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What global financial crisis means to us (II)

Last week, I traced the history and showed the shape of the current financial crisis that has held the world hostage; today, I discus the direct impact it could have to Uganda. 

Will the rescue efforts by governments in the west to contain the current financial crisis work? History is always an important reference point for learning from past experiences. According to Milton Friedman in A Monetary History of the United States, the source of the great depression was not the stock market crash of September 1929. Rather, it was the credit crunch that began earlier leading to the collapse of 608 banks by 1930, among them the Bank of the United States which accounted for about one third of deposits that were lost.

The solution to the crisis would have been for the Federal Reserve to pump money into the banking system. Instead, it did the opposite and withheld all credit to banks.

This forced banks to sell their assets in a frantic effort to raise cash. This drove down prices of assets thus making the banks’ balance sheets look worse. A bank’s greatest asset is public confidence. If people think they are going to lose their money in it, they run to withdraw it. As people ran to banks to collect their money, commercial bank deposits fell dramatically and by 1931, 1860 banks had gone under.

That is why today, the Fed and the treasury are doing something different ” pumping US$ 700 billion into the markets to boost confidence. Fed Chairman, Ben Bernanke is a student of the depression. From the outset of the crisis, he had consistently cut federal interest rates from 5.25% to 0.25% to allow banks to borrow and pumped even more money into the system through a number of creative ways like arranging for mergers and/or acquisitions, financially guaranteeing them or providing cheap federal credit to make them work. An example was cheap money to JP Morgan to buy Bear Sterns.

The US$ 700 billion will allow the federal government to buy bad debts from banks. This is aimed at cleaning the balance sheets of banks so that they can be able to lend each other and to other institutions. I think this is a smart move. But it is beginning to go far for many people’s comfort. For example, Britain was the first country to nationalise banks like Northern Rock. Last week the US followed suit and bought shares in private companies. One should get scared when governments begin to use the crisis to acquire stakes in business. One hopes that this is only temporary to allow markets to recover. However, historical experience shows that such government interventions tend to outlive their welcome.

In the case of the original attempts at bailouts by buying company debt, the moral argument is: why use taxpayers’ money to rescue financial firms whose managers caused disaster. Why rescue investors (or shareholders) who were speculators that should pay the price of their risk by going under? Clearly the move to nationalise enterprises or acquire stakes in them through the rescue is driven by this political fear that taxpayers’ money should not be used to rescue private interests.  Although such a move may be politically appealing, it can be economically damaging in the long term.

It is not certain that the rescue efforts will end the crisis. The financial sector in Western nations has changed over the years. In 1930 most credit was to businesses. Today, a lot of it is to consumers. Today, most people in Western nations buy goods and services on credit. In the USA, consumer indebtedness is 139% of disposable income. In UK, it is about 173%. The crisis therefore presents a unique situation whose answers we possibly do not know yet. However, markets tend to crash because of expectations. The rescue is good for its psychological effects.

One of the greatest contributions to this subject is Charles Kindleberger’s book, Mania’s Panics and Crashes. He argues that a new invention or innovation in a sector or market creates profit opportunities. As investors (and speculators) flock in to make a killing, demand exceeds supply. So prices soar and with them, profits. This creates a mood of optimism which drives increasing entry into the sector or market.

Initially, optimism feeds on itself; bringing in ever more investors who push prices further up and hence creating more profits. Kindleberger calls this optimism, “euphoria.” Because people have positive expectations, the sector enters a speculative bubble ” people are willing to pay high prices today in expectation of even higher prices tomorrow. But there is a limit to how high prices can rise. When that limit is reached, the party begins to unravel. Prices begin to fall, and with them profits.

At this point, optimism gives way to pessimism; positive expectations give way to negative expectations. Panic takes over. People rush to dump their holdings in that sector ” they may be houses, stocks or a currency. Because everyone is selling and very few are buying, prices plummet and with them, profits. As profits fall, people rush to sell their holdings. What was a rush turns into a stampede. Exactly as optimism drove up prices and profits, pessimism drives them down with an even higher impetus. The market tumbles then crushes down.

