soaked with extra savings and they were in search of the best investment opportunities. This heavy demand for investments resulted in the developing asset markets in the USA including the housing market and stock market.

Sub-Prime Mortgage

Attracted by the near to the ground interest rates coupled with the international saving glut associated with lax lending norms and with the belief that prices of houses would continue to soar, substantial borrowers availed mortgages and became homeowners between 2001 and 2006. These borrowers include a number of “subprime” borrowers where their loan applications did not fulfill even minimum conditions. For instance, mortgage loans were sanctioned whosoever walked into the bank and those have high present debt-to-income proportions or poor credit records. It is to be observed that in 2006; about 20% of the new mortgages sanctioned were subprime mortgages. The phenomenon of low interest rates prevailed for more than two years in the USA. After two years, between 2004 to 2006, the Federal Reserve increased the interest rates from 1.25 percent to 5.25 percent mainly due to inflation. One another argument for justifying the Fed’s action was that the interest rates were too low in the past years and Fed intervened and raised the same to a more reasonable level. The increase in interest rates has pushed the demand for homes down as the cost of borrowing has increased beyond the level of middle-class sections of the USA. At this stage, the interest rates on subprime mortgage moved from low teaser rates to higher market rates and its impact on housing prices were more acute. In 2007, about 16% of subprime mortgages with adjustable rates were turned into non-performing assets. Thus, the low-interest rates have kindled a housing boom in the USA but ended in defaults when interest rates moved upwards resulting in the subprime mortgage debacle.

In the meantime, banks in the USA have indulged in securitisation of their sub-prime mortgages. Like a buffet offered in a star hotel, securitisation consisted of collocating together a large chunk of individual financial commitments like mortgages and then cut them and dice them into varied pieces that attracted varied varieties of investors. These mortgage securities will be taken by hedge funds in the anticipation of profiting a high volume of return later. Likewise, a pension fund may subscribe to a safer portion with the limitation imposed by the bye-laws within which it operates. The remaining portion of the mortgage is called by different acronyms and names like collateralised debt obligations, asset-backed commercial papers and mortgage-based securities.

In general, collating a chunk of numbers of assets can branch out the peril linked with any individual asset. For example, a single subprime mortgage may be vulnerably risky and if one places tens of hundreds together and only a few may become a default, the total sum of these instruments will be mostly insulated against risks. However, in the case of the subprime mortgage debacle, the underlying mortgage was demonstrated to be riskier than anticipated by the majority of the investors.

Mortgage banks that created mortgages disposed of them off and did not have to bear the brunt of their specific mortgage have defaulted. Due to this, lending norms were worsened. The fundamental belief in the process of securitisation is that the major chunk of mortgages will not go bad at a time. This assumption is based on the fact that in the annuls of the USA’s housing market, though some regions experienced a downfall in housing rates, the overall country’s market remained stable.

Due to inflation, when Federal Reserve was compelled to increase the interest rates, the housing market in the USA started to tumble as more and more repayment under subprime mortgages failed substantially, the housing price across the nation fell drastically and this compelled further non-repayment of more existing mortgages. Thus, an innovative financial concept “securitisation” is actually failed as it could not insulate against the aggregate risk as it was apprehended.

An innovative financial instrument like securitisation was designed and traded but it is arduous to learn how much exposure an individual bank had share to this risk.

In August 2007, the banks started to charge higher interest rates for interbank loans otherwise than for short-term loans. Thus, banks have either ceased to lend to those banks which have a higher risk in the subprime mortgage crisis or demand a premium for such interbank advances. These situations created a panic among bankers and they rushed to park their funds in U.S government bonds namely ‘treasury bills’ which mature within a period of twelve months which are famously known as “T-bills and avoided lending to other banks on a short-run basis.

As the yield on treasury bills crossed over 3.5 percent and all cash-rich banks deposited their funds in T-bills rather than resorting to interbank short-term investments which will yield some 1 or more percentage than on yield from T-bills. Thus, cash-rich banks have virtually stopped their investment in interbank investments due to the inherent risk involved in these investments and this has created a liquidity crisis in the US banking system. The liquidity crisis is a situation where the volume of transactions in certain financial markets decline deeply, making it arduous to evaluate some financial assets and thereby raising a scenario where the banks having those assets are viewed cautiously. The liquidity crisis was blown out to a magnificent level in September 2008 where the risk premium exploded from just 1 % to more than 3.5% points.

