Global Financial Instability by Mansi Gupta (winner of Ecosynthesis)

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of
foolishness, we had everything before us, we had nothing before us…”

Charles Dickens

Such is the global state of affairs today that you would not be called a Cassandra to predict that it might only get worse from here. And, would you not call the lurking Contagion, a looming doomsday in the air? Well, some might say “all is not that unwell”. But, the roaring waters might soon start flowing post the danger mark.

It might just be too little, too late constructing a dam, then. And we may see why?

Let us turn around the tables towards the earlier considered to be “too big to fail” developed economies. These economies marred with heavy debt burdens and weak growth prospects don’t seem to be proving themselves as the ‘messiah’ of the global financial recovery in the immediate future. And I doubt they were ever seen as one in the past four years of crisis. The ‘emerging economies’, also seen as the engines of growth during the slowdown, are battling the problems of their own, and despite brighter growth prospects, are vulnerable to financial reversals and stubborn inflationary pressures. To add to the global agonies, the fears of sovereign defaults by
the countries, earlier seen as a ‘normal phenomenon’, leading to a colossal financial contagion only proves how fragile an International Financial System we are putting up with. And as, the global investors move towards safety and where the higher interest rates take them to, amidst the low interest environment and high levels of uncertainties, the effects of volatile asset allocations remain worrisome. The role of these variables as the indicators of the next financial crisis, albeit a much bigger one, largely remains to be probed.

The catastrophic disaster hit the slow recovery from the worst of the financial crisis in March
this year when The Great East Japan Earthquake and tsunami did not churn out major losses only to the Japanese economy but
,also swelled unrest in the oil producing countries. The importation of crude oil supporting 61% of Japanese energy demands 1
got affected adversely when the catastrophe forced the manufacturing companies including the automobile giants to shut some of their centers, causing global oil prices to fall

Fig 1: Oil Price Movement in March’ 11 (Source: Hidden Levers)
just below USD 100 a barrel2.

Tokyo, Commodity Online, March 11, 2011
CBS News, March 11,2011

A question that might arise is that where did the impact of the Middle East strife; the much acclaimed Jasmine Revolution and Libyan unrest subside to as reflected in falling oil prices during that period? In late February 2011 to early March 2011, before the Japanese catastrophe, the oil prices were peaking at USD 125 -115[1] a barrel due to Libyan unrest that supplies 2% of world’s daily crude oil demand. The prices calmed with Saudi Arabia and OPEC increasing spare supply to make good of the cut Libyan supply. But the important take away here is for how long will this supply-demand mismatch continue with the shrinking OPEC pool, as evident in Figure 2

.Fig 2: Shrinking OPEC oil pool dampening global oil prices (source: Nomura)

The global fault lines cranked further under the weight of US ballooning debt – increasing fiscal deficit and the debate over raising the US debt ceiling. With US being the epicenter of the world wrecking financial crisis in 2008, the debate over raising the debt ceiling from USD 14.3 trillion to USD 16.4 trillion fueled fresh rounds of speculations over the sovereign default by the World’s largest economy! With the current US GDP estimated to be at USD 15.003 trillion (as on July 29, 2011)[2] , and the debt to GDP ratio at a staggering 98%, the non-conformity of opinions between the Republicans and the incumbent Democrats led to everyone doubting the political willingness of the US over adopting a sustainable fiscal course of action. Of course, this debate led S&P, one of the three prime credit rating agencies globally, to downgrade the triple-A rating of the US Treasury, which it held for nearly 70 years to a tad lower to AA+, at par with Belgium’s and New Zealand’s and lower than almost a dozen nations world wide! Of course, the impact of such a downgrade on investors’ sentiments and money markets was then a little undermined keeping into consideration, the state of the global affairs and the lurking Euro Zone crisis.

Fig 3: US Debt from 1940 to 2010 (source: Whitehouse Budget Historicals)

And, just when everyone would have had laid their hopes and bet on Euro Zone, it disappointed with the fears of disintegration and sovereign defaults lurking in the air. Policy indecision led to renewed financial instability across the globe, with the eyes set upon the European Commission Bank (ECB) and the biggies in the Euro area, the likes of Germany and France. With the doubts resurfacing in spring this year, and been strengthening with every passing day, notwithstanding the strong policy measures as pledged in the EU Summit held on July 21, 2011. And I wonder why would the worries subside without a substantial political willingness to draft a fool-proof policy framework for an economic-cum-political union to withhold its existence? Of course, the resulting formation of a horrible acronym PIGS (or PIIGS, with Italy included) was but obvious, howsoever undesired! Portugal, Ireland, Greece and Spain, and now, the anxieties including Ita to form PIIGS, refers to the most debt laden economies of Europe and with Greece almost on the brink of a sovereign default.

[1] The Economist, March 3, 2011

[2] US Department of Commerce, Bureau of Economic Analysis

How ugly is the situation and why might it lead to a much worse contagion amidst the dead slow global recovery, can be estimated from the fact that S&P Europe 350 index shows negative total returns (-2.75%) and price returns (-6.19%) for a period of one year[1]. The index level has also sharply declined from 1121 on June 1, 2011 to the till date 936.24 value recording a 16% fall in a span of four months as evident in Fig 4.