The lesson is that in times of crisis, the most important thing to do is work on people’s psychology ” create confidence in the market that prices will not fall further. It is in this context that we understand the efforts of governments to promise to pump more money into the markets. It is not that the money so pumped in that will solve the financial problem. Rather it is meant to create positive expectations. This is highly necessary to stabilise markets and to stop the stampede.

Implications for the world economy

America has been running huge budget and trade deficits. These are financed by borrowing heavily from abroad. The continued health of the United States economy thus depends on its international lenders ” both governments and private institutions around the world, sustaining confidence in the ability of the country to wriggle out of its crisis. Should this confidence plummet and many governments and private institutions begin selling their dollar holdings, the US economy would come crashing down like a park of cards. Yet this possibility may not happen because the US economy is too important for the global economy to fail. Should it fail, there would be no winners ” except of course Osama Bin Laden.

Let us take the example of the world’s fastest growing economy ” China. The Chinese hold large sums of dollars in form of foreign exchange ” worth US$ 1.8 Trillion. These are invested in both public and private bonds in the United States. Estimates say up to 50% of the securities that Fannie Mae and Freddie Mac hold actually belong to the Chinese. If the US failed to guarantee foreign investors in these bonds, it would cause loss of confidence in its securities market. This would force many foreign investors into a stampede to dump their bond holdings. The dollar would collapse and with it, the American and global economy.

The Chinese heavily invest in US securities primarily to keep their currency cheap relative to the dollar. This is because China has been enjoying high rates of economic growth that are primarily driven by exports. Over 50% of total Chinese exports go to the US. Keeping the Chinese currency devalued relative to the dollar has enabled the Chinese to keep American consumers hooked on Chinese products. So, the Chinese have literally been lending the Americans money to buy Chinese goods. The collapse of the US economy would signal disaster for China.

It would be wrong to infer from this therefore that the Americans are at the mercy of the Chinese. What we are seeing is a mutual hostage situation ” the American economy is critically important to the Chinese, its failure would spell disaster for China. Equally, the Chinese economy is critically important for the Americans. If it buckles, the US would be unable to keep its own economy afloat. Never in the history of the world have two economies gotten financially tied together in a dangerous embrace like China and the USA.

Implications for Uganda

The bad news is that the financial crisis in the West will certainly impact on Uganda negatively since the country is integrated into the international financial system. The good news is that the impact will be small because our integration is not so deep. Uganda currently has foreign exchange reserves in excess of US$ 2.5 billion. If most of this money is held in fixed deposit accounts of US banks, the depreciation of the dollar will mean that Uganda’s holdings will correspondingly depreciate.

If Bank of Uganda holds these reserves in US government bonds, they are safe but depreciating. If they hold them in private bonds, the rescue will save them from being wiped out. But if they are held in equities in companies like Lehman Brothers, then Uganda would have lost everything. I failed to get in touch with BOU Governor, Emmanuel Tumusiime-Mutebile to ascertain where they are held. But some sources say that they are held in conservative instruments like different foreign currencies and government bonds.

This financial year, Uganda will depend on foreign aid for 30% of its budget, down from 50% three years ago. The reduction in foreign aid dependence reduces our exposure especially if the crisis forces donor countries to cut down the money they spend as aid to poor countries. So far, it is not clear what is likely to happen. For example, Western economies will be stabilised by the rescue efforts and immediately return to growth immediately after. If this happens, the crisis will have been a small blip with limited ramifications on Uganda.

However, if the rescue efforts fail to stop the slide downwards and Western economies descend into a depression, then Uganda will get significantly affected by the crisis. For example, the country gets close to US$ 1 billion in remittances by its citizens living and working abroad. If their income is affected, the remittances will certainly decline. As said earlier, aid may also be reduced, thus reducing the amount of foreign exchange entering the country. It would also reduce the price of Uganda’s commodity exports thus reducing foreign exchange earnings. Finally, it can also lead to reduced inflows of foreign direct investment.

Yet the opposite can also be the case with foreign direct investment. If the current financial crisis degenerates into an economic crisis and western economies tumble into a depression, investors may seek to diversify their portfolios. Over the last three years, Africa has had the most profitable stock market of any continent in the world. A depression in the West could induce investors to begin looking at Africa and Uganda would be a beneficiary of this change in investor focus.

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