Due to this liquidity crisis, the U.S government during September 2008 is forced to take over the mortgage institutions like Freddie Mac and Fanny Mac. The renowned Mortgage bank namely Lehman Brothers filed a bankruptcy petition. Bank of America acquired the famous financial institution “Merrill-lynch”. To save another famous financial institution namely “AIG “, the Federal Reserve of America organised an $85 billion bailout.

Financial Crisis and Oil Prices

The global financial crisis has been impacted by the steep movement in oil prices during 2008. The oil prices were in tranquillity for nearly the last two decades. However, in the middle of 2008, the oil prices soared to an unprecedented level. The oil prices were as low as $ 20 per barrel in the year 2002 was soared to more than $ 140 per barrel during the first half of the year 2008. This seven-fold increase was more or less amounted to the magnitude of oil prices that occurred in the year 1970s. Due to the impact of unprecedented oil prices, the prices of coal, natural gas, corn, steel, rice and wheat also soared up. This price increase has added more oil to the global financial crisis fire. Due to unprecedented oil price increase, the consumption of oil has declined in OECD nations including the USA. However, the decline in demand has been offset by the rising demand from nations like India, China and the Middle East. Thus, an outward ship in demand has been represented by rising quantities and also rising in prices which resulted in rising demand for oil throughout the world amidst of unprecedented increase in oil prices. The demand for oil despite its high price by the developing nations has in fact simulated an increase in the price of fundamental commodities. Short-run elements like poor crop yields, macroeconomic volatility in China, United States and elsewhere, and in the USA seem to have played a leading role in infuriating the movements in prices.

Liquidity Crisis and Bank Runs

In the 1930s, at the time of the great depression, the banks experienced great difficulty due to a liquidity crisis as the depositors lost their confidence in the banks and demanded to return their deposits jointly. This paved all the depositors of the bank to congregate at a time to get back their deposits back from banks. However, with the limited cash resources and reserves, the bank may be unable to repay almost all the deposits at a time as the major chunk of the bank’s assets are in the form of investments and loans and thus in the illiquid forms that are difficult to change back into cash rapidly at their fair value. The bank is compelled to call in its outstanding loans and forced to dispose of off their investments rapidly to repay all of its deposits. To the magnitude that these actions lead the values of these assets to decline, the bank run itself may compel the bank to possess negative equity, a kind of self-fulfilling insight. Due to the difficulties witnessed by the banks, the Federal Deposit Insurance Corporation (FDIC) was established in the year 1933 to offer government guarantees or insurance to the public deposits in the banks as a measure not only to boost up the investor’s confidence in the nation’s banks but also to alleviate the kind of trauma that banks witnessed during their bank run.

An associated issue on the liability side has happened during the recent financial crisis. However, during the recent financial crisis, the withdrawal of public deposits has not occurred but the real problem was the short-term debt. In the process of the management of their loans, deposits and investments, financial institutions frequently have relatively huge amounts of short-term debt. The best illustration is the commercial paper which is frequently traded with maturities of seven days or less. Banks may be necessitated to borrow in the commercial paper market to finance the ‘cash’ balances on the asset side of their balance sheet which is employed to administer their day-to-day financial commitments. Due to the fall of the Lehman Brothers, during the fag end of the year 2008, financial institutions have become more cautious about advancing the funds through the commercial paper to other financial institutions that are on the verge of insolvency. Due to these factors, the interest rates on commercial paper shoot up drastically to more than 5 percentage points, and hence using this kind of finance by banks has been sharply reduced. Then, the banks were in the position to sell some portion of their semi-liquid assets at “fire sale “prices which contracted their networth. This is also known as the liquidity crisis.

Leverage and Financial Crisis

We can describe the leverage as the spirit or genie that comes out from the magic lamp. At the time when the asset prices are experiencing a high return, leverage can turn a just ten percent return into a fifty percent return. In the time up to this current financial debacle, the genie was able to grant the wishes and thus, the financial institutions enjoyed massive gains by expanding their leverage. When banks quote leveraged bets which paid off about nine times out of ten, they even can have long runs of astonishing returns.