Fig 4: S&P Index Level Performance (Source: S&P Europe 350 Index)

The economy of Greece last bailed out by ECB and IMF in May 2010 with a Euro 110 billion loan just brought in a breeze of respite, which could only bought a little time

for Greece to put its financial house in order. And of course, the task was no child’s play and proved to be herculean with Greece’s debt to GDP ratios at staggering 142.8% in 2010, as compared to Euro zone’s average of 85.3%[2]. The European Financial Stability Facility (EFSF) created on May 9, 2010 with a mandate to safeguard financial stability in the Euro zone by raising funds in the capital markets to finance loans for euro area member states is being seen as the lender of last resort with a safety net of Euro 440 billion, as approved by ECB, IMF and Euro group, most recently Germany. This safety net however, seen to be contentious, “too little too late”, is expected to buy Greece an year’s time considered precious for it to bring about a breeze of financial stability.

The French Societe Generale (downgraded from Aa2 to Aa3) and Credit Agricole (downgraded from Aa1 to Aa2) ratings fall by another prime credit rating agency globally, Moody’s Investor Services sent a fresh round of financial instability shocks down the global economy on Sept 14, 2011. The fears of French banks’ exposure to debt laden Euro economies have resulted in sharp falls in the prices of French banking shares.

Fig 5: Greek debt in comparison to Euro zone Average (source: Bloomberg)

[1] S&P Europe 350 index, as on August 31, 2011

[2] Bloomberg Markets

Italy is now taking the centre stage of the Euro debt crisis, amidst the fears of default and its exposure to Greek junk bonds. And of course, why should it not hog the lime light with its debt to GDP ratio being at a whopping 120% and economic growth recorded at a mere 0.3%? [1]

Fig 6: Growing Chinese Exports (Source: Trade Economics, September 2011)

The emerging economies more recently raised to the clout of the ‘world’s savior’ with their brighter growth prospects and glitzy numbers are heating up with their central banks trying to put forth their best foot forward in cooling down the economies.

Closer home, the Chinese saga often ridiculed for its ‘grotesque’ economic policies depending on high exports and low domestic consumption, has been a subject for world wide criticism for not doing its bit enough for the global financial stability. With the Chinese exports registering a growth of 31.3% to USD 1.58 trillion in 2010[2], more than India’s GDP which stood at USD 1.38 Trillion[3] at current prices in 2009 which meant USD 1.49 Trillion in 2010 considering 8.5% GDP growth, the road ahead for the Chinese dragon without bolstering domestic consumption and CPI inflation levels at 27-month high hovering around 6.2% since July 2011[4], shall remain a bumpy ride.

The domestic turf, the ‘Emerging Indiabattles against the central bank’s worst enemy, the stubborn inflationary pressures, with the RBI increasing the policy rates 12 times since March 2010, the latest being a 25 basis point hike on September 16 with the repo rate now standing at 8.25%[5]. Of course, whether such a policy stand often accusing RBI of killing growth by India Inc

. is effective in curbing food and overall inflation which stands stubbornly tall at over 10% much above RBI’s comfort level of 4-5%, remains largely debatable. And as if the gargantuan inflationary levels were not enough to make D Subbarao sleep deprived, the recent Rupee slide due to investors’ fears over Euro crisis, moving Rupee 50-to-a-dollar mark, raised importer’s worries and crude oil imports expensive.  The rising borrowing costs are putting business profitability and margins under pressures, questioning the current monetary policy stand of RBI. The moderated growth numbers undermine investors’ sentiments leading to capital flights.

Fig 7: Rupee to Dollar Movement in September 2011 (Source: Exchange

[1] CNN Reports, Aug 2011

[2] Trade Economics data, September 2011

[3] World Bank, World Economic Indicators

[4] Chinese Business News, September 27, 2011

[5] CNBC- TV 18, September 29, 2011

Needless to say, rampant consumerism, seeking material goods without the ability to afford them, is often attributed to be one of the main causes for the current global economic crisis and financial instability, but the question remains for how long?? The ballooning fiscal deficits world wide and the rising debt levels for developed economies; capital flows volatility and inflationary pressures in the emerging economies make them jostling with their own share of worries. The huge bail out packages pledged world wide to give a momentary respite to the economies almost on the verge of a breakdown, remains questionable and fuels speculations to the billion-dollar question: Are we living in the era of another bubble formation with the next financial crisis just around the corner, waiting to gulp down the investors’ sentiments and confidence putting the global economy on the edge?? The tremors of double dip recession and sovereign defaults can be experienced often now and then. And of course, as optimists hope for some sanity to prevail in the global financial systems, I hope the Cassandra in me soon puts her worries to rest.

Signing off with a tune that is buzzing in my mind:

“Along a trail that’s winding always upward,
this troubled world is not my final home…
But until then my heart will go on singing
until then with joy I’ll carry on…”

–          Until then by Ray Price, 1996

Until then, Amen!

Written by:

Mansi Gupta, Master of International Business

Delhi School of Economics, Delhi University

Batch of 2012


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