However, a genie can deliver negative results when there is a decline in the price of housing since 2006 and the diminution in the stock prices which have combined impact to put the of the solvency of many financial institutions at stake. As the financial system is so integrated and as the financial institutions lend and borrow large quantum with each other on daily basis in normal periods, problems in some banks can stimulate a systematic risk for the other financial system as a whole. In general, people lost their confidence in the banks even though some banks remained stable and financially mighty. This is analogous to a scenario like where ten bottles of water and one bottle of poison and are mixed and an individual does not know which bottle is poison and which bottle is water, then he will not dare to drink it even though he is experiencing acute thirst.

The features of the time before the financial crisis

Pre-financial meltdown era was boasted by expansion in the money supply that was accompanied by enforcement of low-interest rates. This economic scenario created a boost in real estate demand that slowly materialised into economic bubbles. Through income and wealth effect, the soaring prices of real estate have caused a boost in the consumption that ultimately ended in a vast shortfall in the current account of the balance of payments, which in its circle created a huge influx of US dollar into both developing and other developed countries. At the same time, to alleviate the velocity of increase in the value of the local currency with that of US dollar, these nations began to interfere greatly in the markets of foreign exchange, which ended in the replacement of aggregate of foreign assets and thereby corroborating the filling the gaps in their current account huge deficits and supporting the US budget.

Thus, the future of the macroeconomic atmosphere in the US resulted in the depreciation of the US dollar around the globe and compelled the major developed nations to lessen the interest rates to help to increase the value of their currency with that of the US dollar. These transactions ended in analogous scenarios in the real markets in these nations: a boost in demand and the creation of “bubbles” in the realty prices.

As a result, the vast deficit in the budget of the USA coupled with the higher real estate prices and the analogous scenarios in other developed nations ended in high levels of increase in both the consumption and income of the developed nations all over the world before the year 2007.

Due to this impact, the prices of raw materials have soared, which poignantly resulted in the amplification of the export from developing nations which has such abundant exportable merchandise. On the other side, the prevalence of lower interest rates in global markets induced the flow of foreign direct investments to develop nations from developed nations. Developing countries also witnessed the increase in speed of credit expansion due to the high rates of income growth and favourable environment of economic activity. Due to this, unprecedented high growth rates were witnessed by the developing countries in the pre-crisis period. The aftermath of all the above has reverberated in the real market when the constantly increasing demand ended at soaring prices on reality markets and generated “bubbles”.

A significant issue in this respect was the vigorous developments of financial inventions due to which global credit volumes and financial flows sped up. In addition, since 2004, in many nations the inflationary forces started to occur, and to find out a solution to this issue, various nations started to administer financial condensation frameworks like augmenting Central Bank interest rates and step by step minimising public deficit and these corrective actions did not yield much effect on structuring an over warming atmosphere. Further, in the scenario of over warming, the financial institutions across the globe undervalued the future perils and even in an atmosphere of changing interest rates prolonged to accomplish credit expansion through varied financial mechanisms.

Global recession and its spillovers

Due to globalisation, all developing nations have now integrated into the international economy. Due to this, a global economic meltdown is expected to have a major effect on these developing nations. Due to declining global demand, developing nations are experiencing a fall in trade volumes. Further, major developing nations will also be affected by lower foreign aid and reduced foreign direct investments and remittance from their non-residents. Due to the recent decline in the fuel and food prices, for net importers of fuel and food, the negative effect will not be to the full extent. (IMF Report 24).

Global financial crisis and trend in trade

Over the past two decades, trade has become a vital source of development for developing nations. The proportion of the aggregate of imports and exports to Gross Domestic Product which is known as “trade openness” of the developing nations has augmented substantially from 1991 and has been followed by a speeding up of growth. It is to be observed that lion’s share of developing nations exports are made to developed nations and this share is declining nowadays. The percentage of exports of merchandises by developing nations has been estimated to the proximate 70%. Thus, the global economic slowdown definitely will have an impact on the developing nation’s economy as they are more reliable on merchandises exports. (IMF Report 15).

Global Financial Crisis and Remittances from Non-Residents

For developing nations, remittances from non-residents comprise a significant basis of external financing offering contribution to the growth of their economy and income to the poor. According to a World Bank survey conducted in the year 2006, since the 1990s, on a global scale, remittances from non-residents have soared at a double-digit rate per annum.

Due to the global economic meltdown, current estimates demonstrate a downward trend in remittances which stagnated in the latter half of 2008 and contracting in the year 2009. The recent decline is anticipated in developing nations Pacific, Asia and Europe. A recent substantiation demonstrates that in some nations, the downfall in remittances can be major and for example, in Honduras, the decline in remittances was reported at 4.5 % in October 2008. (IMF Report 16).

Global Financial Crisis and Foreign Direct Investment

Due to globalisation, the inflow of FDI has witnessed tremendous growth in almost all nations in the last two decades. On a mean basis, FDI in developing nations has increased by five folds since 1990 in the percentage of their GDP. However, due to the global economic crisis, inflows of FDI have shrunk sharply. As per WEO estimations, inflows of FDI are expected to fall by about 20% from their 2008 levels. Due to the global financial crisis, multinational companies are experiencing lesser profits coupled with difficult financing environments and high ever-changing prices of merchandises and this has resulted in either suspension of their earlier FDI commitments or not being in a position to earmark fresh FDI for new projects. For instance, in Mozambique and Lao PDR, FDI pertaining to the expansion of mining and hydroelectric projects has been either suspended or delayed.

Thus, a reduction in the flow of FDI is anticipated to have a major effect in over of the countries around the globe. Asian and Latin American countries are expected to be the worst affected due to the global financial crisis. (IMF Report 20).

Global Financial Crisis and Foreign Financial Aid Inflows

During this decade, many advanced nations indulged in poverty-mitigation efforts around the world which have paved financial aid flows to the developing and underdeveloped nations. During the year 2006, financial aid peaked mirroring debt relief joined with the augmented inflows from a prospective donors like GCC nations, China and Russia. According to the OECD Report of 2008, in 2006-07, the net official development assistance continued and unaltered in real sense.

Probable contractions in financial aid flow to poor and under-developed nations raise grave concerns. Considering the gravity of the economic meltdown in the growth of developed nations, a major chunk of reduction in financial aid cannot be lined out. Rwanda, Burundi, and Afghanistan are especially susceptible to a decline in aid inflows. (IMF Report 21).

Global Financial Crisis and Debt and Fiscal Sustainability Impact

Fiscal exposures are materialising in the guise of decline in revenues, coercion on spending is on the increase, and deterioration on financial conditions. In most exposed nations, the global financial crisis will aggravate the perils of debt distress. The majority of developing nations will be suffering from fiscal vulnerability due to global recession and financial crisis. Budgeted revenues of the developing nations are projected to suffer due to slow down in the economic activity, fall in merchandise prices, increased pressure on spending, and financing scenarios continue to be stiff. (IMF Report 21).

Global Financial Crisis and Debt and pressures on governmental spending

Merchandise export syndicates which have suffered by falling prices and by lower demand may approach the government to compensate them against their falling revenues. The government may be compelled to subsidise the exports by offering various incentives like duty drawbacks, export incentives, and income tax exemptions for exports.

In capital-intensive industries like oil industries, if output declines, the effect on employment would be restricted at least for a short period. However, for countries which are predominantly export agricultural products, falling merchandise prices would lessen both the rural income and employment thereby augmenting poverty in rural areas. If energy and food prices decrease, the urban poor will reap the major benefits. Different studies on the subject demonstrate that there have been two percent increases in the poverty rate if mean growth declines by one percent. (IMF Report 23).

The financial crisis made the nations that have the access to the international capital markets and have to defer higher interest rates and there has been a substantial increase in loan base points during the last year. (IMF Report 23).

Global Financial Crisis and its effect on the Debt Sustainability

The debt pointers of developing nations have increased substantially in recent years. During the past decade, debt relief efforts have obviously minimised the large volume of external debts with which developing nations are frequently hampered. With the financial aid from donors and development partners like World Bank and IMF, developing nations have been striving hard to maintain future debts at affordable cost and within their repaying capacity. Enhanced sustainability of debt has assisted to create donor and investor confidence as is corroborated by sizable FDI and aid inflows to developing nations over the last twelve months.

To offset the impact of a current global financial crisis by resorting to higher borrowing could result in serious risk especially for developing nations that already have a large debt commitment. It is to be observed that about 28 developing nations have debt over sixty percent of their GDP.

Considering that about fifty percent of developing nation’s debt is external, exchange rate depreciation will kindle the proportion of debt to fiscal revenues and GDP. (IMF Report 25).

Global Economic Crisis and Unemployment Issues

As per the International Labour Organisation (ILO), the International economic meltdown is compounding and experts predict a protracted labour market recession.

  • At the international level, after 5 years of growth, the magnitude of unemployment increased in 2008 by fourteen million. The international unemployment quantum could reach thirty million employees in the year 2009 and will be exceeding more than fifty million if the scenario prolongs to get worse.
  • Many developing countries which are having export-oriented sectors are major suppliers of proper jobs are witnessing a fall of jobs due to swiftly shrinking world markets. A large chunk of employees employed in these sectors is anticipated to lose their employment either completely or to see their hours and wages cut down.
  • Earlier financial debacles demonstrated that it can take about the labour market 4 to 5 years to spring back after economic revival, which is not anticipated before the end of 2010.
  • The economic meltdown, which is estimated to be most harsh in developed nations, is expected to have bubble impacts on low and middle-income nations via a fall in the demand for exports, plunging tourism revenues and a fall in foreign direct investment.
  • The fall in remittances from family members working and living in developed economies will harm many developing nations and may also lead to a return to their motherland.
  • The returnees are less likely to be absorbed by labour markets of the countries of origin despite the fact that they are having useful new skill sets.

Any fall in foreign aid due to the economic recession in developing nations has a large pessimistic impact. In Africa, for instance, more than half of the aggregate of public health spending emanates from international aid. As such significant development efforts like the Global Fund to Fight Malaria, Tuberculosis, and HIV/AID’s, will be facing budget shortfalls.

The features of the post-crisis period

The economic boom had existed only for a short while. As akin to an ordinary business cycle, the retardation of the growth rates of the economy and even compression of the economy was anticipated. Nonetheless, there were no exact perceptions and predictions on a preliminary period of economic compression, degree and velocity of decline. The earlier symptoms were noticed in the middle of the year 2007 on the real market of the USA when the price “bubbles” exploded, the financial failures then fell on banks, insurance companies, and on other players of the monetary market. The crumble of the financial market in the US and prolonged economic debacle spread all across the globe. Thus, the real price “bubbles” had their ramifications in almost all nations as the reverberations in the US economy were observed both in developing, and developed nations. This connotes, crisp diminution of realty prices, radical worsening of the portfolios of the participants of the financial market, a keen decline of the credit quantum and there was a feeling of anticipation of economic downturn. All the above referred, by diffusing all around the globe implicated the steep decline of postulate for investments by corporate and consumption quantum by consumers. Dramatic price decrease for the raw materials was observed in the global commodity markets which stimulated these raw materials exporting nation’s exports to decline poignantly.

In total, in a very short period of time, the macroeconomic developments witnessed during the periods of economic growth commenced moving on the opposite route.

The Republic of Armenia which is one of the small open economies, witnessed earlier symptoms of economic depression as it witnessed a drastic fall of export rates in 2008 by six percent and in the half of the year 2009 about 48 percent. A thirty-five percent decline was witnessed in the indicators of remittances from the income generation side during the first half of the year 2009. The conditions of income decrease, the expectation of decline by the corporate and consumers which resulted in high rates of decrease of consumption and private investments.

The construction industry has become the chief driver for ensuring high rates of economic growth rate during the growth phase of economic activity. It goes without saying that the construction industry is the first to be impacted by the financial crisis. Sharp diminution prices of commodities on global markets straightaway impacted the magnitude of production of these merchandises all over the globe%.

The banking system was not unaffected by these incidents. The diminution of real-estate prices, the occurrence of the economic recession poignantly diminished the pointers of income of banks. Due to the high rate of mortgage defaults, the banking system announced the lending conditions more inflexible, taking into consideration the hypothesis of future risks. This type of banks’ performance, as it has been demonstrated by plentiful crisis affairs in the global economy, is rather cogent from the outlook of a solitary bank, but maybe illogical from the outlook of the entire system, since the degree of lending continued almost the similar and it becomes an extra feature stamping down the demand. No doubt, these happenings will affect the bank’s performance retrospectively: by amplifying the volume of non-yielding loans.

As regards the investments, when the demand is rising endlessly, the investments, which have been commenced to flow but not wrapped up yet during the development stage of economic activity, remained incomplete when the economic slump started. The investments have not reached their targets due to the quick and radical declines of internal and external demands, stiffening lending scenarios by the banks and negative anticipations of the corporate were the features for which in its roll turned those investments fruitless ones. The extensive housing construction which had started years ahead and was not completed ceased instantaneously due to the demand turn down and low echelon of accessibility of investments resources.

Ostensible inflexibilities of prices and wages are the significant causes, from the perspective of frustrating economic recession. Nominal wages decline in the labor sector was essential to balance augmented marginal expenses of companies and to lessen the inevitable unemployment. However, the inflexibility of wages in the labor sector stimulated the detrimental diminution of output and employment

On the other side, so as to reinstate real comprehensive demand to a certain degree, the decline in prices of goods was essential, which would facilitate to augment the purchasing power in a real sense. Nonetheless, in the commodities sector, there exist price adjustment inflexibilities too, which are disciplined mainly by the prevalence of non-competitive markets, due to which the prices did not decline to a degree, which was required for probably lesser diminution of quantum of production.

Is the Current Financial Crisis is a global One?

One another significant feature of the present financial crisis is that it is now international in scope. The most advanced nations like Germany, France, U.K and Japan are all in or seem to face a deep recession; For instance, of late, Japan has declared that GDP in the last quarter of 2008 declined at the rate of 12.8% per annum which is the sharpest fall since 1974. International Monetary Fund has estimated that for the years 2009 and 2010, the GDP will register by only 0.5% in 2009 which is the lowest rate that prevailed since the Second World War. IMF also forecasted that development in emerging markets including China will be at a slow phase during 2009.

There are two significant propositions of the global nature of this financial debacle. The exports are going to suffer substantially as there is less demand globally. The lesser demand for export will be definitely having an impact on the GDP growth of any nation. Moreover, the global nature of the crisis highlights that the current recession is entirely diverse from what has occurred earlier. The current global recession is unique in nature and it was not voluntarily designed by the Fed to minimise inflation. The recent recession is nothing more than that of the balance sheet crisis both on the household side and the firm side and more or fewer analogs to the Great Depression than any other recession.

Methodology

This chapter will aim to justify the methodological decisions taken and used to investigate this research problem, through the choice of research design, data collection method, measurement tools, sample and size. The objective is to match the most appropriate methodological approach to the problem, bearing in mind time frame restrictions and limited resources.

Many collections of published works, which deal with the recent ideas and debates of the global financial crisis are examined, analysed and then deliberated. Some case study examples and evidence from across the world have also been widely discussed in this research. To support the theme and idea, this research has utilised the data published by the WTO, World Bank on the subject to support its findings.

Results

The present baseline projections for the year 2009 by IMF indicate that the sum of further financing need for developing nations is about USD 25 billion. Further, present estimations by IMF visualises an unfavourable balance of payments brunt for 40 developing nations in the year 2009 aggregating to about USD165 billion. Further, IMF estimates that there will be a decline in reserves of about USD 131.1 billion. Due to the global economic crisis, total reserve losses sustained by the developing nations are estimated at USD 25 billion which is equal to about 81 percent of the aggregate of the annual foreign aid received by the developing nations over the past 5 years (IMF Report 35).

Discussion

Many developing economies have no pre-plan action to implement counter cycle policies to highlight the effect of the global financial crisis. This spotlights the significance of the support of donors which will require speeding up to enable developing nations to fine-tune the impact of the global financial crisis on poverty. Governments should initiate some important policy decisions to reduce the impact of the global financial crisis like targeted spending to safeguard the poor, facilitate adjustment of exchange rate flexibility, and cautious financial management.

Nations with low tax to GDP proportion should attempt to source further domestic revenue to meet any shortfall in their fiscal budgets. A tax-to-GDP proportion of fifteen percent is regarded as a sound target for most nations and those nations which have tax to GDP well below this ratio. It does not connote that tax rates should be enhanced. In some nations, especially on mobile production elements like capital and skilled labor may act as an obstacle to sound economic development. Thus, nations should make endeavours to diversify their income base as it would help to reduce fiscal deficits. (IMF Report 31).

By increasing spending efficiency and by rationalising the expenditure, fiscal space can be created. If the government could unable to raise revenues through quality efforts in a short period, then this method would be more appropriate. Though limiting the recurring unproductive expenditure would often be politically arduous and however, that should be given first priority. Some of the unproductive expenditures like “white elephant projects ‘, offering generalised subsidies, large-scale government employment, and transfers to loss-making enterprises. In recent years, in response to the escalation in international oil prices, many nations have increased their subsidies. If there is a fall in oil prices, then the financial outlay of such subsidies would decrease. Further, fortification of financial supervision structure would result in enhancing expenditure efficiency thereby ensuring that resources are allocated to real beneficiaries. It is wise to avoid across–the–board spending cut down which can pave to inefficiency and arrears and are frequently not sustainable.

In about 18 developing nations, inflation still exceeded fifteen percent at the end of 2008 and it is expected to remain in double digits in another 12 developing nations throughout 2009. The reason for such high inflation is due to these countries’ loose fiscal and monetary policies which include in the shape of current high wage awards in Mongolia, negative real interest rates in Azerbaijan, and an expansionary deficit as witnessed in Ethiopia and Ghana. Further, developing nations may not find it relevant to restrict imports through quantitative or tariffs restrictions which minimises welfare by disfiguring incentives and new barriers can be difficult to rescind when the present pressures subside. Developing nations should pave immediate attention to crisis prevention measures which includes remediation plans and by establishing contingency plan for the financial system. (IMF Report 33).

Conclusion & Recommendations

From the year 2006 onwards, the U.S housing market is witnessing a downtrend. Due to massive foreclosures, the housing market is witnessing a difficult time. Many banks and mortgage institutions have filed bankruptcy petitions due to the subprime mortgage crisis in the U.S.A. The financial crisis in the USA has its aftermath all over the globe as U.S mortgage securities have been sold or resold to the banks and financial institutions of many nations. Thus, this research study has attempted to find out the real causes of the recent global financial crisis and to suggest ways and means avoid the same in the future.

The current global recession is so unique that future macroeconomic performance over the next sixty months is much uncertain. By all measures, the Great Depression was extraordinary with unemployment went to heights n 1933 at an amazing proportion of twenty-five percent. Though unemployment may not reach the proportion of the Great Depression during the current global crisis, it may well reach just fifty percent of it.

Recommendations

As a long-run measure, governments should introduce forceful economic reforms channelised towards broadening their economy with the creation of an efficient incentive system for allocation of resources, beefing up the anti-monopoly strategies, etc. It is poignant to make the sure efficient movement of the workforce in the labor market. Labor market with non-mobile nature is the main cause for not adapting the wages adequate to alleviate the vacillation of business cycles.

It is important to highlight the function of the banking structure in a cycle of development. In this respect, the anticipated serious restructuring in the financial systems of the developed nations which will be aimed towards the deterrence of economic disaster in the future which has to be taken into deliberation by the Central Bank of every nation.

Nations should spotlight the stability of the macroeconomic sector. In certain nations with decreasing inflation, there may be a possibility for easing monetary conditions. However, the majority of the developing nations would experience either renewed or continued price pressures. Those nations with flexible exchange rates may permit them to move so that they act as jolt absorbers. However, nations with fixed exchange rates regimes may fall under specific pressure owing to the adverse direct effect of the economic debacle. It is the need of the hour to initiate steps to thwart the international financial meltdown extending to their domestic financial segments.

To mitigate the financial crisis, nations should focus on urgent crisis management strategies which include preparing remediation and contingency strategies for the financial structure. Dynamics in financial markets and domestic debt may have grave overrun effects on the internal banking structure and the availability of credit. Evaluation of such association should be made both at systemic and institutional levels. Financial institutions, at the private sector level, should initiate repairing their balance sheets. In case, where there is a weak capital structure, fresh equity may be required to be pumped in or by resorting to medium-term funding even if the cost of doing so is high.

Financial institutions’ overall risk administration structure especially for counterparty risk management and for liquidity needs to be critically evaluated. A stress test should be carried out to identify probable balance firm-specific contingency strategies..

Timeline of project milestones

20 August – 25 August 2009
26th August- 01 September 2009
Introduction
Literature Review.
02 September 2009 – 10 September 2009 Plan the methods and research strategy.
11 September2009 – 17 September 2009 Data collection.
18 September 2009 – 25 September 2009 Data analysis.
26 September 2009 – 10 October 2009 Writing dissertation.
10 October 2009 – 20 October 2009 Final review and Submission.

Works Cited

  1. Ali, Abbas. Business and Management Environment in Saudi Arabia. New York: Taylor & Francis, 2009.
  2. International Monetary Fund. The Implications of the global financial crisis. World Economic Outlook, Washington, 2009.
  3. Jones, Charles, I. The Global Financial Crisis. Stanford: Stanford University, 2009.
  4. Shiller, Robert J. The Subprime Solution. How Today Global Financial Crisis Happened. Princeton: Princeton University Press, 2008.
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